Few Surprises in JP Morgan's Third-Quarter Results

 JP Morgan Chase (JPM) reported net income of $4.3 billion, or $1.02 per share, for the third quarter of 2011, which was in line with our expectations. We are leaving our fair value estimate unchanged. In our view, the primary risks to our thesis and valuation are related to loan and revenue growth in a potentially extended period of economic malaise, and we therefore have focused our attention on the bank's performance in these areas.

Overall, we were pleased with the bank's loan growth in the current environment. JP Morgan's gross loan balance increased from $690 billion to $697 billion during the quarter, driven by growth in wholesale loans. Total loans in its commercial banking segment, on the other hand, increased by $4.7 billion, with balances held in the company's Treasury and securities services, asset management, and investment bank segments also increasing during the quarter. In the bank's retail financial services segment, loans fell by about $6 billion during the third quarter, due in large part to runoff of mortgage and home equity loans. We're not surprised that consumer loan growth continues to be weak, even excluding the effects of the Washington Mutual portfolio runoff, so we were encouraged that JP Morgan managed to grow credit card loans by $1.6 billion during the quarter, following several quarters of declining balances. We expect commercial lending to continue to be the main driver of loan growth in the near term.

Net interest margin continues to be a concern due to the low rate environment. Though net interest income remained flat quarter over quarter, JP Morgan's reported interest rate spread fell to 2.56% from 2.64% in the previous quarter and 2.94% in third-quarter 2010. We think JP Morgan has achieved most of the benefit from low rates on the liability side of its balance sheet, funding its assets at a cost of less than 0.6% during the quarter, but that low rates will continue to pressure yields on the company's assets. It's possible that net interest margin may take longer to rebound than we currently expect, but we think improving asset quality and any steepening of the yield curve during the next five years will account for the modest long-term expansion incorporated in our valuation. We therefore do not see a slight near-term spread compression as overly concerning.

Not surprisingly, investment banking and private equity results were hampered by a difficult quarter for the capital markets. Though JP Morgan's net peripheral European exposure is manageable at $15 billion, in our opinion, the turmoil in Europe undoubtedly affected the bank's other business. The company's private equity business posted negative net revenue of more than $500 million on write-downs and declines in the value of publicly traded securities. Investment bank net revenue totaled $6.4 billion, including debit and credit valuation adjustments, but debt and equity underwriting fees were down 37% and 47%, respectively, year over year. Our outlook for the fourth quarter is very much the same, but we'd expect the firm's investment bank to perform better in a more normal environment.

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