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Sotheby’s released its 2017 earnings last week with solid improvements that show the management team, especially Sotheby’s new CFO Michael Goss, are making the most of a number of subtle advantages.
Sotheby’s CEO, Tad Smith, has what might be called a dual mandate. On the one hand, he needs to project the company into a new broader-based suite of businesses; on the other, he needs to maximize the value generated from the business where it currently makes all of its money.
Unfortunately for the readers of the New York Times, a veteran stock analyst who has followed Sotheby’s for years, doesn’t seem to know the difference between the two mandates:
“There’s more optimism,” David Schick, the director of research and lead luxury analyst at Consumer Edge Research, said. “This is an old brand that’s bringing a lot of new business practices. Some of those initiatives are starting to bear fruit.”
What are some of those initiatives bearing fruit? Why private sales, a mainstay of Sotheby’s business for decades, particularly in the years after the global financial crisis.
All of the fruit harvested in Sotheby’s annual report, which resulted in a 60% increase in income over the previous year, comes from Sotheby’s traditional businesses. Let’s look at how.
CFO Michael Goss made it clear in the conference call remarks last week that although compensation and expenses are up at Sotheby’s—the firm talks a lot about its plans to continue to invest in digital expansion but the truth is they seem to have as much money earmarked for real estate upgrades—the only publicly-traded auction house was able to increase earnings due to increased private sales, more auction sales but also tax advantages coming from being a US corporation where a huge corporate tax cut has just been passed and Goss’s clever use of capital to reduce interest costs in the financial services arm.
Deeper in the annual report, we also learn that Sotheby’s was able to generate more revenue by selling down its inventory and making good guarantee deals that added to income. In other words, Sotheby’s is buoyed up by its new head of private sales, its increased auction sales and having a top-notch CFO with plenty of tax advantages to work with. You can call these new business practices if you want to but that doesn’t make them anything more than better management and good timing.
None of this should be construed as a negative comment on Sotheby’s efforts to broaden the base of its businesses. Those efforts just haven’t shown up in the earnings report. CEO Smith has a mandate from his owners to expand the company through investment in digital businesses. But most of those investments are either in improving internal systems, which will be hard to see pay off from the outside (no one is pretending that the big jump in private sales comes from having a better database or a tailor-made CRM system that increases sales at a lower cost,) or in digital retail businesses that will take some time go grow.
If Schick doesn’t know that, he ought to. If he does, his quote in the Times is silly.
Of Sotheby’s other major investment in broadening the base of its revenue, the $85 acquisition of Art Agency, Partners, the annual report finally gives us some greater visibility on that business. The rubric under which Sotheby’s reports AAP’s revenue consistently produced $17m in 2016 and 2017 after making the jump from $10.3m in 2015. The annual report makes reference to this: “revenues increased $7.6 million (73%) in 2016 due to advisory fees earned by AAP, which was acquired in January 2016.”
So AAP’s business was making $7.6m in fees in 2016. It has since expanded into representing artists estates but the reporting has not increased. Meanwhile, other items that are contained under that rubric like royalties from Sotheby’s International Realty for using the Sotheby’s name which increased by a million dollars and revenue from RM Sotheby’s and a joint venture with Acquavella Gallery which contributed $2.9m in 2017 suggest that AAP’s contribution has not remained at $7.6m.
Because Sotheby’s paid $50m outright for the business and AAP earned and additional $35m for hitting performance targets, the company has paid AAP more in compensation during 2017 than the company earned. So that’s one initiative that is not yet bearing fruit. Having paid a little more than 11-times revenue for AAP, the firm is not likely to have a meaningful effect on Sotheby’s earnings for some time to come. To be sure, Sotheby’s paid $85m for more than just the revenue and growth potential of APP. All that is important here is to recognize that Sotheby’s improved earnings are a function of the traditional art business it has been in for quite some time, not the new initiatives it hopes to build.
While we are on the subject of the art business, it is worth asking what we know about the auction business that improved revenues. Private sales commissions rose by $13.7m or 26% to $66m; Auction sales commissions rose $46.7m to $654m or up 8%. We know from previous earnings reports that the monster sales like Jean-Michel Basquiat’s untitled head that made $110m did not produce an out-sized impact on sales commissions. One reason is the use of irrevocable bids which share the upside in exchange for off-loading risk. The other reason is the pervasive used of enhanced hammer commissions where the consignor for very expensive lots takes some of the buyer’s premium leaving Sotheby’s with an effective commission in the single digits.
Nonetheless, Sotheby’s was able to maintain a global commission rate of 17% across all of its sales. So despite the bigger ticket items, Sotheby’s wasn’t giving up margin. In fact, the annual report tells us that Sotheby’s sold 192 lots priced at $3m or above which were worth an aggregate $1.7bn or nearly 37% of its total auction sales. An additional, 366 lots priced between $1m and $3m were sold for an aggregate value of $621.8m.
More to the point, Sotheby’s commissions break at $3m where they drop from 20% to 12%. Sotheby’s guides us through their commission to think of the “middle market” as works between $200k and $3m or the 20% commission bracket. This happens to be the value band of the Contemporary art day sales where Sotheby’s saw very strong performance throughout 2017. The number of works in the $1m to $3m band stayed the same from 2016 to 2017 as Sotheby’s raised the commission rate providing the firm with more revenue and maintaining the 17% commission level.
Again, not to beat up on David Schick so heavily, this is Sotheby’s traditional bread-and-butter business, not a new initiative. (It is also a reminder to those who focus on the top of the art market that the money is maid in robust full-commission sales.)
Finally, there’s one other thing to follow up on from Sotheby’s earnings call which has some direct bearing on the issue of strategy. As mentioned above, Sotheby’s CEO has a dual mandate. He must generate better financial results while telling Wall Street a story about transforming Sotheby’s through digital initiatives and a broader array of services for art and luxury buyers. Like most dual mandates, these two goals are somewhat in opposition to each other and must be carefully balanced.
On the earnings call, Goss was quick to caution that expenses would remain at elevated levels as the company continued to invest in these “initiatives.” Nonetheless, through improved sales, commissions and better financial management, Smith and Goss have been able to generate plenty of free cash. What is to become of that cash?
We were told on the call that Sotheby’s board had decided to devote an additional $100m to buy back shares of Sotheby’s stock. Why does this matter? Well, there is a bit of an irony developing around the company. Right now two entities, Third Point and Taikang own a little more than 27.5% of the company. That gives the two effective control of the firm. It has been presumed that Daniel Loeb, the investment manager running Third Point, wants to see the company’s shares rise to a point where he can exit with a significant profit.
But the longer Loeb is in the stock the harder it is to see a return from public trading unless Sotheby’s can substantially increase its revenues and earnings. Loeb has made it known through magazine profiles and press reports that he considers his investment in Sotheby’s a long-term move and one that he has already seen a profit upon. Without a dramatic breakout in revenues, Sotheby’s already has a likely strategic buyer in Taikang, the Chinese insurance company that also owns China Guardian auction house in Asia. Owning Sotheby’s gives Taikang insight into best practices in the global art market and access to an extraordinarily valuable global brand (that only seems to be getting more valuable.)
Sotheby’s has a standstill agreement with Taikang not to increase its 15% stake through stock purchases over the next two years. Taikang also has a slight problem in the fact that China has capital controls that would make it difficult for the firm to buy the rest of Sotheby’s and take it private. With that in mind, it is worth paying attention to Sotheby’s stock buybacks. Since 2015, Sotheby’s has extinguished 26% of its shares outsanding. At current prices, the $196m that Sotheby’s now says it will spend buying its own stock will further reduce the float of shares by another 7.5%.
Curiously, Sotheby’s only bought a small number of shares in the last quarter of 2017. In fact, Sotheby’s bought 94,400 shares at an average price of $45.58. That’s only $4m of the $100m authorized. BID only traded around that level in early November. That means Sotheby’s is using its share repurchase program sparingly and waiting for moments when the stock price falls below the $50 level.
In a gingerly manner, Sotheby’s is setting itself up to let the company provide the capital that neither Loeb nor Taikang wants to contribute to take full ownership. The more successful Smith is at selling the digital story to analysts like David Schick the more expensive the stock becomes and the share repurchases will provide less leverage than when the stock falls. If Taikang’s goal is to eventually own Sotheby’s, it benefits by letting the company buyback shares at lower price. If Loeb’s ultimate goal is to be the last significant owner so he can capture the premium from a Taikang’s taking the firm private, he too benefits from buying the stock at the lowest price.
So we have the irony of Sotheby’s sitting plenty of cash to buy its shares whenever they dip into the mid-40s. But the public statements of the firm driving the stock price above $50 where there seems to be little appetite for purchases.
Sotheby’s Has Encouraging Fourth Quarter (The New York Times)