Earnings Paper Cuts Impeding J.P. Morgan's Value

By Stephen D. Simpson, CFA | Updated September 02, 2014 AAA

Among the major banks, very few have better near-term returns on tangible equity than J.P. Morgan Chase (NYSE:JPM). Unfortunately, investors have been treated to a series of “death by a thousand paper cuts” quarters where New York-based J.P. Morgan's underlying earnings power has been masked by shortfalls and one-time items. Investors are increasingly starting to ask whether these items are indeed one-time events and this goes a long way toward explaining why J.P. Morgan doesn't enjoy a stronger valuation premium to peers like Charlotte, N.C.-based Bank of America (NYSE:BAC), New York's Citigroup (NYSE:C), and McLean, Va.-based Capital One (NYSE:COF).

Trading Undermined First Quarter Results

Adjusted revenue declined 8% for the first quarter, as net interest income fell 2% and fee income declined 13%. Although the weakness was fairly widespread, a 21% decline in fixed income trading was the big surprise and a major source of the downside. 

J.P. Morgan did reasonably well with expenses, as operating expenses declined about 3% from the year-ago period. All told, that led to a 13% decline in core pre-provision profits. 

Loan Growth Still Sluggish, But Credit Quality Seems Stable

Loans declined 1% on a sequential basis, with flat consumer lending (including a 5% decline in credit card loans) and commercial lending up 1%. Management commented that core loans increased 4%. By comparison, San Francisco-based Wells Fargo (NYSE:WFC) saw adjusted sequential loan growth of 1%, with soft results in both consumer and commercial. All told, loan growth continues to be sluggish for large banks while smaller banks are gaining share. 

Non-accrual loans have basically flattened out (true for Wells Fargo as well), but loan loss provisions increased on a sequential basis. Management's comments on the call suggested that significant reserve releases from mortgage and credit cards are not all that likely anymore.

Closer To Having Most Of Its Challenges In The Past

J.P. Morgan continues to tie up the remaining loose ends it has with respect to legal and capital issues. Early in February, the company reached a $614 million settlement with the Department of Justice and multiple government housing agencies. The company followed that a month later with the $3.5 billion sale of its physical commodity business. 

On the capital side, J.P. Morgan ended the first quarter with a Basel III leverage ratio of 5.1% and a Basel Tier 1 common ratio of 9.5%. Given the company's capital position, the Fed signed off on management's intention to pay a $1.60/share dividend for 2014 and buy back up to $6.5 billion in stock. Looking further down the road, management's comments at its February investor day suggest that capital returns could increase after 2015, including the possibility of a special dividend. 

A Strong Business Underneath It All

J.P. Morgan remains a strong bank in multiple respects. Only a handful of large banks have significantly higher returns on tangible equity (including Wells Fargo, Minneapolis-based U.S. Bancorp (NYSE:USB), and Winston-Salem, N.C.-based BB&T (NYSE:BBT). J.P. Morgan ranks third in the U.S. with 10.9% deposit share, trailing just Bank of America at 12% and Wells Fargo at 10.9%. J.P. Morgan also boasts the second-largest branch network in the country (after Bank of America) and the second-largest mortgage business after Wells Fargo. 

J.P. Morgan also enjoys a sizable presence in commercial middle market banking and large corporate banking. On the investment banking side, J.P. Morgan is among the share leaders in most areas of trading and underwriting, though it is clustered fairly close with Citi and Bank of America in terms of share. 

J.P. Morgan is also among the leading credit card companies in the country, it is the largest Visa (NYSE:V) issuer in the country and one of the largest merchant acquirers as well. Although the company's long-term history of charge-offs is nearly double that of the industry, management has made some meaningful improvements in this regard in recent years.

The Bottom Line

Although J.P. Morgan's earnings power, credit quality and returns on capital are quite good on a relative basis, the market seems to be undervaluing these qualities. A long-term excess return model using a long-term 11% ROE target leads to a $62.50 fair value today, while a 14% ROTCE for 2014 should have the shares trading closer to $69. Sooner or later these quarterly misses are going to lead to analysts and investors trimming down their long-term return on capital/equity assumptions, and with that, the underlying estimated fair value of the shares. Assuming that management can move past these trading issues in the first quarter and get sell-side analysts dialed in on the near-term earnings, these shares could outperform as valuation moves more in line with what the returns on capital would suggest.

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