Bes Stocks To Buy 2014, Best Stocks For 2014: Goldman Sachs, Morgan Stanley Bring Out Chainsaws

Friday, January 20, 2012

Goldman Sachs, Morgan Stanley Bring Out Chainsaws

Pure-play investment banks Goldman Sachs(GS) and Morgan Stanley(MS) will be under pressure to cut compensation, people and bonuses to boost profits as the outlook for their core capital markets and trading businesses remaining weak heading into 2012.

Their flexibility to do so will be tested when the firms report earnings this week; Goldman is scheduled to report on Wednesday, while Morgan Stanley reports on Thursday.

Analysts ratcheted down fourth-quarter estimates for both Goldman Sachs and Morgan Stanley in the last several months, as it became evident that the weakness in capital markets was likely to stay for some time. Yet, the disappointing trading and investment banking performances from JPMorgan Chase(JPM) and Citigroup(C) in the fourth quarter may have lowered the bar even further.

Investors will be paying attention to management plans to reduce workforce, cap bonuses and defer a greater portion of compensation to the future, all steps that Wall Street has taken in the past to juice up profits when revenues disappoint.

But competitive pressures may prevent banks from cutting too close to the bone and it is quite likely that compensation cuts might not be able to fully offset the declines in revenues in 2011, according to analysts.

Meanwhile, it remains to be seen whether further initiatives on the compensation- and headcount- reduction front will be enough to offset the more long-lasting impact of a changing regulatory environment, one that restricts taking proprietary bets with capital and using leverage to boost returns to shareholders.

2011 may have been a forgettable year for the big banks overall, but the headwinds for Goldman Sachs and Morgan Stanley are particularly intense in 2012.

The European crisis remains a major ov! erhang f or capital market activity heading into the first quarter, usually a seasonally strong one for investment banks.

Of greater concern is the impact the Volcker rule, expected to be implemented in July, will have on traditional investment banking business models.

The draft of the rules has raised concerns that the high degree of monitoring and compliance will increase the cost of trading. Worse, some fear that the narrow definitions of traditional functions of traders such as market-making might impact liquidity, particularly in fixed-income markets.

So far, banks have remained cautious in their commentary about the impact of Volcker, as regulators continue to seek industry input on a range of issues. But the uncertainty has made it difficult to make long-term decisions on capital allocation and staffing.

Goldman Sachs has, so far, maintained that the current weakness in the environment is purely cyclical and it would take sustained weakness for more than two years for it to make sizeable cuts to its workforce. Still, in the first nine months of 2011, Goldman laid off about 1900 jobs across entities, bringing its total workforce to 36,800.

Any significant cuts to compensation in the fourth quarter at Goldman, best known for its hefty bonuses, will get the markets to sit up and take notice. Its 38,700 employees in 2010 earned an average salary of $397,312, a rough calculation shows. The averages are, of course, skewed by eye-popping bonuses paid out to the company's partners.

Goldman has historically has a fourth-quarter compensation "true-up", a practice wherein it adjusts its compensation relative to revenues in the final quarter to boost overall profits. Analysts however, do not expect the company to make significant adjustments this time to its compensation-to-revenue ratio.

Wells Fargo Securities analyst Matthew Burnell expects the bank to report a compensation-to-revenue ratio of 43% in the ! fourth q uarter, higher than the 39% reported in 2010, given a "challenging top-line picture."

Overall, he expects compensation to decline by just 20%, led by a 10% reduction in employee count. That could lower the average compensation per employee by a little more than 10% to about $350,000.

That may not be enough to please shareholders, who are increasingly tired of single-digit returns on capital. It certainly won't be enough to silence critics of Wall Street who argue that traders and investment bank employees are overpaid.

But Wall Street has had less flexibility to use compensation as a lever in recent years since the crisis, primarily because the backlash against bonuses has led them to change compensation practices.

A greater portion of compensation is now fixed, compared to the past. Banks are deferring bonus payouts to discourage short-term risk taking. That has the effect of reducing compensation costs in the current year, but increases the payout in future years, reducing the flexibility to tinker significantly with compensation costs.

Universal banks including JPMorgan Chase(JPM) and Citigroup(C) have nevertheless made efforts to trim salaries for capital markets employees. Compensation declined 36% in 2010 at JPMorgan's investment banking division, with the average compensation per employee declining 8% to $341,551.

Citigroup does not breakout its "securities and banking" compensation costs but the bank is laying off nearly 5,000 workers, 25% of which is in the investment banking business.

At Goldman's smaller rival Morgan Stanley, plans are underway to lay off 1600 employees by the first quarter of 2012. Because of its substantial wealth management operation, Morgan has a slightly different compensation structure relative to investment banking peers, with compensation often taking up as much as 50% of revenues.

The in vestment bank may cap cash bonuses for senior management for 2011 at $125,000 and defer as much as 75% of their compensation, up from about 65% in recent years, according to a Wall Street Journal report . The same report suggested that Goldman Sachs may cut the bonuses of its 400 partners by half.

More long-term changes could still be in store for Goldman and Morgan Stanley employees. Bernstein analyst Brad Hintz expects Goldman to respond to Volcker by automating market making activities; reduce staffing on trading floors and shrink overhead to enhance business margins. "We foresee a "'new"' Goldman Sachs that will remain a powerful global securities house and investment bank, but with a much more tightly limited balance sheet and a much changed fixed income business model," the analyst wrote in a recent report.

Bernstein believes that "the new Morgan Stanley will be less reliant on trading and have alower-risk business model, will control the leading market share position in retail brokerage, and will maintain its top ranking in M&A advisory and equity capital markets."

Analysts are expecting Goldman Sachs, scheduled to report Wednesday, to post an earnings per share of $1.46, according to consensus estimates from Zacks Investment Research .

Revenues and earnings per share are expected to come in at $6.544 billion and $1.24 per share respectively, according to consensus estimates from Thomson Reuters.

Estimates for Goldman, in fact, vary quite widely across the Street, ranging from 70 cents on the low end to $2.5 on the upper end, a reflection of just how difficult it is to predict trading revenues.

Barclays Capital analyst Roger Freeman expects Goldman's 2011 income to be its lowest since 1998 and its revenues to be the lowest since 2005.

Morgan Stanley is expected to report a loss of 58 cents per share, according to consensus estimates from Zacks Investment Research.. !

The company has said it will take a $1.8 billion pre-tax loss in the fourth quarter, arising out of a settlement with bond insurer MBIA(MBI) over lawsuits related credit default swaps purchased for protection on commercial mortgage-backed securities. >To follow the writer on Twitter, go to http://twitter.com/shavenk.

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