Goldman Shares Sink Despite Q3 Earnings Beat Over Long-Term Concerns

At first glance, Goldman Sachs’ (NYSE:GS) performance figures for the third quarter of the year released on Thursday, October 16 look good, with the investment bank beating market expectations for the twelfth consecutive quarter. ((Third Quarter 2014 Results, Goldman Sachs Press Releases, Oct 16 2014)) Revenues jumped 25% compared to the same period last year, allowing net income to rise 50% year-on-year. Also, each of the bank’s operating divisions posted marked improvements over their performance a year ago. But there are three factors at play that undermine Goldman’s strong results.

Firstly, the year-ago period (Q3 2013) was one of the bank’s worst quarters in the last three years, so even a mediocre performance in Q3 2014 is bound to shine in comparison. Secondly, Goldman’s decision to slash compensation by almost 29% in Q3 2014 compared to Q2 2014 was instrumental in the bank’s 10% improvement in earnings quarter-on-quarter despite a sequential 8% reduction in revenues. And finally, the biggest source of concern in terms of long-term sustainability is the fact that the bank’s Investing and Lending division was responsible for a little more than 20% of the revenues for this quarter. The division primarily generates profits by investing the bank’s own money, and although it benefits from very high operating margins, it is extremely volatile and will have to be scaled down over coming years in response to Volcker Rule restrictions.

Investors were quick to read into these problems, and promptly sent the bank’s shares 2.6% lower over trading on Thursday. We have pointed out these recurring problems with Goldman’s quarterly earnings on several occasions in the past, and have already factored them in our analysis of the bank. We have a $188 price estimate for Goldman’s stock – about 10% ahead of the current market price.

See the full Trefis analysis for Goldman Sachs

Performance Of Trading Desks Was Lukewarm

Unlike many of its peers, Goldman Sachs has chosen to focus on its fixed-income, currencies and commodities (FICC) trading business over recent quarters. Our analysis of the bank shows that its trading activities (FICC and equities combined) account for almost 45% of its total value – something we highlight in the chart above. But stricter regulatory requirements and changing economic conditions have made it difficult for the investment bank to generate the kind of revenues it has achieved in the past.

Adjusting the figures for any accounting gains/losses from a revaluation of its own debt, Goldman reported total trading revenues of just under $3.8 billion in Q3 2014 – 32% higher than the figure seen a year ago, but slightly below what it made in the previous quarter. Notably, equities trading yielded $1.6 billion in each of these three quarters, so the fluctuations in total trading revenues are completely from FICC trading. While debt market conditions have definitely improved in 2014 compared to the second half of 2013, debt trading activity has remained soft for the larger part of the year. The increased volatility stemming from global economic concerns was an important factor behind increased client activity towards the end of the quarter – something that likely helped rescue Goldman’s trading revenues for the period.

Lower Compensation Expenses

An interesting move from Goldman in Q3 2014 was its decision to slash compensation costs for the quarter to $2.8 billion. The reason why this stands out is because Goldman incurred $2.4 billion in compensation expenses in Q3 2013 when it earned $6.7 billion in revenues. So even though the bank’s revenues have increased 25% compared to the year-ago period, these expenses have only increased 17%. Additionally, compensation expenses for the previous quarter were a much higher $3.9 billion with revenues of $9.1 billion.

The discrepancy here is easier to understand when one compares the ratio of compensation expenses to revenues for Goldman over the last several quarters. This ratio has averaged around 40% over the last fifteen quarters, with the figure being 43% or 44% for ten of the fifteen quarters. So while the ratio figure was 43% for Q2 2014 and 35% for Q3 2013, it was only 33% for Q3 2014. This could suggest that the investment bank has delayed bonuses accrued in Q3 2014 to the next quarter.

The chart below captures operating margins for Goldman’s Investing and Lending division – the bank’s most volatile unit as is evident from the sharp changes in the margin figure over the years. You can see how changes in this margin affects Goldman’s share value by making changes to this chart.

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