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Morningstar | Goldman Performs Well in Shaky 2Q; First Quarter of 2020 Goals and New Initiatives in Spotlight

Narrow-moat Goldman Sachs reported respectable performance in the second quarter, despite swings in sentiment regarding U.S. trade policy and global monetary policy. The company reported net income to common shareholders of $2.2 billion, or $5.81 per diluted share, on $9.5 billion of net revenue. Net revenue decreased 2% from the previous year, as a 20% increase in principal investment equity gains to $1.5 billion wasn't enough to offset declines in debt underwriting, fixed income, currency, and commodities (FICC) trading, and asset management incentive fees. Overall, the company had a reasonable annualized return on equity of 11.1% in the quarter and return on tangible equity of 11.7%. We don't anticipate making a material change to our $257 fair value estimate for Goldman Sachs and assess shares as modestly undervalued with them trading near the company's book value per share of $214.10.

Management continues to emphasize new initiatives, while whetting investor appetite for the release of more concrete goals in January 2020. An announced change in the second quarter was the company putting several of its alternative investment management teams under one umbrella and emphasizing more capital raising for funds from third parties. This fits into the ongoing theme of a shift in business mix to more capital-light and predictable earnings businesses. Goldman Sachs is also talking more about its new initiatives, like digital banking and treasury management, as being "scale" businesses that will have a different cost and return profile than traditional investment banking, generally more fixed non-compensation expenses and high incremental operating margins once fully scaled. The company is heavily investing in new initiatives in 2019 through 2020, booking $275 million of costs related to many of these projects year to date, with the market eagerly awaiting more clarity into the earnings potential of these initiatives in the 2020 strategic update.

In the second quarter, Goldman Sachs announced it was buying wealth management firm United Capital Financial partners for $750 million. United Capital has approximately $25 billion in assets under management and over 220 advisors. This compares with Goldman Sachs' existing wealth management and Ayco businesses that have nearly $500 billion in client assets.

Overall, we thought that the price tag for United Capital was a bit high, but the $750 million price tag is only about 1% of Goldman Sachs' current market capitalization and Goldman seems like it was paying for capabilities and synergies instead of the value of he United Capital as a standalone business. United Capital fills a gap in Goldman Sachs' wealth management business. Goldman's current wealth management business primarily caters to ultra-high net worth clients and corporate executives through its Ayco business. However, United Capital should allow Goldman Sachs to service non-executive employees at the corporations that Goldman has relationships with. Additionally, there should be some synergy with the company's traditional banking franchise and potentially its asset management business.

In regards to Goldman Sachs' partnership with Apple for launching a credit card, we see its principle aim as marketing and to garner retail customer relationships. Other financial service firms were supposedly in the running for the Apple credit card relationship, but likely dropped out due to the challenging economics of the agreement. While we don't currently believe the economics of the business will be fantastic for Goldman Sachs, the company likely gained some benefits that other financial service firms may not have reaped. By leveraging the Apple brand, Goldman should be able to gain mass visibility and new main street relationships. If another traditional bank were to partner with Apple, the bank might have gained little additional mind share among main street customers and fewer new retail relationships. For example, if Apple were to have partnered with Bank of America, Bank of America already has high awareness among most Americans and many Americans already have an account with the bank, so Bank of America would have had to rely on the credit card agreement with Apple for incremental profits, while Goldman Sachs may garner completely new retail relationships that may eventually translate into deposits, loans, or wealth management services.

Goldman Sachs received a non-objection to its 2019 capital plan from the Federal Reserve. The company's capital plan is for $8.8 billion: $7 billion of repurchases and $1.8 billion of common stock dividends. On a per share basis, Goldman Sachs' quarterly common stock dividend is increasing nearly 50% to $1.25 from $0.85. The $8.8 billion of capital returns is equivalent to about 90% of the company's net income to common shareholders in 2018, and the new dividend equates to about a 20% payout ratio. Given where the stock is currently trading, repurchases at this level should be modestly accretive.

Real GDP growth in the United States in the first quarter was 3.2% annualized, an improvement from the 2.2% rate of fourth-quarter 2018. Recent economic data indicates lower growth in the second quarter, with the Federal Reserve Bank of Atlanta forecast model estimating GDP growth of 1.4%. The consumer price index increased at an annual rate of 0.7% in June, declining from the near-1% rate in May. And, the core level of inflation, which excludes food and energy, posted a 3.5% annualized rate in June, breaking a streak of four consecutive months below the Fed’s 2% target.

The ISM purchasing managers' manufacturing index, generally the first data release following month-end, fell to 51.7 in June, its lowest level since October 2016. Similarly, the ISM non-manufacturing index, at 55.1 for June, also fell to a multi-year low. An index level over 50 represents continued expansion, and the ISM metrics indicate a potential slowdown, rather than imminent recession. The IMF projects GDP growth of 2.3% for the U.S. economy in 2019, with forecast growth declining to 1.9% in 2020. The IMF is also forecasting 2% inflation for the year, with prices expected to rise at a 2.7% clip in 2020.

The Federal Reserve maintained the target range for interest rates at 2.25%-2.50% following its June meeting, holding benchmark rates stable since the last increase in December. In contrast to previous meetings, the vote to maintain rates was not unanimous, with one member voting to lower rates. The Fed has made clear it will "act as appropriate to sustain the (economic) expansion" and Chairman Jerome Powell has indicated that rate cuts are on the table with intensifying economic and geopolitical risks. Any near-term rate cuts would likely be more to prevent a significant slowdown in the U.S. economy than an indication that we’ve entered into a recession. The futures market is anticipating a rate cut at the next Fed meeting in late July, and it appears a dovish shift in Fed monetary policy is on the horizon.