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Stock Analyst Update

Goldman Sachs in Profitable Deal to Reach Retail Investors

Acquisition boosts trading and clearing, makes stock more attractive.

Goldman Sachs’ (GS) $6.5 billion deal Monday to acquire leading specialist firm Spear, Leeds & Kellogg boosts its recurring revenues through a larger presence in stock execution and clearing. And because this will help make earnings more consistent, it should benefit Goldman’s stock price as well. Thus, although the stock was up more than 6% early Monday afternoon, close to an all-time high of $133, its shares continue to look attractive for long-term investors.

The deal will add about 2% to Goldman’s bottom line, or about $0.13 to next year’s current earnings estimate of $6.65 per share. But on a cash earnings basis--without amortization charges--Goldman is estimating the deal will add 9% to earnings. The price paid was partly based on ensuring the deal was immediately accretive to Goldman’s earnings. And the addition to earnings only includes $50 million in savings achieved through lower financing costs; it doesn’t take into account any possible revenue synergies.

Thus, chances are that Goldman’s earnings will benefit significantly more than current estimates. Spear Leeds is a highly profitable firm without a money-losing month since 1992. And with Goldman’s backing, Spear Leeds will be able to take its successful U.S. franchise and expand overseas, particularly in Europe and Asia.

It is in fact in these geographic areas and through cross-selling to the firms’ respective clients that Goldman and Spear Leeds expect to see the biggest advantages from their combination. Because Spear Leeds caters more to the retail client and Goldman has primarily focused on the institutional investor, there’s not a lot of client overlap between the firms. And combined, both firms now have a larger set of products to offer clients.

Also, through this deal, Goldman is hedging its bets on the future direction of the major stock exchanges. It will gain at least a 20% stake in Redibook, the third-largest electronic communications network, which cuts out the middleman by electronically transacting buy and sell orders. Goldman will also increase its share of Nasdaq market-making volume, moving to fourth place behind Knight Trading , Merrill Lynch , and Schwab Capital Markets, part of Charles Schwab (SCH).

In fact, the leading Nasdaq market maker, Knight, is one firm that’s been left out of the ongoing consolidation of market-making firms. In the last few months, it has seen formidable competitors become greater rivals in field, including Merrill through its purchase of Herzog Heine, and FleetBoston  through its purchase of M.J. Meehan. In fact, Knight is now one of the few remaining market makers not part of a larger, more diversified financial institution.

Thus, Knight looks like an attractive takeover target as it trades at 12 times projected 2000 earnings, a substantial discount to the price/earnings multiples of the Standard & Poor's 500 index and the securities industry. Potential acquirers include Morgan Stanley Dean Witter , which is the only one of the top three investment banks that has yet to increase its market-making presence, or possibly a large bank such as Chase Manhattan (CMB) or Citigroup (C).

Alyssa Sibley has a position in the following securities mentioned above: GS. Find out about Morningstar’s editorial policies.