Goldman’s Strong Q2 Performance Comes With Caveats

Investors expected a lukewarm performance at best from Goldman Sachs (NYSE:GS) for the second quarter of the year, after rivals Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) announced in late May that fixed-income, currencies and commodities (FICC) trading activity was significantly depressed for the first two months of the period. ^[1] After all, FICC trading is the single biggest driver of Goldman’s revenue, generating roughly 35% of the bank’s total revenues on average. But an improvement in global debt trading activity in June, coupled with particularly strong results for Goldman’s Investing and Lending division, saw the investment bank trounce market expectations to report revenues that were 6% higher than the figure a year ago and just 2% shy of the seasonally boosted performance for the previous quarter. ^[2]

While the numbers present a great picture overall, there are some concerns that emerge from a more detailed look. The biggest question raised by the results is whether Goldman’s strong performance is really sustainable in the long run. This is because revenues for the Investing and Lending division primarily come from the bank’s private equity unit, which is notoriously volatile – churning out huge returns in some quarters while incurring heavy losses in others. So the division being responsible for nearly one-fourth of Goldman’s total revenues this quarter could potentially be a one-time incident. If trading revenues do not recover completely over the coming quarters, then the bank’s revenue figures are likely to take a hit going forward. Also, Goldman’s non-interest expenses of $6.3 billion for the period were the same as the figure for the previous quarter and a good 6% higher than the year-ago period. While a contributing factor here is higher performance-related pay to employees, an increase in legal provisions by almost $300 million in Q2 also inflated expenses – putting pressure on the bank’s profit margins.

In view of the better-than-expected FICC trading revenues for the quarter, the strengthening capital structure as well as the progress in the share repurchase program, we have increased our price estimate for Goldman’s stock from $180 to $185. The new price target is about 10% ahead of the current market price.

See the full Trefis analysis for Goldman Sachs

FICC Trading Desk Yet To Reach Its Full Potential

Goldman Sachs is one of the few global banking giants which remain keen on growing their FICC  trading desks even as many banks shutter these operations to cope with stricter regulatory requirements and changing economic conditions. Our analysis of the bank shows that the FICC trading desk is Goldman’s most valuable division – being responsible for nearly 30% of the bank’s total value, according to our estimates. The unit generated $2.2 billion in revenues in Q2 – 10% lower than the $2.5 billion figure for Q2 2013 and 22% below the $2.9 billion it brought in for Q1 2014 (after adjusting for accounting gains or losses from a revaluation of its own debt). This is not bad given that the first quarter sees seasonally high debt trading activity each year, and also because the poor debt market conditions over a major part of the quarter pointed towards revenues of under $2 billion for the quarter.

While debt market conditions have definitely improved compared to the second half of 2013, the demand is still soft due to fears that the Fed may pull the plug too quickly on its asset purchase program. As the interest rate environment stabilizes over the coming quarters, we expect trading activity to normalize and trading yields to increase slightly. You can see how this impacts Goldman’s share price by making changes to the chart below.

Private Equity Gains Tipped Scale In Goldman’s Favor This Time

Revenues for Goldman Sachs’ Investing and Lending division, which houses its private equity unit, were $2.07 billion for Q2 2014 – 46% higher than the $1.4 billion seen a year ago and 36% higher than the $1.5 billion reported for the first quarter. It should be noted that the figure for Q2 2013 was already inflated by the bank’s sale of its stake in the Industrial and Commercial Bank of China (see Goldman Cashes In Its Remaining Stake In ICBC). As the bank attributes the high revenues this quarter to “company-specific events and strong corporate performance,” it likely has more to do with one-time private equity gains than from recurring revenue sources.

While an integral part of Goldman’s business model, the private equity unit has historically reported revenues that swing considerably from one quarter to the next. This can be seen in the chart below, which captures Goldman’s total revenues from principal investments in debt, equity as well as other investment vehicles.

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1. Citigroup Trading Revenue Will Likely Drop Further, CFO Says, The Wall Street Journal, May 27 2014 [↩]
2. Second Quarter 2014 Results, Goldman Sachs Press Releases, Jul 16 2014 [↩]