Goldman Downgraded to Underperform

We have downgraded our recommendation on The Goldman Sachs Group Inc. (GS - Analyst Report) to Underperform from Neutral. The downgraded recommendation is based on the expectation of continued lower top line as in 2011, coupled with fundamental pressure on the banking sector.

During 2011, the operating environment was dominated by macroeconomic concerns, which resulted into subdued client activity. The market was focused on sovereign risk within the Eurozone. The complexities surrounding various economic considerations have created terrific uncertainty regarding the state of the world's economy and resulted in limited confidence among market participants. Therefore, owing to these uncertainties, many of Goldman’s clients have significantly reduced their risk exposure, and thus, the activity levels declined consequently.

In December 2011, the Federal Reserve came up with a set of new stringent rules for the largest U.S. banking institutions. This step was taken to stabilize the financial system. Moreover, even stricter rules will be implemented for the companies with over $500 billion in assets including JPMorgan Chase & Co. (JPM - Analyst Report), Goldman and Citigroup Inc. (C - Analyst Report) as they are restricted from entering credit exposure of not more than 10% with any other bank. Through this rule, the Fed will limit excessive interconnections between banks, and will minimize the chances of risks exposed to a single financial institution as a percentage of the bank's regulatory capital.

Most of the U.S. bank officials are in the opposition of these new rules. According to them, such stringent rules will slow down the economic recovery as holding extra cash will limit the availability of credit in the market and would affect business growth.

On the flip side, in the current difficult economic and financial conditions, Goldman has taken an internal initiative to identify areas where it can operate more efficiently. The company targets about $1.4 billion in run rate compensation and non-compensation reductions and expects to complete them as soon as possible.

Moreover, in the ongoing challenging environment, Goldman continues to balance near-term uncertainties with longer-term strategic goals. It plans to hold more capital to protect itself from the current macro uncertainties and to be able to stick to the commitment of providing strong relative return to shareholders. The company proposes to invest in attractive regions and businesses to enhance growth and reduce the number of businesses experiencing lower client demand.

Goldman reported fourth-quarter 2011 earnings per share of $1.84, significantly surpassing the Zacks Consensus Estimate of $1.46 per share. Moreover, earnings compared favorably with the loss of 84 cents per share reported in the prior quarter. In spite of the global macro-economic concerns, the results improved sequentially driven by an increase in investment banking revenues. However, higher operating expenses were on the downside.

For the full year, revenue was $28.8 billion, down 26% from $39.2 billion in 2010. Moreover, this compares unfavorably with the Zacks Consensus Estimate of $29.7 billion.

Though the company reported profits, increased operating expenses and lower equity trading revenues remain a matter of concern. Though, we anticipate Goldman to benefit from its well-managed global franchise and strong capital base, regulatory issues, including lawsuits, are expected to dent the financials of the company in the upcoming quarters.

Goldman currently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.

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