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Sotheby’s earnings came out first thing last week. The earnings call and presentation was masterfully done. Although the firm reported the lowest earnings in five years, the stock leapt 20% over the course of the week following the announcement.
That’s an extraordinary performance for any stock but especially for a company that’s value has been channel bound for many years now. On Friday, Sotheby’s stock price briefly hit a 52-week high just under $50 per share before falling back slightly.
Since the beginning of the current art market boom in 2004, BID has never sustained $50 as a price. So the most important question surrounding these earnings is whether the stock price is sustainable and what happens to Sotheby’s shares when the stock is concentrated among institutional, activist and strategic owners.
The first thing to acknowledge is that CEO Tad Smith deserves a great deal of the credit for soaring stock price. That may be less for his ability to turn the company around—these earnings show that any real talk of Sotheby’s being on a strong footing is premature—than for his ability to tell Wall Street a story it desperately wants to hear.
In his presentation, Smith transformed a modest gain in the fourth quarter into a momentum story: “this quarter demonstrated that when the market stabilizes, let alone when it returns to its secular growth trajectory, our company is poised to capitalize on the upturn and do very well for our shareholders.”
Given the intense media focus on the 2016 drop in auction sales across the art market, the impression that Smith’s team gave was that Sotheby’s would ride an upward market trajectory to substantial profits.
Add to that the fact that Sotheby’s has reduced its outstanding shares by 23% over the last three years—mostly due to a massive stock repurchase provoked by activist investors—and you can understand why there’s a perception that Sotheby’s is about to take off.
There’s only one problem with that view. Sotheby’s current stock price, after the rise, is 36 times the 2016 earnings. If the company could find its way back to 2007 when it posted annual earnings of $3.25, the stock’s p/e at the current price would still be a healthy 15x.
The next best year for Sotheby’s earnings was 2010, the year after the auction house laid off nearly 1/5 of its staff and slashed marketing budgets to achieve $2.34 per share or 20x the current stock price.
The financial press focuses on the the salad days of 2013-2015 of the art market hoping that the current “slump” is a just a pause before the market resumes its peak. That maybe the case, but boom years were not very good to Sotheby’s earnings.
Here’s an important point. The record profits of 2007 were driven by direct auction guarantees. Sotheby’s used its superior market knowledge to effectively buy works from consignors and get a higher commission margin when they were sold above the seller’s expectations.
That sort of information advantage doesn’t last very long. Even had the global financial crisis not intervened, the consignors, dealers and other interested parties would have found an equilibrium point.
The earnings release rightly made much of the big jump in Sotheby’s commission margin to 17%. CFO Michael Goss made clear in the call that a big part of that rise was due to a new commission structure instituted toward the end of the year. Goss also pointed out that commission margin can rise only so much given the structure and mix of works they sell.
If the top end of the art market returns, the commission margin will fall (Sotheby’s fee schedule drops to 12.5% at $3m and above. That’s before the additional incentives the firm might give a seller to gain their business.
Adam Chinn, the recently promoted Chief Operating Officer, is by all accounts another reason margins are rising. He has imposed discipline among the deal-makers to stem the giveaways. But a smart deal-maker like Chinn (and Goss and Smith) knows that the firm makes more absolute revenue from, say, 5% commission on a $50m painting than it does from a 12.5% commission on a $10m painting.
In addition to the hopes of a high-end recovery in the art business, Smith stoked the analysts’ interest in the firm’s potential for online sales. We’ll deal with that subject in its own post shortly. Suffice it to say here, that may play well on the street but the reality of shifting the business to become a so-called online platform is much more complex than is presented by the corporation.
Central to any discussion of Sotheby’s stock has to be the ownership constituency. Sotheby’s reached a standstill agreement with Chinese insurance firm, and owner of China Guardian, Taikang to limit their stake to 15%. The agreement lasts 3 years. Presumably, Taikang is a strategic buyer that may want to acquire the rest of the firm after that 3 year period.
The also presumes Taikang doesn’t want to take a fast profit on the shares that they bought for ~$35 when BID is selling at $50. The Chinese may have no reason to sell, but the activist funds headed by Mick McGuire and Daniel Loeb may be more inclined to realize their profits.
McGuire too bought in around ~$35. He has had to cut his stake without making much money in recent months. With the excess cash on Sotheby’s balance sheet now spent and no plans to sell the headquarters building in Manhattan, Mercato may have not reason to stick around past $50.
Daniel Loeb bought in a bit higher. He’s barely above water now and it would seem odd for him to sell the second largest position in stock with little to show for his three-year tenure. Maybe the momentum will continue carrying the stock past its historic high of $57. But that seems like a big ask for one quarter that was better than expected and sales in London that were strong for that venue but not enough to make up for the pullback elsewhere.