Frustrated Ally Investors Are Concerned About Capital, Exec Comp

Following a near-death experience late last decade, Ally Financial built an enviable online bank, renewed its focus on auto lending, and returned to profitability.

Those steps forward haven't brought much benefit to the company's shareholders, though.

Ally's initial public offering in April 2014 fell short of expectations. And since then, the company's stock price has fallen by 36%, compared with an 8% decline in the KBW bank stock index. On Friday, shares in Ally were worth just 54% of the firm's equity.

In early January, impatience with the company's poor stock performance spilled into public view after a hedge-fund investor, Lion Point Capital, asked Ally's board to create a strategic alternatives committee. Ally loudly rejected the idea, stating in a press release that the proposed move would be interpreted as a decision to sell the $156 billion-asset company.

But discontent at Detroit-based Ally is not limited to Lion Point, and the public focus on whether Ally should pursue a sale has obscured other issues being raised by the firm's unhappy investors.

High among their demands is that Ally start returning more capital to shareholders – something it can't do without regulators' blessing. They also want changes in how Ally, which until 2010 was known as GMAC, pays its executives, in order to more closely align the interests of the firm's management with those of shareholders.

Underlying the tension between Ally and the activist shareholders are broader market anxieties about the state of auto lending, which is the company's bread and butter.

Now the stage is set for a showdown. Ally is scheduled to report its fourth-quarter earnings on Tuesday, hold its inaugural investor day on Feb. 11, and host its annual meeting on May 3. Unless a compromise can be hammered out, a shareholder vote is expected at the annual meeting on two candidates that Lion Point has proposed for election to Ally's board.

Though Ally said in its Jan. 4 press release that it would carefully consider and evaluate Lion Point's nominations, it also voiced strong support for its board: "The company has a highly qualified board of experienced professionals with extensive expertise in banking, consumer finance and the financial sector more generally."

The government bailout of Ally in 2008 and 2009 brought the company back from the brink of failure, but it has also made the company less flexible than many of its competitors. Now Ally finds itself squeezed between the demands of activist shareholders and the requirements of its regulators.

Some analysts expressed befuddlement over the tactics being employed by Lion Point.

Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods, argued that Ally's management has done a good job of managing through a difficult post-crisis era.

"Usually activism occurs when management is ineffectively managing the scenario," he said.

Christopher Donat, an analyst at Sandler O'Neill, gave a similar assessment.

"I have a 'buy' on the stock. I think it's undervalued in certain ways. But I think that's a market problem, not a management problem," Donat said.

To be sure, Ally has encountered its share of operational difficulties. Its chief executive officer, Jeffrey Brown, was promoted to the job in February 2015 following the unexpected departure of former CEO Michael Carpenter, who was said to have had strained relations with regulators.

Around the same time, Ally's onetime parent company, General Motors, decided to bring its subsidized auto-leasing business back in-house. That move left a big hole in Ally's balance sheet, since subsidized leases for GM cars totaled 13% of the company's originations in 2014.

In comparison to other banks, Ally's recent financial performance has been subpar. The firm's return on equity during the first three quarters of 2015 was 6.85%, compared with 9.33% for the industry as a whole, according to data from the Federal Deposit Insurance Corp.

But while Ally's profits are not particularly strong, they do not seem weak enough to explain the plunge in its market value. Moreover, the firm has some notable assets, including Ally Bank, a branchless deposit franchise that has reduced the company's dependence on higher-cost funding.

The mismatch between the company's performance and its stock price appears to be partly the result of negative perceptions among investors about the current state of the auto-finance business, according to analysts.

Auto lending flourished in the years following the Great Recession, driven by low interest rates and pent-up consumer demand. But delinquencies on loans to subprime borrowers have ticked up of late, and there's broader concern that consumer demand for cars will slow this year after hitting an all-time high in 2015.

"We've just had a huge lending boom," said Jeff Davis, managing director of the financial institutions group at Mercer Capital. "There's a sense among investors that there's a piper that must be paid."

Those worries are more acute at Ally, where more than three-quarters of all earning assets are related to the auto sector, than at more diversified competitors. Ally's decision last year to lean more heavily on subprime auto loans has further fanned investors' concerns.

Moreover, some analysts believe that Ally, since its split from GM, has some key disadvantages in the auto-lending business. Competitors include both the financing arms of auto manufacturers, known as captive lenders, and banks with branch networks that pay a lower price for deposits than Ally does.

"They're in a challenging spot in the market. They're not a captive lender, which makes it tougher for them on new cars," Donat argued.

"If you're Ford or Toyota, you can allocate your spending between marketing and finance, and there's times you can dial up either one. It's more complicated for Ally. They have an arm's-length relationship with manufacturers like GM."

In used-car lending, Ally competes against Wells Fargo, JPMorgan Chase, Capital One Financial as well as regional banks, credit unions and small banks. "They're just one other competitor without the branch-based deposits that can create a cost-of-funds advantage," Donat said.

Observers expressed skepticism that Ally, the 19th largest banking company in the U.S., could find a buyer at a fair price.

"I just don't know how much interest there is in buying them at this point in time, quite frankly," Sakhrani said.

But even if a sale is off the table, the activist investors, led publicly by Lion Point, could force changes inside of Ally.

Lion Point, which owns less than 1% of Ally's common stock, declined to comment for this article. But in a Jan. 6 press release, the hedge fund stated: "Lion Point's goal is to ensure that the voices of

Ally's shareholders are heard and that policies are in place to address the significant undervaluation of the company should such undervaluation persist."

"The nonbinding shareholder proposal we submitted to Ally regarding the assessment of strategic opportunities, highlighted so prevalently by the company, is merely one facet of this conversation," Lion Point added.

One issue that is said to be part of the conversation is whether Ally will start returning more capital to its shareholders. On that question, Ally's management team appears to be sandwiched between the demands of certain shareholders and the requirements of the Federal Reserve.

There are some signs of progress.

Relations between Ally and its regulators are said to have improved under Brown's leadership. And late last year, Ally announced that it had received approval from the Fed to redeem more than 1.2 million shares of preferred stock. Those shares were developed during the financial crisis and had prevented company from offering a dividend on common equity shares.

"Addressing this remaining legacy security will remove the restriction the company had on offering common equity distributions and position Ally to meet its objective of initiating a dividend and share repurchase program in 2016," Ally CEO Brown said in a Nov. 12 press release.

But Ally still needs the Fed's approval for a capital return program. Under the Comprehensive Capital Analysis and Review process, Ally must be able to show that it would be able to weather a severe economic downturn before the Fed will approve the return of more capital to the firm's shareholders.

"We have said that that is something that we're going to focus on," Ally spokeswoman Gina Proia said.

A second area where Ally's management is facing shareholder pressure involves executive compensation. The question is whether the company will modify its pay packages to provide more compensation in the form of equity, in an effort to more closely align the interests of the firm's management and board members with those of shareholders.

Again on this issue, Ally's options were long limited by the U.S. government.

For several years, the company was subject to executive-compensation rules as part of the Troubled Asset Relief Program, under which Ally was rescued. But in March 2015, Ally announced a new executive compensation program that included both cash and stock-based payments.

Ally declined to comment when asked whether its current compensation structure adequately aligns the interests of management and shareholders.