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Podcast #84: Sleepwell and Enlightened are allied in the $ALLY bull case
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Transcript begins below
Andrew Walker: All right. Hello and welcome to Yet Another Value Podcast. I'm your host Andrew Walker and with me today I'm excited to have two guests. We’ve got Sleepwell Capital who we’ll be calling Sleep and then we got Enlightened Capital who we’ll be calling Enlightened and they're gonna stay anonymous but that’s okay ‘cause I really respect them both. Sleep, Enlightened, how’s it going?
Enlightened Capital: Good.
Sleepwell Capital: Andrew, thanks for having us.
Enlightened: Yeah. Thanks for having us.
Andrew: Great. Hey, thanks for coming on. Let me start this podcast the way I do every podcast. First, a quick disclaimer to remind everyone who’s listening that nothing on this podcast is investing advice. Then second, a pitch for the two of you, my guests. It’s a little different having two guests on instead of one at the same time but, both of you run some of my favorite blogs, you do great fundamental work on companies. Obviously, Sleep is the master of the music industry. I've learned so much from you but, I've been long time follower of both of your blogs. I love them both. It required reading for me so, really excited to figure out a way to have you both on the pod. That out of the way, let’s turn to the company we’re gonna talk about. The company’s Ally Financial. The ticker is A-L-L-Y, Ally. Sleep, Enlightened, whoever anyone sort, what is Ally? Why are we so excited about it today?
Sleep: Yeah. So I can kick it off. I think it’s important to understand that the history of this company as well in the context of kind of where it came from and where we think it’s going. So, Ally Financial is the largest online bank in the U.S. It has a hundred thirty billion dollar in deposits but probably it’s historically more known for its auto lending business. It actually rebranded around 10 years ago. It used to be the GMAC business. So it was the GM auto lending business.
Sleep: We know what happened to General Motors in the financial crisis so, basically, what took place during that time, given the distress in the auto industry and the OEMs was that the captive financing arms kind of got separated from the parent companies. In the case of GMAC, it turn into a bank holding company in large part so they could receive part funds.
At the same time, something that kind of got them into big trouble was that they sort of diversified "away" from auto lending and started getting big into mortgage lending. I think they were actually one of the biggest mortgage lenders back in 2000s. So, ResCap which was part of GMAC was really what bled the most money during that time in this part of the business. So, it received multiple part injections and after a couple of years of trying to solve their legacy business, they were able to finally sort of lay off that mortgage portfolio through a bankruptcy and a couple of settlements, and finally they also did a rebranding and turn into Ally Bank because they also receive the Chrysler loan book and in 2015 in IPO.
During this time, as they went through the rebranding, they also established an online bank that has grown an incredible rate I would say the past 5 to 10 years have been around 20% CAGR in deposit growth. They have been focusing on this newer part of the business for the past 5 years. Enlightened, I don’t know if you wanna add some to that.
Enlightened: Sure. Yeah. No, that was a good overview but yeah, really, over the last 10 years are really grown, their online bank, they're now the largest online only bank in the U.S. So they don’t have a branch network. Much as really interesting aspect to the company, leading to a lower cost structure, and they're also, Sleep mentioned one of the largest auto lenders in the country as well. So those are a couple unique aspects. The IPO the government-owned, a good portion of the company which has since been repaid. Yeah. That’s kind of a nice overview of the company.
Andrew: Perfect. I'm gonna dive into a bunch of different parts of that in a second but Enlightened, why don’t you start ‘cause I believe you had a post on your blog recently about Ally if I'm remembering correctly. It’s tough because we’re in COVID and I can't remember who wrote what. Why don’t you just start? You’ve laid out the basics to what the company is but you're both attracts the company ‘cause you think it’s undervalued, you think you can make a lot of money on this thing. So, why don’t you just lay out this simple kind of why is this undervalued both case here?
Enlightened: Sure. Definitely. So, a couple of key aspects. One, the company substantially brought down its funding cost over time. Now, the company IPOd, they were still in the process of building their online bank. So most of their funding was really secured, unsecured debt. Whenever the past, since they IPOd, they brought that down to about 10% and now 90% of their funding is deposit on them. So they’ve really reduced other cost of fund over time. Now, down about 1% and then as high as, I think 5% or so, they made that [inaudible] an end, really brought down their cost of funding. As a result, they’ve seem pretty strong improvement of margin, their net interest margin over time.
Actually, this year, they're up about a hundred basis points over last year. So they're on the 35, 36 area, their net interest margin. That compares to other largest banks or high ones area, low too’s, so they have significant margin differential between them and other large U.S. banks, money-centered banks, large regionals. They also lower cost structure as a results of being online only. They have a much lower frequency ratio, which allows them to then pay a higher rate on deposits. So, one of the key reasons they’ve been able to grow their deposits at such a high rate. Over time is that they're paying much higher deposit rates than a Bank of America, JP Morgan, or Wells. Typically about 50 basis points higher and really all that cost savings as a result of having no bank branches. So it attracted a ton of deposits.
It’s also driven by the overall model that are customer service. They continually won awards being the top online bank over the past 5 plus years. But as a result, it’s really, really strong deposit growth which has then lead into the lower funding cost. So that’s one of the key drivers here, one of the key advantages for the company. The stronger margins, lower cost structure, stronger growth there. Then another interesting aspect of really the last few years, the company has started diversifying a way a little bit from auto in terms the asset side of the balance sheet. So, their auto business, including loans and insurances, still got 90% of that remains but over time, you see that declining. They’ve added a number of capabilities, they’ve got mortgages again, and this time it’s not subprime, this time it’s much higher quality mortgages. Their FICO score is 780 in the mortgage book.
They’ve added personal loans. They’ve added corporate loan lending. Just recently their quarter earnings, they announced the acquisition of a credit card company, Fair Square Financials. That really rounds out their product offering for consumer. So now you can get checking savings account, credit card, personal loan, mortgage, you can also trade and invest through Ally as well. So a lot of those additional product offerings have been added through acquisitions in the last 3 to 5 years.
Andrew: Perfect. That’s great. You know what I love? I love that I said lay out the bull case for me, and you didn’t mention valuation once. You just talked about their advantage for deposits and everything. So, I’ll mention valuation for you. The stock trades at one point two times, one point one times book, somewhere around there. The way I've always looked at banks is, all right. If you're a normal bank with no competitive advantage or anything. You probably deserve to trade for about book. You’ll probably make about your return on capital probably around 8% ROE, I don’t know. So you trade around book. So at one point two times book, you would think this is a company that’s earning a little bit above their cost of capital and I'm just looking at the slides. This is a company that right now their return on equity is over 20%. Probably comes down a little bit over the long term, but they’ve consistently done mid 10s, high 10s, 20% ROE. If that’s the case, this is a company that you trade for. Even I could argue two times book, 3 times book, and then depend a little bit on. Is it 15 or 20%? How big is the growth prospect, right? So that’s the valuation case.
I wanna dive into some of the things you said there. Right? Because ROE is gonna be a function of two things. How cheap your deposits are, which lowers your interest cost, and how good your loan book is, which increases your earns [?]. Sleep, I guess, Enlightened started but on the deposit side. Deposits are commodity to me and he mentioned they pay less for the deposit because it’s an online model. I kind of looked at it as, okay, I get that but the traditional banks, the Wells Fargo and JP Morgan, they’ve got the lowest cost of deposits because they're around every corner and people go put their deposits done. Ally is online. I don’t understand why they can pay higher rates in the banks but lower than all the other online players ‘cause there's tons of online players. SoFi, everyone’s trying to get there. Why can Ally sustainably pay more than JP Morgan but less than all the other guys and that’s kind of where their edge is. Does that make sense?
Sleep: Yeah. Well, I think when it comes to deposits, rate is definitely a very important aspect of deciding who you're going to bank with but it’s not necessarily the only one and one thing that Ally has done really well is building a customer experience that’s very seamless, easy to use, low fee. So they’ve never had, for example, ATM fees. They took away overdraft fees. If you wanna talk to a person on the phone, it will probably take you 3 minutes to wait for the representative to answer. I think they’ve built a product that has tailored to millennials really well. The majority of their customers are millennials and these kinds of customers really appreciate kind of having that online experience that they're looking for. So even if Ally is not really being that kind of top payer. Looking at their retention numbers at 96% on an annual basis compared to industry average of around 85% really speaks to kind of the customer engagement and just these people are happy banking with Ally because they're really helping them out with all of their financial needs. So I don’t...
Andrew: Can I?
Sleep: Yeah, go ahead.
Andrew: Yeah. I just wanna drill on that ‘cause as a stupid generalist, who started looking at Ally a day and a half ago and actually it’s pretty interesting and everything you seen. Everything you just said makes sense for the stickiness, right? Sleep makes a deposit there, he loves it, great customer service. Then Andrew comes along, he says, “Hey, Sleep. Ally is paying you 1%, why don’t you switch over to me and I’ll pay you one point one percent. ” You say, “No. I love it at Ally.” But for attracting new money ‘cause Ally has attracted a lot of new money. It seems like if Enlightened is looking for a new place to park money, my one point one percent offer versus your 1% offer, he doesn’t really know how great the customer services there. This is the old hot money deposit thing, right? There's lots of banks who would grow on hot deposits but then somebody come along and beat him by 10 points so they lost them all. So, how has Ally been growing while offering less than kind of other online players?
Sleep: Well, I think part of it is word of mouth and they’ve also been really effective on their marketing campaigns. It’s interesting because I was actually listening to a podcast of their chief marketing officer and I mean, I would’ve never thought I’d end up kind of doing research on the marketing department of a bank but, it turns out this is a very big part of this company and kind of the culture. They’ve done all these different initiatives that have really helped the awareness of the brand across this part of the millennial market that seems to have been working really well. I mean, if we go back 10 years, you can see the deposit growth has been pretty consistent as we’re talking about it. It’s been close to 20% since then. I think what they're doing is working and through that combination of their effective marketing campaigns and kind of the word of mouth and happy customers that love banking with them, I think it has helped them to maintain that growth. I don’t know. If you have anything to add there, Enlightened.
Enlightened: Yeah. No. I think that’s all spot on. They continually win awards the best online bank. At this point, they’re established and they're known for all their capabilities and I think additionally with all the additional products that they're starting to offer that they’ve been offering the last few years. I think that helps achieve stickier customer relationships and also helps attract new customers especially now at the credit card offering as well. I think all of that kind of works together.
Andrew: Perfect. I should just note. I'm such a bad podcaster but I'm just gonna reinforce the listeners. Sleep and Enlightened both write blogs. They’ll be linked to the blogs in the show notes. You guys should definitely check them out, subscribe. I’ll include Enlightened’s, I think it was February as I was looking up his write-up on Ally. So I’ll include that. Everyone go check that out. I feel like a bad podcaster for not hammering that home. But, let’s continue and ignore my oversight.
Enlightened, so the second part. I think we did a credible job just now talking about how they attract they deposits, how their stickiness there. Let’s turn to the other side. So you’ve got deposits, you’ve got a low cost of funding, thanks that. You’ve got to make money on the lumps, right? They do have strategic relationships with GM and Chrysler which are really beneficial and we’ll probably talk more about the strategic relationships but, I would struck by quote which I included in my notes when I was preparing for this and they said. It was a quote around, “Hey, we have a very high strategic most around our business because you need very sophisticated underwriting and service capabilities.” That struck me because, again, when I look at banking and lending, I think it’s the ultimate commodity play. Borrowing a dollar from you versus me, depositing, it’s kind of the same you go with whoever gives you the best rate. Right?
Here, auto lending. I get, you and I probably can't lend autos but it seems like there's a thousand people who can lending in auto is pretty well. There was also been great. Why do they have a strategic moat around lending? What data advantage do they really have against a JP Morgan lending or any of the other hundred thousand people who can give an auto loan?
Enlightened: Yeah. That’s a good question. I think there's a couple of things that differentiate them. I think one is the fact that they're viewing their dealerships as their customer really. So their work is to service the dealership. So it’s not only lending money to consumer but it’s also dealership or plan loans. So not every auto lender is gonna offer loans to the dealers themselves.
Andrew: Can you just describe what a dealership or plan loan is for the listeners?
Enlightened: Sure. So the dealerships need substantial inventory to attract customers. So Ally is lending money to the dealerships to help them maintain substantial amount of inventory, which has actually been a real headwind over the last 12, 18 months due to COVID. Inventory is way down.
Andrew: There's no inventories [inaudible].
Enlightened: Right. There's no inventory. There’s [inaudible] or the commercial loans are down almost 50% the last year but nevertheless, that is a key capability that they have that many of their peers don’t.
Another key differentiator which people I think don’t realize when they think about Ally is Ally actually is a big insurance business. It’s not auto insurance like a progressive or all-state but its warranty insurance is a big one. Insurance for the consumer but also insurance for dealerships to ensure their inventory as well as just sort of general property casualty insurance. So, they’ve really sticky relationships with these dealerships because they can bundle all these products and something like 80% of their dealerships also have insurance as well as the auto lending.
Andrew: Can I just zoom in a little harder because you did a great job explaining but I wanna make, the one part I think that was missing was, what is the moat around that, right? They’ve got the relationships and everything for sure but again, on dealer floor plan, it doesn’t seem like it should be that hard. Like. you're lending against, I'm gonna pick a number up. A hundred cars and if I lend to a hundred cars to Enlightened and I lend a hundred cars to Sleepwell. They're all coming from the same GM, it’s auto dealerships. It just doesn’t seem like it should be that hard to break into the industry. So is there any real strategic moat them or is it similar to a lot of small businesses where the relationship is you’ve got to go knock on some doors and it takes a long time to just place that?
Enlightened: So the second part is definitely a big part of it. They have about 20,000 dealership relationships. Some of these or many of these are really mom-and-pop small dealers that don’t have large networks.
Sleep: They're the biggest too, right?
Enlightened: Right. They are the biggest. So that is a big advantage. Just the scale the number of products they can offer, and then the insurance side too is something that a lot of their peers are knocking off.
Andrew: They got...
Sleep: I would say, Andrew.
Andrew: Go ahead, Sleep.
Sleep: Also, on the auto lending is, it may not be that intuitive but it’s not the same as lending to a house where you're basically when it comes to pricing and the value of that house you're just looking at comparables, right? The pricing on auto is not as transparent ‘cause also remember they have a big used car lending business.
Because they’re such a big national player. They have a ton of data that they’ve for the past 200 years actually, because they’ve been around for so long. To kind of track the performance of all these different loans for all these different models. If you think there's probably thousands of different car models out there, different vintages, etcetera. They can probably price a lot more appropriately than someone who’s just coming in and started lending out without having access to this data, independent track record that they have.
I think also what they’ve shown is they’ve been very flexible in terms of where they’re playing depending on where the market is. So for example, the used market right now is super strong so they’ve shifted a lot of their underwriting capabilities to that part of the market. Five years ago, they used to lend more on the super-prime but then kind of the actual near prime or just above prime. It became more attractive because there was less competition and they started migrating the book towards that. So, they’ve shown that they can adapt pretty quickly to these market changes and their loan book actually turns around pretty quickly in around 3 or 4 years.
Andrew: That’s fantastic. Let me, just one more thing on the loan. So they’ve got their strategic relationship with GM and Chrysler. I believe the Chrysler relationship might be going away at some point. I think Chrysler’s taken the first steps to kind of having their own internal capabilities but, what is the strategic relationship with GM mean? If you are a GM dealer, could you work with someone other than Ally, or you kind of forced to work with Ally if you want floor plan, financing, insurance, all that type of stuff? I...
Sleep: Yeah. So...
Andrew: Let’s not all talk at once. Sleep will talk a quiet. No, no, no.
Sleep: I can take it. Actually, just to be clear. The GM relationship used to be exclusive but that agreement basically terminated a number of years ago actually. So, one thing that I think they’ve been able to show and it speaks through their track record is that they were able to diversify a way from those lost volumes. PMU growth initiatives and kind of new dealerships. So they still lend a big part to GM automobiles but it’s not exclusive anymore.
Andrew: So it’s just like a strategic partnership now ‘cause I know they highlight the partnership. It’s just kinda...
Sleep: Well, yeah. They still have their relationship with a lot of these dealers but they're just not the exclusive financing arm to these dealers anymore. These dealers can end up choosing someone else. In many cases it’s GM themselves that end up taking the loan. But the other thing that I’ll say is that they’re not necessarily competing in the same parts of the market and FICO scores that some of these captives focus on.
Historically, the captives have been very focused on leasing for example. Sometimes look at different credit scores as well. I think Ally is very well-aware of what the captives are, what is financing arms of the big OEMs are doing, and they’ve been able to adjust pretty well over time. You're correct that Chrysler is gonna set up their own captive as well and Ally is well-aware of that.
Andrew: Enlightened, I’ll let you add on there but I would just say. To me, that, again, I've only looked at the company for a day but that makes me a little more bullish, right? Because I had thought that it was an exclusive partnership. So there was the possibility, they were over earning a little bit because it’s exclusive but the fact that they’re actually out there competing with an internal GM arm and you, me, and whoever wants their money around and they're still earning these returns and growing and doing well. That’s a much different story than if it was a completely exclusive and they might be overearning but did you want to add anything to what Sleep just said?
Enlightened: Sure. Yeah. So GM also has GM Financial. That’s the other entity that issues loans. But yeah, just in terms of their origination mix. In 2014 when they IPOd, they were about 80% GM Chrysler and now they're 50% GM Chrysler, and the other 50% compare their growth initiatives which is through Carvana, CarMax, they do a lot of lending through some of these online players.
Andrew: None of those are exclusive? Those are also, yeah.
Enlightened: So they’ve consciously diversified away from being as served.
Sleep: Yeah. There's other brands as well. Mitsubishi and whatever.
Andrew: I think we’ve done a nice job of explaining, hey, this is a company, the ROE is 15, 20% or something, and the ROE is gonna be a function of your cost of capital. So that’s mainly deposits on one side and how good you are at lending. I think we’ve done a good job of talking about both of those sides. So, the obvious next question would be, okay guys, great. You’ve just described by the cost of deposit got an advantage of on the lending side. This is a company that is trading for one point one or one point two times book. So clearly, the market is looking at this company and saying we don’t think returns are sustainable, right? You can barely earn above your cost of capital.
I know both of you are bulls, so you think the market’s wrong. But, what is the market scene? What is the market price in here that returns are gonna come down over time?
Enlightened: I mean, I guess, I can start. I think a couple of things. I think historically. This company was pre-COVID was kind of earning 10 to 12% or at least and then it come up since the IPO. So I think historically that’s kind of where the company was. So I think it’s a little bit of a show-me story and I think over the last year, management is really guided to much higher or at least than the company has generated historically and I think based on the things we talked about. Lower funding cost, new products, etcetera, I personally believe the company will get there but I think it’s still kind of a show-me story because 2021 results have been possibly impacted by reserve releases from the last year, that’s non-recurring. There's been some positive impact some of the used car side from higher used car prices. So that’s also not recurring but I think if you look at management’s guidance they're talking about 15, 16% returns on equity in a more normalized environment. So they're already taking that to consideration that used car price are really high, they're gonna come down as inventories normalize. But again, I think it’s kind of a show-me story because that’s a much higher level of earnings than the company has had historically pre-COVID.
Andrew: Sleep, I'm gonna let you dive in but that was exactly what I was thinking, right? This is a company that returns have gone up a lot thanks to COVID and just all the funkiness with that. What it seems to me with the stock about one point two is the market is just going. “Hey, this is a great bump but you're gonna go back to 10% over time.” What the two of you are kind of betting on is, we don’t think it’s going back to 10%. Maybe it’s probably not seen that 20 or 25 but we think it’s going to 15, 16, 17 and at 15, 16,17 this is a two X plus business. Sleep, did you wanna add anything there?
Sleep: Yes. I mean, I'll just echo a couple of things that Enlightened touched on. Management has been pretty clear in the fact that they're underwriting based off a normalized environment where used car price is declining, right? So, they’re definitely over earning right now and management knows that and we know that. But once things return to a normal environment, it’s not like things are gonna come crashing down, right? I think this is a kind of a nuance in terms of really understanding the impact that used car pricing has on their loan book, right?
The two places where really hits them is on the loan side, it’s only when a consumer defaults, right? So, even if you have car prices crash coming down, whatever, 30, 50%, but you have a low default environment, it’s not gonna be that bad for them because they’ll just repossess the vehicle and recover less and they would otherwise if you start pricing was a bit stronger. The other part is on the leasing side of the business which is not that big a part of the business and again, I think they’ve been pretty clear on the fact that they’re underwriting for normalized environment. So, they are seeing a short term benefit right now but in a kind of 20, like 2022, 2023 scenario when things become more traditional in terms of the curve of used car pricing, then I have all the reasons to believe that management is gonna hit their return targets and they’ve been pretty clear in terms of how they can get there.
Andrew: Perfect. This is an overcapitalized company, I wanna move into the M&A, they're doing industry share buybacks and everything but I wanna pause here talk. We’ve talked about the cost of deposits, return of equity, the loan, but is there anything on kind of this valuation, funding, cost capital side that you guys think that we should have talked about a little bit more?
Enlightened: No. I think we've hit all the key points.
Andrew: Perfect. Just wanted to make sure. So, let’s go to the next point. One of the great things about going from 10% ROE to 20% ROE is suddenly your gushing cash flow, right? You guys are way overcapitalized now. They’ve been pretty clear about that. They're doing something with that overcapitalization. They're doing some acquisitions, they’re doing some pretty nice share buybacks and everything. I think that’s great. I just wanna talk about the acquisitions are strategic, they seem really interesting to me, the share buybacks at one point two times book are really interesting to me. But, let’s talk about what they're doing and how they're kind of growing in terms of value through capital allocations. So, Enlightened, why don’t we start with you and then we can switch over to Sleep.
Enlightened: Sure. So, yeah. On the repurchase side, so, because they’re bank holding company in the U.S., they're regulated by the FED. So they have to get FED permission in terms of dividends and buybacks. So last year unfortunately during COVID, they have to pause share repurchases. So, to your point, they began the year super overcapitalized, well above their targets, well above FED requirements. They got FED approval for two billion of share repurchases this year and they're well on track for that. So they're gonna to repurchase two billion this year to substantial relative to the size of the company.
Andrew: Yeah. I'm pulling up the market cap right now ‘cause I couldn’t remember it off the top of my head. The market cap here is...
Sleep: It’s like sixteen billion, right?
Andrew: Sixteen billion. So we’re talking about over 10% of the capital. I mean, that is a big boy of share amount.
Enlightened: Yes. They have a long history of repurchasing shares. They’ve repurchased over 25% of shares in the last...
Sleep: Yeah. Since 2016 or something. Just add to that really quickly. I like how they framed that in the past too because you can tell that management understands the math of these buybacks. We know very clearly that many times, a lot of good management teams don’t even think about buybacks that way but they’ve explained how buybacks are kind of a really high ROE investment on themselves, right? So I've always been attracted to how they think about that.
Andrew: Consistent share buybacks at reasonable to unreasonable prices and unreasonable, I mean, very cheap prices are, they're just catnip to me. Every time I look at my portfolio and I see something that doesn’t have an ongoing share buyback. I'm like, “Why do I own this thing?” Maybe that’s a false of mind but I really love having companies that share buyback. The other way they're taking advantage of their overcapitalization is they're doing some M&A. They recently announced a deal. It was huge in the grand scheme of things but I think it was very strategic, very creative. I'm interested in that deal both on its own merits and because this kind of speaks to some deals they could do in the future that could be strategic and continue kind of expanding that deep strategic moat they talked about. So Sleep, do you wanna talk about their most recent deal and how they kind of look at M&A going forward?
Sleep: Sure. Just so, ‘cause I don’t think we’ve actually talked a lot about this, but in terms of their new growth initiatives. If you think about their deposit product having been, they’ve been working on that for the past 10 years. They’ve slowly been adding complementary products to that, right? Enlightened mentioned this but you have the kind of mortgages, personal lending, there's also an investing platform, and if you look at kind of that full banking spectrum of offerings, the one missing piece was credit cards.
I think this was pretty much expected. So, they did announce that this recent acquisition in the last earning is called Fair Square Financial.
Sleep: As you said, it’s not really that big of an acquisition but I think it makes sense in the sense that it’s gonna give them a platform to grow out of and that’s what they’ve done with these other ones if you look at the personal lending side, they also started out with an acquisition. If you look at investing, they bought TradeKing a couple of years ago so they're executing on that exact same strategy of buying a quality asset that has a good track record at a good price and sort of building on top of that. A lot of it will come down to kind of cross-selling the product to their existing deposit customers.
Andrew: Yup. Enlightened, would you wanna add anything there?
Enlightened: Yeah. Really, the only thing to add is they've done a really good job of growing all of these additional products and they're all relatively small from an earnings perspective right now. But I think over time, that'll be a really nice diversify. Now multi-product customers are up to 9, 10%. That's from zero in 2016. So, they've done a pretty well growing all these product lines.
Andrew: This might be me putting too much of rose-colored glass on but, it's an online bank so it makes sense. But I was impressed by when reading through it. How similar it is to a lot of, I guess, the new banks start-ups and stuff where they talk about. Hey, we started with this one product, mainly loans, then we went to deposits, nobody had more than one product with us for the most part. But now we've got this massive deposit bank base. We've got a relationships with millions and millions of consumers, and as Sleep was talking to earlier. Our NPS is really high. We're the best online bank, and we've got all these gaps to fill them. They've just slowly filled them like, it's a little surprise to me that they chose to fill investing before they did credit cards ‘cause credit cards are just so bread and butter with a deposit base. But, it just seems like a new bank strategy and it all makes total sense to me.
Sleep: Yes. It's interesting because they've kind of considered themselves the original FinTech because they started an online banking in 2009. I mean, I can't think of anyone else that would have said in 2009. “Oh, let's start a bank," right? That's probably the worst time if you think but now that you look back, it made a lot of sense the way that they did it.
Andrew: One of you said, I can't remember who, I'm sorry. But you said this was they already had investing the back auto loans, now they have credit cards. I think you said this was the kind of the last missing piece to their offering the whole suite of financial products. Is that right?
Sleep: Yeah. It's kind of the obvious piece, right? Like, you could add more products to this but of the traditional banking...
Andrew: Do you have crypto? I don't see any crypto offering on the website yet.
Sleep: Exactly, right?
Andrew: Enlightened, do you agree with that or do you think there's any kind of maybe not so obvious but strategic things that they can bolt on or add on here?
Enlightened: I think on the consumer side, they have a really nice product portfolio. I think they'll just continue to grow and build these out. I think on the investing side, their asset base their AUM is pretty small relative to a lot of the really scaled players. So you like to see them kind of scale that up over time. But yeah, I think from a portfolio perspective there really nice product mix.
Andrew: Okay. A little bit of pushback here. So I think my first and biggest pushback would just be, all right. Everything you're saying and I think everyone can tell when I listen to this. I think this is a great pitch. I think it's really interesting. I pass over it for a while for reasons we'll discuss second but, I think the biggest pushback would be. Okay, that's great. It's cheap. They've got a great strategy. They've got a great moat. It's underearning. They're returning capital. Why don't insiders agree, right? Because Ally has been standalone for a long time. Insider ownership here is pretty poor. I can't remember off the top of my head but the way I generally look at it is I look at the CEOs pay versus how much stock he owns. I can't remember what exactly it is, but it is not a great ratio here. Insiders, I posted the last chart in my kind of tweet thing, I posted it. We haven't seen a single insider buy. I think there might have been one or two at the depths of March 2020. But this year, it's just tons of insider sells. Not one or two, it's just insider sales every month constantly. When I look at that I look at no insider ownership constant insider selling. I look at that versus a story where I say really reasonable valuation, maybe unreasonable on the cheap side, returning capital. They seem to get on capital allocation. I say, “Well, they seem to get it but they don't seem to be putting their own money here. What is the divergence here? Why are the insiders not kind of really taking advantage of these prices?
Sleep: Yeah. I think that's definitely a good point and very valid pushback. When it comes to kind of judging management for me personally, insider ownership is obviously a big part of it but, I'm not necessarily gonna discredit them too much for that because I kind of take a step back as well and try to look at their track record and how they're incentivized in terms of their long-term incentives. Right? So in the case of Ally and their executive officers, their long-term pay is based off ROTC and tangible book value per share growth, which kind of explains why they're aggressive on the buybacks as well. So, from that side, I think shareholders are pretty well-aligned with the management team. I agree that the board doesn't have as much shares as I would like them. I think the CEO has if you include the RSUs and PSUs, etcetera, has around forty to fifty million. If you asked me, yeah, I would like him to have more but, I wouldn't necessarily discredit him or penalize him because he doesn't own enough shares. I actually liked the CFO a lot as well but she only became CFO, I think it was 2 or 3 years ago. So I also wouldn't expect her to have a ton of shares at this point. But that's kind of how I think about it. I agree. I would like them to have more but I'm not gonna penalize them for that in my mind.
Andrew: Sleep, can I just do one more push back there? So you said, they are the CEO, I look at how they're paid. They're paid on return on tangible capital employed I believe it is, and tangible book value growth. Which is great because ultimately, how investors are gonna to make money is tangible book value growing and return on capital going up. Right?
Andrew: But I do worry. It is not that the same as them getting paid on total shareholder return, which there's issues with that too. But when you say we're gonna get paid on tangible book value growth and return on tangible capital going up. Returns on tangible capital going up, the best way to do that is to lever the shit out of the balance sheet and really put the company at risk. Tangible book value per share going up, the best way to do that is not to buy back shares when they're cheap because if they're over booked value and you're buying back shares, you're actually decreasing your tangible book value per share. Right? Do you see what I'm saying where I could be a little bit worried about...
Sleep: Right. Yeah. That's a good point. It is tangible book value per share.
Andrew: But that still goes down when you buy...
Sleep: Yeah, you're right. When you buy a book, I guess, it's not a creative item. So that's...
Andrew: This is the old, oh, Facebook's tangible book is $2 per share and they're buying back shares at 200. They're destroying value, it’s like, no [inaudible].
Sleep: Right. I mean, intrinsic values is really what matters at the end of the day. I mean, one thing that I think is worth pointing out to is that if you look back over the last 3 years and kind of the thresholds that they have for each of those metrics, they've been going up in time. So, it reflects where management thinks that the company can go and their kind of their credibility. So I would think that at least makes me more comfortable with looking at those metrics.
Andrew: Enlightened, do you wanna add anything there or I have another question for you actually?
Enlightened: Just very quickly. I'd say, I think management was dealt a really bad head when this company IPOd, this was not a high quality company in 2014, 2015. They've done a great job, all the things we've said but really chiefly building the product portfolio, lowering the funding costs, building up the online bank. I mean, management, I think it's proved a really good track record for last 5, 6 years. So yes, I would prefer they own more but I think the track record and the way they're compensated are too strong positives.
Andrew: Let me ask my next question. This is the reason I've historically passed on Ally despite some great write-ups. There was a design sitting right up. There was very timely came out yesterday, which I thought was great. I know you wrote this up 30% ago in February before the SEC had a big run.
I will always remember a couple of years ago, somebody came out with a bank pitch. Somebody else, it might have been literally an AIG on Twitter but they said, "Of all the stocks in the world, your best pitch right now is a bank." What they were saying or at least what I interviewed them and saying was like, okay. Yeah, you can make some money in a bank but it's not gonna be-- I know Sleep loves Spotify. It's not gonna be Spotify where people revalue it from oh, they might want music streaming too." They have one music streaming, they’re Netflix 2.0. The EV goes from 50 billion to 300 billion in 3 years. Right? With Ally Financial, we're talking about a stock at one point two book, maybe belongs at two book but there's tons of blow-up risk. I think of Wells Fargo, 5 years ago, Wells Fargo is the gold standard. Buffett says it's the opportunity ‘cause I evaluate everything else on and today, Wells Fargo I think is trading below book. I haven't looked in a while but Wells Fargo's reputation is tarnished. You look back to the financial crisis banks seem like they're just minting 20% ROEs forever and then everything blows up.
I guess my pushback and the reason I asked is have you Enlightened this because I'm looking at your recent write-ups there, Progressive, which is a very interesting company, insurance company, great underwriter, but it trades at 4 times book and there's a lot of FinTech coming in insurance.
First Republic, incredible bank but honestly, it could be Wells Fargo 2.0. Right? Right now everybody talks about the culture but 5 years from now, maybe they were ripping off all their high net worth clients. I wanted to give that both overall and Ally specifics. Why is our best idea versus all the other things in the world we can invest in, a bank trading at one point two times book value?
Enlightened: Whoa. That's a loaded question.
Andrew: I'm sorry to ramble but it was the thing when we were gonna talk about it. That was the thing in my mind as I researched this.
Sleep: Yeah. I have some thoughts on that and maybe you can add after but, it's definitely a really good question. I think they're in a sweet spot were, as Enlightened just said, this used to be a turnaround story for a really long time. They basically they're behind that. I don't think the market is giving them credit for that at this valuation. If you actually look at where this traded at the IPO. It was trading at one point one, one point two times book. They had all these headwinds going against them. The ROEs are probably at 7 or 8%. We're talking twice that on a normalized environment at this point. So, the way that I think about it in the next kind of 4 to 5 years is, yeah, you have a one point one, one point two times book value but it's not necessarily just gonna be the multiple expansion to me going forward. At the same time, the book value is growing at a mid 10s percent at this point. You also have the buybacks that have been pretty opportunistic over time. So I'm pretty comfortable underwriting kind of a 20% plus IRR on a 4 to 5 year basis which, I mean, when I look at other opportunity sets in out there and even in my portfolio, there's not that many that I get to that level.
Andrew: Not so much today but at the height of the growth stuff in February or maybe even July, I think there would have been a lot of people said, 20% IRR for a few years, let's try a few days. Today 20% IRR, that is literally world-beating returns.
Andrew: Yeah. But...
Sleep: I have some confidence on that too because of what we explained. Right? There's some good visibility with the asset side and the funding costs coming down, etcetera.
Andrew: Enlightened, Sleep jumped in and stole your question, but I wanna give it over to you. Sleep, you did a great job. But I wanna flip it over to you talking both about Ally and then maybe we can also just generalize ‘cause, again, Progressive, First Republic, it seems like you do like these stories with great companies that I can do the same thing. You can kind of spreadsheet mount on where book is 10 today, they're gonna 15% already in a beat. But I'll flip it over to you.
Enlightened: Sure. Yeah. I mean, I agree with Sleep in terms of thinking about IRRs over time and getting similar number in terms of expected IRRs. You get the multiple expansion but even without that, I think they'll continue to drive double-digit EPS growth, book value per share growth, driven by the higher net interest margin, strong loan growth, strong growth, and all these other products. So I think there's a number of levers there, and then you get the multiple expansion on top of that. Usually, I don't try to include a lot of multiple expansion. My underwriting usually just kind of looking at EPS growth, but here's the story where I think simply phrase that it's just undervalued relative to the quality of the company. So I think you're getting a double whammy there.
Andrew: Perfect. Do you wanna talk about just generally for just the Progressive, First Republic, how you think about those versus other opportunity costs?
Enlightened: Sure. So First Republic, I actually don't currently think is that attractive. I also occasionally will write up companies in the blog that are really high quality companies that I will wanna track over time and hopefully that the market will present a good opportunity. But that's just one of those really, really high quality bank compounders that's generated a ton of value over time. Their playbook, I think will continue for a long time. They have a very small a market share in the key markets that they're in.
Andrew: First Republic, I'll just give a little anecdote. I used to be at one of the big private equity shops. When I was very low level, First Republic comes in and they make an intro and they're like, "Hey, we want all of your business. We've got a strategic partnership with this and now all the compound [?] offers in First Republic." I always think back to that. I was like, look, these guys, not that I was guaranteed to be a success or something but they went to every person in the same way as us and they knew. “Hey, get them while they're young." I haven't seen that at any other bank try that, go to all the probably don't do Goldman ‘cause Goldman's got their own thing. But a McKinsey or a private equity, just go to them and say, “Yeah, right now we're not gonna make a lot of money off you ‘cause you're a 25-year-old kid and you've got nothing." But you've got the human capital invest with that so I thought that was a really interesting thing.
I've got a couple more questions but I wanna make sure, ‘cause there's two of you so I'm bouncing back and forth. Anything you think we should have touched on that we haven't touched on yet or you wish we had touched on a little harder? Enlightened, I'll start with you and then we'll go to Sleep.
Enlightened: Yes. I guess the one thing I say about the current environment that Ally is benefiting in a few ways that we've talked about just in terms of higher used car prices but there are also a number of headwinds here. So one, if you look at new car volumes in the U.S. new car sales, they're actually not that high, they're pretty low right now. It's at about thirteen million, November. In pre-COVID were at sixteen, seventeen million. So we're well below where we were pre-COVID in terms of new car sales. So as that normalizes, some of the inventory and ship shortages, that'll be a benefit.
Also, as we talked about their lending to all these dealerships is way down because none of the dealers have any inventory. So, they’re actually, this is not the peak environment for them by any means.
Andrew: That actually transitions in nicely into one of the tail risks I wanted to talk about. So I'll just bring it up here, if that's okay with you. Thirteen million new car sales that's on the low end historically. I agree with you but I think there's two things there. A) The rise of Uber and at some point, maybe a hundred years from now, I don't know, but self-driving cars. I do think car ownership comes down over time. That can also transition into a very tail risk where you know, I had a guy, Eric from Warren Capital have research on. You started talking about Tesla and I know one of the things they think is all of the Tesla and EVs are coming so quickly that all of the legacy auto stuff is gonna be stranded very quickly. Not tomorrow, but it will happen. If all of the legacy auto was kind of stranded and I'm talking about combustible vehicles. Four years from now, EVs are so good that combustible vehicle prices are plummeting, they're going to zero. That could present a risk.
So I guess the two things. Let's start with the first one. You said thirteen million is on the low end. What if car ownership is actually trailing down because people can use cars a little bit longer ‘cause there's so much better now, and people can Uber, so two-car households become one-car households. What if that's the case?
Enlightened: I think that's fair but I think that plays out over a long period of time and we were just at seventeen million pre-COVID. So maybe we'd be at 16 now or whatever but 13 is very low historically. We were at 16, 17 for years pre-COVID. So, I don't necessarily think we go from 17 to 13 or 12 overnight absent COVID. I think that takes time because pre-COVID, Uber was still very popular. Lyft was very popular and we're putting up seventeen million. I think that takes time. I think in terms of some of the other things, Ally is moving more towards the used car market and right now EVs are only 1% of the overall car fleet. They're tiny. Because the life of a car is 15 plus years now. So it just takes a long time for the fleet to turn over. So Ally can do great in the used car market for a long period of time.
Andrew: Sleep, do you wanna add anything to that?
Sleep: Yeah. Because I think it's very important to make it clear that thirteen million, it can be very misleading because it's not a demand problem at all, and we all know this. Right? Because there's a huge supply chain specifically to the chip shortages that we're seeing in autos, but the demand of autos is through the roof. If you go to a dealer right now and you try to buy a car, they'll tell you, “Yeah. You can buy it, but you'll have to wait 9 months." That's why most people are going out and buying used cars. That's why used car prices are up. I don't know, 50, 70% through the year. So the demand is certainly there. It's just that we haven't happened to have this kind of bottleneck at the moment. Yeah, I agree with Enlightened that this is certainly something to keep track of but at least in my mind, it's kind of a 5-plus year thing to when it actually kind of starts to play out and we could see EVs and autonomous vehicles being a much bigger part of the total sales, but you'll still have a big fleet of existing cars that are gonna be in the market. Even if prices fall down, Ally will be lending towards whoever wants to be buying that, it's still driving, right?
Andrew: Tell me if I'm wrong here. This is one of the things I was thinking about when I was thinking about this. ‘Cause I've got a lot more work to do on this, but I could see myself owning this one day. One thing I was thinking was, well, they are bank holding company, right? They've got relationships with consumers. They've got the deposit base, like this is not the Ally of 7 years ago where if car lending went to zero, they'd have no clue what to do ‘cause that's literally all that exists.
If car lending went to zero, yeah, they'd have a lot of capitals to deploy but you're buying them for one point one times book value, which technically book value should be what if you liquidated the whole company, you could payout. Book value should grow because they're gonna earn now and they've got all these customer relationships. So they've got the deposits, they can go fund other loans, and everything if they-- am I thinking about that wrong? Or is that [crosstalk/inaudible].
Sleep: That's definitely like that will be a crazy scenario if all of a sudden people stopped buying cars or for whatever reason. But then yes, essentially what would happen is these loans would get rolled off and just can get paid down and turn into cash and theoretically, they can redeploy them into some of these other products over time.
That's the other thing. They're diversifying away from this, right? Enlightened touched on this already but as it stands today, autos and that includes retail auto and commercial auto, etcetera, is 80% plus of their loan book. Over the next 5 years or so, that's probably be coming down to 75 or 70. So over time, they're diversifying away from that and they've been pretty transparent in the sense that they wanna grow these other businesses to become a more diversified bank. [crosstalk] That's one of the reasons why I think it trades at Edward trades as it will. People look at their auto exposure and will be like, "Holy, I don't wanna touch this."
Andrew: It would suck if those went away because as we discussed earlier. They have an advantage lending to the dealers and everything in there. But again, it's not the end of the world ‘cause they'd still have the advantage on their deposit bank, deposit base, they could still find other stuff. Let's see. Oh, and Sleep, I gave Enlightened a chance, so I wanna give you a chance. Anything else you think we should have talked about with Ally that we didn't talk about or you wanna talk a little bit harder or anything?
Sleep: Yeah. I remember that one of the points you put out in your thread related to kind of Tesla owning their own supply chain and vertical integration and the entire process and I thought that that was a very interesting question. I think...
Andrew: For the listeners, the point was GM, they don't own their dealerships. Right? It's independent dealerships. In many states, I believe it's actually illegal for a car dealer to try to operate a dealership. But Tesla has skirted those laws in those states. But Tesla you go to Tesla store, it's owned by Tesla. It's not an independent franchisee. So I was wondering, what if GM looks at the Tesla Model says, that's way better than our model and eventually goes there. Sorry. Just to give that background, please continue.
Sleep: Right. I will say this is in my mind a very hypothetical scenario because I think we both know that, the three of us know that these legacy auto OEMs are very slow in adapting and moving and I think right now they've woken up to the fact of that EVs are the new priority, etcetera. But I don't think they'd get into that anytime soon. You're right that, I think it's actually in all states that the franchise has to be separate from the parent company. The reason why Tesla does it that way is because they have stores but you can't buy a Tesla in a store, you have to buy it online. It's only really a showroom. I don't think GM or Ford will be able to pull that off either way.
Andrew: I'm gonna look it up out of curiosity. But I remember GM, you have their Saturn brand. I think part of the pitch for the Saturn brand was GM owned like the Saturn locations and there was not a [crosstalk/inaudible] they argued. They argued it's a low-cost model, but nobody should quote me on that. I'll look it up. But that's an interesting stuff. Last thing, I wanna talk endgame. So, I'll start with Sleep and then I'm going to come to Enlightened with a slightly modified version of this. Sleep, you mentioned I can underwrite 20% IRR over the next couple years. So, could you just walk me out like your base case? Five years from now, you and I, we've got a couple of extra gray hairs on our heads, we're filming a follow-up to this podcast. What is Ally look like in your base case?
Sleep: In the metaverse, right?
Sleep: Yeah. In my mind. So if we think about the outlook that has given us in the medium term, it's basically mid to high 3% net interest margin and a 15 to16% plus ROE. The reason why they have that plus is because of this recent credit card acquisition. But, when I kind of run those numbers and see how realistic that can be. I actually think it's pretty conservative in terms of how we can see and play it out. Again, just speaking to management track record, they've laid out all these different outlooks going back in time and they've basically hit all of them go because it came from a low ROE, and over time they just kept increasing as they executed on their plan.
So yeah, in my base case, I have book value growing at mid 10s and ROEs stepping up over time to 17%. I think by then, you don't even have to assume that much multiple expansion, call it 15, 17, it doesn't even have to be like a two times book value for you to get to that IRR. That also assumes that they consistently buy back their shares at these very attractive prices. So obviously, things can change and the share price can go up substantially and they wouldn't probably be as aggressive buying back that stock, but it's not that heavily dependent on that either. If anything that gives them some extra cash to pursue other acquisitions or increase their loan exposure, etcetera.
Andrew: We lost Enlightened apparently. Maybe he got so excited talking about 20% IRRs he just disconnected. So I'll give you Enlightened's question and he can add on. My last question, I look at Ally Financial. I look at an online only bank with lots of car relationships and everything. We talked about how they're doing bolt-on acquisitions. I kind of wonder about the other way, right? Does an aspiring FinTech player with a massive multiple come and buy these guys for this customer relationships in the deposit base. Or, I know crypto is taking over the world but if I was a crypto company with a big valuation, maybe I'm just too old school but, I look at this and say, "Oh, I can go buy a heck of a lot of customer relationships." That's a positive base. A lot of crypto players are paying like 20% per day interest rates on some of their crypto stuff. I'm being a little hyperbolic. But that deposit base would look pretty attractive for funding now. I don't know how the regulators are gonna deposit banks funding, crypto stuff but, do you think there could be some strategic interest whether it's from a Wells Fargo trying to spruce up their image and their online product or I don't know who else. But could there be strategic interest here?
Sleep: Yeah. I haven't given much thought to an M&A scenario here in terms of them being taken out. I think it's a very valid and interesting question. I think for a large bank, it would be probably hard to pull off especially like the top 4 or 5 that the JP Morgan and Bank of America and Wells of the world because they have such a big mark. [audio cut]
Andrew: Oops. Hey, Sleep. You got muted for a second there. I think when Enlightened joined, I press the wrong button.
Andrew: This is gonna be the goofiest last 5 minutes of podcast I've had yet.
Sleep: It's all good. So I was saying, I think for one of the large banks to pull it off it would probably be a little bit hard just because Ally, I mean, it's a hundred and eighty-five plus billion dollars in assets. So, it wouldn't look good on the kind of FED [crosstalk/inaudible].
Enlightened: The regulatory fund. Yeah.
Sleep: Yeah, exactly. But the FinTech question is actually pretty interesting because if we look at some of the underlying trends of some of these large FinTech companies, I think a lot of them will end up turning into banks because at some point, and this is just a theory that I have read, but I think we've seen some hints of this I believe it's SoFi was actually considering this are already did something like this turning into a bank holding company. But, I could see a big valuation FinTech kind of looking at something add an asset like this as a way to kind of quickly turn into a bank and have the low-cost deposit base that would give them an additional advantage. I mean, I wouldn't necessarily say that's zero probability of any. There's probably some chance to that happening. We'll see.
Andrew: That was exactly I was wondering. Enlightened just managed to rejoin us. Enlightened, I'll just give you the last kind of words here. We were talking about both endgame for Ally as a standalone and Sleep was kind of walking us through the math there. Then I asked him, this was gonna be your question but you disconnected. I asked him about possible strategic interest in Ally whether he said legacy banks probably can't buy them for regulatory reasons to make sort of sense. Or I mentioned, FinTech players with huge multiples might just look at their customer relationships and deposit base and say, that is a really good strategic asset. So I'll let you just kind of jam on those for a couple of seconds.
Enlightened: Sure, definitely. Yeah. I agree in terms of larger banks from a regulatory perspective just not being able to buy Ally. I can't see like a JP Morgan or Bank of America being able to buy Ally that's just would not fly from a regulatory perspective. Then in terms of FinTech, I think it is interesting Sleep's comments there I think Square. Now, I think has a banking license. I could be wrong about that but I know some of the FinTech players are getting banking licenses or certainly are partnering with banks for a variety of financial services. So it's certainly a possibility but I also don't necessarily think a FinTech player wants to acquire hundred billion of auto loans.
Andrew: Yeah. I haven't studied the Buy Now Pay Later people in depth but I could see a Buy Now Pay Later guys saying, "Oh, these guys got deposits which we can use to fund those Buy Now Pay Later loans. They've got those deposits. They've got huge customer relationships, which we can use to go push Buy Now Pay Later products and we've got a massive multiple which we can use take them out." But I do agree with you there. Enlightened, ‘cause you disconnected for a few minutes. Any last thoughts here before we wrap this up?
Enlightened: No. I think we covered everything. Yeah. I mean, I think just overall in terms of the bull case continued strong EPS and tangible book value growth, multiple expansion here. I think we've acknowledged some of the risks, but I don't really see them playing out in the next few years, 3 to 5 years. The company continues to do a really good job diversifying its product portfolio, diversifying across both new and used car loans as well as across different OEMs. So I think that story continues to improve overall. So yeah, we continue to like the company story.
Andrew: Perfect. Well, hey, I think we'll wrap it up here. But you guys have both been on my wish list of people to get on the podcast and I'm glad we can get you both on. We'll have to try and have you on individually at some point as well. Sleep, you know you owe me a music podcast at some point.
Sleep: For sure.
Andrew: But hey, for the listeners. Sleepwell Capital, Enlightened Capital, two great blogs, I'm gonna include links to them in the show notes including write-ups on Ally. I believe Sleep has not done a write-up on Ally. So Enlightened write-ups on Ally will be there and the science of hitting friend of the podcasts, he just did a great write-up on Ally on Monday. I'll include the link to his write-up as well if you wanna learn a little bit more about the company. But Sleep, Enlightened, thank you guys so much for coming on and looking forward to the next time.
Sleep: Thank you, Andrew.
Enlightened: Definitely. Thank you, yeah. Thanks for having us.