Thursday, December 1 2022

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Introduction

As a dividend growth investor, I am constantly looking for income producing investments to supplement my passive income. Most of the time, I add to existing posts that I find appealing. On other occasions, I start a new position to further diversify my portfolio, increase my revenues and gain exposure to new segments. Current market volatility may provide an opportunity to acquire future revenue at lower prices.

My dividend growth portfolio lacks exposure to two main sectors: financial services and information technology. Therefore, I will analyze more companies in these two sectors, as they have both suffered from the current downturn. I own banks, insurers and asset managers in the financial sector. I will analyze a digital bank, Ally Financial (NYSE: ALLY), in this article.

I will analyze the company using my dividend growth stock analysis methodology. I use the same method to make it easier to compare searched companies. I will examine the fundamentals, valuation, growth opportunities and risks of the business. I will then try to determine if it is a good investment.

Seeking Alpha’s business overview shows that:

Ally Financial, a digital financial services company, provides various digital financial products and services to consumers, businesses and enterprises primarily in the United States and Canada. It operates through four segments: Automotive Finance Operations, Insurance Operations, Mortgage Finance Operations and Corporate Finance Operations.

Fundamentals

Ally Financial’s sales have grown 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 for financing new purchases from the public have supported the company’s growth model. Looking ahead, analyst consensus, as seen on Seeking Alpha, expects Ally Financial to continue to grow sales at an annual rate of 2.5% over the medium term as it faces to slower growth due to higher rates.

Chart
Data by YCharts

EPS (earnings per share) grew much faster during this decade. EPS nearly quadrupled in that decade because the company could raise funds more cheaply, offer low interest rates on deposits, and earn a high margin on its loans. Fewer shares, higher sales and higher margins led to rapid growth. Going forward, analyst consensus, as seen on Seeking Alpha, expects Ally Financial to suffer from lower EPS before leveling off in 2024 as the company faces higher rates. high and possibly a recession with higher loads. Even in this scenario, projected EPS for 2023 of $4.49 will be higher than 2019 and 2020 EPS.

Chart
Data by YCharts

Ally Financial is a new dividend payer. He does not have a long track record as he has only increased his payments for five consecutive years. However, the payout seems relatively safe, with a payout rate of 24%. Additionally, the dividend yield is attractive due to the current extremely low valuation, and investors can enjoy a 4.61% yield. However, due to the current business environment and rising rates, investors should expect modest increases in dividends as the company strives to preserve more capital than regulatory requirements.

Chart
Data by YCharts

Another form of returning capital to shareholders is through share buybacks. Over the past five years, Ally Financial has repurchased over 30% of its outstanding shares. Buyouts support EPS growth and are very effective as the business grows as they unlock even faster growth resulting in higher dividend growth. If the company trades for such a valuation, buybacks will be very effective.

Chart
Data by YCharts

Evaluation

The P/B ratio (price to book value) has decreased significantly over the last twelve months. At the start of the year, Ally Financial shares were trading at roughly their book value. However, as we have seen interest rates rise and recession risk increase, valuations have contracted. The shares are trading at a nearly 25% discount to book value. Investors are expecting tough times ahead, and so there is a discount.

Chart
Data by YCharts

Looking at the chart below from Fastgraphs, we see that Ally Financial is priced attractively compared to its past valuation. Since the IPO in 2014, the average P/E ratio is 9.5, and the current P/E ratio is more than 50% lower at 4.1. Therefore, a significant discount stems from investor concern about its performance during the recession and high interest rates.

Valuation analysis

Quick graphics

In conclusion, Ally Financial is a solid company. A track record of sales and EPS growth allows the company to pay growing dividends and buy more shares. The valuation is attractive as investors fear that higher rates will affect the company more significantly than other financial institutions. They think the risk is high. So the potential also seems high.

Opportunities

The company’s first growth opportunity is the growth of its Ally Bank business. The bank has total deposits of $146 billion, up $6.3 billion year-on-year, and it is managing to increase the number of its 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 enable rapid growth in the future.

Ally Financial is completely digital, which has several advantages as we move forward. It appeals to the younger generation and can roll out new products faster. The use of data allows the bank to better customize offers for different customers, and it also allows the bank to save significant amounts of money on staff, rent, etc., and to be a very lean financial institution and efficient.

The company has proven that it can perform well even in times of uncertainty. This financial institution has been around for over 100 years, and as a result, it has faced significant challenges, including periods of high inflation and high unemployment. With the current safety margin due to the low valuation, there seems to be a medium-term opportunity for valuation expansion if the market becomes less worried.

Risks

Interest rates are rising and this poses a risk for Ally Financial. On the one hand, the company must offer higher rates to those who deposit their money in the bank. On the other hand, since the rates it charges on its loans are already higher than average, raising them further could reduce the number of future clients seeking a loan. Some potential customers may prefer to postpone their purchases.

Another risk is recession which may or may not occur due to higher rates. Although rates may make new loans less attractive, a recession will make it harder for Ally Financial to profit from its current portfolio. As unemployment rises during recessions, there is a growing risk of write-offs and the company will lose money on an increasing portion of its portfolio.

This risk is particularly relevant to Ally Financial as it targets difficult customers. The company targets customers with lower credit scores to charge higher interest rates. Therefore, these customers will be the first to suffer from a weakening economy, especially during a recession. Therefore, the customer profile is also a risk if the weak economy is here to stay.

conclusion

Ally Financial is a high risk, high reward game in the stock market. The company has strong fundamentals with growing sales and EPS. It has also been rewarding shareholders for several years. However, the business is in the risky business of high-interest loans, and it may become more difficult to grow during recessions. Therefore, investors should consider that ups and downs are important here.

Since there is such a large gap between positive and negative scenarios, this investment is not suitable for any dividend growth investor. Most dividend growth investors are looking for stability and a steady, growing stream of dividends. Ally Financial has a different risk profile. So there is more room for volatility. It should suit dividend growth oriented investors with a higher appetite for risk.

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