Goldman Sachs - Moving From Wall Street To Main Street

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About: The Goldman Sachs Group, Inc. (GS), Includes: CS, DB, JPM, MS, UBS
by: Regents Research
Summary

GS remains in a state of strategic flux as its new management team conducts a fundamental review of the business.

This places a higher degree of uncertainty on the stock than peers and justifies the discounted multiple on which it trades (0.9x P/TNAV, 8x PE).

Moreover, strategic decisions already taken are pushing the company away from its traditional strengths in institutional investment banking and into the tough competitive space of consumer and mid-corporate lending.

This is a radical departure for GS with no guarantee of success. Indeed, extremely rapid credit growth at this point of the cycle is a questionable decision and risks storing up problems for the future. I'm wary of investment banks generally, given uncertainties around the market outlook. But if I had to choose, I'd avoid Goldman Sacks and stick with Morgan Stanley instead.

GS is the cheapest of the major US banks and indeed the only one still trading at a discount to tangible net asset value (current multiple 0.9x). It is also trading at multi-year lows on a PE basis (8x). Is it time to buy?

The short answer is no. In my view is that there is a much greater degree of uncertainty surrounding GS than peers as the new management team led by David Solomon conducts a fundamental review of the business. In the words of CFO Stephen Scheer:

We're conducting broad and deep reviews. Our cadence and approach remain deliberate; no business, no revenue source, no capital or resources out of scope. (1Q19 earnings call)

The process is taking longer than expected. Originally an update was scheduled for this spring. That has now been pushed out to 1Q20. In the meantime, GS hasn't set performance targets, especially an ROE goal, and this adds an additional level of uncertainty to forecasting earnings compared to peer.

GS has in the past been over-reliant on FICC trading revenues

In truth, this strategic review already began under Lloyd Blankfein and was prompted by GS's historic over-reliance and Fixed Income & Commodities trading (FICC). Post-GFC regulations have made this a much less lucrative business than in the past and the industry revenue pool has been in structural decline for some time.

Having accounted for 25% of GS's revenues in 2016 the contribution of FICC fell to 16% in 2018.

Source: company report & accounts

GS has struggled to find replacement revenues and has consequently posted lower growth than peers in recent years. Revenue CAGR between 2016-2018 was under 3% compared to above 4% for MS and 5% for JPM.

Source: company report & accounts

Additionally, even within the shrinking global FICC revenue pool, GS has underperformed peers. FICC revenues fell by 22% 2018/2016 compared to a 17% decline for MS and only a 2% decline for JPM. This partly reflects GS's historic reliance on hedge funds, where the decline in FICC activity has been particularly marked, and its under-penetration of long-only asset managers and bank-to-bank business.

Source: company report & accounts

As GS has struggled in its core revenue franchise it has also struggled to reach acceptable levels of return. ROTE was 13.4% in 2018, a similar level to MS but well below the 16% JPM earns from its Investment Bank. It is also well below GS's historic cycle average level of 15-20% and seems inadequate compensation for the more volatile mix of GS's business versus peers.

Source: company report & accounts

Of equal concern to management is the lack of confidence in the future evidenced by Street forward estimates of ROTE which see GS delivering the lowest return of peers in 2019 (and 2020).

Source: consensus data from Thomson Reuters

The outlines of the new strategy are already clear

While GS has said it will take until 1Q next year to fully complete the strategy review some of its key contours are already clear and indeed were spelled out as long ago as September 2017 by then COO Harvey Schwartz.

He outlined a >$5bn incremental revenue opportunity coming from a number of initiatives as outlined in the following slide.

Source: Harvey Schwartz presentation to the Barclays Financial Services Conference, September 2017

GS said in a presentation last November that it has successfully delivered ~$2.5bn of these incremental revenues.

Source: CFO Stephen Scheer presentation to the Bank of America Future of Financials Conference, November 2018

Pivoting to from Wall Street to Main Street is a core component of the strategy

The most eye-catching component of these initiatives is a big push by GS into businesses that are more Main Street than Wall Street. These include:

  • Marcus, the highest profile of the new businesses. Marcus is targeted on the "mass affluent" retail banking space and has been launched in both the US and the UK. In the words of CFO Stephen Scheer:

We are building Marcus as a fully integrated digital business. As a broad multi-product platform, wealth management will be a key component. This is a very large market with $9 trillion in mass affluent customer assets across more than 20 million U.S. households. (1Q19 earnings call)

So far, Marcus has collected over $27bn of deposits and made over $4bn of loans. GS's original target is for this number eventually to reach ~$12bn

  • Mid-corporate lending. GS has traditionally been an advisory banker to large companies. The new strategy includes a pivot to much small companies with enterprise values below $2bn.
  • Consumer lending. This includes the recently announced JV with Apple to launch a consumer credit card.

GS has rapidly expanded its lending activities

Fundamental to all of these initiatives is a willingness by GS to grow lending volumes very quickly.

Total loan volumes reached $95bn in 2018, double the level of 2015. Annual growth is running at 28% p.a. over the period 2015-2018, a remarkably high level for any bank.

Source: company report & accounts

The comparison to Morgan Stanley makes this clear: over the same period MS's annual loan growth has been only 9%. Indeed in every major lending category GS's growth rate has been exponentially higher, for example:

  • 25% annual growth in corporate lending vs MS 12%
  • 28% annual growth in consumer lending vs MS 9%
  • 36% annual growth in commercial real estate lending vs MS 3%
  • 53% annual growth in residential real estate lending vs MS 8%

Source: company report & accounts

None of this should come as a huge surprise to investors. Going back to Harvey Schwartz's 2017 presentation in which these initiatives were launched, it was clear that lending growth was a core aim.

He outlined $28bn of "incremental balance sheet" that would be deployed. In fact, the total commitment to loan growth was even higher than this since he also outlined another $5bn that was to be deployed in the FICC business for "client inventory financing" i.e. margin lending.

Source: Harvey Schwartz presentation to the Barclays Financial Services Conference, September 2017

Also, it should be said that in some of these lending categories GS was starting from a comparatively low base so the growth rates are not the full story. Total balances are still lower than peers. So, for example, if we compare GS's overall loan book to that of MS it is equivalent to 105% of equity whereas MS is at 156%, even after the rapid growth of the recent period.

Source: company report & accounts

Rapid growth brings new risks

Nonetheless, I think GS's push into lending, and into Main Street more generally, raises a number of important questions, the answers to which will only become apparent over time.

  • How big is the credit risk? Experience tells us that the surest way to lose money in banking is to extend a lot of credit at the top of the cycle. This may not be the top of the cycle and GS is not any ordinary bank: it has an exceptional track record and its underwriting standards are likely to be first-rate.

Nevertheless, it is pushing very fast into areas that are new to it at a point where credit standards do appear to be slipping across the industry. It is entirely possible that as these new lending commitments season, they will bring higher loss rates than anticipated.

  • What does this say about the GS brand? Mass affluent retail banking, credit cards and mid-corporate lending are very different businesses to the large corporate advisory and institutional trading activities that have been GS's staple for decades. They are also highly competitive with many existing players. There is a risk of GS diluting its brand and/or losing its focus as management try to juggle businesses that have very different characteristics and success factors.
  • Can GS gain sufficient scale to be profitable? GS says it has deliberately targeted market segments that are large and where it doesn't need leadership positions to be successful

In each of them, we have looked at and looked for markets that are big where we don't need to capture commanding market share to be relevant. (CFO Stephen Scheer, 1Q19 earnings call).

But there is no doubt that the returns of many of GS's competitors in these businesses are at least partially the result of scale economies and very efficient cost structures. Starting from a much smaller base, there is no guarantee GS will be able to replicate this, especially given the necessary investment spend. As an example, JPM runs its Consumer & Community Banking segment on a 50% cost:income ratio, a full 15ppts lower than the current suite of businesses of GS.

  • Will M&A be needed? It's possible that at some juncture in the future GS concludes it needs greater scale in these businesses that can only come through acquisitions. This could raise a host of questions like how big might M&A be, what price, how would it be funded etc.?
  • What will be the ultimate return? Finally, there is the question of what the ultimate payback will be. GS has said it thinks the marginal ROE on the growth initiatives it outlined in 2017 is ~30%. So far, it's hard to tell if this is accurate given the program is still in its early stages. The market appears to have its doubts, at least for the short-term, given GS is expected to deliver the lowest ROTE of peers in 2019 (10.6%).

A well run mass affluent/retail banking business can definitely deliver attractive returns: JPM posted a 28% ROTE in Consumer & Community Banking last year. The issue is whether GS will be able to replicate this and until management lays out new performance targets in 1Q20 this will remain an open question.

In any event, the returns probably won't match a well-run wealth management business, which has been the growth avenue chosen by several peers like MS, UBS and CS. MS is earning 35-40% ROTE in its Wealth business currently.

Source: company report & accounts

Estimate slippage is an additional, shorter-term risk for GS

I've concentrated so far on the mid-term strategic challenges facing GS. In the shorter-run there's also the risk of estimate slippage to think about.

I highlighted this recently in an article on MS (you can find it here) where I noted that, in spite of more turbulent markets recently and an analysis by MS's own strategists pointing to the risk of a bear market, Street estimates see earnings continuing to hit new all-time highs in coming years.

Many of the same remarks hold also for GS. It clearly remains a highly cyclical business. Revenues and earnings were at multi-year highs in 2018. Yet revenues are anticipated to grow further from here and earnings in 2020 are anticipated to be 5% higher than the 2018 high water market and 10% higher by 2021.

Perhaps markets will continue their upward march, in which case these estimates may well be delivered on. But there is also the possibility that the reason GS trades on a multi-year low PE is because the market is already bracing for cuts.

Source: company report & accounts, Thomson Reuters consensus data

Conclusions

GS is facing the same dilemma as other investment banks: how to remodel a trading-based business that worked well in the pre-GFC era but that no longer generates adequate returns under the weight of new, post-GFC regulations and capital requirements.

Some banks like Deutsche Bank (NYSE: DB) still seem utterly lost. Several others (UBS [NYSE: UBS], CS [NYSE: CS], MS) have decided the future is in wealth management and are pointing to the many apparent synergies it enjoys with institutional investment banking.

GS has chosen a different route entirely. It is entering markets it has never been in before, mass affluent retail and mid-corporate lending. It is releveraging its balance sheet through loan growth and hoping its superior digital technology can make it more competitive and profitable than the incumbents.

It is a unique story among the investment banks and it will be fascinating to watch how it plays out in the coming years.

But for shareholders, there are obvious risks and the ultimate return is very hard to judge at this early stage. With management not committing to provide further insights on the strategy or financial targets until next year, this situation will persist for the immediate future.

I expect the uncertainty to weigh on GS's share price and for the large valuation discount to peers to persist for some time. Market uncertainty is an added headwind for all investment banks but if I had to choose, I'm far more comfortable with the wealth management-led strategy being pursued by MS.

Disclosure: I/we 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.