July 16, 2010 - 4:01pm EST by
2010 2011
Price: 39.11 EPS $3.45 $4.66
Shares Out. (in M): 4,000 P/E 11.0x 8.2x
Market Cap (in $M): 155,494 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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JPM covered calls currently represent a very attractive risk/reward.  I recommend selling the Jan 2012 calls with a $40 strike while buying the common at $39.  The upside is 26% simple and 17% annualized.  This is compelling now because: (i) volatility has obviously increased, so it is more attractive to sell volatility, (ii) JPM is trading at a low valuation so this set-up has good downside protection, and (iii) the fundamentals are improving pretty significantly which also helps on the downside.

In terms of the downside protection, the break-even stock price for the covered calls is $32, meaning if you hold the stock and the short call position through expiration in Jan 2012, you break-even because your net cash out the door is $39 for the stock less the $7 option premium.  The break-even price represents 1.1x current tangible book value of $28.44 and 0.95x 2011 estimated tangible book value of about $33.  To put this in perspective, the absolute low in JPM's stock during the crisis in March 2009 was $15.90 which was 0.7x tangible book value of $23 at the time.  It is not totally reasonable to just look at the absolute low price because it only broke below $20 for 5 days.  What's perhaps more reasonable is to look at the average price during March 2009 which was $23, or 1.0x tangible book value.  So, in the downside case, the stock reverts to the trough valuation realized at the peak of the crisis and you breakeven.

However, I think this downside case is very unlikely because JPM is in much better shape than it was in March 2009.  Back then loan losses were rising sharply.  The Treasury was performing its stress tests of the banks.  There was real fear that the common equity holders would be diluted to oblivion by forced equity raises and debt-for-equity conversions.  Roubini and Krugman were in the press everyday saying that the banks should be nationalized.  I recognize that the economic environment today is ugly, but I think the outlook for banks is not as bad as it was back then when JPM was reaching its lows.

In terms of fundamentals, JPM is very strong particularly relative to other banks and to itself back in the crisis.  Its Tier 1 Common Ratio is 9.6% which is basically the highest among the top 30 banks in the country and compares to 7.3% back in March 2009.  It is also among the best reserved if you look at the so called "Texas Ratio" which measures the ratio of non-performing loans to capital and reserves.  It never had a losing quarter during the crisis and the CEO Jamie Dimon has obviously earned a lot of acclaim for dodging the sub-prime mess and playing offense by acquiring Bear Stearns and Wamu on the cheap.  

My general view is that declining credit costs will be a major tailwind for the banking industry for the next several years.  Loan losses represent the biggest single expense for banks, losses are at the highest level since the Great Depression, and losses are starting to fall.  There are only a finite amount of bad loans in the system.  Virtually every bad sub-prime loan, no-doc loan, or credit card loan to an unemployed person has now worked its way through the system, and only pristine loans have been made in the last 2 years.  JPM's loan losses are now down 30% from the peak in Q3 2009.  There are still major problems, such as home equity loans.  A double dip in housing, and perhaps a double dip in the economy, combined with the foreclosure glut, will continue to keep residential loan losses elevated.  But, I think it is unlikely that losses will revert above prior peak levels.  Interestingly, JPM took down its guidance for home equity and residential loan losses during its earnings call yesterday while consciously taking into account these risks.  

While international regulators will ultimately determine new more stringent capital and reserve levels, JPM will be among the first banks to return capital via a higher dividend and buybacks.  The CEO said at their investor day five months ago that he thought they had $20-30 bn of excess capital.  In fact, the company announced in their Q2 earnings yesterday that they bought back $500 mm of stock at the end of June.  It is a token amount, but it is important symbolically.  For what it is worth, Jamie said he viewed the buyback as an opportunistic value investment on behalf of shareholders rather than a return of capital, and apparently he has recently been saying in investor meetings that the stock is very cheap.

So what is the stock worth?  My estimate is $50-$55, or 10-11x normalized earnings which should be realized in 2012/13.  Plus, I think there is upside to that range from excess capital, but that is a little more nebulous given we don't know how capital requirements will change.  Consensus estimates are for $5.75 of normalized EPS, before buybacks, which could be significant.  This is consistent with the company's own guidance at its investor day in February.  If you add up all the regulatory hits from the regulatory reform bill that just passed, I think that takes about 10% off of normalized earnings, assuming some offsets, so $5 is a reasonable normalized estimate.  This implies a 13% ROE with low leverage which is comparable to a high teens long term average for big banks.  So, in this scenario regulators have taken a pound of flesh but JPM is not quite a utility either.

People can debate endlessly about normalized earnings, new capital requirements, and the headwind from tougher regulation.  The stock is cheap and the covered calls give you a good up/down over a finite period without having to be exactly right on these factors.    


Decay of option premium.
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