Goldman surprises, but investors remain wary

Earnings for the three months to March 31 beat analyst expectations, but December write-offs and a $5 billion capital-raising turn sentiment bearish.

Goldman Sachs kicked off the US earnings season with a bag of surprises after the US market closed on Monday. The earnings for the first quarter of 2009, released a day earlier than scheduled, were significantly better than consensus estimates, driven by gains in fixed income and commodities trading. And the simultaneously announced $5 billion public offering of common stock to repay bailout funding it received last year initially received a positive nod from the market.

However, the performance in the elusive month of December 2008, coupled with the aggressive size and pricing of the new issue, eventually dampened investor sentiment and the shares lost ground yesterday.
Goldman Sachs posted net revenues of $9.43 billion for the January-March period on which it achieved earnings of $1.81 billion, translating into an earnings per share of $3.39. This compares with an EPS of $3.23 for the comparable first quarter of 2008 and a loss per share of $4.97 for the preceding quarter ended November 28, 2008.

The first quarters of 2008 and 2009 are not strictly comparable as the previous one was the three months between December 2007 and February 2008 while this one runs from January to March 2009. The reason for this is that Goldman Sachs transformed into a bank holding company in September last year and will from now on declare fiscal results on a calendar year basis, rather than for the 12 months ending November 30 as was earlier the case.

Goldman Sachs broke out its December 2008 results in isolation and showed that one month separately. December net revenues were $183 million, net earnings were negative $780 million and EPS was negative $2.15. Some analysts have complained that this method of accounting has allowed Goldman to treat the month of December as a dumping ground for past sins, without consolidating the 30-day period with the following quarter.
Trading is the area where Goldman turned the corner during the most recent quarter, with a net revenue of $7.15 billion, compared to $5.12 billion for the first quarter of 2008 and a loss of $4.36 billion for the fourth quarter 2008. The improved performance was driven by fixed income, currency and commodities (FICC). FICC revenues for the quarter amounted to $6.56 billion, or more than double the comparable quarter of 2008. Interest rate products, commodities and credit products were the star performers. "Net revenues in currencies were solid", says the firm, although down on the first quarter 2008. Some analysts have suggested that the firm may have taken excessive risk on its trading book.
Revenues in equities were $2 billion, 20% down on the first quarter 2008, which the firm attributed to lower levels of activity outside the US.
Principal investments made a net loss of $1.41 billion during the quarter, which comprises $640 million of losses from real estate principal investments, $621 million from corporate principal investments and a $151 million loss related to the firm's investment in Industrial and Commercial Bank of China (ICBC). Goldman agreed in March to hold at least 80% of its 4.93% stake in ICBC until the end of April next year, while under the initial terms it would have been allowed to sell 50% of that stake after April 28 this year and the other 50% after October 28. Goldman paid $2.58 billion for the ICBC shares in April 2006. The position is held on a mark-to-market basis and "the extension of the transfer restrictions increased our liquidity discount", explained the firm on an analyst call posted on seekingalpha yesterday.

Principal investments have at least managed to contain the losses this quarter, suggesting the economy and markets could be plateauing. The division made a loss of $3.6 billion in the fourth quarter of 2008, of which $2 billion was attributable to corporate principal, another $961 million to real estate principal investing and $631 million on account of the ICBC investment. This led to a loss of $3.9 billion in principal investing for the fiscal year ended November 30.

On a call with analysts on December 16, Goldman's chief financial officer David Viniar said: "It is important to distinguish between fair value losses on these long-term portfolio assets and losses on residual troubled asset exposures. Although we have no intention of selling these assets in the near term, fair value accounting rules require that we value them based on current market conditions. That doesn't mean they can't go down in value from here. They can. But many of these positions represent excellent long-term investments."
Some specialists reckon Goldman is proactively and conservatively writing down the unlisted portion of the principal investing portfolio to very low levels so that no further write-downs will be necessary.
Investment banking revenues fell 30% quarter-on-quarter and 20% sequentially to $823 million. More worrying, both for the firm and the industry as a whole, is that the rate of the fall seems difficult to arrest. Goldman's investment banking revenues fell 31% in 2008 from 2007. No doubt 2007 was a blockbuster year, but revenues continue to fall even on a much smaller base.
Revenues in asset management and securities services (which include prime brokerage) were $1.45 billion, down 29% quarter-on-quarter and 17% sequentially.
Compensation and benefit expenses were $4.71 billion, 18% higher than the first quarter of 2008. This pegged the compensation-to-revenue ratio at 50% for the quarter, up from 48% for fiscal 2008 (the 48% excluded $275 million of fourth quarter severance costs).
In an address to the Council of Institutional Investors earlier this month, Goldman Sachs chief executive officer Lloyd Blankfein outlined guidelines on compensation adopted by the firm. These include measures to ensure that the percentage of compensation awarded in equity should increase significantly as an employee's total compensation increases and for senior employees most of the compensation should be in deferred equity.
As Goldman would have declared bonuses during the past quarter it is possible that some of the stock awards have been generous, perhaps to compensate for the illiquidity.

Employee numbers are down 7% from the 30,067 headcount at the end of November 2008 and now stand at 27,898. The headcount is 12% lower than in the first quarter of 2008.
Goldman also announced a public offering of $5 billion worth of common stock, for which it is acting as the sole underwriter. Shares are being offered at $123 apiece.

This latest capital-raising follows a $5.75 billion public stock sale, also at $123 a share, in September last year, and a simultaneous $5 billion preferred stock and warrant issue to Warren Buffet's investment firm, Berkshire Hathaway. Berkshire bought perpetual preferred stock carrying a 10% annual dividend and warrants to acquire another $5 billion worth of stock at a price of $115 per share, exerciseable at any time over the next five years.

The investment bank said it intends to use the $5 billion of capital it raises plus additional resources to redeem the $10 billion it received last year under the US government's Troubled Asset Relief Program (Tarp). It is generally believed that Goldman is eager to repay the Tarp money because it does not want the enhanced oversight and scrutiny. What it does want is independence to set strategic direction, including compensation policies.

One of the issues that is unclear is how much Goldman Sachs and other investment banks benefited from the US government's decision to recapitalise American International Group last year. The beleaguered insurer was sitting on a book of derivative-based protection, known as credit default swaps (CDS), with counterparties across the banking world. Goldman Sachs and others did not take any financial loss for AIG's financial position, with the entire brunt of the collapse being borne by the US government through the $160 billion of bailout funds provided. The US government has not disclosed who the counterparties were.

On an earnings call yesterday an analyst questioned whether Goldman made money from AIG's bailout. The answer was unclear as Goldman replied that in the first quarter there was no impact, but did not clarify what the impact in December was.

Goldman's share price gained 4.7% on Monday to $130.15 amid early euphoria about the results. But reality hit yesterday as investors digested the numbers and the implications of the capital raising, especially after the bank held its 7am Eastern Standard Time analyst call, and the shares closed the day down 11.6% at $115.

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