Goldman Sachs is an immensely profitable, high quality investment bank with an irreplaceable culture. They hire talented, disciplined, hard-working employees who are dedicated to making more profit than competitors, monitoring risks as best as possible and doing what’s right for the firm without turf wars.

 

Nevertheless, much of GS is a discount-deserving cyclical trading business near a cycle peak. However, GS is priced at 10x colossal peak earnings. Since July, the stock has zoomed from $150 to $200 based, apparently, on the perception that current capital market frothiness is somewhat sustainable. I believe earnings will compress over the next two years with a ceiling valuation of $142. This write-up will not be a comprehensive review of GS. Rather, the aim is to find the current profit-growth driver and expose the cyclicality and operating leverage.

 

Why GS and not other IBs?

- Low risk of being acquired (unique culture + many potential future CEOs lined up)

- Pure play on turn in the credit cycle. 80% of profits are in trading, as opposed to more diversified IBs.

- High-risk high-reward. GS’s trading profit is pumped because they’re very aggressive on the way up. They will earn as much as possible while the going is good but current earnings cannot be used as a normalized mid-cycle number.

- Sticky compensation expense on the downside. GS stands on solid ground; they're diligent, focused on long-term success and have no need to please Wall Street. As in past cycle downturns, they will likely retain staff much more than others, which will further compress earnings.

- For similar reasons and also because GS has remained profitable in past cycles turns, this shorting opportunity has no risk of management lying and pumping up the share price.

 

Looking at GS’s statements is like reading the market’s history. Earnings have suffered in past liquidity crunches: down 81% in 1994 vs. 1993 and down 35% in 2002 vs. 2000. These losses were driven mainly by (i) a decline in the volume of trading or M&A activity (ii) losses in proprietary trading, long-term investments and other collateral damage. In the post-2003 credit roar, IBs have seen booming profits in anything fixed-income related (froth in bank loans, derivatives, housing and hedge funds). While there’s nothing wrong with these, the trading profits and volumes of trading/hedging/selling/securitization are unsustainable. Many unsound mortgages, corporate loans and other investments have been assumed; there is also a surplus of hedge funds and other investors engaging not only in hedging but also naked positions. When the excitement surrounding unsound assets, unsound trades and unsound market participants disappears, the go-go trading, inventory creation and prop desk profits will decline. Some trades will even take a beating or two. In sum, Wall Street is a sales organization that operates in cycles and this time is no different.

 

GS breaks out its reporting into the following 3 segments, the second of which we shall later split into 2 sub-segments.

(i) investment banking

(ii) trading and principal investments

(iii) asset management and securities services

 

Latest 10-Q, nine months ended Aug:                        2006                2005

 

Investment banking net revenues                               4,285               2,723  

Trading & principal investments net revenues            8,565              12,258  

Asset management & securities net revenues             5,045               3,515

Total Net Revenues                                                27,895             18,496  

 

Total operating expense                                          18,320              12,702

Pre-tax earnings (millions)                                      $ 9,575             $ 5,794  

 

Observations: (i) earnings growth benefited from operating leverage (ii) the rise in net revenues was due mainly to trading & investments, which we examine next:

 

Trading & investments - nine-months ending Aug:        2006                2005

 

FICC (Fixed Income Commodities & Currencies)     10,795              6,634

Equities trading                                                            3,730              2,073  

Equities commissions                                                   2,622              2,175

Other                                                                          1,418              1,376

Total net revenues                                                      18,565            12,258  

Operating expenses                                                    11,900              8,025  

Pre-tax earnings (millions)                                          $ 6,665           $ 4,233

 

So growth in trading mostly comes from FICC. To explore further, we examine data on GS’s potential loss from exposure to its off-balance sheet VIEs (entities that are formed to issue ABS and CDO paper). This gives us an overall view of risks associated with holding residuals in securitizations as well as market making & guaranteeing of pieces thereof. Highlights from page 24 in the 10-Q:

 

                                                                                            Aug 06             Nov 05

($ amounts in billions)

Interests in CDOs                                                                   2.1                   0.8  

Derivatives off of CDOs                                                          9.4                   5.3  

Derivatives – asset repackagings & credit-linked                     3.2                    1.5  

Other                                                                                      4.1                   2.4

Total                                                                                      18.8                10.0

 

So the huge increase in 2006 was mostly linked to the CDO boom. According to JP Morgan’s survey, CDO issuance is now running at about 80% YoY.

  

Goldman offers a list of direct holdings which are more difficult to fund on a secured basis during times of market stress. We examine this list to further narrow things down:

 

                                                                       Aug 06            Nov 05          Nov 04

 

Mortgage whole loans & CDOs                                  36,507             31,459           18,346

Bank loans (funded commitments & inventory)            27,254             13,843             8,900

High-yield securities                                                      8,318               8,822             6,057

Emerging market debt securities                                    2,285               1,789             1,653

SMFG convertible preferred stock                               4,938                4,058            2,556

Other corporate principal investments                           3,207                1,723            1,278

Real estate principal investments                                      621                   745               820

 

Two noticeable observations:

(i) GS was mass-producing mortgage CDOs until 11:59PM of the housing bubble, which indicates a culture of attempting maximum profit from all booms (with noteworthy risk controls, no doubt). This culture assures growing profits throughout the boom, a certain amount of pain when the cycle turns and more importantly, a massive slowdown thereafter.

(ii) GS’s current profits in CDOs & derivatives is largely attributable to bank loans as opposed to anything connected with real estate. We note that the volume in M&A, debt-financed dividends and buybacks & rescue loans is currently at unsustainable levels. To assess future earnings, we therefore ask what lies ahead for the bank loan market. Here are some opinions, the first from Goldman itself.

 

GS’s Chief Underwriting Officer for Europe and Asia, Eugene Leouzon: “The markets are really, really red hot […] The things we are seeing being done, both on the investment grade side and the non-investment grade side, are I would say borderline stupid.”

 

Warren Hellman speech: “Hellman said his firm recently passed on a deal that had bankers offering to lend at nine times cash flow”

 

Michael Peterson, editor of Creditflux: "Just about every man and his dog is trying to do a CLO at the moment"

 

Louise Purtle, senior analyst at CreditSights: "Times are good, default rates are low, and you're probably seeing loans that in a few years will seem far too generous"

 

Mark L. Gold, HillMark Capital (CLO manager): "If you look at the record issuance [of loans] that's been done, clearly you're setting the stage for record problems."

 

Simon A. Mikhailovich, Eidesis Capital: “Fundamental credit analysis of borrowers' ability to repay loans is being shortchanged”

 

 

To guess how GS will be impacted by the turn in the credit cycle, we start with two tables showing that earnings declined sharply in 1994 and 2001-2002 not only due to losses and dropping volume, but also because compensation was sticky.

 

 

 

 * Irregular jump from 1998 to 1999 reflect GS’s conversion to corporate form

 

 

Let’s compare the Underwriting and M&A booms of 2000 and 2006 using the Investment Banking segment:

 

(E) Estimated, 10-Q not yet filed

 

Two observations: (i) operating expenses for the segment have been much sticker than revenues (ii) pre-tax earnings could very easily return to sub-500mm levels if/when the market returns to normal

 

Next we look at revenue for the three big areas in Trading & Principal Investments: FICC, Equity Trading (ET) and equities commissions (EC). Later, we shall brake off EC profits into its own segment because it's more stable and deserves a higher multiple. (GS used to report EC as part of its asset management and securities segment. After switching to the fee-based business model it moved it into trading).

 

(E) 2006 operating expenses and pre-tax income are estimated (10-Q not yet filed), some figures for 2000 unavailable due to older discontinued reporting format

 

Observations: (i) in equity trading, profits got smashed 71% from 2000 to 2002. 2005 didn't surpass 2001 and only in 2006 did they finally blow through previous results. (ii) the new froth culprit, FICC, was growing nicely up until this year and is now going berserk.

 

 

------------ Valuation ------------

 

In putting it all together we have 4 segments. My valuation only assumes that the market's behavior returns to normal; no blowup is assumed whatsoever. Since we don't know when exactly the cycle will turn, my numbers are not necessarily a prediction for the next 4 Q's.

 

1) Investment banking: assuming return to 2005, adding 25% global growth, I estimate 500mm in pre-tax earnings. 14 P/E * 65% * 500mm = 4.55B

 

2a) Non-EC portion of Trading and Principal Investments: A lot can be said about this segment. For any type of market-making or structured products, this is driven by volume. For prop trading, it's about what GS can do. No one knows if they'll get whacked a lot, a bit, or not at all, but 2006 profit levels are just not realistic. Assuming a simple return to 2005 numbers, 5B pre-tax, 10 P/E * 65% * 5B = 32.5B

 

2b) The EC portion of Trading and Principal Investments: assuming 1.2B pre-tax: 14 P/E * 65% * 1.2B = 10.92B

 

3) Asset management and securities: though this segment includes hedge funds, I'm still going to give them credit for stability, growth and success. 2.2B pre tax: 14 P/E * 65% * 2.2B = 20.02B

 

Total Valuation            68B

Preferred dividend      Assume negligible

Diluted shares             480mm

Per share value:          $142

 

$142 is the best-case valuation. If FICC trading goes down 71% like equity trading did in 2000, We're down to $100.

 

Risks:

- “Go-go” trading volume stays high, i.e. bets in various derivatives continue at the current pace, hedge fund growth does not reverse by any significant amount and markets forever remain more short-term oriented and data-dependant than they used to be. Historically short-termism has gotten whacked but we never know. The “this time is different” argument is difficult to refute 100%.

- GS buys assets on the cheap or otherwise profits from increased volatility. I only list this as a risk because GS is known to be ahead of the pack. The fact of the matter is that even for GS, there are limits to what can be done - they're not a Berkshire Hathaway sitting on cash and ready to pounce. Their capital is mostly tied up with a strategy of riding the wave; the stock is likely to follow that ride and their destiny will eventually be correlated with that of Wall Street as a whole, even if above-average

- The liquidity cycle does not end in a bang. Personally I believe soft landings are more catch-phrase than reality but this risk may be offset by doing a pair trade - I would recommend Barclays as a hedge (see skyhawk’s write-up)

- International growth. The decline in earnings may be partially cushioned if international business doesn't slow down.

- Acquisition risk: quite unlikely because Goldman is Goldman, plus it’s a quite large, but today anything is possible