What Analysts Are Missing On Goldman Sachs
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Goldman Sachs (NYSE: GS) had a historically weak second quarter. But analysts had such limited expectations for both revenue and profit from the big investment bank that expectations were exceeded by wide margins, and Wall Street is reacting favorably. It is tough being an investment bank these days, as there is not a lot of trust in the American economy, and the European economy is a disaster. The last big capital deal that was done, while not led by Goldman, was nonetheless enough of a miserable experience for all interested parties that the Facebook (FB) fiasco will be on the minds of enough people to suppress initial public offerings, as well.
In the second quarter, Goldman Sachs reported that revenues declined 9% from the second quarter of last year to $6.63 billion. Analysts had been expecting $6.2 billion. Net income fell modestly from last year's $1.09 billion, or $1.85 per share, to arrive at $962 million, or $1.78 per share. The mean analyst expectation for the quarter was $1.17 per share. Since expectations are more important criteria to Wall Street than reality, Goldman's stock is being bid up near $100 per share, a level not seen since mid-May.
Goldman Sachs is a widely diversified firm with nearly $1 trillion in assets. If it were a commercial bank, it would rank as the fifth largest in the country. Not because of its size, but rather due to its substantial worldwide role in all aspects of investment banking and market making, it was included during the fourth quarter of 2011 in the Financial Stability Board's list of 29 Global Banks Too Big to Fail.
As befits a diversified firm, parts of Goldman Sachs' units performed admirably in the second quarter, while others did not. From a revenue perspective, the investment bank struggled nearly across the board. Only debt underwriting showed any improvement from the year earlier quarter, while equity underwriting (down 37%) and financial advisory (down 26%) were sharply down. Overall, investment banking revenues fell 17% from last year to $1.2 billion.
Institutional Client Services is Goldman Sachs' largest unit. Strength in fixed income, currency, and commodities overwhelmed weakness in the equities side of the unit, and overall revenues increased 11% from last year's second quarter to $3.9 billion. While the revenue improvement was welcome, it still was not a strong showing, as in the first quarter of this year the unit posted revenues of $5.7 billion.
The investment and lending unit basically flamed out in the quarter, with revenues of just $203 million, compared to $1.04 billion a year ago, and $1.91 billion in the first quarter of the year. The investment management division performed adequately, with revenues up five percent from a year ago, and up 13% from the first quarter, to $1.33 billion.
One thing that jumps out from reviewing Goldman Sachs's income statement from the second quarter is that its proprietary trading has fallen 91% from the first quarter, as the firm is generally ahead of the curve in meeting anticipated Volcker Rule amendments that will eliminate most proprietary trading.
The halcyon days of pre-recessionary years may be gone for many more years to come. It behooves Goldman Sachs to adapt its expenses to what each week seems more and more to be the new norm of revenues. True enough, Goldman Sachs' expenses fell 8% from the year earlier quarter, and 23% from the first quarter of 2012, to $5.2 billion. The largest component of the expense entry is of course personnel costs, and that also fell 9% from the year ago, and 33% from the first quarter of 2012, to $2.9 billion. Management seeks to cut another $500 million from its expenses during the second half of this year.
Recent news for Goldman Sachs includes the recent sale of its hedge fund management business to State Street (NYSE: STT) for $550 million, and a civil suit from the inventors of Dragon Systems speech recognition software, which will likely become very public and possibly embarrassing in that it will remind all of the infamous Greg Smith letter accusing his former employer of losing its way in caring for its customers. State Streets addition to its portfolio makes it the largest servicer of hedge funds in the world.
And most forbiddingly, the infamous Abacus related litigation, that dogged Goldman Sachs in the years as the banking crisis relaxed, seems to be rearing its head once again. Recall this involved Goldman Sachs touting and selling subprime mortgage packages to investors, while at the same time selling those very investments short. Goldman Sachs has also announced plans to expand its commercial bank from its current, roughly $12 billion asset size to about $100 billion. The bank would continue as a private bank; you won't see Goldman Sachs branches in your grocery stores. The private bank would cater to high net worth individuals and business clients.
Due to macroeconomic issues, I do not expect stellar earnings from Morgan Stanley (NYSE: MS) or any of the smaller investment banks such as FBR (FBRC), and Cohen & Steers (CNS). Morgan Stanley's second quarter earnings were weak, as profits dropped 50%. The principle headwind of fear in the markets appears nearly daily in the press, and as long as there is a public view of pending economic doom, it will be hard for anyone to make large debt, credit, or other capital moves. Other than a few tech stocks, I cannot recall any large IPO's in recent months.
Analysts peg Goldman Sachs earnings in 2012 at a little over $10 per share, though I have a hard time seeing it earn much over $9 per share. Even at my lower estimate, Goldman Sachs is only trading for about eleven times earnings, and its estimated five year PEG is 0.66. Those numbers scream of an undervalued situation. However, this is a highly volatile company whose earnings ultimately are hard to foresee or predict. Only those willing to accept risk need consider this for an investment.
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