The expectation for most banks this year has been that core growth will be challenging given low rates and competitive lending markets. Those banks that can wring out better credit and/or better fee income should do a little better, and that seems to be the case for JPMorgan (NYSE:JPM). An influx of deposits thumped the net interest margin and lending growth was iffy, but overall results were boosted by good credit outcomes and solid fee income results. All told, this remains an undervalued bank and one with solid earnings power in the coming years.
SEE: Bank Earnings In Focus
Q2 Results End Up Okay, But There Was Plenty Of Noise Along The Way
All of the large banks (a list including JPMorgan, Citigroup (NYSE:C), and Bank Of America (NYSE:BAC) report pretty messy and opaque financial reports, and this quarter was no exception for JPMorgan.
Overall revenue jumped by 13% from last year, though net interest income dropped 4% (and was down 2% sequentially). Earning assets grew more than expected, but the net interest margin fell a surprising 27bp from last year (and 17bp from the prior quarter), as the company found itself with a much larger amount of cash deposits than it expected.
Fee income was pretty solid as well, jumping more than 30% from the year-ago level and increasing 2% sequentially. While trading revenue did decrease sequentially, it was solid relative to expectations and JPMorgan did very well with its investment banking business. The trust business was okay, but not especially strong.
Expenses rose again (up 6% and 3%), but the efficiency ratio continues to improve and JPMorgan is now below 59%. Assessing JPMorgan's operating results is one of those times where the accounting gets foggy and no two analysts or investors seem to make the same adjustments. For may part, I say that pre-provision income rose 2% sequentially and was well ahead of expectation.
The Core Business Is Still Puttering Along
Overall lending growth is still fairly weak. On an end-of-period basis, loans were down slightly, though both mortgage banking originations and auto loans were up by double-digit percentages relative to the year-ago period. Solid credit is allowing larger banks like JPMorgan (not to mention Wells Fargo (NYSE: WFC), U.S. Bancorp (NYSE:USB) and many others) to compete pretty strongly on loan pricing, but clearly the net growth is still soft.
Speaking of credit, JPMorgan's NPA and NCO ratios continue to decline, with a 10bp sequential drop in the former and a nearly 20bp drop in the latter. Credit card charge-offs continue to decline as well, and the company had a sizable reserve release this quarer.
The Capital Dilemma – Choosing Between Regulators And Shareholders
JPMorgan saw its tangible book value improve by 1% and the company looks to be in good shape with respect to its Tier 1 common and Basel 3 Tier 1 common ratios. On the other hand, the company reported that it's Basel 3 leverage ratio is 4.7% - about 30bp shy of the 5% level that will likely be required of banks like JPMorgan, Citi, and Bank of America.
Capital generation isn't really the problem, the company could easily close that gap this year. The question is what it may do to the capital return program. In the absence of strong lending prospects and/or core earnings growth, investors seem to be obsessed with the amount of capital banks are returning, and JPMorgan may have an uncomfortable decision to make with respect with whose happiness to prioritize (regulators or shareholders). Barring another London Whale-type scandal, I don't see JPMorgan's capital adequacy to be an issue, but it could put a near-term ceiling on further capital returns.
The Bottom Line
I continue to believe that the Street underestimates and undervalues JPMorgan's true core earnings power. A long-term return on equity model suggests a fair value of over $61 on the basis of a long-term ROE of 11% (a half-point higher than my prior assumption), while the company's return on tangible assets suggests a 1.5x to 1.6x multiple on tangible book, or a fair value in the range of $60 to $64.
Many investors will continue to steer clear of JPMorgan due to the complexity of the business, the risk of its derivatives book blowing a crater in its capital, and/or the threat of further regulation (including a possible reintroduction of something like Glass-Steagall). I certainly won't try to sway those investors, other than to point out that JPMorgan continues to deliver the goods and appears to offer underrated potential among the larger U.S. banks.
Disclosure – As of this writing, the author owns shares of JPMorgan.