Is 7% Earnings Growth Realistic for JPMorgan?
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JPMorgan (NYSE: JPM) CEO Jamie Dimon has received accolades as one of the best bankers in the world. The bank made it through the worst financial crisis in decades. In fact, it has grown its net income from $5.6 billion in 2008 to $18.9 billion in 2011. This translates to net income margins of 8.33% to 17.67%, implying that profitability is above pre-crisis levels. In contrast, its peers were in an uncomfortable position during the same period. Citibank was not profitable until 2010. It reported net profit of $10 billion in 2010, which translates to a margin of 12% to 14%. Separately, Goldman Sachs (NYSE: GS) reported net income of $2.3 billion in 2008 and increased its net income $4.4 billion in 2011. Net income margins for Goldman Sachs averaged 8% to 19% for the same period.
JPMorgan's strong performance is attributed to its common sense approach to risk management and will lead us to conclude that it will continue to outperform its peers. For the next five years, the firm is expected to grow its earnings by 7% per year, which seems good considering that the global economy is still fragile.
Despite the bank's recent $2 billion loss, Mr. Dimon said that the bank is still well capitalized. It also expects that it will remain profitable for the year. My back of the envelope calculation suggest that earnings per share will decline to $1.96 per share after a trading loss of $9 billion. This is significantly lower than the $4.71 earnings per share in 2011. Net margins will be at 7%, below the 2008 levels. I believe this is still optimistic, as some analysts estimate JPMorgan's 2012 earnings to hit $0.56 per share. Its dividends and share repurchase plan will also be reduced. Assuming a 10% payout, it is expected to pay dividends of $0.19 per share. This implies a dividend yield of 0.55%, which seems unfortunate as it had expressed that it would increase its dividends by 20% this year. It also halted its $15 billion share repurchase program, which analysts expect will resume next year.
Since the trading loss will go directly to its profit and loss statement, I believe its capital ratios will remain stable. Its financial leverage is still reasonable at 13 times equity, below the levels of the financial crisis. In short, it seems that the loss appears small relative to the size of its balance sheet. It has total assets of more than $900 billion in 2011, implying that it has enough of a cushion against potential future losses.
I also believe that there is no need for the bank to raise additional funds from this loss alone. If the bank plans to raise funds, it should approach Berkshire Hathaway's (NYSE: BRK-A) Chairman Warren Buffett. Buffett has invested personally in JPMorgan and believes in the abilities of Mr. Dimon to turn things around.
In 2008, Goldman Sachs offered Buffett convertible bonds. I believe that JPMorgan preferred stock will yield Buffett some 10% to 12%. While the cost of money for JPMorgan will move higher, it will rebuild its tainted reputation. The stock has declined by more than 20% over the last three months since the announcement of its $2 billion trading loss. In my view, a Buffett imprimatur will appease investors in the short term.
Is this a question of governance or size?
There are arguments that the size of bigger banks is an obstacle to strong corporate governance. It is not easy for a Wall Street CEO to effectively manage a bank with diversified services. The British Banking System has implemented rules that retail and investment banking should be operating as separate businesses. With this, the CEO of a large bank can manage risks and funding costs effectively.
Going forward, investors will scrutinize the risk management practices of banks in a stressed environment. It is indeed difficult to model possible scenarios and incorporate them in banks' risk management strategies. However, the future qualities of a CEO will be someone who has the character and ability to handle unforeseen future risks. I also believe that regulators will require additional disclosures in terms of how banks manage their trades.
Broad Industry Valuations are Too Low
JPMorgan is currently trading at 9 times earnings. If it earns $1.96 per share, this will suggest an earnings multiple of 18. Over the last five years, it has traded between 7 and 39 times earnings.
Major financial stocks are currently trading at historically low multiples. Citigroup is valued at 7 times earnings. Goldman Sachs is trading at 14 times earnings. Other banks like Wells Fargo and U.S. Bancorp are trading at 11 and 12 times, respectively.
These valuations reflect uncertainties in the current stressed environment. Financial stocks have increased slightly by 2% this year. I expect flat to zero capital gains this year from financials unless I see catalysts. These catalysts include share buybacks, higher dividends, and better than expected earnings.
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