2023-03-08 09:47:37 ET
Summary
- Ally Financial is growing rapidly due to increased net interest income now that interest rates are higher. However, its net income was lower because of larger credit loss provisions.
- While the buyback yield was huge at 22.6% in 2022, the stock price crashed.
- Now the stock's valuation is at a favorable level, and if analysts are right with their earnings forecast for 2025, the rewards could be great.
- However, the risk of recession is significant, and I prefer to wait until the recession risk is over.
Introduction
Ally Financial ( ALLY ) offers financing products in the United States and Canada: Automotive Finance, Insurance, Mortgage Finance and Corporate Finance solutions. The company is notable because several fund managers have taken large positions in Ally. It appears Punch Card Management believes the company offers more value than the stock is worth today and has allocated 27.6% of its stock portfolio to Ally. Chou Associates also reported a large position of 5.4% of its total stock portfolio. And Bill Nygren reported an allocation of 4.2%. These are all significant positions, and we have to wonder if they are seeing something we are not.
We see a meager stock price return from about 9 years ago until now compared to the return of the S&P500. The stock price rose significantly after the 2020 crash due to lower interest rates and consumers rushing to get a cheap loan. Now the stock is down significantly from its all-time high. And with the current market conditions, investors are concerned about possible defaults and delinquencies. Investors were not pleased with Ally's announcement to acquire subprime lender CardWorks in 2020. And fortunately, the deal didn't go through. Subprime loans are considered high risk, especially during an economic recession .
Shares are down significantly from their highs, but its earnings report gave us a good hint that a storm is coming. Another chart shows an increased risk of a possible recession within a year. The stock is cheaply valued, but the risks outweigh the potential returns.
Net interest margin (Ally's 4Q22 Investor Presentation)
Massive $1.2B Provision For Credit Losses
Net income for full-year 2022 was $1.6 billion compared to $3 billion in 2021 due to higher provisions for credit losses, higher noninterest expense and lower other income. Provisions for loan losses increased $1.2 billion compared to 2021 due to higher net charge-offs.
Ally's fourth-quarter net income declined to $251 million, primarily due to higher provisions due to continued credit normalization, a modest reserve build-up and higher noninterest expense due to costs associated with the termination of a legacy pension plan.
Ally Financial derives its income mainly from net interest margin. Its net interest margin was high at 3.88% in 2022 because of increased interest rates. In the fourth quarter of 2022, the net interest margin was 3.65% as higher interest rates outpaced growth in income from earned assets. Interest rates are expected to rise further this year, and Ally could see its net interest margin increasing. However, an increased interest rate environment is also the source of more delinquencies and charge-offs.
Credit risk management (Ally's 4Q22 investor presentation)
If we look at its credit risk management, we see that its annual net charge-offs have increased slightly from the 2020 figures. But this is still lower than the 2019 figure. Still, Ally reserved a huge $1.2 billion sum for future credit losses, which is a lot compared to its revenue of $7.94 billion for 2022.
Credit risk management (Ally's 4Q22 investor presentation)
Ally seems to expect a storm to be brewing due to high provisions for credit losses. If net write-downs increase significantly, it will have a major impact on Ally's earnings. In an article I wrote earlier, I showed the graph of the yield spread that can predict recessions very well. Here is the chart:
Yield curve (FRED and author's own visualization)
The yellow highlighted areas tell us when the S&P500 has fallen more than 20% from its peak. Also, the chart tells us that there is an increased risk of a recession between now and 1 year when the yield spread is below zero (inverted yield curve). Today the yield spread is below zero. This may be why Ally has increased its provisions.
If we look at the table (see source) "Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks" we see that indeed when the yield curve is below 0, and slightly above it, that the charge-off rates for all consumer loans increase significantly. This tells us that bad weather is coming for Ally Financial, and that investors should beware.
A look at the price chart of Credit Acceptance (CACC), a peer in consumer financing, shows that there was extreme price volatility during the period of the financial crisis (a 64% drop in price from peak to trough). And now that the yield curve is inverted, the same price volatility could be on the horizon for Ally as well.
Dividends And Share Repurchases
Ally's management pays a good dividend that has grown from $0.40 in 2017 to $1.20 in 2022; representing an annual growth rate of 24.6%. The dividend yield is currently 3.93%, which is almost equal to the yield on 3-month Treasury bonds.
Dividend growth history (Seeking Alpha's ALLY's ticker page)
If we look at the cash flow statements, we see that Ally also repurchased many shares over the past 4 years. The cash amount of shares repurchased was less than net income (84%). The share repurchases are large compared to its market capitalization; the buyback yield in 2022 was huge at 22.6%. Share buybacks increase dividends and earnings per share but can also drive up the share price because there are fewer shares outstanding while demand increases if they are bought on the open market. I find it remarkable that the buyback yield is 22.6% and the share price has fallen from $53 to $26 in 2022, this indicates that many investors are more likely to be on the sell side. However, the low share price could indicate a cheap valuation of the stock.
Ally Financial's cash flow highlights (SEC and author's own calculations)
Ally Is Valued Favorably
Ally is currently down 44% from its all-time high, so recession risk may already be factored into the stock price.
To understand the stock's valuation, I compare Ally to Credit Acceptance and Capital One ( COF ), which are all consumer finance companies.
Looking at the PE ratio, Credit Acceptance has the highest PE ratio among its industry peers at 11.6. I consider Credit Acceptance the highest risk because they specialize in subprime loans and have been sued by the U.S. Consumer Financial Protection Bureau. Capital One is closely tied to Ally and its PE ratio is almost equal to Ally's. However, we see strong volatility in its PE ratio, indicating that its earnings per share is not growing steadily, but is rather volatile. I like companies with steadily growing earnings, and Credit Acceptance's earnings and free cash flow statements look the most attractive to me. But the stock's high valuation is not worth the risks mentioned in my article.
Currently, Ally's PE ratio is low compared to the historical figure of 6.4 over 3 years. The PE ratio is also low compared to the general market, but that is due to the higher risk profile of companies in the consumer finance sector.
Analysts have made their forecast for the coming years and expect earnings per share to fall 38% by 2023. From then on, earnings per share are expected to rise sharply. The projected PE ratio for 2025 is 4.5, indicating undervaluation of the stock price at this level. Compared to the historical 3-year PE ratio of 6.4, the stock appears 42% undervalued.
Ally's Earnings Estimates (Seeking Alpha's Ally's ticker page)
Another metric of the stock's valuation is its price-to-book ratio, which currently stands at 0.87. The stock is trading below its book value and also below its three-year average of 0.9. Based on the chart below, I think the price-to-book value is in line with its historical average.
Investors should ask themselves whether they should value Ally at 4.5x earnings while also taking into account the high risk of a possible recession. In my opinion, it is not worth the risk. I would wait until recession fears are over, when inflation is around 2% and when interest rates are cut. Right now it seems like it's 2006 again, not knowing that a major recession is coming.
Conclusion
Ally Financial is growing rapidly due to increased net interest income now that interest rates are higher. However, its net income was lower because of larger credit loss provisions. Looking at a recession indicator, the risk of an economic recession has increased between now and one year. And historically, during recessions, net charge-offs were much higher than before. Ally sees stormy weather ahead. And if we look at other financial stocks before the 2008 financial crisis, we see that stock prices fell significantly during a recession. Now it seems like 2006 again, not knowing that a recession is coming soon.
The company returns a lot of cash to shareholders by paying dividends and buying back shares. And while the buyback yield was huge at 22.6% in 2022, the stock price still managed to crash. Now the stock's valuation is at a favorable level, and if analysts are right with their earnings forecast for 2025, I think that the rewards could be great. However, the risk of recession is significant and I prefer to wait until the recession risk is over.
For further details see:
Ally: Large Credit Loss Provisions, Recession Looming