Breaking Up Goldman: A History Lesson

by: Joseph Levy

Recently a headline flashed across the CNBC screen with the message: Hedgies say “GS is not the same firm it was a decade ago”. This sentiment also appeared in an article published by John Carney Senior Editor, entitled “Goldman’s New Critics: Hedge Funds”. The article had various “anonymous” quotes that made disparaging references to Goldman Sachs (NYSE:GS) and the conclusion that “Goldman Sachs no longer puts its clients first.” According to the author “None of them (referring to the hedgies) would speak on the record – a testament to the power Goldman still wields on Wall Street.” This timidity is a testimonial to why GS has usually been on the more profitable side of trades versus its competition and peers.

Most amusing to me was the inference that GS was somehow different back some ten years ago. I guess most of today’s hedge fund managers are younger than me; or their memories have blanked out the period of “super-greed”, which prevailed in 1999-2000; when GS was the lead or participating underwriter in some of the most overpriced and over-hyped IPO’s and secondary offerings in recent history. You don’t need a team of brilliant minds with MBA’s from Harvard and Wharton to know that pushing clients into stocks priced at more than 15+ times "annual sales", with large operating losses and negative cash flows was wrong and in my opinion, unethical. Common sense tells you this practice would inevitably turn out badly for clients that continued holding such overpriced shares.

Arguably, the actions of GS and other major investment bankers contributed to the creation of the biggest investment bubble in the NASDAQ, which reached an all time interim day high of $5,132.52 in March 2000. Now, more than ten years later, the June 11, 2010 NASDAQ closing price of $2,243.60 is down -56.3% when compared to the March 2000 peak. Many of the IPO’s and secondary’s underwritten and promoted by GS as “growth stocks” in 1999-2000 are today worth fractions of what they traded for at the time GS did the underwritings. GS, and its predecessor partnership, have been the subject of various law suits dating back more than ten years ago and continuing up to the present. Anyone that believes GS operated with higher “morals” and “ethics” ten years ago is either: naive, does not have the facts, or must be joking.

Underwriters like Goldman were making out like bandits in 1999-2000 by collecting fees and commissions based on the hyped up “bargain” IPO and insider prices. In most instances these were obscenely excessive in relation to a company’s fundamentals and future potential. Also, underwriters were getting additional shares of IPO’s by exercising their underwriters’ over-allotment options and it is a safe bet that firms like GS squeezed out handsome returns from these options. Below are 15 shamefully overpriced IPO’s that Goldman was the lead underwriter for in 1999 and 2000.

The table above shows the original “bargain” offer price for the IPO and the closing price on the first day of trading. The market cap was calculated by using the closing price on the first day of trading and the number of common shares outstanding listed in the first 10Q or 10K after the IPO date. The sales and net income (loss) from continuing operations were for the fiscal year that included the IPO date (either 1999 or 2000).

The average annual sales for the 15 shamefully overpriced IPO’s was $158 million and their average net loss from continuing operations amounted to $(16.7) million, when using the fiscal year that included the IPO date. The average Market Cap, based on the closing price the first day of trading, came to $5.3 billion per issue, which was equal to an obscene 33 x annual sales despite the fact that, on the average, these companies were incurring substantial net losses.

Even if PALM (PALM) was eliminated (because of its large market cap), the averages for the other 14 IPO’s were: Annual sales of $94 million and annual net losses of $(21) million. The average Market Cap was $1.8 billion or just under 20 x annual sales for these 14 companies, that on the average were reporting annual net losses equal to 22.6% of sales. You don’t need an MBA from Harvard, Wharton, or any reputable school to know that the pricing methods used by GS and its contemporaries was based on pure “greed” and with total disregard for the financial health of clients looking for sound long-term investment value.

It is easy to be a Monday morning quarterback but what Goldman and its contemporaries were doing in 1999-2000 was readily apparent to anyone who studies fundamentals as part of their investment decision making process. Looking at the 15 shamefully overpriced underwritings today, demonstrates how anti-client the original “pricing and hyping” was for those seeking sound “long-term” investments.

Below is a table presenting historical and current information about these 15 stocks, along with the decline in their market caps, when comparing the current market cap with the market cap after their first day of trading in 1999 or 2000.

The sales and net income (loss) from continuing operations amounts shown above were calculated as the annual average amounts for all years after the IPO year and continuing through the fiscal year ending in 2009. The current market cap was calculated by multiplying the closing price on June 11, 2010 by the number of common shares outstanding listed in the most recent 10Q or 10K filed in 2010.

The average current market cap for the 15 companies declined from $5.3 billion (based on their closing prices after the first day of trading as a public company) to $206.3 million as of the close on June 11, 2010. This is an incredible decline, in the average market cap, of over $5 billion dollars per issue or a decline of -96.1% from 1999-2000 to June 11, 2010. All for companies underwritten and marketed by Goldman and its cronies as “growth stocks”. Even if the June 11, 2010 market caps were compared to the market cap valuations calculated using the “bargain” IPO original offer prices, the decline in market cap was over -90%.

There were other companies underwritten by GS in 1999-2000, not listed above, which had similar declines, including a number of secondaries where Goldman was the lead or participating underwriter. Also, Goldman and its contemporaries were recommending to clients many other individual stocks in 1999 and 2000, which were not IPO’s or secondaries and which had fundamentals similar to the 15 shamefully overpriced IPO underwritings. It was clear to most investment professionals who paid attention to fundamentals that Goldman and other “prominent” investment bankers were overpricing and over\-hyping IPO’s (as well as secondary and other individual stocks). Such improper behavior was instrumental in creating the investment bubble in NASDAQ stocks, which resulted in that index peaking at $5,132.52 in March 2000.

There were a limited number of good long-term investments arising from the ashes of Goldman’s underwriting and hyping activities in 1999-2000, including Goldman’s own IPO (no surprise, based on how the investment bank has made its money over the years). I came across one Goldman IPO in 1999-2000 that qualifies as an “outstanding” long-term investment, when subjected to the test of time.

Coach Inc. (COH) had it’s IPO in October 2000, with an offer price of $16.00. After the IPO, COH had 43.5 million shares outstanding, which translated into a market cap of $883.7, using the closing price of $20.31 after the first day of trading. The company’s annual sales in the fiscal year, which included the Coach IPO, totaled just over $600 million; the Company reported net income of $64 million; and generated $124.million in operating cash flow.

Thus, the COH initial public offering was priced at 1.47 x annual sales versus the average 33 x annual sales for the15 shamefully overpriced IPO’s noted above. Also, Coach was generating good operating profits and positive cash flow, while the other 15 IPO's were on the average reporting large net losses and burning cash from operating activities. Also, the pricing of the COH shares in October 2000 was after the NASDAQ bubble burst in March 2000.

Coach Inc. has been an excellent long-term investment since coming public in October 2000. The company's sales grew sequentially in each fiscal year ending from June 30, 1999 (sales of $507.8 million) right up the most recent12 months ended March 31, 2010 (sales of $3.4 billion). Net Income increased at a faster pace, rising from $16.7 million in the fiscal year ended June 30, 1999 to a pre-recession peak of $783 million in the fiscal year ended June 30, 2008, before declining for the first time to $623.4 million in the fiscal year ended June 30, 2009 (still excellent relative performance for a luxury retailer in a fiscal year that includes a major recession). In the most recent twelve months ended March 31, 2010, net income rebounded to $685 million.

The recent Coach Inc.10Q filing lists 305.1 million common stock shares outstanding (the company has had three 2:1 stock splits since the IPO), which results in a market cap of $13 billion based on the COH closing price of $42.81 on June 11, 2010. Thus, the market cap for common stockholders grew just under 15 times from the IPO date (market cap of $883.7 million) to June 11, 2010 (market cap of $13 billion). However, having one outstanding long-term investment (“15 bagger”) can not begin to make up for the large losses sustained by Goldman clients (seeking good long-term investments), arising out of the many disastrous stock recommendations, IPO’s and secondary’s pitched by Goldman to clients in 1999 and 2000.

When looking for reasonable performers, you don’t have to go further than Goldman Sachs' own IPO. The investment bank completed its IPO on May 7, 1999 by selling 51 million shares of common stock. The offer price was $53.00 per share and has since appreciated to a closing price of $135.64 on June 11, 2010. Unlike many of the other companies it brought public in 1999-2000, GS had good fundamentals reporting Revenue (net of interest expense) of $13.3 billion, net earnings of $2.7 billion and diluted EPS of $5.57 in the fiscal year ending November 1999, which includes the IPO date. Below is a summary of Goldman’s operating history for fiscal years ending from 1999 through 2009.

After going public, GS grew its business reaching a peak in the fiscal year ended November 30, 2007, when net revenue amounted to $46 billion, net income after preferred dividends $11.4 billion and diluted EPS of $24.73. When the economy collapsed, and with the onset of the major financial crises in 2008, Goldman’s net revenues plunged to $22.2, net income after preferred dividends dropped to $2.0 billion and diluted EPS declined to $4.47 in the fiscal year ended November 30, 2008. The Company changed its fiscal year end beginning in 2009 to December 31. For the year ended December 31, 2009 net revenue rebounded to $45.2 billion, net income after preferred dividends amounted to $12.2 billion and diluted earnings per share were $22.13. With the changeover from a November 30 to a December 31 year end, a net loss after preferred dividends of $(1.0) billion and diluted loss per share of $(2.12) for the month of December 2008 were obscured (not reported as part of the year end amounts for either 2008 or 2009). However, Goldman’s good fortune has continued into Q-1 2010, when it reported net revenues of $12.8 billion, net income after preferred dividends $3.3 billion and diluted EPS $5.59.

The composition of Goldman’s Revenue (net of interest expense) shows that the “Trading and Principal Investments” category has grown at the fastest pace after fiscal 2002. Below is a summary of Revenues by categories reported by Goldman for fiscal years ending from 1999 through 2009:

Trading & Principal Investments Revenue grew from $8.6 billion in fiscal 2003 to $28.9 in fiscal 2009 and amounted to $9.2 billion in Q-1 2010, which was 72% to the total Net Revenue ($12.8 billion) in the quarter ended March 31, 2010. When providing a breakdown of the source of Pre-Tax Earnings generated in 2009, Goldman reported that 87% came from Trading & Principal Investments; 6% was from Investment Banking; and 7% from Asset Management & Securities Services. This compares with 56% from Trading & Principal Investments; 18% from Investment Banking; and 27% from Asset Management & Securities Services in fiscal 2001. It is evident from the breakdown of Revenues and Pre-Tax Earnings that the Trading & Principal Investments area has been the fastest growing and most profitable business segment for Goldman in recent years.

Goldman and other so called 'prominent" bankers were heavily involved with subprime related securities (CDO’s etc) that brought the entire financial system to the brink of a major collapse. As gleaned from its operating history, GS profited handsomely during the period when it and its cohorts helped "finance and trade” a major real estate bubble and the unprecedented expansion of sub-prime securities and lending. The punishment (really a reward) for engaging in activities that nearly collapsed worldwide economies was achieving the status of “Too Big to Fail”.

Maybe I’m missing something, but would not it make more sense to separate Goldman’s hedge fund and speculative trading activities from pure banking functions and adopt a “Too Big to Continue” philosophy in order to restore and reinvigorate “Capitalism”. As I see it, the “biggest” threats to the U.S. and international economies arise out of the confluence of “Big Government” that is too large, inefficient, inept and in the pockets of powerful interest groups; “Big Business” with self-serving executives far removed from its shareholders - owners and often times acting to the detriment of most of its employees and shareholders; and “Big Labor” who have extracted unfunded and unaffordable benefits (primarily retirement packages) from corrupt “Big Government” and corrupt “Big Business”.

History shows that Goldman operated smack in the middle and benefited from the creation of the NASDAQ bubble that burst in March 2000 and similarly the real estate and sub-prime securities/lending bubbles that came to a head at the end of 2008 and early 2009. Therefore, I see little difference in the Goldman today as compared to how it did business a decade ago.

In my opinion financial markets, as well as the banking system and the shareholders of Goldman, would all be better off if the company was broken into separate entities. The purpose would be to separate pure banking functions from speculative and hedge fund activities. Breaking Goldman up would eliminate the need for any “Too Big to Fail” policy for a company that has been smack in the middle and benefited handsomely from two major financial crises and bubbles during the last decade.

Disclosure: No positions in any of the stocks mentioned