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How Goldman wins with risky trades
High-profile mergers certainly helped, but Goldman Sachs posted blowout earnings because of its trading success. That's a good reason to steer clear of the stock.
By Robert Walberg
It's become conventional wisdom: What's the best way to get a piece of Wall Street's merger mania? Buy the dealmakers.
Just look at Goldman Sachs (GS, news, msgs). The company reported record revenue and earnings in its fiscal first quarter, bolstered by strength in its investment banking and trading divisions. The numbers were so good that they made a mockery of the Street's estimates for Goldman's earnings.
Goldmans earnings jumped 64% from a year ago, to $2.48 billion, or $5.08 a share. Revenue surged 61% to $10.34 billion. According to Thomson First Call, analysts were expecting earnings of $3.29 a share on revenue of $7.19 billion.
Not surprisingly, the stock is up big today, about 5%. And with high-profile deals -- such as recently announced acquisitions by Capital One Financial (COF, news, msgs) and AT&T (T, news, msgs) -- back in vogue, it's not a stretch to think Goldman's stock will keep climbing.
But before you buy shares of Goldman, or one of the other major investment banks, such as Lehman (LEH, news, msgs) or Bear Stearns (BSC, news, msgs) -- both of which report results later this week -- take a close look at how Goldman managed to post such great results.
Big gains from small divisions
Mergers and acquisitions played a key role in the companys surprisingly strong quarter, as investment banking revenue rose 65% to $1.47 billion. Underwriting bond and stock offerings contributed about half of that total, with the other half coming from a 78% jump in M&A activity. Impressive numbers, but note that even with the big gains, investment banking only contributed about 14% of total revenues. The companys investment banking backlog declined during the quarter, suggesting that growth going forward is apt to slow.
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If not M&A, maybe its the companys asset management business that will keep the stock rolling. That group posted the biggest jump in revenue, which climbed 99% to $1.49 billion. The gain was largely due the fact that incentive fees rose to $739 million from $131 million last year. Assets under management rose 7% to $571 billion, with most of that gain coming from market appreciation.
While growth in the asset management business was impressive and bodes well for the future, it still represents only about 14% of total revenue.
Risky business
To understand why Wall Street's estimates were so far off, look at Goldmans trading operations. The group posted revenue of $6.88 billion, 57% above last years total. More importantly, the division accounts for 66.5% of total revenue.
Thats right, the company makes most of its money trading its own accounts and making markets for its customers. Now, the cynical among you might contend that Goldman utilizes the market information from its client base to improve its chances of success in trading its own account, and at some point that apparent conflict of interest might need to be addressed by regulators. For now, though, its fair game. Favorable conditions in the volatile commodities markets, where gold and oil prices have soared in recent years, have helped. In fact, revenue from trading in this group was up 50% in the first quarter.
But the real growth in this division comes from equity trading, which jumped 94% year-over-year and now accounts for 23% of the groups total revenue, up from 19% last year. The company cited favorable market conditions. What it didnt say, and what some on the Street are growing increasingly concerned about, is that the risks the company is taking to achieve these trading returns have also gone up sharply.
Consider the value at risk metric, which basically is a calculation that measures how much a firm could lose on any given day if all of its trades went against it. Goldmans value at risk has been rising steadily, jumping 41% from the year-ago period.
Obviously, the company has been on the right side of most of its trades in recent quarters, so this hasnt been an issue. However, if the market were to turn down for a prolonged period, Goldman might experience a sizeable swing in this divisions profitability -- and at two-thirds of overall revenue that would be bad news.
This might seem like nitpicking on what was otherwise a brilliant quarter. After all, Goldman's stock is up 15.7% year to date and 34.3% over the past 52-weeks.
The question I'm asking, though, is whether to invest in Goldman today. Considering its increasingly risky trading practices, and the fact that this quarter's great results will be all that much harder to beat in coming quarters, this is not the time to buy.
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
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