If you thought the bad second quarter results from Goldman Sachs were a temporary blip, think again. This chart casts doubt on the bank’s longer-term prospects…
However hard you try to paint a flattering picture of Goldman Sachs’ second quarter results (it was a tough quarter for everyone, revenues are only down by 8% compared with last year, fixed income trading bounced back, things can only get better…), it’s hard to escape the fairly stark message in the chart above.
It shows the trailing 12 month (or four quarter) pretax return on equity at Goldman Sachs compared with the rest of the investment banking industry. Over the past four quarters pretax ROE was a miserable 7.2%. This is less than half the level it was over the 12 months to the end of June last year, and less than a quarter where it was this time two years ago.
In other words, setting aside the short-term volatility from one quarter to the next, profitability at Goldman Sachs has collapsed over the past three years. Revenues at Goldman Sachs in the 12 months to the end of June are down by 30% on a year earlier, but expenses have been cut by just 15% – which translates into a plunge in pretax profits of 60%.
This leaves the inescapable impression that, notwithstanding the bank’s efforts to cut costs and reshuffle its business, it is left with a legacy cost base and capital structure that can no longer generate the sorts of revenues required to be consistently profitable.
Of course, it hasn’t been a vintage few years for the rest of the industry either, but JP Morgan managed a pretax ROE in its investment bank of 20.0% over the past 12 months, while the rest of the industry (and that includes loss-making investment banks such as Credit Suisse and UBS) mustered 9.9% in the 12 months to the end of March.
To put this number in perspective, if you assume a 30% tax rate and a cost of equity of 12%, Goldman Sachs would need to have a pretax ROE of 17% to generate a net economic profit.
In order to generate that sort of ROE, Goldman Sachs would need to have made pretax profits of around $11.5bn over the past 12 months, compared with the $4.9bn it actually made. So Goldman Sachs would either have to magic another $6.6bn in revenues out of thin air (that’s a 25% increase on its actual revenues over the past four quarters) or cut costs by the same amount (which would add up to a 31% cut in costs over the past year).
Realistically, it will have to do a bit of both and perform the difficult balancing act of taking the knife to costs while at the same increasing revenues.
Glenn Schorr, banks analyst at Nomura, summarised the problem pithily when he said that Goldman Sachs ‘cannot thrive on quarterly revenues of $6.6bn’ (to put that in perspective, revenues in the second quarter of 2009 were $14.1bn). Brad Hintz, an analyst at Sanford Bernstein, was less polite when he wrote that ‘Goldman Sachs is trading like an honorary European bank’.
That may be unfair, but for the timebeing the business model of the once dominant investment bank on Wall St isn’t working – and it is hard to see that changing anytime soon.
Note: all of the above numbers exclude DVA / own credit, and where relevant all figures have been converted into US dollars at the prevailing quarterly exchange rate. The numbers are based on my analysis of the banks’ published reports.