Goldman Sachs Saves Quarter by Slashing Pay (Update1)

Goldman pay article updated with management commentary, share price.

NEW YORK ( TheStreet) -- Goldman Sachs ( GS) cut compensation costs and expenses more than expected in the fourth quarter, helping the investment bank beat analyst expectations by a wide margin.

Compensation as a percentage of revenues rose to 36.5% in the fourth quarter compared to 26% in the corresponding quarter of the previous year.

Although the ratio rose in the fourth quarter compared to a year earlier, it appears Goldman has managed compensation expenses better than what analysts were expecting.

Goldman has historically had a fourth-quarter compensation "true-up", a practice where it accrues compensation expenses at a standard rate in the first three quarters and then adjusts its compensation relative to revenues in the final quarter to reflect actual expenses.

Often, especially in a good year, the fourth quarter compensation- to- revenue ratio is significantly lower than earlier quarters, helping to boost profits.

Analysts had predicted that Goldman might have far less flexibility to make major adjustments to compensation this time around, given competitive pressures. Wells Fargo analyst Matt Burnell, for instance, had expected the compensation- to- revenue ratio to stay at about 44% in the fourth quarter.

However, Goldman laid off 900 employees in the fourth quarter, more than anticipated, with total staff at the end of the fourth quarter standing at 33,300(34,700 on a consolidated basis.)

CFO David Viniar also said on the analyst conference call that the firm had made significant cuts to variable compensation- read bonuses- to drive down expenses.
Goldman Sachs CEO and Chairman Lloyd Blankfein

For the entire year, Goldman set aside $12.2 billion towards compensation expenses or 42.4% of revenues. That is down 21% from the amount set aside in 2010.

The investment bank's 34,700 employees (includes staff at consolidated entities) earned an average compensation of about $352,248 in 2011. That is down 11% from 2010, when the firm's 38,700 employees earned an average salary of $397,312.

The average compensation is computed by dividing total compensation expenses by the number of employees on staff at the end of the year on a consolidated basis. The averages are, of course, skewed by eye-popping bonuses paid out to the company's partners.

But in the last year, Goldman has lost 50 or so partners, according to press reports. Last week, the firm saw the exit of two members of its management committee, including trading co-heads Edward Eisler and David Heller.

Observers have interpreted the departures as a sign that Goldman is looking to contain the hefty payouts it has to make to its partners.

Over the conference call, Viniar called the departures a "normal progression" in the business, with 15 to 20% of partners turning over every two years. In more recent years, the number of retirements had been slower than normal as partners chose to stay on in the firm following the crisis, Viniar said.

In the final analysis, though, the 21% decline in overall compensation expenses could not really offset the decline in trading and capital markets revenues. Total revenue declined 26% in 2011, leading to a 47% drop in profits for the entire year to $2.5 billion.

The management said it is committed to being more disciplined on expenses in 2012 and upped its cost savings target to $1.4 billion from $1.2 billion previously. "We will not cut our way to prosperity but we will size our firm appropriately," Viniar told analysts, stressing that finding opportunities to grow the top line remained critical to their ability to drive shareholder returns.

Large banks may have had a forgettable year in 2011 but the headwinds for Goldman Sachs and rival Morgan Stanley ( MS)are particularly intense in 2012.

The European crisis remains a major overhang for 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 or significant changes to its business model.

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 investment 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 have cut the bonuses of its 400 partners by half.

Morgan Stanley is scheduled to report on Thursday.

Earlier this week, JPMorgan Chase ( JPM), reported a 36% drop in compensation expenses, lowering the average compensation per employee by 8% to $341,552.

The bank laid off more than 300 employees in the investment banking division over the year. That is lower than most rivals, reflecting JPMorgan's inherent strengths and continuing focus on expansion.

Citigroup ( C) does not break out employee details by division but said that it would lay off as many as 4,500 employees; over a quarter of the cuts will come from the investment banking division.

While banks may cut staff and expenses in response to a weak environment, more long-term changes could be in store for Goldman and Morgan Stanley employees.

Bernstein analyst Brad Hintz expects Goldman to respond to the Volcker rule 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.

Shares of Goldman were climbing 5.5% to $103.25 on Wednesday morning, following its earnings beat.

--Written by Shanthi Bharatwaj in New York

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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