J.P. Morgan Setting Stage for Future Growth

 J.P. Morgan Chase (JPM) reported net income of $21.3 billion, or $5.20 per diluted share, for 2012. The results were consistent with our expectations, and we do not expect to alter our fair value estimate.  

Skillful capital allocation has long been a hallmark of J.P. Morgan, but the company is scaling back on its capital return plans in 2013. Management indicated that achieving Basel III targets, including a 9.5% Basel III Tier 1 common ratio, by the end of 2013 is now a greater priority than returning capital to shareholders. The company has authorization to repurchase $3 billion in shares during the first quarter, but management indicated a reduced desire to buy back stock for the remainder of 2013. The current share price represents a premium to tangible book value and is close to our fair value estimate, so we agree that buybacks are not as attractive as they might have been in the wake of the "London Whale" incident. Furthermore, achieving regulatory minimums quickly is probably a prudent decision in light of the consent orders the bank entered with the Federal Reserve and Office of the Comptroller of the Currency earlier this week. The company's internally estimated Basel III ratio was 8.7% at the close of the fourth quarter.  

J.P. Morgan also released the results of its internal review of the "London Whale" incident and announced that CEO Jamie Dimon's compensation will total $11.5 million for the year, with the restricted-stock portion of compensation falling 53.5% from 2011. In our view, this seemingly large compensation package is not inappropriate. Although the trading losses were large and oversight of the firm's chief investment office was clearly lacking, J.P. Morgan still performed acceptably under Dimon's leadership, achieving a 0.94% return on assets for the year in a difficult environment and despite the loss. Dimon's compensation also totaled only 0.05% of the company's earnings.

Financial-services firms are continuing to struggle with low interest rates and relatively weak loan demand, leaving expense control as one of the major levers management can use to improve results. Noninterest expenses at J.P. Morgan totaled $16 billion during the fourth quarter, up 10% from the final quarter of 2011. These expenses included $1.2 billion in litigation costs and core mortgage servicing expenses around $375 million higher than management's long-term target. These costs eventually should fall considerably, but expenses are also growing along with the business. J.P. Morgan is building branches, adding head count in some areas, and paying out more to employees as revenue grows. We expect more details at the company's investor day next month, but it's hard to see much room for the firm to cut fat going forward, and management has not shown the inclination to reduce head count to the same extent as some peers.

That said, the company is positioning itself to grow earnings at a modest pace, especially if the U.S. economy continues to improve. The company achieved record levels of assets under management ($1.4 trillion) and custody ($18.8 trillion) during the quarter, and grew deposits by 5% in the final few months of the year. The company's deposits/loans ratio stands at 163%, giving the bank plenty of room to add higher-yielding assets if the rate environment changes. In fact, while consumer and credit card loan balances declined during 2012, J.P. Morgan added commercial loans at a healthy clip (11%) during the year.

Finally, the firm is reorganizing its business around client needs rather than product lines. We have previously pointed out that while universal banking appears to make sense in theory, execution has been lacking. J.P. Morgan, like peers  Citigroup (C) and  Bank of America (BAC), was assembled relatively recently from product-focused predecessors. In our view, a silo approach has limited the ability of these firms to achieve promised synergies during the past decade and probably contributed to the problems experienced by large banks in the same time frame. We're therefore excited to learn more about the company's plans at its upcoming investor day.

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