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There is a growing split right now between “Main Street” and “Wall Street” banks, with the larger, more complex banks taking a bigger hit from weaker investment banking, tougher capital requirements, and ongoing infrastructure investment, while comparatively simpler banks are enjoying the benefits of healthy loan demand and strong interest leverage. Such is the case for JPMorgan (NYSE:JPM), where the “Main Street” business is performing rather well, but other elements of the business are dragging on results.
These shares have more or less kept pace with other large banks since my last update but have definitely lost some ground to smaller “Main Street” banks, and I frankly expect that to continue for a couple more quarters given JPMorgan’s need to reduce risk-weighted assets (or RWAs) to build capital and management’s decision to keep reinvesting in the business (higher operating expenses / lower operating leverage). Still, for long-term investors, I do believe today’s price is an attractive entry point and one that can reasonably expect to generate long-term total annualized returns in the double digits.
A Not-So-Surprising Surprise
Relative to a preview piece I wrote on large banks like Citigroup (C), JPMorgan, and others prior to second quarter results, I’m a little surprised that the average sell-side estimates weren’t revised lower than they were heading into the quarter. There was ample evidence, for instance, that investment banking activity was weak throughout the second quarter.
In any case, JPMorgan came up about $0.05/share shy of estimates on a core basis by my calculations – I’ll note here again the boilerplate warning that for large, complex banks like JPMorgan, it’s not uncommon for analysts to arrive at different numbers for core EPS, so your mileage may vary.
Revenue rose 1% year over year and was flat sequentially, missing by about 2%. Net interest income was quite strong, up 19% yoy and 9% qoq, and 1% better than expected, as JPMorgan did a little better than expected on asset sensitivity (getting more benefit from higher rates). Non-interest income declined 12% yoy and 7%, missing by 5%, with a 25% miss in the investment banking segment (down 61% yoy) driving a lot of that.
Expenses continue to rise, growing 6% yoy and 3% qoq, and while overall expenses were lower than expected, the reality is that growing expenses on flattish revenue leads to negative operating leverage. Pre-provision operating profit declined 6% yoy and rose 4%, missing by about $0.04/share. By unit, the Corporate and Investment Banking (or CIB) operations did far worse, missing by about $0.16/share, though I’d note that the Consumer and Community Banking (or CCB) business was also a bit weak relative to sell-side expectations.
Lending trends were mixed. While JPMorgan more or less kept pace with other large banks in terms of C&I and commercial real estate lending (as per Fed H.8 data) and outperformed on card lending, core consumer lending was softer, with ex-card consumer lending down about 4% yoy versus healthy mid-single-digit growth in the sector. Credit quality remains benign for now.
Paying For Complexity, While Also Prepaying For Growth
The two biggest drivers for JPMorgan’s business over the next several quarters are both negative – the need to build capital to comply with Fed stress test results and high levels of ongoing operating spending intended to drive future growth.
On the capital side, management is looking to get its CET 1 ratio above 13% by Q1’23 and will be reducing RWAs to help achieve those targets. Management reduced RWAs by over $40B in Q2’22 and will likely need to reduce by another $50B or so by Q1’23. JPMorgan will be reducing “non-franchise” lending activities (including substantial reductions in certain mortgage lending lines) but will likely also be pulling some capital from highly profitable businesses like trading.
CEO Jamie Dimon also talked of reducing the required stress capital buffer in 2023 by “reducing the things that created it”. I’ll be curious to see how the bank achieves that, while also maintaining the 17%-plus ROTCE target, as the bank’s increasingly global operating structure and significant Level 3 asset holdings are pretty much core to the business at this point and also important drivers of that higher capital buffer.
As far as the sizable operating expenses go, there’s not as much here that’s new relative to my last update on the company earlier in 2022. Management is making significant structural and tech investments across its operating units with an eye toward gaining share in pretty much every business where it operates, with perhaps particular attention on increasing retail deposit share (in the U.S. and abroad) through digital banking, growing the payments business, growing the wealth management/advisory business, and growing the middle-market lending franchise.
I continue to believe this is a good strategic move for the future, but it’s also one where you either believe in the approach or you don’t – while I believe JPMorgan’s track record argues that these investments will be leveraged to gain share at the expense of smaller banks in the future, there’s not a lot at this point to rebut the “no they won’t” bearish argument.
Likewise, you could plausibly argue that just as JPMorgan was slow to react and prepare for higher capital requirements (leading to a suspension of share buybacks and the need to spend several quarters building capital), they were too slow to start these growth projects and that banks like Bank of America (BAC) and PNC (PNC) are better-positioned, at least in some markets. I don’t think that’s the case, but I think it’s fair to present at least some of the bear case.
The Outlook
I was more conservative with my estimates for JPMorgan six months ago and the end result of that is that I’ve had to change my earnings expectations far less than many sell-side analysts to account for the impact of capital-building and more challenging markets in areas like investment banking. My 2022 core earnings estimate is actually unchanged and my 2023 estimate is slightly higher. Likewise, my mid-term and long-term core growth rate estimates of 3% to 4% really haven’t changed much.
Still, there are negative impacts to the valuation process. Higher rates mean higher discount rates and my core earnings-based fair value does decline by about $15 to around $143. My ROTCE-based P/TBV approach takes an even bigger hit, as I expect a weaker near-term ROTCE of around 15.5% versus 17.5%, and that pulls the fair multiple down to 1.8x, for a fair value of $125.
The Bottom Line
Sentiment on JPMorgan is weak now, and considering the need to build capital (which will hurt earnings power), the choice to continue spending to drive future growth, and the risk of a weaker U.S. and global economy in the second half of 2022 and into 2023, I don’t expect sentiment to reverse quickly. While the “Main Street” banking operations are performing well now, and pre-provision earnings growth should reaccelerate next year, overall operating leverage is not strong today.
I’d expect smaller, nimbler, less complex banks to outperform in the near term, though they’re also (speaking very generally) more at risk if there’s a sudden downturn in the economy and credit quality. Specific to JPMorgan, then, while this is perhaps not the time to buy for optimal short-term market outperformance, I think this is a good time to accumulate shares for long-term outperformance, as I believe this is a premier banking franchise that will leverage those considerable opex investments into higher share and greater profitability down the road.
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