Ally Financial

Ally reported solid second-quarter earnings thanks to improving credit results and lower funding costs, with adjusted earnings per share coming in at $1.21, up 22% from last year. These results translated into an 11.0% return on equity, a good result for the firm but still below its long-term goals.

Why it matters: The second quarter reinforces our view that improving fundamentals should drive stronger long-term earnings for the firm. Credit continues to normalize, funding costs are easing, capital remains strong, and loan demand has stayed resilient. Ally's retail auto net charge-offs came in at 1.57%, down 18 basis points from last year and marking five straight quarters of year-over-year improvement. Its retail auto delinquencies also continue to trend downwards, albeit at a slower rate, falling 8 basis points from last year. The bank's net interest margin expanded to 3.63% from the previous year's 3.45%, thanks to falling deposit costs and a higher average auto loan yield. This was particularly good to see, as NIM expansion is a core part of the firm's strategy to reach its goal of a midteens return on equity.

The bottom line: We are maintaining our fair value estimate of $49.90 a share for no-moat Ally Financial. We see the company's shares as modestly undervalued at current prices, as we do not think the market is giving the bank enough credit for its improving profitability. Management maintained its full-year NIM guidance at 3.6%-3.7%. While we continue to be skeptical of the exit rate implied by the high end of Ally's guidance, improved leasing results and lower deposit costs should provide a substantial tailwind to net interest income over time. We also expect the bank to continue to benefit from falling credit costs. In line with this, Ally narrowed its consolidated net charge-off outlook to 1.2%-1.3%, an improvement on 1.2%-1.4% previously.

Loan growth came in strong during the quarter, with consumer auto originations totaling $13.3 billion, driven by a record 4.6 million auto finance applications, which was up 17% from last year. This is a good change in the firm's performance, in our view, as Ally's loan growth in recent years has trailed that of major auto loan rivals, like Capital One.

Along with the release of second-quarter earnings, the firm increased its 2026 guidance for average earning asset growth, looking at 3% to 5% growth now, up from between 2% and 4% previously. We should also note that the bank did a good job of controlling costs in the second quarter, as its efficiency ratio reached 48.7%, reflecting ongoing operating leverage as revenue growth once again outpaced expense growth.

We are decreasing our fair value estimate for Ally to $49.10 per share from $49.90. About $0.40 of the decrease reflects the impact of higher interest rates on Ally's short-term results. While Ally does benefit from higher interest rates in the long term, immediate results will see pressure since the bank's deposit costs react faster to changes in interest rates than the average yield on its loan book. The remainder of the negative adjustment comes from higher expense growth, partially offset by lower near-term credit cost projections, as a surprisingly resilient labor market is leading to lower net charge-off expectations across our consumer finance coverage. Our fair value estimate translates to 12.52 times projected 2026 earnings and a price/book ratio of 1.21.

Like other consumer lenders, Ally has seen its credit costs rise materially in 2023 and 2024. We expect credit costs to remain modestly elevated in 2026, acting as a headwind to Ally's profits. That said, we do expect credit costs to improve as 2026 progresses, with auto loan net charge-offs returning to their long-term average of 1.65% by the end of 2027. Additionally, the bank is in a solid financial position with strong reserves and should be able to withstand higher credit losses if the labor market weakens further than expected.

We expect Ally's loan growth to improve in 2026, as the firm turns a corner on credit quality and loosens underwriting. We expect auto loans to grow at an average rate of around 4.6% over the next five years, up from only 0.9% over the last three.

We expect deposit growth to return in 2026, but it should remain modest. Ally, like many online banks, has benefited from the growth of digital banking, with rising interest rates and high inflation pushing savers to make use of high-yield online savings accounts. However, with nearly 90% of its funding now coming from deposits and the firm allowing its mortgage book run off, Ally simply has less need for additional deposits, reducing its motivation to chase additional accounts and giving it the option to become more aggressive on pricing.

We project that Ally's net interest margin in 2026 will be 3.67% (as calculated), higher than last year's level. The bank's net interest margin from 2023 to 2024 was compressed by rising interest rates, as the cost of its deposits increased faster than the average yield of its loan book. While we expect pressure on Ally's net interest margin from rising interest rates in 2027, the long-term picture remains healthy. Over time, Ally's loan book has been shifting toward higher-yielding loans, creating a tailwind for its net interest margin. Additionally, the bank has decided to stop originating new mortgages and plans to allow its mortgage loan book to naturally decline. This will also provide a tailwind to Ally's margins, as this segment carried lower yields than the firmwide average, and reduced funding needs will allow it to be more aggressive on deposit pricing. Finally, the firm's leasing business has incurred remarketing losses due to a collapse in the value of certain models. Over time, this downward pressure on leasing yields will fade as well.

We see the bank's net interest margin normalizing to 3.82% by 2029, well above its prepandemic level, as we believe improvements to Ally's loan book and funding structure have enhanced the firm's long-term profitability. We see the company's efficiency ratio stabilizing at 59.5% by the end of 2030, leading to a long-term ROTE of 11.5%.

We assign Ally Financial a Morningstar Economic Moat Rating of none, as the firm lacks material competitive advantages that would enable it to generate a reliable return on equity above its cost of capital. While the firm enjoyed a period of enhanced profitability in 2021 and 2022, during which it generated returns well above its cost of equity, we see a cyclical peak in auto market conditions and unusually low industrywide default rates as the primary drivers of this strength. While we do expect Ally to outperform its prepandemic returns, thanks to an improved funding structure and a shift away from dealer financing, we anticipate that this improvement will be insufficient for the firm to reliably earn excess returns. Case in point: the firm underperformed its cost of capital in both 2023 and 2024 due to elevated credit costs and net interest margin compression.

We typically assess bank moats as stemming primarily from cost advantages or switching costs. In our view, Ally does not enjoy a competitive advantage from either potential moat source in the bank's automotive financing business, which provides the bulk of the firm's revenue and operating income.

Ally uses an indirect lending model for its consumer auto loans. Specifically, it does not originate its own loan applications; instead, auto dealers collect loan application data from customers so they can obtain price quotes from lenders, then Ally (or another indirect lender) acquires the loans from the dealers themselves. This means that Ally does not have an in-house method of generating retail auto loan business and is reliant on its dealer clients for origination in its most profitable business line. For many auto dealers, this process has become a major profit driver, and because the relationship between Ally and the dealer is not exclusive, dealers have both the ability and the incentive to price-compare loan offers with one another. Each auto sale a dealer makes can be financed by a different lender on an ad hoc basis, meaning there are limited switching costs for a dealer to switch from one indirect lender to another. We do not see Ally as having meaningful pricing power in the relationship with its dealer clients and do not see a way for the firm to realistically acquire loans at a meaningful discount to its peers. Additionally, because Ally lacks an internal distribution channel for auto loans, there is no effective means for the company to generate repeat business or retain relationships with its end borrowers. As a result, the benefit from its large existing pool of auto lenders is limited to cross-selling potential with its deposit and other consumer lending products.

Cost advantages in banking can stem from three factors: a low-cost deposit base, operating efficiency, or conservative underwriting. Ally Financial is a purely digital bank, with no physical branches. Like other digital banks, Ally offers deposit rates well above those featured by traditional banks, which offsets the benefit from lower operating costs due to not needing to maintain a network of branches. Ally has benefited from a noticeable shift among consumers toward digital bank accounts, with the bank's deposits now making up 88% of total funding in 2024 from 54% in 2016. This has improved Ally's funding structure, but the bank still has higher deposit costs than both traditional banks and other large digital banks with stronger brands and deposit bases. Thus, while the situation has improved, we see Ally as still being at a cost of funds disadvantage to many of its peers. Additionally, Ally's efficiency ratio, which is typically in the high 50s to low 60s, would be good for a traditional bank but is weaker than other digital banks. In our view the combination of high funding costs and somewhat above average operating efficiency come together to provide Ally with a weaker cost structure than many of its peers. From a credit cost perspective, Ally's short history as a public firm means there is insufficient data to effectively assess the quality of the bank's underwriting through a full cycle. Moreover, what data we have seen from the current credit cycle has not been impressive, with the firm waiting too long to begin tightening underwriting. All in all, we see little indication that Ally's lending business benefits from a cost advantage over its peers.

Likewise, we see limited room for a competitive advantage in the firm's insurance business. Like its auto loans, Ally's insurance products are sold only through its dealer relationships. The firm does not have the scale to compete with major auto insurers and instead focuses on niche insurance products, specifically vehicle service contracts and gap insurance. The focus on smaller product categories is a smart choice and can be an effective strategy for smaller insurers to generate good returns. However, Ally lacks a compelling data or distribution advantage to create a competitive advantage. This is reflected in a combined ratio that averaged 96.2% from 2013-22, which is worse than what we would expect from a firm with a material competitive advantage, particularly given that Ally's insurance results have historically been quite volatile.

All in all, we believe that Ally lacks a material competitive advantage in its core business lines. We see the firm's recent returns as being driven by positive cyclical conditions and while its improved funding structure and loan mix will likely lead to better long-term profitability, this is alone is not sufficient to warrant a moat rating for Ally.

Ally has had material success in improving its funding structure, which could lead to wider net interest margins.

Ally's decision to exit the mortgage business is a positive step for the firm, as the company could benefit from better focus on its core auto lending business.

Resilient used-car prices could lead to Ally's credit losses coming in lower than expected.

Ally's auto loans are in a period of higher credit costs as economic pressure weighs on consumers. Credit costs could remain elevated for longer than expected.

Better market conditions for auto lenders could lead to more intense competition in the future.

While Ally has multiple lending segments, a significant majority of its revenue and operating income comes from retail auto lending. This gives it fewer options if market conditions for auto loans are unfavorable.