Description

I like the J.P. Morgan Chase TARP warrants (JPM/WS).

JPM is a good business:

The average bank is a bad business.  Capital intensive, commodity, low growth, blow-up prone, etc.

A well-run bank is a good business.  Banking offers essential services; the services tend to produce recurring revenue; there are high customer switching costs across various business lines; there are network effect benefits due to physical branches and ATMs; there are scale advantages in various regulatory, transaction processing, IT investment and other areas.

JPM’s advantages in these areas manifest themselves in a low cost of deposits (11bps in Q1), high fee income, efficient operations and relatively stable earnings through the cycle.  The reason having low funding costs matters so much is that it allows a bank to match competitors on price while maintaining similar or better spread income and taking lower risk. Where banking goes bad is on underwriting credit and reaching for yield in worse credits.  

My view is that JPM management is terrific and shareholder oriented.  

Some stats at Q1:

*Strong balance sheet: 10.7% CET1 ratio; 56% loans to deposits

*Well reserved: loss reserve coverage of 3.3x charge offs, 1.85x NPAs and 1.9% of loans

*Demonstrable ability to earn through problem loans: 4.8% q1 annualized pre-tax pre-provision income to loans

*Diversified earnings stream: 38% consumer, 43% i-bank, 10% commercial, 9% asset management

*Decent returns: 0.94% ROA; 11% ROE; 14% ROTCE

Review the 10 year charts on page 3 and 4 of the Annual Report.  They are really good illustrations of the consistency of the business.  Particularly noteworthy is the steady rise in book value right through the financial crisis as JPM remained profitable throughout. Also check out the comparison of JPM efficiency and return metrics vs. best in class peers on page 7.

JPM looks cheap

EPS estimates per Bloomberg are $5.88, $6.54, $7.20 and $8.20 in FY15-18.  These seem reasonable, more or less. JPM trades at a bit over 10X FY16 EPS est.  Book and tangible book value are currently $45.45 and $57.77, so it trades at about 1.5x and 1.15x respectively.

Despite being cheap on current numbers, profitability is subdued by low interest rates.  See page 34 from the Feb investor day.

JPM/WS offers low-cost leverage to continued growth of book value

October 2018 expiration

$66.42 JPM common (A)

$24.50 JPM/WS warrant (B)

$42.363 strike (C)

$24.06 intrinsic value  (A - C)

$0.44 warrant premium (B - intrinsic value)

Additionally, there is a complex formula that resets the warrant strike lower for dividends in excess of $0.38 per quarter and resets the warrant number higher.  

Here’s how I view the warrant.  I am putting down equity of $24.06 to purchase a $66.42 stock.  I am borrowing the difference ($42.363).  The cost associated with that loan is a combination of foregone dividends (14 quarterly dividends of $0.38) and warrant premium ($0.44) or $5.76.  Very simplistically, I am leveraging my capital about 2.75 times at a cost of 3.9% annually over a 3.5 year period.  Additionally, we are getting a $42.363 strike 3.5 year put for free.  (Jan ‘17 $42.50 puts are indicated at a $1.23/$1.45 bid/ask, though not active).

I guess a proper response is so what?  Well, the street is at $8.20 for FY18 EPS.  I am at a bit over $77 of book at Q4’18 and I believe an 11% ROE or $8.50 of EPS is achievable +/- 10%.

In 2018, I see JPM common as:

On the upside, 10-14X FY18 EPS is $82-115.  

On the downside, 0.85X book is $66.

In a crisis, anything goes.

The range of outcomes for the warrants looks pretty attractive to me.

Risks:

Trading liquidity is very thin vs. the common, but worst case you can convert warrants to common and lose the premium

It’s a bank, macro is front and center.  (historic risk management has been quite good.)

It’s a warrant, market risk is high.  (can be hedged.)

Derivatives!!!  (‘08/’09 was a pretty good risk management test and the management team appears well aware of the liquidity and rate shock dangers lurking in the current environment.)  

Regulatory/Legal?  (They’ve survived it to date and we might be over the hump where things are incrementally less bad.)

Regulatory/capital?  (I am not very concerned as services will re-price to account for higher capital.  Also, peers with lesser capital requirements are more likely to be forced by the markets to move to JPM’s capital standards over time, particularly in another crisis.)

This write up is obviously incomplete so you should do your own homework and not rely on my numbers.

Prospectus:

http://www.sec.gov/Archives/edgar/data/19617/000119312509249391/d424b7.htm

Warrant adjustment disclosures here:

http://investor.shareholder.com/jpmorganchase/warrant-info.cfm

Annual report here:

http://files.shareholder.com/downloads/ONE/4017615670x0x820077/8af78e45-1d81-4363-931c-439d04312ebc/JPMC-AR2014-LetterToShareholders.pdf

Investor presentations here

http://investor.shareholder.com/jpmorganchase/presentations.cfm

Catalyst

time