Wednesday, May 6, 1998

Cash-King Portfolio Report
by Phil Weiss

Towaco, NJ (May 6, 1998) -- Yesterday I promised to talk about how I evaluated a bank using our existing Cash-King criteria. Because the Cash-King financial criteria really aren't appropriate for assessing banks, we have to make some modifications to our approach. I'm going to try my best tonight, based upon a simplified approach I came up with after reviewing the way that Zacks presents financial information for banks. I promise not to go into a lot of real detailed explanations in tonight’s report as that’s something that Dale Wettlaufer is handling real well over in the Drip Portfolio reports.

I currently have a Dividend Reinvestment Plan in J.P. Morgan (NYSE: JPM). With the bank’s recent price run up, I've been having some doubts about whether or not I should continue to purchase the bank’s stock every month through my plan. I’m afraid that it may be a case where the stock has run up too quickly for regular monthly purchases to continue to be beneficial. For that reason, I'd like to review J.P. Morgan in tonight's column.

For our purposes, I’m just going to summarize the 1997 income statement as follows:

(in millions) 
 Interest revenue         $12,353 
 Interest expense         $10,481 
 Net interest revenue      $1,872 
 Noninterest revenues      $5,348 
 Total revenues, net  
 of interest expense       $7,220 
 Total operating expenses  $5,066 
 Income before inc. taxes  $2,154 
 Net income                $1,465 

Pause over those entries for a second, and you'll get the general picture. J.P. Morgan has net interest-payment revenue of $1.872 billion, non-interest-payment revenue of $5.3 billion, and bottom-line earnings for the year of $1.465 billion.

Ok, so now we can go ahead and calculate J.P. Morgan’s gross profit margin and its net profit margin. But wait a second, you cry! How can we calculate gross profit margin? There’s no cost of goods sold or cost of revenues appearing above, so how can we possibly calculate the gross profit margin?

Well, let’s think about how a bank makes money. It makes money primarily by loaning money to others. The only way that it can do this is to have a certain amount of cash on hand in the form of deposits -- money to lend. What are the costs? Well, the bank pays out interest to those that deposit money in accounts with the bank. You have a balancing here of money going out (loans which the bank makes interest on) and money coming in (deposits which the bank pays interest on). Not surprisingly, then, I’m going to say that interest expense is the same thing as cost of goods sold for our other companies. Interest payments are the cost of being in the banking business.

Okay, now we’re ready. J.P. Morgan has total revenues of $17.701 billion (interest revenue + noninterest revenue) and cost of goods sold of $10.481 billion. That leaves gross profits of $7.220 billion and a gross profit margin of 41%. We’re really looking for 50% in our Cash-King companies. Even worse, in last night’s report I mentioned that the average gross profit margin for the group of banks that I looked at was 70%. Too much of J.P. Morgan's business is tied up in interest revenues.

Next up is the net profit margin (net income divided by sales), which for J.P. Morgan rings in at 8.3%. That looks a little bit better, and meets our C-K criteria, but once again it is much less than the average 13.3% net margin among the 12 banks I mentioned last night. So our brief tour down the income statement has us moderately disappointed with the cost side of J.P. Morgan's business and the bottom-line return for its efforts.

Onward, to the balance sheet, Fools! This is definitely the more difficult statement to read when reviewing the banking world. The first thing we have to do is determine the amount of cash and marketable securities the bank has. To do this we add the following: 1) Cash and capital due from banks of $1.8 billion; 2) Interest-earning deposits with banks of $2.1 billion; 3) Net trading account assets of $111.8 billion; 4) Securities purchased under agreements to resell of $39.0 billion; and 5) Securities borrowed of $38.4 billion. The total comes out to $193.1 billion. What I was looking for when I classified these amounts was those items held as cash or those readily convertible into cash. Each of these seems to fit the bill to me.

Now we need to determine the bank’s accounts receivable balance. That means that we’re looking for any loans it may have. J.P. Morgan has net loans of $31.0 billion and accrued interest and accounts receivable of $5.0 billion. I’m going to add these together for a total of 36.0 billion. Of course, here accrued interest receivable and accounts receivable were combined. What do you do if they’re not? You still include the accrued interest receivable with accounts receivable as it just represents interest owed to the bank on outstanding loans.

The next thing that we want to look for is inventory. This is something that most banks don’t have. If they do, it would be called something like loans held for sale. I don’t see any here, so we can skip right over that one. The rest of J.P. Morgan’s assets can be classified as other and are considered non-current, so we don’t have to worry much about them for purposes of this analysis.

That brings us to the liability section of the balance sheet. We can start with accounts payable. This one is pretty easy. It consists of deposits of $58.9 billion and accounts payable and accrued expenses of $10.9 billion. That totals up to $69.8 billion. I included deposits here because they actually represent money owed to the bank’s customers.

Next up are the notes payable. Here we’re looking for debts and liabilities that are related to trading, and other types of securities (bonds, notes, commercial paper, etc.) and liabilities related to borrowed money. We'll add trading account liabilities $71.1 billion; 2) Securities sold under agreements to repurchase $57.8 billion; 3) commercial paper if $6.6 billion; and 4) other liabilities for borrowed money of $17.2 billion. That all totals up to $152.7 billion in liabilities.

Now we have enough information to calculate JP Morgan’s Flow Ratio.

Let’s summarize the current assets and liabilities determined above first.

(in millions) 
 Cash and marketable securities   $193.1 
 Accounts Receivable               $36.0 
 Total current assets             $229.1 
 Notes payable                    $152.7 
 Accounts payable                  $69.7 
 Total current liabilities        $222.4 

Our Flow Ratio divides current assets less cash -- of $36 billion here -- divided by current liabilities of $222.4 billion. The result is 0.2, which falls well below the average of 0.6 that I came up with for the 12 banks that I researched. The low Flow Ratios at banks are a result of their not carrying any inventory -- any computer parts, any unsold furniture, any food in a freezer. That makes them extremely light businesses in terms of material carrying costs.

The only numerical based Cash-King characteristic that we haven’t looked at yet is the ratio of cash to long-term debt. We’ve already determined how much cash this bank has, so now all we have to do is figure out how much long-term debt it has. That’s pretty easy, too. We just dig up long-term debt of $4.7 billion and the long-term debt not qualifying as risk-based capital of $18.2 billion. And that totals up to $22.9 billion in debt.

J.P. Morgan's cash is running 8.4 times larger than debt, so this test is easily passed. This is almost double the average of 4.35 for the 12 banks that I researched. Obviously, most banks have pretty high cash balances.

Ok, let’s check our scorecard. J.P. Morgan passed three of the four Cash-King criteria that we looked at above -- a solid flow ratio, passable net margins, and a strong cash position. It failed on gross margins. Generally, that is solid, but I’m still not convinced that J.P. Morgan is a Cash-King. Why? Primarily because I’m not sure that it has the compelling future prospects that we generally look for in Cash-Kings. It also hasn’t had the consistent performance that we like to see either. Another problem is that it doesn’t stack up all that well when compared to the other banks that I’ve looked at.

When I started my J.P. Morgan Drip, I felt the stock was undervalued. With the recent price run-up, I’m no longer sure that it is. For now, I’m going to stop contributing to my J.P. Morgan Drip. That's generally what I do with my non-Cash-Kings. I watch them like a hawk; I keep a closer eye on valuation; and I prepare to sell them or slow down my contributions to them if I believe valuation has swept well past value.

I hope that this has helped give you some understanding of how you can evaluate a bank’s income statement and balance sheet from a Cash-King context. It's certainly only a very casual way to assess a bank's position, and there are better metrics to use to evaluate banks. I hope, however, that this got you started. If you have any questions about this, please drop by the Cash-King message folder.

Fool on,

Phil Weiss


Stock  Change    Bid 
 CHV   -  1/2   85.69 
 KO    -  1/8   75.88 
 GPS   -  1/2   51.31 
 EK    -1 5/16  73.44 
 XON   +  7/16  74.44 
 GM    -  1/2   67.94 
 INTC  -  1/2   81.31 
 MSFT  -1 7/16  86.31 
 PFE   -2 15/16 108.75 
 TROW  +  1/8   36.50 
                  Day   Month    Year  History 
         C-K      -0.73%  -0.65%   7.76%   7.76% 
         S&P:     -0.96%  -0.62%  10.35%  10.35% 
         NASDAQ:  -0.44%  -0.63%  12.33%  12.33% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    108.75    32.14% 
     2/3/98   24 Microsoft     78.27     86.31    10.28% 
    2/27/98   27 Coca-Cola     69.11     75.88     9.79% 
     2/6/98   56 T. Rowe Pr    33.67     36.50     8.39% 
     5/1/98   37 Gap Inc.      51.09     51.31     0.44% 
    2/13/98   22 Intel         84.67     81.31    -3.97% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     73.44    16.30% 
    3/12/98   20 Exxon         64.34     74.44    15.70% 
    3/12/98   15 Chevron       83.34     85.69     2.81% 
    3/12/98   17 General Mo    72.41     67.94    -6.17% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   22 Pfizer      1810.58   2392.50   $581.92 
     2/3/98   24 Microsoft   1878.45   2071.50   $193.05 
    2/27/98   27 Coca-Cola   1865.89   2048.63   $182.74 
     2/6/98   56 T. Rowe Pr  1885.70   2044.00   $158.30 
     5/1/98   37 Gap Inc.    1890.33   1898.56     $8.23 
    2/13/98   22 Intel       1862.83   1788.88   -$73.95 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1468.75   $205.80 
    3/12/98   20 Exxon       1286.70   1488.75   $202.05 
    3/12/98   15 Chevron     1250.14   1285.31    $35.17 
    3/12/98   17 General Mo  1230.89   1154.94   -$75.95 
                               CASH   $3910.83 
                              TOTAL  $21552.64 
 *The year for the S&P and Nasdaq will be as of 02/03/98