On Goldman Sachs Group Inc. (NYSE: GS) following 3Q results.
On July 24, 2020, Goldman said it reached an agreement in principle with the Government of Malaysia to resolve all criminal and regulatory proceedings in Malaysia. The agreement includes a $2.5 billion payment to the Malaysian government and a guarantee that the government will receive at least $1.4 billion in assets and proceeds from assets seized by governmental authorities around the world. The dispute dates back to December 2018, when Malaysia’s attorney general filed criminal charges against Goldman related to a $6.5 billion bond offered in 2012-2013 for the Malaysia Development Bhd (1MDB). The funds were expected to be used for a variety of development projects, but some $2.7 billion of the proceeds were allegedly stolen, and a Goldman partner pleaded guilty to money-laundering and bribing Malaysian government officials. Goldman has now restated its 2Q20 earnings to account for an additional $2.01 billion legal and regulatory provision taken after the release of its quarterly results. While the agreement removes some headline risk, we note that Goldman continues to face inquiries about the matter from the U.S. Department of Justice.
The company held its first-ever Investor Day on January 29, 2020, during which it outlined its growth objectives and provided financial targets. Goldman intends to focus on four areas for growth: transaction banking, third-party alternatives, digital consumer banking, and wealth management, which it believes will help it expand its addressable market. In transaction banking, the company believes it has a five-year opportunity to grow deposit balances to $50 billion. In third-party alternatives, Goldman sees a five-year opportunity for $100 billion in net inflows, noting its multiasset class franchise, unique sourcing capabilities, and strong track record. In digital banking, Goldman sees a five-year opportunity for $125 billion in consumer deposit balances and growth to more than $20 billion in loans and credit card balances. Here the company has launched its Marcus platform for deposits and the Apple credit card, and is pursuing additional products and partnerships. Goldman is well aware that its historical reliance on wholesale funding has put it at a disadvantage with respect to the more retail-oriented and lower-cost funding mix of peers. In wealth management, Goldman sees a five-year opportunity to add 30 corporate clients annually as it integrates the United Capital acquisition and launches new Marcus products.
Goldman is also addressing its expense base. Its goal is to achieve $1.3 billion in run-rate savings in three years by streamlining its organization, including moving some jobs to lower-cost locations, and consolidating platforms. Management did not indicate whether the company’s bonus structure would be impacted.
In its more traditional investment banking, M&A, and equity trading businesses, where the company already holds leading positions, its goals include expanding the client footprint, increasing penetration in select areas, and boosting market share.
In the medium term (which Goldman defines as three years), the company is targeting a return on equity of more than 13% (up from 10.0% in 2019), a return on tangible common equity (ROTE) of more than 14% (up from 10.6% in 2019), and a tier 1 common equity ratio of 13.0%-13.5%. Management believes it can generate mid-teens or higher returns. It expects the ROE/ROTE improvement to be driven by reduced litigation and tax expense, revenue growth, and the above-mentioned cost-cutting initiatives and funding mix improvements. Goldman sees its efficiency ratio improving over the three-year period to about 60% from 68.1% in 2019.
We applaud the company for providing greater detail on its business segments, medium-term strategy, and financial targets. We note, however, that the financial targets will take three years to achieve, and (particularly for ROE) will place the company only in the middle of the pack with respect to peers. Operating in the same environment, peers will likely raise the bar by moving their own ROE targets higher over the same time frame. Goldman is also entering business segments that, while adjacent in some cases, are still new. This puts the company at an experience disadvantage from a through-cycle perspective. Credit card lending, in particular, can quickly produce losses in a downturn even for companies with strong underwriting standards, as witnessed recently during the coronavirus pandemic. Peers also have large mortgage lending balances with lower charge-offs, which provide an offset.
We note several of the goals outlined above are for new business initiatives, where returns will take time to achieve. We will continue to look for financial metrics to improve toward peer-average levels.
In late 2016, it launched the consumer digital-lending platform Marcus (named for founder Marcus Goldman). In mid-2019, the company partnered with Apple to launch a new credit card that is part of the Apple Wallet. And in May, Goldman acquired United Capital, an adviser to high-net-worth clients that will help expand wealth management offerings to individuals. Other avenues highlighted for growth include retirement products and personal finance. However, credit costs bear watching as the company rapidly builds its consumer lending business, a still relatively new segment.
Revenues of $10.8 billion were up 30% from the prior year, aided by higher investment banking fees, global markets revenue and asset management fees. Operating expenses were up 6%, reflecting higher compensation and benefits expense.
On July 24, the company restated its 2Q20 earnings to account for an additional $2.01 billion legal and regulatory provision for the settlement with the Government of Malaysia. The provision brought earnings for the quarter to $0.53 per share, down more than 90% from the originally reported $6.26.
EARNINGS & GROWTH ANALYSIS
The company is rapidly building up its consumer and wealth management business. We detail 3Q earnings by segment below.
Investment Banking revenues rose 7% to $2.77 billion, with gains in underwriting (mostly IPOs and debt underwriting) offset by lower corporate lending and financial advisory revenues. The company noted that its investment banking transaction backlog at the end of 3Q increased significantly on a sequential basis, indicating a likely healthy 4Q.
Aided by a 49% increase in the fixed-income, currency and commodities segment (FICC), and a 10% rise in equities revenue.
Asset Management revenues jumped 71% to $2.77 billion, aided by gains on investments in public equities and higher assets under supervision.
Consumer & Wealth Management revenues rose 13% to $1.49 billion, reflecting higher average assets under supervision and greater transaction volume.
We believe that amounts here bear watching as the company builds its consumer lending business amid a sharp downturn in consumer credit quality.
In 2019, the ratio of compensation and benefits to net revenues, an important swing factor in earnings, was 33.8%, up slightly from 33.7%.
The return to a risk-on environment in 3Q led to better-than-expected capital markets activity, particularly investment banking and trading. We note that Goldman remains more dependent on client activity levels than peers, and thus tends to have more volatile quarterly results.
As we have noted, credit costs bear watching. Loss provisions in 2Q increased more than sevenfold from the prior year, reflecting weakness in wholesale lending as well as the company’s recent foray into credit card lending, before leveling off in 3Q. Goldman has considerably less experience than other credit card lenders and has mentioned a recent tightening of underwriting standards in this area.
Difficulties in forecasting capital markets activity typically lead to a wide range of analyst estimates.
FINANCIAL STRENGTH & DIVIDEND
Using the advanced approach, at September 30, 2020.
In 1Q20, the company repurchased 8.2 million shares of common stock for $1.93 billion.
MANAGEMENT & RISKS
Goldman is now led by CEO David Solomon, who took over following the retirement of Lloyd Blankfein on October 1, 2018. Goldman has more recently provided greater transparency with respect to its earnings and strategic initiatives. Stephen Scherr is the CFO.
Goldman is broadly exposed to global economic and financial market conditions, and has also dealt with a wide range of new regulations resulting from the financial crisis. While management has taken steps to improve disclosure, investors must remember that quarterly results are volatile and difficult to predict in many parts of Goldman’s business.
Derivatives trading and clearing are in a period of transition, and global regulators continue to debate capital and liquidity requirements.
The Goldman Sachs Group provides investment banking, securities, and investment management services to corporations, financial institutions, governments, and high-net-worth individuals worldwide. The company manages its business and reports results across four segments: Investment Banking, Institutional Client Services, Investing & Lending, and Investment Management.
With a high percentage of revenue tied to investment banking and various client services, Goldman remains more sensitive to swings in capital markets activity than other global banks. Goldman has been attempting to diversify its revenue base by entering businesses such as consumer lending, and we believe that a shift toward steadier asset management and traditional banking will help its multiples over time. However, for now, we apply a discount to GS shares based on the company’s more volatile business mix.