Tuesday, April 14, 2009

Goldman Sachs and the Financials

A few thoughts on Goldman's two announcements last night.

First off, I find it somewhat amusing that the entire financial arena is trading up in the pre-market on Goldman's earnings release (except Goldman which is trading slightly lower). Most of Goldman's business segments registered declines in the quarter. The quarter was really driven by a blowout performance in the fixed income, currency and commodity (FICC) trading group, where revenues more than doubled year-over-year. On the conference call, Goldman made a point of stressing that FICC benefited from less competition.

So, the business lines that the large competitors operate in are still in decline. The one bright spot is a business line that the competition pulled back from. This competitor retrenchment meant outsized profits for Goldman, but it also means that the competition won't be enjoying the same boost to revenue and earnings. Let's not forget that trading is extremely lumpy. Projecting this type of performance forward would not be prudent.

Goldman clearly benefited in the quarter due to an opportunity that the competition provided. Does it really make sense to view Goldman's report as bullish for the entire sector?

Also, Goldman reported that they will be raising $5 billion in equity to help fund the repayment of the TARP capital. The TARP funds cost Goldman 5% for the first 3 years and then 9% afterward. So, Goldman wants to dilute its shareholders to the tune of 8% to pay back funds that are costing it 5%. There is no way that Goldman could get access to a cheaper $10 billion right now.

Recall, the preferred deal that Buffett struck with Goldman last September. That will cost Goldman 10% (on $5 billion) every year. In addition, Buffett received warrants on $5 billion of new Goldman shares. So why isn't Goldman using the funds it will raise from the offering to pay off the Buffett preferred? Goldman would have to pay a 10% penalty, so the cost today would be $5.5 billion, but it would save $500 million a year. Over 5 years, that would work out to $2.5 billion. Instead, Goldman wants to repay TARP. A $5.5 billion repayment of TARP would save $275 million over the first three years (at 5% interest) and $495 million over subsequent years.

To sum up, paying back Buffett would save $2.5 billion over 5 years while paying back a comparable amount of TARP would save just over $1.8 billion over 5 years. Goldman could save $685 million over the next 5 years by paying back Buffett instead of the Treasury. The only logical explanation is that the cost of the TARP funds is more than just the 5% financial cost. Goldman doesn't want the government dictating how it runs its business. More specifically, I suspect, Goldman doesn't want the government limiting their compensation.

It looks like shareholders are getting a raw deal. They are being diluted to raise funds to repay inexpensive funds so management can extract more value from the company in the form of higher compensation which will be paid by the same shareholders. Furthermore, the folks at Goldman are bright people. They're not selling stock here because they think its cheap. If they're selling, I'm not buying.

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