Goldman to Investors: No Soup for You

JULY 20, 2011   THE WALL STREET JOURNAL

By DAVID REILLY

When it comes to dividing the spoils at Goldman Sachs Group, the firm is making sure employees get hearty helpings, while shareholders are left with crumbs.

The Wall Street titan posted a disappointing first quarter. Revenue in Goldman's core fixed-income trading division fell 63% sequentially and 53% year-over-year due to reduced trading activity and economic uncertainty. That, along with weakness in its lending-and-investing division, led to an 18% year-on-year decline in overall firm revenue.

The result was a very un-Goldman-like return on common equity of 6.1%. Investors looking at that number could be forgiven for thinking they had mistakenly picked up Morgan Stanley's results—due Thursday—since Goldman's long-term average is about 20%. Meanwhile, compensation, although down 16% in dollar terms, was equal to 44% of revenue, unchanged from the first quarter and not far off the firm's long-term average of around 45%.

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As long as that disparity between returns and compensation persists, Goldman's stock will suffer. And returns don't look likely to bounce back soon. Speaking on Goldman's earnings call, Chief Financial OfficerDavid Viniar gave a weak reiteration of the firm's goal of a 20% return target, acknowledging this may not happen by the end of the year.

Mr. Viniar did say Goldman is targeting $1.2 billion in cost reductions, which could include the elimination of 1,000 positions from a work force of about 35,000. Yet he added that expense cuts wouldn't mean lowering individual compensation levels for employees, just cutting staff.

For now, the firm seems to figure it needs to continue paying for talent even as it works its way through a dry spell. There is some argument to be made for waiting out a cyclical downturn, especially as the firm's investment-banking arm is performing well. Revenue for that business was up 54% year-on-year, to $1.45 billion.

But the big worry for investors concerns the all-important trading business. If new regulation, higher capital requirements and a reduced risk appetite among investors add up to a structural, not temporary, shift in Wall Street's business model, then Goldman's compensation levels are out of whack with the new reality.

Failure to recognize that will hurt Goldman's valuation. Investors seemed to drive that very point home Tuesday, as the stock traded below its book value of $131.44 a share. This is especially telling since Goldman's balance sheet looks solid and its capital ratios are strong. And with the continued threat of government investigations, there is even the risk Goldman's stock falls to its tangible book value of $121.60.

The clock is ticking. The onus is on Goldman to show it isn't a relic of a Wall Street model whose time has come, and gone.