Buy Goldman Sachs: Hidden Growth With An Attractive Valuation Offering Best In Class Risk/Reward

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About: The Goldman Sachs Group, Inc. (GS), Includes: JPM, MS
by: Freyr Capital
Summary

Goldman Sachs is a top investment bank looking to diversify its legacy business with new services.

Strategy defined by management would bring top line growth, and a higher multiple due to better revenue visibility.

Management is acting on its strategy with various new initiatives.

Goldman Sachs is cheap both compared to its peers given its financials and compared to its historical valuation, even moreso given new projects.

We recommend buying Goldman Sachs and monitoring execution of strategy.

Investment Thesis

We believe that Goldman Sachs provides an asymmetric risk / reward to with a low relative valuation, excellent financials and growth optionality, which is a very rare combination in the banking universe. We suggest investors take advantage of this opportunity.

Intro

Goldman Sachs (GS) is one of the best known investment banks and one of the largest financial institutions in the world. While its earnings are dominated by traditional investment banking services, it is now looking to diversify and grow its business.

Our analysis of Goldman starts with assessing each new growth lever and how it fits to Goldman’s big picture strategy. We then look at relative valuation and financial metrics of Goldman relative to peers and history. After discussing its shareholder friendliness, we comment on the timing of the investment, answering “why now?”.

Recent Growth Initiatives Show Disciplined Approach to Transformation and Provide Plenty of Optionality

The Bank makes it obvious that it wants to grow its business in its strategy detailed in its investor presentation (Source: GS 2019 Sanford Bernstein Conf Presentation). Of Goldman’s 3 listed strategy pillars 2 are related to growing the business and one is “Diversify Business Mix with New Products and Services”. Goldman is putting its money where its mouth is with 45% of its colossal $4 bn engineering budget going to investments. The Bank has set its intentions of new growth with targeting $5 bn new revenue by 2020, a goal set in 2017 (Source: GS 2017 Barclays Conf Presentation) and is well under way in achieving the ambitious goal.

The main strategy for this new revenue is to source it from a transition to stable revenues from more cyclical ones as well as growing in consumer business. Main initiatives are consumer finance, retail banking, cash management and robo advisory. Of the 4, 3 consumer facing initiatives talk to each other very well and provide lots of synergies. Rollout will be easier with initiatives using each other’s member base as a launching pad, providing more efficient marketing spend and faster growth. Cash management, although different from other new initiatives, is a tangent business to Goldman’s existing client services and should be relatively easy for them to penetrate.

Consumer Finance Initiatives Offer Monumental Revenue Optionality if Successful

Marcus – Successful Launch With Rapid Growth

Goldman is benefiting from its late entry into retail banking with attractive pricing enabled by non-existent brick and mortar operations. Its digital only strategy gives it much better cost structure relative to peers and hence allows lower fees. Despite almost all banking possible digitally, legacy banks cannot close their brick and mortar operations giving Marcus a distinct competitive advantage of better margins which Goldman transfers to the consumer. With younger generations which are more likely to prefer digital banking and lower fees earning more and more of total income, Marcus benefits from secular growth trends. Launched in 2016 Marcus showcased this, displaying extraordinary growth, by reaching 4 mn customers, $4.7 bn loans and $46 bn deposits ( Source: GS 2019 Sanford Bernstein Conf Presentation ).

Credit Cards – Apple Card Will be a Large Earnings Boost as well as Assisting Consumer Transition

The only Goldman credit card is the Apple Card right now, specifically designed for Apple Wallet with attractive cash back offers and low fees. Like Marcus, the product is particularly attractive for younger segments.

With Iphone install base at 189 mn at December 2018 (Source: 9to5mac), Apple Card gives Goldman access to a massive audience to which we think the product is very attractive and will penetrate a significant share. The install base can then be used, with attractive offers, to grow Marcus and potentially robo advisory initiatives.

Robo Advisory – Prime Example of an Incumbent Investing in the Future of its Industry

Goldman management is smart to recognize the future of asset management and invest in nascent technology. One of Goldman’s largest current revenue sources is wealth management, so one might consider cannibalization from new services. We would like to point out that Goldman serves high net worth individuals, while robo advisory is a mass product and that cannibalization will be very little at this point.

Goldman has partnered with the sector leader Betterment, offering a smart beta fund for Bettermint customers, and invested in a UK based robo adviser Nutmeg. These will be negligible on Goldman’s bottom line currently, but indicates management’s intentions of and dedication to transformation as well as providing future revenue optionality.

Cash Management – A Massive Market Next Door to Goldman’s Existing Business Services

The Bank is looking to launch the service in 2020, entering a market which has made $250 bn for big banks where even a small share would have a large impact (Source: Oliver Wyman). Goldman is targeting an intuitive, user friendly, efficient product which will be attractive given that the legacy services are “clunky and outdated” according to an expert (Source: Reuters). Goldman already offers hedging and strategic advice to large corporates, making its entry into this horizontal relatively easier.

Peer Relative Valuation – Goldman Screens as the Best Risk / Reward Large Cap Bank and Offers its Best Entry Valuation in a Long Time

Goldman’s valuation isn’t excessive by any measure compared to peers, especially when comparing financial metrics in addition to valuation. We compare Goldman to both US and EU peers of BAC, BCS, C, CS, JPM, MS, and UBS.

Source: Data from Gurufocus, Freyr visualization

It is tough to digest a table, so we provide an intuitive 3 dimensional figure. We identify P/TBV as a good proxy for value. It is the most correlated with net margins and ROE and hence illustrates what the market awards relevant banks. We also like to compare ROE’s and net margins of banks to show profitability.

Sources: Data from Gurufocus, Freyr visualization

From our 3 dimensional illustration we see that Goldman is an anomaly due to its high returns, low valuation, and stellar margins. We screen MS as overpriced and JPM as the operationally best in class with a well deserved high multiple. European banks screen as cheaper and less profitable compared to their American counterparts, reflecting the shaky EEA economy and higher exposure to fragile markets (Italy, Turkey, etc.). Goldman’s valuation, when combined with growth levers unique to it as discussed above, offers plenty of upside and downside buffer.

Historical Relative Valuation – Goldman Sachs Near All Time Low Multiples

Source: Gurufocus

Looking at the PE, PS, and P/TBV metrics for the last 10 years, one can see that the market is discounting Goldman nearly at an all-time high at a time when future prospects of the company are arguably also at an all-time high.

Shareholder Returns

Goldman has one of the larger and long standing shareholder return programs. The Bank has been purchasing 3.9% of its shares outstanding annually in the last 3 years and will likely continue to do so. It also offers a modest but very safe dividend of ~1.7% with a payout ratio of 0.13. This return profile is very unique for a company that is investing in its future. When combined with an inexpensive valuation, we strongly believe that there is strong downside protection.

Why Now?

We believe 2019 may be where expectations are the lowest, reflected in the valuation due to:

  • Large investment spend in achieving strategic pillars. Perhaps peak investment spend
  • Low liquidity affecting trading business
  • Low M&A activity due to volatility in 4Q18 affecting transaction business
  • Low rates decreasing margins
  • Macro uncertainty (trade wars, Turkey, Argentina, Italy) expected to continue and further drive trading and M&A revenues lower

We believe that the market is assuming the worst for all of these, but we see upside due to:

  • Investment will start bearing fruit 2020 and beyond
  • In our view, most likely one of 2 things will happen regarding macro policy: either the policy will become more growth friendly increasing Goldman’s business, or further QE will come increasing liquidity. We view the risk reward for banks is very attractive right now in general.
  • Goldman’s new initiatives will likely grow regardless of GDP and the transition to stable and growing revenues will warrant a higher multiple.

Conclusion – Buy and Monitor Growth Initiatives

We see exceptional risk / reward in Goldman Sachs right now due to two main factors: 1) the Bank is investing in future growth and transitioning its business to one which will warrant a higher multiple, and that 2) it is priced very pessimistically and the valuation offers downside risk protection. We recommend investors Buy Goldman Sachs at current levels and hold for the long term and monitor the transition to consumer banking and other new growth initiatives. In the event that the company management decides not to push through with these new initiatives and offers higher dividends / buybacks, we recommend investors let go the equity as it will offer little differentiation from peers other than a pure value play.

Disclosure: I am/we are long GS. 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.