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The U.S. economy has been facing a low interest rate environment, which has caused a substantial decline in the net interest margins of the banks. As the profit-generation capacity of the core business activity remains limited by the economic environment, bank holding companies like Goldman Sachs (NYSE:GS) have turned to a thorough process of cost cutting in order to generate profits. This notion of a shift in focus toward cost-efficient operations instead of top-line growth has been the theme for all major players in the banking industry. As reflected in the first-quarter results, Goldman Sachs has been successful in pursuing its cost-cutting measures and beating analysts' estimates. Furthermore, the lower interest rates are assisting the company's investment banking segment due to improvements in volume.

First-Quarter Financial Performance

The Institutional Client Services segment contributes to a disproportionately large part, approximately half, of Goldman Sachs' revenues. This portion of the business reported an 18% increase in revenues compared with the previous quarter due to a sizable improvement in fixed income, currency and commodities client execution, which improved by 58% compared with the last quarter. This improvement, however, was partially offset by a decline in revenues from investment management activities. Overall, revenues of $10.1 billion posted an increase of 9% compared with last quarter and 1% compared with the first quarter of 2012. This net revenues figure beat consensus estimates of $9.65 billion.

On the other hand, operating expenses decreased by 1% compared with the first quarter of the last year as compensation and benefits to employees was reduced to $4.3 billion. Consequently, earnings of $4.29 per share beat the estimates marginally even after most analysts raised their estimates of Goldman Sachs. The return on equity remained limited to only 12.4%, which was clearly not as exciting as the figures posted by Goldman Sachs in the past years. The key factor of cost cutting can be represented by the compensation ratio, which has settled at approximately 43%. Analysts feel that it is still a high level of compensation as it is one of the major variable costs faced by the company. Moreover, in terms of expense cuts in general, Goldman Sachs appears to be doing a better job than its competitors.

Outlook: What Should Investors Consider?

The businesses of large banking corporations have started to adapt to the environment, and most of their growth has started to come from the trading and capital markets. Therefore, the long-term growth will depend on these factors for as long as the economic environment starts to recover and lending becomes attractive for these companies. In this context, Goldman Sachs seems to have adapted much faster than most of its competitors. In the near term, a share repurchase has been approved by the Federal Reserve, which is likely to drive the share price upwards.

Valuation and Risks

Goldman Sachs is currently trading at a P/E of 10.05 compared with the industry average of 35.79. The company's P/S and P/CF are at 1.62 and 7.47 versus the industry averages of 3.69 and 21.38, respectively. Furthermore, the PEG ratio of 0.97 also suggests that the stock is an attractive investment.

The first major risk factor for Goldman Sachs is its sensitivity to interest rates. A change in the interest rate environment is likely to affect the company's performance. Also, regulatory pressures have risen for the whole banking industry making it more difficult to survive without submitting to appropriate levels of capital requirements. Goldman Sachs seems to have adapted to the current challenges aptly.

Conclusion

The company's financial performance remains robust to adverse factors as the management reported decent results in the face of economic and regulatory pressures. The settling of large variable costs such as the compensation for employees serves as apt examples. The growth of the business has been put to a halt due to the slow down but from a profit making standpoint, some segments of the business have projected a promising picture of profitable growth in the future. These prospects, coupled with undervaluation of Goldman Sachs, provide strong upside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. IAEResearch is not a registered investment advisor or broker/dealer. This article was written by an analyst at IAEResearch and represents his/her personal opinion about the companies mentioned in the article. The article is for informational purposes only and it should not be taken as an investment advice. Investors are encouraged to conduct their own due diligence before making an investment decision. I am not receiving any compensation (other than Seeking Alpha) for this article, and have no relationship with the companies mentioned in the article.

Source: Is Goldman Sachs A Good Investment?