Cheapest Bank Stock out There!

In the current inflationary environment in which we find ourselves, the entire market has been piling into the seemingly undervalued big banks - trying to capitalize on the anticipated increase in profits from higher rates. Though I did recommend buying Bank of Nova Scotia a few months ago, I have found what I believe to be a better place to park your money in the banking sector moving forward. The market has decidedly undervalued one of the fastest growth, though smaller banks in the industry. That being Ally Financial. You might know the company from their dominant position in the vehicle finance vertical. This leadership makes sense considering its origin as GM’s financial unit, and it has maintained those relationships as a spun-off entity. The bank has managed to differentiate itself in the ever-more-competitive industry by focusing on a few key areas that are important to consumers:

1. A 0.5% savings account return, much higher than the traditional banks.

2. A digital first approach and a very good digital ecosystem with physical integrations, driving convenience up

3. Leveraging their previously mentioned ubiquity in the vehicle market to expand services

These key pillars are what has led massive user attraction and an industry leading 96% retention rate and over 135 billion in deposits. I think that Ally’s increasingly digital focus, coupled with its customer acquisition strategy of actually paying their deposit customers will give it lasting competitive advantages that should allow it to outgrow the banking industry’s average and deliver lasting returns for shareholders. Especially, since they are a small bank, leaving for tons of market share gain potential.

Ally Business Model & Success

The company operates in a few different sectors:

Auto Loans: This is their primary loan originator and their core competency. With over 21k dealer partners, they were able to achieve $46.3 Billion in consumer originations and over 13 million applications. Ally was able to generate a 7.1% yield with only 31 bps of net charge-offs.

Ally Insurance: Consists of their insurance premiums business, primarily in the auto sector. Recently it hit 1.2B in originations.

Ally Bank: This is their consumer arm. Recently, they reached 135B in deposits, from 10 million depositors.

Ally Home: This represents the mortgages, which includes $10.4B of originations up 123% yoy.

Ally Invest: This consists of investment and brokerage accounts set up, as well as management offered by the bank. Total assets ballooned to 17.4B recently, up 24% yoy.

Ally lending: Consisting of the small business and POS financing, at 1.2B in originations up

147% yoy

Corporate Finance: Making up 7.8B in originations up 29% yoy

Credit Cards: This involves the recent Fair Square acquisition - $953 million credit card loan balances, up 66% yoy & 756k customers, up 67% yoy

As we can see, the company is a comprehensive financial juggernaut with all the operations you would expect from any large financial institution or bank. Of course, all of these are somewhat small potatoes in comparison to the truly massive consumer banks on wall street like JpMorgan or Bank of America, but it does leave a ton of room for expansion. Especially since the fully digital model resonates very well with the millennial and gen z generations, generations that are only growing in importance. Also, it’s easy to see strong growth in the business as a whole, with strong growth across all businesses, in both originations and usage of financing.

Future Growth & Fair Square acquisition

Ally Financial has seemingly shown that their growth strategy moving forward is to continue to push for the organic expansion of their core business segments at 5-6% growth every year. Meanwhile, they plan to expand at faster rates through acquisitions using their excellent free cash flow position, as well maintain the potential for outperformance. There are a few major opportunities for vastly outperforming the expectations. Firstly, factored into expectations is a gradual deceleration in used vehicle prices as the supply constraints loosen ( a projected 15-20% decrease in used car values), and so any resilience would lead to substantial outperformance. Second, all business segments have shown virtually no sign of slowing down, despite conservative estimates surrounding slowing home demand, and cooling interest in their new products after a massive runup. Furthermore, the company is a bank stock, and so should benefit from margin expansion due to the rising rates that have been plaguing the market. Finally, they have an excellent cash position, and substantial opportunity to purchase complementary financial services companies like Fair Square Financial - companies that will help grow sales and earnings.

Fairsquare Financial operates as a credit card provider under the ollo brand, and has a similar business model as capital one. Essentially, they fund credit card purchases and collect interest if you miss payments. This proven lucrative model has been growing leaps and bounds for them (66% in the most recent quarter) and should be a substantial leader of business growth for the company moving forward.

Shareholder Return on Capital

Ally has always been committed to returning capital to shareholders. They currently pay out a yield of approximately 2.5% with a payout ratio of only 10.5%. They also recently announced a 2 Billion share repurchase program with a market cap of around only 16 Billion. When we standardize this return of capital, it is essentially a one year return of 15% based on the combined capital deployment. Additionally, when we compare their distributions vs. their payout, the dividend yield is in fact much cheaper than other banks’ when adjusted for payout and thus growth potential.

• Jpmorgan has a yield of 2.75%, and a payout of 25%

• Bank of America has a yield of 1.85% and a payout of 21.85%

• Even small banks like Citizens Financial Group have a yield of 3% with a payout of 30%

First of all, the share buyback program should create a floor for the share price and give forward momentum to the shares. Additionally, if we do a quick standardization exercise and assume that over time the company brings their dividend payout in line with the industry, they would have a yield of almost 6% with only a 25% payout ratio. They are in fact raising their dividend, up 20% in the most recent announcement. All in all, the market is clearly underappreciating the company’s earnings generation in relation to their capital distribution.

Valuation

The company is incredibly undervalued even on the basis of its conservative projections and cash flow expectations. The first way to analyze this is through the use of a forward earnings to growth comparison within the industry:

• Citizens financial group goes for 10.5 times forward earnings. Meanwhile, it expects growth of 10% on the top line, much of this growth being attributable to returning to pre-2020 levels of revenue

• Jpmorgan trades for 12 times forward earnings with projected 6% sales growth, after 0% growth this year

• Bank of America goes for 12.5 times forward earnings with sales growth of 6 to 7%, with part of that being accounted for in returning to pre-2020 levels.

With Ally at today’s price of $45/share trading for 6 times forward earnings, and forecasting 6% sales growth after growing almost 30% this year, we can see why I think it to be so cheap. Additionally, this comes from a projected decrease in eps because of the previously mentioned headwinds expected from used car prices and the compression in margins associated with that - though the deceleration is expected to stabilize and return to steady growth afterwards. Considering this info, we can also take a free cash flow model analysis to get a number value on the undervaluation. Keep in mind that we’ll be using some pretty upbeat expectations for the banking sector and assuming that the coming period will be exceptionally profitable due to the rate increases, which is why they will all seem pretty undervalued.

• Bank of America (big bank analysis): with $3.7 eps forecasted next year, and using a 6.5% sales growth rate for the next 5 years, before levelling off to 3% perpetually, and with a required rate of return of 11% (which goes up to 12.8% with the dividend), you get a value of $55 - a 22% margin of safety. This seems like a very good deal until you compare it to Ally.

• Citizens Financial Group (small bank analysis): with 5.01 eps expected, and using an 6.5% expected growth rate for 5 years, levelling to 3% perpetually, with a required rate of return of 11% (which goes to 14% with the dividend), you get a value of $79/share - a 51% margin of safety.

• Meanwhile, Ally, with their reduced earnings forecast of 7.32 eps, using 6% sales growth for the next 5 years, and then 3% perpetually, with a required rate of return of 15% (which goes to 17.5% with the dividend), you get a price of $70.6/share. This suggests a 56% undervaluation based on much higher required rates of return and a pessimistic view of their margins from used car price slowdowns.

Essentially, any way that you look at it, the company trades for much less than its peers, in an industry that is expected to have one of its best periods in recent history on the back of rate hikes.

Balance sheet & liquidity metrics

One of the most important things to do with any bank stock is to analyze their liquidity and balance sheet to get an idea of if it is exhibiting healthy behavior. There are a few key ratios I think are the most important:

• NIM (net interest margin), represents the spread between their cost of capital and return on investment from their loans

• Cet1 ratio, compares the bank’s capital to its assets

• Tangible book value per share vs. share price

• ROTCE (Return on tangible common equity)

Let’s take a look at their competitors:

Bank of America:

• NIM of 1.84% most recently, but generally around 2%

• Cet1 ratio: 11.8%

• Tangible book value/share: 24.89

• ROTCE: 15.8%

Citizens Financial:

• NIM of 2.66%

• Cet1 ratio: 9.9%

• Tangible book value/share: 50.71

• ROTCE: 14.6%

Ally Financial:

• NIM of 3.56%

• Cet1 ratio of 10.3%

• Tangible book value/share of 43.58 GAAP, 38.73 adjusted

• ROTCE of 17% going forward expected

Virtually any way you look at it, the company is either in line with the market, and arguably outperforming. Especially since it has transformed its funding mix to 89% of loans being funded through deposits vs. 41% in 2014. This significantly derisks their operations & makes it a much more stable bank play. In general, Ally is substantially outperforming the industry on Net Interest Margin, and is in line with the other small banks in terms of book value per share on a proportional basis. The big banks get a premium on the book value due to their size & safety - as attributable by the much higher cet1 ratio, where Ally is still slightly higher than its smaller bank competitors. Essentially, the company has shown the ability to make the most out of their money and produce the most ROI, though they are still less safe on a leverage and balance sheet basis than a bigger traditional bank.

Risks

There are four real things holding the company back. The first is the aforementioned leverage & liquidity ratios that the bank has below the big banks. Of course, all of these metrics are over double the mandatory limit, but all the same, they are still better to have higher, and so investors can deservedly give it a lower multiple because of it. Should these metrics deteriorate amongst the used car price drop that we mentioned before was weighing on the company, you could see them be forced to halt certain operations and raise their liquidity. The third thing that could make the investment risky is the Fairsquare acquisition. Though it has been performing very well, there are always risks with an acquisition, and if a company fails to integrate it efficiently or realize the synergies expected, it could significantly weigh on the company’s results. Finally, the fact that the company is expected to have lower earnings next year than this year makes investors nervous due to the uncertainty associated with if that is truly the bottom. Should the company’s earnings and revenues for some reason drop further, and seriously surprise management, the company could be revalued to a price reflecting deceleration to 2019 numbers.

Decision

All in all, when you think about purchasing shares in this company, you should look at it as a growing company, with key competitive operational advantages, benefitting from secular growth trends and rising interest rates. With this backdrop, it is hard to see why you wouldn’t pick up shares for 6 times earnings, almost half the price of its closest competitors… Though there are of course risks associated with the company, the risk-reward principles are clearly out of sync, and the company’s generous planned shareholder capital return policies pay you to wait while the market wakes up.

By: Mateo Gjinali