Goldman: Riding a Rising Tide
A rebounding equity market, smart risks, and growing businesses bode well for the banking titan. That's why it has S&P's highest rating
We at Standard & Poor's Equity Research think the Goldman Sachs Group (GS; recent price, $99) is benefiting from improving global equity markets, a pickup in mergers and acquisitions (M&A) activity, and gains in merchant banking. We think the shares should trade at a premium to Goldman's industry peers, based on our view of the firm's global footprint, significant operating leverage, and strong client relationships. Advertisement
We also think Goldman could win additional business, given clients' potential concerns about management-control issues, reduced employee morale, shareholder dissent, and media attention at Morgan Stanley (MWD: 3 STARS, hold; $50), especially after news of the planned departure of that firm's embattled CEO, Philip Purcell (see BW Online, 06/13/05, "Morgan Stanley CEO Purcell to Retire"). We view the valuation on the shares compared with peers and the S&P 500-stock index as attractive. Goldman carries our highest investment ranking of 5 STARS (strong buy).
Goldman is one of the world's leading investment-banking and securities companies. Its activities are divided into three segments: investment banking, trading and principal investments, and asset-management and securities services.
DARING APPROACH. Trading and principal investments accounted for 65% of net revenues in fiscal 2004 (ended November). Goldman makes markets in equity and fixed-income products, currencies, and commodities. It also enters into derivative transactions such as swaps, and it engages in proprietary trading and arbitrage.
Goldman's trading operations, which it refers to as Fixed Income, Currency, and Commodities (FICC), focus on interest rates, credit, mortgages, currencies, and commodities. Although FICC's results have been volatile on a quarterly basis, we note that the segment has demonstrated strong long-term growth over the past decade.
We view Goldman's willingness to take significant trading risk for appropriate reward as a competitive advantage. Although it has the highest value-at-risk (VaR), a measure of market risk in trading positions, among its major competitors, we're impressed that Goldman's standard deviation of quarterly trading revenues is among the lowest relative to its largest peers. It's bested only by Bear Stearns (BSC; 5 STARS, strong buy; $99).
BROKERAGE EDGE. In its principal investments business, Goldman invests in private-equity deals as well as real estate. At the end of fiscal 2004, principal investments consisted of $820 million in real estate and $3.83 billion in corporate investments, including a $2.56 billion convertible preferred stock investment in Japan-based Sumitomo Mitsui Financial Group (SMFG) carried at fair value. Principal investments produced net revenue of $1.33 billion in fiscal 2004, up from $566 million in fiscal 2003.
Despite its quarterly volatility, we view Goldman's fixed-income operation as a growth business. Although merchant-banking results can be uneven, we view the segment as a core business and don't exclude gains and losses from our operating estimates.
Goldman's securities services business provides prime brokerage, financing-services, and securities lending services to mutual funds, pension funds, hedge funds, foundations, and high-net-worth individuals worldwide. We view its significant market position in prime brokerage, which provides services to hedge funds, as a competitive advantage.
HEDGE-FUND BOOST. Goldman's investment-banking segment accounted for 16% of net revenues in fiscal 2004, and it underwrites a wide variety of securities and other instruments. In the financial advisory business, it advises clients on corporate takeovers, defenses, and mergers and acquisitions. Goldman also provides acquisition financing, currency hedging, and cross-border structuring expertise. We think Goldman has a particularly strong competitive position in underwriting high-yield and leveraged loans within its debt underwriting business.
The asset-management and securities services business accounted for 19% of net revenues in fiscal 2004, with assets under management at $452 billion at the end of fiscal 2004. Goldman experienced net client inflows of $52 billion in fiscal 2004, across all asset classes. That's up significantly from $15 billion in the previous year. Securities services has benefited in recent years, in our view, from new institutional clients and the creation and growth of new and existing hedge funds, as well as the rally in equity markets.
In December, 2002, Goldman and other leading investment banks entered into a $1.4 billion agreement to settle allegations that their research was tainted with conflicts of interest and misled investors. Goldman's share of the settlement was $110 million. The banks also agreed to make organizational changes to reduce conflicts of interest in their research departments.
LONG-TERM MUSCLE. We believe that Goldman has cautious risk-management policies despite its willingness to take significant trading risks. It considers risk management to be one of its most vital functions and begins at the top of the firm with the establishment of risk limits for major business units. Its average daily VaR was $67 million in fiscal 2004, up from $58 million in fiscal 2003 and $46 million in fiscal 2002. Despite the increase in VaR, we view trading risks as appropriate relative to the firm's capital base and total size.
We forecast earnings per shre of $9.70 in fiscal 2005, up from $8.92 in fiscal 2004, aided by prudent expense growth and merchant-banking gains. Although we expect revenue to be weak in the May quarter, we see a rebound in proprietary trading, equity underwriting, merger advisory, and merchant-banking gains in second-half 2005. Announced M&A activity has slowed thus far in the second quarter, in part due to weak equity markets, but we envision a pickup in the fiscal year's second half, as the equity markets and CEO confidence rebound, as we expect. We also see an increase in initial public offerings (IPOs).
Segment results are difficult to forecast on a quarterly basis given volatile market conditions, but we think they'll exhibit strong long-term growth on an annual basis. We expect trading revenues to ease throughout the remainder of fiscal 2005, following record first-quarter results, in light of a flattening yield curve and tightening credit spreads. Equity underwriting, asset management, and advisory fees should experience strong growth, in our view.
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