Laudani: Taking Ally Financial for a Test Drive

Underwriters priced the shares of Ally Financial (ALLY) Wednesday at $25, which was at the low end of the $25 to $28 range. Will investors drive away with profits or will they end up in a wreck on the side of the road?

Ally Financial was originally founded in 1919 as GMAC, or General Motors (GM) Acceptance Corporation. It is one of the largest providers of automotive financing and the 19th-largest bank holding company in the U.S. The company hit a pothole during the global financial crisis 2008. In order to accept a bailout from the Federal Reserve Troubled Asset Relief Program (TARP), GMAC was forced to transform into a bank-holding company and agree to be regulated as a bank.

The company changed its name to Ally. All told, the Fed dumped $17.2 billion into the company in return for 74% ownership. Cerberus Capital invested $366 million for 9%. The GM Trust (10%) and a few other investors (8%) own the remaining pieces.

From 1985 to 2005, GMAC aggressively expanded into subprime mortgages. By 2006, GMAC was the nation's 10th-largest mortgage producer, originating nearly $162 billion in loans. The company was hit with a double-whammy. As the economy turned down, the auto-financing business went south and the subprime-mortgage business turned toxic. It was like a tsunami of bad debt.

At the time, the bailout was subject to blistering criticism by both ends of political spectrum. Critics wondered why the taxpayers were bailing out one of the nation's largest subprime mortgage lenders. At the time of the offering, Ally has already repaid about $15.3 billion of the $17 billion the company received in the bailout.

The U.S. Treasury is selling 95 million shares today, and has granted the underwriters the option of selling an additional 14.2 million shares if demand for the offering is strong enough. The deal is expected to raise at least $2.38 billion, with all of the proceeds to go to the taxpayers. The Treasury will hang on to the remaining 17% it still owns. (The Obama administration will book a healthy profit on this bailout.)

I think the underwriters have intentionally under priced this offering, and I expect demand for the shares to be strong. As of Dec. 31, Ally Bank had deposits of $52.9 billion in 1.5 million accounts. Ally's auto financing business has some 16,000 dealerships that use Ally as a source of funds to finance auto purchases and leases. According to the prospectus, about 11% of the company's loans are classified as subprime.

At $25 per share, Ally looks to be valued at just one-quarter the value of auto-lender Credit Acceptance Corp. (CACC). That's probably because of Ally's renewed focus on auto- (and subprime) lending.

While not without risk, I think investors will be very interested in this turnaround story. Ally's return on tangible common equity was a dismal 4% last year. But, because of it reduced dependence on expensive financing, the company is expected to improve its profitability to 10% by 2015. The increased returns should be enough to drive the shares higher over the remainder of the year.

At the time of publication Laudani had no positions in any stocks mentioned.r

  Christopher Laudani is the founder and president of ShortIdeas.com, a short-only equity research firm.

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