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A Realistic View of Goldman Sachs and Their Lastest Quarterly Results

I'm about to go over Goldman Sach's 1st quarter 2010 results, but before I do, let's recap the last quarter's price movement and the consequences of believing in infallible name brands. This is basically a continuation of the rant - So, How Many Banks and Analysts Were Bearish On Goldman Before Today? and Is the Threat to the Banks Over? Implied Volatility Says So. Some may ask why I'm being so generous in regards to the extent of this quarter's earning review. Well... A European institutional subscriber recently stated he was able to get the same content found in my offerings from his investment bank research. Whaaatt!!! I told him that he probably wasn't reading the subscriber content. He wrote back stating that that wasn't the case. He also said that he doesn't see any fundamental analysis in the work. I nearly fell out of my chair. Hmmmm. Well, on the day that Goldman executives are due to testify before the Senate, let's review the opinions of the ONLY entity that I know of that had a bearish perspective (rightfully and profitably so - twice and counting) on Goldman Sachs. If I am not mistaken, nearly every bank and analyst (save Meredith Whitney, you know I love you ) had a strong buy or hold on this company both back in 2008 and last month. So much for relying on that name brand investment bank research. For any others who may hold the sell side propaganda machine in such high regard (or is it me in such low regard), might I recommend the following two posts before we move on: For Those Who Chose Not To Heed My Warning About Buying Products From Name Brand Wall Street Banks, and "Blog vs. Broker, whom do you trust!."

Map those base Jumping, spelunking, sky diving drops in Goldman's share price with the research linked below. This company is very, very risky and the risks are there for all to see. All you have to do is look for them!!!

To recap:

GS return on equity has declined substantially due to deleveraging and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike. Using your method, our valuation would drop from where it is to an even lower point.

Second, it still has a bunch of trash on its balance sheet, see Reggie Middleton vs Goldman Sachs, Round 2. If you look at the period of the most recent credit bubble, Goldman did everything that the other failed and bailed out banks did: leveraged up on trash assets, invested in and sold the worthless junk, and ran to the government for aid and bailouts:

So, what is GS if you strip it of its government protected, name branded hedge fund status. Well, my subscribers already know. Let' take a peek into one of their subscription documents (Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages). I believe many with short term memory actually forgot what got this bank into trouble in the first place, and exactly how it created the perception that it got out of trouble. The (Off) Balance Sheet!!!

Larger Image

Contrary to popular belief, it does not appear that Goldman is a superior risk manager as compared to the rest of the Street. They may the same mistakes and had to accept the same bailouts. They are apparently well connected though, because they have one of the riskiest balance sheet compositions around yet managed to get themselves insured and protected by the FDIC like a real bank. This bank's portfolio looked quite scary at the height of the bubble.

Now, on to the latest GS results:

1Q10 Results review

In 1Q10, GS reported 33% (q-o-q) and 36% (y-o-y) improvement in net revenues to 12.8 billion from $9.6 billion in 4Q09 and $9.4 billion in 1Q09, largely driven by trading revenues which jumped 82% (q-o-q) and 61% (y-o- y) to $9.2 billion on the back to increased client activity while bid-ask spreads tightened to some extent. Contribution of trading revenues has been inching up with trading revenues accounting for 72% of the total net revenues in 1Q10 against 52.5% in 4Q09 and 60.5% in 1Q09. Revenues from investment banking were up 44% (y-o-y) but down 28% (q-o-q) at $1.18 billion and revenues from asset management and securities services were down 1% (y-o-y) and 16% (q-o-q) at $0.9 billion. Comp ratio was down to 43% from 50%, last year and the compensation expense stood at $5.4 billion. Non compensation expense was 2% higher as compared to 1Q09 largely owing to higher levels of business activity, charitable contribution of $40 million and net provisions for regulatory proceedings of $21 million.

The surge in trading revenues trickled down to the bottom line and the net earnings grew nearly 91% (y-o-y) to $ 3.5 billion from $1.8 billion in 1Q09.

The BoomBustBlog view

For those who have forgotten the implications of the highly leveraged and opaque financial holdings (the true value of which rests at the mercy of market sentiment) and can turn blind eye to the highly volatile nature of the trading revenues combined with a literal tsunami of regulatory pressure and potential litigious onslaught (all issues which we have repetitively brought up in the past as what appears to be the sole voice of contrarian reason), Goldman Sachs holds a strong investment proposition. However, if fundamental considerations such as the company's solvency, true economic profit (not the accounting earnings you hear preached from your brokerage's sell side marketing propaganda research reports) and the sustainability of income are to be considered, GS should NOT appear among the preferred lot.

GS swims and sinks with the financial markets and the performance at the trading desks determines not only the profitability, but the survival of the Company. The market's unfounded exuberance (largely driven by liquidity rather than fundamentals), combined with the collapse or near collapse of 3 of its 4 largest competitors is enabling GS to generate extraordinarily strong trading results. Trading revenues which account for more than 60% of the revenues not only dictate GS's profitability but also serves as a cushion to absorb the write-downs on the investments. Thus, Goldman Sachs is amongst the most vulnerable to a major market disruption which can severely dent its earnings stream and expose it substantial equity erosion from investment write-downs. Apart from that, the recent fraud charges filed against GS not only adds to the risk of incurring huge litigation costs but also add to the risk of tighter regulation and oversight of the sector which can hinder the business activity in the coming years.

The chart below demonstrates how the volatility of the revenues from the trading and principal investments trickles down into volatility of the total revenues and profits of Goldman Sachs...

As of December, 2009, the GS's investments portfolio amounted to $342 billion (nearly 580% of the tangible equity) out of which cash instruments amount to nearly $267 billion (nearly 450% of the tangible equity) while the rest was the fair value of the derivatives instruments. Composition of cash instruments has changed substantially over the last year with a substantial proportion moved from mortgage backed securities and bank loans to foreign government securities. However, given the heightened sovereign risk environment, the money parked in government (US or foreign) securities is no longer safe from serious write-downs. From the frying pan and into the fire??? See LTTP (Late to the Party), Euro Style: Goldman Recommends Betting On Contagion Risk In Portuguese, Spanish And Italian Banks 3 Months After BoomBustBlog for what we see coming down the pike. Subscribers, peruse the Global Macro and Commercial Banking sections of the downloads for relevant subscription material.

While little disclosures are made about the write-downs on the total portfolio, information about realized and unrealized losses on level 3 assets (highly illiquid) gives some idea about the amount of write-downs being recorded on various types of investment securities. Although level 3 assets amount to just 13% of the total cash instruments, the realized and unrealized losses have been significantly influencing the total revenues from trading and principal investments.

Level 3 cash instruments came down nearly 30% to $34.9 billion (59.3% of tangible equity) as of December, 2009 from $49.6 billion as of November, 2008 largely owing to sale of nearly $8.6 billion and write-downs (realized and unrealized losses) of nearly $3.0 billion. Write-downs on level 3 assets have declined sharply with the total investment losses (realized and unrealized) coming down sharply. GS recorded a gain of nearly 1.2% in 4Q09 against a peak loss rate of nearly 16.8% in 4Q08.

Level 3 cash instruments portfolio largely consist of equities and convertible debentures, mortgage backed securities, bank loans, corporate debt securities etc. Break-up of the realized/unrealized gains or losses for various types of securities in the level 3 portfolio was not available prior to 1Q09. However, looking at the trend over the last four quarters, largest improvement is seen in the corporate debt securities followed by CMBS and equities and convertible debentures. Based on the following table, it is observed that while situation is yet to stabilize in markets like commercial real estate, GS has "imagined modeled" quite optimistic assumptions when valuing the related securities.

Subscribers can find our most recent valuation estimates of Goldman Sachs here - GS 4Q09 Final Review and Updated Valuation, current as of January 2010, the month I started reiterating my warnings about this company's drastic overvaluation.

 

More of Reggie on Goldman Sachs

Reggie Middleton vs Goldman Sachs, Round 2
Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off
Get Your Federally Insured Hedge Fund Here, Twice the Price Sale Going on Now!
Reggie Middleton on Goldman Sachs' fourth quarter, 2008 results
Goldman and Morgan losses in the news, about 11 months late
Blog vs. Broker, whom do you trust!
Monkey business on Goldman Superheroes
Reggie Middleton asks, "Do you guys know who you're messin' with?"
Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis
Reggie Middleton on Goldman Sachs Q3 2008
As Reality hits, the Masters of the Universe are starting to look like regular bank employees
Reggie Middleton's Goldman Sach's Stress Test: Breaking Ranks with the Crowd Once Again!
Who is the Newest Riskiest Bank on the Street?

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