Goldman Sachs - Profits Remain Firm As Compensation Is Cut Aggressively

Oct.21.13 | About: Goldman Sachs (GS)

Shares of Goldman Sachs (NYSE:GS) saw a modest sell-off at the end of last week after the investment bank reported its third quarter results. Investors are not too pleased with the weak third quarter revenues being reported, falling short of already low expectations.

At the same time, Goldman is clearly working for its shareholders nowadays as it cut compensation expenses aggressively to please shareholders.

At current levels shares remain fairly valued in my opinion, as earnings remain volatile in times ahead.

Third Quarter Results

Goldman Sachs generated third quarter revenues of $6.72 billion, down 20% compared to a year earlier, and down 22% from the second quarter. Revenues fell short of consensus estimates of $7.35 billion.

Despite very quiet conditions in the late summer, Goldman managed to report a $1.52 billion profit for the quarter. Earnings per share came in at $2.88 per share, up three cents compared to last year, but down from the $3.70 per share reported in the second quarter.

Note that earnings came in ahead of estimates at $2.43 per share, driven by lower tax rates, lower compensation costs and fairly aggressive share repurchases.

CEO and Chairman Lloyd Blankfein commented on the third quarter performance, "The third quarter's results reflected a period of slow client activity. Still, we saw various signs that our clients are prepared to act on significant transactions and we believe that the firm is well positioned to help our clients accomplish their objectives."

Looking Into The Results..

Goldman faced a tough quarter, notably in its investment banking and institutional client services business. Despite the diversification across different businesses, quiet market conditions still took a toll on the company's revenues and earnings.

Yet through its variable compensation the bank can smoothen out earnings swings quite well. Note that revenues fell by 20% compared to last year. In actual dollar terms they fell by $1.63 billion to $6.72 billion. At the same time, Goldman cut its total compensation and benefits by 35% to $2.38 billion, or $1.29 billion. As such it were employees, not shareholders taking the majority of the pain.

As a result of this and general tight operational expense management, net earnings fell by merely 2% to $1.43 billion.

Despite the steep fall in revenues, the average compensation per worker still totaled $73,000 for the quarter, some $292,000 per year.

And Looking Through Each Individual Business

As mentioned above, notably the investment banking and institutional client business fared relatively poorly over the past quarter.

Investment banking revenues were stable compared to last year, at $1.17 billion, but revenues were down 25% compared to the second quarter. Both advisory and underwriting activity was rather low. Goldman benefited from a surge in IPO's recently, while merger & acquisition activity was lower in recent months.

Revenues from the so important institutional client services fell by 32% compared to last year, and even by 34% compared to the previous quarter. Revenues of the most important business totaled just $2.86 billion. Fixed income, currency and commodity revenues halved compared to the second quarter, being the major driver behind these shortfalls.

The investing & lending business performed reasonably well, posting a 4% revenue increase compared to the second quarter, although revenues were still down 18% compared to last year. Total revenues came in at $1.48 billion as debt securities and loans fell on the year before.

The investment management business was the only business reporting revenue growth compared to a year earlier, although it only was 2%.

Valuation

Goldman ended the quarter with a relative solid capital base. The Tier-1 capital ratio was 16.3% as the Tier-1 common ratio was 14.2%, each under the Basel I regulatory capital requirements.

Goldman now operates with $77.6 billion in shareholder equity on a total balance sheet of $923 billion.

Book value per share stood at $153.58, while tangible book value was $143.86 per share. This values the company at 1.04 times book value and 1.10 times the tangible book value.

Revenues for the first nine months of the year came in at $25.4 billion, up 2% on the year before. Net earnings rose by 23% to $5.5 billion, as diluted earnings per share rose by 27% to $10.89 per share on the back of share repurchases. At this pace annual revenues could come in around $32-$34 billion, as earnings could come in around $7 billion.

Trading around $159 per share, the market values Goldman Sachs at $71 billion. This values the bank at 2.1 times annual revenues and 10 times annual earnings.

The bank hiked its quarterly dividend by 10% to $0.55 per share, for an annual dividend yield of 1.4%.

Some Historical Perspective

Shares of Goldman Sachs peaked around $230 per share back in 2007. Shares fell to levels as low as $50 in the 2008 crisis but quickly bounced back to trade in a $100-$200 trading range ever since.

After shares have risen some 25% so far this year, shares are currently exchanging hands at $159 per share.

Between 2009 and 2012, Goldman Sachs has seen its revenues fall by a cumulative 20% to $41.7 billion. Earnings have fallen by some 45% to $7.5 billion in the meantime. Note that the bank has retired roughly fifteen percent of its shares outstanding from their levels in 2010.

Investment Thesis

It has been a really tough quarter at Goldman Sachs, even more so for its bankers, than for shareholders. A 20% shortfall in revenues on the year before was offset by cost cuts, which in Goldman's case means lower bonuses. As such, earnings per share actually increased a little bit. Yet investor are more worried about the fact that Goldman failed on revenue estimates, even though it beat on earnings, as such cost cuts can not continue forever without impacting morale.

Investors are also worried that Goldman's revenues were much softer in the quarter, compared to some of its competitors. The company has a relative large mortgage-bond trading business, and has many hedge funds as clients which trade on economic data, some of which was not released during the government shutdown. Despite this, CFO Schwartz noted that management is "not happy" with the bank's performance. Note that Goldman's physical commodities trading business, which has been hugely profitable in recent years, is coming under increased scrutiny.

To further offset the impact of the weak trading and banking environment over the past quarter, Goldman raised its quarterly dividend by 10% to $0.55 per share. Goldman furthermore repurchased 10.2 million shares at $161.59 per share during the quarter, for a total of $1.65 billion. This implies that it currently repurchases shares at a rate of 9.3% per annum.

The firm continues to manage its firm for the long term, currently operating with ample liquidity. The firm continues to operate, with what is calls "an exceptional strong capital position", to offer clients many opportunities and trust for the long term.

Back in October of last year, I last took a look at Goldman's prospects. I concluded around the time that the recovery was better for Goldman's employees rather than its shareholders, something which has completely been turnaround over the past quarter. Since last year, shares have risen some 28%, as Goldman has focused on pleasing its shareholders in recent times.

I concluded at the time that life was better being a banker at Goldman Sachs, rather than being a shareholders. The dividend yield is relatively low, while shares are still trading a third below their highs of 2007. The fact is that Goldman has shown much more discipline in recent times to please its shareholders.

I remain on the sidelines, not having compelling arguments to either the long or short thesis.

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