The Long and Short
Ally Financial undervalued
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
In the wake of credit problems at First Brands and Tricolor, both directly connected to the auto industry, markets repriced other auto lenders. Though some of these lenders have started to rebound, consumer finance companies with auto exposure continue to reflect significant investor concerns. Given its sound risk management and moderate exposure to private credit, there’s reason to believe that Ally Financial (ALLY: Baa3/BBB-/BBB-) corporate bonds are being undervalued.
Given its cyclical nature, ALLY will always remain sensitive to US consumer sentiment. Credit spreads and CDS should swing with the strength of the economy. Still, more recent market fluctuations are more a function of the aggressive growth in private lending than acute concerns in auto credit quality. ALLY’s direct exposure to middle market lending and private credit appears limited to its $11 billion portfolio of non-auto corporate finance loans amidst total loans of $135 billion. And credit performance in these $11 billion has remained solid, with no reported net charge-offs in over a year. Furthermore, overall lending at Ally Bank to non-bank financial institutions (NBFI) represents just 2.37% of total assets compared to an average level of about 6% across all US banks. Growth in that segment for ALLY has been just 5% over the past year, demonstrating restraint in that arena. The 5-year growth rate of 246% is about neutral compared to the rest of the industry.
While ALLY credit instruments rightfully trade in a tighter range than the most conservative cohort of low-‘BBB’ middle-market lenders, such as business development companies or BDCs, they still reflect a substantial discount to similarly-positioned banks and lenders (Exhibit 1). This presents an opportunity to increase exposure to the credit and consider alternatives to move down in structure to ALLY’s subordinated and hybrid instruments for incremental spread and yield.
Exhibit 1: ALLY trades wide to investment-grade bank, consumer finance peers
Source: Santander US Capital Markets LLC, Bloomberg/TRACE G-Spread indications only
ALLY has helped alleviate concerns about credit deterioration in auto lending in recent operating results. In the third quarter, retail auto net charge-offs were 1.88%, up just 13 bp sequentially and down 36 bp year-over-year. Meanwhile, the all-in delinquency rate for retail auto was 4.90%, which was just 2 bp higher sequentially and down 30 bp year-over-year. While these remain somewhat elevated to pre-pandemic levels, the lack of acceleration demonstrates ALLY’s conservative lending standards across its franchises. The provision for credit costs decreased $230 million year-over-year to $415 million, and reserves of $3.5 billion are up modestly from $3.4 billion in the prior quarter.
ALLY increased its concentration in auto lending over the past year through the sale of its credit card and mortgage businesses. The loss of those businesses could also make the lender slightly more susceptible to deposit migration for its all-online deposit base. However, in doing so the company significantly enhanced net interest margins going forward (approximately 40 bp), reduced expected credit losses, and can focus more on its core competencies. The digital deposit base results in higher deposit betas relative to typical lenders but greatly reduces costs associated with brick-and-mortar branch banking.
ALLY’s digital deposit platform remains highly liability sensitive with increasingly competitive rates to depositors. Further rate cuts would provide margin relief and enhance profitability. Deposits represent approximately 88% of funding, which is up from 66% just seven years ago. Meanwhile, ALLY’s reliance on brokered deposits, which are considerably less sticky and potentially more costly, has declined to just 3.39% over the last twelve months off a recent peak of over 8% in 2022 and as high as 14% back in 2018. ALLY also benefits from an extremely low level of uninsured deposits (just 11%) relative to typical bank lenders given its unique auto-focused loan mix.
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