We continue to profile the 2Q 2012 earnings reports of large cap companies (recap of Alcoa's results here). Going into earnings season, many companies reduced guidance and analysts cut their projections. We now want to find out if expectations were reduced low enough to reflect the generally pessimistic view of 2H 2012. JPMorgan's (JPM) Q2 earnings release on Friday sparked a 6% jump in the stock and a relief rally in the overall market. In this update we look past the noise of the London Whale trade and focus on some of the trends behind JPMorgan's earnings and the implications for other companies and the broad market.
How Did The Company's Stock Perform Going Into Earnings?
JPMorgan's stock has been declining following the announcement of the London Whale trading loss from its recent highs at approximately $46 per share to the low-$30s. The stock did not fully test its 52-week lows, but over the last two months it has traded in the area of last year's correction, reflecting the reduced expectations for 2Q 2012 earnings.
The initial positive reaction to JPMorgan's earnings on Friday likely included some short covering, so it will be important to see if the market's reaction next week confirms the initial move. Although the initial 6% move was impressive, the stock has not yet marked new upside territory. The $37.50 range seems like a key reference point to judge investor optimism.
Did The Company Beat Expectations And Have Expectations Been Rising/Declining?
JPMorgan's 2Q earnings release and related material can be found here.
The following is a summary of the results:
(Source: JPMorgan's 2Q 2012 earnings material.)
In 2Q, JPMorgan generated $5.0 billion of net income and $1.21 of earnings per share.
The net income results included several significant items:
- CIO ("London Whale") trading loss: $4.4 billion pretax loss ($0.69 per share after-tax reduction in earnings)
- CIO securities gains: $1.0 billion pretax benefit ($0.16 per share after-tax increase in earnings)
- Gain from reduced loan loss reserves: $2.1 billion pretax benefit ($0.33 per share after-tax increase in earnings)
- Gain from debit valuation adjustments ("DVA") adjustments: $0.8 billion pretax gain ($0.12 per share after-tax increase in earnings)
- Gain from recovery of a Bear Stearns note: $0.5 billion pretax gain ($0.09 per share after-tax increase in earnings)
Analysts had projected EPS of $0.76 (according to several press reports), so JPMorgan's results compare favorably to the estimates, even after backing out the gains from the DVA and loan loss reserve reduction.
According to Reuters estimates (via Capital IQ), the analyst estimates for normalized EPS called for $0.73 (slightly below the numbers in several press reports). One month ago the estimates called for $0.88 and $1.21 three months ago.
Additionally, JPMorgan restated its 1Q 2012 results to reduce net income by $459 million due to the London Whale trading loss.
What Drove The Results?
A lot has been said about JPMorgan's results, especially the London Whale trading loss, but we want to highlight a few other points.
Investment banking activity was down. Overall investment banking fees were down 35% from the prior year and the combined Fixed Income and Equity Markets revenue was down 10% from the prior year.
Mortgage loan origination was up 29% from the prior year and 14% from the prior quarter. Mortgage loan applications were up 37% from the prior year and 12% from the prior quarter. We have heard positive comments about the possible bottoming of the housing market from several companies. The mortgage origination business was impacted by several factors, but it is a good sign for the housing market. The question will be how long JPMorgan's mortgage business can continue to rebound at these rates.
One of the factors that has been a drag on JPMorgan's results is the Net Interest Margin ("NIM"). The NIM is the difference between the interest income and interest expense, relative to the size of the loan book. As seen in the chart below, JPMorgan's NIM has been declining, which indicates lower profitability for the bank. Many other banks are also facing declining NIMs, so this isn't a problem just for JPMorgan. Rather, it is a result of low interest rates. JPMorgan says that it expects continued NIM pressure in 3Q, which will act as a headwind for earnings.
(Source: JPMorgan's 2Q 2012 earnings material.)
JPMorgan's earnings release explains the decrease in Net Interest Income, which is impacted, in part, by the NIM:
Net interest income was $11.3 billion, down by $616 million, or 5%, compared with the prior year, reflecting the impact of low interest rates, as well as lower trading asset balances, higher financing costs associated with mortgage-backed securities, and the runoff of higher-yielding loans, largely offset by lower other borrowing and deposit costs.
Commenting on the results in the Retail Financial Services division, JPMorgan's earnings release states:
Net interest income was $3.9 billion, down $126 million, or 3%, driven by the impact of lower deposit spreads and lower loan balances due to portfolio runoff, largely offset by higher deposit balances.
Similarly, regarding the Consumer and Business Banking division, JPMorgan's earnings release states:
Net interest income was $2.7 billion, down 1% compared with the prior year, driven by the impact of lower deposit spreads predominantly offset by higher deposit balances.
Regarding the Card Services and Auto division, JPMorgan's earnings release states:
Net interest income was $3.3 billion, down $176 million, or 5%, from the prior year. The decrease was driven by narrower loan spreads, partially offset by lower revenue reversals associated with lower net charge-offs.
Pressure on the NIM does not necessarily mean that there will be declines in Net Interest Income, but it is a headwind. It will be interesting to see when, and if, the NIM trends turn around.
What Are The Implications For The General Economy?
Healthy results for JPMorgan indicate good things about the economy. When asked about the economy, Jamie Dimon said (see full transcript of the earnings call here):
Corporate America, middle market companies, small business are okay... We had slow to modest growth. We started to see it in our calculations...
Additionally, JPMorgan's good credit card results may have implications for the upcoming results of Visa (V) and Mastercard (MA). Accoding to a Jefferies analyst, JPMorgan's credit card portfolio is split 75%/25% Visa/Mastercard. See more information here.
However, JPMorgan's investment banking results were weak:
Net revenue was $6.8 billion, compared with $7.3 billion in the prior year. Investment banking fees were $1.2 billion (down 35%), which consists of debt underwriting fees of $639 million (down 26%), equity underwriting fees of $250 million (down 45%), and advisory fees of $356 million (down 41%). Combined Fixed Income and Equity Markets revenue was $5.0 billion, down 10% from the prior year. Credit Portfolio reported revenue of $544 million.
The weakness in the investment bank was expected considering the capital markets trends in Q2. It will be interesting to see how Goldman Sachs (GS) and Morgan Stanley (MS) fared in Q2 and how their results compared to JPMorgan's.
What Is The Guidance Going Forward?
Jamie Dimon made important comments about the buyback, which has been suspended, and JPMorgan's earnings power.
Regarding the buyback, he said:
And that's why we think it's a logical thing to buyback stock... We can get to 9% Basel III by the end of 2013, and buy $23 billion, you can get to 9.5%, and buy $15 billion. So clearly, we have the ability.
What are we going to do? We would like to buyback stock, but after discussion with the Federal Reserve, we need to work with the Federal Reserve, the board has determined not to buyback stock until two things take place. Until we finish the Board review, I think it's a logical thing, so we come to the conclusion of the Board review, and we find no other major stuff, which I don't expect this time. And that we submit a new plan, capital plan as we've said, only as to repurchase not as to dividends or dividend these type of things, and hopefully if this all goes well we can stop buying back stocks early in the fourth quarter.
Here is the slide from the Executive Comments presentation that he was referring to when he mentioned the capital ratios:
(Source: JPMorgan's Q2 2012 earnings material.)
Regarding the earnings power of the firm, Jamie Dimon said:
Our earnings, the real reason we're here is to grow our company. We think that with strong and diversified by business model, it's been a source of strength to this company, not a source of weakness, particularly in the storm. We have great earnings power, we still think the earnings power to adjust all kind of ins and outs about $24 billion a year.
There were several questions from analysts about how the decision to restructure the CIO office will impact the earnings potential, since the CIO office had been a source of profit for the overall firm. In response, Jamie Dimon said:
There was $2 billion of profit in this book over a four, five year period. We didn't assume any of it going forward at all, so it's not like we take a lot of risk in extremely big projects, we were not. So it was not in our numbers, it doesn't change the $24 billion or anything like that.
The company also presented a slide about growth in Book Value Per Share and Tangible Book Value Per Share. With all the discussion of the London Whale incident, the real test for the bank is its ability to grow Book Value and Tangible Book Value. Despite JPMorgan's mistakes and its size it is growing at a nice pace.
(Source: JPMorgan's 2Q 2012 earnings material.)
Regarding the valuation, Jamie Dimon has said several times that he thinks the stock represents a good value when it trades around 1x Tangible Book Value Per Share, which is where the stock is currently trading. In response to a question, Jamie Dimon said, "in terms of book value, I think our stock is a great buy."
What Is The Market's Reaction To The Results?
The initial reaction was positive as seen in the 6% jump in the stock price on Friday. As we mentioned above, it will be interesting to see if there is follow through on the upside next week into new upside territory above $37.50 per share.
Although there was been a lot of criticism of JPMorgan, and Jamie Dimon specifically, the results were impressive. Despite the London Whale trading loss EPS was $1.21 per share, ROE was 11% and ROTCE was 15%. Furthermore, JPMorgan grew Book Value Per Share 8% y-o-y and Tangible Book Value Per Share 12% y-o-y. As of 2Q 2012, Tangible Book Value Per Share was $35.71. With a stock price of $36.07 per share as of the close on Friday, the valuation does not seem high.
There are a lot of reasons to avoid investing in JPMorgan. The macro environment is scary, especially considering the mess in Europe and its banking system. Growth in the US is subpar. There is pressure on the NIM and investment banking activity is weak. Banks, especially the size of JPMorgan, are largely a black box with limited visibility. Furthermore, as the London Whale incident demonstrated, JPMorgan's portfolio has lots of trading positions that can cause multi billion dollar losses. Finally, JPMorgan faces regulatory pressure and may face potential liability from the LIBOR scandal.
Nonetheless, JPMorgan has survived a lot of troubles during the last few years and it is still growing with good fundamentals and a reasonable valuation.