Ally Financial Inc

NYSE:ALLY

Earnings Call Transcript 2017-Q4

[Operator]

Good day ladies and gentlemen and welcome to the Q4 2017 Ally Financial Incorporated earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s conference, Mr. Michael Brown, Executive Director of Investor Relations. Please go ahead.

[Michael Brown, Executive Director, Investor Relations]

Thanks Operator, and thank you everyone for joining us as we review Ally Financial’s full year and fourth quarter 2017 results. You can find the presentation we’ll reference during the call on the Investor Relations section of our website, ally.com.

I’d like to direct your attention to the second slide of today’s presentation regarding forward-looking statements and risk factors. The content of our conference call will be governed by this language.

I’d also like to note Slides 3 and 4 of today’s presentation, where we disclose some of our key GAAP and non-GAAP or core measures. These and other core measures are used by management and we believe they are useful to investors in assessing the company’s operating performance and capital measures, but they are supplemental to and not a substitute for U.S. GAAP measures. Please refer to the supplemental slides at the end for full definitions and reconciliations.

This morning our CEO, Jeff Brown and our CFO, Chris Halmy will cover the financial results. CFO designate Jenn LaClair is also here with us today. We’ll have some time set aside for Q&A at the end.

Now I’d like to turn the call over to Jeff Brown.

[Jeff Brown, Chief Executive Officer]

Thanks Michael. Good morning everyone. Thank you for joining our call. Before we cover details on the quarter, I’d like to recap highlights from 2017 and then discuss our priorities in 2018.

We delivered adjusted EPS of $2.39, up 11% year-over-year, which included a strong finish in 4Q of $0.70 per share. 2017 was a transition year with the lease portfolio declining and provision building, so we’re pleased with delivering that kind of earnings growth and steady upward trends across a number of key metrics.

Total net revenue of $5.8 billion was up nearly $340 million year-over-year for a 6% increase. Total deposit growth was very strong, over $14 billion for the year. We welcomed about 200,000 new retail deposit customers in 2017, up from about 166,000 in the prior year.

On the consumer auto side, we originated nearly $35 billion of loans and leases in 2017. We remain a strong leader in the industry, that includes for our dealers, for consumers and for OEMs. We remain disciplined on the credit side and feel really confident in the risk-adjusted profitability of what we put on the books this past year.

As we discussed last quarter, we completed the multi-year process of normalizing the regulatory structure at Ally Bank. We now originate the full spectrum of retail loans at the bank and importantly have reduced the Tier 1 leverage ratio requirement, which frees liquidity to the parent. Through the CCAR process, we were able to increase the amount of dividends and share buybacks by around 16%.

On the product expansion side, our corporate finance business is a bright spot with earnings up 60% year-over-year. We also made strides with Ally Home and Ally Invest. Both of these businesses are now in the market, are integrating with our banking platform, and are beginning to show some modest growth, so overall another strong year with steady progress executing our financial and strategic plan.

Turning to Slide No. 6, let’s cover result against our key financial targets for 2017. Chris hosted the financial outlook call last year and guided you on our expectations. I’m happy to say we delivered across all of these metrics: adjusted earnings per share growth up 11% year-over-year, core ROTC around the 10% level we’ve been targeting, holding the line on expenses and overall efficiency with a mid-40% efficiency ratio, even as we continue to steadily invest in our businesses and technologies. Obviously a lot of focus on credit trends throughout the year, and we came in a touch better than the midpoint of the 1.4 to 1.6 annual range for charge-offs.

With respect to the lease portfolio and used vehicle prices, we saw favorability particularly in the back part of the year with some of the benefit from hurricane-driven demand, and total deposit growth exceeded the $12 billion target for 2017. Similar to last year, we will have another financial outlook call in March to provide updated thoughts on the year ahead.

Slide No. 7 has our key quarterly metrics - $0.70 of adjusted EPS, the highest since the IPO. Quarterly net revenue of nearly $1.5 billion was another record. Total deposits increased to over $93 billion driven by $3 billion of retail deposit growth in 4Q, which is our best fourth quarter ever. Adjusted tangible book value was pretty flat this quarter, given impacts from the tax reform that Chris will cover in a minute.

Let’s cover our key priorities as we head into 2018 on Slide No. 8. At the top of the list is continuing our path of growing deposits and customers. These are important to the financial path and the self-help earnings growth story we’ve been demonstrating. Deposit rate area constant focus as we continue to look to optimize the overall cost of funds to see profitability expand. We’re watching our deposit rates carefully and in conjunction with market interest rates, competitor rates, and overall flows. We also seem to be hitting solid efficiencies to scale as we outpace growth relative to every other direct bank throughout this past year, and did not use rate to achieve those results. It’s also important to the strategic path to align ourselves with trends in digital banking, being the leader in that space, expand our brand, and get more out of this great franchise.

Next within our auto finance and insurance businesses, we will optimize risk-adjusted returns while maintaining a strong focus on credit and underwriting discipline. We feel great about what we’re delivering in terms of profitable retail originations that sets us up very well going forward. We continue evolving the insurance business while generating higher premiums. We are positioning these businesses to be the leaders for the very long term. We’re getting ahead of developing trends within the auto and insurance ecosystems and will continue to adapt as new trends emerge, and we’ve announced some key examples in 2017 by partnering with players like Carvana and DriveTime and furthering our own development with Clearlane.

Next, culture. A healthy culture is critical to the success of any organization. Our culture is centered around doing it right with a relentless focus on our customers, communities, associates, shareholders, and risk management. I emphasize culture over and over with our associate base and recognize culture as something that must be constantly nurtured.

On the product expansion side, we’re focused on getting scale in 2018. The seeds are planted in mortgage, wealth management and credit card, and we see opportunities for them to grow more meaningfully in 2018. Corporate finance, as mentioned, has been doing really well, and we’d like to see continued growth while remaining disciplined on credit.

Finally, deliver financially and drive long-term value to our shareholders. We’ve been on an attractive earnings growth path and we expect that to accelerate, particularly with tax reform, which I’m sure is on your mind, so let’s spend the next couple slides providing our perspective.

The bottom of Slide 9 are the punch lines - we expect the vast majority of the benefit of a lower tax rate to flow to the bottom line, which puts us in a stronger position to distribute more to common shareholders. We are announcing today a $1,000 per employee bonus that will be expensed in the first quarter. We think it’s important to share some of the benefit and continue to invest in our associates. In addition, we’re going to increase our charitable contributions by around $6 million as we continue to be focused on giving back to the communities we serve.

From an overall operating perspective, we’ve already had a path of increased investment in technology, customer interface and product expansion to benefit our customers, and we don’t currently view there being any incremental investment to make due to tax reform. In essence, that’s already been in our outlook. As far as indirect benefits, assuming tax reform stimulates economic activity, we see potential benefits across several dimensions. If it stimulates demand for consumers purchasing new vehicles, that would support both sales activity as well as used vehicle prices. Extra cash in paychecks means the additional ability to service consumer debt. There could be additional benefit from home sales activity as people have more disposable income and if they feel generally better about their economic outlook. You could still see incremental dollars being saved or invested in a bank or wealth management account. We’re not currently embedding this economic upside into our forecast, but a better economy is better for Ally.

More directly, when the lower tax rate drops to the bottom line, we will see an acceleration of the earnings growth path we’ve been on. We’ve talked about expanding our ROTC from the 10% range, where we’ve been running, to around 12% in the medium term. The lower tax rate is certainly supportive of ROE expansion.

As we generate more capital organically through earnings, we’ll have more capital to deploy. As always, we’ll continue to look for attractive ways to deploy that through lending and supporting our customers as part of our ongoing capital allocation framework. Could some of the tax benefit get eroded through dynamics in the marketplace or inflationary pressures that affect the company? It’s possible, and we’ll just have to see how that plays out; but simply put, the tax changes put us in a stronger position to enhance distributions to shareholders, as we still see that as an attractive capital deployment alternative in the near term.

I’ll turn it over to Chris now to walk through some more of the immediate detailed impacts.

[Chris Halmy, Chief Financial Officer]

Thanks JB. Before I get into the details, let me summarize the tax reform impact since it affects several of the numbers. Going forward, we expect our effective tax rate to drop around 11% and land in the 23 to 24% area on an annual basis. We’ll also look for ways to opportunistically reduce ongoing taxes similar to this quarter, where we released some valuation allowance against our DTA.

The tax bill in 4Q resulted in a $119 million charge due to the revaluation of our deferred tax asset as well as some adjustments related to low income housing investments. Since a decent amount of the DTA is disallowed for regulatory capital purposes, that minimized the impact and resulted in an approximately 5 basis point reduction to capital. We don’t expect that to have any impact to our weight of capital distributions for the remainder of the CCAR 2017 cycle, and as you saw, we raised the dividend by a penny in January.

For adjusted tangible book value per share, the DTA revaluation caused a $0.29 reduction. We also had a $0.38 impact related to the amount of OID we deduct from the adjusted tangible book value since we’re now tax effecting the deduction at a lower rate. While earnings would have otherwise driven this metric up quarter over quarter, those adjustments caused it to be down slightly.

Now jumping into the numbers on Slide 11, in general a solid 4Q with everything trending as expected. Net financing revenue was $1.1 billion, up $14 million from last quarter driven by some modest NIM expansion and balance sheet growth. The deposit growth continues to be a primary driver. Other revenue of $379 million was pretty consistent with last quarter. Provision expense of $294 million was down from last quarter due to the hurricane reserve we built in 3Q, but up year-over-year given the portfolio mix normalization that’s been ongoing but is now largely complete.

Non-interest expense of $769 million was up $16 million from last quarter primarily due to severance costs related to a workforce reduction as well as increased marketing costs in the quarter.

Looking at the key metrics for the quarter, GAAP EPS was affected by a $0.27 impact due to the DTA revaluation. Excluding that and the OID expense, we earned $0.70 of adjusted EPS. The $0.70 did benefit from an effective tax rate of around 27% if you adjust for the tax reform impact. We’ve got a [indiscernible] in the appendix showing some of the details on the effective tax rate. Core ROTCE was 10.8%, which is the highest quarter since becoming a public company.

Over the next several slides, we recap the annual trajectory, starting on Slide 12. EPS has been running at a 13% CAGR since 2014 when we did the IPO. While we’ve had a self-help earnings growth story from a combination of deposits and bringing down expensive capital markets funding, we’ve also had some headwinds the last couple years given the business transition on the auto side. Our lease portfolio, which had been very profitable, has been declining significantly in balances and has almost reached the level we expect to maintain. That’s been replaced with a growing full spectrum order loan portfolio. Those have been good, profitable loans but have required a decent increase in annual provision expense. Both of those dynamics are starting to normalize, which should help accelerate earnings growth. That acceleration will now be further supported by a lower tax rate, creating a favorable trajectory going forward.

Total adjusted revenue is on Slide 13. We’ll dive deeper on the following slides, but it’s notable that total annual revenue is up around $850 million or 17% since 2014.

Looking more specifically at net financing revenue on Slide 14, we were up $328 million to around $4.3 billion despite facing a significant headwind with lease net financing revenue coming down $263 million in 2017. Lease revenue will still come down in ’18 but we expect a much lower headwind this year. Going forward, we expect a similar trend of net financing revenue benefiting from a growing and more profitable loan portfolio.

Adjusted other revenue is on Slide 15. It was up around $100 million cumulatively over the last few years and was pretty consistent from ’16 to ’17. We had lower investment gains in ’17 but higher loan sale gains to keep us pretty flat.

Provision expense on Slide 16 shows another part of the business transition story where we were up $231 million last year. As we’ve replaced leases with loans, we’ve built provision because of loan growth and a deliberate shift in the credit mix of those loans. That’s played out well from a net financing revenue perspective as we just looked at, but we built provision to support that growth. That build is now complete as the portfolio is normalizing in size and credit mix versus the last few years.

Looking at expenses on Slide 17, our efficiency ratio has come down from 2014 and been pretty flat over the last few years. Our expenses have moved up as our deposits and lending businesses have grown and we invest in new products and technology. We would expect expenses to move higher as we grow and make investments in those areas, but over time we would expect revenue growth to significantly outpace expense growth, and positive operating leverage is obviously our long-term objective.

Turning to the balance sheet on Slide 18, total assets were up almost $5 billion last year. Overall, the order finance business has been pretty flat with leases being replaced with loans. We had more material growth in the mortgage and securities portfolio which we would expect to continue. Remember, these are low capital intensive assets, which supports our efforts to expand ROTCE. We’ve been pretty vocal for a while about our intention to grow those assets.

On Slide 19, total deposit growth of $14.2 billion for the year was driven by $8.4 billion coming from new customers, $2.9 billion from existing customers supplemented with $2.9 billion of other deposit growth. We benefit from having that large critical mass of existing customers that love banking with Ally and continue to put more money on deposit with us. The $11.3 billion of retail deposit growth in 2017 was a record for us.

Let’s look at some of the quarterly numbers now, starting on Slide 20 with net interest margin. NIM excluding OID was up slightly this quarter to 2.8%, which is 20 basis points higher than 4Q last year. Our asset yields were up one basis point quarter over quarter as higher retail order yields were partially offset by lower lease balances and yields. Cost of funds was flat for the quarter as the benefit of lower balances of unsecured and secured debt offset the impact of rising rates in the deposit book and other borrowings, like FHLB advances. We expect a lot of these same trends to continue over time - higher retail order and commercial assets yields, lower expense in capital markets funding, and higher deposit rates.

Let’s talk more about deposits on Slide 21, another solid quarter of retail deposit growth of $3 billion. We made some pricing moves on our retail portfolio recently and our overall deposit rate is up 20 basis points on a year-over-year basis, which is similar to pure banks. Our retail deposit rate of 1.3% today relative to the start of the tightening cycle in 4Q of ’15 has resulted in a mid-teens beta so far. We’re very focused on remaining disciplined in our deposit rate moves, and as we’ve mentioned previously, we do embed in our forecasts an assumption that deposit rate increases will accelerate with additional rate hikes. Deposit customer growth continues to be a good story for us, and we now have over 1.4 million customers with strong growth, adding another 41,000 this quarter.

Moving to capital on Slide 22, our fully phased in Basel III common equity Tier 1 ratio was up over 30 basis points in ’17 to 9.5% as we generated capital organically and continued to reduce the disallowed DTA. Next quarter, we do expect a five to 10 basis point negative impact to CET-1 related to accounting pronouncements that are coming into effect, primarily related to revenue recognition in the insurance business. Even though risk-weighted asset balances were flat from the prior year, we added nearly $5 billion of earning assets which were primarily capital efficient investment securities and mortgages. From a capital allocation perspective, we leaned into buybacks and repurchased another 1.5% of shares outstanding this quarter.

Let’s turn to asset quality on Slide 23. Consolidated charge-offs of 101 basis points were up 13 basis points year over year. Provision expense was $294 million. The increase year-over-year was from higher retail order charge-offs and a release in mortgage last year. The retail auto coverage rate came down a few basis points to 1.57% as we reserved for hurricane-related losses in 3Q. Retail auto charge-offs came in at 1.74% this quarter, up 18 basis points year over year as we’ve had an ongoing credit mix shift in the portfolio that’s largely been completed at this point. Based on current trends, we expect to remain in the 1.4 to 1.6% annual range on retail auto charge-offs similar to 2017.

On Slide 24, auto finance reported pre-tax income of $285 million. Net financing revenue was up $32 million year over year driven by retail auto balances up $2.3 billion and supplemented by higher yields, which offset the expected lease portfolio decline. Provision expense was down quarter over quarter given the hurricane allowance we recorded in 3Q. We originally booked $48 million for the hurricanes and have now adjusted that down to $40 million based on the latest performance data.

Looking at the bottom left, we show the breakout of our annual originations by FICO as well as our estimated yields. While FICO certainly isn’t the only risk metric that matters, in general we haven’t been taking more risk in the retail auto portfolio but we’ve seen higher yields come through, which continues to set up a positive dynamic within the auto portfolio.

On Slide 25, originations were $9.1 billion this quarter, up 11% from last year. We feel good about our origination levels and are putting on a diversified mix across the credit spectrum with new and used loans at higher expected risk-adjusted returns. Consumer balances have been pretty flat as retail growth is offsetting lease decline. We broke out the commercial auto assets in the bottom right. Floor plan balances were down $2 billion from last year as manufacturers rationalized inventory levels in the second half of 2017, which is a healthy sign for the industry.

On Slide 26, insurance reported pre-tax income of $80 million, up $11 million. The higher rates on our retail inventory insurance product continues to support higher earned premiums. Written premiums were $265 million for the quarter, up 12% from the prior year as we benefited from both increased volume and higher rates. Losses were down from seasonally lower weather events in 4Q. As a reminder, $30 million of weather loss coverage above our $12 million attachment point remains from 1Q18, so we still have coverage for the unpredictable early spring season. We’re currently in conversations with the reinsurers about extending that coverage for another year.

On Slide 27, our corporate finance business earned pre-tax income of $32 million, up $10 million from the prior quarter. Strong portfolio growth is driving higher net financing revenue versus the prior year and quarter. Asset levels are up 23% year over year from growth in existing segments combined with the addition of specialized lending verticals in healthcare, real estate and technology over the last year. Provision expense was up primarily due to growth of the loan book. We feel good about the performance of the portfolio as well as the healthy diversification across industries and clients.

On Slide 28, our mortgage finance business earned $2 million of pre-tax income, which was flat from last quarter. Provision was down from the hurricane-related reserve we built in 3Q. Non-interest expense was up a few million dollars from last quarter primarily driven by additional marketing expense, and up from the prior year as we invest in the build-out of Ally Home, our direct-to-consumer product offering. Total asset balances were up almost $2 billion from last quarter and up over 40% from the prior year.

We executed $2.2 billion of prime jumbo bulk purchases in the quarter. Asset balance growth from bulk purchases and gradual contribution from our direct-to-consumer offering should drive higher contribution from this segment over time, so overall we had a great quarter.

With that, I’ll turn it back to JB to wrap up.

[Jeff Brown, Chief Executive Officer]

All right, great. Thanks Chris. Wrapping up briefly on Slide No. 29, 2017 was a strong year of operational and financial execution. We’re focused on accelerating the momentum in 2018. Our deposit growth and expanding risk-adjusted yields in auto support continued earnings growth combined with incremental benefit from tax reform. There have been a lot of discussions on the auto cycle over the past few years, and our business had undergone a dramatic transformation by design. That transition is now largely complete and we feel incredibly well positioned to navigate the cycles. Strategically, we’re focused on investing in the brand, building scale in the products we’ve introduced, and doing more for our customers.

Now before we move into Q&A, since this is his last earnings call, I do want to take a quick moment and express my gratitude to Chris on behalf of the management team, the entire associate base, and our board of directors. As you’re aware, on March 1 Jenn LaClair will take over officially as the CFO and Chris is going to remain with the company until around June in an advisory capacity to help on transition.

Chris has been at Ally for nearly nine years. He was actually the second hire I made after I got here, and during that time, Ally has really undergone one of the most significant restructurings in corporate history. A large part of that restructuring was obviously liability and capital related, and Chris was really at the center of that process. Funding the company, redoing the capital stack, paying back TARP, building out a world-class finance team inside of a bank - the list goes really on and on. So Chris, I just wanted to publicly thank you for everything you’ve done, for being such a close partner to me, and just being a terrific leader overall and culture-carrier for ally. We just wish you the very, very best.

Today we’re also welcoming Jenn LaClair on the call. Jenn, not to put you on the spot, but anything you’d like to add?

[Jenn LaClair, Chief Financial Officer designate]

Sure, thanks JB. I’m very glad to be here at an exciting time for the company. I look forward to meeting many of you on the line today at conferences or on the road later this year.

[Jeff Brown, Chief Executive Officer]

Terrific. Welcome, Jenn. Michael, I’ll turn it back to you and we can take on Q&A.

[Michael Brown, Executive Director, Investor Relations]

Thanks JB. As we do move into Q&A, we request that you please limit yourself to one question plus a single follow-up. If you have additional follow-up questions after the Q&A session, the IR team will be available after the call.

Operator, if you could please start the Q&A.

[Operator]

[Operator instructions]

Our first question comes from Moshe Orenbuch from Credit Suisse. Your line is open.

[Moshe Orenbuch, Credit Suisse]

Great. I’d add my congratulations to Chris as well, and welcome to Jenn. On the issues of deposit growth and pricing, you guys have had extraordinary growth and you’re still in the middle of transitioning from the secured and unsecured debt to that, but is there a level at which you think you could be comfortable with a dollar amount of deposits, and when you were to reach that, are there ways to optimize the overall cost of those deposits? How do you think about that over the next two to three years?

[Jeff Brown, Chief Executive Officer]

Yes, keep in mind we have over $90 billion of deposits but we have $155 billion of earning assets, so we still have a pretty big runway or appetite to continue to want to grow the deposit base, which we’ll continue to do. Moshe, when we get to that point where we don’t need to grow or have a desire to grow at the rate we’re growing today, is there going to be an ability to hold back rates and have much lower betas at that time? I think the answer is yes. We’re obviously seeing a lot of competition in the market for deposits, and we’ve gotten our fair share, or more than our fair share, really, in the direct banking space, and that’s been great for us. But as we look in the future, and that future is probably three or four years away, is there an ability to hold back price and really let a lot of that drop to the bottom line and increase in the overall NIM? I think the answer is yes, which is why we’re building for that today.

[Moshe Orenbuch, Credit Suisse]

Great. I guess I was pleased to hear that you’re keeping the charge-off guidance range relatively stable for 2018. Could you talk a little bit about the interplay of net interest income, and can that continue to have improving asset yields while the charge-off guidance increases, if at all, at a smaller rate? How do we think about that also over a slightly longer term?

[Chris Halmy, Chief Financial Officer]

Yes, I mean, this is really the dynamic of the income statement that we’ve been waiting for as we got through 2017, of our transition year. When you look at the portfolio of retail auto loans, they’re sitting at about a 5.8% yield. We’re currently putting loans on somewhere in that 6.5% type range, so that portfolio will migrate up and therefore help expand the overall net interest income over time.

At the same time, we’re not taking more risk in the overall portfolio, so the big provision build that happened really through 2016 and ’17 should really start to taper off this year, so you’ll get real expansion when it comes to the bottom line, which is something obviously that we’ve been waiting for.

[Moshe Orenbuch, Credit Suisse]

Thanks very much.

[Operator]

Thank you. Our next question comes from Sanjay Sakhrani from KBW. Your line is open.

[Sanjay Sakhrani, KBW]

Thanks. Congrats, Chris, and welcome Jenn as well. Maybe just to touch on that point, Chris, that you mentioned on the 6.5%, when we think about the competitive dynamics in this space, one of your competitors talked about an increase in one or two participants in the market and that was sort of having an impact. Are you guys just not seeing that impact? How stable is that 6.5%?

[Chris Halmy, Chief Financial Officer]

We do think that the competitive market has remained pretty stable. What we saw in the fourth quarter in particular was really a migration up from a credit perspective. This is normally a seasonal thing - in the fourth quarter, you’ll see more new cars sold, more leases, and much less on the used car front, so the credit tends to skew higher. So we had great originations in the quarter, they tended to skew higher credit, and from a competitive aspect we actually some of the manufacturers actually back off some of their subvented dollars particularly in December, so we saw a pretty big spike actually in some of our new car originations, which we think was good.

Now, we sacrificed a little yield for that which we did in the fourth quarter on origination, but we expect that to bounce back as you start getting towards the spring months. So our overall view is that the competitive market remains pretty steady and hasn’t really dramatically shifted over the last, call it six months.

[Sanjay Sakhrani, KBW]

Okay. I guess my follow-up question is on capital, and maybe taking a longer term view in looking at CCIL, given it’s supposed to be implemented early 2020 if you elect that. Is there anything we should consider about your capital actions going forward as we prepare for CCIL, and maybe you can just talk through sort of the impacts?

Then just on an unrelated topic, the outlook call in March, is there something that’s meaningfully going to change between now and then to give us more of an outlook for this year at that point? Thanks.

[Chris Halmy, Chief Financial Officer]

Yes, let me take the second question first. So we obviously have guidance out there in the market, like a 15% CAGR on our EPS in the medium term. We feel very comfortable about that guidance today, and I actually feel better about it because of tax reform. We obviously have guidance out there on things like the charge-off rate for the year, so I don’t expect you to hear anything significantly different or materially different in March, but we think it’s a good opportunity to maybe give a little bit more of the details around the dynamics of the balance sheet and income statement, and give you more of an opportunity to kind of meet Jenn firsthand, so that’s a little bit of the motivation behind that, similar to what we did last year.

Now, on your first question around capital and CCIL, there is a lot of discussion--JB can jump in here because he’s been dealing with this in DC, but there’s been a lot of discussion among the regulators on how to handle CCIL when it comes in. There’s obviously going to be a material impact to capital. I think the hope among the industry is that there is some kind of solution from a regulatory capital perspective.

As we go into CCAR 2018, and we’re still waiting for the scenario which we haven’t received yet, but our current thinking is that we will not really bring CCIL into play and not look to build capital for CCIL, at least as we go through the 2018 cycle. But that’s obviously a risk that we’re going to have to look at in the outer years.

[Jeff Brown, Chief Executive Officer]

Yes Sanjay, I’d just add myself and a number of similar sized banking institution CEOs have visited DC together to address this point. I think it’s on their radar and our point is, you’re going to need some period of capital transition, so obviously that clarity has not been provided yet. I think it is highly unlikely that any bank is going to go through an early adoption period, so you’re probably not going to start really seeing impacts or feeling impacts until 1/1/2010. It’s on the Fed’s radar but it’s too early to give you any sense of clarity of how we’re going to transition to it.

[Sanjay Sakhrani, KBW]

Thank you.

[Jeff Brown, Chief Executive Officer]

Thanks.

[Operator]

Thank you. Our next question comes from Betsy Graseck from Morgan Stanley. Your line is open.

[Jeff Brown, Chief Executive Officer]

Hey Betsy. Betsy, are you on mute?

[Betsy Graseck, Morgan Stanley]

Yes, I am. Hi, good morning - thanks. Okay, so the first question just has to do with the outlook. You were talking about how the EPS growth rate should be higher. Part of it is coming from tax, but could you give us a sense as to how you think the EPS growth rate could traject over the next couple years if you exclude the tax, because I think we can calculate the tax piece pretty simply.

[Chris Halmy, Chief Financial Officer]

Yes, we’ve had guidance out there, and in our guidance, what we call medium term, which is really we’re thinking three to four years, starting back at the end of ’16, we thought a 15% CAGR was pretty reasonable for the institution. We obviously went up 11% in 2017, so we would expect to be, as we look out over the next two to three years, above the 15% growth rate, slightly.

[Betsy Graseck, Morgan Stanley]

Right, okay. Got it. Then obviously the tax gives you a nice boost on top of that, and I see on your slide everything you’re anticipating, it’s going to benefit the company, but maybe give us a sense as to how much you think you immediately drop to the bottom line versus reinvest to gain share, not only in auto but in the other pieces of your business that you’re building out. I would think there’s an opportunity for potentially some more aggressive organic growth, or even inorganic growth given the tax benefit.

[Chris Halmy, Chief Financial Officer]

Yes, it’s a bit early to tell what will happen in the competitive environment, so that’s something we obviously have to watch. We’ve had some investments, I would say, in new businesses, in things like technology, a lot of our customer-facing interfaces, and we’ve had a lot of that really built into the plan as we went through ’17 and even into ’18. So as we got the tax reform and we evaluate what’s falling to the bottom line, we honestly have a pretty full plate of what I would consider incremental investments in the company over the next couple years, so we don’t really look at tax reform as an incremental opportunity to necessarily spend more from an investment perspective, at least yet. I mean, there could be opportunities as we move forward.

I think the other thing that you mentioned, which is how do you look at the businesses, we think about some of this, or a majority of this falling to the bottom line. That creates incremental capital, then you get to really your capital allocation framework of how should you invest that capital - should we grow some of the businesses? As you know, we’ve been keeping auto pretty flat - should you grow auto if you see the right opportunity? Should we accelerate things like our bulk purchases in mortgage, should we accelerate some of the growth in corporate finance? So I think that’s all part of what I would consider our capital allocation framework, and I think to the extent that we see opportunities to grow businesses at the right return on equity, I think we’ll look to do that. Otherwise, we’ll distribute that capital back to shareholders.

[Betsy Graseck, Morgan Stanley]

Okay, what about on the--I know it’s been rebranded from Trade King, but the business line of investing in the--you know, direct investments for your clients, I’m wondering if there’s an opportunity there? We saw a competition lean out of that recently, and I was wondering if you’re seeing opportunities to lean in.

[Chris Halmy, Chief Financial Officer]

Yes, we really like that business, and we’ve actually been spending a lot on technology, and I think this year as you get kind of mid-year, you’re going to see some new interfaces coming out , some new front-facing customer apps and websites, and we’re pretty excited about that business.

You know, that business is a lot about volatility as well, and the market has not been very volatile in 2017; but we expect that volatility to pick up in ’18 and we think that’s a great opportunity to kind of grow the customer base and really grow the earnings of that business.

[Jeff Brown, Chief Executive Officer]

Yes Betsy, the only thing I’d add there, obviously to date it’s largely been getting the business up and integrated, obviously regulations are a little different from FINRA into FRED and UDFI state-regulated institutions, so part of that has been getting compliance integrated, audit standards integrated, all that, getting the technology there - I think we’re close on the technology. But this is a business we like for the future. I think the legacy Trade King was largely positioned more as a trading shop, and I think we see that will continue in the near term but there’s broader play in building out a wealth management business, particularly with the client base we’ve established at Ally Bank. So that’s an area we do expect to grow and contribute meaningfully to the bottom line going forward, but I think to Chris’ point as it ties into taxes, a lot of that was already contemplated into the plan. So could you see a small tweak here or there? Possibly, but I think we’ve got a lot of that already planned in the radar for this year.

[Betsy Graseck, Morgan Stanley]

Okay, well it gives you more flexibility for sure, and to me that’s really helpful color. Chris, thanks so much - it’s been a pleasure working with you.

[Chris Halmy, Chief Financial Officer]

Thanks Betsy.

[Operator]

Thank you. Our next question comes from Geoffrey Elliott from Autonomous Research. Your line is open.

[Geoffrey Elliott, Autonomous Research]

Hello, good morning. Thanks for taking the question. I guess looking at the competitive environment post-tax reform, I know it’s early days, but indirect auto feels like it should be an area where it’s easy for a competitor to see after-tax returns have mechanically gone up because of the lower tax rate and then increase originations, cut lending rates, expand the credit box, somehow respond to that. Does that sound like a fair assessment of indirect auto as a business, and then have you seen any evidence at all of that yet, given that it’s still early days?

[Chris Halmy, Chief Financial Officer]

We haven’t seen any evidence of what I would call increased competition or new players or a dropping of rates. I mean, keep in mind also that given the dynamic in the industry, where the Fed fund rates continue to go up and there’s pressure to actually raise rates in the business given where the economy is, we don’t see many people in there really trying to drop rates. If anything, we’re trying to see people push rates higher in the industry, which we think is good for everyone.

Given where we are just from a cycle perspective, obviously you have to think through credit, so putting anything on your books is going to last for the next two, three, four years, and you really need to understand the credit of the industry in order to go and do that. So do I expect there’d potentially be some increased competition at the very high end where credit is very low and yields are low? Sure. You can get what I would call those fringe players in the commoditized product up in the very super prime space, and that may indeed happen; but we don’t really play in that space in a very big way. We’re much more of a full spectrum lender based on the relationships that we have in the dealer because we understand credit, so we don’t necessarily see it really driving our originations down in any big way.

[Geoffrey Elliott, Autonomous Research]

Got it. Then just to quickly follow up on the net financing revenue, I think you said you kind of expected the trend of growth to continue. Last year, you grew that line 8%. Is that the sort of growth rate that you’re pointing to when you say the trend continues, or is it something different given deposit competition obviously is going to be higher in ’18 than it was in ’17?

[Chris Halmy, Chief Financial Officer]

You know, give or take, meaning we expect--I don’t want to just point to 8%, but it’s probably somewhere in that area, maybe slightly less this year. But we do expect net interest income to continue to really move forward and move up, so as you’re putting your models together and your plan, we are expecting really an expanded net interest income line item in a similar range to this year.

[Geoffrey Elliott, Autonomous Research]

Great, thanks very much.

[Operator]

Thank you. Our next question comes from Rick Shane from JP Morgan. Your line is open.

[Rick Shane, JP Morgan]

Thanks for taking my questions this morning. Chris, congratulations - it’s really been a pleasure working with you over the years; and Jenn, welcome.

I’d like to talk a little bit about the origination mix. We’ve seen a pretty steady shift towards used and actually saw a little bit of a pick-up in leased this quarter. Tactically, you guys had been reducing leased exposure in part because of concerns about residual values. Are you increasingly comfortable with where residuals are headed, given the greater concentration in both used and leased, where I think you take a little bit more residual risk?

[Chris Halmy, Chief Financial Officer]

The answer is yes. I mean, we really--first of all, we like lease and we’ve always like lease, although obviously it’s come down pretty significantly due to some of the actions of the manufacturers, but we really believe that we’re experts in understanding used car values over time. I know there’s been a lot of fear in the market over the last couple years, but as you’ve seen, our lease portfolio has performed extremely well and we’ve honestly made a lot of money out of it. So are we comfortable with our prediction on used car values? Sure. Is it volatile, does it have volatile aspects of it going forward? Yes, that happens, but our expectation is that we’ll be able to manage that through how we really set the residuals, so we feel good about it.

Now, you saw lease pop up a little bit in the fourth quarter. A lot of that really has to do with just OEM behavior. Like I said, fourth quarter tends to be higher credit quality and leases as you get into kind of the holiday months, so we saw a bit of a pop in lease and we think that’s been a good thing. Some of that will reverse as you go through the first quarter into the second quarter - you’ll see our used volume really pick up, you’ll probably see the new car mix come down a bit, but yes, we feel very good about it.

[Jeff Brown, Chief Executive Officer]

Rick, probably the other dynamic there just to be mindful of, as Chris pointed out in his prepared remarks, is just what’s going on in dealer floor plan balances and how inventory levels have been dramatically rationalized. I mean, we were--and some of the manufacturers in excess of the 100 days midpoint of this year, they’re down into the low 60s right now, so that enables manufacturers to be directing a little less with subvented dollars, things like that, and I think that positions us very well.

[Rick Shane, JP Morgan]

Got it, okay. Just to follow up, if you were to cite one factor that gives you comfort about stability and visibility in terms of used car prices over the next year or two, what would it be?

[Chris Halmy, Chief Financial Officer]

Well first of all, we expect used car values to continue to come down in that 5% area, but we have a lot of visibility into used car values, particularly given our smart auction platform. Remember, we run the biggest auction platform in the country, so we really understand the value of cars when they’re coming off, so we have real expertise and that expertise internally gives us that comfort.

[Jeff Brown, Chief Executive Officer]

Yes, and from a macro perspective, I think we probably sound like a broken record but employment still matters, and obviously as you continue to see strength in employment and those getting close to historically low unemployment rates, that bodes very well for the used vehicle market.

[Rick Shane, JP Morgan]

Got it, okay. Chris, I’m going to miss these conversations. Thank you, guys.

[Chris Halmy, Chief Financial Officer]

Thanks.

[Jeff Brown, Chief Executive Officer]

Thanks Rick.

[Operator]

Thank you. Our next question comes from Donald Fandetti from Wells Fargo. Your line is open.

[Donald Fandetti, Wells Fargo]

Hey, how’s it going? Chris and Jenn, obviously congratulations. My question is around the subprime auto market. Can you talk a little bit about what you’re seeing competitively and also on credit, and just generally what you think about that segment of the market?

[Chris Halmy, Chief Financial Officer]

You know, I always want to caveat this - where we play in subprime tends to be the top end of the subprime, but we’re seeing the competition being pretty rational right now. There’s obviously a couple of big players, but we’re seeing it pretty rational. The securitization markets continue to be open and be pretty hot these days, so there’s no concern about getting liquidity, so there are what I would call finance company players that continue to do pretty good business in there.

I think, though, the peak of competition was really when you went back to 2015, and I think things have rationalized a bit over the last couple of years, so the market seems to be a much better place today than it has been in the past, and I think that has something to do with just the overall competitive environment and really some people getting stung by the 2015 vintage. So there’s been a little bit of a pullback there, but overall when we look at where the economy is, and JB just mentioned unemployment, but just the overall macro economy has really been pretty conducive to collections and a pretty steady charge-off rate.

So we feel pretty constructive about credit going forward, and that’s even enhanced with the tax bill. You know, $100 in people’s paychecks, which should start coming in February, is pretty meaningful when it comes to that segment of the market, so we’re constructive on credit and we’re constructive overall on the subprime market.

[Jeff Brown, Chief Executive Officer]

Yes Don, I’d agree completely with everything Chris said. I mean, 2015 clearly wasn’t a very clean vintage in hindsight, but it’s worked its way--the vast majority of that has kind of worked its way through already. 2016 - slightly cleaner, still working through . I’d say across 2017, it’s still very early, but if anything it maybe feels like a small over-correction across the industry - everyone got a little too tight on credit. So you know, I think as Chris pointed out, we feel pretty good about it, particularly with our book which is on the upper end of the subprime, but trends we’re seeing right now feel very clean. That’s part of the reason why Chris put out the guidance of that 1.4 to 1.6 annual charge-off range continuing into the future. We feel really good about the quality of the book today.

[Donald Fandetti, Wells Fargo]

Thank you.

[Operator]

Thank you. Our next question comes from Arren Cyganovich from Citi. Your line is open.

[Arren Cyganovich, Citigroup]

Thanks. You mentioned that the subvented from the OEMs got pulled back a little bit in the fourth quarter. Are you seeing that trend into the first quarter? Then the second part of question is as I think of rates rising, I would think of more subvented rate action versus cash on the hood. How do you view that over the next year or two as the rates continue to rise?

[Chris Halmy, Chief Financial Officer]

Yes, we’ve seen the subvention come back in the first quarter, so that seemed to be just an end of the year phenomenon. Having said that, we feel pretty good about our originations already in the first quarter. Originations are strong, so that’s continuing pretty well as we sit here at the end of January.

Now moving forward, our belief has always been as rates rise, subvented dollars become more expensive for the manufacturers. Now, does it become more attractive to consumers? Sure, it does. Having a zero percent rate when the rates are higher obviously means more, but that also means a higher expense for the manufacturer. So we actually think that banks like us, with a lower cost of capital, have a bigger competitive advantage at those times because putting some cash on the hood and allowing banks to compete at that time could allow the manufacturers to rationalize some of their overall expenses.

[Arren Cyganovich, Citigroup]

That’s helpful, thank you.

[Operator]

Thank you. Our next question comes from Chris Donat from Sandler O’Neill. Your line is open.

[Chris Donat, Sandler O’Neill]

Good morning, it’s Chris Donat. Thanks for taking my questions, and Chris, wanted to add my congratulations for moving on, and Jenn, welcome. One question - just as we think about how the competitive environment evolves, and I know you’re waiting to see how it evolves, but as we think about loan pricing, deposit pricing, terms, credit quality maybe moving down the spectrum, where do you think the greatest risk of seeing higher competition from competitors taking advantage of the lower tax rates could appear?

[Chris Halmy, Chief Financial Officer]

You know, I think we’re seeing the biggest competitive pressure on the deposit side. There’s a lot of appetite overall for direct deposits today, so the competitive space is a bit crowded, so if you have an appetite to grow like Ally does, you’re seeing some competitive pressures really on the deposit side, I’d say, more than on the asset side currently.

[Chris Donat, Sandler O’Neill]

Okay. Then Chris, we’ll take advantage of your historical perspective while we’ve still got you. Thinking about 2015 and the vintages then, that was kind of an interesting time because we had the benefit of lower gasoline prices, which should have been good for consumers. It seems like we might in somewhat of an analogous situation here with the tax reform giving people more take-home pay. Anyway, do you think that there is a fair comparison to be made between some of what happened in 2015 with low gas prices and the current environment we’re in?

[Chris Halmy, Chief Financial Officer]

Yes, from the standpoint that the consumer will have more money in their pocket. When we think about gas prices, what we get concerned about really is shocks in gas prices, as opposed to, I would say, gradual changes one way or the other. We haven’t seen much change, I think in the credit environment, because of changes in gas prices, so overall I would say that the tax cut will probably have a bigger impact in a positive credit environment moving forward than any change really in gas prices over the last couple years.

[Jeff Brown, Chief Executive Officer]

Yes, I’d just add also in consumer psyche. You start seeing your paychecks being higher, whatever it is - $100, $200 a month, that does have some impact.

[Chris Halmy, Chief Financial Officer]

And I’ll give you another view, which is you would normally think that trucks, SUVs would be less attractive as gas prices moved higher, but they’re not. I mean, that’s where we’re seeing the biggest demand, is still in trucks and SUVs today.

[Operator]

Thank you, and that does conclude our question and answer session for today’s conference. I would now like to turn the conference back over to Michael Brown for any closing remarks.

[Michael Brown, Executive Director, Investor Relations]

Great, thanks Operator. If you do have additional questions, please feel free to reach out to Investor Relations. Thanks for joining us this morning. Thanks Operator.

[Operator]

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a wonderful day.