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Goldman Lowered to Underperform

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We have downgraded our recommendation on The Goldman Sachs GroupInc. (GS - Free Report) to Underperform from Neutral due to the recent fraud charges faced by the company.

Goldman is continuously facing fraudulent issues. In July 2011, the company was sued by several insurance companies for misrepresenting the financial condition of Freddie Mac as an underwriter of Freddie's offering of Series Z preferred stock in late 2007. The investors also alleged that Goldman misled them with statements and omissions related to the preferred stock offering based on which they invested $37.5 billion. Last year, however, Goldman settled a charge by paying $550 million for not disclosing to the buyers the role of a hedge fund in formulating the CDOs and taking a short position and betting on them to perform poorly in the open market. Therefore, we believe that such charges will dent Goldman’s reputation and its financials.

Though Basel 2.5 and Basel III capital guidelines have been finalized, their implementation is expected to take place over an extended transition period, starting at the end of 2011 for Basel 2.5 and end of 2012 for Basel III. The Dodd-Frank Act also focuses on similar leverage and risk-based capital requirements as required under Basel III. The Federal Reserve Board will be implementing the new leverage and risk-based capital regulations by January 2012. The proposed requirements will add further uncertainty related to the company’s future capital structure.

Uncertainty in economy growth and Goldman’s inefficient investment of funds led to the decline in annualized return on common equity (ROE) to 7.1% in the first quarter of 2011 from 10.1% in the prior quarter. Further, Return on Assets (ROA) also decreased to 3.2% from 3.5% in the prior quarter. The decline in ratios authenticates the company’s inefficiency in the use of assets.

Despite the broad macro concerns, Goldman experienced increased client activity across many of its businesses within Institutional Client Services during the first quarter of 2011, although volumes were still restrained. Reflecting seasonal upswing, the company recorded improved client activity in each of its major businesses within Fixed Income, Currency and Commodities (FICC) client execution, in addition to higher volumes across equities as reflected in equities client execution and commissions and fees. The increased activity reflects the company’s continual investments in the global client franchise, which is expected to prevail in the upcoming quarters.

Estimate Revision Trends

Goldman is expected to release its second-quarter 2011 earnings on July 19, 2011. Over the last 30 days, 15 out of the 19 analysts covering Goldman have lowered their estimates for the second quarter, while none moved in the opposite direction. Furthermore, for 2011, 14 out of the 20 analysts have lowered their estimates, while no upward revision was witnessed over the last 30 days.

Currently, the Zacks Consensus Estimate for the second quarter is operating earnings of $2.52 per share, a decline of 8.40% from the year-ago quarter. Furthermore, over the last 30 days, operating earnings estimates for the second quarter of 2011 and fiscal 2011 have plummeted from $3.63 to $2.52 and $14.19 to $12.75, respectively.

Fundamentally, we expect the company to benefit from its well-managed global franchise, strong capital base, and industry leading position in trading and asset management. However, regulatory issues including lawsuits are expected to affect the financials of the company in the upcoming quarters.

Goldman currently retains a Zacks #5 Rank, which translates into a short-term ‘Strong Sell’ rating.

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