Ally Financial: Credit Concerns Likely Limit Upside After Q2 Results (Downgrade) (ALLY)

Shares of Ally Financial Inc. (NYSE:ALLY) have been a strong performer over the past year, rising about 60% and sitting at a 52-week-high. However, shares did drop about 3% after reporting Q2 earnings on Wednesday morning. Results were solid, and this pullback likely reflects some profit-taking after a strong run.

I last covered Ally in April, reiterating shares as a buy. Since then, they are up about 14%, just ahead of the market’s gain. Still, shares are now firmly at my $42-45 targeted price range, making now a good time to revisit the stock.

Taxes create noise in EPS

In the company’s second quarter, Ally earned $0.97, beating the consensus estimates by $0.33, as revenue beat by $10 million. This beat was flattered by the fact its income tax bill was -$37 million, as it received a $92 million tax credit for electric vehicle (“EV”) leases. This tax benefit is passed on to the consumer via lower lease payments, and over the life of the lease, ALLY earns nothing on this credit. Rather, there is a timing issue, where it receives the value of the income tax saving in this quarter and then under-earns on the auto loan each month over the balance of the loan’s life.

This tax saving amounts to about $0.30 a share in additional EPS. As noted, this is not really an economic profit, just a timing recognition one. If we subtract this from earnings, Ally’s true run-rate earnings were $0.67, about $0.03 ahead of consensus. This negative tax rate issue will continue to impact results. However, as more EV loans are originated, its interest income will start to be depressed, negating some of this impact. As such, the $0.30 benefit will start to shrink gradually and at one point become an accounting headwind. It will be important to adjust for this noise when looking at Ally’s underlying operating results.

Net interest margin trends are encouraging

Ultimately, there were two competing forces in this quarter. Ally outperformed on its net interest margin (NIM) and also pointed to some credit weakness. Focusing on the positive first, last quarter, I suggest Ally was likely at a NIM inflation point as it began reducing deposit rates. This appears to be playing out. Its net interest margin was 3.30%, up 14bps sequentially.

Ally reduced deposit costs by 7bps to 4.21% on average during the quarter. With higher-yielding CDs rolling off and pricing cuts occurring during the quarter, this tailwind should continue to persist, especially with its deposit rates still relatively high compared to peer banks. Additionally, I am expecting the Federal Reserve to begin reducing rates this September, and I expect ALLY to flow these cuts through to its deposit rates.

Now, I would note that deposits declined $3 billion to $152.4 billion. I have frequently emphasized the need for stable deposits. I do not view this decline as troubling. First, as you can see below, Ally has proven to be a strong deposit gatherer over its history. It blamed this decline on seasonal tax outflows and maintained a strong 96% retention rate. Additionally, it still added 54,000 retail deposit customers in the quarter, indicating its level of rates is still attractive, even with some Q2 rate cuts.

While I will continue to monitor deposit growth, I view management’s explanation of the decline being due to tax payments as reasonable. Moreover, Ally does not need explosive deposit growth because the lending activity has been somewhat muted, given the high-rate environment. As such, it can afford some attrition from its highest-cost depositors, as it may not be able to immediately put incremental funds to work.

Indeed, average loan balances declined by $2 billion to $147.2 billion. The yield on its loans rose by 10bps to 8.22%. Ally continues to benefit from lower rate auto loans paying down and being replaced by new originations at higher market levels. When the Fed begins to reduce rates, I would expect this to weigh on loan yields, though likely more slowly than on deposit costs.

Ally’s NIM performance was strong, and it was the primary driver of the beat in Q2. Given the momentum on deposit pricing, I expect to see further NIM improvement. Management raised NIM guidance, and based on the data I see, this increase makes sense.

Credit trends are more mixed

While NIM trends are clearly encouraging, its credit trends are more mixed. As you can see below, delinquencies picked back up in Q2 to 4.33% from 3.88% in Q1. Now, in Q1, I cautioned that this decline was likely due to seasonality. Tax refunds during Q1 are often used to pay down debt and help to reduce delinquencies, as such, I did not expect the decline to persist. Still, the size of the sequential increase is a bit higher than expected.

Now, despite higher delinquencies, we did see lower net charge-offs of $435 million. Still, this is about $36 million higher than a year ago. Charge-offs lag delinquencies, and the seasonal benefit from delinquencies in Q1 tends to help charge-offs in Q2. With delinquencies rising again, I do see a risk of somewhat higher charge-offs in H2.

During the quarter, Ally took $457 million of provisions for credit losses, about $22 million above charge-offs. It continues to reserve fairly conservatively, expecting a weaker than average credit environment. Reserve coverage is about 30bps above normal levels in auto and more in other categories. It has about 3x coverage of its 60+ day delinquencies, which I view as conservative. I typically like to see 2.5x coverage, so Ally is prepared for some modest further deterioration.

Credit trends from here will be critical to monitor. My expectation is that much of the H1 volatility was due to seasonal factors, and I expect delinquencies to rise only slightly from here. This view is predicated on my expectation for slow but positive economic growth and a Fed rate cutting cycle. If we do have a recession, Ally would likely see more credit reserving.

Outlook

Alongside results, Ally adjusted its full-year guidance. It now expects NIM at 3.3% from 3.25-3.3% previously, with an exit rate of 3.45-3.50%. I had viewed prior NIM guidance as slightly conservative, and with solid deposit pricing action, I expect NIM to meet or even exceed the high end of this guidance.

Alongside that, Ally expects net charge-offs to run at the high end of guidance, given slightly higher auto charge-offs. Given the rise in Q2 delinquencies, this increase does make sense. I do not expect charge-offs to continue rising, given my macro outlook, but some investors will likely be cautious about further potential losses. I would also note that its tax rate is lower due to the EV issue noted above.

Conclusion

Ally is performing broadly in line with my expectations, enjoying a meaningful NIM benefit, while economic expansion should mitigate further credit deterioration. It is also well capitalized with a common equity tier 1 (CET1) capital ratio of 9.6%, up 18bps from Q1. This is a bit above its 9% CET1 target. ALLY has a 2.7% dividend yield, which I view as secure given its capital posture.

Given this outlook, I still see ALLY as poised to exit this year with $4 in normalized earnings power. I view about 11x earnings as fair value, given its high-quality deposit base but riskier loan profile. As such, some modest profit taking on this earnings release is reasonable, as Ally Financial Inc. shares are around fair value. I am moving shares to a hold. Until there are signs of delinquencies falling, shares likely will struggle to break past $45. As such, the upside is likely limited.