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JP Morgan: The Benefit Of Low Expectations

|Includes: JPMorgan Chase & Co. (JPM)

Summary

  • JP Morgan beat low second quarter expectations, reporting earnings that beat the Wall Street estimate.
  • Despite this and evidence that Fixed Income trading is on the rebound, the market is still discounting the stock.
  • We believe that JP Morgan's solid dividend, cheap valuation and the prospect for better-than-expected earnings going forward make it an attractive bet for dividend investors.

Analysis

Second Quarter Earnings Beat Expectations. JP Morgan (NYSE:JPM)beat earnings expectations in the second quarter, reporting a profit of $1.55 per share compared to the average analyst estimate of $1.43. Despite the beat, JP Morgan's revenues were only slightly better than they were a year earlier, rising 2.9%, while its Net Income was actually slightly lower by around $100 million. The rise in its per-share earnings was the result of a lower share count as JP Morgan increased its stock buyback program.

JP Morgan's second quarter earnings were fueled by a strong pickup in its fixed income trading revenues and higher credit card spending. One interesting takeaway from JP Morgan management's comments following its early earnings release was that it viewed Brexit as more of a political and economic headwind, which can be viewed as a positive for the stock.

Dividend and Outlook. In the immediate aftermath of JP Morgan's second quarter results, its stock rose by 1.5%. However, in the week since, the stock has given up much of these gains and is actually down by 3.5% in the year-to-date. Still, it's worth noting that JP Morgan's stock is up by 20% since its nadir in February, when markets were roiled by low oil prices and general economic uncertainty surrounding emerging markets.

JP Morgan's current dividend yield is at 3%, placing it among the upper half of Dow component stocks by dividend yield. This means than an investor who buys $10,000 worth of JP Morgan stock can expect annual passive income of around $300. JP Morgan last raised its dividend in July by 9.1% to $0.48 per quarter. Over the last five years, JP Morgan's dividend yield has averaged 2.92% and its average increase has been around 14%. Given its history, JP Morgan's next dividend could range between $0.50 and $0.52 per share.

JP Morgan's ability to pay future dividends is good: while its standard financial strength ratios are mostly in-line with industry averages, as indicated in its earnings release, it is fully-compliant with the required Basel III CET-1 ratio of 7% with a CET-1 ratio of 12.1%. CET-1 is the minimum common equity required to cover a bank's risk-weighted assets. We believe that this is a more useful metric in evaluating banks than typical liquidity ratios because it directly addresses the risks that banks take during the normal course of business. At the same time, it is a regulatory standard that banks must adhere to.

Meanwhile, JP Morgan's Value-at-Risk (NYSE:VAR), which measures how much it stands to lose from its investments on a normal trading day given their relative riskiness, has also been trending favorably: it was at its lowest level in four quarters during the second quarter.

Given JP Morgan's compliance with this standard and its less-risky trading positions, there is a good probability that the Federal Reserve will pose no objections to JP Morgan's future capital plans, which is good news for dividend investors since these include its plans for future dividend payments and stock buybacks.

Moreover, despite its less-risky trading profile, JP Morgan's Fixed Income business is booming whereas other banks' are not. To wit, while JP Morgan's fixed income trading revenues rose by 7% in the second quarter, Goldman Sachs' (NYSE:GS) experienced a 24% dropped, Morgan Stanley's (NYSE:MS) slipped by 36% and both Citigroup (NYSE:C) and Bank of America (NYSE:BAC) registered flat performance.

It wasn't only in Fixed Income that JP Morgan had a good quarter. As mentioned, its credit card business picked up nearly 5% in the second quarter as more confident consumers took to spending in the face of better employment conditions and low fuel prices.

Despite this, analysts remain skeptical of JP Morgan's prospects, lowering their estimates for the 3rd and 4th quarters as well as for 2016 in the last 7 days despite JP Morgan reiterating its previous guidance. Part of this is because of the inherent volatility of the financial markets from which banks earn their income - another is regulatory in nature. Just the other day, federal agents arrested an HSBC (NYSE:HSBC) banker as part of a larger fraud and currency manipulation investigation. Considering the interconnected nature of Wall Street, this raises the specter of another round of investigations into banks' practices that could result in substantial settlements.

A strong second quarter and a 20% price surge since February notwithstanding, JP Morgan is trading rather cheaply at under 11-times its trailing year's earnings. That's well below the market multiples for both the Dow and S&P500 and also quite a bit less than that for the financial sector. Even on a forward earnings multiple basis, the same story holds. What's more, on a Price-to-Book basis, JP Morgan is trading at around 1.05x - far less than 7.7x for its industry and 3.2x for the financial sector.

What this means is that most investors remain wary of the risks - as well as the regulatory restrictions - surrounding systematically important banks like JP Morgan. The simple reality is that the Federal Reserve acts as a de facto "third stakeholder" for banks and can influence decisions as fundamental as what risks to take (through the enforcement of Dodd-Frank, specifically the Volcker Rules), and how much money to return to shareholders.

In such an environment, it is difficult to see how banks can grow their businesses in a manner that excites their shareholders. In fact, current analyst estimates are looking for just 4.5% annual growth from JP Morgan over the next half-decade, which is more in-line with the growth estimates for Global GDP than it is with exciting companies like Tesla (NASDAQ:TSLA).

Conclusion

Notwithstanding these low expectations, we see JP Morgan as a strong candidate for dividend-focused portfolio. As we've mentioned, its dividend yield is in the upper half of Dow stocks and, at 3%, is actually higher than its 5-year average. What's more, the actions taken by the Fed in reducing banks' systemic risk by imposing regulations such as Basel III and requiring strict adherence to Dodd-Frank - as well as what appears to be a nascent recovery in the fixed income business mean - suggest that the market may be overestimating its risks and low-balling JP Morgan's future prospects.

This being the case, buying the stock now or during periods of market weakness would be a solid strategy for dividend investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.