March 5, 2010

Sotheby's: Turnaround Strategy Works, Target Price Increased to $32, Dealer Segment Profitability and Low Private Sales Commissions Remain Areas of Concern
The art stocks tracked by Skate's began the year by moving in different directions. Shares have mostly been down; the exception was the auction houses in South Korea and Japan, as well as the global powerhouse Sotheby's, which have all been recording positive gains. Prior to the announcement of its financial results for 2009, Sotheby's shares were up 8.1%.
When Sotheby's released its numbers, the company's shares rose by more than 7% in the two days of March 1-2 and were trading over USD 31 at the time of this article's publication, lifting spirits for the global art trade. The timing could not have been more perfect given the start of the Armory Show this week followed by TEFAF next week.
So what does Sotheby's disclosure tell us?
Our key takeaway from the 2009 results is that Sotheby's strategy of focusing on higher-end items, developing the dealer / private sales business and executing a widespread cost-reduction program has worked. The firm is now working on considerably lower volumes but is maintaining largely intact operating margins and thus successfully defending its strong market position despite a continuously challenging competitive environment and emerging competition from online trade. Among the other things we have learned from Sotheby's disclosure:

  1. Major contraction of global art trade. Sotheby's business environment was a nightmare in 2009 - its auction volumes decreased by more than 50% from USD 4.2 billion in 2008 to a mere USD 1.9 billion the following year, bringing the company back to its volume levels of 2004. This is a very important benchmark, as Sotheby's contributed to 44% of the global art auction trade in 2009 as measured by the volumes at Sotheby's and Christie's, which means that the global art trade underwent a major contraction. We estimate that the auction trade with fine art was well below USD 6 billion even when the major local auctions are included. Even with the increase in the non-auction trade - with a market share improvement from 50% to approximately 70% of global volumes - this could not keep the global art trade from experiencing a sizeable decrease in volume. Skate's estimates that the annual global art trade volume declined from its peak of around USD 50 billion in 2007 to a current level of just above USD 20 billion.

    Skate's conferred with Clare McAndrew on the size of the global art trade. Perhaps the most authoritative source of art market macroeconomic information in the world and the author of the recently published "The International Art Market 2007-2009, Trends in the Art Trade during Global Recession" (in cooperation with TEFAF), McAndrew estimates that the market peak in fine and decorative art and antiques (dealers and auctions) was slightly higher at nearly USD 65 billion and that it contracted by more than 30% to approximately USD 45 billion in 2009.

  2. Sotheby's handles a third of its volume off-auction, and private sales represented the only growth area (in terms of revenue) for the company in 2009. Using the total art trade turnover of USD 2.8 billion reported by Sotheby's for 2009 (the so-called "consolidated sales" defined as the "sum of aggregate auction sales, private sales and dealer revenues" in the company's press release dated March 1) we conclude that Sotheby's dealer and private sales totaled approximately USD 800 million, or half of its auction sales.

  3. While Sotheby's handles less auction volume, it makes more on each sale. Skate's measures auction house efficiency by converting auction trade volume into revenues through the "Intake Ratio" defined as "Auction and Related Revenues as Percentage of Net Auction Sales." Sotheby's Intake Ratio, which dropped almost four percentage points in 2008, increased dramatically from 14.7% in 2008 to 23.5% in 2009, thus well exceeding the levels of 2005-2007 and thereby defining Sotheby's as having a very robust auction model. Sotheby's shareholders should be happy, but clients should be aware that Sotheby's (and the other major auction houses) remain a very expensive marketplace where transaction expenses far exceed those found not only in mainstream but also in other major alternative investment markets.

  4. To lower transaction costs, one should deal with art through Sotheby's but outside auction room. Sotheby's off-auction turnover of approximately USD 800 million translated into USD 37.5 million in revenues from private sales (up by 11% from 2008) and USD 22.3 million in revenues from the Dealer segment (Form 10K, pg. 24). These figures suggest an Intake Ratio of only 7.5%, leading Skate's to conclude that clients' transaction expenses incurred with private sales at Sotheby's were on average only a third of those incurred at auction.

Outlook for 2010
Our major area of concern was the decline in EBITDA in both absolute and relative terms, as well as the continuously bleeding Dealer segment, which has consistently been the only loss-making segment at Sotheby's over the last three years.

Exhibit 1 - Sotheby's EBITDA
EBITDA / Year200920082007EBITDA77.7105.6323.6EBITDA Margin16%15%35%
Source: Sotheby's Form 10-K.
The Dealer segment reported a segment loss of USD 10.4 million over segment revenues of USD 22.3 million. Apparently the only reason the loss was smaller than in 2008 (USD 28 million) was due to a reduction in the size of activity, leading to a decline by more than 50% in segment revenue from the level of USD 55.6 million in 2008.
Our conclusion above is central to our outlook for Sotheby's in 2010. While Sotheby's business model has historically raised valid concerns, Skate's believes Sotheby's does have a solid turnaround strategy in place. Bringing auction volumes back up (the first two months of the year have shown us that Sotheby's is perfectly capable of such an achievement), operating a strongly profitable auction segment, raising commissions for private sales and fixing losses in the Dealer segment seem to be the key elements of the strategy.
As online art trade continues to grow, Sotheby's remains sufficiently shielded from this competition due to its focus on the higher end art market. Although the company is losing out on market share to Christie's, Sotheby's is quite likely on the right track through its emphasis on profitability over market share and avoidance of risky gambles in the form of excessive auction guarantees.
We remain fairly positive for Sotheby's in 2010 and are increasing our target price to USD 32 per share. We will be specifically watching for Sotheby's to fix profitability issues in its Dealer segment. We also expect the company to be careful with expansion and financial risks going forward. Finally, we believe that modestly increasing private sales commissions to avoid cannibalization of the auction segment should be an important priority for 2010.

Exhibit 2 - Sotheby's vs. Skate's Art Stocks Index - 2010 YTD
Source: Skate's Art Market Research.

Exhibit 3 - Skate's Art Stocks - February 2010
CompanyListing / CurrencyFebruary 2010
PerformanceYTD 2010
as of Feb-26, 2010
USDMarket Cap
as of Feb-26, 2010
USD mlnSotheby'sNYSE / USD4.6%8.1%24.301,635Artprice.comParis / EUR-15.4%-20.7%10.4465ArtnetFrankfurt / EUR-6.0%-11.5%6.2935Collectors UniverseNASDAQ / USD-0.2%1.7%9.5180MallettLondon / GBX-6.3%4.1%107.7615Finarte Casa d'AsteMilan / EUR-13.7%-19.9%0.2311Gruppo FMRMilan / EUR-16.8%-15.8%5.4520Camera WorkFrankfurt / EUR-3.6%-10.3%6,428.00257Art VivantTokyo / JPY7.0%10.3%3.0147Seoul AuctionsSeoul / WON-6.6%9.6%2.6443Shinwa Art AuctionTokyo / JPY-9.6%-17.3%210.7113Stanley GibbonsLondon / GBX-13.0%-17.1%179.6045Skate??ôs Art Stocks Index1.5%2.8%123.92,268
Source: Skate's Art Market Research.

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