JPM: Boring stock with exciting upside

JPM (JP Morgan Chase) is the third largest integrated bank in the US behind Citigroup and Bank of America. JPM participates in several branches of the financial services that range from investment banking, consumer banking, consumer loans, commercial and residential mortgages, as well as credit card business. I believe that JPM is likely to be primary beneficiary of the moderating economy and stabilizing interest rate environment.

Unpleasant History and looming turnaround

JPM was formed by a mega merger between JP Morgan and Chase Bank. The merger initially brought disastrous results for the combine entity. As tech bubble burst in the middle of 2000, investment banking environment deteriorated significantly. JP Morgan and Chase did not share common business operation. The business was simply stitched together with significant overlap in the client base for similar line of investment business. When the clients started to pull back their spending, JP Morgan Chase was hit harder than other investment banking firms. The company started to show significant earning shortfalls and the street lost the confidence in the management team and took the stock price to multi-year low level in late 2002.

The things started to turn around when new CEO Jamie Dimon join the company via Bank One acquisition to expand the consumer banking business. Dimon left Citigroup when he failed to become a CEO to lead the turnaround efforts at Bank One. The Bank One share soared under Jamie Dimon's leadership which emphasizes details and cost cutting in running his business. Simply put, Jamie Dimon has been superb in streamlining the business and maximizing the shareholder return. Last Q results show signs of life for JPM. JPM handily beat the consensus EPS estimate by whopping 12 cents although the guidance was still cautious under the difficult interest rate environment. To me, JPM is being conservative with its guidance and upside to the consensus EPS number exists for the quarter ending in June.

Several areas for business operation efficiency improvement represents substantial upside room for earning leverage

Operational margin and net profit margin of the well-run banks such as Citigroup, Bank of America, and Wells Fargo are well ahead of JPM's number. While operational margin and net profit margin number typically are in the low fifties and high twenties respectively, JPM number is barely above 40% op ex and 21% for net profit. ROE (return on equity) also lags the competitions as well. Ironically, these lags in the operational metrics represent extra rooms for the share price appreciation. In my opinion, current CEO with proven track record of cutting the cost and elevating shareholder equity will be successful in raising performance metrics in par with other large integrated bank such as C and BAC. JPM is currently on the run rate of achieving $4 EPS. Based on this number and closing share price of $45.52, the company is trading with PE slightly higher than 11. Average PE for S&P now stands just above 15 so the stock is cheap on a relative basis.

Now what would happen if JPM is able to improve performance metrics to the level that is inline with its competitors? By analyst estimate, JPM is thought to be making roughly 65 billion for its fiscal year 07. If I apply net profit margin of Citibank (~32%) with the outstanding share count of 3.47 Billion, the company would make approximately $6 a share which is 50% higher than the current EPS of $4. If I multiply extremely conservative PE of 10, assuming continued difficult rate environment, still share price of $60 is possible strictly based on the operational performance improvement. If Fed finally stops interest rate hiking, I believe the PE multiple for the banking sector will expand to 13 to 14 on a forward basis and take the share price to somewhere between $70 to 80 level if the management is indeed successful in streamlining the company operation and make JPM highly profitable entity. The current CEO has been hiring new senior management team, outsourcing operation to India to cut cost, and upgrading the database system to make operations more efficient. Again this is not going to happen overnight and I think investors need to be patient over next two years to see this. However, the bottom-line is that there is a significant share price upside potential from the current level.

Fed is nearly done.

In my opinion, Fed is nearly completed its rate raising cycle. Fed has been aggressively hiking rates for 17 consecutive times to fight inflationary pressure. Finally the economy is showing signs of moderating with steep cooling in the housing and consumer spending related sectors. I believe cooling economy will offset the effect of rising energy and material cost and inflationary pressure will remain in check. At worst case, Fed may have to do a few more tweaking but it appears as though it is almost done with the interest rate hiking. Stabilizing interest rate environment is particularly bullish for large integrated banks. According to research report published by Lehman (08-09-06), large banks tend to outperform the market showing 9% gain three month post completion of rate hike, 20% six months out, 32% one year later, and 69% two years later. In case of pause, large integrated still outperformed the market (in the year 84, 88, 94, and 99). Lehman report also outline that even in the case of the yield inversion, large integrated bank fared well as the investors anticipate the next rate move for Fed is to cut to a lower level. Thus, unless Fed continues to raise rates aggressively, JPM is poised to rise further as Fed is nearing its rate cycle. Additional rate hike by Fed may initially trigger sell-off in the stock; however, I expect economy will decelerate more noticeably thereafter and as investor anticipate the rate cut, the stock price will see a firm support.

Conclusion

Boring stock with great upside potential. Buy it and wait it out. Get paid while you wait with nice dividend that yields 3.00%. If you stick with the stock for a couple of years, you will be pleasantly surprised by amount of money you have made. It is my top pick for 2006 as upside greatly outweighs downside.