The investment banking business is all about client relationships, and the quality of the personnel of the institution. In terms of a pure play investment bank, there is no finer institution than Goldman Sachs (GS) from a profitability standpoint. While the firm is not likely to win many popularity contests these days, Goldman Sachs is continuing to win market share from the dearth of pure-play investment banks, and from the pullback in European banks, due to their deleveraging process. Investment banking is not a business where I'd be interested paying multiples on book value, but at the right price, and with the strongest capital strength in my lifetime, I'd be more than willing to pay tangible book value or less for the preeminent investment banking franchise in the world. Three to five years from now Goldman Sachs and the other banks will be posting record profits and the regulatory environment will likely be more conducive due to the hard lessons learned, that a strong financial system is imperative to a robust U.S. economy in the modern era, and that a prolonged witch-hunt on your largest banks is not good for promoting lending or job growth. When this happens, market participants will likely be willing to pay 1.5-2 times book value, but instead of being the sheep following the herd, I'd urge you to look at Goldman Sachs and the other financials while there is still so much mistrust in the system.
In today's regulatory environment, capital, scale and deeply integrated client relationships are the keys to attaining a respectable return on equity in investment banking. Low-margins have already and will continue to push the weaker competitors to focus on different business lines. A perfect example is in the fixed income and commodities trading business where even a behemoth like UBS (UBS) simply finds the business uneconomical to maintain based on the return profile, and capital requirements. Regulators and politicians should think about this and consider the competitive fallout of breaking up the integrated banks. The United States has the strongest financial system in the world and why we would be willing to give that up in an era of outsourcing and robots performing human jobs makes no sense to me. The beauty of less competition is that ultimately it should create an oligarchy of leadership, which eventually will help margins, and bolster the semi-durable competitive advantages that a company like Goldman possesses. The strengths of Goldman are somewhat hidden due to the weak economic outlook that we have been in since the Great Recession. Every time that momentum has built there has been a panic that has caused things to slow down. This environment won't last forever and as Goldman Sachs and the other banks continue adjusting their business and cost structures, returns on equity will head towards the mid-teen range.
On April 16th, Goldman Sachs reported 1st quarter 2013 net revenues of $10.090 billion, which was up 1% YoY. Net earnings applicable to common shareholders were $2.188 billion, up 7% YoY. Earnings per diluted share were $4.29, which was up 9% from the same time last year. Total Investment Banking revenues were $1.568 billion in the quarter, up 36% YoY. Debt and equity underwriting were strong, but there was a 37% sequential decrease in M&A volumes, despite some big deals early in the year. Institutional Client Services revenue was $5.139 billion, down 10% from the same time last year. The quarter was mixed with strong equity and debt markets contrasted with a relatively weak macroeconomic backdrop. Investing and Lending revenues were $2.068 billion, up 5% YoY. Total Investment Management revenue was $1.315 billion, which was up 12% from the first quarter of 2012. The accrual for compensation and benefits expenses was $4.34 billion for the 1st quarter of 2013, and the ratio of compensation and benefits to net revenues was 43%, down 1% from 44% in last year's first quarter. Non-compensation expenses were $2.38 billion in the 1st quarter, which was roughly flat with last year. Annualized return on equity was a solid but not stellar 12.4%.
Goldman Sachs continues to strengthen its balance sheet with total capital of $244.24 billion, which consists of $77.23 billion in total shareholders' equity, and $167.01 billion in unsecured long-term borrowings. Total shareholders' equity includes $71.03 billion in common shareholders' equity and $6.20 billion in preferred stock. Book value per common share was $148.41 and tangible book value per common share was $138.62, both up around 3% from the end of the 4th quarter of 2012. On March 25th, 2013, Goldman Sachs announced that it had reached an agreement with Berkshire Hathaway (BRK.A) (BRK.B) where it will deliver the number of shares of common stock equal in value to the difference between the average closing price of the firm's common stock over the 10 trading days preceding October 1, 2013 and the exercise price of $115 multiplied by the number of shares of common stock ($43.5MM) covered by the warrant. During the 1st quarter, Goldman bought back 10.1MM shares of common stock at an average cost per share of $150.53, for a total cost of $1.52 billion. In addition, on April 15, 2013, the Board of Directors authorized the repurchase of an additional 75MM shares of common stock pursuant to firm's existing share repurchase program. Combined with the remaining share authorization, the total amount of stock Goldman can buy back is 86.4MM shares. I view this utilization of capital as being highly accretive based on Goldman Sachs's current stock price, so this could materially help grow both book value and earnings per share.
Source-GS 1st Quarter Financials Press Release here.
Goldman Sachs is one of the best capitalized banks in the world with a Tier 1 capital ratio of 14.4% and a Tier 1 common ratio of 12.7%, as of March 31, 2013. These numbers are lower than they were in the 4th quarter, but it is apples to oranges due to the revised market risk regulatory capital requirements, which became effective on January 1, 2013. The firm estimates its Basel III Tier 1 common ratio to be approximately 9%, putting it well on pace for its capital plans. The firm was carrying $174 billion of global excess liquidity as of the end of the 1st quarter, so if opportunities pop up, the company has the resources to capitalize on them. Total assets were $959 billion on March 31st, and level 3 assets were $46 billion, which represented 4.8% of total assets.
Based on 509.8MM shares outstanding and a recent price of $144.10, Goldman Sachs has a market capitalization of roughly $73.462. The stock trades at a discount to book value, which is likely to grow considerably due to retained earnings, and stock buybacks at a discount to book value. While I don't believe investors should pay a rich premium to own a bank, buying the best investment bank at a discount to book value, while it has the best balance sheet in its long and illustrious history, makes a lot of sense. If Goldman can compound common shareholders' equity per share by just 10% a year, which I think is exceptionally conservative, in ten years book value would be roughly $300, and I believe the stock would trade around that. In bull markets, most market participants tend to think they will compound at 20% a year, but in that 10-year time frame you are likely to see much higher interest rates and stock prices aren't cheap on an absolute basis. Obviously, there could be material upside beyond that when we see some real economic buoyancy. A 13% return on equity for the year would put earnings per share at just over $19, putting the forward earnings multiple at less than 8 times.
For investors looking to manufacture a cheaper price into the stock, you might consider selling the January 2015 $145 puts for about $21.50. This would create a breakeven of $123.50, which is a nice discount to tangible book value. Assuming the stock expires above $145, investors would make 17.4% on the maximum risk, or 10% on an annualized basis. Certainly dips in the overall market could potentially provide nice opportunities to dollar cost average as well. I'm currently not long Goldman Sachs simply because we are big in the other large banks, which trade at even cheaper prices, but I'd be a willing buyer at these levels over most opportunities that aren't currently in our portfolios.