The Federal Reserve lowered its benchmark federal funds rate on Wednesday, Sept. 18. To the surprise of some analysts, the Fed lowered the rate a half point rather than the expected quarter point. The impact of such an action is about to reverberate across the entire economy.
Rate cuts like this especially impact financial institutions and lenders such as banks. When the Federal Reserve lowers the federal funds rate it tends to also get reflected in interest rates that banks charge each other and the rates they use with their customers. For example, it becomes more affordable to get a loan from a bank. At the same time, banks tend to lower how much they pay out to depositors from high-yield savings accounts.
One banking player that felt the pinch when the federal funds rate started rising in March 2022 was Ally Financial (ALLY -1.37%). Now, the opposite is likely to occur. Here's why dividend grower Ally Financial will thrive in a declining interest rate environment.
Ally Financial is a consumer bank that got its start making automotive loans. It has expanded its services and now takes in deposits from individuals for its online bank -- currently with 3.2 million customers and $142 billion in deposits. Auto loans are still a big part of its operation though because much of its revenue comes from lending out its depositors' funds to people buying a car. Profits come from the spread between its payments to depositors and the interest payments on its loan book.
Right now, a depositor with Ally can earn a 4.2% annual yield for money stored in a savings account. This yield rose consistently as the Federal Reserve raised its own benchmark interest rate in 2022 and 2023, so Ally had to pay more and more out to depositors in interest every quarter. Last quarter, the average cost of Ally deposits was 4.21%, compared to 0.76% in 2022.
While this is normal, Ally has faced a squeeze on its profits as the interest rate paid to depositors increased so quickly. The bank's loan book doesn't turn over every quarter, but when it raises the interest rate paid to depositors, every dollar gets paid a higher annual yield.
Today, Ally still has existing loans on its balance sheet that were made when interest rates were close to zero, and therefore yield much less. This is reflected in Ally's net interest margin (NIM), which measures the average spread between the interest paid to depositors and the yield it gets on its total loan book.
Last quarter, Ally's NIM was 3.27%. In Q2 of 2022, it was 4.06%. This is a big reason why Ally's net income has fallen in recent years. During the pandemic, Ally's net income soared to over $2 billion (annualized) but has since fallen to $823 million. This drop in margin goes a long way toward explaining why Ally's stock trades down 40% from all-time highs while the broad market indexes are soaring.
The good news for Ally is it looks like these interest rate-hike headwinds will turn into tailwinds beginning this month.
Ally's loan book has gradually matured since early 2022, with higher-yielding loans making up a greater portion of the balance sheet. The average yield it earned on assets was 7.36% last quarter, compared to 5.11% in the same quarter in 2022.
With the Federal Reserve lowering its rate, look for Ally to increase its NIM over the next few quarters. When this occurs, overall earnings should start to grow. When overall earnings start to grow, management can start to grow the dividend per share.
Ally's dividend per share has grown by 275% since it was initiated in 2018, but increases were paused when interest rate headwinds began. With a 3.54% annual dividend yield, Ally has an attractive-looking dividend with room to grow over the next few years.
One concern for the bank is the rising loss ratios on its automotive loans. Earlier this month, an executive said that delinquencies on loans rose slightly in July and August of this year. Investors need to watch these figures closely. If the economy hits a recessionary period, Ally's loan delinquencies may continue to rise.
Ally Financial looks like a cheap stock compared to other financial sector stocks. It has a price-to-earnings ratio (P/E) of 14.9, which comes in below the 16.2 P/E for the sector. Compared to regional banks (at 14.2), its P/E is slightly higher but still relatively cheap as most bank stocks are at the moment.
Given its 6.67% earnings yield, it has plenty of firepower to continue paying its 3.54% annual dividend yield even if earnings don't grow in the near term. Remember that these are depressed earnings due to the interest rate-pinch impact on the company's earnings power.
If the Fed continues to cut rates (something analysts fully expect) and Ally's annual net income recovers to the point where it is again hitting $2 billion, the stock will trade at just 5x its current market cap of $10 billion. That's a dirt cheap forward earnings multiple. It's part of why I think now is a perfect time to buy this dividend-growth stock as the Federal Reserve begins to lower interest rates.