The challenges at Goldman Sachs (GS) are well-documented: a difficult operating environment as low business confidence suppresses deal-making and client-trading; and tougher regulation of proprietary trading and the use of leverage. There is also structural change in the trading businesses as clients are more cautious about the more complex (high-margin) derivative products and as execution of the more standard products migrates increasingly to (low-margin) automated platforms.
This article argues that the risk/reward of GS to stockholders is nonetheless attractive because the reduction in global tail risk (as, for example, there are signs of stabilization of Chinese growth and the European financial system), together with the firm's improved capital position, creates the potential for an improved operating environment and more aggressive stock buyback.
In particular, we expect GS to buy back stock to offset the potential dilutive impact of the likely exercise in September 2013 of warrants held by Mr. Warren Buffett, particularly if the stock price falls towards or below the $115 exercise price of these warrants.
Improving Operating Environment
GS reports its full-year results this Wednesday, January 16th and analysts are expecting revenue of $32.7 billion (representing a 13% increase over 2011) and EPS of $12.1. For context, we provide a 5-year financial summary (and note that GS changed its business-line reporting in 2009 to break out client-trading businesses or "institutional client services" from more proprietary businesses or "investing and lending" which include the private equity portfolio).
Investment banking will continue below-trend because, as CEO Lloyd Blankfein pointed out in a recent presentation, and as illustrated in the chart below, corporate cash levels are high (suppressing the need to issue equity) and business confidence is low (suppressing appetite for acquisitions). For example, as of November, announced global M&A for 2012, expressed as a percentage of market capitalization, was running nearly 30% below the prior 10-year average.
However, revenue from Institutional Client Services will have improved meaningfully as fixed income trading benefits from the tightening of credit spreads that has followed Central Bank actions (albeit with some offset from lower volumes and commission rates in equity trading). And the "investing and lending" portfolio benefits from higher valuations ("positive marks") as both credit and equity markets rally.
GS has been buying back stock (including repurchasing 11.8 million shares last quarter at a cost of ~$106/share for a total of $1.25 billion out of the year-to-date amount of $3.1 billion). As a result, the basic share count has fallen to 491 million, representing a decline of ~10% from the average in 2010.
Along with this decline in the "basic" share count (used to calculate book value per share), the "diluted" share count (used to calculate earnings per share) has also fallen ~13% to 511 million.
Author's Note: We expect the diluted share count to increase temporarily because of year-end stock-based employee compensation and because, as the stock price rises above $115, there is as an accounting matter a greater contribution to the count from the 43.5 million warrants held by Warren Buffett at that strike price. (In passing, we note that in April 2011, GS spent $5.5 billion to repurchase the $5 billion preferred shares, with a coupon of 10%, issued to Mr. Buffett with the warrants in September 2008).
Analysts and the media have commented that, going forward, GS could become more aggressive with stock buybacks returning EPS to pre-crisis levels of ~$23 next year. However, this analysis was predicated on a stock price in the range of $95-120, not the higher price of today.
Balancing the Buyback Opportunity Against Global Tail Risk
Despite the 60% rally from the recent lows in summer 2012 of ~$90, GS stock is still trading approximately in line with a book value/share of ~$140 and tangible book value/share of $130. During conference calls in July 2012 and October 2012, CFO David Viniar articulated management's conflict over finding the stock price attractive for buyback and wanting to maintain a conservative stance towards capital management given tail risks in the global economy:
We tend to conserve cash and conserve capital, and yet, we have a stock price trading well below tangible book. And I know when we look back in the future, we're going to wish we'd bought back more at this price.
Regarding capital management, we've been extremely focused on balancing the competing objectives of returning excess capital to shareholders with the prudence associated with maintaining conservative risk-adjusted capitalization in a difficult operating environment with undefined capital rules.
While the rally in the stock price to above tangible book value may have made stock buybacks less attractive than before, GS's stronger capital position, and lower tail risks in the economy, will allow management to be more aggressive.
On the capital position, CFO David Viniar has indicated that the Tier 1 capital ratio under Basel 3 could be around 10% by year-end. This estimate excludes the (negative) effect of any stock buyback and (positive) effect of active management to optimize the balance sheet, but includes the passive roll-off of certain capital-absorbing positions, such as mortgage and credit-correlation portfolios. Below is the specific commentary in July 2012:
If we looked at Basel 3 today, it would be slightly below 8%. And if we roll forward, and only just pure math and consensus estimate and largely, the passive items like credit correlation, mortgage securitization, they're going to roll off. By the end of 2013, we get to slightly under 10%.
In the October 2012 conference call, Mr. Viniar clarified that GS was building for an expected regulatory capital requirement of 8.5% plus a 1% cushion over and above the requirement:
While Basel III capital rules are not finalized and will not be fully phased-in for many years, our best estimate from what we know today is that, at the end of the third quarter, our Basel III Tier 1 common ratio would be approximately 8.5%. We expect that we will ultimately operate with a capital cushion in the proximity of 100 basis points versus our regulatory requirement
CEO Lloyd Blankfein reinforced this guidance in November with the following chart putting GS's capital plan in the context of the potential regulatory requirements for competitors:
Potential For Excess Capital
In summary, GS could have excess capital by year-end of at least ~$2 billion (representing the difference between the 10% projected capital ratio and the long-run target of 9.5% on risk-weighted assets of $435 billion). In practice, the capital available for buybacks will be higher for several reasons.
First, Mr. Buffett has indicated he will be exercising his warrants (generating $5 billion of capital); second, the firm does not need to reach the 8.5% minimum regulatory requirement, let alone add a 1% cushion, until 2019; and third, management is taking active steps to improve the capital ratio which are not included in the projected ratio of 10%:
As Basel III rules have started to be finalized and we are closer to implementation, we've begun to focus on optimizing our balance sheet in preparation for these changes. We've previously announced that we expected $88 billion of risk-weighted assets to passively roll off by 2015, and we have begun to roll out the necessary tools to facilitate a more active approach to mitigating risk-weighted assets.
Of course, the $5 billion from Mr. Buffett will not contribute to a reduced share count unless GS is able to buy back stock at below the exercise price of $115; indeed, it will be dilutive (i.e., tend to increase the share count) if GS buys back stock above $115.
When the stock was well below tangible book value of ~$130/share, GS seemed motivated to buy back stock, but constrained by a concern over tail risk in the global economy and uncertainty over regulatory capital requirements. We expect this constraint to be less of a factor given the firm's stronger capital position (and, indeed, projected capital surplus for the end of 2013 assuming no buyback), reduced tail risks, and increasing clarity on regulatory requirements.
While the stock has now rallied above tangible book value, GS will likely at least offset the dilutive impact of the presumed exercise in September 2013 of $5 billion of warrants held by Mr. Warren Buffett. We expect GS to be more aggressive if the stock price falls towards or below the warrant exercise price of ~$115, so that this price may tend to act as a floor.
Disclosure: I am long GS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.