JPMorgan (JPM) announced on Monday that it is redeeming nearly $5 billion in trust preferred securities. The move comes after similar announcements from other financial institutions in response to new regulations that no longer allow equity from preferred securities to be counted in capital calculations. Since preferreds are relatively expensive forms of debt for financial institutions, it stands to reason these securities would be the first to be redeemed when possible. JPM has made a huge step towards simplifying its capital structure and making it cheaper to operate its business with these redemptions; this article will examine the financial impact of the redemptions and implications for shareholders.
First, the financials for the list of securities being redeemed is seen below.
We can see that JPM is redeeming $4.9375 billion of preferred trust securities with a weighted average coupon of 6.47%. This means the preferreds JPM is redeeming are currently costing the bank about $320 million annually in dividend payments to the preferred shareholders.
It's important to note that the preferreds are being redeemed at face value so no premium is being paid to holders. This is a vital fact in that it means JPM is not eschewing some of its interest savings later by paying it out in principal now to the preferred shareholders.
Next, we can assess how these interest savings will affect the company's value on the open market. We know that $320 million is currently being paid each year in dividends on these preferreds and that this amount is deductible for tax purposes as an expense of conducting business. With JPM's 2012 tax rate coming in at 26.4%, we can compute that these interest payments have an after-tax effect on the income statement of negative $235.3 million annually. We can now infer from this that, assuming JPM's tax rate stays about where it was last year, that JPM will now be saving approximately $235 million per year in after-tax interest expense, which will flow directly to the bottom line.
What does this mean for shareholders? We know that JPM has about 3.8 billion shares outstanding and that the $235 million of after-tax interest savings therefore equates to $0.062 per share annually in additional earnings. While this may not seem like a lot, consider that since the interest savings from redeeming these preferreds is permanent, it is appropriate and necessary to apply JPM's earnings multiple to such savings. This means that if we apply a conservative earnings multiple of only nine to the savings, we can assume that JPM will be worth about $2.1 billion more in the marketplace than it was before the preferreds redemptions. This equates to about $0.56 per share in additional value that will be created once the preferreds are redeemed, all else equal.
Apart from the multi-billion dollar bump in market cap that should arise from these redemptions, the larger picture of this action is that JPM is profitably reinvesting capital it has stored by running its business prudently throughout the financial crisis and since. The weighted average interest rate of the securities being redeemed is 6.47%; high grade corporate bonds are selling for less than 2%. In addition, since the Federal Reserve's unending quantitative easing began, mortgages and other ways of providing credit are at historic lows in terms of rates. This means that for the money a bank has tied up in expensive preferreds, it is nearly impossible to profitably invest as the bar is so high to reach break even. Since JPM is ridding itself of these expensive forms of debt, it can now either reissue the debt more cheaply or, hopefully, simply enjoy the fact that the company doesn't need the money and can now save $235 million per year in interest.
To be honest, $2.1 billion in additional market cap for JPM is not a huge needle mover, but what it does signify is that JPM management is looking for creative ways to create value. As a shareholder, you cannot ask for better representation. After management rids itself of this expensive debt, shareholders will reap the benefits in terms of higher earnings forever. If you think an additional $0.062 per share in annual earnings is meaningless, consider what would happen if one of the analysts that covers JPM came out tomorrow with an upgrade and an upward earnings revision of $0.06; investors would cheer and the stock would probably be bid up. The preferreds redemptions are better than an analyst upgrade because it is resulting in real money being saved and trickling down to net income. If the stock doesn't open up at least 1.25% on Tuesday, consider it a gift.