Goldman Downgraded to Underperform - Analyst Blog

We have downgraded our recommendation on Goldman Sachs Group Inc. (GS) to Underperform from Neutral following the company’s second quarter earnings release. Our decision is based on the negative impact of the new financial regulatory reform on the company’s business model, its fundamentals and its competitive landscape.

 

 

Goldman’s earnings per share of $2.75 were well ahead of the Zacks Consensus Estimate of $2.10 in the quarter. Earnings surpassed the estimate due to lower operating expenses. However, including the impact of $600 million charges related to the U.K. bank payroll tax and $550 million related to the SEC settlement, earnings per share were 78 cents in the reported quarter.

 

Goldman’s results typified the difficult market environment during the quarter, which resulted in decreased client activity across its businesses. Total revenue decreased 31% from the prior quarter and 36% year over year to $8.8 billion.

 

Goldman agreed to pay $550 million to the SEC to settle a civil fraud suit linked with mortgage investments, which had been filed in April. During the reported quarter, the U.K. government enacted a law that imposed a non-deductible 50% tax on certain financial institutions for discretionary bonuses in excess of £25,000 ($0.4 million) awarded to relevant banking employees under arrangements made between December 9, 2009 and April 5, 2010.

 

 

Following the earnings release, we observe a downward bias in estimate revisions by analysts covering the stock. The enactment of the regulatory reforms and the current operating environment are detrimental to any enthusiastic response on the stock.

 

 

From the estimate revision trends, it becomes clear that a majority of the analysts anticipate a weak outlook for Goldman’s earnings in 3Q10, FY10 and FY11. Over the last 30 days, 12 analysts decreased estimates for 3Q10 while none have pushed it up. For FY10, 15 analysts have lowered estimates while only 1 has made upward revisions. For FY11, 14 analysts have brought down the estimates and none moved in the opposite direction.

 

The regulatory reform bill that became law in July 2010 has a provision − the Volcker Rule, named after Paul A Volcker, the former Federal Reserve chairman − that restricts banks from risky speculations in order to prevent precarious bets.

 

Banks will now be restricted from proprietary trading and investing more than 3% of their capital in private equity or hedge fund investments in the long term. Proprietary trading has been a pivotal source of investment bank profits and the step is an attempt to minimize the speculation on banks, which might be the reason of the recent financial crisis.

 

At present, Goldman has more than 27% of its capital invested in such entities, followed by Morgan Stanley (MS) at 9%, and Citigroup Inc. (C) and Bank of America Corporation (BAC) 4% each. Such substantial amounts invested in these entities will affect the bank’s trading revenues to a greater extent in the coming years. Goldman has already decided to spin off the unit of proprietary trading businesses following the regulatory reform, which poses as a revenue challenge for the company.

 

 

Following a detailed look into the magnitude of estimate revision trends, we notice that over the last 30 days, estimates for 3Q10 decreased to $3.46 per share from $3.98. For FY10, estimates fell to $14.93 from $16.82 while estimates for FY11 came down to $18.67 from $19.22. Clearly, the magnitude of such downward revisions depicts a significant negative bias and hence justify why it is not worth to hold the stock in an investors’ kitty.

 

 

The downward estimate revision trends and their magnitude denote a significant downward pressure on the shares of Goldman over the near term. This results in its current Zacks #5 Rank (Strong Sell).

 

Apart from Goldman , U.S. banks including Citigroup, Bank of America Corporation, JPMorgan Chase & Co. (JPM), Wells Fargo & Company (WFC) and Morgan Stanley are trying to reduce their investments in hedge funds and private equity. Though it will take several years before the Volcker effect becomes apparent, these banks are considering options to comply with it.

 

Though Goldman’s second quarter earnings were well ahead of the Zacks Consensus Estimate on the back of lower operating expenses, we notice that its results reflected a difficult market environment. Litigation issues not only impact a company’s reputation but also dent its financials. Further, the new regulatory reform will continue to pressure trading revenues, which will hurt the profitability of Goldman in the upcoming quarters.

 

Therefore, we have a long-term Underperform recommendation on the shares of Goldman.