Equity Analysis: JPMorgan Chase

JPMorgan Chase & Co. (JPM) is in the financial services or financials sector. The financial services sector includes companies whose primary line of business involves banking, mortgage finance, consumer finance, specialized finance, investment banking, insurance, real estate, asset management and custody, corporate lending, financial investment, and/or brokerage services.

Some of the major competitors in the financials sector are Berkshire Hathaway Inc. (BRK-A), HSBC Holdings plc (HBC), Wells Fargo & Company (WFC), Citigroup Inc. (C), Bank of America Corporation (BAC), China Life Insurance Co. Ltd. (LFC), and Royal Bank of Canada (RY).

Industry
JPMorgan Chase & Co. generates a substantial portion of its revenue and/or earnings from the investment bank, retail financial services, and card services & auto segments. JPMorgan Chase & Co. is classified in the diversified commercial bank, and investment banking & brokerage industries.

Bank of America is in the same peer group as JPMorgan Chase & Co.: both firms derive a substantial portion of their revenue and/or earnings from similar business activities. HSBC Holdings plc, Wells Fargo & Company, Citigroup Inc., and Royal Bank of Canada are in the same peer group.

The HSBC Holdings plc and Royal Bank of Canada have exposure to different geographic locations: the closet comparable companies are Bank of America, Citigroup, and Wells Fargo & Company.

A firm can also be classified based on its sensitivity to the economic cycle. JPMorgan's revenue and earnings are strongly correlated with the economic cycle making the firm cyclical.

Barriers to Entry and Industry Concentration
Investment banking is concentrated with strong pricing power. Asset management is fragmented with strong pricing power. U.S. banking is fragmented with weak pricing power.

The barriers to entry into investment banking are high and the industry is concentrated. Investment banks are able to earn economic profits and can generate high returns on invested capital. The operating margin of the investment bank are high. Starting an investment bank requires a substantial amount of capital. Further, the intellectual capital required to attract customers is enormous. Lastly, the investment banking industry consolidated the past five to ten years.

The asset management industry is fragmented with strong pricing power. The barriers to entry into asset management are low: starting an asset management firm doesn't require a large amount of capital. However, large firms have the track record and advertising budget to attract and retain capital. The operating margin is high and JPMorgan generates high returns on invested capital.

U.S. banking is fragmented with weak pricing power. Regulation promotes competition in the U.S. banking industry. However, the barriers to industry entry are high. JPMorgan Chase & Co.'s combined bank margins are highs. Following the financial crisis, the industry trend has been towards consolidation.

Industry Capacity
The investment banking industry went through a period of overcapacity between 2007 and 2010. Following the financial crisis, firms left the investment banking industry as the demand for investment banking services declined. JPMorgan Chase & Co. purchased Bear Sterns which increased the firm's investment banking revenue. However, some firms are still cutting back on investment banking staff as demand for investment banking services continues to remain at subdued levels. JPMorgan's investment bank is well positioned for an increase in demand for investment banking services.

Capacity in the US banking industry increased between 2000 and 2008. Following and during the financial crisis, capacity in the industry declined: banks failed, reduced branches, and pulled out of some markets. In 2008, JPMorgan Chase & Co. purchased Washington Mutual and expanded its consumer branch network into California, Florida, and Washington State. The decline in industry capacity increased pricing power in the industry. JPMorgan Chase & Co. is well positioned for an increase in U.S. banking service demand.

Market Share Stability
The market share between JPMorgan Chase & Co., Wells Fargo, Citigroup, and Bank of America is stable. Stable market share typically indicates less competitive industries. The pace of innovation in the banking industry is slow, and depending on the service, the switching costs can be high.

Industry Life Cycle
The investment banking, asset management and US banking industries are in the mature life-cycle stage. The industries don't grow much, are consolidating and have relatively high barriers to entry. Industry growth is limited to replacement demand and population expansion. The industry is an oligopoly. The firm's customers are loyal to the brands. Also, the firms have efficient cost structures.

Macroeconomic Influences
The advance reading of third quarter GDP said the economy expanded at an annualized rate of 2.0 percent that is up from 1.3 percent in the second quarter. A faster pace of expansion leads to increased demand for financial services.

Interest rates have remained at extraordinarily low levels as the Federal Reserve maintains its quantitative easing program. Recent data points suggest increased demand for auto and home loans. Further, businesses have increased borrowing as lending standards eased.

The PCE price index, excluding food and energy, increased 0.1 percent in September, the same increase as in August. The subdued level of inflation suggests interest rates should remain low, and consumers and businesses should remain relatively confident.

Demographic Influences
Between April 1, 2010 and July 1, 2011, the population in the US increased 0.9 percent. The percentage of the population under 18 was 23.7 percent and the percentage of the population 65 and over was 13.3 percent.

The demographic trends are favorable. The US population is increasing, although, at a modest pace. The age distribution of the population doesn't suggest a declining workforce.

Products and Services
JPMorgan Chase & Co. offers investment banking services to corporate clients. The investment bank provides merger and acquisition solutions and advises on equity and debt financing. The firm also provides information management solutions to assist clients in managing multiple accounts seamlessly for increased cash management and transaction visibility. Investment management and advice offers strategies and advice that span the full spectrum of asset classes. Risk management creates solutions to help issuer and investor clients manage risk.

Retirement plan services provides U.S.-based companies and their employees with services, solutions and expertise needed to achieve retirement goals. Cross-border trade finance helps clients facilitate financing, optimize working capital, reduce risk and streamline trade flows. Payables and receivables provides solutions to reduce costs and payment risk. Commodities offers market making, structuring, risk management, financing and warehousing across commodity asset classes. Global corporate banking manages the firm's relationships with large corporations, financial institutions, and public sector organizations internationally.

The solutions for financial institutions and advisors include: financial institutionns and government assist clients with strategic advisory and capital raising services. Treasury services and solutions offers a full range of treasury services, capital market solutions, safekeeping and securities services, credit and global products. Capital markets advises clients on equity and debt financing to help them achieve objectives. Securities lending provides customized solutions to meet clients' specific risk/reward requirements. Prime services offers integrated financing, clearing, settlement and related execution platform to help clients run their business.

Small and medium-size business solutions include: cash management services, credit products, asset-based lending, health savings accounts, business banking, commercial real estate banking, international banking, and investment management advice.

Public sector and non-profit solutions include: public finance, retirement plan services, commercial cards for local and state governments, debt capital markets, investment management and advice, global liquidity services, government debit cards, global corporate banking, and card solutions for the federal government.

Solutions for individuals and families include: private banking, retirement savings, investment management, structured products, wealth management and brokerage, and mutual funds.

Demand For Products
Investment banking revenue is increasing. That said, revenue from the segment leveled off in recent quarters. Investment banking revenue declined 1.4 percent in the third quarter compared to the year-ago quarter. Revenue declined 7.2 percent compared to 2012's second quarter. Compared to 2010's third quarter, revenue increased 17.3 percent. Finally, compared to the third quarter of 2009, revenue declined 16.4 percent. Revenue in 2006 was in the $4 billion range and is now in the $6-8 billion range. Part of the increase in revenue is because of the Bear Sterns merger and part is because of improvements in business conditions. investment banking revenue is increasing at $109 million a quarter or 1.7 percent of third quarter revenue.

Retail financial service revenue increased from $3.8 billion in the first quarter of 2006 to over $8 billion in the third quarter of 2012. The increase in revenue is partly attributable to improved business conditions and mostly attributable to the acquisition of Washington Mutual. Retail financial service revenue is increasing at $169 million a quarter or 2.1 percent of third quarter revenue.

Card and auto service revenue increased from $3.7 billion in first quarter of 2006 to over $4.7 billion in the third quarter of 2012, a 27 percent increase. The increase in card and auto service revenue is because of the Washington Mutual transaction. Card and auto service revenue is increasing at $53 million a quarter or 1.1 percent of third quarter revenue.

The growth in JPMorgan Chase & Co.'s operating segments is primarily acquisition related, however, part of the increase stems from increased demand for the firm's products and services.

The outlook is for continued short-, medium- and long-term growth in demand for JPMorgan's products and services.

Consolidated Profitability
The net profit margin of the consolidated firm improved since 2008. Profitability is almost at pre-2008 levels, although, in 2011, profitability remained three hundred basis points below the 2006 level of 23 percent.

Segments Net Profit Margin
The investment bank is relatively high margin. The net profit margin is between roughly 20 and roughly 30 percent. Further, the profit margin increased since 2006.

Retail financial services net profit margin isn't stable. Sometimes the net profit margin is near 30 percent and at other times it is closer to 0 percent. The segment's net profit margin declined since 2006 as revenue increased.
Card and auto services is a stable, high margin segment. The segment is cyclical. Net profit margin ranges between roughly 20 and 30 percent.

The asset management segment's revenue is stable and the net profit margin is relatively high. That said, since 2006 the net profit margin declined from roughly 21 to about 18 percent.

Retail financial services is the largest segment by revenue. We'll have to watch the segment's financial performance, because it may be a drag on the consolidated business.

Return on Common Equity
JPMorgan Chase & Co.'s consolidated return on common equity increased in the third quarter to 2.96 percent from 2.63 percent in the second quarter. The increase in return on common equity is attributable to an increase in total common equity and an increase in net income applicable to common equity. On an annualized basis, return on common equity increased from 11 percent to 12 percent.

ROCE increased because the increase in net income applicable to common equity was greater than the increase in total common equity. It doesn't seem as though there were any significant accounting changes during the period that impacted return on common equity.

Book Value of Common Equity
JPMorgan Chase & Co. had a market capitalization or total market value of $156.3 billion at the close of trading on October 26, 2012. The total common equity reported at the end of the third quarter was $190.6 billion.

The market value of a firm reflects the historic operating and financial decisions of a firm's management as well as investors' collective assessment and expectations about the company's future cash flows generated by its positive net present value investment opportunities.

Investors don't believe that JPMorgan Chase & Co. has a large number of future cash flow-generating investment opportunities: the market value of equity is below the book value of common equity. Investors could also believe that the historic operating and financial decisions of the firm were negative net present value investments. Either, way investors believe the net present value of the firm's investments is negative.

In terms of investment opportunities, JPMorgan Chase & Co. may be able to expand its operations outside of the US. The firm could attempt to increase revenue and net income outside of the US in the asset management and investment banking segments. As developing markets continue to grow at a faster pace than developed markets, JPMorgan Chase & Co. could increase the proportion of total cash flows that are generated outside of the US.

In terms of return on assets, JPMorgan Chase reported an annualized return on assets of 1.01 percent. As previously stated, the return on common equity reported in the third quarter at an annualized rate was 12 percent. Return on tangible common equity was 16 percent.

Solvency
The tier one capital ratio, a measure of solvency, increased the past several years. At the end of 2004, the tier one capital ratio was 8.7 and declined to a low of 8.4 at the end of 2007's fourth quarter before reaching a high of 12.3 at the end of 2011. At the end of 2012's third quarter, the tier one capital ratio was reported as 11.9. The increase in the firm's tier one capital ratio is expected to be sustained.

Although the amount of tier one capital increased, the financial leverage increased. In 2005, the financial leverage ratio was 11.09 and reached a high of 12.88 in 2008 before declining to about 12 in 2012. Based on the financial leverage ratio, JPMorgan became less able to meet its debt obligations.

Growth Rates
Net revenue peaked in 2010 at $102.69 billion. Net revenue grew 57 percent between 2006 and 2011 or just over 11 percent per annum. Net income increased 31 percent between 2006 and 2011 or about 6.2 percent per annum.

Valuations
Based on a present value dividend discount model, JPMorgan is worth about $39.50-share. The current market price of about $42-share suggests the firm is fairly valued.

Using short-term multiplier model valuations, the firm is fairly valued to overvalued. Based on the absolute values of the multiplier model valuations, JPMorgan Chase & Co. is undervalued.

Investment Thesis
I think profitability is peaking and the short-term valuations are peaking. The recent economic data is also near a peak. JPMorgan is a short sale candidate. The market is probably headed back to $30-$33-share zone. Fourth quarter data probably won't be as good as the third quarter, and the market is in the process of discounting fourth quarter financials.

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.