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JPMorgan: Value Hiding in Plain Sight

June 04, 2014 | About:
ValueStalker

ValueStalker

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JPMorgan (JPM) common is value hiding in plain sight. JPM will earn in excess of $8 per share in 2016, using base case management expectations. This takes no dramatic assumptions. It simply calls for JPMorgan to keep doing what it has been doing (running the best megabank franchise). At a 12 multiple, it is a $100 stock versus the current price of $54, in less than two years.

Management and Business

JPMorgan is a critically important, large universal bank. Despite what some may think, the role of a large universal bank is still as necessary as ever and remains a very privileged position. Within the bank, every single one of JPM’s businesses is growing, is strongly profitable, and is a formidable competitor. Each is also a leader in its respective field. This includes a preeminent investment bank that is No. 1 in global investment banking fees, a consumer bank that is the No. 1 card issuer in the U.S., a commercial bank that is the No. 1 middle market lender, a monopoly-like custody business with $20 trillion in assets under custody, and an asset management business with $1.6 trillion in AUM. The company is also the top-performing bank in terms of deposit growth, with gains in market share in all of its top 25 markets. There can be plenty said of the company’s management, but I will leave it at this: The CEO, Jamie Dimon, is the best in the business. For reference, read his annual reports (the very best, excluding Buffett’s) and check his handling of the financial crisis (the company did not lose money during a single quarter). The rest of the executive team is seasoned and their average tenure is about twice that of the other megabanks.

Valuation, Financial, Outlook

JPM earnings were $17.9 billion in fiscal 2013, or $4.35 per share. Excluding the one-time settlement fees and benefits from reserve releases, earnings were $5.94 per share (Dimon concurs with this figure as the core earnings number, $23 billion). With this adjustment, return on tangible equity has been 15% in each of the last four years (a span which includes the $6 billion Whale Trade). These returns came during a period in which Basel III Tier 1 common increased from under 7.0% to 9.5%. The performance is just unbelievably impressive, given the results of the other big banks, ex-Wells. While the megabanks have continued to be punished by SIFI implementation and the looming fears that higher capital requirements will decrease returns on equity, JPM's Basel III common target is 10%, so the capital increases at the firm are essentially complete. And it is clear from the company’s results that these required increases in capital can be managed to maintain acceptable returns on equity.

JPMorgan’s tangible book was $40.81 at year-end 2013. If it compounds at 12% per annum for two years (15% ROE less dividends), the company’s tangible book value will be around $51.20 at the end of 2015. Keep in mind that it has compounded at a rate in excess of 12% since Jamie Dimon took the helm, and that includes the Great Recession. Here is a snapshot of JPM’s track record since Dimon took over:

A 16% ROE on $51.20 is $8.20 per share. JPM's expectations are for a full-cycle return on tangible of 15% to 16%, so I'm not really taking any liberty here with any unreasonable assumptions. This type of return is already happening.

There are a number of ways to get to the incremental earnings (less than $8 billion, before any repurchases) needed to hit the $8.20 per share figure, but all it really takes is for JPM to keep doing what it's doing. Here are a few of the levers that will drive earnings:

1. Net interest margins were 2.23% in 2013. From 2005 to 2010, they averaged 2.95%. The company anticipates a margin of 2.65% to 2.75% over a full cycle.

Dimon says normalized interest margins could improve after-tax profits by $6 billion. I use 2.70% and calculate $9.3 billion in incremental pre-tax net interest income, so I tend to agree. Bear in mind that it does not take a big rate jump for this to occur — the biggest issue is that the loan-to-deposit ratio for the bank has dropped from the mid-70s to 57%.

2. The company also expects an additional $3.5 billion in annual income from current investments that include the opening of 600 additional branches, 2,100 additional Chase Private Client locations, and the continued build-out of its international prime brokerage platform. The entire breakout is listed below and the firm will feel the impact over the next several years.

3. Expenses from mortgage issues will continue to come down. Most people who are familiar with the industry are well aware of the thousands of legacy asset servicing workers that will continue to roll off over the next several years (JPM’s consumer and community banking headcount is down 14,000 since the beginning of 2013), as issues with dealing trouble mortgages continue to decline. Also, since 2010, JPMorgan has incurred more than $20 billion in after-tax legal expenses and $9 billion in regulatory costs mostly related to legacy issues and the implementation of new regulatory controls. JPM expects a normalized overhead ratio closer to 55% over the next few years, which compares to an adjusted figure of 59% in 2013 and 52% in 2010.

4. Lastly, any of the incremental $50 billion that the company will earn over the next two years can also be put to work toward new investments or share repurchases, which will help JPM get closer to the $8 earnings figure. The company has noted that its current stock price is attractive — even significantly above the current valuation as it has continued to trade at a discount to peers. Given that capital levels are now approaching targets, incremental repurchase activity shouldn’t be unexpected.

Conclusion

JPMorgan is worth well in excess of the sub-9x earnings multiple reflected in the market. The number of issues weighing on the price of the stock — short-term difficulty demonstrating normalized earnings power, risks associated with the legacy mortgage business, timing of operating cost normalization, Basel III rules and U.S. implementation of SIFI buffer, and the current economic environment (NIM, credit losses, loan demand) — should continue to subside over the next one to two years. As this occurs, the stock should reprice closer to $100.

Risks

This is a bank dealing with $1.6 trillion in risk-weighted assets, so the minute risk that some opaque part of the bank sheet causes an issue will always exist. In the end, this leaves an investor to rely upon the talent and integrity of management. To this I would argue that there is not a better guy than Dimon to trust.

The economy and loan growth remain sluggish. In this case, one is stuck sitting on a stock with a $55 stock paying a 3% dividend with $6 or more per share in growing earnings power that takes longer to reprice.


Rating: 5.0/5 (8 votes)

Voters:

Comments

WEBNYC
WEBNYC - 1 month ago

Do you expect returns to decline, given that the fact that the company will need more capital going forward to comply with all the regulations?

ValueStalker
ValueStalker - 4 weeks ago

I believe returns on tangible equity of around 15-16% are still likely. The company reduced its targeted full-cycle return from 16% to 15-16%, based on all of the various new regulations. Per Dimon: "In the past, we told you we would expect our average return on tangible equity through the cycle (by this, we mean in average times with normalized credit losses) to be 16%. With higher levels of capital, significant regulatory changes and some remaining uncertainties, we moved the number to be somewhere between 15% and 16%."
With JPM's Basel III Tier 1 at 9.5%, the capital build is essentially over. It is pretty clear that when banks have to hold higher capital and higher liquidity-all things being equal-returns will come down. But all things aren't equal and the company has adjusted to the changing economics. This involves a number of things including the run-off of unprofitable products, product repricing, and other tactical changes. It's important to remember that some products will always have an extremely high return because of the small amount of equity involved (money management, transaction processing, etc.). Just do the math on the business lines. Asset management only requires $9b in retained equity and in earns well in excess of 20% on capital every year. Card services takes $15b and will also earn 20%+ on equity (it did 28% last year). The Consumer and Business Banking target is 30% ROTE. In the end, some banks will continue to earn better-than-average ROEs and JPM will be among this group. So I would give the probability of a 12% return on book (15% on tangible) as greater than 50%. That would leave Citi and BAC earning something closer to utility like returns. To invert, ask yourself this question: do you not think that Citi and BAC are going to improve their returns on tangible equity to something above the sub-8% range that we have seen over the last few years? If not, theyre going to have a tough time remaining in business. JPM has faced many of the same headwinds and has generated close to a 16% return over the last four quarters on growing equity.

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