Bulls will talk at some length about JPMorgan Chase's (JPM +0.29%) leadership across the banking landscape, including leading deposit share across most of its 23-state footprint, #1 share in trading, and leading share in corporate lending, but the fact remained that the bank had logged four straight sequential declines in core pre-provision profits. With a higher-quality, broad-based beat in the first quarter, JPMorgan has shored up some of the nagging concerns and remains well-placed to take advantage of any meaningful steepening in the yield curve.
The numbers are always messy, but JPMorgan beat where it mattered
Because of the numerous "one-time" costs, charges, and benefits, there is always some difference of opinion between analysts and investors regarding the real/core earnings for large banks like JPMorgan, Citigroup, and Bank of America (and to a lesser extent other large banks like US Bancorp and Wells Fargo). That said, just about every permutation of the numbers shows a strong beat, with core earnings of around $1.43/share versus the $1.29 average guess on Wall Street.
Core revenue declined 3% yoy, but did rise 2% sequentially and beat expectations by around 5%. Better still, the revenue strength (relative to expectations) was seen across the board, with all major reporting segments faring better than expected (and Consumer & Community Banking leading with 9% growth).
Net interest income ticked up 2% (and 1% sequentially), as net interest margin has stabilized. Core fee income fell about 7%, with trading revenue down 14%. While that's an ugly looking number, it was better than the 20% decline that JPMorgan had projected. Citi was even weaker in its trading operations (down 36%) and while it's early in the reporting season it looks as though JPMorgan is maintaining or building its share lead.
Core pre-provision profits were down 2% from last year's level, but up a strong 8% from the first quarter – the first sequential improvement after four straight declines. About half of the beat was due to the strength in the investment banking operations, while the consumer business supplied the majority of the remainder.
More than holding its own in lending?
JPMorgan reported that core loans grew 8% from last year and 4% from the prior quarter. That's stronger than both Citi and Wells Fargo, and JPMorgan saw balanced growth across its lending platform. Balances in the large card business grew about 1% yoy, but the company nevertheless appears to be gaining some share and credit quality continues to improve. JPMorgan is also seeing good performance in its consumer lending, while gaining some share in corporate lending.
While the loan book grows, credit quality continues to improve. The company's non-performing asset ratio improved again, to 1.16% from 1.46% last year and 1.24% in the first quarter, and the net charge-off ratio also declined (from 0.77% to 0.63%). Provisions declined 19% sequentially and while it seems improbable that large banks like JPMorgan, Citi, and Wells Fargo have much left to squeeze from improving credit, it's encouraging to see good credit numbers.
Will "normal" come back?
Comparing today's net interest margin (2.20%) to the FY 2010 figure of 3.06% gives you some idea of how the low rate environment has crimped business for major banks like JPMorgan, Citi, and so on. Low-cost capital was invaluable when banks needed to recapitalize their businesses (particularly for weaker players like Bank of America, Citi, and Wells Fargo), but it is now weighing on returns.
For JPMorgan there aren't a lot of easy answers. Aggressive expense reductions have been a big part of the plan for Bank of America and Citi, but JPMorgan has made it clear that it views its branch banking network as an asset and a driver of long-term value. Likewise, any bank can talk about wanting to grow the loan book, but with almost every bank trying to do that (particularly in commercial lending), there is a lot of competition out there and especially for the good credits.
Strength in investment banking (trading and advisory services) certainly helps, and so too does the company's strong position in cards and card services. A strong position in commercial lending (particularly large-scale corporate debt) also provides a good stream of fees and profits for the bank.
All told, though, it's going to be basic profit margin improvement that helps JPMorgan. New rules on capital ratios aren't going to let a bank like JPMorgan significantly increase leverage (though the company is fine vis a vis Basel 3 requirements), but a 0.1% improvement in NIM holding all else constant would help return on equity by more than 1 point.
The Bottom Line
I continue to value JPMorgan on the basis of an 11.5% long-term ROE and an 10.5% cost of equity, supporting a fair value of more than $65 by an excess returns model. I also use the company's near-term return on tangible equity as an alternative valuation metric; historically there is a close relationship between returns on tangible equity and the price/tangible book value multiple and JPMorgan's RoTE supports a 1.5x multiple to tangible book value, or a target of around $65.
Trading 10% below my estimate of fair value, I continue to believe that JPMorgan is one of the few bargains left in the banking sector. A flat rate curve limits near-term earnings growth potential, as does the company's commitment to a large full-service branch network, but the company's leading market position in multiple segments looks like a coiled spring that can generate good earnings leverage when the curve steepens again.
