BUYSIDE January 2004

Cover Story:
GOLDMAN SACHS' REFORMATION

With the No. 1 Market Share of Mergers and Acquisitions, the Street's Oldest Firm Embarks on a New Mission to Restore Investor Confidence

BY BEN MATTLIN

A few years ago, Goldman Sachs was especially proud of its Internet coverage, which had been launched in 1994, ahead of most, if not all, rival Wall Street behemoths. New offices in Menlo Park, Calif., were held up as proof of its devotion to Silicon Valley and the "new economy."

A lot has changed since then -- not the least of which is the Goldman Sachs Group's message. In June 2003, when Henry (Hank) Merritt Paulson Jr., chairman and CEO of the publicly-held New York-based full-service investment banking and brokerage firm (2002 sales: $22.6 billion), addressed the National Press Club in Washington, D.C., his comments were entitled, "Restoring Investor Confidence: An Agenda for Change." Various measures were put in place to safeguard against potential conflicts of interest and help ensure good corporate governance. Most recently, for example, Goldman barred senior management from sitting on boards of public companies, a once-common practice now deemed "independence compromising."

The market seems to love the newly-chastened Goldman Sachs. Through mid-November, shares jumped 38% this year to a recent $94, beating the Standard & Poor's 500 index by a whopping 20 percentage points. Yet what do Wall Street insiders think of Goldman Sachs' rededication to corporate citizenship? Did it truly need to clean up its act, or is all this mere spin doctoring? Most importantly, what does Paulson's reformed Goldman mean for institutional investors from here on?

STAYING SCANDAL-FREE

Despite several attempts to get information and reaction from Goldman Sachs, the firm failed to respond by deadline. Nevertheless, it has certainly managed to stay clear of most of the scandals that rocked world markets over the past year or two. As a major Wall Street house, it shared in the legal settlements with New York Attorney General Eliot Spitzer and the U.S. Securities and Exchange Commission. However, it largely skirted the kinds of improprieties that embarrassed competitors such as Merrill Lynch and Citigroup's Salomon Smith Barney in particular. Largely, but not entirely.

Recently, a former Goldman economist named John Youngdahl pleaded guilty to insider trading and other criminal charges resulting from his October 2001 purchase of $300 million worth of 30-year Treasury bonds less than 10 minutes before the federal government announced it was ending the sale of the bonds. In another case publicized in October 2003, the National Association of Securities Dealers accused Goldman's Spear, Leeds & Kellogg unit, a leading specialist agency, of fraudulent trading practices. Separately, one disgruntled Goldman client, Herman Bluestein, went so far as to set up a Web site -- www.GoldmanSuchs.com -- to collect defamatory information about the brokerage house to support his pending lawsuit, which charges Goldman with giving "unsuitable advice." (Bluestein recently abandoned the site.) And the ongoing mutual-fund scandal still threatens to ensnare Goldman along with many other fund-management organizations.

Industry watchers, however, believe all this will have negligible long-term impact. "Goldman Sachs is less likely than companies like Merrill Lynch and Morgan Stanley to be hurt by events such as the mutual-fund scandal for two key reasons," explains analyst Richard Bové of San Francisco-based Hoefer & Arnett. "First, it has a smaller sales force, and second, that sales force is oriented more toward large, institutional clients. Everybody might pay a large fine, which won't be that large relative to their cash flow, but the only way these allegations could become a real problem is if the government requires better disclosure of soft-dollar payments. That would put an end to -- what? -- free trips to Hawaii," he chuckles.

Not surprisingly, Bové has a Strong Buy on Goldman Sachs stock. "It will be fine," he says.

FORMIDABLE INVESTMENT BANKING

Yet if Goldman can shrug off a host of Wall Street scandals, why the renewed emphasis on restoring investor confidence? Part of the answer can be found in the firm's commitment to equity markets, a historical area of strength. Even if it lags in its retail sales network, Goldman is unabashedly all about equity -- equity brokering, equity trading and especially equity underwriting.

In the most recent quarter, ended August 29, Goldman ranked No. 1 globally in equity underwritings and mergers and acquisitions (both completed and announced). It has a dominant 23.8% share of the M&A market as measured by Bloomberg -- nearly twice as much as its nearest competitor, Morgan Stanley -- and was involved in some of the quarter's largest deals, including Canadian aluminum giant Alcan's purchase of France's rival metals group Pechiney for $5.5 billion, British telecom provider Vodafone Group's $2.3 billion sale of Japan Telecom Holdings' fixed-line business to U.S. investment-fund manager Ripplewood Holdings, and Citigroup's $5 billion acquisition of Sears, Roebuck & Co.'s credit card business. The aggregate value of its M&A business: $182.6 billion. Total investment-banking net revenue for the quarter was $687 million, up four percent sequentially and five percent year-over-year. Overall, the organization's quarterly net earnings were $677 million, or $1.32 per diluted share, a 32% gain over the corresponding period a year earlier.

"Goldman blows away even Morgan Stanley in terms of the percent of revenue that comes from equity underwriting and M&As, two high-margin businesses," observes Sanford C. Bernstein & Co. analyst Brad Hintz, who rates Goldman Sachs an Outperform with a target price of $105. "M&A advisory is the highest margin business the securities industry has, and Goldman is by far the firm most exposed to an M&A and corporate-finance recovery." Hintz argues further that the recently rising GDP is a sure sign of growing M&A activity, just as rising corporate earnings are of an escalation in equity underwritings. For Goldman Sachs, that's about the best news possible. "The highest margin part of equity underwriting is the initial public offering business," he adds, "and a rise in IPOs will generate profitability to Goldman more than to more diversified firms such as Morgan Stanley."

RESEARCH REPORT: A MIXED BAG

Ironically, as dominant as Goldman is in investment banking, its research analysts may be struggling to keep up. Not that its crew of roughly 200 industry analysts globally, who track a total of 1,654 companies representing more than 50 economies and 25 different stock exchanges, isn't widely respected. In fact, as a group, they tied for sixth place in Institutional Investor's 2003 All-America Research Team, unchanged from the year before. Unfortunately, though, it slipped in that magazine's fixed-income rankings from eighth to ninth this year. What's worse, in the most recent global equity roster -- once a point of pride for Goldman Sachs -- the team plummeted from the third to the seventh tier. Goldman analysts didn't fare much better in The Wall Street Journal's 2003 Best on the Street Survey; they landed in the 19th position.

Despite these disappointing showings, many insiders affirm that Goldman's analysts are broadly respected for their industry knowledge and their integrity. "Among the large firms, it's always had a good research department," says Richard Lipstein of Boyden Global Executive Search in New York, who's been involved in placing high-level financial professionals for 14 years. "But because Goldman's bankers are so extraordinary, its analysts have never been as high up in the food chain as they might be at other firms. On the other hand, they also haven't been utilized to the same degree for bringing in investment-banking business."

RECENT IMPROVEMENTS IN RESEARCH

While Goldman may have under-recognized yet honest analysts, for some investors, a more significant development was October's announcement of the imminent retirement of research Co-Director Andrew Melnick. Melnick, due to leave at year-end, had headed Merrill Lynch's research in the bad old days of Henry Blodget. Now 62, Melnick had supervised the onetime Internet analyst for three years, during which Blodget allegedly touted stocks he privately derided. "I didn't like it that they hired Andy Melnick, because he'd been Blodget's boss," acknowledges Robert Olstein, manager of the $1.6 billion Olstein Financial Alert Fund, which soared 28% this year through mid-November, outstripping the S&P 500 by 10.5 percentage points. Since its inception in 1995, the fund has returned 17% on an annualized basis. An expert in financial disclosure and reporting practices, Olstein was so incensed by the Melnick hiring that he ultimately wrote CEO Paulson a stern letter about it. The New York Times picked up the story in August. "After he saw the Times article, Paulson actually called me personally to talk about my views, which I thought was an outstanding gesture," Olstein marvels.

Whether he would have gotten the same response without the Times write-up -- and indeed, whether his views had any bearing on Melnick's eventual decision to retire -- one can only speculate. Through it all, though, Olstein remained a loyal Goldman Sachs shareholder. He started buying it late last year, in the low $60s; 12 months later it's up nearly 50%. "Management made a mistake, in my opinion, but everybody makes mistakes," he holds. "It's still a great company, a long-term survivor run by a very competent guy."

In fairness, Melnick's brief tenure with Goldman Sachs -- he was hired in February 2002 -- was eventful and effective. Melnick and co-director Suzanne Nora Johnson, who is expected to stay on as sole research director, oversaw the cost-cutting ouster of more than a dozen analysts and helped revamp the firm's rating system in accordance with new regulatory standards. Part of that change involved regrouping analyst ratings into three simple categories: Outperform, In-Line and Underperform, equivalent to Buy, Hold and Sell, respectively.

Recommendations have also been rebalanced for a more equal, more credible distribution across those three designations. Recently, just 26% of the firm's stocks under coverage were rated Outperform or Buy. Even more significantly, the portion dubbed Underperform or Sell was a hefty 21%. "In the past, analysts were overly optimistic," notes Thomson First Call Research Director Charles Hill, referring not specifically to Goldman Sachs but to Wall Street generally before new reporting rules took effect September 2002.

Hill argues that the percentage of a firm's total coverage universe that's pegged with a Sell rating can tell you a lot about the objectivity and honesty of its analysts. If the Sells make up too small a portion of the total universe, the analysts' opinions are probably exaggerated and untrustworthy even in the best of bull markets. And what about Goldman's 21% Sell allocation? "Anything over 15% strikes me as realistic," Hill says.

A HISTORY OF PARTNERSHIP

Realistic stock appraisals, no matter how bearish they may have to be at times, are somehow in keeping with Goldman Sachs' devotion to corporate citizenship. Surprisingly, this sense of responsibility and even civic duty turns out to be not so much a new development as part of Goldman's corporate culture and tradition, its ethos. Community service and taking an active interest in major economic policy are said to be hallmarks of the organization. Employees at every level are encouraged to volunteer in their communities, and Goldman executives have long participated in federal government -- often to the envy of other firms which covet its powerful ties. Joshua Bolten, the present director of the Office of Management and Budget, is a veteran of Goldman's London office. Other Goldman alumni active in federal government include New Jersey Senator Jon Corzine, Clinton Administration Treasury Secretary Robert Rubin and Reagan Administration Deputy Secretary of State John Whitehead. Presidents Franklin Roosevelt and Harry Truman were advised by ex-Goldman chairman Sidney Weinberg, and even current Goldman chairman and CEO Paulson served in the Nixon White House and the Department of Defense.

Such close connections can't be bad for investment-banking business, to be sure, but this familiarity with the seats of power can almost be imagined as a goal -- or pipe dream -- of firm founder Marcus Goldman, a German immigrant. In 1869, the legend goes, he established a commercial paper dealership in his one-room basement apartment in lower Manhattan by buying up promissory notes from local businesses, which the businesses had accepted from customers in lieu of cash, and selling them to commercial banks. By the 1880s he was forging customer relationships with major European banks. In 1896, the fledgling private partnership joined the New York Stock Exchange, and 10 years later it was the lead manager of Sears, Roebuck & Co.'s initial public offering.

Today, despite an 11% staff reduction in the past 12 months, the firm employs nearly 20,000 people spread across offices in New York, London, Frankfurt, Tokyo, Hong Kong and most of the world's other major financial centers. But in a way it's still like a small entrepreneurial shop, observers say. Roughly half the shares are owned by insiders -- not surprising, perhaps, considering the firm has only been publicly traded since May 1999. "These guys are playing with their own money, in a sense," offers Bernstein's Hintz. In part, he credits the firm's "partnership culture" with helping it steer a mostly straight course through the perils of intense regulatory scrutiny. "These manager/partners are like player/coaches," he says, "and they're going to be very reluctant to do anything that could damage their franchise."

RESTORE INVESTOR CONFIDENCE

It's not surprising, then, that CEO Paulson would be interested in grand themes such as "restoring investor confidence." Paulson, 56, became chair and chief executive officer in May 1999, the same month the company went public. Before that, he headed the London operations and served as chief operating officer. He earned an MBA from Harvard University in 1970.

Bulls may be divided as to how much of the credit he deserves, or whether it's simply a mix of normal cyclicality and good luck, but Goldman Sachs is arguably perfectly aligned with current economic trends such as rising stock prices, rising corporate earnings, and rising GDP. "When the equity markets had slowed down dramatically, Goldman Sachs tended to feel it more than other brokers," recalls Hoefer & Arnett's Bové. "But now that we're seeing M&As and underwritings picking up, too, Goldman will clearly be the primary beneficiary. Its earnings outlook is very positive."