Ally Financial (ALLY -1.00%) spooked its investors last week. At an investment conference, an executive said that delinquencies and net charge-offs for its consumer automotive loans rose in the past two months. This is not good for an already struggling banking business. If fewer people are paying back their loans, Ally will make less in profit. After the update, Ally's stock plummeted close to 20% and now sits at around $33.
The largest investor in Ally Financial is Berkshire Hathaway, the conglomerate run by legendary investor Warren Buffett. The company has held its shares in Ally Financial even though it has trimmed the majority of its exposure to the banking sector in the past year or two. With Berkshire Hathaway still -- at least as of the end of the second quarter -- holding its position in Ally Financial, does now look like a good buy-the-dip opportunity for the stock?
Let's take a closer look and find out.
Working with a tightening consumer
Rising interest rates in the past few years have squeezed Ally's profit margins. As a bank, it earns money through the spread between what it pays depositors in interest versus the interest income it earns on loans and other investments. It specializes in automotive loans to consumers.
When the Federal Reserve began rapidly raising interest rates, Ally's net interest margin (NIM) began to narrow since its existing automotive loans were made when interest rates were lower. Once the Fed paused its interest rate hikes and signaled it planned to soon lower interest rates, Ally stock began to soar. At one point, it was up 50% earlier this year compared to a year ago.
Now, it looks like some of the loans Ally made in the past few years -- especially in 2022 -- are performing a bit worse than people expected. At the investment conference, the company's finance chief said that delinquencies and net charge-offs for its automotive loans were 10 to 20 basis points higher in July and August than they originally forecasted. (A basis point is one one-hundredth of a percentage point.) This means the loss metrics are up by around 0.1%-0.2%. While this seems low, last quarter Ally had an annualized net charge-off rate of 1.81%.
Just a slight increase in borrowers defaulting on loans can mean a big hit to Ally's earnings power. This is why the stock fell so much on the news.
Long term, the business model is fine
If Ally made some bad loans in 2022, that will have an impact of the company's earnings for the next year or two (automotive loans are almost all less than five years in length). This is not good for the company's profit potential. However, investors should put this into perspective. It's not like Ally's loans are all going bust; they are simply performing slightly worse than initially expected. At the conference, management said the company would still be profitable if recent trends persisted.
Investors need to remember that this is only two months of loans. It may just be a short-term blip and not any indication of a long-term trend. Investors should wait to receive more data before coming to any conclusions. That is what I bet the long-term investors at Berkshire Hathaway are doing.
Speaking of long term, Ally's business model looks to be just fine. Depositors keep coming to the digital bank with the high interest rates it pays on deposits -- 54,000 were added last quarter to bring the company's total to 3.2 million. It has $142 billion in retail deposits, almost all of which are guaranteed by the Federal Deposit Insurance Corporation. It can keep using these deposits to make automotive loans, which has been a wonderful business model over the long term. During the past 10 years, Ally has never posted an annual net loss.
ALLY Net Income (TTM) data by YCharts
Time to buy the dip?
Due to the short-term headwinds from interest rate hikes, Ally's net income declined from a peak of more than $2.5 billion in 2021 to $823 million during the past 12 months. These headwinds are officially over and may form a tailwind once the Fed begins to lower interest rates this year as expected. Yes, the rising delinquencies may be another headwind, but it is nothing Ally cannot get through over the long term.
Today, Ally stock trades at a price-to-earnings (P/E) ratio of 14.6, which is about half the S&P 500 index's average. Remember, too, that these are depressed earnings. With a market cap of just $10 billion, Ally's P/E could fall to 10 or lower if its annual net earnings revert back to the $1 billion to $2 billion range. On a longer time horizon, Ally's earnings can surpass this range if the company keeps attracting more depositors to its consumer bank.
Ignore the short-term noise. Now is a great time to buy the dip on Ally Financial and hold for many years into the future. The stock looks very cheap at the moment.
