- JPMorgan reported results which disappointed investors. However, the results did have a couple of positives for long-term investors.
- The first positive was the absence of "items" from earnings. It is very bullish if the gap between core earnings and as reported earnings narrows towards the core.
- The second positive was clarification that the $6.5 billion buyback plan included $1.5 billion to offset employee issuances, thus implying $5 billion shareholder value being returned.
- A rise in sustainable earnings and adjusted payout ratio is very bullish for a future period when risk aversion levels might decline.
I recently posted my perspective on value for JPMorgan (NYSE:JPM) just before earnings, where I suggested a nibble price of $52, with lower buy and bite targets. JPM closed Friday at $55.30.
Momentum remains negative, and so there are reasonable odds that the $52 nibble target will be achieved.
Source: Alpha Omega Mathematica
In this post I will present a bullish view for JPMorgan, based on some very interesting factors which emerged during the earnings conference call. This is a bullish view, and in no way negates the nibble, buy and bite targets expressed in my prior post - those are the kind of attractive entry points in a market when fear rules. Those were levels which might be attractive to buy and hold style investors, who traditionally buy fear and low expectations at levels at and below book value and tangible book value.
Earnings disappointed possibly because short term expectations were too high. But there were a couple of very interesting signs for long-term investors.
Non-Core and Non-Recurring Expenses
Marianne Lake, the Chief Financial Officer at JPMorgan said:
"Reported expenses for the firm were basically the same as adjusted expenses this quarter at $14.6 billion, in line with our expectations and our guidance for full year adjusted expenses to be below $59 billion. Firm-wide legal expense for the quarter was immaterial.
Of note, you will see that we didn't disclose any significant items this quarter on the front page of the presentation. There were items in the quarter that we consider non-core or non-recurring, each individually didn't rise to the level of being disclosed on the front page and importantly, the net of all such items across businesses was not significant to the firm's reported results.
To be clear, this means that our reported net income of $5.3 billion is very close to being a core performance number, which we consider a solid result given the challenging environment for those markets and mortgage. Importantly, underlying drivers across most businesses continued among impressive trends."
During 2013, JPMorgan reported $4.35 in earnings, made up of $5.70 in core earnings less $1.35 in items considered non-core or non-recurring. Here is a reconciliation of diluted earnings per share for 2013 to diluted earnings per share ex-items.
Source: JPMorgan Q4 2013 Press Release
As you can see the big items are firm wide and corporate legal expenses. I have always presumed that the pesky "items", are not as non-recurring or non-core as is assumed, mainly because Jamie Dimon is so vocal about the terrible impact that additional regulation will have on the business.
Now one quarter does not make a trend, but the absence of non-core and non-recurring items this quarter is encouraging, given the significance of non-core and non-recurring items reported during 2013. I say this with a nervous twitch because Q1 2013 had no non-recurring firm-wide and corporate legal expenses, while Q2, Q3 and Q4 2013 did! But all said and done, the absence of non-core and non-recurring items is very encouraging. If the level of non-core and non-recurring items reduces or is eliminated, the level of sustainable earnings which can be grown over the long-term will rise. And that has a major impact on valuation.
Capital Repurchase Program
On March 26th, JPMorgan released details of their intended capital return plan, which spoke of an annual dividend of $1.60 and a common equity repurchase program of $6.5 billion.
Not all of an equity repurchase program represents a return of shareholder, and given that JPMorgan has been spectacularly unsuccessful in returning value to shareholders via buybacks over the past decade, I remained cautious. While the $6.5 billion common equity repurchase program to be executed between April 1st 2014 and 31st March 2015 did look generous, I was skeptical of the extent of value which would be returned to shareholders.
The value returned via buybacks has two components. The first is value returned to shareholders. You can quantify this by seeing the drop in share-count over the years. For example if a stock has a payout of 35% and a dividend yield of 2%, and the share count is declining at 2% per year, you have an adjusted payout of 70%. The second part of a buyback program represents payment for investment in growth. Companies reinvest retained earnings in growth. Part of this investment is in human capital - it is made via issuance of share options and grants to motivate, retain, and incentivize employees. When a company buys back shares to offset the resulting dilution, it is not a return of shareholder value - it is payment for a past investment in growth. You can also have buybacks aimed at countering other dilutions caused by issuance of dilutive hybrid (convertible) financial instruments. That too does not represent a return of shareholder value: it represents a cash payment for a past investment to drive growth.
The information of a $6.5 billion buyback did not give adequate information to determine the extent to which the buyback program represents a return of shareholder value.
During the conference call, this was clarified by Marianne Lake when she said,
"Finally, we are pleased that our capital plan was approved in the quarter and the Board announced its intention to increase our quarterly common stock dividend to $0.40 a share effective in the second quarter, as well as the authorization to repurchase a gross $6.5 billion of common equity or net a little over $5 billion, that net of expected employee issuance."
This is important because it tells us that significant ($5 billion) amounts will be returned to shareholders.
Bullish Value View
This is a bullish take on JPMorgan post its earnings call, the aim of which is to present a price target which is achievable in a market where fear is absent. This view helps an investor decide whether it might be worthwhile to nibble the dip.
First off we have the adjusted payout ratio. We know that JPMorgan earned $4.35 during 2013, and they earned $5.70 in core earnings. Of this they are happy to return $1.60 to shareholders via dividends. The dividend payout ratio is 28% of core earnings, and I will interpret this as a signal of the extent of value JPMorgan intends to return to shareholders via dividends over the long-term. The dividend provides shareholders with a yield of 2.89%. JPMorgan has also expressed the intent to return a further $5 billion to shareholders via a one year capital repurchase plan ending March 31st 2015. This amounts to 2.42% of the present market capitalization of $207.69 billion. This suggests that JPMorgan is comfortable paying out a further 24% of core earnings via buybacks. I will interpret this as a signal of the extent of value JPMorgan intends to return to shareholders via buybacks over the long-term. The total adjusted payout ratio is 52%.
Next we have long-term growth expectations. With a payout of 52%, 48% is retained to reinvest in growth. This 48% of retained earnings is tangible. During 2013, JPMorgan earned $5.70 in core earnings on a tangible book value per share of $40.81. Thus the return on tangible book value is 14%. JPMorgan set a target of 15% to 16% for return on tangible common equity on their investor day (see page 14). If we accept that they will achieve a 15% return on tangible common equity, by re-investing 48% of profits, JPMorgan can grow at a long-term rate of 7% (15% * 48%).
Then we have long-term return expectations. The Value Line report, which you can download here, reports a beta of 1.30 for JPMorgan. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one. I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.42, and I adjust it to 1.24 on account of the beta's tendency to converge towards one. What is our long-term return expectation for a stock with a beta of 1.24, a long-term risk-free rate of 4.50%, and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk-Free Rate plus Beta Multiplied by Market Return less Risk-Free Rate. Thus, for JPMorgan, we should be targeting a long-term return of 11.63%.
And finally we have sustainable earnings. Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I will use the 2013 core earnings $5.70 as an estimate of sustainable earnings. This is a reasonable though optimistic estimate of sustainable earnings which is 10.55% of book value ($54.05) as at March 31st, or 13.66% of tangible book value ($41.73) as at March 31st, versus a JPMorgan target of 15% to 16% return on tangible common equity. A target of 15% return on tangible common equity would indicate core earnings of $6.26. You can find details of book and tangible book value on JPMorgan's Q1 2014 earnings release.
Mathematically, the worth of JPMorgan is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Pay-out Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Using the estimates set out in the prior paragraphs implies that JPMorgan has upside to a value of $68.50 [107% * $5.70 * 52% / (11.63%-7%)] in a market where fear is absent.
In my view, it is well worth nibbling the dip should poor momentum take the price down to $52.