JPM: Earnings Power and Buyback Capacity Under-Estimated
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
May 19, 2014
JPM: Earnings Power and Buyback Capacity Under-Estimated
- With declining Treasury rates over the last few months and a first-quarter earnings miss, consensus 2015 EPS for JPM has fallen to just above $6.00 from $6.35 in March. This is overdone, and we expect the bank to beat comfortably in 2015 as rising net interest margins lever over expense-saves particularly in the branch network. Our EPS estimate for 2015 is $6.30 including in-line legal expenses at an average run-rate of $500mm/quarter (so representing ~30 cents on full-year EPS). We differ from consensus in two main areas:
- Net Interest Margin: Management has guided for the NIM to be “stable to slightly positive” in 2015 while the forward markets, notwithstanding recent declines, are indicating a more meaningful up-move: 6-month Libor to 1.5% by mid-2015 (vs. 0.3% today) and 3-year swaps up even more, so that the curve steepens, to 2.4% (vs. 0.9% today). In the past, banks have captured ~one half of the increase in short rates through their deposit franchises and, while new liquidity regulations could blunt this somewhat, JPM has already adjusted. We are modeling a core (i.e. excluding markets-related activities), managed (i.e. taxable-equivalent) net interest margin of 2.4% in 2015 vs. 2.2% today and believe the risk is more to the upside than downside.
- Core Expenses (i.e. excluding litigation): Management has guided core expenses to “below $59bn” for 2014 with the first-quarter report annualizing at $58.4bn. Given this is seasonally comp-heavy and that JPM continues to capture efficiencies (with more detailed information expected in the Q2 report), we expect the full-year number to be closer to $57bn. Furthermore, as discussed in our note of April 23rd titled “Mobile Banking will Increase Scale Economies”, there is a secular decline in the cost-to-serve of retail customers as they migrate to mobile and online channels with JPM expected to cut branch staff by 20% over the next two years.
- Finally, JPM is in a position to increase its stock buyback in 2015 to at least $10bn (or ~5% of current market cap of $202bn). This will not create additional accounting leverage even assuming a $5bn adverse impact to equity from other comprehensive income (as rising rates lead to negative securities marks). Given JPM will reach its 10% target for the Basel 3 CET1 ratio by year-end and will move the firm SLR above the current 5.1%, we do not believe regulatory capital or the CCAR process will prevent the modeled 70% payout in 2015.
JPM has lost 12% of its market value since April 1st with nearly 10% (from 4/9 to 4/11) after the bank reported 2014Q1 results missing revenue and earnings estimates which management attributed to headwinds in mortgage and markets; the decline since then in interest rates (with the yield on the 10-year Treasury falling to just over 2.5% from over 2.7% three weeks ago) has rekindled concerns about whether management guidance for a “stable” net interest margin can be relied upon. The result is that EPS estimates for 2014 have been cut sharply and now stand at around $5.40 from $5.90 in March along with those for 2015 which now stand at just over $6.00 from $6.35 in March.
Positive Surprise in 2015
The 2015 numbers are too low particularly since JPM appears on track to deliver 2014 core expenses near $57bn vs. management guidance for under $59bn. Furthermore, the 2015 forward markets are indicating a meaningfully more favorable rate environment with 6-month Libor at 1.5% (vs. just over 30 basis points today) and the 3-year swap rate at 2.4% (vs. 0.9% today). While loan spreads are coming in, we expect a combination of rising short rates and a steepening curve to lift the core (i.e. excluding the impact of market-related activities) net interest margin in 2015 materially above the 2.2% reported in 2014Q1. Our specific estimate is for 2.4% which, with every 10 basis points on average interest-earning assets of ~$2tn adding 25 cents to EPS, generates an EPS estimate of $6.30 (see Appendix for summary model).
We believe consensus reflects management guidance for the core NIM to be relatively stable in 2014 and “stable to slightly positive in 2015 assuming the implied rate curve stays where it is” and that this guidance is too conservative particularly given JPM, having for example doubled deposits-at-banks to $320bn from the year-ago quarter, is compliant with “LCR” regulatory requirements for liquidity.
Plus Stock Buyback of $10bn
In the 2014Q1 report, JPM confirmed that it would be increasing the dividend to 40 cents/share (from the current 38 cents) beginning in the second quarter and had received no regulatory objection to its plan for stock buyback of $6.5bn ($5bn net of employee issuance) from 2014Q2 through 2015Q2. Even if JPM front-loads this somewhat to buyback $5bn of stock over the last three quarters of 2014, it will still de-lever meaningfully with the equity-to-assets ratio rising to 9.3% by year-end from 8.9% today. For example, the equity-to-assets ratio will increase to 9.1% even assuming a negative $2bn impact from other comprehensive income (so $3bn in the last three quarters given the $1.1bn positive impact in 2014Q1). Moving into 2015, JPM will retain this accounting leverage if with a stock buyback of $10bn (so near 5% of the current market cap of $202bn) even assuming: an increase in the dividend to 44 cents/share in 2015Q2; an adverse impact on equity of $5bn from other comprehensive income reflecting the impact of rising rates on the available-for-sale securities portfolio; and no benefit from reissuance of Treasury stock (see Exhibit 1).
Exhibit 1: Forecast Buyback and Changes in Stockholder Equity
We expect JPM to act aggressively to buy-back stock at current levels. On February 25th (when the stock was at $57 vs. $53 today), management commented on their analysis the stock price discounted a CAPM-based cost-of-equity of 10% and a return on tangible equity of 13% (vs. their target of 15-16%). While not endorsing the methodology, we agree directionally with the conclusion; more important is management’s take-away that “repurchasing stock at prices significantly higher than current levels creates shareholder value”. We do not expect regulatory stress-tests to limit a buyback to below our estimate as JPM will not grow the balance sheet (with, for example, 4% core loan growth in Q1 offset by run-off portfolios in card and mortgage) on either a risk-weighted or notional basis, and will accrete regulatory capital in 2014H2 to reach a fully-phased Basel 3 CET1 ratio of 10% by year-end (vs. 9.5% today) and raise the firm’s fully-phased SLR above the today’s 5.1%
Appendix A1: JPM Model – Revenue and EPS
Appendix A2: JPM Model – Equity and Returns
Appendix A3: JPM Model – Balance Sheet, Loans, and Rates
- Doubling deposits-at-banks over the last year to $320bn (or ~15% of the balance sheet), for example
- Core non-compensation expenses are annualizing at $27bn for 2014Q1 vs. the 2013FY result of $28.5bn.
- JPM, at its February investor day, guided to a $40bn reduction in RWA; current RWA are $1.638tn