Will Goldman keep rolling in 2007?

By SmartMoney

The headlines suggested Goldman Sachs (GS, news, msgs) had laid on the holiday cheer a bit thick when it awarded $16.5 billion in year-end bonuses, but shareholders have reason to cheer the massively profitable investment bank, whose shares were up 58% this year.

Goldman owes its stellar year to a steady rise in share prices, fueled by a robust proprietary-trading operation and a near-record year for mergers and acquisitions. However, Wall Street and the popular press have expressed doubts that the New York company will continue to storm the heights at the same pace it attained in 2006.

Through share-price gains alone, Goldman tacked on close to $27 billion in market capitalization in 2006, a year in which its global reach supplied the momentum it needed to rack up record profits and bestow record bonuses.

Average bonus: $622,000

CEO Lloyd Blankfein got the most attention for his staggering $53.4 million 2006 compensation, though Goldman's co-presidents, Gary Cohn and Jon Winkelreid, didn't fare poorly, either. Each got $26 million in restricted stock and option bonuses.

Averaged out through the entire bank, Goldman bonuses would have been $622,000 for each employee, more than twice the average for competitors such as Bear Stearns (BSC, news, msgs) and Lehman Bros. (LEH, news, msgs).

The indignant tone struck by pundits decrying the "gross levels of inequality in human well-being" of these top-drawer, top-brass payouts missed the point: This is a business about making money -- quite a lot of it -- and top bankers work essentially for the bonus money they get when they make money for their employer.

"This is the industry, all of finance services, where the company roughly has to split the revenue with its people," says Phil Guziec, an analyst at Morningstar. "Everywhere, from the big (investment banks) to tiny hedge funds to trading firms, if you don't do that, they can jump ship and work somewhere else."

Talent has a price, and Goldman was very clearly able to afford some of the best. Its equities-trading desk boosted its fourth-quarter revenues 105%, catching a market wave that lifted fiscal-year revenue to $14.3 billion, a 60% lift from fiscal 2005.

Its investment-banking unit, which management plans to push into middle-market transactions to expand Goldman's market share, also saw a hefty revenue boost, climbing to $5.6 billion, up 53% from 2005's very respectable $3.7 billion.

Total fiscal 2006 revenue, net of interest expense, reached $37.7 billion, nearly 50% above the previous year.

Lightest boat in a rising tide?

It's an impressive performance, and that may be the trouble with the stock. Goldman was able to capitalize on global economic conditions so well that Wall Street started to think it was just the lightest boat in a rising tide.

The stock had ebbed 1.5% from its peak close Dec. 8, as valuation concerns and macroeconomic risks tempered the market's enthusiasm.

"A victim of its own success?" asked analyst Jeff Harte in a Dec. 13 research note, written after Goldman posted fourth-quarter earnings of $6.59 a share, well above Wall Street's consensus estimate of $6.04 a share.

Mark Morgan of Rochdale Research, an independent equity-research firm in New York, weighed in a week later, downgrading the stock to "hold" from "buy," largely because of its strong second-half run-up, when shares climbed nearly 40%. Simply put, Morgan wrote, "the recent rise in the stock price has made the risk-return profile for the stock less attractive at its current valuation."

The bearish view isn't totally unwarranted. Goldman does what it does very well, but it's easier to stand out against a backdrop of strong economic conditions, Guziec says.

"You've got a great company that's doing well in healthy times," he says. "All global financial markets have been healthy in just about every dimension since around 2003 -- every one of their businesses is doing well all at once."

Guziec lauds Goldman for expanding its geographic reach. "They can take on all kinds of global uncertainty because they're so diversified. They're a far cry from an M&A (mergers-and-acquisitions) shop that used to swing between massive profits and losses the way it did in the past. And they connect to just about every transaction as a counterparty because their book is big."

Aggressive assumptions required

Goldman's happy 2006 isn't necessarily headed straight for a write-up in the Journal of Irreproducible Results, but a view on the stock is wedded to a view on the world economy, and that's a complex and risky undertaking.

It's also a hazard of assessing an investment in calendar-year increments, instead of the business cycles that really affect a business such as investment banking.

"We believe outperformance for the stock requires aggressive assumptions about future capital growth and returns on capital," Rochdale's Morgan wrote. "The combination of an inverted yield curve, cooling housing market and the potential for a slowdown in U.S. consumer spending raises the risk for further economic slowing in 2007, in our view."

Mergers and acquisitions, which make up a relatively small part of the investment banking sector's revenues, hit near record levels in 2006, thanks to both public- and private-investment activity. Steven Bernard, the director of M&A market analysis at Milwaukee investment bank Robert W. Baird, says that should continue at least through the first half of 2007.

Even when it does start to trail off, Goldman won't crumble in the face of a weaker economy. Still, investment-banking stocks aren't known for their consistency, Guziec cautions.

"The key to this is to remember that this is a lumpy business, and when things go south, they do so dramatically," Guziec says. "But remember, it's not a zero-sum game. If business dries up, they still get to keep that cash. But we don't expect this level of performance in perpetuity. If you don't expect it, then the valuation of the shares is a little bit rich."

As are Goldman's top executives and traders. And, as long as all cylinders keep firing, so are the company's shareholders.

This article was reported and written by Will Swarts for SmartMoney.