Description

As outlined below, Sotheby's has evolved significantly since 2008-2009 in 5 critical ways:

1) Expansion of China sales & diversification of both global market and Sotheby's revenue base. Art market today materially different from makeup at prior peak in 2007

2) Focus on Private sales which have grown as % of total sales

3) Use of Guarantees - scaled back use of guarantees which removes a major source of off balance sheet liability's and risky business ventures

4) Reduced cost structure and improving margins

5) Strong liquidity and net cash position (2008 net debt balance of $204mm vs. 6/30/11 net cash of $186mm) 

Investment Highlights include:

• Global duopoly with strong franchise/brand value; Along with Christies, dominates the global auction market
• Strong Barriers to entry provides Sotheby's with a competitive moat and strong hold on the global art market
• Significant improvements made to the business model since the recession: 1) reduction of financially risky guarantee arrangements; 2) slashed costs thereby reducing fixed cost basis - has led to record EBITDA margins (53%) in Q2 2011 as Sotheby's benefits from improved operational scale
• Asset light business model - High EBITDA to FCF conversion with minimal capex; tremendous ROIC scale potential given can grow business significantly (i.e. more volume/higher prices at auctions) without need to scale up fixed costs of operations
• Diversifying revenues outside of auction into private art sales ($38.2mm in H1 2011 revenue; 176% increase YoY)
• China story: Much more diversified revenue base: 14% of revenue now from China (Hong Kong)
• Growth of Asian market broadens buyer base and provides for huge growth potential

Overview of Sotheby's Business & Fine Art Industry

Business Overview

Sotheby's  is one of the world's two largest auctioneers of authenticated fine and decorative art, jewelry and collectibles engaging in over 70 fine art categories.

Sotheby's operates through three segments: Auction, Finance & Dealer:

• Auction (historically 90-95% of sales; 94.4% 2010 sales): Sotheby's primarily acts as an agent, offering authenticated works of art for sale at auction.
• Additionally, the company sells items through the brokering of private sales:
• o Conducted 278 auctions in ten salesrooms around the world in 2010; principally in New York, London and Hong Kong.
• o Operates globally with 90 locations in 40 countries.
• § The New York and London salesrooms represented 72% of Sotheby's 2010 worldwide aggregate auction sales;
• Revenues from China (Hong Kong) were 14.4% of sales and have been rapidly expanding (5 year Sales CAGR of 27%).
• Finance (1.3% of 2010 sales with $192.7mm in secured loans outstanding at 6/30/11, total credit loss allotment of less than $834K):
• Provides art related financing to certain collectors and art dealers secured by pieces of art with a target LTV for loans of 50% or lower.
• Historically the loans have performed very well (of $2.9bn loans from 1991-2010, total loan loss of $11.3mm, 0.4% of total loans).  Two types of loans advanced:
• o (1) advances secured by consigned property to borrowers who are contractually committed, in the near term, to sell the property at auction
• (effectively provides up front liquidity to sellers without seller sacrificing the upside realized upon actual sale of the item)
• o (2) general purpose term loans secured by property not presently intended for sale (i.e. Term Loans), typically made with full recourse against the borrower.
• Dealer(3.8% of 2010 sales): Select art dealers in which Sotheby's has investments; includes equity investment in Acquavella Modern Art, a NY based dealer
• Sotheby's also engages in Brand Licensing ($3.1mm or 0.5% of 2010 sales); Reology Corp licenses the Sotheby's brand for its luxury residential real estate brokering business

            The sale of works of art in the international art market is primarily effected through the major auction houses, numerous art dealers, smaller auction houses and also directly between collectors. The art market is notoriously difficult to size as art dealers and smaller auction houses generally do not report sales figures publicly. Sotheby's along with many other market commentators (i.e. Clare McAndrew of Art Economics) believes that art dealers account for the majority of the volume of transactions in the international art market. In its Q2 2011 CC, management casually indicated that the Global auction marketplace is probably $20-30bn in size and non auction is probably similar in size. The only available data is from the auction houses so the below analysis is inherently limited since it does not and cannot include the private sale market. The most accurate data available on the auction side of the market is provided by Sotheby's which aggregates its auction sales along with those of Christies (Private) and Phillips (Private), historically the number 3 global auction house (recently bumped to #4 by an Asian auction house) but of much smaller scale and significance compared to Sotheby's and Christies (i.e. $300mm in 2010 auction sales compared to combined auction sales of Sotheby's and Christies of $8.7bn). The auction data from Sotheby's & Christies ("S+C")is presented below:

            The aggregate auction volumes for S+C in the last 20 years exhibits cyclical tendencies. At 3 points in the last 20 years, the total annual S+C auction sales declined in size. The 1991 crash is attributable to the collapse of the Japanese stock and real estate markets as the Japanese "stopped buying art overnight" with "art catalogs that had been 2 inches thick shrank to being a centimeter thick." The S+C market (along with rest of art market) slowly recovered over the next few years with every year post 1991 larger in size than the prior year except for a slight decline in 2000. The 2000 collapse of the internet bubble drove the aggregate S+C auction sales volume lower. The market stayed at lower levels before taking off again in the 2004-2007 periods. The market then crashed again in the most recent recession, primarily in late 2008 and through 2009. 2008 and 2009 were financially difficult years for Sotheby's as it was negatively impacted by the fixed operating leverage in its business. A high fixed cost basis, primarily SG&A strained the company as revenues dropped by 25% and 30% in 2008 and 2009 respectively. Along with the recovery of the stock market, however, the aggregate S+C auction sales came back strongly and continues to demonstrate strength though aggregate 2010 S+C auction sales were still lower than peak 2007 levels. Aggregate 2011 auction sales for Sotheby's as of 6/30/11 were $3.0bn, with Q2 2011 Sotheby's highest quarterly revenue ever.

Competitive Positioning of Sotheby's: Participant in Global Duopoly with Strong Barriers to Entry; Competition is driving margins lower, however

            Together with Christies, Sotheby's operates in what is effectively a duopoly in control of the global auction market for fine art in the West (historically, Chinese and other Asian art markets were significantly smaller than the market for Western art). The two companies have historically narrowly traded supremacy with each other and the split in their aggregate auction sales in a given year over the last twenty has roughly stayed in a tight band of 45-55% split between the two companies. There are significant barriers to entry for any other auction house which would attempt to take meaningful market share from S+C. The moat protecting both Sotheby's & Christies is twofold:

• 1) Network effect: there is a virtuous cycle which reinforces the dominance of S+C as the two companies have strong records and deep contacts within the industry for both the buyers and sellers. Sellers are subsequently compelled to sell through one of the two auction houses as they know that S+C are best positioned to market the items and to reach the widest and most relevant buyers. Buyers then direct their attention to the S+C auctions since they know S+C will get the most sought after items. The cycle then reinforces itself as more buyers and sellers look to S+C. This has gone on for several centuries and we expect this trend to be a long term trend for the industry. As a case in point, Phillips (around since 1796), historically the #3 global auction house has never succeeded in retaining meaningful market share from S&C per the data available from Sotheby's detailing auction sales of S+C and Phillips over the last 20 years. This despite a nearly 10 year ownership and backing by LVMH from 1999-2008.
• 2) Expertise & Trust: Sotheby's (founded 1744) & Christies (1766) have centuries of experience through which they have developed client trust, credibility, unparalleled contacts within the industry, market knowledge/data as well as detailed appraisal history and expertise. Additionally, the companies have logistical expertise and scale which facilitate the global demands that the auction market can demand (i.e. import & export expertise, cultural patrimony expertise, tax & estate planning expertise). Finally, the two companies have proprietary research on provenance and identity of ownership for over 100 years.

                  a. Particularly as it relates to trust, Sotheby's and Christies have an edge over other auction houses and galleries (including Chinese auction houses where corruption and trust remain major issues) when it comes to Chinese buyers (see below) as "Chinese collectors prefer buying at auction rather than privately (Artvest Spring 2011 Report)."

Against Christies, Sotheby's attempts to differentiate itself by portraying itself as focusing on a smaller volume of higher value items while simultaneously painting Christies as emphasizing high volume and lower valued items. In its Q3 2009 Conference Call management commented:

" I think we are not focused on gaining share from Christie's. We are focused on client relationships and focused on the high end of the marketplace. We are in such different businesses than Christie's. We do less than 50% of the lots that they sell. Our average lot is twice as valuable as Christie's lot on average, over time. And we are, as an organization, really in quite a different business despite the media obligation to compare us on an hour-by-hour basis."

            Going forward, we expect Sotheby's and Christies to maintain their dominance of the Western art market while making inroads into the Chinese market (see below). Against each other, we expect the two companies to remain intensely competitive (see discussion of Net Auction Margins below) yet much more rational than they were at the height of the peak market in 2007 and continuing into 2008 when both companies were negatively impacted by the Auction guarantees that they had issued.

Art Market Supply Side          

            On the supply side, the principal reasons for sale are outlined by Sotheby's as the 4 Ds: Death, Divorce, Discretion (i.e. change in taste or collection focus, redecorating, strong market) and Debt. These are for the most part driven by life events or personal issues which more or less are perpetual sources of resupply of art pieces (on top of new works created by living artists) into the market. Furthermore, only 10-15% of the pieces sold by auction in the art market have been purchased by institutions or other entities whose purchases removed those pieces of art from the global supply. Finally, the emergence of the Chinese art market has introduced a new and likely permanent source of fine art supply to the global marketplace (see below).

Art Market Demand Side

            On the demand side, the typical buyers of the fine art targeted by Sotheby's which is at the highest end of the value spectrum, are high net worth individuals. Sotheby's summarizes some key facts from the "2011 World Wealth Report" (published by Merrill Lynch and Cap Gemini about High Net Worth Individuals (HNWI) in 2010) which highlight that the buyers on the demand side of the market are as strong as ever as the global rich continue to get richer:

• Globally, HNWIs' financial wealth grew 9.7% in 2010 to reach $42.7 trillion, surpassing the 2007 pre-crisis peak. The global population of HNWIs grew 8.3% to10.9 million.
• Regionally, the population of HNWIs in Asia-Pacific, at 3.3 million individuals, is now the second-largest in the world behind North America, and ahead of Europe for the first time. The combined wealth of Asia-Pacific HNWIs had already topped Europe's in 2009, and that gap widened in 2010.
• Ultra-HNWIs posted slightly stronger-than-average gains in their numbers and wealth. The global population of Ultra-HNWIs grew by 10.2% in 2010 and its wealth by 11.5%. As a result, Ultra-HNWIs accounted for 36.1% of global HNWI wealth, up from 35.5%, while representing only 0.9% of the global HNWI population

Basically, as everyone knows, the rich are getting much richer and wealth continues to skew toward the very wealthy which is great for Sotheby's since the more uber rich people out there, the more people with money that needs to be spent with fine art an obvious beneficiary.     

Demand has been further strengthened as many global buyers have become disillusioned with the stock market among other assets (this psychological attraction reason is inherently not quantifiable). This theory posits that much like the flight to gold, buyers are increasingly drawn to diversify into art. On its Q2 2011 CC, management suggested that the recent volatility in the stock market actually benefits the art market as the flight to hard assets whose value is not driven by economic conditions (unlike real estate or stocks).

China Story

            As the rich are getting richer, the most important change in the global art market has been the strengthening of both Chinese buyers interest in global art in general and in particular the rapid growth of the market for Chinese art. According to data provided by Artprice.com (publicly traded), the number of $1mm+ items sold in China (only looking at auctions where data is available) jumped from 84 in 2009 to 490 in 2010. A similar story emerges when considering Chinese art sales as compared to total global art sales (including private & auction) in other countries in data compiled by Artvest, a NY based art advisory firm (Artvest Spring 2011 Market Analysis) -

                        Growing Chinese Art Market Share                

Year                 2006    2008    2010

Mkt Size($bn)  $57.2   $59.5   $57.4    <<<<Global Market Estimate per Artvest/TEFAF

USA                 46%     35%     32%

UK                   27%     34%     29%

France              6%       6%       5%

China              5%       9%       19%

Other               16%     16%     15%

Total                100%   100%   100%

            Notably the geographic breakdown of Sothebys' sales over the past few years captures the growing role that China is playing in the global art market. As a gauge for the longer term stability of the current strong art market particularly as it impacts Sotheby's, it is crucial to recognize that a significant portion of Sothebys' sales increases in 2010 was attributable to China and not just a rebound of US/UK:

Sotheby's (BID) Sales Breakdown by Geography                                                                                                       

$(mm)               2005    2006    2007    2008    2009    2010    % of 2010                  

US                   213.4   312.5   371.5   227.6   203.1   318.1   41.1%              China CAGR

UK                   194.3   231.5   352.5   296.7   145.3   233.8   30.2%              2005-2010

China               32.9     40.5     59.6     52.3     50.1     111.7   14.4%              27.7%

France              0.0       15.3     30.8     41.6     29.2     44.8     5.8%               

Other               74.0     66.1     105.5   76.7     60.9     73.5     9.5%               

Intercompany  (0.6)     (1.1)     (2.1)     (3.3)     (3.6)     (7.5)     -1.0%              

Total                513.9   664.8   917.7   691.6   485.0   774.3   100.0%                                   

Even so, Sotheby's/Christies only have a small portion of the China/Hong Kong market with 7 of the top 10 global auction houses located in mainland China (In contrast to Sotheby's revenue, Sotheby's does not break out auction sales by location which we would need to compare net auction margins across geographies).

It is incorrect then to conclude that the strong art market seen in 2010 and 2011 is just a reenactment, albeit slightly lower, of the peak period in 2007 with the identical vulnerabilities to global shock. The strong results in 2010 show that the US and UK still are below the peak periods in 2007 with the gap of the increased in sales coming from a growing market in China. While the art market is no doubt always impacted by macro issues, the rapid growth of the Chinese art market and Chinese demand has altered the global art market and certainly diversifies the prior geographic revenue concentration which characterized Sotheby's operations. Despite record revenues and a very strong art market (recent Fall results from Sotheby's auction of Chinese art were robust), the market has slammed the stock much more than the rest of the market the past several months as people fear given the macro environment, the art market may collapse. The market today is a much more diverse (China) market than it was a few years ago and the key players (ultra rich) have made a lot of money since the recession. The art market can very possibly go down in size in the near term on account of macro issues which is why we think this investment is best for funds with long term horizons (i.e. can be patient to wait for a double in 2-3 years and likely earlier given difficulty in timing art market). In the long run, however, the market is poised to continue to grow larger as the market for Chinese art is just getting started (see recent article in WSJ on 10/7/11 on the Chinese art market).

Industry Outlook

            It is exceedingly difficult to try and gauge how large the art market will be in a given future year. Nonetheless, recent trends in 2010 and 2011 show a very strong market with a much more diversified buyer base than when the market last peaked in 2007. On the supply side, favoring a continued strong art market is data from Skate which shows that the premium segment of the global art market is becoming increasingly diverse. "Of the 223 artists whose works changed hands at auction above the Skate's Top 5,000 threshold of $1.87mm, 47 were artists with no prior price records in the ranking, 46 were living artists and 53 artists came from BRIC countries." The more premium pieces of art in circulation, the larger the available supply driven by the 4 Ds outlined above that can be resold into the market in a given year. From talks with people in the industry, an art market contraction is more likely to result from sellers holding off on bringing items to market (i.e. prefer to sell item that has been on shelf for 40 years in a frothier environment; waiting a year is easy to do). Demand is actually the stronger side as the HNWI are well positioned and continuously looking to purchase premium art. While it is easy to draw parallels from late 2008 and 2009 when the decline in the stock market correlated with the decline in the art market, a longer term fallout from Europe would not necessarily have the same extreme negative impact on the art market as the global recession did in 2009.With the ultra rich continuing to get richer, an increasingly larger number of global billionaires and individuals with substantial wealth, a general flight to tangible assets after the stock market crash in 2009 as both a safe store of value and a hedge against inflation, and importantly, the rise of the Chinese buyer, the demand side of the art market is better positioned for a global economic fallout than it was in 2009. Confidence in strong demand would then encourage sellers to bring pieces to market even in a weak macro environment. However it plays out in the short run, over the long run (i.e. next 5-10 years), we expect the art market to continue to expand from current levels.

Auction Business Model

            The bulk of Sotheby's business is conducted through its Auction segment where Sotheby's makes money by earning a commission on items sold at auction or brokered through private sales. At auction, commissions (both seller & buyer) are earned as a % of the Hammer Price, namely the final bid accepted at the auction whose conclusion is signified by the banging of the auction hammer. As an agent, Sotheby's role is to stimulate buyer interest through professional marketing techniques and to match sellers and buyers through the auction or private sale process. Prior to offering a work of art for sale, Sotheby's experts perform significant due diligence activities to authenticate and determine the ownership history of the property being sold.

            In a typical transaction, Sotheby's serves as a middle man. Upon completion of auction, Sotheby's books a receivable for the Hammer price plus the buyer's premium (which varies depending on Hammer Price: 25% for first $50K, 20% through $1mm and 12% for any amounts on items larger than $1mm. Premium is cumulative so an item sold for $1.1mm will have 3 different premiums applied with 25% applied to $50K, 20% applied to next $950K and 12% applied to the $100K above $1mm). Simultaneously, Sotheby's records a payable to the consignor (seller of the item) for  the Hammer price less commissions and expenses. Auction commission (buyer + seller) accounted for 86% of 2010 sales.

Net Auction Margin

Financial Summary

      Sotheby's financial performance is driven by global art sales with Net Auction sales the key driver. Sales and EBITDA peaked in 2007 before the collapse of the market in 2008/2009. The industry is highly seasonal with major sales taking place in Q2 and Q4. Accordingly, Sotheby's generally books a loss in Q1 and Q3 due to the delevraging of the fixed costs inherent in its business. The losses are typically more than made up through the earnings in Q2 and Q4. Notably, Sotheby's earned a small profit in Q1 of 2011. Since 2007, Sotheby's business model has evolved such that Sotheby's in 2011 is significantly improved financially from its makeup at its 2007 peak:

1) Expansion of China sales & diversification of both global market and Sotheby's revenue base (see above)

2) Focus on Private sales which have grown as % of total sales (see above)

3) Use of Guarantees: As competition between Sotheby's and Christies heightened at the peak of the market in 2007 and into 2008, both companies utilized large amounts of auction guarantees to win business. Effectively, the companies guaranteed a minimum price to the seller which enabled the seller to sell with a floor value while retaining upside potential should the auction price clear the guarantee. When the market fell apart in 2008, both auction houses were left with severe losses as they were on the hook for the guarantees in an environment in which buyers were willing to pay the guaranteed price. The guarantee activities are included in a line item called "Principal Activities" found in the Revenue Breakout comprising the Auction segment (above). In 2008, $60.2mm of the loss in principle activities was directly attributable to guarantees. Since the recession, both Sotheby's and Christies have dramatically scaled back the use of risky guarantees:

Recently, even when it does utilize guarantees, Sotheby's has generally succeeded in removing the risk associated with the guarantees through attaining third party bids in which outside parties commit to the guaranteed level while gaining participation in the upside should item sell for more than the guarantee amount:

4) Reduced cost structure and improving margins: Sotheby's eliminated 20% of its workforce in 2008 and 2009. Sotheby's is currently a much leaner organization with tremendous operating scale as it leverages its fixed costs in an improving art market. The bulk of Sotheby's costs are in Salaries and G&A. G&A is down ~$30mm ($176mm in 2007 to $142mm in LTM). Most of G&A is fixed (includes leases). Salaries is split between fixed costs and variable costs:

Full time salaries, the fixed component is down $25mm from a 2008 peak. The bulk of the remaining costs in Salaries are variable in nature (incentives/share based) and thus have increased as the company's performance has improved. In short, Sotheby's has a much leaner fixed cost basis than it did in 2007/2008 which has resulted in record EBITDA margins (53% in Q2 2011).

Catalyst