Ally Financial Earnings: The Current Narrative Could Change Rather Quickly (NYSE:ALLY)

With rampant speculation on the future trajectory of interest rates, the financial sector has come under scrutiny over the past year or so.

Consequently, more nice players in the sector like Ally Financial Inc. (NYSE:ALLY), for example, have been on the receiving end of bearish narratives due to the risks associated with higher for longer interest rates.

I initially warned against these narratives in early 2023 and since then the stock has delivered a 31% total return – nearly twice that of the S&P 500.

Having said that, ALLY is still a much riskier play within the financial sector due to its smaller size and heavy exposure to the cyclical market of auto loans. Therefore, higher volatility is to be expected and the share price also offers significantly higher risk-reward ratio than the larger and more diversified banking institutions.

This is clearly illustrated by the share price performance against the Financial Select Sector SPDR® Fund ETF (XLF) over the past five years.

Even though over the course of 2024 Ally’s share price performance will continue to be at the mercy of macroeconomic factors, there are some important aspects of the company that investors should keep a close eye on as the company is scheduled to report its full fiscal year results later this week.

Implications Form The Bearish Narrative

First and foremost, it appears that a very negative scenario for the state of the automotive lending industry is being priced into Ally’s current share price. Over the past year or so, we have seen a major increase in the number of domestic banks who are tightening conditions within the sector (the blue line below) and a notable drop for institutions reporting stronger demand for auto loans (the red line).

As expected, this has resulted in a very grim view for the industry, even though conditions have somehow improved during the last months of 2023.

As a result, most sell-side analyst following ALLY have revised their forecasts downward for both future earnings and revenue. The largest downward revisions happened at the end of 2022, but the trend continued throughout 2023.

Sell-side analysts’ ratings have also worsened significantly over the past two years from 100% of analysts rating ALLY as a buy, to less than 50% now having a favourable view of the company.

Nevertheless, ALLY’s share price experienced a sharp increase during the last months of 2023 on the back of falling Treasury yields and more specifically a changing dynamic between short and long-term rates (see below).

Even though this uplift could prove to be short-lived, Ally’s business fundamentals are poised to improve within the current environment.

In terms of actual business performance, Ally’s share price was largely in-line with the quarterly trend of the company’s Return on Tangible Common Equity (ROTCE).

With ALLY’s stock now trading at around $33 a share, the implied ROTCE stands at roughly 16%. Therefore, during the upcoming earnings release, investors should expect a meaningful ROTCE improvement from the 12.9% levels reported in Q3 2023. Even if the company does not achieve 16% during the last quarter of 2023, a positive guidance for 2024 would be more than enough to justify the current share price.

Deposits And Origination Pricing

During the last reported quarter, Ally’s net interest margin experienced significant headwinds as short-term rates skyrocketed and the yield curve remained in inverted territory.

(…) net interest margin of 3.26% was down 15 basis points quarter-over-quarter. Momentum within earning asset yields continued in the quarter, but was offset by deposit costs as the OSA rate moved up within the quarter.

Source: Ally Financial Q3 2023 Earnings Transcript

Even though higher long-term rates mean higher yield on loans, the front-end of the curve puts enormous pressure on the company’s deposit costs, which as we see on the graph below skyrocketed in 2023.

Now that the yield curve is steepening, Ally’s net interest margin is likely to gradually improve over the coming quarters.

As one of the leaders within Automotive Finance, ALLY also has significant competitive advantages in the form of pricing and bargaining power with customers. We see the latter in the significant drop of the company’s approval rate as consumer applications continue to increase.

The pricing power of ALLY is also very strong and this has resulted in a large jump in the company’s origination yield in 2023.

The dynamic between origination yields of the company and the rates paid on its deposits for the fourth quarter of 2023 would be of paramount importance for future ROTCE and analysts’ expectations I mentioned earlier. So far, it appears that ALLY is in a very good spot to report strong results and to provide a favourable outlook for the current year.

And I do think that the competitive environment that we’re seeing now is durable and so will give us the ability to maintain that 10.7% yield for a while. I don’t want to speculate on rates coming down, but obviously, rates coming down create a tailwind for us just in terms of that portfolio replacement effect that’s currently causing a headwind.

Source: Ally Financial Q3 2023 Earnings Transcript

The outlook for 2024 would be far more important during the upcoming earnings release as it would take time for the net interest margin to stabilize.

We expect NIM to trough a couple of quarters after rates stabilize, followed by gradual expansion each quarter, even without the benefit of rate cuts.

Source: Ally Financial Q3 2023 Earnings Transcript

Conclusion

Based on the bearish narrative around Ally Financial and the gradual improvement of financial conditions, the company is in a very good spot to surprise the market with better than expected results. Of course, risks related to the overall health of the industry remain and investors should keep a close eye on business fundamentals, such as origination yields and deposit costs.