Business Analysis
As you can see, Goldman’s year-to-date results are hardly something to write home about. In fact, in terms of revenues through the first three quarters of the year, 2016’s results are the poorest since 2011.
Source: Simply Safe Dividends
Only Goldman’s most recent quarter showed any signs of a recovery in sales, though improvements in operating margin and EPS have been underway for three and four quarters, respectively.
That’s due in part to the bank’s strong emphasis on cost cutting. For example, in the last quarter expenses fell 26%, mainly due to non-compensation expenses declining by about 40%.
In addition, Goldman is attempting to diversify into more stable retail (i.e. consumer) banking thanks to a recent acquisition of General Electric Company (NYSE:GE) Capital’s deposits that saw its retail banking deposits soar to over $100 billion, up from just $15 billion in 2007.
Source: Goldman Sachs Investor Presentation
However, while Goldman has managed to make good progress in diversifying its revenue streams and cutting expenses, there are two main problems faced by the bank that make JPMorgan Chase and Wells Fargo seemingly better long-term investments.
The first is that retail deposits, which serve as a cheap source of capital, despite their impressive growth, still represent a very small source of funding for the bank. In addition, retail banking is generally far more stable than investment banking because consumers continue to use retail banking services even during economic downturns while things like IPOs and mergers and acquisitions tend to fall off a cliff.
In addition, one of the biggest earnings growth catalysts for retail banks is the potential for rising interest rates. If the Federal Reserve’s current projection that interest rates will rise to 3.25% by the end of 2020 proves true, certain banks will be big beneficiaries.
Hybrid consumer/investment banks such as JPMorgan Chase, Citigroup, and Bank of America are very well situated to benefit from rising interest rates. That’s because the net interest margin, or difference between the cost of borrowing and lending to consumers, widens in a higher rate environment.
In fact, with just a 1% increase in short and long-term interest rates, Citigroup, JPMorgan Chase, and Bank of America stand to earn an extra, $1.4 billion, $3 billion, and $5.3 billion per year in profits, compared to just an addition $419 million for Goldman Sachs.
In other words, Goldman Sachs’ very small presence in retail banking results in higher costs of capital, more cyclical revenues, and less potential upside in the event of interest rate normalization.
In addition, the bank faces another competitive disadvantage relative to its rivals.
It’s a lot easier to cut costs at a retail bank because investment banking is more reliant on the skills of individual employees, which requires larger bonuses to retail top talent. This means that hybrid retail/investment banks such as Citigroup, Bank of America, and JPMorgan Chase have the potential for far larger margins and higher returns on shareholder capital than investment banks such as Goldman or Morgan Stanley.
For example, thanks to large bonuses, over the past two years roughly 40% of Goldman’s revenue went to employee compensation. Since investment banking profits typically rise when the economy and market are doing well, Goldman has little hope of cutting compensation expenses during good times, while its hybrid rivals are able to continue cutting costs at their retail operations and thus achieve superior economies of scale.
Or to put it another way, under today’s new, more regulated banking environment, Goldman Sachs has less profit potential than Citigroup, Bank of America, and JPMorgan Chase.
