Ally Faces Challenging Conditions in 2023, but the Long-Term Picture Remains Healthy

Equity Analyst

Michael Miller

Ally is the largest indirect auto lender in the U.S. with the firm acquiring auto loans from tens of thousands of auto dealerships. The bank also offers auto insurance, commercial lending, mortgage finance, as well as credit cards and personal loans, though auto loans remain its core focus and largest source of revenue. 

Ally has benefited from the growth of online banking as the bank has been able to materially improve its funding structure in a relatively short period of time, with deposits now making up 88% of total funding from 54% in 2016. Additionally, the quality of its deposit base has improved at the same time, with its more expensive certificates of deposit making up a smaller portion of total deposits. Ally's net interest income will be a long-term beneficiary of this improvement and we expect the bank's net interest margin to remain wider than it was prior to 2020. 

After a period of strong profitability, Ally will likely see weaker returns in 2023 as a slower auto market and higher credit costs weigh on the company's results. Defaults are increasing across all consumer lending categories and auto loans are no exception. Additionally, after massive price inflation during and immediately after the pandemic, used-car prices are expected to continue to decline in 2023, creating a downward trend in the value of the collateral behind Ally's loans. That said, we see this weakness as being driven by cyclical factors and Ally's good financial position should protect it from any serious harm. 

In the long term, the benefit of Ally's improved funding structure will lead to wider net interest margins and better returns. Auto lending will likely remain a highly competitive space as any improvement in market conditions will cause the segment to draw increased attention from other lenders. Ally has recently expanded into other consumer credit categories, acquiring the credit card issuer Fair Square Financial at the end of 2021. We like the expansion for Ally, as the firm will be able to take better advantage of its large deposit base, however it will take considerable time for these new lending categories to move the needle for the firm as a whole, if ever.

Business Strategy & Outlook

We do not believe Ally Financial has an economic moat as the firm lacks material competitive advantages that would allow it to generate a return on equity above its cost of capital reliably. While the firm enjoyed a period of enhanced profitability in 2021 and 2022, during which the firm generated returns well above its cost of equity, we see this strength being driven primarily by a cyclical peak in auto market conditions as well as unusually low default rates industry wide. While we do expect Ally to outperform its pre pandemic returns, thanks to an improved funding structure and a shift away from dealer financing, we anticipate that this improvement will be insufficient for the firm to reliably earn excess returns. 

We typically assess bank moats as primarily stemming from either cost advantages or switching costs. In our view, Ally does not enjoy a competitive advantage from either potential moat source in the bank's automotive financing business, which provides the bulk of the firm's revenue and operating income. 

Ally uses an indirect lending model for its consumer auto loans. Specifically, Ally does not directly source its own loan applications, instead auto dealers take loan application data from customers so they can receive price quotes from lenders, then Ally (or a different indirect lender) acquires the loans from the dealers themselves. This means that Ally does not have an in-house method of generating retail auto loan business and is reliant on its dealer clients for origination in its most profitable business line. For many auto dealers this process has become a major profit driver and because the relationship between Ally and the dealer is not exclusive, dealers have both the ability and an incentive to price compare loan offers against each other. Each auto sale a dealer makes can be financed by different lender on an ad-hoc basic, meaning there are limited switching costs for a dealer to switch from one indirect lender to another. We do not see Ally as having meaningful pricing power in the relationship with its dealer clients and do not see a way for the firm to realistically acquire loans at a meaningful discount to its peers. Additionally, because Ally lacks an internal distribution channel for auto loans there is no effective means for the company to generate repeat business or retain relationships with its end borrowers. As a result, the benefit from its large existing pool of auto lenders is limited to cross selling potential with its deposit and other consumer lending products. 

Cost advantages in banking can stem from three factors: a lost-cost deposit base, operating efficiency, or conservative underwriting. Ally financial is a purely digital bank, with no physical branches. Like other digital banks, Ally offers deposit rates well above those featured by traditional banks which offsets the benefit from lower operating costs due to not needing to maintain a network of branches. Ally has benefited from a noticeable shift among consumers toward digital bank accounts, with the bank's deposits now making up 88% of total funding in 2022 from 54% in 2016. This has improved Ally's funding structure, but the bank still has higher deposit costs than both traditional banks and other large digital banks with stronger brands and deposit bases. Thus, while the situation has improved, we see Ally as still being at a cost of funds disadvantage to many of its peers. Additionally, Ally's efficiency ratio, which is typically in the high 50s, would be good for a traditional bank but is weaker than other digital banks. In our view the combination of high funding costs and somewhat above average operating efficiency come together to provide Ally with a weaker cost structure than many of its peers. From a credit cost perspective, Ally's short history as a public firm means there is insufficient data to effectively assess the quality of the bank's underwriting through a full cycle. All in all, we see little indication that Ally's lending business benefits from a cost advantage over its peers. 

Likewise, we see limited room for a competitive advantage in the firm's insurance business. Like its auto loans, Ally's insurance products are sold only through its dealer relationships. The firm does not have the scale to compete with major auto insurers and instead focuses on niche insurance products, specifically vehicle service contracts and gap insurance. The focus on smaller product categories is a smart choice and can be an effective strategy for smaller insurers to generate good returns. However, Ally lacks a compelling data or distribution advantage to create a competitive advantage. This is reflected in a combined ratio that averaged 96.2% from 2013 to 2022, which is worse than what we would expect from a firm with a material competitive advantage, particularly given that Ally's insurance results have historically been quite volatile. 

While Ally's personal loans and credit card businesses could potentially benefit from switching costs or cost advantages born from synergies with its deposit and investing platforms, these business lines are too small to be real drivers. With unsecured consumer credit making up less than 2.5% of total loans at the end of 2022, this part of Ally's business is simply too small to drive a competitive moat around the firm's business. 

All in all, we believe that Ally lacks a material competitive advantage in its core business lines. We see the firm's recent returns as being driven by positive cyclical conditions and while its improved funding structure and loan mix will likely lead to better long-term profitability, this is alone is not sufficient to warrant a moat rating for Ally.

None

Economic Moat

Ally Financial

Ally Financial, Inc. is a holding company, which provides digital financial services to consumers, businesses, automotive dealers, and corporate clients. It operates through the following segments: Automotive Finance Operations, Insurance Operations, Mortgage Finance Operations, and Corporate Finance Operations. The Automotive Finance Operations segment offers retail installment sales contracts, loans and leases, offering term loans to dealers, financing dealer floorplans and other lines of credit to dealers, warehouse lines to companies, fleet financing, providing financing to companies and municipalities for the purchase or lease of vehicles and equipment, and vehicle remarketing services. The Insurance Operations segment focuses on finance protection and insurance products sold primarily through the automotive dealer channel, and commercial insurance products sold directly to dealers. The Mortgage Finance Operations segment consists of the management of a held-for-investment consumer mortgage finance loan portfolio, which includes bulk purchases of jumbo and LMI mortgage loans originated by third parties. The Corporate Finance Operations segment provides senior secured leveraged cash flow and asset-based loans to mostly United States based middle market companies focused on businesses owned by private equity sponsors with loans typically used for leveraged buyouts, mergers and acquisitions, debt refinancing, restructurings, and working capital. The company was founded in 1919 and is headquartered in Detroit, MI.

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Ally Financial, Inc. engages in the provision of online banking, securities brokerage, and investment advisory services. It operates through the following segments: Automotive Finance Operations, Insurance Operations, Mortgage Finance Operations, Corporate Finance Operations, and Corporate and Other. The Automotive Finance Operations segment offers retail installment sales contracts, loans, and operating leases, offering term loans to dealers, financing dealer floor plans and other lines of credit to dealers, warehouse lines to automotive retailers, fleet financing, providing financing to companies and municipalities for the purchase or lease of vehicles, and vehicle-remarketing services. The Insurance Operations segment focuses on consumer financial and insurance products such as vehicle service and vehicle maintenance contracts, and guaranteed asset protection. The Mortgage Finance Operations segment includes Ally Home Mortgage (ALM) offering and bulk purchases of high-quality jumbo and low-to-moderate income mortgage loans. The Corporate Finance Operations segment provides senior secured leveraged asset-based and cash flow loans to middle-market companies, with a focus on businesses owned by private equity sponsors. The Corporate and Other segment is involved in centralized corporate treasury activities such as management of the cash and corporate investment securities and loan portfolios, short- and long-term debt, retail and brokered deposit liabilities, derivative instruments, original issue discount, and the residual impacts of corporate funds-transfer pricing and treasury ALM activities. The company was founded in 1919 and is headquartered in Detroit, MI.

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