Don’t hold your breath waiting for greater transparency in accounting. Especially if you invest in the financial services sector where secrecy still reigns supreme. It’s the same at most firms, but take Goldman Sachs as an example. Look at its first-quarter earnings and see what it reveals about its equities income.
Net revenues in the first quarter of 2002 for this part of the firm were $105 million. That’s 76% less than the 2001 fourth-quarter figure of $435 million and 96% less than the $1.18 billion it brought in during the first quarter of 2001.
It has been a terrible few months for the equities business. Volatility was way down, and the lack of M&A announcements hit the equity arbitrage trading side of the business.
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But there was also a small matter of “the negative effect of a single block trade”. Modesty, and fear of upsetting clients, forbids Goldman from saying which block trade that was but everyone knows it was Vivendi Universal. In early January Deutsche Bank, with Goldman as co-lead, underwrote a block trade for the French conglomerate, taking on 55 million shares. The offer price was e61, making the size of the trade e3.35 billion ($2.9 billion). Deutsche, as lead bank, took 60% of the deal, Goldman 40%. They will have bought the shares at a discounted price of, observers reckon, e58 a share.
The stock plummeted, hitting the sale and forcing Deutsche to say that it had taken “an investment stake” in the company. The stock now trades at around e45, though it was as low as e40 in early March – and Goldman says it sold out its position by the end of the quarter. That would make for a maximum loss of $18 a share. But observers believe the underwriters managed to sell at least half of their allocation, if not two-thirds, at e61. That would put Goldman’s maximum loss at between e162 million and e198 million. But let’s assume they’re cleverer than that, and don’t have to sell it all at e40 a share. So they get back, say, e35 million. That’s still a loss of e137 million to e163 million, or $121 million to $144 million. Other observers put the loss at under $150 million.
The loss on Vivendi, says CSFB brokerage analyst Joan Solotar, was so huge that it “appears to have virtually wiped out equities trading revenues for the quarter”. But Goldman, which prides itself on its equity franchise and which spent nearly $7 billion buying US equities market maker Spear Leeds Kellogg in 2000, feels under no compunction to disclose to its shareholders how much it lost on a deal so badly mispriced by one of its core business units. Solotar and other analysts tried to push CFO David Viniar for more information during the conference call but his response was to say more than once: “We won’t quantify it.” Admitting to some kind of loss is as far as they’ll go. To break it down further, they say, is not material.
It is being regarded, it seems, as a one-off. Solotar dubs such practices “one of the negative trends in the business – use of capital which shifts what was formerly a profitable secondary underwriting business to a riskier block trading business.” But she also says “the loss does not suggest anything for second-quarter equities trading, and such losses tend to make the company less aggressive, at least in the near term.”
But it could easily happen again to Goldman or any other leading equities firm. Issuers are part of the problem. “Because of the volatility caused by Enron a lot of companies are trying to pick their moment to go to market,” says a European head of equity capital markets. “So there are more accelerated deals. Most are being very protective of their intentions and allow no lead time.”
And bankers exacerbate it. They’ve been chasing almost any piece of business to prove the worth of their franchises, and to protect their jobs, in the low-deal environment. “It’s highly competitive and the fees are low,” says the ECM banker. “But there’s been paranoia in the ECM departments about lack of business.” Showing their nerve, though, the day after the Vivendi fiasco Goldman bid for and
won the mandate for Infineon’s e1 billion block trade and e1 billion convertible.
In Europe, roughly 50% of deals in recent months have been similar to Vivendi – sudden, accelerated equity offerings with no roadshow or back-up research, or outright bought deals. And that increases the chances of a Vivendi-style mistake happening again. That makes it a more material consideration for investors – is the broker they own taking more risk on underwriting than they are comfortable with?
Not disclosing it also simply increases speculation about what else Goldman might have lost – especially given that this quarter’s equities revenue was less than one-tenth of the revenue from the same quarter last year.
“It is certainly possible that there were other losses also related to the need, in the current competitive and low-deal-flying setting, to put more capital at risk to maintain market share in equity capital markets,” says Salomon Smith Barney brokerage analyst Guy Moskowski. Perhaps there were smaller losses on other block trades or they lost money arbitraging on the HP-Compaq merger fiasco. No-one outside the firm knows.
One other event that reduced revenues in equities was the change in status in Goldman accounts of its Nasdaq trading business. Along with all other brokers, Goldman has started to charge a commission for trading Nasdaq stocks as opposed to making money on the spread. Goldman chooses to account for commission revenues in the asset management and securities services section.
The bank only switched in January, whereas the quarter started in December, so some revenue is still spread-based and accounted for under equities. But again we’re not allowed to know how much. Caveat emptor.
