Goldman Sachs Group (GS)

GS reported net income of $1.51 billion, or $3.23 a share, for the quarter ended Feb. 29, compared to $3.2 billion, or $6.67 a share last year. Revenue decreased 35% to $8.34 billion. Analysts estimates were for earnings of $2.58 a share on revenue of $7.47 billion. Other numbers:

• Return on equity was 17%;
• Trading and principal investments segment saw revenue decrease 46% because of credit and investment losses.
• Investment banking revenue dropped 32% because of a decline in debt underwriting;
• Asset management unit recorded a 23% increase on higher fees.

Not great, but, better than expected. When you combine these results with those at Lehman Brothers Fin SA (LEH), they make the Bear Stearns Companies (BSC) situation look more like a management issue rather than a systemic event.

Furthermore, losses the banks are seeing are unrealized for the most part. This means they are writing down the value of a security because of an assumed market value of it, not because of a tangible deterioration of the assets performance. That is a huge point. It means that when we can now value these instruments higher, earnings jump, fast.

In every financial "crisis" there is a sacrificial lamb. In this one it was Bear Stearns. Now that the Fed has opened the discount window to not only the banks, but the brokers, the liquidity squeeze that destroyed Bear will not be repeated. Now, poor management may take a smaller institution under, but if that happens, it will not be anywhere near the scale of a Bear Stearns.

The time Goldman spent cultivating relationships in China has already paid off big time, but the benefits should continue to roll in. Since Goldman and UBS are the only foreign banks allowed to do business in China, there's at least a 50% chance that any Chinese company needing someone to handle its IPO or underwrite some securities will turn to Goldman. Add that to the fact that Goldman's been in China for so long, and it becomes clear that Goldman's in a prime position to benefit from economic growth in China. Take the October 2006 IPO of the Industrial and Commercial Bank of China (which, by the way, is now the largest bank in the world by market cap, its $254 billion market cap surpassing even Citigroup (C)). Because of its relationships in the Chinese business industry, Goldman got to invest $2.6 billion in ICBC before the company went public, which amounted to about a 7% stake. The fact that Goldman's connections run so deep in such a key market is a huge advantage for an already impressive investment bank.

Recent investments into Mexican Highways, Asian Manufacturing and the rumbling of wanting to invest $800Million Euros into Eurotunnel (The connecting tunnel between the UK and France) have broadened Goldman's investment portfolio while management continually signals that through tough times in the US, the company will continue to be intelligently short. Not a bad bet to take given current economic headwinds. For these reasons, Goldman is the best player in the investment banking game and I think, while sideways trading may keep this good name down for longer than most would like, the opportunity is there to use current weakness to build up or start positions in this name

As on March 5th, the weakness in the overall economy has brought a wave of selling, cutting the best performing market stocks, contracting P/E ratios and pessimistic earnings outlooks have been the main culprits over the last quarter and Goldman Sachs has been no exception. Although Analysts still hold a high regard for the company, it has been difficult getting any momentum back for the shares. Falling from a high of over $250 to its current values makes for a 40% valuation hit. While that is in line with virtually all of its peers in the financial business Goldman has proven with its track record to just simply be more flexible, better managed, and in fact smarter than the other Investment Firms. While earnings expectations have been toned down this year to around $19-$20 and $22-$23 next year, there is no reason for Goldman to be trading in the 7 P/E range. Even though 2008 profitability is expected to be lower than 2007, it still only values Goldman with a FP/E in the 8/9 range. This is a company that had over a trillion dollars worth of assets on its balance sheet at the end of 2007. It made almost $12 billion in profit on revenue of $88 billion.

Moreover, they are trying to make money over the credit crunch as well. There are Level1, Level 2 and Level 3 assets. Level 1 assets are the easy to price, liquid holdings on the banks balance sheets. Think US Treasuries. Level 2 assets may be less liquid, but they are priced according to comparable marketable assets, even if they arent' actively trading themselves. Level 3 assets, though, are the illiquid holdings that have gotten everyone in trouble lately - the mortgage backed structured products, derivatives, all that toxic waste. Those are illiquid, and have been priced according to "mark to model" theoretical pricing programs. Basically they are prices made up out of thin air. Keep with us here - last month there was an offer to the investment banks to come to the discount window of the Fed (something not done for over 70 years) and use those level 3 assets for collateral for 100 cents on the dollar FULLY LIQUID, US TREASURY-NOTE BASED LOANS. Now think about that! It's truly turning lead into gold with this type of accounting alchemy.

We saw, in most banks quarterly earnings releases, huge transfers of assets from "level 2" into "level 3", basically (we suspect) to take advantage of this total windfall of taxpayer cash to the banks. And yes, you can thank Henry Paulsen (of Goldman Sachs pedigree) for this $200 billion taxpayer funded program. Morgan Stanley has $32 billion now in Level 3 assets (it increased by 45% in Q108) and Goldman themselves added $27 billion to make their "level 3" pile $96 billion. WOW!

Setting aside the discussion of the morality / ethicality of bailing out the Wall Street banks with taxpayer money, this happened last month and we have to figure out how to make an investment return on it. The Wall Street investment banks are now in a position to swap off the worst toxic waste on their balance sheets for US Treasury notes. That's exactly what they're doing, and there's nothing you or I, or Congress, or the President of the United States can do about it. As a matter of fact, they're looking at this $200 or $300 billion program as the cost of maintaining our financial system's integrity. I guess every once in a while the roots of the tree of global finance have to be replenished with the US taxpayers' capital. (Apologies to Thomas Jefferson's great quote regarding the tree of Liberty).

'Well-Founded Relations'. The firm has numerous relationships with CEOs across corporate America. It's alumni base is also the most extensive. Both factors are integral to winning business on the street.

Goldman remains the king of cross selling. A strong example concerns the firm's private equity business which later advises firms on raising capital from the public markets. By actively engaging in cross selling, Goldman maximizes its revenue per client.

Crisis Management

The only Wall Street brokerage to buck the trend was Goldman Sachs Group Inc., which rose to first place in the past 12 months from second, ousting Morgan Stanley. Goldman, the largest and most profitable investment bank, has led annual rankings in nine of the past 10 years, according to Bloomberg data.

Led by Chief Executive Officer Lloyd Blankfein, Goldman managed the subprime-mortgage crisis that led to quarterly losses at Merrill, Morgan Stanley and Lehman, and forced Bear Stearns to sell itself to New York-based JPMorgan to avert bankruptcy.

Goldman Sachs reported a $2.1 billion quarterly profit Tuesday, beating analyst forecasts while continuing to avoid a credit crunch that has hurt many of its Wall Street rivals. The New York-based investment bank said that net earnings for the quarter ended May 30, 2008 came in at $4.58 per share, 11% lower than earnings of $4.93 per share a year ago. Goldman’s revenues fell 7.5% to $9.42 billion in the period, but this more than topped a consensus forecast of $8.74 billion. Chairman and CEO Lloyd Blankfein was "particularly pleased," to report results better than Street estimates. Though revenue from investment banking, one of the cornerstones of Goldman's business, fell 2% during the quarter, a sharp decline in leveraged loan activity was offset by a surge in equity underwriting as more and more companies looked to raise capital.

Caveat : One of the hardest hit segments was Goldman’s fixed income, currency and commodities business, which fell 29% from a year earlier due to a $500 million hedging-related loss

The company reported a profit of $2.05 billion, or $4.58 per share, compared to $2.29 billion, or $4.93 per share a year earlier. Revenue fell 7 percent to $9.42 billion from $10.18 billion a year earlier.

That easily surpassed Wall Street expectations for a profit of $3.42 per share on $8.74 billion of revenue, according to analysts polled by Thomson Financial.

"Given the difficult market conditions, we are particularly pleased to be able to report strong results for the second quarter," said Chairman and Chief Executive Lloyd Blankfein in a statement. "We are realistic about the market challenges we face, but times of market dislocation also produce opportunities, and we will continue to take advantage of the most attractive of these as they arise."

Goldman benefited from a $725 million gain during the quarter from its own investments, including a $214 million gain from its stake in Industrial and Commercial Bank of China Ltd. Revenue for all of Goldman's trading and principal investments fell 16 percent to $5.59 billion.

As on March 5th, the weakness in the overall economy has brought a wave of selling, cutting the best performing market stocks, contracting P/E ratios and pessimistic earnings outlooks have been the main culprits over the last quarter and Goldman Sachs has been no exception. Although Analysts still hold a high regard for the company, it has been difficult getting any momentum back for the shares. Falling from a high of over $250 to its current values makes for a 40% valuation hit. While that is in line with virtually all of its peers in the financial business Goldman has proven with its track record to just simply be more flexible, better managed, and in fact smarter than the other Investment Firms.

While earnings expectations have been toned down this year to around $19-$20 and $22-$23 next year, there is no reason for Goldman to be trading in the 7 P/E range. Even though 2008 profitability is expected to be lower than 2007, it still only values Goldman with a FP/E in the 8/9 range. This is a company that had over a trillion dollars worth of assets on its balance sheet at the end of 2007. It made almost $12 b illion in profit on revenue of $88 billion. Just staggering at the money machine that is this bank, moving in all sorts of Investment directions.