JPMorgan Chase: Retained Earnings to Boost Long-Term Returns

JPMorgan Chase (JPM) is taking a breather from buybacks to boost its capital position. While disappointing over the short term, I think the move will further strengthen the long-term potential of the bank, and I reckon the shares are now in the buy zone.

That said, there is no short-term catalyst for the stock, and you may well use short in-the-money puts to position in the shares. At the end of the day, the stock is still trading at a hefty premium to book value. Hence, the recovery in the share price should be a slow grind higher.

JPMorgan Chase operates in five key divisions: Consumer & Community Banking (CCB) at about 40% of Q2 2022 revenue; Corporate & Investment Bank (CIB) at 37.8% of Q2 2022 revenue; Commercial Banking (CB) at 8.5% of Q2 2022 revenue; Asset & Wealth Management (AWM) at 13.6% of Q2 2022 revenue and Corporate at 0.2% of Q2 2022 revenue.

Q2 2022 Operational Overview

Q2 2022 was a mixed quarter for JPMorgan Chase. On the one hand, the bank managed to deliver a 17% return on tangible common equity (RoTCE). This is 1% higher than the 16% in Q1 2022 and within the higher range that I deem currently achievable, minus any adverse credit events in a quarter.

The interest rate spread increased 7 basis points quarter-over-quarter to 1.68% and should improve further as the Fed keeps raising rates. JPMorgan is also conservatively building its allowance for credit losses, which is up 8.3% year-to-date to $17.75B, outpacing loan growth of 2.4% over the same period.

On the other hand, tangible book value per share is down 2.8% year-to-date, and the bank had to suspend share buybacks to boost its CET1 capital position of 12.2% (CET1 requirement set to reach 12.5% in Q1 2023). The losses in tangible book value can largely be attributed to $14.4B in negative accumulated other comprehensive income in Q1 and Q2.

On the conference call, management pointed out that most of the losses should reverse at a rate of circa 10 basis points per year of CET1 capital. Operating leverage was also negative, with expense growth at 6% year-over-year, outpacing revenue growth of 1%.

I think it is important to highlight that the 17% RoTCE was achieved despite substantial declines in some areas of the Corporate & Investment Bank. For example, Investment banking revenue is down 61% year-over-year, partially offset by a 15% rise in Markets revenue year-over-year. All in all, some recovery should be expected over the coming quarters, albeit by no means to unsustainable levels of 2021.

Finally, JPMorgan boosted its forecast for Net interest income by 3.5% to $58B on the back of expectations that the Fed funds rate reaches 3.5% by year-end.

2022 Stress Test

The stress test for JPMorgan envisaged the bank booking a net pre-tax loss of $40.9B through Q1 2024, with the CET1 capital ending at 10.6% in 2024. On the Q2 2022 conference call, management observed that the bank has weathered economic shocks in the past years without posting a net loss, as well as the progress made on de-risking the bank since 2007. All things considered, I think it is fair to say management views the stress test as too conservative, given the earnings potential and track record of the bank.

Nevertheless, at this stage, JPMorgan will have to retain a significant portion (circa 65%) of organically generated capital to reach its projection of about 13.2% CET1 capital at the end of Q1 2023.

Capital Return Path

As things stand, assuming stable risk-weighted assets of $1.71 trillion, the CET1 capital needs to rise from $207B to $225B over the next three quarters. Adding in the circa $3B a quarter needed to maintain the current dividend level of $1/share per quarter, we are looking at a net income run-rate of about $9B a quarter.

I think it is realistic to assume a more negative economic environment in the coming nine months, offset by the full run-rate effect of higher rates. All in all, the circa 13.2% CET1 aspiration looks achievable and can be accomplished by active balance sheet management. Case in point, management did manage to reduce risk-weighted assets by 2.5% quarter-over-quarter. This was beyond the effect of market risk normalization, which explained roughly 50% of the achieved decline.

At the end of the day, it is important to remember that the retained capital over the next year or so will boost the long-term earnings potential of the bank. Thus, I think, a return to dividend growth and/or buybacks is likely in the second half of 2023.

To sum up, looking over the medium term, I think investors are looking at a circa 5% dividend/buyback yield coupled with a high single-digit earnings growth, which bodes well for long-term returns in the low double-digit area.

Wall Street’s Take on JPM

From Wall Street analysts, JPMorgan earns a Moderate Buy consensus rating based on eleven Buys, five Holds, and two Sell ratings. Additionally, JPMorgan’s average price target is $147.53 (36.6% upside potential).

Key Takeaways for JPM Stakeholders

Shares of JPMorgan Chase have taken a beating this year and are trading at levels last seen in the aftermath of the Covid-19 correction in 2020. I think the stock is overly punished for the buyback suspension, and investors are ignoring the earnings boost that will come with higher retained earnings.

Thus, I think, gradually accumulating a long position in the company’s stock will pay off in the long term, keeping in mind the lack of near-term positive catalyst as well as the premium you pay in terms of tangible book for earnings consistency and solid operational track record.

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