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Thursday, 22 July 2010 05:35

The BoomBustBlog Review of Goldman Sach's 2nd Quarter, 2010 Performance: I Told You So!

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About three months ago, Boombustblog forewarned that GS will stand out to be the worst hit in the event of trend reversal in the financial markets and the company will have little means to escape the implications of the same on its profitability and solvency. The company generates 60-70% of the revenues from trading activities which is largely dictated by the unpredictable turn of financial events. While the financial markets were celebrating the US officially coming out of recession in the 1Q10, the subsequent Eurozone crisis (see the Pan-European Sovereign Debt Crisis series) and the slowdown of expectations in 2Q10 has beaten down the irrational exuberance and the markets experienced spurt in volatility and drop in prices. The consequent softening of trading revenues in 2Q10 vis-à-vis 1Q10 drove 31% drop in revenues and 82% drop in net income.

The chart below demonstrates how the volatility of the revenues from the trading and principal investments trickles down into volatility of the total revenues and profits of Goldman Sachs. I don't call Goldman the world's most expensive federally insured hedge fund for nothing!

If those that follow me remember, I was bearish on Goldman long before became popular, and profitably too (as the media and analysts fawned all over this company)!

Surges in volatility not only hurt the profitability of GS, but also raises questions over its solvency. GS’s considerable leverage provides a means (the lever) of high returns to shareholders when asset prices are appreciating but the same becomes a very material economic concern when the asset prices lose value. With low trading revenues, GS has little cushion to absorb write-downs on these assets, leading to erosion of equity. As of March, 2010, the GS’s investments portfolio amounted to $339 billion (nearly 566% of the tangible equity). Referencing my previous posts, "Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look" and "When the Patina Fades… The Rise and Fall of Goldman Sachs???", we can reminisce over the fact that Goldman BARELY earns its cost of capital on an economic basis, and that's before considering the potential horrors which may (and probably do) lay on the balance sheet (for more on BS horror, reference Reggie Middleton vs Goldman Sachs, Round 2 ) .

GS return on equity has declined substantially due to deleverage and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike.

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Subscribers can download my full review of GS's most recent quarter here: File Icon GS 2Q10 review. It is a recommended read, for we have performed some sleuthing and believe we may have conclusive evidence that the solvency of this overly marketed hedge fund investment bank is again at risk, just as it was in 2008. For those who wish to partake in our services, you may subscribe here.