I just finished going over the JP Morgan earnings release and listening to the conference call. Here's a summary of what stood out to me:
- The company reported EPS this quarter of $0.68 versus expectations of $0.64. This is down from $1.34 for the same quarter last year. That's a 49% decline. Furthermore, $0.27 of this quarter's earnings came from a one-time gain from the sale of Visa shares in its IPO, so operating EPS was more like $0.41.
- This next part is a little tricky. According to fair-market accounting rules, firms get to report a gain when the debt that they've issued weakens. According to a recent Barrons article, "Here's how the accounting works: When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." This quarter, JPM recorded a $949 million benefit from this accounting treatment in its investment banking treatment. Management stated that there was an offsetting amount in several other business lines to the tune of "several hundred million dollars." No one followed up on this during the call, so we don't know the exact figure, but let's assume that the company's net benefit from this was $500 million. That works out to about $0.10 of EPS.
- Any financial company has a bit of latitude in massaging its earnings due to their control over the amount of money they set aside for loan losses. This is as much an art as a science. Overall, JPM added $2.5 billion to its credit reserves which isn't terribly surprising. When you look a little closer at the pieces, however, there are a couple surprises.
- The Card Services division actually had a lower provision for losses (by $112 million) this quarter than last quarter even though net charge-offs increased from 3.89% to 4.37% and the 30-day managed delinquency rate was 3.66% vs 3.48% last quarter. Given the stress on the consumer in the current economic environment and the fact that the company's loss experience is deteriorating, I would think the loss provision should be increasing. The managed portfolio did shrink by 4% over this period, but the reserving here could have been much more conservative.
- The allowance for loan losses in the Commercial Bank segment was essentially flat with last quarter at $101 million even though nonperforming loans increased by $300 million. The net charge-off rate rose sharply from .21% last quarter to .48% this quarter.
- Every $100 million in loss provision works out to about a $0.02 swing in EPS.
- The Commercial business is growing nicely. This could be a bit concerning given the deterioration in the economy. The company stated that they're not doing much real-estate related business, and they specifically mentioned government and non-profit business as areas of recent focus. The charge-offs in this division have started rising, so this needs to be watched closely. The company claims this recent increase is just a normalization from very low levels of losses. We'll see.
- Their page on Prime Mortgages was very disconcerting. The 30-day delinquencies have been moving up strongly from just under 1.00% last June to over 3.00% this quarter. The company has obviously been tightening underwriting standards, but this is troubling.
- The Bear Stearns acquisition remains a big question mark. It's expected to close June 30, 2008. Time will tell whether this turns out to be a terrific buy or an albatross.
I expect this stock to move with the financials which will continue to be subject to violent swings in sentiment. We seem to alternate between "The worst is behind us. It's time to buy!" and "Run for cover! Here comes another wave of write-downs!" At some point, the financial sector in general will again be a buy, but for the time being I'm comfortable opportunistically adding to my net short position.
