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Goldman: Riding a Rising Tide

By Robert Hansen, CFA We at Standard & Poor's Equity Research think the Goldman Sachs Group (GS

; recent price, $99) is benefiting from improving global equity markets, a pickup in mergers and acquisitions (M&A) activity, and gains in merchant banking. We think the shares should trade at a premium to Goldman's industry peers, based on our view of the firm's global footprint, significant operating leverage, and strong client relationships.

We also think Goldman could win additional business, given clients' potential concerns about management-control issues, reduced employee morale, shareholder dissent, and media attention at Morgan Stanley (MWD

: 3 STARS, hold; $50), especially after news of the planned departure of that firm's embattled CEO, Philip Purcell (see BW Online, 06/13/05, "Morgan Stanley CEO Purcell to Retire"). We view the valuation on the shares compared with peers and the S&P 500-stock index as attractive. Goldman carries our highest investment ranking of 5 STARS (strong buy).

Goldman is one of the world's leading investment-banking and securities companies. Its activities are divided into three segments: investment banking, trading and principal investments, and asset-management and securities services.

DARING APPROACH. Trading and principal investments accounted for 65% of net revenues in fiscal 2004 (ended November). Goldman makes markets in equity and fixed-income products, currencies, and commodities. It also enters into derivative transactions such as swaps, and it engages in proprietary trading and arbitrage.

Goldman's trading operations, which it refers to as Fixed Income, Currency, and Commodities (FICC), focus on interest rates, credit, mortgages, currencies, and commodities. Although FICC's results have been volatile on a quarterly basis, we note that the segment has demonstrated strong long-term growth over the past decade.

We view Goldman's willingness to take significant trading risk for appropriate reward as a competitive advantage. Although it has the highest value-at-risk (VaR), a measure of market risk in trading positions, among its major competitors, we're impressed that Goldman's standard deviation of quarterly trading revenues is among the lowest relative to its largest peers. It's bested only by Bear Stearns (BSC

; 5 STARS, strong buy; $99).

BROKERAGE EDGE. In its principal investments business, Goldman invests in private-equity deals as well as real estate. At the end of fiscal 2004, principal investments consisted of $820 million in real estate and $3.83 billion in corporate investments, including a $2.56 billion convertible preferred stock investment in Japan-based Sumitomo Mitsui Financial Group (SMFG) carried at fair value. Principal investments produced net revenue of $1.33 billion in fiscal 2004, up from $566 million in fiscal 2003.

Despite its quarterly volatility, we view Goldman's fixed-income operation as a growth business. Although merchant-banking results can be uneven, we view the segment as a core business and don't exclude gains and losses from our operating estimates.

Goldman's securities services business provides prime brokerage, financing-services, and securities lending services to mutual funds, pension funds, hedge funds, foundations, and high-net-worth individuals worldwide. We view its significant market position in prime brokerage, which provides services to hedge funds, as a competitive advantage.

HEDGE-FUND BOOST. Goldman's investment-banking segment accounted for 16% of net revenues in fiscal 2004, and it underwrites a wide variety of securities and other instruments. In the financial advisory business, it advises clients on corporate takeovers, defenses, and mergers and acquisitions. Goldman also provides acquisition financing, currency hedging, and cross-border structuring expertise. We think Goldman has a particularly strong competitive position in underwriting high-yield and leveraged loans within its debt underwriting business.

The asset-management and securities services business accounted for 19% of net revenues in fiscal 2004, with assets under management at $452 billion at the end of fiscal 2004. Goldman experienced net client inflows of $52 billion in fiscal 2004, across all asset classes. That's up significantly from $15 billion in the previous year. Securities services has benefited in recent years, in our view, from new institutional clients and the creation and growth of new and existing hedge funds, as well as the rally in equity markets.

In December, 2002, Goldman and other leading investment banks entered into a $1.4 billion agreement to settle allegations that their research was tainted with conflicts of interest and misled investors. Goldman's share of the settlement was $110 million. The banks also agreed to make organizational changes to reduce conflicts of interest in their research departments.

LONG-TERM MUSCLE. We believe that Goldman has cautious risk-management policies despite its willingness to take significant trading risks. It considers risk management to be one of its most vital functions and begins at the top of the firm with the establishment of risk limits for major business units. Its average daily VaR was $67 million in fiscal 2004, up from $58 million in fiscal 2003 and $46 million in fiscal 2002. Despite the increase in VaR, we view trading risks as appropriate relative to the firm's capital base and total size.

We forecast earnings per shre of $9.70 in fiscal 2005, up from $8.92 in fiscal 2004, aided by prudent expense growth and merchant-banking gains. Although we expect revenue to be weak in the May quarter, we see a rebound in proprietary trading, equity underwriting, merger advisory, and merchant-banking gains in second-half 2005. Announced M&A activity has slowed thus far in the second quarter, in part due to weak equity markets, but we envision a pickup in the fiscal year's second half, as the equity markets and CEO confidence rebound, as we expect. We also see an increase in initial public offerings (IPOs).

Segment results are difficult to forecast on a quarterly basis given volatile market conditions, but we think they'll exhibit strong long-term growth on an annual basis. We expect trading revenues to ease throughout the remainder of fiscal 2005, following record first-quarter results, in light of a flattening yield curve and tightening credit spreads. Equity underwriting, asset management, and advisory fees should experience strong growth, in our view.

WATCHFUL ON EXPENSES. Moreover, we anticipate the securities services business to register strong results, driven by higher margin balances and a greater mix of electronic trading activity. We see higher merchant-banking gains in fiscal 2005, aided by appreciation in the Sumitomo Mitsui investment.

Several of Goldman's other businesses should see solid growth, we believe, including interest rate products, credit derivatives, high-yield underwriting, asset management, and prime brokerage. Despite challenging hedge-fund returns thus far in 2005, we expect strong revenue growth in fiscal 2005 from hedge-fund clients, given continued healthy growth in assets under management, as we anticipate. We also envision stronger growth in equity underwriting fees, given that the equity markets should improve.

Goldman has had increased earnings consistency, in part, due to its businesses being diversified. Its profit picture in fiscal 2005 will be aided by continued prudent expense management, we believe. Compensation to net revenue will trend up slightly. We expect Goldman to use its strong free cash flow to pay dividends and repurchase common shares in fiscal 2005.

STOCK UPSWING? Our Standard & Poor's Core Earnings analysis suggests that our fiscal 2005 EPS estimate of $9.70 would be reduced by 53 cents if stock options were expensed. We view Goldman's executive compensation, including stock-option grants, as generous, which largely accounts for our lower Core EPS estimate relative to our operating EPS estimate.

Concerns over hedge-fund profitability have recently weighed on Goldman's valuation, in our view. We also think valuations for industry participants, including Goldman, have been hurt by concerns about the large proportion of profitability generated by proprietary trading activities. However, over the long term, hedge-fund assets will grow, in our view. And we see Goldman as primarily an intermediary, committing its capital, leveraging its market information, and managing risks in order to facilitate customer-driven activity.

Despite quarterly volatility, we view Goldman's various segments as growth businesses over the long term, worthy of a higher multiple. The firm's stock-buyback program and consistent returns on tangible equity above its 20% target should also help support its valuation, we believe.

SHAKING OFF ADVERSITY. The shares have been weak, with prices down about 4% thus far in 2005. This is largely due, we think, to concerns about rising interest rates, a flattening yield curve, wider credit spreads, and hedge-fund profitability, as well as generally weak equity markets. We think the shares have also been hurt due to comments by competitors that the current quarter would be difficult. We also note that the 5% gain in share prices in 2004 lagged behind both the 9% gain for the S&P 500 and the 14% gain among Goldman's peers.

However, we see a rebound in equity markets, generally improving trading revenues, and a pickup in investment-banking activity in the second half of 2005. The shares recently traded at a price-earnings ratio of about 10 times our fiscal 2005 EPS estimate, a significant discount to both Goldman's peers and the shares' historical average p-e multiple of about 17 times. Our 12-month target price is $140, which equals a p-e multiple of about 14 times our FY 05 estimate, a modest premium to the peer-group average.

Goldman has traded at an average p-e of over 15 times since its initial public offering in 1999. We think its multiple can recapture its premium as the company demonstrates consistency of earnings during an adverse fixed-income environment. We also believe that the multiple can expand given, in our view, Goldman's impressive return on tangible equity vs. its peers, diversified business model, and potential for increased M&A activity. Add this to its competitive advantage due to its willingness to make large proprietary investments and its cautious risk-management approach.

VULNERABLE SPOTS. We believe that Goldman's corporate-governance practices are generally sound, but we think that the company could make improvements. We like that the board of directors consists of a supermajority (over 75%) of independent outside directors. We also view favorably that the nominating, audit, and compensation committees each comprise solely independent outside directors. However, we view executive compensation, including stock-option grants, as generous and would prefer that Goldman declassify its board of directors and redeem its nonshareholder-approved poison pill.

Risks to our recommendation and target price, in our opinion, include stock and bond market depreciation, potentially higher interest rates, and enhanced regulatory scrutiny. Additional risks include the steepness of the yield curve, compliance with regulatory matters, counterparty credit risk, and principal exposure on proprietary investments, which could result in losses on dealer positions or hedges on its origination pipeline.

Goldman often makes large proprietary investments in its trading businesses to facilitate customer trades, which can increase earnings volatility. For example, in fiscal 1998, it reportedly lost more than $600 million, mostly from proprietary trading, after Russia defaulted on its debt. In the third quarter of fiscal 2003, revenue in Goldman's FICC division declined 37%, year-over-year, reportedly due to a series of poorly timed trades in residential mortgage backed securities (MBS).

Finally, we remain concerned about increasing competition, notably from the largest commercial banks, which are gaining market share in investment banking. Analyst Hansen follows shares of investment banks for Standard & Poor's Equity Research Services

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