JPM: Beyond Improving Expense and Capital Efficiency

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Howard Mason – hmason@ssrllc.com

January 17, 2016

JPM: Beyond Improving Expense and Capital Efficiency

  • By end-2016, JPM will have tangible book value/share of $50 supporting a market valuation of $75 (1.5x tangible book vs. current 1.3x) given a return on tangible equity of ~13% – see Chart. This profitability is protected near-term by improving expense and capital efficiency as the firm delivers on its 2017 target of lowering core expenses by ~$5bn from 2014 levels and optimizes the risk balance sheet to reduce risk-weighted assets (by 7%+ in 2015 to the current level of ~$1.5tn despite loan growth of 16% on a core basis and 11% in aggregate).
  • However, the firm will have then met its 3-year expense-save targets and exhausted the ability of capital optimization to offset loan growth. This is why the reduction in the (internally-computed) minimum requirement for the CET1 ratio to 10.5% from 11.5% is important since, if accepted by regulators, it can prevent trapped capital from diluting returns and allow the payout ratio to improve from the current 55% even as riskweighted assets begin to increase in 2017.
  • To be conservative, we assume no regulatory benefit so that the CET1 ratio increases to the current management target of 12% (incorporating a 50bps buffer over the regulatory minimum) by end-2016 and then holds flat. This flattening allows the payout ratio to be maintained in the mid-50s as risk-weighted assets increase in 2017 and hence for JPM to maintain the dividend yield of 2.8% while increasing the buyback of stock to ~2% of outstanding, after allowing for the valuation re-rating we expect, from 1.4% in 2015. There is upside to the payout ratio if management is able to reduce its target for the capital ratio.
  • Obviously, there are risks in the energy sector but they lie within a margin of safety. For example, if oil remains at $30/barrel for the next 18 months (versus an end-2016 forward price of mid-to-high 40s), JPM expects to post additional reserves on its wholesale oil-and-gas portfolio of $750mm (versus $550mm in 2015). For context, the firm expects to earn an incremental $2bn in net interest income in 2016 even if rates are flat from today; based on a more favorable rate environment, we are modeling an improvement of nearer $3bn.

Chart: Valuation of US Banks (Source – CapitalIQ)

JPM: Balance-Sheet Risk is Over-Discounted

A “risk-off” environment is creating opportunity for bank investors.

We prefer C and BAC for their capital leverage, but JPM has reached a valuation that is difficult to ignore. Even assuming a 2016 payout ratio in line with 2015 at ~55% and near $2bn reserve build (so that coverage increases to by ~10bps to 1.7% of loans), JPM will end the year with a tangible book value of $50/share. With the return on tangible common equity running at 13%, and hence supporting a valuation of 1.5x book value (versus 1.3x today), this suggests upside in the share price of ~30% to $75/share.

The risks are of a capital hole in the balance sheet or meaningful decline in trend-profitability, with balance-sheet concerns centered on the energy sector and China. On energy, JPM has guided that, if oil stays at $30/barrel for 18 months (versus a forward curve suggesting mid-to-high 40s for end-2016), it will need to increase reserves on the wholesale oil and gas portfolio by $750mm in 2016, equivalent to ~15 cents/share on a tax-effected basis, and versus the $550mm build in 2015. For context, JPM expects to add $2bn to net interest income in 2016 if rates do not move from today’s levels; in practice, we expect a favorable move and model a $2.8bn increase. As to China, JPM has country-exposure of $16bn (or ~$3.10/share on a tax-affected basis) split roughly equally between lending and other activities such as trading and investing.

Trend-profitability at JPM is protected by improving expense and capital efficiency. The firm’s 3-year expense target for 2017 was to reduce the core burden by $5bn from a 2014 level of $58.4bn with $2bn of savings from the consumer business (as consumers migrate to digital channels) and $2.8bn from the institutional business (from business simplification and back-office rationalization). JPM is halfway along to both targets although there are offsets from investment (including $150mm in 2015Q4 for the consumer bank, for example). We model JPM reducing core expenses by a further $1bn in 2016 before flattening them out at $55bn in 2017.

Through 2015, JPM has become significantly more capital-efficient reducing risk-weighted assets by 7%+ to $1.5tn and the internally-modeled minimum common-equity tier 1 (CET1) ratio requirement to 10.5% from 11.5%. This matters since management’s target CET1 ratio of 12% is based on a 50bps buffer to the minimum requirement and will therefore likely decline with this minimum requirement, if regulators accept JPM’s computations, albeit after a lag; furthermore for JPM, unlike most banks, it is this ratio that is binding rather than the CCAR stress-tests.

Our model (see Appendix) assumes JPM raises the CET1 ratio from the current 11.6% to 12% by year-end and then holds it flat; the flattening will allow the current payout ratio to be maintained in the mid-50s even as risk-weighted assets begin to increase in 2017 with capital optimization no longer able to fully offset the impact of loan growth (of 16% on a core basis in 2015). Given this payout assumption, JPM can maintain the current dividend yield of 2.8% while increasing the buyback of stock to near 2% of outstanding, from 1.4% in 2015, and more if the stock is not re-rated as we expect to 1.5x tangible book value from the current 1.3x. There is upside to the payout ratio to the extent that JPM can reduce its minimum target CET1 ratio below 12% while still finding it, rather than CCAR, the binding constraint on capital management.

Appendix: JPM Model

Source: Capital IQ, SSR Analysis

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.

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