Stockwatch: Goldman, Sachs & Co.

So early today, Goldman announced Q3 earnings, and again, it blew away the numbers. Still, the market has gotten used to Goldman outperforming and had high expectations, especially after JP Morgan’s great numbers the day before.

First, the numbers. Goldman earned $3.19 billion, or $5.25 per share, compared to the average analyst estimate of $4.24 per share. Revenue was $12.37 billion, again, far in excess of analyst estimates of $11.02 billion. The firm’s return on equity was 21.4%, despite high capital levels that would drag down the return on equity.

Next, the more interesting part: the business model and its sustainability. This is the part of the analysis that they never talk about post earnings. A quick look at the income statement tells you the following:

- Increased Fixed Income Share. The key was trading and principal investments, and in particular, fixed income. But in addition to skill, Goldman’s revenues in this area were driven by the disappearance of its competitors Lehman (a bond house), Bear Stearns and to a certain extent, Merrill Lynch. As Goldman’s CFO Dave Viniar said on the conference call, “we’re getting a bigger piece of a smaller pie.” Consider the Trading and Principal Investments line for the last three quarters: $5.7 billion in Q1; $9.3 billion in Q2; and $8.8 billion in Q3.

- Cost Cutting. The media coverage never talks about this, but cost cutting made a significant contribution to the bottom line. Again, look at the operating expense line: $6.8 billion in Q1; $8.7 billion in Q2; and $7.6 billion in Q3.

- Investment Banking Declined. Investment banking fell from $1.4 billion in Q2 to $899 million in Q3 , mostly due to a decline in leveraged loans. While a negative, investment banking is traditionally lowest in the 3^rd quarter because of slow IPO and merger activity during the summer, and because of vacations.

All this speaks to the trend in earnings: $3.49 per share in Q1; $4.93 per share in Q2; and $5.25 per share in Q3. Today, the stock closed at $188.63. And look at the profit margin by quarter: 17.6% in Q1; 19.8% in Q2; and 24.5% in Q3.

Today, the stock closed at $188.63. Based on 2009 estimated earnings of $17.74, that’s 10.6x PE. Based on 2010 estimated earnings of $18.05, that would be 10.5x forward earnings (these are today’s numbers, so these are pre-Q3 earnings estimates).

Now we get to the big question – what does Goldman look like in the long term? Are these numbers sustainable? It’s very possible.

- Investment Banking. Next year, in 2010, IPOs and mergers and acquisitions activity should pick up as the big fish with cash buy out the small fish that are still struggling upstream.

- FICC (Fixed Income, Currency and Commodities). You would think that a compression in the yield curve would hurt revenues here, but Meredith Whitney asked this exact question on the earnings call: “When the government stops buying assets (Such as mortgage securities. The government’s buying keeps prices high, yields low, expanding the yield curve), who will be the substitute buyers and how will that reduced buying affect Goldman’s business?” Dave Viniar’s answer: “There’s plenty of other buyers with lots of cash to spend. It won’t affect us because our profits are not based on positioning, but on velocity.” Meaning volume, and the commission earned on the turnover, is what is generating profits. If we are to take him at his word, this means that the fall of Lehman and Bear brought them business which can be expected to continue into the future. Time will tell, but for the moment I think we can take him at his word.

- Principal Investments. This is always a tricky line, because the company can manage this number, and what drives this number changes. This quarter, $344 million came from the sale of Goldman’s stake in ICBC (share in the Chinese bank) plus $911 from “Other corporate and real estates gains and losses.” Chances are, these are sales and mark-ups on assets. Whether this level will be maintained is hard to say. One fact that bodes well for this area is Goldman’s high level of capital. When the credit crisis recedes further, Goldman is likely to deploy the capital that it is holding in reserve. So no certainty here, but Goldman can probably find ways to sustain this number if necessary.

All in all, there’s no reason to think that Goldman couldn’t maintain $5 per share in earnings per quarter through 2010 (given $5.25 this quarter and $4.93 in the previous quarter). That would mean $20 per year in earnings, and with a 10x – 11x PE, that’s $200-210 on the conservative side.

Here’s one other way to calculate future share price. Book value per common share increased 4% to $110.75 this quarter. Based on today’s $188 close, the stock trades at 1.7x book. If we were to assume that book value could be increased at 4% per quarter, that gives us a $220 stock. And if Goldman increases its ROE, then of course, we get a bigger number.

If Goldman hits $220 within the next year, based on today’s $188 price, that would be a 17% gain. I’m currently long Goldman and would buy at this level. It may still trade down a bit as the stock rests, but that’s just another buying opportunity.