ALLY

Publicly traded companies mentioned herein: Ally Financial Inc (ALLY)

Highlights

The presenter is short Ally Financial Inc (ALLY), the largest auto lender in the US. Over the last 6 years, Ally has been trying to diversify into mortgages, insurance, and corporate loans, but for the most part the company remains largely focused on used car financing.

The used car market was on a gradual uptrend over the last decade due to a steady supply of used cars coming off-lease. However, just before COVID, used car prices began trending down due to a glut of off-lease vehicles flooding the market. When COVID and the ensuing chip supply shortages hit, new cars became extraordinarily difficult to come by and demand for used cars exploded.

The auto segment is 80% of Ally’s pre-tax income and the presenter estimates that Ally’s stock price is roughly 88% correlated to used car prices.

Regarding the company’s reserves, Ally had been running about $200MM in reserves per quarter. When COVID hit, the company massively increased reserves to $750MM in Q1 2020– assuming a recession was imminent. Those much-higher reserve allowances continued throughout much of 2020.

When it became clear the recession wasn’t happening, the company began to pull back sharply on reserves. By Q1 and Q2 of 2021, the company wasn’t reserving at all.

This sharp cutback in reserves was understandable as the allowance for reserves had historically been about 1.2% but during COVID it climbed as high as 3%. It was clear that Ally would be pulling back sharply on reserves to balance out the over-allowances made in the prior quarters. 

Without having to reserve at anywhere close to historic levels, that action served as a huge source of pre-tax income for 2021.

The leasing market also served up an unusual source of income for Ally in 2021. Normally when a lease goes bad, Ally repossesses the vehicle and sells it at a loss. However, the used car market was so red-hot last year that Ally could sell those cars back into the market for a profit. This was an incredibly unusual scenario that served to boost pre-tax profits even further.

This action also caused distortion in the depreciation of the lease portfolio. Before the pandemic, Ally had been depreciating their lease portfolio by about $260MM per quarter. In the most recent quarters, that depreciation has declined to as low as $80MM per quarter, reflecting the extraordinarily high pricing in the used car market.

As a result of these circumstances, the presenter believes the company’s pre-tax earnings were artificially high by about 40% in 2021. The short call is based on the premise that the used car market is poised for a sharp downturn this year. If so, he believes these imbalances which benefited the company’s profits last year will correct hard in 2022. 

The consensus assumption is that used car prices will decline gradually and that Ally will have a soft landing. Consensus FY 2021 EPS is roughly $8.60 per share, up from $3 before the pandemic. Consensus FY 2022 EPS is $7.60, illustrating that even the consensus has acknowledged a slowdown is coming.

The presenter argues that the setup is there for Ally to experience significant macroeconomic headwinds. Used car prices have already begun to decline. They were down 3% in December and are likely to be down in January. Government stimulus during the pandemic years won’t be there in 2022. Fed tightening to combat inflation will raise the cost of financing for would-be customers. The yield curve is flattening and there’s evidence of an inverted curve coming by September, which would dramatically impact the bank’s spread and the cost of financing its balance sheet.

The last time the used car market took a hard turn downward, about 5 years ago, the stock wound up trading at a 20% discount to tangible book value. Currently, the stock is $48 and TBV is $39. The presenter’s price target for the stock is the low $30s.

There is evidence that this move down has already started. ALLY reported Q4’21 earnings on Jan. 21 and the stock fell about 5% due to the disclosure that the pace of new loans had begun slowing. The company underwrote $10.9B in Q4’21, down from $12B in Q3’21.