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The year 2000 will be remembered as one of enormous repositioning on Wall Street. Stalwarts PaineWebber and Donaldson, Lufkin & Jenrette disappeared, subsumed by Swiss banking groups UBS and Credit Suisse First Boston, respectively. These mergers are in keeping with the new look of world financial institutions: international behemoths that are an amalgam of commercial bank, investment bank, brokerage, and trading arm -- with an insurance unit thrown in for good measure. Giant Citigroup (C
) is the model most are striving to imitate.
Of course, not everyone is playing this game. Perhaps the most notable dissenter from the all-things-to-all-customers strategy is the venerable investment bank Goldman, Sachs (GS
). Goldman has largely eschewed the retail brokerage business that has been such a winner for Morgan Stanley Dean Witter (MWD
) and instead has stayed focused on investment banking. It tops the charts in global equity underwritings, and its proprietary trading revenues hit $2.1 billion in the fiscal third quarter that ended in August.
Until lately, it was hard to fault Goldman's tightly focused strategy. But the company's Dec. 19 announcement of its disappointing results for the fiscal year that ended Nov. 27 may have changed that. Goldman's press release says it reported "record net earnings." But analysts who delve beneath the hype question the strength of the firm's earnings in the latest quarter. Many also predict that Goldman will have a pretty hairy 2001 if the Federal Reserve doesn't come through with lower interest rates fast. That's because principal transactions -- trading for its own accounts and for clients -- are such a crucial component of its business. If U.S. stock markets are bearish in 2001, Goldman will be hit harder than more diversified Morgan Stanley and Merrill Lynch (MER
).
CONFUSED ANALYSTS. There was nothing irregular about the way Goldman reported its 2000 fiscal earnings. But the announcement nonetheless confused analysts. If you don't count a nonrecurring, $180 million charge related to the $6.5 billion, largely stock purchase of specialist trading firm Spear, Leeds & Kellogg, Goldman made $3.25 billion, or $6.35 per share, in fiscal 2000. But fourth-quarter earnings without the Spear Leeds charge were only $781 million and $1.50 a share. That's 7% below third-quarter 2000 earnings and 3% below fourth-quarter 1999.
Interpreting the announcement is tricky because of the way Goldman handled its tax and compensation reserves for the fourth quarter. Basically, the firm tucked more into its bonus pool and tax fund in the first three quarters than it should have. That's because the stock market started out gangbusters and took a pronounced slide during the last three months. Since bonuses and taxes are calculated as a percentage of earnings, it turned out that Goldman would be able to hold back a little less in the fourth quarter to fulfill its obligations. So, it used a 35% tax rate for the fourth quarter, vs. the 40% it had been using for the rest of the year to achieve an average tax rate for the year of 39%. It pulled a similar maneuver with its bonus pool.
But many analysts believe the step down in tax rates masks some disappointing trends. Without the reduction in the tax and compensation withholding rate, "they clearly didn't make [analysts'] consensus earnings [estimate]," says Guy Moszkowski, financial institutions analyst at Salomon Smith Barney. Indeed, Goldman's trading business failed to deliver the goods. Total revenues from principal transactions fell to just $985 million in the fourth quarter, less than half their level the previous quarter.
BAIL 'EM OUT. The problem likely is Goldman's emphasis on institutional clients. If no one else wants to buy the stock an institutional client wants to sell, Goldman has to buy it -- or risk losing the client. A.G. Edwards analyst Diana Yates believes this kind of pressure left Goldman with a lot of investments on its books that had to be marked to market in the fourth quarter.
As king of the IPO business, Goldman may have been particularly vulnerable in the second half of 2000 when that business dried up. The institutional buyers that were so invaluable in placing IPOs also expect Goldman to help bail out their clients when bad times strike. "[Goldman doesn't] break out the numbers, but it's also possible they had a lot of IPOs on their books at yearend," says Yates.
Greater diversification would have offset some of these problems. A retail brokerage business -- like the ones at Merrill and Morgan Stanley -- has a much wider client base than Goldman has. And, unlike big institutional clients, individual investors don't expect their broker to bail them out during downturns. A bigger asset-management unit also would have helped. Goldman has been spending heavily to increase its revenues from mutual funds and other asset management businesses, and eventually should reap a 30% to 40% profit margin from its investments. But "if it's close to 10% this year, it would be lucky," says Salomon Smith Barney's Moszkowski.
DOWNSIDE RISK? Nonetheless, Moszkowski is bullish on Goldman and its strategy. He has a 12- to 18-month target price of $130 on Goldman shares, 44% above the stock's current trading price of around $90. The problem is the downside risk. He sees a potential low for the stock next year of $50 if the Fed doesn't cut interest rates -- a 44% drop. Another doubter for 2001 is Merrill Lynch, which has lowered its 2001 earnings-per-share forecast for Goldman to $6.15 from $6.35 per share "to reflect a weaker trading outlook," according to a report by analyst Judah Kraushaar on Dec. 20.
The bottom line is that investing in Goldman is -- as always -- largely a bet on the trading environment. If you believe the Fed will ease, averting a serious slowdown and causing euphoria in the capital markets, the stock is a no-brainer. If you're a little less sanguine about what's going to happen next year, you may want to place your bets on its more diversified rivals.
Popper covers the markets for BW Online in our daily Street Wise column Edited by Thane Peterson
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Copyright 2000, Bloomberg L.P.
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