As a dividend growth investor, I am constantly looking for income-producing investments to supplement passive income. Most of the time, I add to existing posts that I find attractive. On other occasions, I start a new position to further diversify my portfolio, and grow income and gain exposure to new sectors. The current market volatility can provide an opportunity for future income at lower rates.
My earnings growth portfolio lacks exposure to two major sectors: Finance and Information Technology. So, I’m going to analyze more companies from these two sectors as both have suffered during the current downturn. I own banks, insurance companies and asset managers in the financial industry. I will analyze a digital bank, Ally Financial (NYSE: ALLY), in this article.
I will analyze the company using my earnings growth stock analysis methodology. I am using the same method to make it easier to compare searched companies. I will examine and evaluate the company’s fundamentals, growth opportunities and risks. I will then try to determine if it is a good investment.
A search of the Alpha company overview shows the following:
Ally Financial, a digital financial services company, provides various digital financial products and services to consumer, commercial and corporate clients primarily in the United States and Canada. It operates through four segments: Auto Finance Operations, Insurance Operations, Mortgage Finance Operations, and Corporate Finance Operations.
Ally Financial’s sales have increased by more than 50% over the past decade. Most of the sales come from its financing operations. The low interest rate environment over the past decade and the growing need to finance new purchases by the public has supported the company’s growth pattern. Going forward, the analyst consensus, as seen on Looking for Alpha, expects Ally Financial to maintain sales growth at an annualized rate of 2.5% over the medium term as it has to deal with slower growth due to higher rates.
EPS (earnings per share) grew the fastest during that decade. Earnings per share nearly quadrupled during that decade as the company could raise money cheaply, offer low interest on deposits, and enjoy high margins on its loans. Low stock count, high sales, and high profit margins led to rapid growth. Going forward, the analyst consensus, as seen on Looking for Alpha, expects Ally Financial to suffer lower earnings per share before stabilizing in 2024 as the company has to deal with higher rates and possibly a slump with higher freight rates. Even under this scenario, the projected earnings per share for 2023, which is $4.49, will be higher than the earnings per share for 2019 and 2020.
Ally Financial New Earnings Driver. It lacks a long track record as it has only raised its payments for five consecutive years. However, the payout appears to be relatively safe, with a 24% payout. Moreover, the dividend yield is attractive due to the current very low valuation, and investors can enjoy a yield of 4.61%. However, given the current business environment and increasing rates, investors should expect lower dividend increases as the company strives to maintain more capital than required by regulations.
Another form of returning capital to shareholders is share buybacks. Over the past five years, Ally Financial has repurchased more than 30% of its outstanding stake. Buybacks support EPS growth and are most efficient when a company is growing, because they unlock faster growth which leads to higher earnings growth. If a company were trading for such a valuation, buybacks would be very effective.
The price to book ratio (price to book value) has decreased significantly over the past 12 months. At the beginning of the year, Ally Financial shares were trading at roughly their book value. However, as interest rates rose and recessionary risks increased, the valuation shrank. The shares are trading at a discount of approximately 25% to book value. Investors expect tough times ahead, and so there is a discount.
Looking at the chart below from Fastgraphs, we see that Ally Financial has an attractive value compared to its previous valuation. Since the IPO in 2014, the average price-earnings ratio has been 9.5, and the current price-earnings ratio is less than 50% at 4.1. Therefore, a significant discount is obtained from the investors’ interest in their performance during recession and high interest rates.
In conclusion, Ally Financial is a solid company. The sales record and EPS growth allows the company to pay an increased dividend and buy more shares. The valuation is attractive as investors fear that higher rates will affect the company more than other financial institutions. They think the risk is high. And so the potential also looks high.
The first growth opportunity for the company is the growth of the Ally Bank business. The bank has total deposits of $146 billion, up $6.3 billion year-on-year, and is able to grow the number of retail customers. This is an important long-term opportunity as these deposits will be used for future loans. Ally Financial now has access to cheap capital that will allow for rapid growth in the future.
Ally Financial is completely digital, and has many advantages as we go forward. It appeals to the younger generation and can launch new products faster. Using data allows the bank to better tailor offers to different customers, and also allows the bank to save significant amounts of money on staff, rent, etc., and to be a very lean and efficient financial institution.
The company has proven its ability to execute well even in times of uncertainty. This financial institution has been around for more than 100 years, and as such, it has dealt with great challenges, including times of high inflation and high unemployment. With the current margin of safety due to the low valuation, there appears to be a medium-term opportunity for the valuation to expand if the market becomes less concerned.
Interest rates are increasing, and this is a risk for Ally Financial. On the other hand, the company has to offer higher rates to those who deposit their money in the bank. On the other hand, since the rates they charge on their loans are already higher than average, increasing them further may reduce the number of future customers seeking a loan. Some potential customers may prefer to delay their purchases.
The other danger is recession, which may or may not come because of the higher rates. While rates may make new loans less attractive, a recession will make it difficult for Ally Financial to leverage its existing portfolio. As the unemployment rate rises during recessions, there is an increased risk of cuts, and the company will lose money in an increasing portion of its portfolio.
These risks are particularly relevant to Ally Financial as it targets sophisticated clients. The company targets customers with lower credit scores to charge higher interest rates. Therefore, those customers will be the first to experience a weak economy, especially during a recession. Therefore, the customer profile is also a risk if the weakness in the economy is here to stay.
Ally Financial is a high risk, high reward game in the stock market. The company has strong fundamentals in terms of sales and EPS growth. It has also been rewarding shareholders for several years. However, the company is in the risky business of high-interest loans, and it can become difficult to grow during recessions. Therefore, investors should take into account that both the upside and the downside are important here.
Since there is a gap between the positive and negative scenarios, this investment is not suitable for every dividend-growing investor. Most dividend growth investors seek stability and a consistent dividend flow. Ally Financial has a different risk profile. So there is more room for fluctuations. It should suit dividend growth investors with increased risk appetite.