JPMorgan Settlement Could Wipe Out Q3 Earnings

Updated from 9:08 a.m. ET with afternoon market action and Attorney General Eric Holder's comments after his meeting with JPMorgan CEO James Dimon.

NEW YORK ( TheStreet) -- JPMorgan Chase ( JPM) could see its third-quarter earnings wiped out, based on the latest leaks reported on Thursday.

The nation's largest bank is negotiating a settlement of criminal and civil charges with the Department of Justice, regulators and other authorities, and the total figure has "shot up to $11 billion," according to a Wall Street Journal report that cited "people familiar with the matter."

Attorney General Eric Holder rejected a $3 billion settlement offer from JPMorgan, according to a Journal report on Tuesday.

JPMorgan Chase CEO James Dimon visited the Justice Department in Washington and met with Holder. During a press conference following that business, Holder limited his prepared comments to discussing "significant enforcement developments in the Justice Department's efforts to crack down on price fixing and bid rigging in the automobile parts industry."

When asked about his meeting with Dimon, Holder said he "did meet with representatives of JPMorgan," and that he expected "to be making further announcements in the coming weeks, the coming months." The Attorney General refused to discuss the details of his conversation with Dimon, but did say "this is something of a priority."

Investors' reaction to JPMorgan's legal circus was muted after the company entered into a $920 million settlement with four regulators over the "London Whale" hedge trading debacle on Sept. 19, with another $369 million in settlements with the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency, springing from an investigation of the bank's " illegal credit card practices."

The firmness in JPMorgan's shares after last week's settlements possibly reflected the relatively small size of the settlements when compared with the estimated $6.2 billion in losses from the hedge-trading problems during 2012. The $1.289 billion total from Sept. 19 was also lower than the third-quarter litigation expenses CFO Marianne Lake hinted at when speaking at a conference on Sept. 9.

Lake said the bank was expecting net losses in its mortgage origination business during the second half of 2013, and that a "crescendo" of regulatory activity would lead to additions to third-quarter additions to litigation reserves "which will more than offset the $1.5 billion or so of consumer reserve releases."

Despite -- or maybe because of -- the endless flow of media reports throwing out potential settlement figures as high as $20 billion, as the leakers from the Justice Department and other agencies, investors really have no idea how much of an effect the expected settlement will have on JPMorgan's earnings.

Oppenheimer analyst Chris Kotowski in his third-quarter earnings preview for large-cap U.S. banks on Thursday cut his third-quarter earnings estimate for JPMorgan Chase by more than 50% to 70 cents a share from $1.42. The analyst's previous estimate assumed "no reserve releases or litigation accruals in it because we figured that they would generally be offsetting." Factoring in an expected decline in trading revenue of $0.5 billion, Kotowski's third-quarter EPS estimate would have declined to $1.35.

In the meantime, with the daily leaks of wildly diverging settlement figures, Kotowski is now factoring a $5 billion global legal settlement into his EPS estimate for JPMorgan. "We obviously have no idea what it will be, but in putting a $5B assumption into our estimate, we want to point out that even this amount would leave JPM with earnings comfortably above its dividend."

JPMorgan pays a quarterly dividend of 38 cents a share, for a yield of 2.94%, based on Wednesday's closing price of $51.70.

But based on Kotowski's figures, an $11 billion third-quarter settlement would completely wipe out JPMorgan's third-quarter results.

A quarterly loss would not threaten the dividend, as it wouldn't be an operating loss, and the dividend is still relatively modest compared to JPMorgan's underlying operating earnings power.

Kotowski rates JPMorgan "outperform," with a $71 price target, and estimates the bank will earn $5.30 a share this year, with EPS growing to $6.44 in 2014.

Deutsche Bank analyst Matt O'Connor expects a much smaller hit to earnings for JPMorgan this quarter, estimating the company "may have existing legal reserves of $4-6b (of the $18b they've taken since 1Q10."

"Adding in another $2b for legal reserves assumed in 3Q13 suggests additional hits should be manageable both in context of reserves/charges likely to be taken and the $5-6b of net income JPM earns per quarter," O'Connor wrote in Deutsche Bank's third-quarter large-cap banks preview late Wednesday. "Maybe more importantly is what it means to other banks if/when JPM settles on some of the broader mortgage issues."

O'Connor estimates JPMorgan will report third-quarter EPS of $1.25. The bank remains one of is "top picks" among bank stocks, as it has the lowest price-to-earnings ratio "of the market sensitive banks" based on Deutsche Bank's operating earnings estimates for 2013, 2014 and 2015.

JPMorgan's stock is indeed cheap. The shares at Wednesday's close traded for 8.5 times the consensus 2014 EPS estimate of $6.08, among analysts polled by Thomson Reuters. Among the 24 components of the KBW Bank Index ( I:BKX), the only other stock trading for less than 10 times its 2014 consensus estimate is Citigroup ( C), which closed at $49.26 Wednesday, or 8.9 times the consensus 2014 EPS estimate of $5.56.

Here's how those valuations compare to the rest of the "big six" U.S. banking club:
  • Shares of Bank of America closed at $14.14 Wednesday and traded for 10.4 times the consensus 2014 EPS estimate of $1.36.
  • Wells Fargo also traded for 10.4 times its consensus estimate of $4.01, when the shares closed Wednesday at $41.81. The contrast between Bank of America and Wells Fargo is striking, as Wells Fargo has been, by far, the strongest earnings performer among the "big six" over the past five years, while Bank of America is still a weak overall earnings performer.
  • Shares of Morgan Stanley closed at $27.22 Wednesday and traded for 10.5 times the consensus 2014 EPS estimate of $2.59.
  • Goldman Sachs closed at $162.31 Wednesday and traded for 10.5 times the consensus 2014 EPS estimate of $15.48.

Investors who may have thought it was too late to make a killing on the recovery of the largest U.S. banks may be looking at a golden opportunity to load up on shares of JPMorgan Chase during this period of awful daily headlines. That assumes the investors who go in have strong enough stomachs to allow the company's underlying operating earnings power to shine over a period of several years.

JPMorgan's shares were up 0.3% in afternoon trading Thursday, to $51.88. The broad indices were all showing solid gains, while the KBW bank index was down 0.2% to 62.60.

JPM Chart JPM data by YCharts

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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