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Goldman Posts Gaudy Earnings, but Other Numbers Aren't So Grand

Expense growth and the sources of revenue gains could come back to haunt investors in the rich stock.

Goldman Sachs (GS) - Get Report breezed past analysts' fiscal third-quarter earnings estimates Tuesday, but Wall Street's most powerful firm did so by booking outsized private equity gains and relying on traditionally volatile trading revenue.

In Goldman's fiscal third quarter, ended Aug. 25, earnings totaled $824 million, or $1.62 per share. The per-share number is 24% higher than the $1.31 posted in the year-ago period, and 9.5% above the $1.48 registered in 2000's second quarter. Analysts surveyed by

First Call/Thomson Financial

expected Goldman to make $1.51 per share in 2000's third quarter.

But Goldman would've fallen well short of the First Call third-quarter estimate if it hadn't been for a massive $480 million in revenue from its principal investment line, which mainly reflected big gains in its private equity portfolio. Also negative: Goldman is experiencing cost pressures. In the third quarter, expenses were 36% higher than in the year-ago period. By contrast, revenues grew by 33%. A Goldman spokeswoman points out, however, that in the first nine months of the firm's fiscal year, revenues and expenses each rose 33%. And on a conference call Tuesday, David Viniar, Goldman's finance chief, pointed out that compensation levels tend to be heavier in the third quarter, because that's when many new recruits are taken on.

Priced for Perfection?

However, the uptick in expenses and the lumpiness of third-quarter revenues could lead some to question whether Goldman deserves the premium valuation on its stock, which trades at 19 times forecast 2000 earnings, and has risen by nearly a third in the last three months alone. Goldman's shares were down 63 cents at $117.94 Tuesday.

The quarter also shows Goldman's increased dependence on its trading desks, which could grow after the firm completes its planned

acquisition of

Spear Leeds & Kellogg

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, a large Wall Street trading firm.

At $872 million, third-quarter revenue from trading in bonds, commodities and currencies rose 38% from the prior quarter and 32% above the year-ago level. That number significantly exceeded the seven-quarter average of $770 million. (This is the average of the seven quarters from third quarter 2000 back to first quarter 1999.)

Meanwhile, equity trading revenue of $763 million was 30% below the prior quarter's total, but 67% above the year-earlier period's. This, too, exceeded by a large margin the seven-quarter average -- of $667 million.

Overall, Goldman's trading and principal investments business line accounted for a sizable 47% of net revenue in the third quarter, its highest share since the second quarter of 1999.

Smoothing Out

A Goldman spokeswoman denies that the firm is relying too much on trading: "The results were diversified across the

trading line; there was no one item that popped." She says the private equity gains chiefly behind the principal investment gain were split more or less evenly between realized gains (for which Goldman gets actual cash) and paper gains, derived from any market appreciation. The spokeswoman adds that the principal investments line "averages out pretty smoothly over a longer period of time."

Maybe. But it certainly helped this quarter. The $480 million figure is well above the $189 million seven-quarter average for principal investments. The difference between those two numbers is $291 million. Assuming (somewhat generously) 50% in costs for principal investments and a 40% tax rate, that line's above-average contribution to net earnings was around $90 million in the third quarter. Subtract that from the $824 million in earnings and Goldman would've made $1.44 per share, which is 5% below the $1.51 expected by analysts.

However, Goldman's Viniar thinks private equity revenue could be heading higher, which would make comparisons with past quarters less valid. On the conference call, he said that, if market conditions permit, Goldman's private equity business will be able to book "higher realization gains."

Goldman wants to build up its asset management operations, since this business is believed to produce revenues that are less volatile than traditional brokerage operations over time. Third quarter revenue of $327 million in asset management was 8% down on the previous quarter's, but a solid 48% up on the year-ago number. However, asset management remains a small part of Goldman's overall business. It contributed 7% of revenue in the third quarter, below the 9% share in the prior quarter.