Description

Recommendation: ShortName: Sotheby’s Holdings IncTicker: BID Shares Outstanding: 44.9 mln Class A 16.5 mln Class B (Fully convertible into Class A) 61.4 mln
Market Capitalization: $740 mln Net Debt: $215 mlnEnterprise Value: $955 mln
P/E: Negative TEV/ EBIT: Negative
Forward P/E: No Analyst Coverage TEV / EBITDA less capex Negative
Price/ Sales: 2.2 x TEV / Sales 2.8x
ROE & ROA: Negative


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Overview:
I believe that the stock is grossly overvalued based on any metric under which you can value this company. Operating earnings have been negative over the last three years in arguably one of the most bullish art markets in history. A review of auction databases shows that the highest painting prices were paid during 89-91 period after the Japanese stock market bubble and in the 99-02 period after the US tech market bubble. The 3rd highest price ever paid for a painting was accomplished during Sotheby’s recent London sale in which a Rubens (Massacre of the Innocents) sold for $79 mln dollars. It is also important to note that operating earnings for Sotheby’s have not grown in a decade!; in fact, they have decreased substantially during the late 80’s to late 90’s period. Peak operating profits were recorded in 1989 of $ 178 mln; in 1998 operating profits were $98 mln on substantially similar revenues, a decrease of 45%. Since then operating profits have declined substantially reaching a low of negative $30 mln in 2001.

Sotheby’s along with Christies of England control approximately 95% of the $4 bn auction world. In early 2000 the companies were accused of conspiring to fix prices charged to clients by the US antitrust department. Both firms subsequently settled with the government in a $512 mln settlement. Furthermore, during the investigation, it became apparent that the Chairmen of the firms had been responsible for the conspiracy and had instructed the senior management of their respective firms to carry out a strategy to insulate the firms from competition. Alfred Taubman, Sotheby’s Chairman and controlling shareholder and Sir Anthony Tennant, Chairman of Christie’s, were sued by the U.S antitrust department and found guilty. Sir Anthony refused to come to the US to face the suit and stayed in England, where price fixing is not illegal and from where he cannot be extradited. Alfred Taubman was sentenced to a year and a day in jail, which he is scheduled to begin serving on August 1st, 2002.

More import than the result of the conspiracy; however; is why the firms began colluding in the first place. The Antitrust suit claims that the collusion began in the early to mid 90s and the reason for this would be easy to explain. The art market had collapsed due to the recession experienced during that period; with the firms facing an uncertain future they began colluding to protect each other from the negative effects of competition. Fast forward 10 years: Its now mid 2002 and the art market is under generally bullish conditions being spurred by buyers having to put their money somewhere other than the stock market where they have faced extensive losses over the last two and half years. Talking to any art expert will tell you that prices cannot stay high for long, furthermore; irrespective of art prices Sotheby’s has been unable to turn a profit and NOW they can’t turn to fixing prices to help them out in a declining environment.

It has been splattered all over the press that Alfred Taubman wants to sell or merge Sotheby’s, not coincidentally when faced with a bad market where he can no longer collude, and I believe that this is one of the reasons why the stock is not trading substantially lower than where it is. On June 3rd, Taubman signed a Stand Still Agreement with Sotheby’s indicating that he would not sell his shares for 90 days while he and the company look for strategic alternatives. Concurrently, Taubman indicated that he had retained Goldman Sachs, to help him and the Company in this endeavor. Goldman Sachs replaced CSFB as the advisor, which to anyone that has worked in M&A means CSFB could not get the job done. It is very difficult to come up with a scenario under which Sotheby’s gets sold, at least at the current price. Strategic buyers do not exist. Christie’s cannot buy Sotheby’s. Phillips, the third largest auction house cannot buy Sotheby’s, but more importantly, Phillips, which was acquired in 1999, just two years ago by LVMH, the French luxury goods giant, was recently sold back to Phillips’ management. LVMH got tired of losing money in the business. Estimated losses were in excess of $100 mln for a company for which LVMH had paid $100 mln purchase price. Furthermore, LVMH’s Chairman, Bernard Arnault indicated that he had no interest in acquiring Sotheby’s as had been speculated incorrectly about in the press. eBay with which Sotheby’s has a strategic alliance bought Butterfield a San Francisco traditional auction house. They shut down the Butterfield operation stating that it did not match their strategy. That leaves us with two options; a financial buyer and an ego buyer. A financial buyer is, I believe out of the question, because they are looking at the same numbers that we are which don’t warrant a purchase price anywhere near where the stock is. I believe an ego buyer to be the greatest risk to the short recommendation. By ego buyer, I call a rich individual wanting to purchase his/her way into the upper echelons of “society”; however; in 1983, Taubman was himself an ego buyer, but he did not pay nearly the price which they are now asking for the company nor were the US / Canadian and European antitrust departments and class action lawyers breathing down the company’s neck.

Operations:

Although Sotheby’s would appear to be a good business at first sight (duopoly) its actually not. To conduct business in this sector you have to have a number of expensive experts in each of the more than 90 fields in which Sotheby’s claims to hold auctions. Furthermore, the experts and employees travel constantly all over the world finding collections of things to sell and convincing people to sell what in many cases are old family heirlooms. To do this, the auction houses have gotten in the habit of fronting customers the cash for their items until they are sold at auction, which in many cases can be several months down the line. Furthermore, they sometimes offer sellers minimum price guarantees. In the event that an item does not sell Sotheby’s pays the guarantee. In the event that an item sells below estimated price Sotheby’s makes up the difference. This wonderful strategy is how LVMH took a bath on Phillips. Sotheby’s clients tend to be the wealthier members of society also, which means that customer service costs are very high and that skimping on catalogue quality or cocktail parties or any form of cost cutting generally does not get you very far. The place to cut costs, is on salaries, which means that you are actually taking away from the experts and relationship managers which generate revenues in the first place. These people are in the unique position of seeing valuable pieces of art, jewelry, etc. before the Company does and can make a “private” deal with a buyer before the Company even knows that something exists or is for sale. All this being said, the only division to post positive operating profits recently has been Real Estate where the expert is not so expensive and where there is no need for a showroom and an incredibly beautifully prepared catalogue.

Liquidity:

Sotheby’s has $230 mln of debt. $130 mln is in a fully drawn secured bank loan. The loan is secured by shares in the operating subsidiaries of the Company and by the 400,000 square foot building out of which Sotheby’s conducts its New York operations. The building is located on the upper east side of Manhattan. The bank loan is due and fully payable on August 11th, 2002. The Bank Loan Agreement has several covenants that restrict the additional indebtedness that the company can incur and specify several financial ratios that must be met. A call to the company asking whether it was in compliance with the covenants of the bank loan produced an affirmative answer. Sotheby’s also has $100 mln unsecured bond issue outstanding due in 2009. The company only has 14 mln in cash on the balance sheet. Historically, the June quarter of operations has been cash-flow positive; however, the September quarter, when the bank loan is due has been negative and the company will not have sufficient funds to cover both the bank loan and the cash-flow shortfall. In all likelihood, the banks will roll on the loan, which would cause Sotheby’s to have to come up with the funds to finance operations, which is no small trick in this environment, in particular for a highly levered company in terms of interest coverage. The company states that in order to meet liquidity needs, it may undertake a sale-leaseback of its New York Property, which is fine, except that the value of that sale leaseback would have to be in excess of $130 mln because the first $130 mln would go to pay off the bank loan. Assigning a $400 dollar per square foot average price to 400,000 square feet in NYC gets you to a $160 mln value for the building. Average midtown purchase prices per square feet during 2001 for commercial real estate were $281 dollars. The property has recently been renewed so looking at the higher end of the range would be appropriate, but in all likelihood the Company will have to raise capital somehow if operations don’t improve. The most likely scenario is a preferred issue, which would be dilutive. Shareholders may front the company the money, but Taubman has already paid $186 mln in cash to settle the antitrust suit and some class action suits, which would probably no make him happy about having to continue funding this Company.

Finances / Valuation:

These are personal projections and they should not be viewed as accurate and should be used for illustrative purposes only


Sotheby’s peak recent earnings were in 1998 and were $45 mln. Assuming that earnings reach that level again in 2004 and applying a 20 times multiple to those earnings, you arrive at a $600mln equity value or $14.5 dollars a share. Not exactly a great short from 12 dollars currently. Breaking this down; however; it would be fair to argue that its going to be damn near impossible for Sotheby’s to have 45 mln in net income in 2004 . The last time they attained those numbers was in 98 with the world economy showing unprecedented growth, the stock market, except for the month of the Russian crisis, reaching ever-higher levels and all the while colluding with Christies. It would also be fair to argue that a multiple of 20 times earnings for a highly cyclical company that has not grown in 10 years is not justified. It was maybe justified while the companies were colluding, but certainly not now. All of this argues for a substantially lower valuation. Average Company net income over the last 15 years has been $40 mln excluding antitrust settlement liabilities. Including settlement liabilities net income has averaged $20 mln dollars. We believe that looking at after liability costs is more appropriate given that the company could not have achieved the results it did had it not been for price fixing. We furthermore note that from peak to peak, net income decreased from $112 mln in 1989 to $45 mln in 1998 a decrease of 60%. The reason for this decrease is that while salaries and expenses grew significantly over the period, the auction market did not as is evidenced by total firm revenues.

Sotheby’s should be valued as a cyclical. As such, we believe that it should be valued at 20 times average net income. This would result in an equity capitalization of $400 mln or $6.5 per share. Furthermore, looking at just the last decade, which takes into account just one peak cycle and not two, average net income over the period has been $35 mln excluding settlement charges and $9 mln including settlement charges. Utilizing this last measure and a multiple of 20 times, results in a per share price of $2.9 dollars.
A DCF analysis for this company is inconclusive because the seasonal working capital requirements are extremely difficult to predict. For illustrative purposes; however, the above projections being discounted at 9.8% and assuming working capital needs of $30 mln per year and capex of $16 mln and a 10 times multiple of 2006 EBITDA gives you a per share value of $6.5 before diluting for the 14.3 mln additional options ($5 / share after dilution).

Additional risks:

Sotheby’s is closely held, which would be another good reason for finding support for the stock. The top 10 owners represent more than 80% of the shares outstanding. Bamco has 30% , Taubman has 22%, Ariel Management 6% and each of GEO and Private Capital Management each hold 3.5% for a total of 65%. One good thing is that Bamco has been selling with sales of 3.5 mln shares out of their 22 mln share holding as of the last filing.

Sotheby’s has also announced a restructuring program whereby they intend to reduce expenses by $60 mln per year with the full benefit expected for 2003. In the event that this program is highly successful and that revenues do not fall at a faster rate than expenses this the stock may trade up. Looking at the 89-93 period would indicate that revenues could fall substantially.

Catalysts:

Several catalysts exist that would cause this company to trade off significantly e.g. a negative European Commission finding in its antitrust inquiry against Sotheby’s stipulating a high fine would be catastrophic for the Company because it would be hard pressed to come up with the funds to pay for any settlement. The same thing goes for a Canadian antitrust division finding. A negative ruling by a judge on any of the pending class action lawsuits would be negative as would any problem regarding the rollover of the bank loan due August 11th, 2002 or for that matter any negative announcement regarding any part of the business in the upcoming earnings announcement expected in early August. Additionally, a case in which a painting or art object sold at auction turns out to be by an artist other than what was stipulated by the auction house’s experts could be negative for the Company.

Summary:

Sotheby’s is an overvalued company facing a deteriorating art market with inflated expenses it cannot substantially reduce. The company survived a similar environment in the early 90’s by colluding with its only competitor. The Company faces liquidity concerns if operations don’t improve and a series of lawsuits and investigations that could have a materially adverse effect on it. The Company’s controlling, 76 year old, shareholder is expected to enter prison on August 1st of 2002 where it will be difficult for him to meet with financial advisors regarding his strategic alternatives.

Conclusion: Sell Short
Appendix:

Art Market. This is a study of the Artfact database. It shows that 106 items were sold at a price greater than $10 mln at auction. Of these items, the vast majority, were sold in the three years following a major stock market peak. Talking to art dealers and gallery owners has corroborated this observation.


Historical results



Looking at historical results, tells you several things:

1) Taubman sold close to the top. When he resold the business to the public in 1988 it took only one year for the business to start deteriorating.
2) Historical earnings have averaged 37 mln dollars for the company over the historical period and have been highly cyclical. Including these charges earnings average earnings have been $20 mln and we could argue that we should look at the earnings with charges to be accurate because earnings without the charges were inflated because of price fixing.

3) From peak earnings in 1989, it took Sotheby;s 7 years to recover earnings back to their historical average which would indicate that maybe by 2005 Sotheby’s could achieve earnings of $40 mln.

Qualitative points:

1) It took Sotheby’s 7 years to recover and achieve its average historical earnings. It did so while colluding in arguably the best economic world environment in history.

2) While real salaries have increased substantially in New York over the last 15 years, Sotheby’ sales have not, which will make it very difficult for the company to cut expenses.

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Catalyst

Several catalysts exist that would cause this company to trade off significantly e.g. a negative European Commission finding in its antitrust inquiry against Sotheby’s stipulating a high fine would be catastrophic for the Company because it would be hard pressed to come up with the funds to pay for any settlement. The same thing goes for a Canadian antitrust division finding. A negative ruling by a judge on any of the pending class action lawsuits would be negative as would any problem regarding the rollover of the bank loan due August 11th, 2002 or for that matter any negative announcement regarding any part of the business in the upcoming earnings announcement expected in early August. Additionally, a case in which a painting or art object sold at auction turns out to be by an artist other than what was stipulated by the auction house’s experts could be negative for the Company.
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