Goldman Sachs: Poor Earnings And An Investigation (NYSE:GS)

Goldman Sachs (NYSE:GS) recently reported a challenging quarter, followed by news that the Federal Reserve is probing its consumer business for possible inadequate safeguards, and negative press about its CEO for his side gig as a DJ. It has been a bad couple of weeks for the company, yet the stock is up 5% over the past month, besting the Financial Select Sector SPDR ETF (XLF). The company faces challenges, but there are also reasons to be optimistic. This article will provide a balanced overview of the business, challenges, financials and valuation, so investors can make a more informed decision.

Business

Goldman Sachs is a global investment bank and financial services company. They offer a wide range of services, including investment banking, securities trading and sales, asset management, and consumer banking. Their investment banking division provides advisory services and raises capital for clients. The securities trading and sales division provides liquidity to markets and executes trades for clients. The asset management division provides investment management services to individual and institutional clients. The consumer banking division offers consumers traditional banking services, including savings, checking accounts, and personal loans.

Strategic Reorganization

In our opinion, Goldman Sachs’ recent organizational changes were a smart move to improve the company’s overall efficiency and competitiveness. By restructuring into three business segments – Asset and Wealth Management, Global Banking and Markets, and Platform Solutions – Goldman has been able to clearly showcase its two primary revenue generators.

The first is the Asset Management franchise, which is a powerhouse in the industry as the fifth-largest active asset manager globally. Coupled with the thriving Wealth Management business, which prioritizes performance and client satisfaction, Goldman is poised to reach its goal of over $10 billion in management and other fees by 2024, including more than $2 billion from alternatives.

The integration of Investment Banking and Global Markets is also a positive change in our opinion. These businesses have been performing well and by combining them, Goldman can offer even better services to clients in financing, risk intermediation, and strategic advisory.

Goldman’s decision to focus on its Consumer segment, while narrowing its ambitions, is also a smart move. By focusing on scale and profitability across platform businesses, transaction banking, and consumer platforms, Goldman is well-positioned to take advantage of the opportunities presented. The increased transparency in the company’s consumer activities is also a welcome development.

We believe Goldman’s recent reorganization is a significant move in their strategic plan. They believe this reorganization will help the firm meet its medium-term goals and drive shareholder value. On February 28th, during the next Investor Day, the firm will provide further information and specific metrics so that their progress can be easily monitored. Despite a challenging operating environment, we believe the firm is working hard to enhance its position, and we are optimistic about the future opportunities.

Financials & Valuation

GS’s financial results have been very lumpy. The company finished 2022 with $47 billion in revenue and $30.06 EPS, down from $59 billion of revenue and $59.45 EPS in 2021, but still up significantly from 2020’s $45 billion of revenue and $24.74 EPS. This lumpiness is why investment banks like Goldman never command high earnings multiples.

In 2022, the decline in revenue was caused by a 50.5% decrease in investment banking revenue y/y, an 83% decrease in equity underwriting, and a 12% decrease in financial advisory. For 2023, the consensus estimates anticipate a modest improvement, with a 6% increase in investment banking and a 57% recovery in equity underwriting, but a persistent 12% decline in financial advisory. Given the highly uncertain macro environment, we would not put much faith in these estimates.

Goldman Sachs is currently trading at a forward price-to-earnings ratio of 10.6x, close to its five-year-high. We consider this to be overpriced given the unfavorable macroeconomic conditions and decreased financial activity due to rising interest rates, compared to the favorable investment banking environment prior to 2022 when the Federal Reserve started increasing rates.

Challenges & Risks

Bad Q4 earnings: Goldman Sachs recently released their fourth quarter earnings report, revealing earnings per share of $3.32. This result fell below consensus of $5.56. The report showed that revenue fell short while both expenses and credit costs increased, leading to a Return on Tangible Equity (ROTE) of less than 5% for the quarter.

In my opinion, the compensation ratio for the fourth quarter, which was reported at 35.5%, was the most significant miss in the earnings report. This result was higher than the estimated 28.9%, resulting in a full-year compensation ratio of 32.0%. For context, the average full-year compensation ratio from 2018 to 2021 was 31.9%, while the average fourth quarter compensation ratio was 25.1%.

To make matters worse, Morgan Stanley (MS) a close peer, reported more in-line earnings. As a result, Morgan Stanley significantly outperformed over the past month, returning 8% points more than Goldman.

Legal problems: The announcement of a new investigation into Goldman Sachs’ consumer business, now under the Federal Reserve, is expected to negatively impact the company’s stock. This comes on top of a previous investigation by the Consumer Financial Protection Bureau into Goldman Sachs’ credit card practices. The focus of the new investigation seems to be on internal compliance, which could result in significant fines for the company but may reduce the likelihood of customer harm. The increasing number of investigations raises concerns about Goldman Sachs’ credibility and ability to effectively manage risk. This, along with poor disclosure practices and other regulatory probes, increases the risk of owning Goldman Sachs stock and the cost of capital for the company.

Conclusion

The recent poor financial performance and the announcement of another regulatory investigation have been a significant negative development for the company. This raises concerns about the sustainability of the company’s current trajectory and highlights the need for management to address these challenges head-on. In light of these challenges, its strategic reorganization could be an appropriate course of action to address the company’s current challenges.

It is important to note that the company’s current valuation, in the face of negative developments and an uncertain economic environment, appears to be overvalued. As a result, we remain on the sidelines.