There is a lot of investor pessimism surrounding the lending industry right now, and it certainly makes sense. After all, soaring interest rates have caused demand for loans to decline, and if a recession hits (like most experts are predicting), it could cause a rise in loan defaults.
However, Ally Financial (ALLY 0.20%) just showed investors that things might be going better than anticipated. The bank recently reported its year-end 2022 results, and shares soared by as much as 20% the day after the announcement. Here's a rundown of Ally's fourth-quarter numbers, why the market reacted so favorably, and why the stock could still be a great buy for long-term investors.
NYSE: ALLY
Key Data Points
Ally handily beat expectations for the fourth quarter
Let's start with the headline numbers. Ally beat expectations on both the top and bottom line. The bank generated $2.2 billion in revenue, $150 million more than expected, and $1.08 in earnings per share (EPS) was 8% better than analysts had been expecting. And it's worth noting that expectations were likely even worse right before the report, as Discover (DFS +0.00%) reported disappointing results and high charge-off rates the day before.
Looking beyond the headlines, Ally originated $9.2 billion in auto loans during the quarter at an average yield of 9.57%, a staggering 260 basis points higher than a year ago. And impressively, net financing revenue was slightly higher year over year, despite the challenging economic conditions.
Ally also did a great job of returning capital to investors and taking advantage of the decline in its stock price. In fact, Ally spent $1.7 billion on repurchases in 2022 -- that's 18% of its entire market cap. And that is in addition to the roughly $350 million the bank stock paid in dividends.
An extremely profitable business model
If you aren't familiar, Ally was spun off from General Motors (GM +0.39%) after the financial crisis, so it shouldn't be a surprise that its primary business is auto loans. About 77% of the bank's loan portfolio is automotive in nature.
However, it's important for investors to realize that the company has evolved into a full-featured online bank with a massive deposit platform. The bank has $137.7 billion in retail deposits, providing a low-cost source of capital for nearly all of its $146 billion in loans.
Here's why that's important. Because deposit interest rates are much lower than other types of financing, Ally's average cost of funds in 2022 was just 1.71%. Meanwhile, the average yield of its new auto loans for the full year was 8.24%. Even with administrative costs and a reasonable default rate, it's not hard to see how this combines for a huge profit margin. In fact, Ally's net interest margin of 3.65% in the fourth quarter is one of the best in the banking industry.
Should investors worry about a rise in defaults?
Ally set aside $480 million during the quarter, more than double than it did in the fourth quarter of last year, but this is still largely in line with pre-pandemic norms and isn't a cause for alarm.
For the full year, Ally's auto loan portfolio saw a 97-basis-point (0.97%) annualized charge-off rate, but this had increased to 166 basis points (1.66%). However, this isn't cause for alarm. This is a bit higher than the 1.33% default rate Ally saw in 2018, but the bank has about 3.6% of its loan portfolio in reserves. The situation is certainly worth watching, but the charge-off rate is still quite manageable.
Ally could still be a great stock for patient investors
Despite the post-earnings pop, Ally still looks extremely attractive from a long-term perspective, especially if you believe the fears of a spike in defaults are overblown. After all, Ally trades for just over 5 times trailing-12-month earnings, and for a 12% discount to its book value per share. The stock is still 40% below its 52-week high.
To be sure, Ally isn't without risk. However, with an extremely profitable business model, an excellent history of returning capital to shareholders, and a cheap valuation, Ally is a bank stock that could pay off very well for patient long-term investors.
