JPMorgan Chase (NYSE:JPM) reported quarterly earnings on Tuesday that were a bit weaker than analysts had expected (press release here). The company earned $1.30 while consensus had been looking for $1.35, though revenue was solid at $24.1 billion. For the year, the company earned $4.35 on $100 billion in revenue, and shares currently have a multiple of 13.3x. Overall though, this quarter makes me believe shares are fully valued at current levels, and investors would be better off investing in Wells Fargo (NYSE:WFC) or Citigroup (NYSE:C).
As expected, mortgages were a headwind for JPMorgan with origination down 54% year over year to $23.3 billion. As I explained in my discussion of Wells Fargo's quarter, declining mortgage refinance volume is inevitable and not really a negative over the long run. Commercial banks want to see interest rates rise as interest earned on loans is far more lucrative than origination fees. 2013's refinancing pace was unsustainable given record low interest rates that eventually had to rise. These low rates have kept banks' net interest margin depressed, but I expect 2014 and 2015 to be fantastic years for net interest margins. With a decent economy, loan demand (especially for autos and home purchases, not refinances) should remain relatively strong. JPMorgan's average interest rate earned will continue to rise as it makes new loans at higher interest rates.
Under Janet Yellen, the Federal Reserve plans on keeping the overnight rate below 0.25% into mid-2015. With a low short-term rate, deposits will continue to yield little, minimizing JPM's interest expense. As the Fed lets the long end gradually rise, the yield curve will continue to steepen, which is accretive for net interest margins. Essentially while volume will decline, each loan will be more lucrative. On the whole, a rising rate environment is positive for JPMorgan. With its significant exposure to credit cards, I expect JPM to grow its net interest margin less than some of its peers, but a 5-10% increase is a reasonable expectation. Even with lower volume, I expect lending to add $0.10-$0.20 in earnings in 2014.
Moreover, JPMorgan's investment bank continues to perform well thanks mostly to strong market share. I expect a relatively strong year for M&A, which will boost revenue. Conversely, rising rates will lead to lower debt issuance and could pressure trading revenue in 2014. Further, as banks adapt to the requirements of the Volcker Rule and Dodd-Frank as a whole, trading will remain under pressure. A stronger economy will help this unit, but headwinds will cap growth to less than 10%.
On the whole, JPMorgan's units are performing well, but I believe shares are pricing in the good news. Further, JPMorgan continues to have a target on its back as the Madoff settlement showed. The bank has said it is appropriately reserved for further litigation, and the bulk of the legal payments should be in the rear view mirror. Still, legal risks do remain, and if major suits are brought, there is a risk that book value could decline by upwards of $2-4 per share, endangering capital returns to shareholders.
In fact, CEO Jamie Dimon said as much to investors. While the company can spend $6 billion on its buyback, it has only spent $2.2 billion and has all but ceased buying shares of late. While Dimon said he personally believes shares are attractive, they are not as cheap as they used to be, so investors should not expect the company to fulfill its buyback in the near term. With extremely rare exceptions, management never tells shareholders a stock is over-priced and they should sell. As a consequence, I would discount Dimon's statement he finds shares attractive. Money speaks louder than words, and there is a reason why the buyback pace has slowed to a crawl.
At $58, it just isn't accretive to buy back shares, so the company won't. When management acts in a way that suggests shares are overpriced, investors should take heed. Further with the legal overhang, I expect the Federal Reserve would not approve significant capital returns in 2014. I expect a smaller buyback of up to $5 billion, and a dividend hike in the 5% range, which will lag many of its peers. With a return on equity of 9% last year, the stock is appropriately trading at a 10% premium to book value. With limited capital returns to investors, I think shares will continue to trade at roughly 10% above book value. Until JPM can generate returns like Wells Fargo (13.5-14%), its shares will deservedly trade at a discount.
After a mediocre quarter, now is not the time to buy shares of JPMorgan. While the bulk of its legal problems are in the rear view mirror, there remains a risk that the Justice Department could take further action, which could cut book value. These actions have also consumed cash that could have otherwise gone to shareholders. Moreover by slowing the buyback pace, management suggests it does not see the value proposition in JPMorgan at current levels. Investors will do better in Wells Fargo, which has significantly higher capital return capacity and should expand NIM more quickly. I would wait for a pullback to $54-$55 before buying shares of JPM. At current prices, downside risk outpaces reward potential.