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JPMorgan (JPM) Investment Write Up

JPMorgan (JPM) Investment Write Up

JPMorgan is the largest global bank with a market cap of $490bn, total assets of $3.4tn, and generates annual revenue of over $120bn. JPMorgan benefits from numerous competitive advantages including its massive scale, strong brand, and high customer switching costs. Furthermore, JPM has a leading market share across its four major businesses: Consumer & Commercial Banking, Corporate & Investment Banking, Commercial Banking, and Asset/Wealth Management. Specifically, JPM has the top global market share in Investment Banking and Capital Markets revenue, operates the largest U.S. retail bank, the 6th largest global Asset Manager, and one of the largest U.S. lenders to small and medium sized businesses.

This has led to peer leading returns on capital, with JPM generating a 14% ROTCE over the past decade, and 15% over the past five years. Additionally, JPM has substantially de-risked its balance sheet over time, as evidenced by much higher capital ratios, improved liquidity, and benign asset quality. As a result, JPM has weathered the brief COVID-19 recession well, and its balance sheet remains in great shape. Going forward I expect higher earnings power than the street expects driven by strong loan growth, Net Interest Margin (NIM) expansion, continued reserve releases, operating leverage, and robust share buybacks driven by JPM’s excess capital position. Furthermore, I believe a higher that historical P/E multiple is warranted due to expected higher ROE’s going forward with management targeting a 17% through the cycle ROTCE, and a stronger balance sheet which makes the bank safer.

The biggest risk facing JPM is increased competition from fintech players primarily targeting its retail banking business. However, JPM maintains a roughly $10bn/yr. tech budget and continues to improve its digital and mobile offerings to appeal to its retail and business banking customers. Furthermore, many of these fintech business models rely on regulatory arbitrage by operating outside of the traditional banking system, and it remains to be seen how viable their business models truly are. JPM along with the rest of the banking sector is also negatively impacted by the low interest rate environment, a headwind facing the sector since 2008, and net interest income accounts for 48% of JPM’s revenue. The bank has partially mitigated this risk through cost reductions, growth in its interest earning assets, and a focus on its many fee-based revenue sources.

From a valuation perspective, JPM is extremely attractive trading at roughly 12.5x my estimate of normalized earnings. Going forward I expect JPM to generate high single digit EPS growth driven by 3-4% revenue growth, modest operating leverage, and a substantial level of share repurchases driven by JPM’s excess capital position. Additionally, JPM would benefit materially from higher interest rates, and represents an attractive hedge against higher inflation and higher rates. 

Introduction & Segment Analysis

JPMorgan is the largest U.S bank with leading market share across its various business lines. The below chart succinctly lays out the numerous product lines JPM offers across its consumer and wholesale businesses.

JPM Business Segments

JPM compares favorably with its best-in-class peers in terms of both efficiency and returns on capital across its major businesses. Outside of Commercial Banking, which only accounts for ~11% of JPM’s earnings, JPM’s ROTCE are inline with its peers.

Segment ROE
Let’s take a quick look at JPM’s historical performance and key stats across its four business segments. Additionally, I’ll discuss my expectations for normalized earnings going forward.

Consumer & Community Banking:

JPM’s CCB segment has accounted for 39% of earnings over past 5 years. The CCB segment was materially impacted by COVID-19, which led to JPM increasing by $7.4bn y/y. However, I expect JPM to release ~$2bn of reserves in this segment in 2021 and for run-rate profitability going forward to improve to $17-$18bn/yr.

This business serves more than 63 million households in the U.S. and 4.3 million small business relationships. JPM is the largest U.S. bank by deposits with a 9.8% market share, as well as a 9.5% business banking share, #1 credit card issuer with 22% market share, #4 mortgage servicer, #2 bank auto lender, and #2 mortgage origination volumes (behind WFC). As of 1Q21 JPM had 4,908 bank branches, with $833bn average deposits across $657bn consumer and $175bn business deposits.

CCB Financials

Corporate & Investment Bank

CIB has accounted for 41% of JPM’s earnings over past 5 years. CIB earnings were elevated in 2020 driven by record high trading volumes in fixed income (+48% y/y) and equities (+33% y/y). Going forward I expect run-rate earnings of $14-$15bn/yr.

This business has dominant market share across its many business lines including #1 in global investment banking fees for the 12th consecutive year with 9.2% market share, #1 in total markets revenue with a 12.9% market share, as well as #1 in FICC and #1 in equities. Additionally, this segment has $31tn of assets under custody ranking #2 globally, and up from $19.9tn in 2015. This segment is also ranked #1 in USD payment volumes with a 23.8% market share up from 19.5% in 2016.

Additionally, JPM has continued to take market share primarily from the European Investment Banks who have retrenched amid weak results (CS, BACR, DB, UBS). JPM’s Investment Banking market share has increased from 7.9% in 2015 to 9.2% in 2020. Similarly, JPM’s Markets revenue has increased from 9.7% in 2015 to 12.9% in 2020, with strong market share gains across Fixed Income and Equities.

CIB Financials

Commercial Banking

CB has accounted for 11% of JPM’s earnings over the past 5 years. CB results were also negatively impacted by COVID-19, with a $1.8bn y/y increase in reserves in 2020. I expect JPM to release reserves in this segment in 2021 as credit conditions improve, and I expect normalized earnings power of roughly $4-5bn/yr. going forward in this segment.

This business operates 137 locations in the U.S. and 30 internationally, and provides credit, banking, and treasury services to 18K Commercial & Industrial clients, and 33K real estate owners and investors. Furthermore, this business ranked #1 in multifamily lending in the U.S. in 2020. As of YE20, the segment has average loans of $219bn avg loans and $238bn avg deposits.

CB Financials

Asset & Wealth Management

This segment has accounted for 9% of JPM’s earnings on average over the past 5 years, and I expect earnings of roughly $3bn/yr. growing at 5-6%/yr. going forward.

Globally, JPM is a top 6 asset management firm with $2.7tn of AUM and has a total of $3.7tn of client assets in its AWM business. JPM is the #1 ranked US private bank with $1.6tn of assets and a 12% market share. Additionally, AWM generates the highest ROE’s of any of JPM’s businesses, averaging 27% over the past five years, with the most stable revenue and earnings across JPM’s businesses.

AWM Financials

Quality of Management

Jamie Dimon has put together an impressive track record during his long tenure as the CEO of JPM since 2004, and Bank One from 2000-2004 (prior to the merger). During that time, JPM and Bank One substantially outperformed the S&P 500 Index and S&P Financials Index, generating an average annual return of 11.9%/yr. compared to 6.5% for the S&P 500 and 4.1% for the S&P Financials Index.

Dimon Performance

Importantly 83% of Jamie Dimon’s variable compensation is based on JPM’s 3-year average ROTCE compared to its peers, with higher payouts made for higher ROTCE’s as shown here. Furthermore, Jamie Dimon has beneficial ownership of 9.4mn share of JPM stock worth ~$1.5bn.

Dimon Comp
While Jamie Dimon is 65 and has been a public company CEO for more than 20 years, I expect him to remain CEO for at least 5 more years as he routinely jokes. Marianne Lake who previously served as JPM’s CFO from 2013-2019, and was recently named the co-CEO of CCB, will likely be Jamie Dimon’s successor.

Strong returns on capital

JPMorgan has generated strong ROE’s and ROTCE’s over the past decade averaging 11% and 14.3% respectively, and 12.1% and 15% over the past five years. Going forward, management is targeting a 17% ROTCE through the cycle, which is equivalent to a 14% ROE. I believe JPM can generate ROE's as high as 21% in a slightly higher interest rate environment as discussed below.

JPM Roe

JPM’s Fortress Balance Sheet

Capital Ratios at all-time highs

JPMorgan has materially improved its capital position since the Financial Crisis. Specifically, JPM has increased its key capital ratios as shown below. JPM’s Tier 1 Common Equity Ratio (CET1) has increased by 580bps since 2006, from 7.3% to 13.1% in 2020. Similarly, JPM’s Tier 1 Capital Ratio has increased from 8.7% to 15% over that time frame. As a result, the bank is much better able to weather future crisis, and in fact was able to improve its capital ratios in 2020 despite the pandemic due to strong earnings, and the halting of share repurchases.

Additionally, JPM’s CET1 of 13.1% is well above the required ratio of 11.3% and management’s target of 12%. JPM has excess capital of roughly $17bn and I expect will get approval from the Federal Reserve to repurchase more share later this year.

JPM Capital Ratios

Asset Quality

From an asset quality perspective, JPM’s asset quality has remained benign despite the COVID-19 pandemic. Through 1Q21, net charge-off’s remained at exceptionally low levels at 0.42% annualized. Similarly, nonperforming loans (NPL’s) as a percent of total loans remain low from a historical perspective at 0.83%. Furthermore, JPM is well reserved, with loan loss reserves at 274% of NPL’s, at the high end of the range since 2010.

JPM Asset Quality
Liquidity

Similarly, JPM maintains extremely robust liquidity, which has also improved substantially since prior to the Financial Crisis. JPM has experienced a massive inflow of deposits stemming from COVID-19 and is now awash with liquidity. As of 1Q21 JPM has $1.5tn of total liquidity including high quality liquid assets of $696bn (cash and treasuries) and marketable securities of $841bn equivalent to 42% of its total assets. JPM's robust liquidity position has put downward pressure on JPM’s NIM, as described below.

Normalized Earnings Power Underappreciated

I believe JPM’s earnings power is under appreciated for a variety of reasons. Specifically, I expect JPM to generate strong loan growth as the economy improves, NIM expansion from the steepening yield curve, asset quality trends to outperform expectations, and JPM to benefit from operating leverage.

Management is targeting a through the cycle 17% ROTCE, equivalent to a 14% ROE. JPM is also targeting a 55% efficiency ratio through the cycle, a reasonable target considering that JPM reported a 54% efficiency ratio in 2020 and a 55.4% efficiency ratio in 2021. Furthermore, JPM will continue to close bank branches and reduce consumer facing headcount, driven by the continued push into mobile and digital banking.

Strong Loan Growth

Over the past decade JPM’s loan portfolio has by 3.9%/yr. roughly in line with U.S. nominal GDP growth of 3.6%/yr. over that time frame.

JPM loan growth
However, JPM’s loan portfolio has declined by 3.6% y/y through 1Q21 because of weak loan growth in 2020 due to COVID-19, and many consumers and businesses focused on deleveraging during the pandemic.

Going forward, I expect JPM to generate strong loan growth in line with GDP growth as JPM has done historically. Most bank management teams expect 1Q21 to mark the bottom in loan balances for the sector, amid improving economic conditions and the vaccine rollout. On earnings calls, most banks said they heard more optimism among customers, loan pipelines are strong, and utilization rates should increase from historically low levels. Additionally, banks have loosened lending standards given the improved economic outlook.

Furthermore, the Fed’s recently released senior loan officer survey indicates there is robust loan demand across many consumer and commercial categories including autos, credit cards, and CRE. C&I loan demand is still weak but is improving rapidly off a weak base in 2020. CRE construction spending is also relatively weak, but demand is increasing significantly as many REIT’s have ramped up their development pipelines.

Improving NIM’s from yield curve steepening and redeployment of excess cash to securities at higher reinvestment rates

As of 1Q21 37% of JPM’s earning assets are in cash and cash equivalents effectively earning 0%, compared to 27% in cash and cash equivalents as of 4Q19. The higher percentage of cash has been driven by the large influx of deposits. As of 1Q21, JPM had $2.3tn of deposits +$442bn y/y, as the consumer savings rate has skyrocketed over the past year. Avg. deposits have increased even more over that time from $1.64tn to $2.22tn. Getting fully invested at 1.4% would increase JPM’s NIM by 17bps to 1.86%, which would increase pre-tax income by 5.3%. Even small changes in interest rates can have a large impact on JPM’s earnings. Given JPM’s $3.1tn of interest-earning assets a 10bps increase in yields would increase NII by $3.12bn.

The yield curve has steepened materially over the past few months driven by concerns regarding higher inflation, and the 2’s 10’s curve is now at its steepest level in over 5 years! As a result, JPM should earn a higher yield on new investments in securities, and loan rates should start to increase as well, a material positive for JPM.

Treasury Curve

Asset quality trends should to outperform expectations

As noted above JPM’s asset quality remains benign. I expect JPM to release $2.5bn of reserves in 2021, driven by an improved economic back drop, and then provisioning should normalize to $5bn/yr. in 2022 and 2023. The Federal Reserve forecasts U.S. real GDP growth to grow by 6.5% in 2021, 3.3% in 2022 and 2.2% in 2023. Similarly, the unemployment rate is expected to decline to 4.5% in 2021, 3.9% in 2022, and 3.5% in 2023. JPM’s loan loss provisions had averaged $4.7bn/yr. from 2014-2019, a period of modest economic growth and subdued unemployment rates.

Increased operating leverage

JPM should benefit from operating leverage going forward. While compensation expense has been flat at 30% of revenue from 2011-2020, JPM experienced efficiency gains in its non-comp expense which declined from 34% of revenue in 2011 to 26% in 2020. As a result, JPM’s efficiency ratio declined from 63.1% to 54.2%, an impressive 890bps of margin expansion. This has been driven by a strong focus on expenses with JPM closing 13% of its bank branches from 2012 to 2020 and marginally reducing headcount by 2% since 2011.

Expense reductions should contine driven by increased penetration of online and mobile banking, and a subsequent decline in in-person banking. Specifically, 69% of JPM’s CCB customers are digitally engaged, including 86% of business banking customers. As of YE20 JPM has more than 55mn active digital customers and more than 40mn active mobile customers. Furthermore, nearly half of JPM’s headcount resides in the CCB segment, and CCB headcount has declined from 161,443 in 2011 to 122,894 today.

Returning capital to shareholders

Finally, JPM has $17bn of excess capital as of 1Q21 with a CET1 ratio of 13.1%, compared to management’s target of 12%. The Federal Reserve’s CET1 requirement for JPM is 11.3%, based on the bank’s size and complexity. I expect JPM to repurchase ~$27bn of shares in 2021 and 2022, which will decrease JPM’s shares outstanding by 5-6%/yr.

Risks

Fintech disruption

JPMorgan faces disruption from numerous fintech companies, primarily in its consumer facing businesses. Jamie Dimon is well aware of this threat and spent considerable verbiage in his 2020 annual letter addressing the risk to banks, and highlighting the rise of shadow banks and growth of emerging competitors.

JPM nonbank competition
However, many of the fintech business models are built on regulatory arbitrage, by avoiding the onerous regulations that face the banking system. For example, this paper estimates that 60% of shadow bank growth is driven by regulation, and 30% from superior technology. In his 2020 Annual Letter, Jamie Dimon lays out the regulatory requirements between banks and their non-bank competitors:

Nonbank regulation
It remains to be seen how viable many of these fintech business models are, and if banking/consumer regulators decide to crack down on them. Nevertheless, JPM is not standing still. JPM has a massive tech budget of $10.3bn in 2020, +5% y/y and increased 12% in 2019 y/y. The bank continues to roll out new functionality as shown below:

JPM consumer tools


The biggest risk is that younger potential customers decide to bank with neobanks or fintech companies such as PYPL or SQ, who offer direct deposit and basic financial services such as checking and savings accounts and are looking to add additional financial services. However, most existing retail customers have multiple products with JPM, and historically switching between banks has been an onerous process. Furthermore, JPM has taken meaningful market share over time in its Consumer & Community Banking business and has taken in a meaningful level of deposits during the COVID-19 pandemic. If anything, JPM is in a stronger competitive position than it was pre-pandemic across all of its businesses.

Continued low interest rate environment

Net Interest Income has accounted for 48% of JPM’s revenue over the past 5 years and has been negatively impacted by the low interest rate environment since the financial crisis. Specifically, JPM’s Net Interest Margin (NIM) has declined from 3.12% in 2009 to 1.98% in 2020, a 114bps decline, which is very meaningful for JPM.

JPM NIM

To mitigate this challenge and improve profitability, JPM has focused on controlling expenses as noted above, has seen strong growth in interest earning assets, in addition to focusing on its many non-interest income revenue sources such as: asset management fees, investment banking fees and markets revenue, and lending fees.

Valuation

From a valuation perspective, JPM is relatively attractive trading at 12.5x my normalized earnings of $40bn, equivalent to an EPS of $13. Going forward, I expect JPM to generate high single digit EPS growth driven by 3-4% revenue growth, modest operating leverage, and substantial share repurchases as noted above. 

Historical Financials

JPM Financials

Normalized Earnings

Over the last year JPM earned $39.6bn despite a global pandemic and record low interest rates! Shown below are my estimates for JPM's normalized earnings as well as an illustration of how much JPM would benefit from higher rates. In that scenario I shown how JPM's earnings would increase by roughly 29% if its NIM increased to 2.25%, well below JPM's NIM in 2018 and 2019 prior to the pandemic. While it would take for higher rates to flow through JPM's income statement given an asset duration of 4-5 years, a NIM of 2.25% in a few years is not an unlikely scenario. 

JPM Normalized Earnings

 Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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