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I write The Winters Report, an independent equity research publication on US banks. Contact me at WintersReport@gmail.com or follow me on Twitter (@HarvardWinters). Previously I worked as a financial services investment banker, at Merrill Lynch, JP Morgan and various middle-market investment... More
  • Why Investors Should Be Cautiously Optimistic About JP Morgan Chase 0 comments
    Apr 22, 2012 12:27 AM | about stocks: JPM

    JP Morgan Chase ("JPM") released its Q1 2012 financial results on Friday, April 13th. JPM reported EPS of $1.31, versus $0.90 in Q4 2011 and $1.28 in Q1 2011. The quarter's results were favorable; the Factset consensus estimate for the quarter was $1.16. While JPM appears cheap today (I estimate its current fair value to be around $50 per share), I think that highly bullish investors with price targets well above this are ignoring some aspects of JPM's franchise:

    - JPM's Q1 2012 reported return on average assets ("ROAA") was 0.95%. I estimate its "normalized" Q1 2012 ROAA (removing all non-recurring income and expense, including securities gains, and using a quarterly provision/average assets ratio that would apply in a healthy economy) to be 0.69%. That's a mediocre ROAA; the long-term average for the industry is about 1.00%, and solid performers consistently get to 1.50% or higher. JPM hasn't delivered a 1.00% ROAA in some time. I think JPM is capable of delivering a 0.82-0.84% "clean" ROAA.

    - JPM's Q1 2012 reported and "normalized" return on average tangible common equity ("ROATCE") were 16.1% and 12.2% (both my estimates), respectively. I'm not sure how much better JPM's ROATCE can get, and 16.1% isn't very good. My 0.82-0.84% "clean" ROAA estimate range translates into a 14.3-14.7% "clean" ROTCE estimate range using JPM's Q1 2012 leverage.

    - With a Q1 2012 tangible common equity/tangible assets ("TCE/TA") ratio of 5.78%, JPM looks thinly capitalized. JPM has argued that this is because it has a lot of low yield (but also low risk) assets. Regulatory capital ratios support this argument. So the presence of these assets depresses ROAA but increases ROATCE. That means ROATCE would be even lower than 14.3-14.7% in the absence of these assets. Will TCE/TA move up as JPM prepares for Basel III capital requirements? If it does, that will be bad for ROTCE. TCE/TA has already crept up a bit, from 5.64% in Q4 2011. I calculate that a 44 basis point increase in JPM's TCE/TA would cause a 1 percentage point decline in ROTCE if ROAA is held constant.

    - Some investors believe that JPM's non-interest expense will fall when JPM gets out from underneath the expenses related to mortgage foreclosures. That may be true, and if it is true, that will be a positive for ROA. On the other hand, JPM's net interest margin ("NIM"), while lower in Q1 2012 (2.60%) than a few quarters back (its high was 3.30% in Q4 2008), is still higher than it was prior to the beginning of the financial crisis (2.07% in Q2 2006, for example). The current wacky yield curve has ultimately helped JPM's NIM and ROAA, because so much of JPM's funding is wholesale. What will reversion to a more normal yield curve do to NIM? (FYI, my 0.82% ROAA estimate above assumes nothing disastrous happens to NIM).

    - I'm not sure how fast JPM will be able to grow going forward. Over the last twenty years, JPM has grown its assets by 1530% (or 15.0% compounded annually), from $139 BN to $2.3 TN. Its compound annual growth rate in assets per share ("APS") (you need to look at per share growth because of all the acquisitions) over the same period? 4.4%. And that's actually better than several of its largest competitors. JPM may be able to put up a few quarters of robust asset growth, especially as the economy recovers, but I doubt that it can achieve even 7% compounded APS growth for any extended period of time, simply because of how big it has become. And ultimately APS growth is what drives EPS growth.

    - From 2005 to 2011, JPM paid out 30% of its net income available to common shareholders as cash dividends, and 31% in the form of share repurchases. That's an aggregate earnings payout ratio of 61%, with a few 0% payout periods mixed in. Do high growth companies return such a high percentage of their earnings to shareholders? Would JPM shareholders be better off if the bank just paid higher dividends?

    - With Q1 2012 tangible book value per share of $34.33, I can get comfortable with a fair value estimate for JPM of $50, as it would imply a price/tangible book multiple of 1.46x. JPM deserves such a multiple in a 10% discount rate environment if it delivers a 14-15% ROTCE. That implies 16% upside from Friday's closing price of $42.72. Fine, but what happens to JPM's fair value if/when interest rates return to normal levels? In the late 1990s, investment bankers used discount rates in the 14-15% range. What would those discount rates do to an estimate of JPM's fair value? Nothing good.

    Thoughts? Feel free to contact me (WintersReport@gmail.com) if you'd like to discuss any of this further.

    Stocks: JPM
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