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Income, Investing  | January 24, 2019

JPMorgan Chase (JPM) reported Q4 2018 results earlier this week with earnings missing the consensus analyst estimate by a considerable margin, as the reported EPS of $1.98 was way off the analyst estimate of $2.20. Despite the miss in Q4, JPMorgan's overall financial performance has improved significantly over the last few years, and I believe investors should jump in to buy JPM shares at any price pull-back. The underlying macro-economic conditions should provide a strong platform for JPM to continue delivering value to its shareholders, and I believe the bank's extensive scope and scale will allow it to hold on to its title as the largest bank in the U.S. In the banking industry, scale remains one of the most important profit drivers as it enables banks to obtain capital at a relatively lower cost than their rivals who do not have the same scale and brand value.

Company Overview and Business Strategy

JPMorgan Chase remains the largest bank in the U.S., which illustrates how the bank has been able to grow a sticky customer base that would not leave the bank due to increasing switching costs and brand loyalty. Being the largest player in the banking industry provides significant cost benefits to JPM, which they have been able to leverage to achieve higher operating efficiency in comparison to its peers. The industry-leading position has further enabled the bank to weather economic downturns in the past, and I expect the company to remain in a position from which they can grow, even if global economic growth slows.

(Source - Author prepared based on data from company filings)

JPMorgan Chase's business operations can be categorized into 4 operating segments.

(Source - Market Realist)

Company management has focused on achieving a few key strategic priorities such as;

  1. Deepening relationships with clients and improving customer experience
  2. Leading innovation in the payments segment by delivering advance solutions
  3. Increasing digital engagement.

Addressing rapidly changing consumer preferences has remained one of the key strategic objectives of the bank, which has so far enabled growth in all of these segments over the last couple of years, and I believe the bank will continue to focus on improving the digital experience of its customers which would in return ensure customer stickiness.

Another key objective of the bank is to widen its reach by expanding into foreign regions. JPM has so far been successful in establishing offices in more than 100 different locations across the globe, and management is focused on increasing their market penetration in existing markets, as well as targeting new markets.

JPM has strategically established their offices in regions they believe will grow the fastest. Moving forward, I believe a significant portion of revenue from the investment management segment will come from regions such as China, India, and Brazil, for example - all areas witnessing strong growth.

The company is positioned to have a first-mover advantage in many developing regions, which would be helpful in bringing in loyal customers to the bank.

(Source - Company website)

Entering into partnerships with industry-leading companies is another strategic objective of the bank, and JPM has already shown signs of seeking growth through such initiatives. JPMorgan's industry-leading position in the banking industry certainly provides the bank with a competitive advantage over its peers to partner with giants from other industries.

Industry Outlook

The global banking industry has come a long way from the bottoms seen in the financial crisis, and banks across the globe have adopted stringent measures to avoid another crisis of a similar magnitude. Currently, the overall banking industry looks to be in a healthy position from which they can support the expected global economic growth.

(Source - Deloitte)

Technological advancements are continuing to disrupt the global banking industry, and the trend is expected to remain the same for many years to come. Industry veterans have openly admitted the challenges posed by continuously changing technological developments, but at the same time, major banks are planning to embrace these developments to drive future growth of the industry.

(Source - Deloitte)

The consumer banking segment will remain one of the prime growth opportunities for banks as global wealth is forecast to reach record highs in the years ahead.

The investment management industry will also become more digitized in the future, and industry players have already invested significant amounts of capital to improve their digital offering and ensure systems are in place to serve a more digitally fluent customer base.

The rise of low fee index funds and robot advisors is already posing major challenges to existing industry leaders, but I believe deep-pocketed market leaders will embrace new developments such as these and continue to maintain profitability in their business operations.

Profit margins of asset managers have certainly deteriorated with the rise of automated and low-fee investing, but eventually, large-scale asset managers and investment management firms will introduce rivalry services of their own, which would provide additional revenue streams, expand their base of customers, and make it more difficult for any pure-play robo advisor to compete with.

Potential rate hikes by the Fed should also be monitored as a key development in the banking industry. Interest rate hikes will have a ripple effect on stock markets, and the negative correlation between stock prices and interest rates should lead to a subdued stock market performance in a macro-economic environment in which interest rates are rising even if rate hikes are expected to slow.

Banks will generally benefit from interest rate hikes particularly when rate hikes are accompanied by yield curve steepening - allowing banks to attract deposits with the higher short-term rates, and invest or lend it at higher long-term rates. The key driver here is that when rates are low across the board, consumers are less likely to 'park' their money in a cash account, whereas when rates rise, they are more likely to deposit their excess cash in a bank account. So, interest rate hikes.

In addition to a favorable yield curve, banking industry profits are closely tied to the level of economic activities in a country, and if rates get too high, they might adversely affect the economy as a whole, and businesses might be less inclined to pursue growth opportunities funded with loans. On the other hand, banks with a significant exposure to capital market operations might have mixed results as fees from asset management will decline along with declines in Assets Under Management (AUM).

Overall, the banking and financial services industry will see dynamic changes in the next decade, and even large-scale players will be put to test. However, I believe banks with clear strategies on providing a more digitized experience to customers, with access to significant capital resources, will grow gradually and steadily.

Analysis of Financial Performance

Even though Q4 2018 results came in below expectations, the big picture for JPMorgan Chase remains intact, and the released financial data are still illustrative of the bank's ongoing growth story.

(Source - AlphaStreet)

Even though JPM's revenue has grown at a modest pace since 2013, the bank has been able to improve its net profit margin at a healthy rate. I believe this will continue to be the trend in the near future as well even as revenue is expected to grow at a slower rate.

(Source - Author prepared based on data from company filings)

In the trailing twelve months (TTM) period, JPM has achieved a Return on Equity (ROE) of above 12%, which is well above most of the major peers except for Wells Fargo (NYSE:WFC).

(Source - Author prepared based on data from company filings)

I believe the banking industry will become increasingly concentrated around a few key players, as smaller banks lack the ability to invest aggressively enough to keep up with the changing environment and would eventually be acquired or be relegated to focus on narrow niches in their smaller respective markets. This will certainly provide an opportunity for JPM and other large banks to build on their market share.

A notable development in the case of JPM in this regard is the increase in non-interest related expenses, especially related to tech and communication. I believe these costs will increase exponentially over the next half a decade as the bank shifts to a digital era - but these expenditures should create opportunities that a smaller bank without the adequate resources would not be able to pursue.

(Source - Author prepared based on company filings)

JPM allocated $1.5 billion as provision for credit losses in Q4, which is an increase of around $240 million from the reported figures in the corresponding quarter last year. Despite the pessimistic signal this provides of the future, I believe the bank has adequate resources, skill, and risk management processes to maintain the quality of their loan portfolio. If anything, this positions the company for a considerable downturn that, if it doesn't occur, would allow the company to reverse those entries and increase earnings.

Valuation

JPM is currently trading at 12.5 times its current earnings and 1.4 times book. I believe JPM will continue to earn returns above its cost of capital due its ability to earn a higher return on its asset base and its competitive position. Despite a higher expected non-interest expense figure, I forecast JPM net earnings to grow in fiscal 2019 as well, and it remains the industry leader in an increasingly competitive market.

As per guidance provided by the Fed, we can expect rate hikes to resume somewhere in the middle of this year, and this will help JPM continue to expand on its margins. Even though there would be an added pressure on the capital market segment of JPM, I stand by the view that the bank will successfully mitigate such risks in the medium term and retain its profitability.

Based on these assumptions, I believe JPM should trade at a slightly higher earnings multiple - close to its 5-year average, and a higher book value multiple as well.

(Source - NASDAQ)

Based on the consensus EPS forecast of $9.93 for the fiscal year 2019, a convergence to the 5-year average P/E multiple of close to 13 gives a fair value of $129.09 for JPM. I believe the consensus EPS forecast for 2019 is achievable and weighs in the growth opportunities and risks accurately.

JPM clearly deserves to trade above industry average multiples as the industry leader, and I believe JPM would be able to weather expected economic storms better than its peers. Moreover, the Net Interest Margin (NIM) is expected to widen in 2019, and the interest rate environment continues to support such a thesis.

JPM as a Dividend Play

JPMorgan Chase has a rich history of paying dividends and distributing wealth to its shareholders. Since 2011, JPM has hiked its dividend on several occasions, representing management's willingness and ability to distribute wealth to shareholders.

(Source - Street Insider)

JPM shares are currently trading with a yield of above 2.6%, and there is a share buyback program in place which should drive per-share valuation metrics in future reporting periods.

It has maintained a dividend payout ratio close to 30%, which has equipped the company with necessary capital to pump into growth operations while paying back loyal shareholders. Striking a balance between distributing and retaining wealth is important, and I believe JPM has done this well and will probably continue to maintain this sustainable payout ratio until growth opportunities diminish.

JPM generates sufficient cash from their operations to service the dividend in the future, which adds a margin of safety.

With dividends set to grow in the future, dividend investors will enjoy a boost to income on top of expected capital gains.

Risks and Challenges

  • The primary risk for the banking industry is the uncertainty surrounding the regulatory environment. The banking industry is closely scrutinized by various regulatory bodies with a view of minimizing the risk of an impending crisis, and this additional scrutiny might bring about adverse changes to regulatory requirements that banks must adhere to. Such policy changes will hinder growth prospects for JPMorgan Chase and all other banks in the industry.
  • On the other hand, the industry is becoming increasingly digitized. With this developing trend, banks are now being more exposed to the risk of hackers than ever before. These scandals need to be addressed by banks, and billions of dollars need to be invested to prevent such illegal account activities from happening. Technology-related overheads are clearly rising, and profit margins will come under further pressure. Failure to comply with growing regulatory framework related to digital banking services and failure to prevent fraudulent activities will lead to hefty fines amounting to billions of dollars. The major issue for banks is that there could be openings for such unauthorized activities even if they take prudent care to prevent those from happening. Such is the nature of technological advancements, and banks will spend more money than ever before on eliminating these threats to the best of their abilities.
  • A slowdown of economic activities is another risk that needs to be considered when investing in banking stocks including JPM. During an economic recession, unemployment levels rise, and consumers curb their spending. In line with these developments, business activities will subside significantly, and the need for banking services will dramatically decline. On the other hand, JPM has a diversified portfolio, and not all of its business segments will be impacted to the same degree by an economic downturn.
  • In an economic downturn, the investment management business should have declines in AUMs, and the payments segment will likely see negative growth as well. And if an economic downturn occurs earlier than expected, it would take longer to recover investments related to infrastructure and digitization.
  • The quality of the loan portfolio will also suffer, and non-performing loans will start eating into company profits as the economy sours.
  • Finally, the rising rate environment will discourage new home buyers, and the demand for re-financing will lose its steam, which would hurt the mortgage business segment of JPM.

Overall, there are several risks of investing in the banking sector, but JPM stands in a position to maneuver through difficult times, if such times arrive sooner than expected, and remain profitable in the long-run.

Our Take

JPM is the leader in the banking industry in the U.S., and the company has a diversified offering of products and services. Investors have become wary of deteriorating growth prospects for the bank, especially after the release of Q4 2018 earnings yesterday. However, I believe investors need not worry about JPM's growth prospects based on the performance of a stand-alone quarter. In any case, JPM was able to beat their comparative figures from the corresponding quarter last year easily. Despite expected headwinds, JPM will continue to earn economic profits based on its strong capital structure, diversified product portfolio, industry-leading position, and competitive advantages of being the industry leader.

The recent indifference shown by the market after the disappointing earnings leads me to believe that there is broad support for the stock and that any good news in the short term will result in considerable upside to the stock price.


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