Goldman Sachs 2Q12 Earnings: Waiting For The Cycle To Turn While Trading Below Book

| About: Goldman Sachs (GS)
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Goldman Sachs' (NYSE:GS) reported 2Q results that beat analyst expectations; however, it is facing a difficult operating environment as its clients are reducing their activity, including in the key areas of trading and M&A. The company reported 2Q ROE of 5.4%, which drew lots of questions from analysts since ROE at this level is below the company's cost of capital. As a result of the poor ROE and challenging environment Goldman Sachs continues to trade at a discount to tangible book value. Interestingly, while Goldman Sachs has been de-risking it repurchased more stock than many thought. The earnings report and conference call were less exciting for investors than the results of the other big banks that reported so far in 2Q 2012 earnings season [see our analyses of JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C)]. In this update we will look at the 2Q 2012 earnings results using our six question checklist and look for clues about performance in 2H 2012 and general economic conditions.

Did the Company Beat Expectations and Have Expectations Been Rising/Declining?

Goldman Sachs reported 2Q 2012 diluted EPS of $1.78, compared to $1.85 for 2Q 2011 and $3.92 for 1Q 2012.

According to press reports, analysts projected EPS of $1.17. According to Reuters (via Capital IQ), analysts projected EPS of $1.13. Goldman Sachs' results exceeded analyst estimates by a large margin.

However, estimates have been declining going into earnings season. According to Reuters (via Capital IQ), one month ago the EPS estimate was $2.19 and three months ago it was $2.65.

How Did the Stock Perform Going Into Earnings?

Goldman Sachs' stock has been declining going into earnings. It is especially interesting to view the stock on a multi-year chart going back to the financial crisis (first chart below). Since that time, Goldman Sachs' stock price has been compressing with lower highs and higher lows. The daily chart (second chart below) highlights the recent declines and shows that the stock has returned to the area where it traded during the correction during Q3/Q4 last year.

The longer time frame indicates indecision about the stock's direction and the shorter time frame indicates that expectations have been falling recently.

(Click to enlarge)

(Click to enlarge)


What Drove the Results?

Goldman Sachs' 2Q 2012 earnings material can be found here.

The tone of the results can be summarized by the quote from Lloyd Blankfein, Chairman and CEO, in the press release:

"During the second quarter, market conditions deteriorated and activity levels for both corporate and investing clients were lower given continued instability in Europe and concerns about global growth."

We would like to highlight a few items from the results.

In the Investment Banking division, net revenues declined 17% from 2Q 2011, but increased 4% from 1Q 2012. On a year-over-year basis, net revenues from Financial Advisory and Equity Underwriting were down. However, Debt Underwriting was up, despite weak performance in leveraged finance.

Institutional Client Services' net revenue was up 11% from 2Q 2011, but down 32% from 1Q 2012. Commenting on the Fixed Income, Currency and Commodities Client Execution (FICC) results, Goldman Sachs said, "[FICC] operated in a challenging environment reflecting broad market concerns and uncertainty, which resulted in generally wider credit spreads and lower activity levels compared with the first quarter of 2012." Equities' results were down as a result of lower trading volume.

Investing and Lending results were negatively impacted by the decline in global equity prices and wider credit spreads. The Investment Management division's net revenues were up 5% compared to 2Q 2011 and 135 compared to 1Q 2012. Assets under management (AUM) increased $12 billion to $836 billion.

As a result of the declines, Goldman Sachs reduced expenses. Operating Expenses were 8% lower than in 2Q 2011 and 23% lower than 1Q 2012. Still, the compensation and benefits ratio was 44.0% in 1H 2012, which raised questions about whether it is too high.

Book Value Per Share was $137.00 and Tangible Book Value Per Share (TBV/S) was $126.12 million at the end of 2Q 2012. Both increased approximately 2% from the end of 1Q 2012. Still, with Goldman Sach's stock price trading at approximately $99 (at the time of this writing), the stock is at a considerable discount to TBV/S.

During 2Q 2012, Goldman Sachs repurchases 14.3 million shares at an average price of $104.81 for a total of $1.5 billion. The large size of the buyback seemed to surprise some analysts. Considering the quarter was weak with limited opportunities to deploy capital, it makes sense that Goldman Sachs is repurchasing stock below TBV/S.

Finally, ROE was 5.4% in 2Q 2012, which is below the cost of capital.

What Are the Implications for the General Economy?

Goldman Sachs' results and comments reflect a reduction in risk by the firm as well as its clients. It is unclear what this means for the general economy, but it is a sign that investors are nervous and prefer to sit on the sidelines than to take big risks. Goldman Sachs is also reducing risk, as seen the lower VaR dating back to 2006.

David Viniar, CFO, made the following comments in the earnings call (see full transcript from Seeking Alpha here):

"Questions surrounding the stability of the global economy and its future prospects resurfaced in the second quarter. The situation in Europe remains a primary concern. Despite the systemic benefits of the European Central Bank's long-term refinancing operations, market refocused on the broader sovereign challenges that remain. In particular, client psychology suffered from continued skepticism regarding the mechanisms and political will required to address the complex series of issues facing European governments. The outlook for the global economy was further clouded by concerns about slowing economic conditions in the United States and China given weak economic data during the quarter. The accumulation of these various macroeconomic concerns increased market uncertainty and reduced client activity."

Regarding, Goldman Sachs' risk appetite, he said:

"The uncertainty has also led the firm to conservatively manage its risk profile, maintaining a high level of risk-adjusted capital and a significant liquidity cushion."

Commenting on the VaR, which is a way to measure risk, he said:

"The VaR, while its just one measure of risk, $92 million is the lowest it's been since the third quarter of 2006."

What Is the Guidance Going Forward?

Goldman Sachs did not give specific forward guidance. When asked about the future David Viniar cited the cyclical nature of the business:

"You never know what the future is going to bring. We're in a cyclical business. We know we're in a cyclical business. It's hard to know when the cycle is going to change. We think we have tremendous upside in a lot of our businesses."

While Goldman Sachs can't predict when the cycle will turn in its favor, it is working on optimizing the two things in its control - expense and capital. David Viniar said:

"We have a long history of adapting, and we'll need to continue to allocate resources effectively to meet our clients' need to maximize returns. In a difficult operating environment, we have 2 principal levers to enhance returns: expense and capital management. A year ago, we announced a $1.2 billion expense initiative. We subsequently increased the amount to $1.4 billion. We've met that target and continue to focus on improving operating efficiencies across the firm. We're currently targeting approximately $500 million in additional run rate cost savings to be achieved by year end. During the quarter, we repurchased 14.3 million shares of common stock for a total cost of $1.5 billion. We believe that we have sufficient flexibility to manage our capital levels appropriately for the remainder of the year. However, the level of ongoing share repurchases will continue to be driven by our assessment of the risk to the broader operating environment, our earnings generation and the potential for more attractive opportunities to put our capital to work for clients."

Despite the lack of an outlook, he did give some guidance on the capital ratios:

"If we looked at Basel 3 today, it would be slightly below 8%. And if we roll forward, and only just pure math and consensus estimate and largely, the passive items like credit correlation, mortgage securitization, they're going to roll off. By the end of 2013, we get to slightly under 10%."

Regarding the stock price, he said:

"We tend to conserve cash and conserve capital, and yet, we have a stock price trading well below tangible book. And I know when we look back in the future, we're going to wish we bought back more at this price."

In the Q&A, David Viniar was asked about the recent Wall Street Journal article about Goldman building a private bank. He responded that there may have been some "overstatements" and that Goldman is already engaged in lending to its clients.

Also, David Viniar said that Goldman Sachs is not part of the LIBOR investigations.

What Is the Market's Reaction to the Results?

Initially, the stock jumped to over $100 per share, but then retreated and is largely flat, as of the time of this writing. The initial jump may have come from some short covering. The market does not seem too excited about the news of Goldman Sachs' "beat" and understands that expectations were low and the bank still faces a challenging environment.

However, it will be important to see the reaction to the initial reaction and if the stock price can move above $100 per share to levels it has not seen since May.


Compared to JPMorgan, Wells Fargo and Citigroup, Goldman Sachs' results and outlook seem the most challenging. When these other banks reported their results they spoke about weakness in investment banking, so the Goldman Sachs results do not come as much of a surprise. However, Goldman Sachs is more tied to the capital markets than the others. It is suffering from capital markets weakness while the others are offsetting that weakness positive trends in other parts of the economy, such as mortgages.

Goldman Sachs is at a low point in its cycle as it is generating a ROE that is below its cost of capital. As a result it is trading at approximately 0.8x TBV/S. Interestingly, Goldman Sachs has reduced risk significantly, but is buying back more stock than expected. It seems to think that its stock is one place where it pays to put its capital.

It is unclear if investors should make the same decision. If the market is about to turn around and enter another Risk On rally, then Goldman Sachs' stock would be a good buy. Its operations would improve and its valuation may be cheap at a discount to TBV/S.

However, if the markets continue to be sluggish, then Goldman Sachs will face more difficultly and the stock could fall significantly. Citigroup is an example of a bank that is trading at an even deeper discount to TBV/S.

Currently, we are taking a wait and see approach to the stock. We may be interested in buying if it sustains a move above $100 per share. Alternatively, if the stock falls back to $90, we may be interested in trading the $90-$100 range.

Disclosure: I am long WFC. We may trade any of the stocks mentioned in this article in the next 72 hours.