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JPMorgan Needs to Win Wall Street's Love Back


While most analysts think the "London Whale" has been harpooned, some still see major challenges ahead for JPMorgan Chase (JPM) and its shareholders.

After JPMorgan on Friday announced a $5 billion second-quarter profit, including a $4.4 billion hedge trading loss by its Chief Investment Office ("CIO") in the now-infamous "London Whale" incident, investors sent the shares up 6%, to $36.07.

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JPMorgan Chase CEO James Dimon said during the company's earnings conference call that "we've significantly reduced the total synthetic credit risk in CIO," and that "hopefully, if all goes well, we can start buying back stock early in the fourth quarter," resuming the share buyback program that was suspended in May after the CIO hedge trading losses were first disclosed.

The second-quarter adjusted earnings of $1.09 a share -- excluding debit valuation adjustments ("DVA") -- soundly beat the consensus estimate of $0.76 a share among analysts polled by Thomson Reuters, and most analysts followed up by raising their 2012 earnings estimates, while some raised their 2013 estimates as well. Increasing the current year earnings estimate following a better-than-expected second quarter is an obvious move and not likely to move the stock, but significant increases to forward earnings estimates can move the shares, which are trading quite low 1.1 times tangible book value, according to Thomson Reuters Bank Insight, and for seven times the consensus 2013 EPS estimate of $5.25.

Along with the prospect of having the CIO losses fading "to painful memory," according to Oppenheimer analyst Chris Kotowski, there were many bright spots in JPMorgan's second-quarter earnings release:

  • Period-end commercial banking loans grew to $120.5 billion as of June 30, from $115.8 billion the previous quarter, and $102.7 billion a year earlier.
  • Mortgage revenue increased to $2.3 billion during the second quarter, from $2.0 billion during the first quarter, and $1.1 billion in the second quarter of 2011.
  • Total noninterest expense declined to $15.0 billion in the second quarter, from $18.3 billion the previous quarter, and $16.8 billion a year earlier, mainly reflecting a decline in litigation expenses, but also a reduction in compensation expenses to $7.4 billion, from $8.6 billion in the first quarter (the annual seasonal spike for bonuses), and $7.6 billion in the second quarter of 2011.

Most analysts remain positive on the JPMorgan story, with 23 out of 33 sell-side analysts polled by Thomson Reuters rating the shares a buy, with a mean price target of $44.84, implying 24% upside for the shares.

So why should investors stay on the sidelines or consider selling JPMorgan Chase, when the shares are so cheaply priced?

FBR analyst Paul Miller rates JPMorgan "Market Perform," with a price target of $37, and said on Monday that the company's second-quarter results "were strengthened by a mix of financial levers pulled by the company," to offset the trading losses, and that in addition to "material headwinds to earnings facing the company and the industry overall, including margin compression as a result of historically low interest rates," the "overhang of the ongoing LIBOR investigation may take the place of the CIO trading losses as the new 'unknown' that we believe may keep some investors on the sidelines."

With various media reports suggesting that the Justice Department may be preparing to file criminal charges against Barclays employees, in the wake of that company's $453 million settlement of British regulators' claims of improper LIBOR rate submissions, Miller said "should other banks become involved, and we suspect they will, fines and other penalties could result, which may have a material impact on JPMorgan should it become involved."

Boiling down JPMorgan Chase's second-quarter earnings release, Miller calculated "core EPS" of $0.71, excluding "the debit valuation adjustment gain of $755 million, $1.0 billion of securities gains, and a $545 million gain from a Bear Stearns note." With JPMorgan winding down the CIO, Miller said it was important that the company disclosed the office's contribution to earnings, so that investors could "get comfortable with the run-rate earnings power of the company." The CIO contributed "8% in earnings in 2011, 23% in 2010, and 49% in 2009, according to the analyst, who added that "the recent lack of contribution to net income from the CIO is encouraging, as future earnings may take a limited hit as the company de-risks the portfolio."

On the negative side, Miller said that JPMorgan's net interest margin "seems unsustainable," in the prolonged low-rate environment, as his firm believes "the bias to interest rates is to the downside." JPMorgan reported a second-quarter net interest margin -- essentially the "spread" between a bank's average yield on loans and investments and its average cost for deposits and wholesale borrowings -- of 2.47%, declining from 2.61% in the first quarter, and 2.72% in the second quarter of 2011. Miller forecasts "forecast a 2013 NIM of 2.40%, 7 bps below the 2.47% reported in 2Q12 and 34 bps below the 2011 margin of 2.74%."

Miller also noted that although JPMorgan's mortgage origination and volume was very strong, its "gain on sale fell to 2.14% from 2.72% last quarter although it was still well above the 1.43% gain seen in 4Q11.

The analyst on Monday lowered his 2012 operating earnings estimate for JPMorgan Chase to $4.25 a share from $5.00 "to take into account the current quarter's result," and his 2013 operating EPS estimate to $5.13 from $5.37, "to account for a slightly lower net interest margin of 2.40% versus our previous 2.45% forecast."

JMP Securities analyst David Trone on Monday reiterated his "Market Underperform" rating for JPMorgan Chase, with a target price of $28, and said that his EPS estimate of $3.99 for 2012 reflects a "still-compressing NIM," along with "tough capital markets conditions, which limit trading and investment banking revenue." The analyst said that "JPMorgan continues to face legal/regulatory challenges, tangential effects and risks of the EU crisis, and a sluggish global economy."

Trone analyst left his 2013 EPS estimate of $4.55 unchanged, saying that JPMorgan "continues to face legal/regulatory challenges, tangential effects and risks of the EU crisis, and a sluggish global economy."

JMP's 2013 estimates assume that JPMorgan's "capital markets revenues decline -11% in 2012 and another -1% in 2013," as "advisory revenues... decline -38% / -6% on declining corporate confidence," and "equity underwriting revenues... decline -27% in 2012 but rise +4% in 2013 as volatility weighs on activity in the medium term," while "debt underwriting revenues to decline -13% in 2012 but rise 4% in 2013 as corporation demand for debt issuance wanes while the global economy remains in flux." Trone also expects "fixed income trading to decline -9% in 2012 but rise 1% in 2013 on soft client activity," and for "equity trading revenues to decline -8% in 2012 but rise 1% in 2013 as institutional investors remain on the sidelines while the Euro crisis unfolds."

For JPMorgan Chase's Retail Financial Services division, Trone expects that "retail banking revenues will decline -1% to -2% annualized as loan growth is mitigated by spread compression," and is also anticipating mortgage and real estate "to decrease by a quarter to a third on weaker mortgage production income and additional put-back costs."

For the company's Card Services business, Trone expects revenue "to decline modestly as loan balances continue to shrink," through the end of this year and in 2013.

For commercial banking, Trone is expecting to "see modestly lower revenues as loan growth is outweighed by margin compression," as an increase in average loans of 6% to 8% annualized, will lead to a revenue decline of "3%-4% annualized as the pace of loan growth moderates and margin compression persists."

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