5 Key Questions for JPMorgan Investors

The consensus view is that  JPMorgan Chase (JPM) will continue to appreciate over the next 12 months as rising rates boost earnings while expenses fall off. However, these factors are largely out of management's control--movements in short-term rates depend on an increasingly cautious Federal Reserve, and the costs of litigation and compliance are continuing to be forced upon the bank from outside. Also, many of JPMorgan's top managers have departed, and the firm is no longer successfully avoiding the blunders of its peers; incidents like the London Whale trades, the Comprehensive Capital Analysis and Review stumble, massive legal settlements, and seemingly endless allegations of wrongdoing recently led us to reduce our Stewardship Rating to Standard from Exemplary.

JPMorgan bulls still see the company as a bargain at just above book value, but we see limited upside in the shares. The firm has never achieved--and management is not targeting--profitability on par with Wells Fargo (WFC), U.S. Bancorp (USB), or PNC Financial (PNC). At the current stock price, we believe the risks facing the bank--regulation, competition, and even disruption--offset the potential for earnings and multiple expansion. Our fair value estimate remains $58 per share.

1. Are Interest Rates Really About to Rise?
The level of interest rates is perhaps the most important factor affecting JPMorgan Chase's earnings prospects over the medium term, but also one of the most uncertain. An increase in short rates will drive increases in yields and margins, but the firm has already acknowledged that net interest margins will be at least 5%-10% lower over the next cycle than over 2005-10. Furthermore, we remain unconvinced that rates are about to rise. For starters, the fed funds rate has now been low for more than five years.

The Japanese experience in a similar economic environment--deleveraging, demographic changes, troubled banks, expanded government borrowing, and so on--lends credibility to the idea that rates may not rebound immediately. The idea of secular stagnation is gaining momentum even as the economy improves, increasing the likelihood that rates will remain low for an extended period. In our opinion, fears of a downturn caused by the premature withdrawal of stimulus--as occurred in the United States in 1937 and more recently in Japan--could continue to delay a return to normal.

Furthermore, the Federal Open Market Committee has been pushing out normalization expectations for some time. Only two years ago, more than half of the committee members expected rates to begin normalizing by 2014. Only one member still believes normalization will begin to occur this year. Instead, rising rates again seem only a few months away.

The FOMC has also scaled back its criteria for increasing rates. Rather than focusing on a given level of the unemployment rate, the FOMC now plans to "assess progress…toward [its] objectives of maximum employment and 2% inflation." Together, these changes temper our enthusiasm over the potential for rising rates.

Finally, it's important to note that our current valuation incorporates a reasonable increase in net interest margin. We think there is a relatively low probability that interest rates increase to a level that would justify a higher valuation--even over our five-year forecast period.

2. How Low Will Expenses Go?
Expenses at JPMorgan have been elevated for some time due to a combination of legal issues, investments in controls, and legacy mortgages. The company is optimistic that expenses will eventually decline, but we think the costs associated with an increased regulatory and legal burden will not be easy to shed. Indeed, the costs of better controls were mentioned 10 times in a recent company conference call. Additionally, new legal issues continue to arise, and we see no reason to believe that banks will become a harder target for prosecutors and politicians in the foreseeable future.

We also believe expense reduction will become harder over time. As revenue rebounds, incentive compensation will surely rise as employees' relative bargaining power rises. At some point, the number of employees will also stop declining. Head count is now back to 2011 levels after several years of layoffs and business simplifications.

For these reasons, we're inclined to wait for more evidence that the company's expense base will decline before penciling in aggressive forecasts in our valuation model. In fact, our long-run expense forecasts are not far from management's $59 billion near-term target.

3. Will New Competitors Win Market Share From Traditional Banks?
We believe the rise of online and mobile banking--and the decline in the importance of branch networks--has created an opportunity for low-cost producers to gain share in consumer lending. Consumer lending is homogeneous, with underwriting done using data and algorithms, making economies of scale and scope critical for success. Indeed, credit card lending is now concentrated at the country's largest banks. As bank branches lose relevance, we think online lenders are well positioned to remove a substantial layer of costs, passing savings on to customers and gaining market share from traditional banks. Discover Financial Services (DFS) and Ally Financial (ALLY) are already leaders in this field, with potentially significant cost advantages in consumer lending.

Peer-to-peer lending also offers the potential for disruption and market share gains. Lending Club is now originating roughly $800 million in loans per quarter, with most used to refinance existing loans or pay off credit cards, while Prosper is originating $100 million per month. These services also offer better rates to both lenders and borrowers than traditional banks, which will make them fierce competitors for consumer market share in the near future.

Finally, shadow banks are already taking a significant share of commercial loans. Banks originated less than three fourths of middle-market commercial loans in 2013, as banks' funding advantages were offset by shadow banks' lower costs of regulation. Furthermore, underwriting standards and pricing in the commercial and industrial market have already been deteriorating for several years. We expect all of these competitive considerations to affect medium-term growth and profitability.

4. How Long Will Dimon's Influence Last?
We've long attributed JPMorgan Chase's relative success to Jamie Dimon's leadership. However, even with Dimon at the helm, profitability has been lacking on an absolute basis. Over the past decade, return on average assets exceeded 1% only in the boom years of 2006 and 2007, and return on average common equity languished in the single digits in five of the past ten years.

Even more concerning is the possibility that profitability will contract--and risk will increase--under lesser management. Dimon is only 58 years old, but eventually someone else will need to take the helm. Dimon's recently announced illness notwithstanding, there has been significant turnover in top management at the company over the past several years, with a number of top lieutenants departing. We think there is a strong possibility that this activity may have thrown a wrench in succession planning, in addition to disrupting day-to-day operations.

Furthermore, the company's relative success makes it more likely that potential successors will be recruited to jump ship to other financial firms. This has already happened to some extent, with Frank Bisignano leaving to become CEO of First Data and Jes Staley joining a hedge fund.

At the same time, while shifting assignments provides JPMorgan's managers with exposure to the firm's diverse lines of operations, it may also contribute to an inconsistent corporate culture--as does the bank's history of M&A activity. By 2000, JPMorgan had combined "four of the largest and oldest money center banking institutions in New York City," followed by a merger with Bank One in 2004 and the acquisitions of Bear Stearns and Washington Mutual during the financial crisis.

Although the firm made it through the financial crisis in fair shape, we're concerned that issues like the London Whale, Madoff investments, foreign exchange manipulation, and others demonstrate that there are still pockets of more reckless corporate cultures embedded in the financial conglomerate.

5. Is JPMorgan Chase Still Undervalued?
Bulls point to JPMorgan Chase's relatively low multiples of book value (1.0 times) and tangible book value (1.3 times). However, we think these multiples are justified for several reasons. First, the company has traded at an average price/book of only 1.08 times over the past decade. This implies a price of $60 per share (1.08 times $55.53), not far from our $58 fair value estimate or the current market price.

An appropriate price/tangible book multiple can also be obtained via the following equation:

P/TBV = (ROTCE-g)/(COE-g)

JPMorgan's target return on tangible common equity is now 15%-16%, and current consensus for 2015 earnings per share stands at $5.95--equivalent to a 14% return on its $43.17 in current tangible common equity.

Our discounted cash flow valuation incorporates a 12% cost of equity for the firm. While this figure is debatable, we think it is justified for several reasons. First, current long-term bond rates are hovering around 3%. Adding a 6% market risk premium implies a 9% cost of equity for the "average" firm. We think JPMorgan Chase's high degree of financial leverage and the relative cyclicality of the firm's earnings warrant a considerably higher cost of equity, and also note that the firm's recent CAPM beta is actually above 1.45--the figure implied by a 12% cost of equity.

Altogether, we think the company's growth and profitability possibilities warrant a price consistent with our fair value estimate.

We think the company's dividend prospects also support our fair value estimate. Assuming a 40% payout ratio and $5.98 in consensus 2015 EPS, the company is likely to be paying a $0.60 per share quarterly dividend by the end of 2015 (we note that this figure depends on both the accuracy of consensus estimates and regulatory approval of a more aggressive capital plan). Using a dividend discount model, the company would need to achieve exceptional growth in earnings over the long run in order to justify a share price much above our $58 fair value estimate.

Finally, we think management's own activity suggests that it does not believe the stock deserves a much higher multiple. Though CFO Marianne Lake recently said management does "see value in our stock at significantly above…1.4 times tangible book value," the firm's repurchase activity slowed significantly as the stock price rose over the past three years.

Furthermore, executive sales far outnumber purchases over the past 12 months. Executives have sold $50 million of stock in the last year at prices not far from our $58 fair value estimate--more than 10% of total beneficial ownership outside of the large stakes held by Dimon and director James Crown, by our estimation.