The Intrinsic Value Of JPMorgan (Part 1)

Jul.16.12 | About: JPMorgan Chase (JPM)

As if public sentiment towards the big bad banks of Wall Street couldn't get any worse, JP Morgan's (JPM) trading scandal gave us over two months of headlines that have utterly devastated the shares and public perception of the company.

Even after the earnings-induced rally that we had on Friday (July 13th), about $20 billion has been lopped off of the company's market cap and there is a sizable population of JPM investors that want Dimon out. Indeed, things haven't been this bad at JP Morgan for quite some time.

I can only imagine the fun we'll have with the new wave of investigations that will arise out of this, especially adding the recent "liebor" scandal that will continually weigh down on shares of JPM as well as other majors like Bank of America (BAC), Citigroup (C), and Morgan Stanley (MS) who were all connected. According to an analysis published by Morgan Stanely, we might see $14 billion of fallout before this ends.

While we continue to shine the spotlight on treacherous bankster traders and the risks that they pose to common shareholders, we need to consider what we're criticizing. While I'm not calling the JP Morgan-slamming outright "sensationalism", many arguments are blowing all these risks out of proportion and running with it. A journalist can gain plenty of instant popularity these days if he drags Dimon (or some other banker) through the mud, or if he/she grabs the few quotes that can make the guy look like an idiot in retrospect.

But, ultimately, public traded companies are exist to simply make a profit. Whether or not the methods are evil or immoral not is up to the government to care about (which they certainly do). Some companies have a very delayed payoff on their business (like many of the early-stage pharmaceutical companies I cover on my site), and others have extremely predictable (but relatively stagnant) streams of income like the healthcare giant Johnson & Johnson (JNJ). JP Morgan, in my view, is a mixture of both. Not only is it an extremely profitable bank (even now), but the real payload comes when (or if) the US economy can recover.

Zero Hedge released a story last week about the lasting effects that would hit JP Morgan's earnings once the CIO group was dissolved, which provided the idea that "up to 30% of the firm's income will disappear forever". Here is the chart that illustrates the viewpoint:

(click to enlarge)Click to enlarge

This CIO division, which has essentially acted as the world's largest prop trading desk, made a killing in 2009 and became a much larger chunk of JP Morgan's income for just that time period. This gives us that "up to 30% of income" statistic, which is a scary thing to hear, but is misleading since it is a bit of an anomaly.

According to company filings, the CIO's position in treasury securities have tripled in value since 2007, riding on one of history's biggest bull runs in the bond market. It makes sense that the CIO was able to post stellar income after unloading treasury positions in 2009, 2010, and even 2011. Indeed, these are the gains that can explain a few years of amazing performance. It probably wouldn't happen again without some major luck - this is the main reason that JP Morgan's income is not being permanently stunted by recent events.

Trading desks are a lopsided deal for the shareholders (bagholders) anyway, no matter how you slice it. If a trading desk makes a trade and wins, bonuses cut deeply into the gains. When losses occur, the traders take their base salary and the rest is up to the accountants. This is one of the biggest arguments people use to dissuade investors from certain Wall Street firms, and I do agree with this one point. Every step that JP Morgan takes away from the trading universe is a good move for the shareholders in the long run.

CIO speculation aside, the real "meat" of JP Morgan's profitable business is in its investment bank and retail services. These divisions have outstanding performance despite one of the worst banking environments the US has ever seen. The investment banking world is in particularly dire straits. Nonetheless, by Q2 2012 data, these 2 divisions constitute about 84% of the bank's income.

In the next part, I will take a look at these two divisions in detail since they represent the vast majority of JP Morgan's profitability. We'll get a better picture of what they have been up to, and what they will add to JP Morgan's intrinsic value.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JPM over the next 72 hours. Events described in article can change quickly.

Additional disclosure: I went long JPM on July 12 in a short-term trade to capture the reaction to the firm's earnings report. I may reenter depending on broader market conditions, and potentially through an options strategy that will make me buy shares.