Why JP Morgan Chase Will See Stronger Gains Than Peers This Year
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It is earnings season. The first Dow 30 stock to report, Alcoa surprised analysts who had expected a first quarter loss by posting profits of $94 million, or $0.10 per share. The first big bank to report, almost every quarter is JP Morgan Chase (NYSE: JPM). It is the largest bank in this country. To many, it is the safest commercial bank in this country as well, and is the top rated commercial bank in the United States at 36th in Global Finance's list of the 50 safest global banks. As the first big bank to report, at least it “sets the bar” for other financial institutions.
I had not been expecting terrific earnings from any of the money center banks in the first quarter of 2012, and I am more interested in the quality of banks' earnings than in the quantity. I want to see loan growth, revenue growth, expense reductions, interest margin stabilization, and in general, earnings growth from some other source than loan provision adjustments. Let's see how JP Morgan did on these parameters.
On the whole, I will give JP Morgan a “B+”, as in many areas, there was actual loan and revenue growth. The one-time factors, while up for debate, were clear and compressible. And I cannot blame JP Morgan for continued sluggishness in its large investment bank, as those same conditions will affect all companies with investment banking operations, and cyclicity is in the very nature of investment banking. When the industry turns around, which I expect may be by the second half of 2012, it will be a boon not just to JP Morgan, but to other institutions such as Goldman Sachs Group, Morgan Stanley and Citigroup.
In the first quarter of 2011, JP Morgan reported profits of $5.38 billion, or $1.31 per share, easily beating Wall Street expectations of $1.18 per share. The $5.38 billion represented a three percent decline from the first quarter of 2011, but the per share actually advanced from $1.28 a year ago due to JP Morgan's aggressive share buyback program that retired over 4% of outstanding shares through 2011.
Throughout 2010 and 2011, banks like JP Morgan were able to dramatically reduce loan losses on a year to year comparison basis, and buttress earnings reports via that practice. In the first quarter of 2011, across all of JP Morgan's business lines, loan loss reserves of $726 million was a relatively narrow $440 million less than the provision made in the year ago quarter. The company did also dip into its reserves for credit card and mortgage losses by $1.8 billion pretax in the quarter, or a net $0.28 per share. This was more than offset by an increased reserve of $2.5 billion pretax for mortgage related litigation costs. The company also benefited by a $1.1 billion dollar legal settlement, largely set off by a $907 million revaluation charge. All these charges, whether one time or not, were included in the results.
Of particular concern to me this season on any bank's balance sheet is their revenues. JP Morgan's was indeed up $1.6 billion from the first quarter of 2011. Its credit costs continued to tumble in this low interest rate environment, falling by $443 million. Offsetting these gains in overall interest income was a huge, $2.35 billion increase in non-interest expenses. This was driven by a combination of technology investments and a 19,000, or 8%, increase in employees. The overall loan portfolio of $721 billion was a $36 billion, or a 6% advance from the same point in 2011.
JP Morgan's investment bank is holding its own in a difficult operating environment, highlighted by generalized uncertainty, especially in Europe. Revenues in the quarter of $7.3 billion, while down 11% from the year earlier, were up 68% on a sequential quarterly basis. Similarly, income from the unit of $1.68 billion was off 29% from the first quarter of 2011, but more than doubled the fourth quarter of 2011. In CEO Dimon's annual letter to shareholders, released in early April, he called for JP Morgan's “absolute and static” earnings, or “EBBTH” (Earnings Before Bad Things Happen) to be $23 to $24 billion. If that is going to happen, a sizable chunk of that is going to have to come from the investment bank. It has won a slew of awards, and when market conditions allow, it can contribute up to $10 billion in annual earnings on its own.
The biggest contributor toward quality earnings in the first quarter for JP Morgan was its retail bank, which includes mortgage operations. Greatly improved credit and substantial loan growth overcame a lowered interest spread to allow earnings of over $1.7 billion, turning around a loss of $400 million in the unit a year ago.
Taking a broader look, Dimon's $23 – $24 billion represents a return on assets of 1.00% - 1.05%, a level not seen by the bank since 2006, and before that not at all in the last twelve years. JP Morgan's first quarter earnings represented a 0.96% annualized return. While it is plausible that the huge increase in non-interest expenses are nothing more than investments in future business opportunities, the bank's efficiency ratio has been driven to an unacceptable 68.4%.
JP Morgan intends to return about 70% of profits to shareholders this year, much of it in the form of a government approved $12 billion share repurchase plan. The share price is trading modestly below the current $46.70 book value per share. But over $15 per share, or one third of the book value is intangible, and much of that highly illiquid. I believe there are better uses for $12 billion than buying stock, but Mr. Dimon is clearly committed to the practice.
Without question, JP Morgan is a safer and better bet than peer banks Citigroup and Bank of America. But other banks, both in the United States and Canada, offer stronger long term prospects and better income yields.
Citibank (April 16), Wells Fargo (April 13), and Bank of America (April 19) and most other financial institutions will be releasing their first quarter earnings in the near future. Over the past few years, there have been clear winners among banks like JP Morgan, Wells Fargo, and U.S. Bancorp, and losers like Bank of America, Citigroup, and Regions Financial. In general, I expect “winners” to post earnings exceeding expectations, and expect losers, well, to fail to meet expectations. We will all see soon enough if that pattern holds during this earnings season.
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