Market Overview

Goldman Beats Earnings Estimates on Lower Tax Rate, Misses Revenue and Cuts Employee Compensation

Goldman Sachs (NYSE: GS) has reported a 58% drop in profits, with net income dropping to $1.01 billion ($1.84 a share) for Q4 2011. However, the bank still exceeded expectations, with per-share earnings 60 cents above previous analyst estimates.

There is usually a seasonal slowdown during the December holidays that makes end-of-year results fall below the previous quarter, but the drop in Goldman's revenue is more than that. The investment bank has been hit by lower trading volumes in both equities and FICC (fixed income, currency, and commodities). The drop in merger and acquisition activity and new IPOs gave the investment bank little opportunities to drum up business that would translate into revenue.

However low the profits are, it's better than the company's third quarter performance, when Goldman posted a loss of 84 cents per share--only the second time the bank ever posted a loss.

The return to profitability was mostly thanks to the bank paying out less taxes than analysts had anticipated. At a tax rate of 18.8%, Goldman paid less taxes than many middle class earners.

This better tax rate is not necessarily a good thing, because it points to the fact that Goldman's normal trading activity was down sharply. Because of this, tax preference items such as interest from municipal bonds and qualifying small business stock--which are taxed at a lower rate--were a bigger share of the bank's earnings, thus driving their total tax rate down. This was only possible because Goldman's total trading revenues were down.

Another factor in the improved earnings was a cut in employee compensation, with salaries and bonuses slashed to a mere $367,057 average annual compensation per employee. I doubt many will be crying for impoverished Goldman Sachs bankers, and many would agree that the pay cut is long overdue. Goldman Sachs also cut its staff by over 2,000 in the past year, with analysts expecting more job cuts to come.

With such fat paychecks, there is still room for Goldman to cut compensation as well. Charles Bobrinskoy, vice chairman of Ariel Investments, told Bloomberg that investment banking "has probably been overcompensated for a long period of time and so we're getting some appropriate adjustment in compensation, particularly given the new levels of profitability."

The bill for paychecks, bonuses, and benefits came to $2.21 billion for Goldman, down 2% from last year thanks to the cuts.

Goldman stocks are barely up in pre-market trading just shy of the $99 mark as investors digest the news. Analysts have recently set price targets above $110, and with an EPS below 7, the stock looks like a bargain. However, Goldman is facing enormous challenges. Thanks to the Dodd-Frank Act, Goldman will be facing the Volcker Rule in July, which will place greater restrictions on how investment bankers can trade. Investment banking remains an easy target for greater regulation, and the risks of tighter rules on investment banks such as higher capital requirements or broader disclosure have never gone away. After Occupy Wall Street made "income disparity" a household term, can investment bankers avoid greater scrutiny?

An even greater threat is higher taxes. Can Goldman sustain an 18.8% tax rate at a time when even Republicans are campaigning against "vulture capitalism"? I don't think anyone alive can remember a time when investment banking was so widely despised, making it an easy target for greater taxes and regulation. The fact that Goldman was able to capture a lower tax rate due to tax preference items weighing more heavily in the company's portfolio suggests that the lower tax rate is a one-shot jolt that the company will not be able to sustain.

ACTION ITEMS:

Bullish:
Traders who believe that Goldman beating expectations will boost the stock might want to consider the following trades:
  • Buy Goldman and wait for a short-term upswing as the market sees promise in Goldman Sachs. Investors might become optimistic in the new year, expecting future drops in pay to widen the investment bank's operating margin and help compensate slightly for lower trading volumes.
  • Buy and hold Goldman: If you think that Goldman's jump in earnings will continue as spring's greater trade volumes create more investment opportunities, Goldman might be a good play for a while now, before the market drives up the price thanks to the bank's return to profitability.

Bearish:
Traders who believe that Goldman's results just aren't good enough may consider alternative positions:

  • Short GS: Possibly, the market might initially applaud the results only to sour on them by the end of the day. This spike might be a good opportunity to sell short and wait for the price to fall as investors realize that falling trade volumes, greater regulation, and future higher taxes will drag on the stock.
  • Invest in commercial banks: While Goldman is suffering from lower investment banking opportunities, a rise in mortgage activity lifted Wells Fargo (NYSE: WFC) earnings in their report Tuesday. If banks are returning to lending as their main revenue engine, we might see commercial banking become a more attractive endeavor than Wall Street.

Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.

Posted-In: Earnings Long Ideas News Short Ideas Trading Ideas Best of Benzinga

 

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