Analyzing JP Morgan (JPM)

By Yaser Anwar, CSC of Equity Investment Ideas

• JPM has posted strong revenues in 2006, driven by solid investment banking fees and excellent trading performance. Management’s outlook for 2007 investment banking is very positive and the fee pipeline remains strong.
• JPM is more than a bet on buoyant global financial markets in 07 and the continuation of the 2006 liquidity wave. Looking out, revenue synergies and more active capital management should become drivers in 07.
• M&A services account for a substantial portion of JPM’s investment banking revenue. Global merger volume reached a record $3 trillion in the first ten months of 06, registering a growth of 37% over the same period in the previous year. This was driven by strong volume growth in Europe and the US. Additionally, as JPM commands a 26% share of the total global volume, a continued rise in international merger activity should benefit the company’s top line.
• The expected merger savings from the Bank One acquisition appears to be on track as the company successfully completed its New York Tri-state consumer conversion, which was a complex undertaking. Management believes that annual merger savings of approximately $3 billion will be achieved by the end of FY07.
• Already, the company realized a merger saving of $655 million in the recently ended quarter. Leverage appeared reasonable as compared to the industry average. JPM’s liquidity position remains strong with quarter ending cash & equivalents of $209.60 billion.
• Despite higher industry bankruptcy filings, JPM’s Oct and Nov Master Trust losses were lower than 3Q levels. The Street project 4th Q Card earnings to decline roughly 3% QoQ with continued net interest margin pressure and sluggish balance growth.
• One time items in the Q included a gain of $625 m from the asset swap with Bank of New York and a tax benefit of $260m. While JPM may take the opportunity to offset this gain with losses by restructuring its securities portfolio, investors should note that JPM has already done significant restructuring earlier this year and that the AOCI balance at the end of 3rd Q was only -$526m. Hence, they should expect at least a portion of the gain to fall to the bottom line.
• I see earnings quality improving as JPM makes further progress in the ongoing integration of Bank 1, helping to offset more volatile businesses. JPM management is expecting to achieve a ROE of 20% in the investment banking segment by 2007. I believe this performance increase will be driven by strong M&A fees in the US and Europe, improved trading performance and expansion of the bank’s commodities divisions (read: today’s Highbridge merger with LD).
• Click here to find out which funds hold JPM

According to BAC- Investors will likely be focused on whether JPM’s investment bank can keep pace with its peers following 3Q results which including a 16% q/q increase in fixed income trading revenues.

a) Given strong results across the industry, we expect JPM’s revenues to benefit similarly from the robust capital markets environment. On average, 4Q brokerage results included 10% q/q gains in fixed income and equity trading revenues and 20% q/q gains in both underwriting and M&A fees.

b) Some revenues associated with the Amaranth trade may leak into 4Q making comparisons easier. In addition, while management acknowledged that Amaranth contributed to 3Q results, even excluding this trade JPM felt “good about the quarter over quarter results”.

c) JPM should begin to see results from leveraging recent investments in the business (e.g. energy and commodities); and

d) We also look for modestly higher credit costs as well as a stable comp ratio (45% of revenues) vs. 3Q. For these reasons, we look for 4Q segment earnings to increase by 7% q/q to $1,040m.

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