Goldman Sachs - Strong Results By This Well-Managed Banking Franchise

Jul.17.14 | About: Goldman Sachs (GS)

Summary

Goldman Sachs reported very strong second-quarter results.

Organic strength, driven by investment banking and less weakness in trading boosted results.

Smart investments added to earnings, as Goldman's management has a strong long-term strong track record.

Structural pressure on trading is now priced into the shares, I am cautiously optimistic.

Goldman Sachs (NYSE:GS) released a strong set of second-quarter results on Tuesday, driven by smart investments and a strong investment banking performance.

The lack of a consumer banking business allows Goldman to avoid the slump in mortgage originations, while the company is quite lean compared to its competitors. Furthermore, Goldman appears to have much lower legal overhang risks compared to some of its competitors.

Second-Quarter News Facts

Goldman Sachs posted second-quarter revenues of $9.12 billion, which was up 6% compared to the year before, but down 2% from the first quarter. Revenues were much better than consensus estimates at $8 billion.

The bank posted net earnings of $1.95 billion, up 5% compared to the previous year. Thanks to share repurchases being undertaken by the bank over the past year, reported earnings were up by 11% on a per share basis.

Reported earnings of $4.10 per share came in way ahead of consensus estimates at $3.05 per share.

Looking Into The Results

CEO Lloyd Blankfein was pleased with the performance of the business amidst mixed operating conditions. Notably, investment management and investment banking were able to offset weaker performance of the institutional client services unit.

Investment banking revenues were up by 15% to $1.78 billion. The rise was driven by increased underwriting activity in equities, with revenues increasing by 20% to $1.28 billion.

Institutional client revenues were down by 14% on an annual basis to $3.83 billion. FICC revenues were down by 10% to $2.22 billion. Just like other major banks, with the exception of Bank of America (NYSE:BAC), the bank was suffering from lower trading activity levels. Equity revenues were down by 13% to $1.61 billion due to lower activity levels, as well as lower commission and fees.

Investing & lending was a bright spot, as revenues jumped by 46% to $2.07 billion. This was driven by $1.25 billion in gains on predominately private equity investments.

The higher markets had a positive effect on the investment management business, which posted an 8% rise in revenues to $1.44 billion.

Overall expenses were up by 6% on an annual basis, keeping track with revenue growth. Total expenses were $6.30 billion for the quarter. In total, some $3.92 billion was designated for the staff of the bank, which resulted in a 43% compensation ratio. Non-compensation costs were up by 5% to $2.38 billion, driven by higher litigation and regulatory costs, which nearly doubled to $284 million.

In the light of multi-billion charges taken at some of its peers, these costs related to legal matters are peanuts.

Balance Sheet, Capital Ratios And Valuation

The lack of traditional banking activities makes Goldman Sachs much smaller and leaner compared to some of its competitors. The total balance sheet actually shrunk rapidly over the past quarter, being down by $56 billion over a three-month period to $860 billion.

Combined with the ever-improving capital ratios, this results in a very strong capital position. The common equity Tier 1 ratio came in at 11.4% under the advanced approach of Basel III.

As such, the book value per share was $158.21 per share at the end of the quarter, while the tangible book value improved to $148.45 per share. Trading at $170 per share, this values the bank at roughly 1.07 times common equity and 1.15 times tangible book value.

On a trailing basis, Goldman has posted revenues of $34 billion, on which it has posted earnings of nearly $8 billion. At $170 per share, equity in the business is valued at $76 billion. This values equity at 2.2 times sales and 9-10 times annual earnings.

Past Performance, And What Will The Future Bring?

Over the past decade, Goldman has grown its overall revenues from about $21 billion in 2004 to a current rate of $34 billion. Note that revenues peaked at $46 billion in 2007, amidst the buoyant market and operating conditions.

The more volatile revenue base creates more volatility in net earnings as well, compared to other banks. The uncertainty and smart bets during the crisis actually made 2009 the most profitable year ever for the bank. Goldman posted net earnings of $13.4 billion amidst the crisis, causing huge controversy at the time.

The overall uncertainty and near-collapse of the financial system required the bank to obtain an investment from Warren Buffett. As one of the few banks, Goldman actually managed to actually slightly reduce its total share count over the past decade, at a time when investors in many other banks suffered from severe dilution.

Final Takeaway

Goldman is moving along just fine, as it actually has strong capital ratios, while it is cutting the size of its total balance sheet. Excess cash is being returned to investors at the moment. In the second quarter, Goldman repurchased $1.25 billion worth of shares, retiring shares at about 6.5% per annum at the current pace. On top of that, it pays out a modest quarterly dividend of $0.55 per share, providing investors with another 1.3% yield.

Goldman is the bank which is most leveraged to financial trading conditions, merger & acquisitions and related banking services, as well as public offerings. While it lacks the more stable consumer banking business, this might actually be a good thing, with competitors suffering from lower mortgage activity at the moment.

The strong merger & acquisition momentum at the moment, as well as the strong line-up of initial public offerings have been a real aid to the results. This has been offset by a weaker performance of the trading and markets business, driven by lower volatility as well as activity levels. Part of this is correction is structural as well, with capital-intensive strategies being no longer profitable for Goldman amidst tougher capital and regulatory rules.

As such, Goldman effectively remains a cyclical business with a structural lower anticipated base of profitability amidst lower trading opportunities. This is being made up for by the strong investment banking performance at this point in time, driven by huge deal-making. Yet, investors have discounted a lot of this bad news, as shares trade at just 9-10 times earnings. The smaller trading base improves the risk profile of the business as well. Traditional investment banking is less risky, while the ending of certain trading activities and positions frees up much capital to be returned to investors.

Given the strong capital position and excellent management, I am willing to give the company the benefit of the doubt, seeing potential to re-test the all-time highs of $230-$240 seen in 2007 in the medium term.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.