Goldman's Golden Quarter


While rival investment banks struggled, Goldman used its global reach and subprime savvy to increase profits sharply

Goldman Sachs (GS) reminded Wall Street on Thursday why it's the undisputed leader of the investment banking sector. While rivals such as Morgan Stanley (MS), Lehman Brothers (LEH), and Bear Stearns (BSC) have reported declining profits (BusinessWeek, 9/7/07) for the third quarter, Goldman's performance was stellar during a period marked by crisis in the U.S. and European credit markets.

Citing a global revenue base and savvy bets on subprime mortgages, Goldman said earnings for the period that ended August 31 soared compared with the same period in 2006. The firm reported a profit of $2.85 billion, or $6.13 a share, up 79% from $1.59 billion, or $3.26 in the third period of 2006. The results exceeded the consensus estimate of $4.36 a share, according to the financial research firm Thomson Financial. Goldman reported third quarter revenue of $12.33 billion, up more than 20% from the $10.18 billion in the comparable period of last year. The revenue figure was the second-highest in the firm's history.

Goldman shares rose on the news. The stock price increased by more than 2% in midday trading, before closing down slightly as the stock market overall dropped on concerns about the broader economy. "This is standout performance by Goldman, which, based on these results, reinforces its leadership among U.S. investment banking players in terms of its ability to adapt [to] and profit from changing environments," analyst Mike Mayo of Deutsche Bank (DB) said in a note to clients.

Sailing Through the Summer

Goldman had a few unusual factors working in its favor. For one, the third quarter of 2007 was five days longer than the third quarter of 2006. The latest quarter's results also included $900 million from the sale of Horizon Wind Energy, in New Jersey. But the quarter also included $1.5 billion in losses stemming from the reduced value of assets such as leveraged buyout loans (BusinessWeek, 9/12/07).

The company all but sailed through one of the most painful and abrupt financial crises in memory. Some analysts and economists believe the summer of 2007 (BusinessWeek, 8/20/07) was worse than the stock market crash of 1987 or the credit crisis of 1998, when Russia defaulted on some of its debt. Goldman reported record revenue in investment banking, equities, and even fixed-income investments.

Goldman managed to adjust on the fly as conditions in the market worsened. When its Global Equity Opportunities Fund took a hit, it assembled a group of investors to put $3 billion into the fund. That allowed the fund to buy assets at a discount. It's up 16% since the capital infusion, according to Goldman Chief Financial Officer David Viniar. And even though Goldman made some bad bets on the subprime mortgage market, they were offset by others wagering that the subprime mortgage market would fall. Its net position was a bet on falling asset prices, Viniar said during a call with investors.

High on China

"Goldman Sachs…has been clever and swift in exploiting volatility in the mortgage market by placing short bets to generate profits that can offset losses in other areas," said Cubillas Ding, a senior analyst at Celent, a financial consulting firm in Boston.

Goldman has benefited tremendously from its globalization. In 2006 it derived 52% of its revenue from outside the U.S., compared with 48% at Lehman, 42% at Merrill Lynch (MER) and Morgan Stanley, and 20% at Bear Stearns, according to a report by Deutsche Bank's Mayo. Mayo said Goldman has one of only two domestic securities licenses in China, allowing it to sell securities on the local exchange, and to "try to capture some of the $3 trillion in domestic savings…and win additional investment banking and trading with a portion of the 250,000 state-owned enterprises that may ultimately go public on the local exchange."

Viniar said revenues from outside the U.S. are currently at 54% and continue to climb. "We are very, very positive on China…It is one of the biggest, if not the biggest focus we have, it is one of the top priorities," the finance chief said. Beyond China, Goldman has extensive business in other "hot spots" such as India, Russia and the Middle East, Mayo said.

Last month, Goldman spent $79 million to buy a 25% stake in Hongshi Holding, a cement maker in China. In 2006, Goldman spearheaded an $815 million buyout of Shuanghui, a meat processing company in China. Last year in India, Goldman underwrote a $5 billion share offering by ICICI, a key bank in that country. The company was recently bookrunner on an IPO by Brazilian ethanol company Cosan.

Paying for Talent

Goldman's biggest risk is that it gets too cocky and takes on too much risk, said Mayo. But he nonetheless has a buy rating on the stock. With a market cap of $83 billion, it is larger and more diversified than rivals such as $16.7 billion Bear Stearns, helping it ride out even a major crisis. Bear reported Thursday that its third quarter profit fell 62%.

The smallest of the top-five investment banks, Bear derives about 45% of its revenue from the hard-hit fixed income market. It had significant exposure to the subprime mortgage market, which forced it to liquidate two hedge funds. Profits for the third quarter were $171.3 million, or $1.16 a share, down from a profit of $438.2 million, or $3.02 a share, in the comparable period of 2006. Revenue was $1.3 billion, down 38% from $2.1 billion in the prior-year quarter. Fixed-income gains were $118 million, down a stunning 88% from $945 million in the third period of 2006. The one bright spot was equities, where income rose 53% to $719 million, from $471 million in the third quarter of 2006.

Goldman looks like it may have the momentum to build on its lead in the industry. As one stock analyst on the company's conference call noted, the latest quarterly results ensure that it will be able to outpay any of its peers in competition to hire top talent.


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