Quick Thoughts: JPM – Cyclical Improvement in NIM and FICC will Lever over Flat-to-Down Expenses for a 2015 EPS Beat
JPM’s economic model is to sustain a tangible ROE of 15-16% despite lifting the CET1 ratio (to 10-10.5% from the current 9.6%) by levering higher net interest income over flat-to-down expenses (for a 55% efficiency ratio vs. 59% in 2013); this assumes flat RWA at $1.6tn and declining reserve releases. Specifically, the firm sees:
- Net Interest Margin (NIM): The net interest margin increasing from 2.2% in 2013 to 2.7% as rates normalize (4% increase in short rates, 2% in long rates) generating incremental net interest income of $8-10bn or ~20% of the current base of $44bn; this assumes core loan growth of 5% (with a declining headwind from legacy run-off) and less of a net rates/mix benefit than in the last up-rate cycle (reflecting more rate-aware consumers, the impact of technology in reducing balance-transfer friction, and stiffer liquidity requirements).
- Expenses: 2014 expenses (ex-legal) coming in below the 2013 level of $59bn as an incremental $1bn in control expenses (equal to the 2013 increment) and $1bn in growth-investments are offset by lower consumer banking expense including a downsized mortgage business (saving $1.5bn) and optimization of the branch network around digital channels (saving $1bn); the control expenses flatten in 2015 while we expect the savings in the branch network to continue.
CFO Marianne Lake confirmed the CET1 (not leverage) ratio is the gating factor on share repurchase; a 10.5% ratio corresponds to an estimated $25bn buffer, before share repurchases, under the CCAR stress test. Assuming qualitative tests are met (e.g. around the stability and sustainability of earnings), this means net income will be available for reinvestment and buyback once the CET1 target is met by end-2015; 5% growth in the balance sheet then corresponds to a gross payout ratio of 65-70%.
JPM is making conservative assumptions particularly on the timing of net interest income which it indicates will be stable over the next two years with “significant upside when front-end rates increase”. We expect meaningful margin upside in 2015 given the forward market is indicating 6-month Libor at 1.5% by mid-year vs. below 0.4% today. We also expect upside from investment banking given JPM reports the adverse effect of secular change in the markets, including FICC, businesses is largely in current revenues, so there is leverage to a recovery in trading volumes and decade-lows in volatility across multiple asset classes.
As a result, we expect JPM to comfortably beat EPS consensus in 2015, and note that a 15-16% tangible ROE corresponds to a valuation of 1.7-1.8x tangible book value (currently $42/share rising to $45 by end-2015 consistent with a $80 share price). Our May 19th research note, “JPM: Earnings Power and Buyback Capacity Under-Estimated”, provides a detailed earnings and capital model supporting our 2015 EPS estimate of $6.30 vs. consensus of just above $6.