Warren Buffett's Berkshire Hathaway purchased shares in the large digital consumer bank Ally Financial (ALLY 0.88%) in two different quarters last year and now owns just shy of a 10% stake in the company.
Like most banks, there has been a lot of uncertainty over Ally as the economy potentially tips into a recession, especially after the banking crisis unfolded in March. So investors may not have been pleased to see Ally trim its full-year earnings guidance recently.
However, I don't believe the lowered guidance has changed the investment thesis. I think management is simply adjusting the guidance to remain conservative in an uncertain environment. Let me explain.
What happened to the guidance?
On Ally's last quarterly earnings call in January, management told investors that the company could generate $4 of earnings per share in 2023. On its most recent earnings call for the first quarter of 2023, management lowered that guidance to $3.65.
Image source: Motley Fool.
However, I wasn't overly concerned by the lower guidance given everything that has happened. Ally has decided to hold higher cash balances in the near term like a lot of banks because liquidity has come under pressure across the sector. Higher interest rates have led customers to move their money into higher-yielding assets or bank account products, so deposits are moving out of the system and forcing banks to pay up for deposits faster than they had anticipated. While roughly 91% of Ally's deposits are insured by the Federal Deposit Insurance Corporation, I don't think it's a bad thing to see management erring on the side of caution.
Furthermore, the chance of at least a mild recession has become more pronounced, which has led most banks to tighten credit. Ally has followed this route and expects to pull back on originations for the year, although it still expects to do about $40 billion of retail auto originations, which the company specializes in. Ally also expects a $0.10 impact on earnings due to valuation adjustments to certain equity investments.
The thesis remains intact
The thesis for Ally's stock is that it trades below its tangible book value, or net worth, and the company should be able to generate higher earnings than it did prior to the pandemic. This is likely one of the reasons that Berkshire bought the stock.
Even though the company is dealing with higher deposit costs in the higher interest rate environment, Ally has done a better job of improving its funding profile. The company is also originating retail auto loans above 10%, which allows Ally to price risk appropriately and should also benefit its margin when deposit prices begin to stabilize.
Furthermore, while this year's guidance is lower, most of the assumptions on the bank's margin, credit quality, and expenses have remained in line with what management laid out in January. Management still expects the net interest margin, which is essentially the difference between what the bank makes on interest-earning assets such as loans and what it pays out on interest-bearing liabilities such as deposits, to hit a low of 3.5% or slightly lower this year before bottoming and then moving back toward 4% over time.
Management also said it continues to view a mid-teens return on tangible common equity (ROTCE) as achievable. Prior to the pandemic, Ally typically only generated a 10% or 11% ROTCE. If management can execute this vision, then the stock looks very cheap, trading at just around 83% of its tangible book value.
