Reputation is a delicate thing, and in less than one quarter JP Morgan (NYSE:JPM) has lost much of the luster it built during the credit crisis. While management has apparently acted quickly to mitigate the damage of a large bad trade, the slow pace of recovery in its core banking business makes it harder to take up the slack. Although investors can certainly find value in JP Morgan at current prices, risks remain from scandals like the LIBOR rigging and a potential worsening of credit conditions if the economy slows significantly.
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Core Operations were Strong in the Second Quarter
Talking about JP Morgan's results outside of the major CIO loss is like ignoring a large elephant in the room, but the reality is that it is in the ongoing operations of the bank that drives its market value.
To that end, JP Morgan did well this quarter. Good results in retail banking and treasury/security services, as well as lower loan loss provision, drove better-than-expected results. Results came in about 30 cents better than "pre-Whale" estimates (or about 25% better than expected), and while much of that was covered by reserve releases, analysts had built in sizable reserve releases into their numbers.
In JP Morgan's investment banking operations, ex-DVA revenue fell 27% from the first quarter, with core trading down about 30%. That doesn't sound great (and it's not), but it wasn't a surprise given the interest rate environment. It's also reasonably encouraging news for companies like Goldman Sachs (NYSE:GS), particularly as Citigroup's (NYSE:C) trading results looked reasonable at first glance.
JP Morgan's consumer and cards business performance were also weak in absolute terms but was decent on a relative basis. Pre-tax pre-provision (PTPP) results in consumer were down 16%, though deposits rose 8%. In cards, PTPP dropped 12%, but the company saw decent credit trends and the company's card results should be bottoming as it runs off undesirable WaMu business. These results are encouraging for other super-regional banks like U.S. Bancorp (NYSE:USB), while the card data is promising for Capital One (NYSE:COF).
SEE: Understanding The Income Statement
A Whale of a Tale
The dominant story around JP Morgan these days is the "London Whale" trading loss. While rumors were spreading before earnings that the scale of the loss could reach $9 billion, the bank reported $5.8 billion in losses ($5.1 billion recognized, with $4.4 billion recognized in the second quarter) and it sounds as though future losses should be contained to less than an incremental $1 billion.
Obviously this is a major embarrassment to the bank, and a reminder that even supposedly well-run banks cannot (or do not) monitor all of their traders in real time. To management's credit, they've moved quickly. The synthetic credit group within the CIO has been closed, employees are losing jobs over this and bonuses are likely to be clawed back. Obviously none of this is as good as avoiding the trouble to begin with, but at least JP Morgan does not seem inclined to let the matter fester.
Where to Now?
Some will point to the London Whale loss as a sign that no bank can be trusted and that investing in bank stocks is just gambling. I won't bother to try to change their minds - bank stocks are clearly not for everybody and there is an element of "known unknowns" that investors simply have to accept if they want to invest in companies like JP Morgan, Citigroup and so on.
For those still open to the idea, though, there are reasons to be optimistic on JP Morgan. While the trading loss has stalled the company's share buyback plans and damaged credibility, it hasn't significantly imperiled the company's capital position. What's more, the company seems to be legitimately gaining share in its retail bank operations, while also stabilizing the card business. Should the United States economy skirt another recession, these improvements should pay dividends in the years to come, as will share gains in Europe.
Though I am concerned that further investigations of LIBOR bid-rigging may involve JP Morgan and could lead to additional regulatory scrutiny (if not criminal charges), I suspect that the magnitude of this scandal will mitigate the damage. It's part of the counter-intuitive reality of global banking that so long as enough major banks are involved, none will face exceptionally severe consequences.
SEE: JP Morgan: The Other Side Of The Hedge
The Bottom Line
JP Morgan now trades at around tangible book value, despite having a very strong franchise in retail banking, credit cards and investment banking. On an excess returns basis, a long-term estimate of a return on equity of 11.5% and a discount rate of 10.5% results in a potential fair value of over $55 per share. Reversing the equation a bit, even with an 11% discount rate, JP Morgan's current value presupposes a long-term return on equity of 9% - a very undemanding assumption for a high-quality global banking franchise.
At the time of writing, Stephen D. Simpson has owned shares of JP Morgan since January of 2006.
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