JPMorgan Chase (JPM) was among other companies, such as Goldman Sachs (GS), Citigroup (C), Bank of America (BAC) and AIG (AIG) which drew heavy criticism about their alleged misbehavior during the mortgage crisis. As a result, the US government bailed out such companies and forced them to accept a public stake in their companies to calm and insert confidence into global capital markets. Having moved past the surrounding public anger after the crisis, JP Morgan made new headlines as it announced a serious deficiency in risk management leading to losses on derivative bets caused by its London trading desk.
I argued at the time, that those derivative trading losses, which remained undetected by the company's risk management operations, are a serious problem that presents weaknesses in JP Morgan's risk assessment process. Though I underestimated the after-tax loss at time of publishing, I understand, that the realized loss in the Q2 financials ist not final as yet. I urged investors, however, to not let this loss cloud their judgment regarding JPM's underlying core profitability. At the time, the loss was estimated to be around $2-3 billion.
As Dick Bove, Rochdale Securities bank analyst, said on CNBC:
The losses could get bigger, but there's a good chance that you may actually see a profit coming out of the residuals from this trade.
The realized loss in Q2 2012 stands at $4.4 billion pre-tax (or a negative $0.69 EPS impact). As a result. the company has addressed its procedural weakness in re-positioning its chief investment office. The loss is certainly regrettable from a shareholder point of view, but investors should focus on the bigger picture and the development of JPM's different business units. Even though the results were not impressive on an absolute level with earnings of $5 billion or $1.21 per share, they are certainly compared to JPM's operational achievements and current market valuation:
- Delinquency trends are encouraging and down-trending in all segments: Home equity, subprime and prime mortgages and credit cards
- JPM has declining loan loss reserves of $23.8 billion down almost $5 billion from a year ago
- JPM has a high loan loss coverage ratio of 2.74%
- It has consistently high league table rankings in debt, equity and IB fees which are the main revenue and earnings drivers
- Basel 1 Tier 1 common ratios are high and increasing with 10.3% in Q2 2012 up 0.2% points compared to last year
- Huge asset base in asset management: Consistently $1.3-1.4 trillion which shows clients' confidence in JPM
- High net profit margin of 28% in core segment investment banking
- Very high pretax margin of 34% in Treasury and Securities Services
- Commercial banking segment with record revenue of $1.7 billion
- The retail financial services segment posted an 11% revenue jump to $7.9 billion while costs have been reduced by 10%
- The Card Services and Auto segment reported declining revenues and earnings, yet still achieves a return on equity of 25%.
Despite being in the headlines for substantial losses, investors should still treat those losses as non-recurring and not let their valuation be distorted by them. The underlying profitability of JP Morgan is very much intact. As I have shown above, the individual segments indicate highly profitable business units within JP Morgan:
The company profits from strong business performance in all segments achieving record revenues in some or double-digit margins in others. Delinquencies are down-trending, but will still need more time to work through. The company is well capitalized with high Tier ratios and liquidity access of $414 billion. More importantly, the company has realized the trading losses in its financial statements and has addressed and cleaned up the situation. With a multiple of 6.6x forward earnings, which translates into an earnings yield of over 15%, the company is dirt cheap given its profitability outlined above. Investors also get to enjoy a decent dividend yield of 3.6% which is not in jeopardy based on the trading losses.
I consider the focus on the trading losses to be overblown, yet regrettable, which is why I continue to rate JPMorgan a deeply undervalued buy candidate.