Recommendation: Buy


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Recommendation: Buy

  1. 1. Recommendation: Buy COMPANY DATA: STOCK DATA: VALUATION DATA: Ticker: GS Most Recent Price: $211.13 Beta: 1.14 Exchange: NYSE 52-Wk Range: $136.79-$220.51 2006 EPS: $19.69 Sector: Financial Dividend Yield: 0.70% P/E (LTM): 10.72 Industry: Investment Market Cap: $86.85 billion PEG: 0.74 Brokerage – National Shares Out: 477.4 million P/B: 2.69 P/S: 2.33 Call Summary – Purchase Full Position: We recommend a buy on Goldman Sachs based upon strong prospects going forward including: • Unmatched reputation in the investment banking industry • Increased M&A activity through 2007 • Ability to leverage all aspects of the deal • Unparalleled financial performance Furthermore, based upon both relative valuation and a residual income model, Goldman Sachs’ shares are attractive at current levels. We recommend a full position of Goldman Sachs, or 250 shares.
  2. 2. TABLE OF CONTENTS Section 1: Company Overview…………………………………………………………………3 Company Profile……………………………………………………………………………..3 Management and Alumni …………………………………………………………………6 Analysis of Last Four Quarters’ Earnings Releases……………………………………..9 Section 2: Industry Analysis…………………………………………………………………..12 Discussion of Competitors………………………………………………………………...12 Industry Performance……………………………………………………………………...16 Section 3: Financial Ratio Analysis…………………………………………………………..18 Section 4: S.W.O.T. Analysis…………………………………………………………………22 Section 5: Valuation……………………………………………………………………………24 Relative Valuation………………………………………………………………………….24 Pro Forma Income Statement ……………………………………………………………26 Discounted Cash Flow …………………………………………………………………….28 Residual Valuation…………………………………………………………………………29 Section 6: Investment Summary and Recommendation …………………………………..30 Appendices ……………………………………………………………………………………..31 Income Statement………………………………………………………………………….31 Balance Sheet……………………………………………………………………………...32 ValueLine Report …………………………………………………………………………..33 2
  3. 3. Section 1: Company Overview Company Profile Goldman Sachs is a global company with a long and prestigious history. They provide a wide range of service to customers worldwide including some of the most powerful corporations, financial institutions, governments, and high net-worth individuals. Their diverse client base and superior expertise enables them to capitalize on opportunities that provide superior returns. The variety of services Goldman offers enables them to facilitate transactions and earn fees from many sources. Since Goldman Sachs is already evaluating businesses, it also invests it own money, giving them added incentive to see value created. Goldman Sachs has built a company unrivaled in quality and reputation in its industry. Goldman operates in three distinct business segments; Investment Banking, Trading and Principal Investments, and Asset Management & Security Services. Revenue by Geographic Region 2006 revenue Breakdown Other Asia 1% Investment Banking 14% 8% Trading & Prinicipal Investments 50% 35% Asset Management & Security Services Europe United States 7% Interest Income 27% 58% % of % of % of 2006 2005 2004 Sales Sales Sales Investment Banking $5,613,000 8.09% $3,599,000 8.29% $3,286,000 11.01% Trading & Principal Investments $24,027,000 34.64% $15,452,000 35.61% $11,984,000 40.16% Asset Management & Security Services $4,527,000 6.53% $3,090,000 7.12% $2,655,000 8.90% Interest Income $35,186,000 50.73% $21,250,000 48.97% $11,914,000 39.93% Total $69,353,000 $43,391,000 $29,839,000 3
  4. 4. Investment Banking Goldman Sachs’ investment banking division identifies, structures, and executes public and private market transactions for a variety of global clients. They have consistently been one of the top investment banks as ranked by Thomson League Tables for the past two years. Goldman’s strong relationships with clients throughout the world and their unique understanding of local economies and industries make them the premier investment bank. 2006 was a record setting year for Goldman Sachs Investment banking segment. Net revenues were 53% higher than 2005. Both the Financial Advisory and Underwriting grew net revenues by 35% and 73% from 2005. Most of this growth can be attributed to the overall growth of Mergers and Acquisitions in the global economy. Though 2006 was a record year for growth and net revenue for Goldman Sachs 2007 is looking to be even better. Even if the market cools Goldman still has a large backlog from 2006 which will provide significant revenues in the face of declining M&A transactions. Mergers and Acquisitions League Table Investment Bank 2006 Volume ($ # 2005 Rank Rank Billions) Deals Goldman Sachs 1 965.7 361 1 Citigroup 2 885.7 336 5 J.P. Morgan Chase 3 857.4 399 3 Morgan Stanley 4 823.0 264 4 Merrill Lynch 5 677.1 264 4 Credit Suisse 6 604.9 326 10 UBS 7 593.7 199 6 Lehman Brothers 8 527.4 199 7 Deutsche Bank 9 456.6 210 9 Lazard 10 347.5 204 8 Trading & Principal Investments Facilitates customer transactions through market making in, and trading of fixed income and equity products, currency, commodities and any other derivatives on those products. Goldman also acts as a specialist for the U.S. equities and options exchanges and they clear customer transactions throughout the world. Their merchant banking segment makes principal investments either directly or through funds that are raised. The two largest investments are in the Industrial and Commercial Bank of Chine Limited (ICBC) and in Sumitomo Mitsui Financial Group. Both of these investments have appreciated in value and provide valuable inroads to Chinese and Japanese markets. 4
  5. 5. Trading and Principal Investments posted net revenue of $25.56 billion for 2006 up 52% from 2005. FICC had net revenues of $14.26 billion which was fueled by fueled by higher net revenues in credit products and commodities. The equities division of the Trading segment had net revenues of $8.48 billion up 50% from 2005. Principle Investments had net revenues of $2.82 billion. This revenue derived from Goldman Sachs largest investments are in ordinary shares of the Industrial and Commercial Bank of China Limited (ICBC) and in convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG). In 2006 the gains on those investments were $937 million for ICBC and $527 million for SMFG. Asset Management & Security Services Provides an assortment of investment strategies, advice, and planning across all major asset classes for their diverse group of customers. Goldman also provides prime brokerage, financing services and securities lending services to mutual funds, pension funds, hedge funds, and high net-worth individuals. Asset Management primarily generates revenues through management and incentive fees. Goldman believes that superior risk management, more in-depth research, as well as their distinct resources and relationships set them apart from their competitors. Asset Management recorded net revenues 45% higher in 2006 than 2005. Assets under management increased 27% to $676 billion. Goldman was able to achieve this revenue growth largely as a result of higher management fees. Securities services had net revenues of $2.18 billion for 2006, 22% higher than 2005. Segment Revenues 30000000 Investment Banking 20000000 Trading & Prinicipal Investments 10000000 Asset Management & Security 0 Services 2006 2005 2004 5
  6. 6. Management and Alumni Management CEO and Chairman – Lloyd C. Blankfein Lloyd C. Blankfein has been Chairman and Chief Executive Officer since June 2006, and a director since April 2003. Previously, he had been Goldman Sachs President and Chief Operating Officer since January 2004. Prior to that, from April 2002 until January 2004, he was a Vice Chairman of Goldman Sachs, with management responsibility for Goldman Sachs’ Fixed Income, Currency and Commodities Division (“FICC”) and Equities Division. Prior to becoming a Vice Chairman, he had served as co-head of FICC since its formation in 1997. From 1994 to 1997, he headed or co-headed the Currency and Commodities Division. Mr. Blankfein is not on the board of any public company other than Goldman Sachs. President and Chief Operating Officer – Gary Cohn Gary Cohn has been a President and Co-Chief Operating Officer and director of Goldman Sachs since June 2006. Previously, he had been the co-head of Goldman Sachs’ global securities businesses since January 2004. He also had been the co-head of Equities since 2003 and the co-head of FICC since September 2002. From March 2002 to September 2002, he served as co-chief operating officer of FICC. Prior to that, beginning in 1999, Mr. Cohn managed the FICC macro businesses. From 1996 to 1999, he was the global head of Goldman Sachs’ commodities business. 6
  7. 7. Vice Chairman – John S. Weinberg John S. Weinberg has been a Vice Chairman of Goldman Sachs since June 2006. He has been co-head of Goldman Sachs’ Investment Banking Division since December 2002. From January 2002 to December 2002, he was co-head of the Investment Banking Division in the Americas. Prior to that, he served as co-head of the Investment Banking Services Department since 1997. Alumni Jim Cramer Former manager of CramerBerkowitz before retiring in 1998. Jim averaged a return of 24% in his run at the hedge fund. Cramer is a director and co-founder of He contributes daily market commentary for's sites and serves as an adviser to the company's CEO. Cramer worked at Goldman Sachs from 1984 to 1987. Cramer graduated from Harvard College in 1977, where he was president of The Harvard Crimson. He was a journalist for four years before earning a law degree from Harvard Law School in 1984. Joshua Bolten Sworn in as White House Chief of Staff on April 14, 2006. From January 2001 through June of 2003, Mr. Bolten was Assistant to the President and Deputy Chief of Staff for Policy at the White House. From March 1999 through November 2000, Mr. Bolten was Policy Director of the Bush-Cheney presidential campaign. From 1994 to 1999, Mr. Bolten was Executive Director, Legal & Government Affairs, for Goldman in London. 7
  8. 8. Robert E. Rubin Sworn in as the 70th Secretary of the Treasury on January 10, 1995. He served until July 2, 1999.From January 20, 1993, to January 10, 1995, Rubin served in the White House as Assistant to the President for Economic Policy. In that capacity, he directed the activities of the National Economic Council. He joined Goldman in 1966 as an associate, became a general partner in 1971 and joined the management committee in 1980. Rubin was Vice Chairman and Co-Chief Operating Officer from 1987 to 1990 and served as Co-Senior Partner and Co-Chairman from 1990 to 1992. Edward Lampert The hard-nosed chairman of ESL Investments merged Kmart with Sears, Roebuck in November, capping one of the greatest corporate comebacks in history. A Lawyer's son inspired by grandmother, devoted viewer of Wall Street Week; spent spare time in high school reading corporate reports and financial textbooks. He was a Skull & Bones member at Yale; he landed job at Goldman Sachs and was mentored by Robert Rubin. He founded is own firm in 1988, accumulating annual returns averaging 29%. He is currently #61 on Forbes’ 400 list. And many others… This is just a partial list but other high profile alumni include current Secretary of the Treasury Hank Paulson, Former chairman of the Federal Reserve of New York John Whitehead, Chairman of the President’s Foreign Intelligence Advisory Board Stephen Friedman, and governor of New Jersey Jon Corzine. 8
  9. 9. Analysis of Last Four Quarters’ Earnings Releases First Quarter In the first quarter, Goldman reported strong results across each of its verticals. Net revenues were $10.34 billion for the quarter, with net earnings of $2.64 billion, excluding a non-cash charge related to a new accounting rule. Then CEO Hank Paulson said of the quarter, “While we know that we cannot expect to achieve these results every quarter, we continue to see attractive opportunities and high levels of client activity.” Highlights of the quarter included: • Investment banking • Net revenues were $1.47 billion, up 65% YoY and 55% QoQ. • Investment banking backlog declined during the quarter. • The firm ranked first in worldwide completed M&A, public common stock offerings and IPOs YTD. • Trading and Principal Investments. • Net revenues were $6.88 billion, up 57% YoY and 68% QoQ. • FICC revenues were up 50% YoY, reflecting high client activity and a favorable environment. • Equities revenues increased 58% YoY, based on higher equity prices and strong customer-driven activity. • Principal investments revenues were strong, with a $405 million gain from the firm’s investment in SMFG convertible preferred stock. • Asset Management • Net revenues were $1.98 billion, up 75% YoY and 60% QoQ. • Revenue growth was driven by both higher incentive and management fees. • Assets under management increased $25 billion, or 7% during the quarter. • Securities services revenues increased 29% YoY. Second Quarter Goldman reported second quarter net revenues of $10.10 billion, with net earnings of $2.40 billion, excluding the non-cash charge under SFAS No. 123-R. the quarter showed similar strength across all verticals to the first quarter, with strong comparisons to the previous year’s period. CEO Lloyd C. Blankfein commented, “We have continued to benefit from the strength, breadth, and depth of our client franchise. Recent market volatility has served as a reminder of the vital importance of investor confidence to the smooth functioning of the global financial system, but we take comfort from the continuation of strong global economic growth.” Highlights of the quarter were: 9
  10. 10. • Investment Banking • Net revenues were $1.53 billion, up 87% YoY and 4% QoQ. IB posted the best quarterly results in six years. • Investment banking backlog increased during the quarter. • Goldman maintained its #1 ranking in M&A, public common stock offerings, and IPOs, and also moved into #1 for equity and equity-related offerings. • Trading and Principal Investments • Net revenues were $6.96 billion, up 148% YoY and essentially flat QoQ. • FICC revenues were up 184% YoY on a favorable environment, seasonal strength, and a $700 million gain from the sail of one of the firm’s power generation facilities. • Equities revenues were up 112% YoY, reflecting continued strength in customer-driven activity and generally favorable conditions despite volatility. • Principal Investments had a strong quarter, driven by corporate and real estate principal investments, and offsetting a loss of $61 million from SMFG. • Asset Management and Securities Services • Net revenues were up 37% YoY, but lower than the first quarter due to lower incentive fees in Asset Management. Third Quarter Goldman posted third quarter net revenues of $7.46 billion and net earnings of $1.68 billion, excluding non-cash charges. The quarter was the third strongest in the firm’s history, particularly noteworthy given a more difficult environment. CEO Lloyd C. Blankfein commented, “This [strong quarter] is particularly noteworthy given our record performance for the first half of the year. While market conditions were more challenging this quarter, our results underscore the strength and depth of our client franchise.” Highlights included: • Investment Banking • Net revenues were $1.29 billion, up 27% YoY and down 16% QoQ against a record comp. • Investment banking backlog was unchanged in the quarter. • Goldman maintained its #1 ranking in worldwide M&A, equity and equity- related offerings, and public common stock offerings. • Trading and Principal Investments • Net revenues were $2.74 billion, down 7% YoY and down 32% QoQ. • FICC revenues were up 4% YoY against a strong comp, reflecting strength in commodities and mortgages and slight weakness in currencies. This gain came despite a less favorable environment with lower customer-driven activity. • Equities revenues were down 3% YoY, reflecting weakness in principal strategies and shares, and partially offset by derivatives and insurance. • Principal investments revenues were $430 million, including a $261 million 10
  11. 11. gain from the SMFG investment. • Asset Management • Net revenues were $1.46 billion, up 20% YoY, based on higher management fees resulting from growth in assets under management. Fourth Quarter Goldman posted net revenues of $9.41 billion and net earnings of $3.15 billion, excluding non-cash charges, rounding out a record year of performance. The quarterly results reflected strong performances across each of the three major verticals. Highlights include: • Investment Banking • Net revenues were $1.34 billion, up 42% YoY. • The firm’s investment banking backlog increased during the quarter. • Goldman maintained its #1 ranking in worldwide M&A, equity and equity- related offerings, and public common stock offerings. • Trading and Principal Investments • Net revenues were $6.63 billion, up 57% YoY and up 37% QoQ. • FICC revenues were up 58% YoY on strength in credit products, commodities, and interest rate products, partially offset by weakness in currencies and mortgages. • Equities revenues were up 52% YoY on strength in shares and derivatives, as well as in the insurance business acquired in 2006. • Principal investments net revenues were $1.40 billion, propelled by a $949 million gain in the investment in ICBC. • Asset Management • Net revenues were $1.43 billion, up 16% YoY and down 2% QoQ, driven by growth in assets under management and growth in securities lending and margin lending. 11
  12. 12. Section 2: Industry Analysis Discussion of Competitors Forward P/E: 11.46 PEG: 1.25 EPS E2007: $4.07 J.P. Morgan Chase & Co. is a global financial services firm with total assets of $1.3 trillion. The product of a merger between J.P. Morgan Chase and Bank One that was consummated on July 1, 2004, the company is a significant player in investment banking and capital markets, corporate banking, asset management, private banking, venture capital, custody and transaction services, and consumer services such as mortgage lending and credit cards. Strengths: • Global Capital Markets and Asset Management: While the merger between J.P. Morgan Chase and Bank One, along with other smaller acquisitions, has made J.P. Morgan a more diversified financial services provider, the company's earnings stream is still heavily weighted toward market sensitive lines of business. • Extensive Franchise and Scale in Key Businesses: With the completion of its acquisition of Bank One, J.P. Morgan now has one of the most extensive retail and commercial banking franchises in the country. The company is a leader in syndicated lending, credit cards and auto finance, and has significant scale in investment banking, securities processing, and mortgage banking. • Card Services Segment: The Card Services segment experienced solid credit quality through the fourth quarter of 2006, with a net charge-off rate of 3.45% during the fourth quarter, an improvement from 6.39% a year earlier. With the exception of increased charge-offs during the fourth quarter of 2005 due to an unprecedented amount of bankruptcies being filed because of new legislation that took effect during October. The legislation should be a long-term positive for J.P. Morgan as more filers are pushed into Chapter 13 instead of Chapter 7, forcing them to pay back more of their debt. Weaknesses: • Integration risk: The proposed acquisition of Bank One presents risk with respect to integration of the two entities. Additionally, deal-related dilution and amortization of the large purchase premium could weigh on operating earnings of the company for several years. • Credit quality no longer an earnings lever: Reserve levels have come down in recent quarters, and commentary from management suggests that first quarter might have 12
  13. 13. been the tough for credit costs. Going forward, there should be a provision to nearly match charge-offs, leaving J.P Morgan without a familiar credit lever. It should also be noted that, although credit quality has recently improved, deteriorating credit quality is always a risk for banks. Forward P/E: 11.00 EPS E2007: $8.17 PEG: 0.90 Lehman Brothers is an investment bank with operations worldwide. The company generated 63%, 25% and12% of its 2005 net revenues in the U.S., Europe, and the Asia/Pacific region, respectively. Lehman Brothers serves institutional, corporate, government and high net worth individual clients through its world headquarters in New York, and regional headquarters in London and Tokyo. The company divides its operations into three segments: Capital Markets; Investment Banking; and Client Services. In 2005, Capital Markets accounted for 67% of net revenues, Investment Banking 20%, and Client Services 13%. Lehman merged with American Express Co.'s Shearson brokerage unit in 1984, and was spun off as an independent public company 10 years later. Strengths: • Global Business Model: The current goal of management at Lehman Brothers is to have 50% of total revenues come from abroad. Lehman Brothers has recently securitized its first self-originated residential mortgage pool in Japan, and its non- U.S. residential and commercial mortgage origination platforms should continue to support securitizations. • Strong Asset Management Business: Lehman Brother’s offers investment services to high net worth individuals and mid-sized institutional accounts. Lehman Brother’s brokers tend not to manage client accounts by trading stocks but direct them toward top money managers. The Asset Management business managed $175 billion in assets with $16 billion in alternative investments. The acquisition of Neuberger Berman, an asset manager, Lincoln Capital Management, a fixed-income manager, and The Crossroads Group, a private equity fund-of-funds, should provide accretion to earnings per share next year. Weaknesses • Growth in Capital Markets: Recent growth in the capital markets segment has largely been attributed to mortgage originations. In recent years, Lehman has acquired several mortgage originators, which it believes is fueling growth of the company's securitization business and increasing vertical integration within its mortgage business. Lehman originated about 60% of its mortgages internally at the end of 2005, versus 20% at the end of 2002.While this is good for its fixed-income business, which generates the majority of total revenue, it is likely revenue growth from this segment will slow dramatically in 2007. 13
  14. 14. Forward P/E:10.91 PEG: 1.00 EPS E2007: $7.71 Merrill Lynch & Co., Inc. (Merrill) is one of the world’s largest and most diversified broker-dealers. In September 2006, Merrill Lynch merged with BlackRock Inc. and acquired a 50% interest. Merrill now operates in two business segments, which contributed the following approximate amounts to net revenues and pre-tax earnings, in the fourth quarter and year ended 2006, respectively, excluding special items: Global Markets & Investment Banking (GMI), 62% and 77%, and Global Wealth Management (GWM), 38% and 23%. The GMI unit is comprised of three business segments, which accounted for the following approximate amounts of net revenues in the fourth quarter: Fixed Income, Currencies and Commodities (FICC), 27%; Equity Markets, 20%; and Investment Banking, 15%. The newly-created GWM Group is comprised of two business segments, Global Private Client and Global Investment Management, which accounted for 36% and 2% of net revenues, respectively, in the fourth quarter of 2006. Strengths: • Merrill’s Size and Scope: Merrill Lynch has a diversified source of revenue, good liquidity and capital strength. Roughly 35% of pre-tax income during 2005 came from non-U.S. business showing that Merrill truly has a global position. • Refocus: Merrill over-expanded during the 1990s and under Stan O’Neal has reshaped its efforts towards improved profitability and disciplined growth. This discipline is demonstrated with the recent merger with BlackRock, which dramatically expanded the asset management segment by providing Merrill’s equity expertise with BlackRock’s fixed-income expertise. • Cost Management: Merrill Lynch remained highly successful in maintaining close control over spending as both compensation and other operating expenses fell sharply in relation to net revenues. For example, despite a 14% increase in compensation & benefits expense in the fourth quarter of 2006, the ratio of expense to net revenues actually fell by 4.5 percentage points to 38.6%, its lowest level during the three year period under review, from 43.1% in the fourth quarter of 2005. Other operating expenses only grew by 6% from the fourth quarter of 2005 to represent 22.4% of net revenue in the fourth quarter of 2006, compared to 26.9% of net revenues in the fourth quarter of 2005. Weaknesses: • Exotic Products: In order to grow its profitability, Merrill has been pushing into more exotic products such as credit derivatives and high yield debt underwriting. While Goldman Sachs is expanding into these exotics, Merrill has always operated as a 14
  15. 15. more traditional bank and the push into these products presents some risk as Merrill may lack the expertise to properly manage the risk associated with exotic products. • Insider Trading Investigation: An unconfirmed New York Times report indicates an ongoing SEC investigation into insider trading at some large investment banks. The story alleges that some bank employees may be tipping off favored hedge fund clients about pending large institutional trades, enabling them to profit from the information Forward P/E:10.38 PEG: 0.86 EPS E2007: $7.33 The company's institutional securities business, representing 63% of total revenues, provides worldwide financial advisory and capital raising services, including investment banking, institutional sales and trading and principal investing activities. The global wealth management group (16%) provides financial advice to individual clients, focusing on affluent and high net worth investors. Morgan Stanley had client assets of $686 billion at the end of 2006, up from $617 billion at the end of 2005. The asset management business represents 8% of total revenues. The company's asset management group had $478 billion in assets under management or supervision at the end of 2006, up from $431 billion at the end of 2005. Discover (13%) had over 50 million general purpose credit card accounts at the end of 2005. Management has decided to spin off the Discover business in a tax-free distribution to shareholders, which should be completed in the third quarter of 2007. Strengths: • Discover Spin-off: Morgan Stanley recently announced the spin-off of investors business to investors. This is a positive move as it is expected to free up cash for reinvestment in Morgan Stanley’s securities operations, which returned 27% on equity in 2006 compared to 22% at Discover. • Investment Banking Revenues: Investment banking revenues should increase markedly in 2007, based on a strong backlog of deals across business lines, as well as a global presence that should aid deal-making. Weaknesses: • Institutional Securities Business: Morgan Stanley’s institutional securities business, its largest segment, is well positioned, but there is a strong chance that Morgan Stanley will lose market share in its retail brokerage, credit card and asset management businesses. • Legal Costs: In April 2003, Morgan Stanley agreed to pay $125 million as part of a $1.4 billion settlement with regulators regarding allegations of conflicts of interest in investment research. In April 2005, Morgan Stanley increased its reserve with respect to the Coleman Holdings litigation to $360 million, and in May 2005, reaffirmed its intention to appeal the verdict and punitive damages. The corporate 15
  16. 16. governance policies are very weak and continued media attention should diminish employee morale and possibly affect 2007 revenue growth. • Asset Management Business: The asset management business continues to be challenged by poor relative investment performance and excessive turnover in recent years among both management and portfolio managers. It is widely expected that Morgan Stanley will explore strategic alternatives, which may include an acquisition or two. Industry Performance Five-Year Margins Analysis FIVE YEAR Goldman JP Lehman Merrill Lynch Morgan AVERAGES Sachs Morgan Brothers Stanley Gross Margin 29.19% n/a 19.95% 22.97% 21.52% Operating Margin 19.68% 17.65% 13.53% 15.12% 15.29% Pretax Margin 19.68% 17.65% 13.53% 15.12% 14.77% Profit Margin 13.14% 12.13% 9.23% 11.01% 10.42% Tax Rate 33.25% 31.24% 31.74% 27.17% 29.47% Return on Common 16.12% 7.46% 16.63% 12.32% 16.44% Equity Return on Average 0.81% 0.53% 0.59% 0.61% 0.65% Assets The above graph is the five-year averages of key margins. In almost all cases, Goldman’s margins are better than its industry peers. One can see that Goldman should probably warrant the label as “best in the industry” in relation to its margin performance. Its ROE is near the top of the industry and its ROA is the best amongst its peers. Five-Year Growth Analysis FIVE YEAR GROWTH Goldman JP Lehman Merrill Lynch Morgan RATES Sachs Morgan Brothers Stanley Revenue Growth 17.37% 4.29% 15.84% 12.08% 11.77% Net Income 32.40% 8.51% 27.38% n/a 16.08% EPS Growth 35.79% -3.60% 25.20% n/a 17.52% Dividend 23.87% 1.23% 27.94% 11.44% 3.26% Gross Margin 2.03% n/a 8.24% -2.06% -4.49% Cash Flow 25.96% 9.36% n/a n/a n/a 16
  17. 17. The previous graph shows the five-year growth rates of key performance measures. All of these measures drive share performance. The graph tells us that Goldman continues to outpace is peers in all regards except for growth in dividend rate. This can be attributed to the probable belief that Goldman can better reinvest earned capital at a higher rate of return than the cost of capital and therefore does not see dividend growth as a proper strategy. Based on these growth rates, Goldman deserves the label as a “best of breed.” Goldman Sachs vs. Broker/Dealer Industry for the Past Five Years Over the past five years, Goldman Sachs has roughly returned the same percent as its industry peers. However, we can see that recently Goldman Sachs has traded upwards and outperformed its counterparts. This trend should continue as Goldman continually seeks to innovate and expand its product base. Goldman Sachs vs. S&P 500 for the Past Five Years The Graph above shows us that Goldman Sachs has easily outperformed the market over the past five years. The market has returned roughly 38% while Goldman has returned 160%. While historical, this further demonstrates the operating superiority of Goldman Sachs. 17
  18. 18. Section 3: Financial Ratio Analysis Liquidity LIQUIDITY RATIOS 2006 2005 2004 2003 2002 JPM MER MS LEH Current Ratio 0.65 0.57 0.49 0.48 0.43 0.80 1.30 0.59 0.18 Quick Ratio 0.65 0.57 0.49 0.48 0.43 0.80 1.30 0.59 0.18 Net Working - - - - - - - - Capital $97,953,000 $102,586,000 $110,324,000 $79,675,000 $77,914,000 $155,785,000 $113,894,000 $225,494,000 $146,851,000 At first glance Goldman Sachs appears to have an unacceptably low current ratio. However Goldman is in no danger of defaulting on any of its loans that will become due. Currently they have a better current ratio than the majority of their direct competitors and the ratio has been improving steadily over the past 5 years. Goldman Sachs ensures they will be able to meet obligations through their policy of prefunding their cash needs in case of an emergency liquidity crisis. They own highly liquid securities that can provide same day liquidity. This is referred to as their global core excess and it is Goldman’s policy that they have sufficient global core excess to replace 110% of unsecured obligations scheduled to mature in the next 12 months. Asset Management ASSET MANAGEMENT RATIOS 2006 2005 2004 2003 2002 JPM MER MS LEH Average Collection Period (days) 489.52 634.10 642.75 562.06 462.17 421.21 1721.77 405.58 169.13 Fixed-asset Turnover 9.92 8.51 7.31 6.70 6.61 4.98 29.67 13.02 16.19 Total-asset Turnover 0.08 0.06 0.06 0.06 0.06 0.04 0.10 0.09 0.11 Goldman Sachs has been improving dramatically in its asset management. Most notably, they have greatly reduced their average collection period, though it is still high. However, it is close to its competitors and is more due to the long-term nature of the business environment that they operate in. There has also been considerable improvement in total asset turnover after staying flat for several years. Goldman has also improved their fixed asset turnover. However, it remains below many of their competitors. Though Goldman is not the leader in asset management their history shows it is dedicated to finding solutions and improving upon processes. 18
  19. 19. Debt Management FINANCIAL LEVERAGE RATIOS 2006 2005 2004 2003 2002 JPM MER MS LEH Debt-to-Asset Ratio 0.96 0.96 0.95 0.95 0.95 0.91 0.95 0.97 0.96 Debt-to-Equity Ratio 22.42 24.24 20.19 17.67 17.71 10.18 18.13 29.79 23.42 Equity Multiplier 23.42 25.24 21.19 18.67 18.71 11.18 19.13 30.79 24.42 TIE coverage Ratio 2.19 2.39 3.36 3.11 2.58 NM NM 1.83 1.60 Goldman Sachs has kept a tight control on their financial leverage. Looking over the past 5 years shows that Goldman has not changed their financing decisions much recently. They have maintained similar proportions of debt to assets and contain similar proportions of debt in comparison with their competitors. Goldman’s equity multiplier had been increasing steadily throughout the past 5 years but it finally decreased and is now more in line with their competitors. It is a little worrisome that TIER has been declining but it is still at a healthy level and well above MS and LEH. Overall Goldman has maintained good control over their leveraging. Employee Revenue & Compensation % Compensation of Revenue 2006 2005 2004 GS 24% 27% 32% Revenue/Employee $ 2,620,357.43 $1,639,437.79 $ 1,127,403.94 JPM 40% 47% 47% Revenue/Employee $ 259,233.77 $ 175,470.29 $ 137,898.60 MER 25% 26% 33% Revenue/Employee $ 1,221,032.03 $ 850,462.63 $ 580,409.25 MS 19% 22% 25% Revenue/Employee $ 1,408,507.98 $ 958,269.70 $ 723,858.76 LEH 19% 22% 27% Revenue/Employee $ 1,800,933.07 $1,250,000.00 $ 819,324.49 Goldman Sachs has a strong advantage in the people they hire. Employees at Goldman have earned more on a per person basis than any of their direct competitors. Since their business model relies on innovation, it is critical to determine what the talent being hired is producing. Goldman’s employees have consistently outperformed their counterparts at other firms and have been rewarded for it. As revenues increase the percentage of revenues paid out as compensation has decreased across the industry. Goldman is in the middle of the pack as far as compensation to revenue. However, Goldman’s superior revenue per employee more than offsets the higher compensation for employees. 19
  20. 20. Profitability PROFITABILITY RATIOS 2006 2005 2004 2003 2002 JPM MER MS LEH Gross Profit Margin 27.43% 27.62% 33.54% 32.98% 27.96% 36.17% 15.19% 14.37% 12.64% EBT Profit Margin 20.99% 19.07% 22.37% 18.82% 14.23% 36.17% 15.19% 14.07% 12.64% Net Profit Margin 13.75% 12.97% 15.26% 12.72% 9.25% 18.77% 10.93% 9.79% 8.48% Return on Assets 1.14% 0.80% 0.86% 0.74% 0.59% 1.05% 1.10% 0.83% 0.97% Return on Equity 26.65% 20.09% 18.15% 13.89% 11.12% 7.91% 21.06% 25.69% 23.58% Profitability Comparison 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2006 2005 2004 2003 2002 Gross Profit Margin Net Profit Margin Return on Equity Goldman Sachs is a highly profitable company when compared to its direct competitors. Even though their gross profit margin has been decreasing slightly for the past two years Goldman is still one of the industry leaders. They operate in a highly competitive industry so an advantage here translates into competitiveness across the company. Goldman enjoys a strong advantage in Net Profit Margin against its competitors though JPM is the leader. Goldman Sachs is the leader in ROE and ROA among its direct competitors. ROE experienced a huge increase in 2006 as a result of many factors but largely due to record amounts of business do to M&A and fees from their asset management. They also lead their competitors in ROA, which Goldman improved drastically from 2005 to 2006. 20
  21. 21. Extended DuPont Analysis EXTENDED DUPONT MODEL Net Profit Total Asset Equity ROE Margin x Turnover x Multiplier 2006 26.65% 13.75% x 0.08 x 23.42 2005 20.09% 12.97% x 0.06 x 25.24 2004 18.15% = 15.26% x 0.06 x 21.19 2003 13.89% = 12.72% x 0.06 x 18.67 2002 11.12% = 9.25% x 0.06 x 18.71 JPM 7.91% = 18.77% x 0.04 x 11.18 MER 21.06% = 10.93% x 0.10 x 19.13 MS 25.69% = 9.79% x 0.09 x 30.79 LEH 23.58% = 8.48% x 0.11 x 24.42 As the DuPont analysis demonstrates, Goldman Sachs has been doing exceptionally well at delivering increasing returns on equity. Most recently this has been a result of greater total asset turnover. Goldman is second only to JPM in net profit margin. This is largely because JPM operates as more of a commercial bank than an investment bank. DuPont Model ROE 30.00% 26.65% 25.00% 20.09% 20.00% 18.15% 15.00% 13.89% 11.12% 10.00% 5.00% 0.00% 2006 2005 2004 2003 2002 Net Profit Margin Equity Multiplier 18.00% 30.00 15.26% 25.24 16.00% 23.42 13.75% 25.00 14.00% 12.97% 12.72% 21.19 18.67 18.71 12.00% 20.00 9.25% 10.00% 15.00 8.00% 10.00 6.00% 4.00% 5.00 2.00% 0.00 0.00% 2006 2005 2004 2003 2002 2006 2005 2004 2003 2002 21
  22. 22. Section 4: S.W.O.T Analysis Strengths Innovation – Goldman Sachs is constantly raising the bar and providing new innovative products for its clients. During the slump from 2000-2003, Goldman went on a buying spree and picked up numerous distressed assets, especially in Asia. It is this kind of forward thinking that keeps Goldman Sachs number one in its industry. Reputation – The Goldman Sach’s name is synonymous with investment banking. When Goldman fell from the number one spot in league tables in Europe, Lloyd Blankfein’s reaction was “it’s considered newsworthy that there’s a place in the world where we aren’t number one in M&A.” Relationships – Goldman Sachs is connected to many of the top people at the largest firms. This reach even extends into government where the past two Secretaries of the Treasury have been Goldman alumni. This type of connectedness forces clients to continue to use Goldman’s services in order to gain access to people. “Inside” Leverage – In its investment banking relationships, Goldman Sachs leverages the buy-side and sell-side of deals. As stated by Nomi Prins, a managing director at Goldman until 2002, “it’s called leverage inside Goldman, it might help set up a fund, be a banker to the fund and then turn the chief into a private client. Connecting business is Goldman’s business.” Versatility – the firm is very willing to alter strategy to take advantage of emerging trends in the financial markets. They are constantly shuffling people between business units. For example, they just sent top executives to the London office to better take advantage of accelerating growth there. Weaknesses Disparate Business Units – Goldman has units all over the world that often compete fiercely with one another and can devote unnecessary resources to the same deal, while creating squabbles between units. Reliance on Trading Revenue – 68% of 2006 revenue was from Proprietary Trading and Principal Investments. This sort of revenue is highly volatile and if the trend of more reliance on trading continues, there will certainly be some risk to Goldman’s share price. 22
  23. 23. Opportunities Exotic Derivatives – the company, always the innovator, is working to create new derivatives products with wide spreads. An example would be a new derivative futures product that plays alternative prices. Asian Markets- While it is becoming cliché to say that a company has an opportunity to expand in Asia, Goldman has a great opportunity in Asia with electronic trading still young and Goldman being the only foreign firm licensed to underwrite offerings in China. It also has a 6% stake in Industrial & Commercial Bank of China and works closely with the bank in developing top-tier talent and access to cheap capital. Threats Being number one – every other firm on the street is shooting for Goldman, many of them mimicking their business plan. They have to constantly strive to remain a step ahead of the competition. Possibility of M&A slowdown – the buyout market has been incredibly hot for the last couple of years, and recent buyouts have become increasingly expensive. There has been speculation that there are few remaining attractive targets, which could result in an M&A slowdown. Global Liquidity Crisis - All of the investment banking firms have done so well recently because of the access to cheap capital. If true global economic slowdown were to present itself, Goldman Sachs would certainly be at risk. 23
  24. 24. Section 5: Valuation Relative Valuation Historical P/E and Valuation P/E Forward TTM 2005 2004 2003 2002 Average GS 11.2 13 11.5 11.7 16.4 19.6 13.8 JPM 12.5 14.4 16.7 25.2 11.3 30 19.52 MER 12.4 14.3 13.1 13.7 14.5 14.4 14 MS 11.4 12.5 11.7 12.4 16 16.8 13.88 LEH 11.6 13.2 11.6 21.1 20.1 23.8 17.96 Industry 19.1 Goldman Sachs Historical P/E 25 20 15 10 5 0 Forward TTM 2005 2004 2003 2002 EPS Most P/E Pessimistic Likely Optimistic $ 16.50 $ 20.93 $ 22.60 Pessimistic 9.03 $ 149.00 $ 189.00 $ 204.08 Most Likely 11.7 $ 193.05 $ 244.88 $ 264.42 Optimistic 13.8 $ 227.70 $ 288.83 $ 311.88 Using 2006 earnings per share of $20.93 as the most likely outcome and the current P/E of 11.7 suggests that the most likely value for Goldman Sachs is $244.88 per share. The pessimistic and optimistic scenarios are analysts high and low estimate of EPS for 2007. For the optimistic P/E the 5-year average of 13.8 was used. Goldman Sachs is trading at a P/E that is close but below that of its competitors and is trading at a significantly lower P/E than its overall industry and 5-year average. Currently Goldman 24
  25. 25. is relatively undervalued compared to its competitors who are trading at a slightly higher multiple. The forward P/E is 11.2 but we see it staying closer to where it is now at 11.7 and probably increasing to be inline with its competitors. Historical P/B and Valuation P/B TTM 2005 2004 2003 2002 Average GS 3 2.1 2 2.2 2 2.4 JPM 1.6 1.3 1.3 1.7 1.2 1.42 MER 2.4 2 1.9 2.1 1.6 2 MS 2.7 2 2 2.4 2.3 2.28 LEH 2.6 2.2 1.7 1.7 1.8 2 Industry 4.7 Historical P/B 3.5 3 2.5 GS 2 JPM MER 1.5 MS LEH 1 0.5 0 TTM 2005 2004 2003 2002 Book Value per Share Most P/B Pessimistic Likely Optimistic $ 80.00 $ 86.64 $ 87.72 Pessimistic 2.07 $ 165.60 $ 179.35 $ 181.58 Most Likely 3 $ 280.00 $ 259.92 $ 263.16 Optimistic 3.5 $ 496.80 $ 538.04 $ 544.74 Goldman Sachs historically has had a comparable P/B in relation to its direct competitors. Recently, it has gone up and for the last 12 months, average P/B is 3 compared to its 5 year average of 2.4. For the most likely scenario, the LTM P/B multiple and the book value per share at the end of fiscal year 2006 were used. This suggested that the most likely value for Goldman Sachs is $259.93 per share. Currently, Goldman is trading at around $213, a significant discount by this comparison. 25
  26. 26. Historical P/S and Valuation P/S TTM 2005 2004 2003 2002 Average GS 2.7 2.6 2.6 3.1 3 2.7 JPM 3.1 2.6 2.6 2.4 1.9 2.52 MER 2.6 2.5 2.6 2.8 1.8 2.46 MS 2.7 2.3 2.4 2.9 2.6 2.58 LEH 2.7 2.4 2 2.2 2.4 2.34 Industry 4.9 Sales per Share Most P/S Pessimistic Likely Optimistic $ 50.00 $ 80.00 $ 154.00 Pessimistic 2.52 $ 126.00 $ 201.60 $ 388.08 Most Likely 2.7 $ 135.00 $ 216.00 $ 415.80 Optimistic 3.12 $ 156.00 $ 249.60 $ 480.48 Goldman Sachs has traditionally traded at a slightly higher P/S than their competitors. For the most likely scenario the 5-year average multiple of 2.7 was used in conjunction with the 5-year average sales per share of $80. For the optimistic scenario, we used 2006 sales per share, and for the pessimistic we used the lowest sales per share for the past 5 years. This indicated a most likely value for Goldman of $216 per share. This is in-line with where it is trading currently. However, we believe P/S is a comparatively poor means of valuing a company like Goldman given the significant margin mix within sales for any given year. Pro-Forma Income Statement Assumptions: Sales: Sales were grown at varying rates. This was because Goldman Sachs business is reliant on the health of global markets. To be more accurate, we built in the expanded slowdown in the global environment. We then also reflected an upswing in the cycle in the final years of the pro-forma. Segment Sales: This was found by taking calculating each segments percent of total revenue for 2006. This percent was then used to find each segments percent of sales in the future. Expenses and Taxes: all expenses were calculated as a percentage of sales. The percent of sales was found using the average for the past three years of operating performance. Taxes were also found using the average of the past three years; however, this was taken as a percentage of earnings rather than sales. 26
  27. 27. Revenues 2004 2005 2006 E2007 E2008 E2009 E2010 E2011 Investment Banking 3,286.00 3,599.00 5,613.00 6,491.44 7,010.76 7,711.83 9,022.84 10,827.41 Trading and Principal Investments 11,984.00 15,452.00 24,027.00 27,588.62 29,795.71 32,775.28 38,347.08 46,016.50 Asset management and securitities services 2,655.00 3,090.00 4,527.00 5,680.01 6,134.41 6,747.85 7,894.99 9,473.99 Interest income 11,914.00 21,250.00 35,186.00 41,382.94 44,693.57 49,162.93 57,520.62 69,024.75 Total revenues 29,839.00 43,391.00 69,353.00 81,143.01 87,634.45 96,397.90 112,785.54 135,342.65 Interest expense 8,888.00 18,153.00 31,688.00 32,457.20 35,053.78 38,559.16 45,114.22 54,137.06 Revenues net of interest expense 20,951.00 25,238.00 37,665.00 48,685.81 52,580.67 57,838.74 67,671.32 81,205.59 Operating Expenses Compensation and benefits 9,681.00 11,768.00 16,457.00 22,529.16 24,331.49 26,764.64 31,314.63 37,577.56 Brokerage, clearing, exchange and distribution fees 1,172.00 1,416.00 1,985.00 2,719.17 2,936.71 3,230.38 3,779.54 4,535.45 Market development 374.00 378.00 492.00 811.43 876.34 963.98 1,127.86 1,353.43 Communications and technology 461.00 490.00 544.00 935.48 1,010.31 1,111.34 1,300.27 1,560.33 Depreciation and Amortization 499.00 501.00 521.00 967.81 1,045.23 1,149.76 1,345.21 1,614.26 Amortization of identifiable intangible assets 125.00 124.00 173.00 387.12 278.72 306.59 358.71 430.45 Occupancy 646.00 728.00 850.00 1,370.87 1,480.54 1,628.59 1,905.45 2,286.54 Professional fees 338.00 475.00 545.00 815.02 880.22 968.25 1,132.85 1,359.42 Cost of power generation 372.00 386.00 406.00 736.15 795.05 874.55 1,023.22 1,227.87 Other expenses 607.00 709.00 1,132.00 1,433.65 1,548.34 1,703.18 1,992.72 2,391.26 Non-compensation expenses 4,594.00 5,207.00 6,648.00 10,176.70 10,851.46 11,936.61 13,965.83 16,759.00 Total operating expenses 14,275.00 16,975.00 23,105.00 32,705.86 35,182.95 38,701.25 45,280.46 54,336.56 Pre-tax earnings 6,676.00 8,263.00 14,560.00 15,979.94 17,397.72 19,137.49 22,390.86 26,869.03 Provision for taxes 2,123.00 2,647.00 5,023.00 5,237.88 5,702.59 6,272.85 7,339.24 8,807.08 Net earnings 4,553.00 5,616.00 9,537.00 10,742.07 11,695.12 12,864.64 15,051.62 18,061.95 Preferred stock dividends 0.00 17.00 139.00 156.56 170.45 187.50 219.37 263.25 Net earnings applicable to common shareholders 4,553.00 5,599.00 9,398.00 10,585.50 11,524.67 12,677.14 14,832.25 17,798.70 EPS Basic 9.30 11.71 20.93 23.58 25.67 28.23 33.03 39.64 EPS diluted 8.92 11.19 19.69 22.17 24.14 26.55 31.07 37.28 Number of shares basic 489.50 478.10 449.00 449.00 449.00 449.00 449.00 449.00 Number of shares diluted 510.50 500.20 477.40 477.40 477.40 477.40 477.40 477.40 27
  28. 28. Discounted Cash Flow E2007 E2008 E2009 E2010 E2011 EBIT 48437.15 52451.50 57696.65 67505.08 81006.09 Plus:Depreciation and Amortization 967.81 1045.23 1149.76 1345.21 1614.26 Minus: Taxes 15876.64 17192.46 18911.71 22126.70 26552.03 Minus: Incremental Working Capital 26383.82 14433.96 19422.48 36175.09 49476.33 Minus: Incremental Fixed Capital 699.79 362.28 474.19 853.59 1104.76 Free Cash Flow to the Firm 6444.70 21508.03 20038.03 9694.91 5487.22 Terminal Value 264269.66 Total Cash Flows 6444.70 21508.03 20038.03 9694.91 269756.89 WACC Calculations Terminal Growth Rate 5% Terminal Growth Rate 6% Total Capital 213672 Weight(ce) 41.06% Weight(pe) 1.45% Weight(d) 57.49% Cost(ce) 11.86% Cost(pe) 6.10% Cost(d) 3.87% WACC 7.18% Enterprise Value $239,078.63 Enterprise Value $400,680.86 Less: Debt $173,846.00 Less: Debt $173,846.00 Equity Value $65,232.63 Equity Value $226,834.86 Shares Outstanding 477.4 Shares Outstanding 477.4 Price per Share $136.64 Price per Share $475.15 As can be clearly seen from the two DCF valuations above, this DCF model in particular was extremely sensitive to the terminal growth rate selected for Goldman Sachs. We do not have any level of confidence choosing between a terminal growth rate of 5% compared to 6%, particularly given the massive ramifications of this decisions. As a result of this unsatisfactory outcome, we chose not to rely on the DCF as a means for valuing Goldman Sachs. Instead, we chose to utilize a valuation methodology that would be less reliant on a terminal growth rate in making the valuation. 28
  29. 29. Residual Valuation Terminal 2006 2007E 2008E 2009E 2010E 2011E Value Book Value $60.86 $79.15 $99.93 $122.67 $147.82 $177.09 EPS $19.69 $22.17 $24.14 $26.55 $31.07 $37.28 Dividend $1.40 $1.40 $1.40 $1.40 $1.80 $1.80 Forecast BV $79.15 $99.93 $122.67 $147.82 $177.09 $212.57 Per-share equity charge $7.22 $9.39 $11.85 $14.55 $17.53 $21.00 Per-share residual income $12.47 $12.79 $12.29 $12.01 $13.54 $16.28 $212.57 Valuation: Book Value0 $79.15 PV of Residual Income $47.78 PV of Terminal Value $121.39 Total: $248.32 Assumptions: 30-yr. T-Bond 4.87% Market Risk Premium 6.13% Beta 1.14 Cost of Equity 11.86% Terminal P/Book 2.0 The above residual valuation model finds that Goldman Sachs shares have an intrinsic value of $248.43, suggesting that GS stock is undervalued by 17.7%. The value under a residual model is largely derived from the current book value of the stock. We believe this is appropriate for Goldman Sachs given that the vast majority of its assets are marketable financial instruments, meaning that their book value is a reasonable estimate of actual value. The model assumes clean surplus accounting, meaning that it assumes that all changes to book value are occurring as a result of net income. While Goldman does use some comprehensive income accounting by way of currency revaluations, the accumulated comprehensive income tends to fluctuate around zero rather than grow continually, suggesting that clean surplus accounting is ultimately approximated. For the terminal value, we assume that Goldman Sachs would trade at 2.0 times book value, its all-time low since going public. Given these factors, we have the highest degree of confidence in the residual valuation model as a means to determine the intrinsic value of Goldman Sachs shares. 29
  30. 30. Section 6: Investment Summary and Recommendation Investment Summary • Unmatched reputation in the investment banking industry • Increased M&A activity through 2007 • Ability to leverage all aspects of the deal • Unparalleled financial performance As outlined in the previous pages, Goldman Sachs is truly an industry leader. Its financial performance is unmatched throughout the industry as demonstrated by its margin performance and financial ratios. Goldman also possesses the unique ability to lever all of its lines of business to maximize profitability. On top of being a great company, Merger & Acquisition activity shows no signs of slowing through 2007 and with a strong presence in Asia and Europe, Goldman hopes to capitalize on the global economy. Recommendation Based upon the qualitative strength of Goldman Sachs’ franchise and their strong prospects going forward, combined with the attractive valuation highlighted both in the relative valuation and the residual value model, we recommend purchase of a full position Goldman Sachs shares, or 250 shares. 30
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