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Summary

  • Company's new policy focuses on digging deep and not wide.
  • ALLY plans to exit TARP soon and undertake robust policies to drive underlying margins.
  • GM's acquisition of AmeriCredit poses a significant challenge to ALLY in the medium term.

Ally Financial's (NYSE:ALLY) IPO saw the US Treasury raise $2.4 billion at an IPO price of $25 per share. While the price was set at the lower bounds of the initial target range of $25-$28, nevertheless, they managed to scrap through.

With the last trading price of $24.50, market participants are wary of the company and are not showing any keen interest in the company.

Ally Financial: A worthy investment?

For a company that received over $15 billion in aid from the government, the journey back wasn't easy. However, look closely and the company hasn't done too badly either.

The company has repaid the US Treasury all of its investment, scaled down its operations to focus on a few key areas, and remarkably improved its risk and liquidity structure.

Also, ALLY plans to leverage the competitive strengths of its auto finance platform and use it to further solidify dealer relationships, profitability, and asset quality position.

Performance at a glance

The most recent quarter saw ALLY post net financing revenue of $841 million. While this works out to a year-over-year growth of ~25%, a rise in loan loss provision and a charge of $98 million owing to a DOJ settlement offset the gains from a rise in the top line.

Furthermore, ALLY recorded a year-over-year growth in net interest margin, or NIM, of ~48 basis points. Redemption of legacy high-cost callable debt and growth in deposits were the primary factors responsible for the growth.

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With a view to continuing the execution of its diversified funding strategy, 2013 saw the company take several steps toward it. While deposits now represent ~40% of Ally's funding profile, the company recently completed an $8.6 billion public securitization to further add to its funding capabilities.

Future plans

Moving forward, the company plans to aggressively drive its return on equity to double digits with a combination of actions like:

  • Lowering the cost of funds to drive margin expansion
  • Streamlining the cost structure to reduce non-interest expenses
  • And normalize the regulatory impacts over time

Moreover, the company plans to completely exit TARP (troubled asset relief program) and adopt a much more aggressive strategy to drive long-term performance.

Valuation

To value ALLY, I will use the traditional dividend discount model. The average dividend paid by the company in the last three fiscals stands at ~$810 million.

However, with the purchase of MCPs, the company will save over $530 million in annual dividends.

For the cost of equity, I am taking the average cost afforded to the financial services (non-banking) industry in the US.

To calculate the cost of equity, I will use the 10-year bond rate as the risk free rate. I will take the sector beta and use the mature market risk premium.

Working on the numbers, I derive a value of ~$30 to a share, which gives me an upside of 20%.

I know a lot of you might ridicule my approach or assumptions, and you have all the right. However, I must highlight that the company has taken some really positive steps to get its house in order and move toward consolidating its position as a major player in the auto finance domain.

Cutting down risky debt, building strong capital position and reducing dividend payments by almost half a billion dollars are all signs sending out a positive signal for the company's future.

Risk parameters

No valuation is complete without mentioning the key risks an investment faces and the impact of such risk on the company's future.

In ALLY's case, the biggest risk stems from GM. Dealers for General Motors and Chrysler together contribute over 60% of the company's revenue. With GM acquiring AmeriCredit Corp., ALLY stands to lose a significant portion of the business to General Motor Financial Company, or GMF (GM renamed AmeriCredit to GMF).

The changing business dynamics have resulted in the company losing ~10 and 18 percentage points respectively on consumer sales accorded by GM and Chrysler (38% to 29%, and 32% to 14%, respectively.)

Moreover, certain exclusivity privileges accorded to ALLY from GM and Chrysler under the terms of an erstwhile agreement have now expired which could have a significant impact on the company's top line.

While the company has taken significant steps to reduce its debt ratio, and it sufficiently covers its existing debt maturities for the next two years, the company still holds a significant amount of debt and has to work toward deleveraging itself to reduce the risk it bears.

Conclusion

After AIG, Ally Financial, probably, was the only company that created so many headwinds. However, the management has really turned the tables around. The US Treasury has recovered (and made a small gain) on its investment in the company, and soon plans to exit. This will only work in favor of the company.

As the company moves out of TARP, it will have much more flexibility to experiment and grow, and at the same time maintain the risk parameters to stay healthy and liquidated.

I think the company is a long-term hold and offers significant value to the investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Ally Financial: Allay Your Fears