Wednesday, 2 October 2013

Sotheby's Strategy

Activist investor Daniel Loeb has written a coruscating critique of Sotheby's and its CEO William Ruprecht (above) in this open letter. It's entertaining reading, but does he have a case? Some of its allegations are unverifiable; it's hard for outsiders to assess the charges of 'dysfunctional divisions and fractured culture'. The claim that Sotheby's has a 'more prestigious brand' than Christie's is just bizarre. But there is a substantive case that gives an interesting insight into the art market.

There's colourful detail about alleged largess by senior executives, but it's trivial in the context of a multi-billion dollar corporation. I have no doubt that an efficient private equity manager could cut some fat, but moving executive off-sites to MacDonald's won't even justify the transaction costs. And you have to smile when you read hedge fund managers criticising generous executive pay and perks. More substantively, Loeb notes that expenses are at 2007 levels but revenues are 15% lower, and they're paying out millions in professional fees without seeing enhanced results. I'm sure that focused management by a private equity firm will improve cost discipline, but the question is whether they will sustain investment at a level to capture the strategic opportunities that both sides recognise. 

Loeb thinks Sotheby's 'should be competing based on the quality of its service, its expertise and ability to generate the highest possible price for its customer'. I don't think any investor or any Sotheby's executive could disagree. But the problem is that the high-end auction business sometimes resembles Walmart rather than Gucci. There's no question that Sotheby's and Christie's offer a premium service, but they are competing on price. They sell the same things at the same time in the same way to the same buyers. Auction records pass between the two houses, but I've never heard it argued that one or other firm is able consistently to achieve better prices for the same property. In some areas one or other firm may have an edge, but I doubt sellers will buy into Loeb's value proposition. The high-end auction market sells luxury goods for mass market margins because competition for valuable consignments is cut-throat. Weak margins have always been a problem, and I'll take some persuading that Loeb can change that. Competing for income increasing requires taking on more risk - providing guarantees to sellers and entering new and riskier markets such as financing art and dealing in their own right.

Christie's was once the supreme art auctioneer; Sotheby's used to sell books. Christie's' aristocratic clients were apparently referred to Sotheby's when they had a library to sell. Sotheby's leveraged those contacts and broke into the big league by offering to sell their pictures and furniture too. More recently Sotheby's has retreated from the mid-market, concentrating on the top lots. That looks like a mistake. Christie's is now leveraging relationships with emerging collectors, and is able to sell an entire estate rather than just its highlights. Loeb identifies the right problem, but the question is whether Sotheby's can regain that lost ground (maybe by buying a few mid-market auctioneers?).  

I'm more sceptical of the claim that Sotheby's should focus more on contemporary and modern art. It's been a big growth area and it's responsible for a large proportion of turnover. But I worry that the prescription is a bit like the (apocryphal?) management consultant's advice that a publisher should stick to bestsellers because that's where they make their profits. There's a lot of sales volume in contemporary and modern art, but it's more volatile, and competing for those high-value lots often requires fine margins and guarantees. Growing in those areas means more risk, more volatility and potentially weaker margins. It may also lead to a loss of focus on other areas that may become more lucrative in future.

Balance sheet
Loeb's focus on costs and income is entirely healthy - businesses that can sell more stuff more cheaply create value for their investors and their customers. Financial engineering gets a lot of attention in the business press, but restructuring the balance sheet is mostly tinkering at the edges. But in the case of Sotheby's it's important for several reasons that are not highlighted in Loeb's letter:
  • They have a lot of cash ($700m), which they keep saying is for strategic purposes. They also have a $300m credit facility in place. Investors could reasonably ask if they need such a big war chest to improve their website and expand in China. 
  • A key competitive issue is willingness to put their own balance sheet at risk. Historically auctioneers were agents - they sell on behalf of their clients, and only pay them when they've received money from the buyer. The auctioneer loses nothing if consignments perform badly, and they get a cashflow benefit. Now sellers of high-value lots demand guarantees and advances. That's inherently risky, and it increases volatility because they auctioneer will have to pay out on guarantees at exactly the moment there's a downturn in the art market. 
  • Auctioneers are now dealing on their own behalf, which requires more capital and involves greater risk. So far returns have been disappointing.
  • Sotheby's is lending money against art. The finance business has grown rapidly, but there has been a significant jump in loans past due, and loans over 90 days past due (see page 64 of their accounts for details). Loan to value ratios are conservative, but art is notoriously volatile and tends to lose value when it's resold quickly. 
Auctioneers have always suffered in market downturns because their revenues decline quickly but their cost base adjusts slowly. Recent developments increase auctioneers' sensitivity to the art market, because they are providing guarantees, owning art outright via dealerships and lending money against art as collateral. If you believe in an art 'super-cycle' driven by wealthy collectors in emerging markets then investing in Sotheby's gives you leveraged exposure, and they have a lot of cash on hand if that proves too optimistic. But financial performance may be increasingly sensitive to market downturns.

Should you invest? Up to you. I'll happily advise you what to buy at Sotheby's, but you'll have to make your own decision about buying Sotheby's. 

Full disclosure: I have no financial interest in any auctioneer or art dealer and I'm writing in a personal capacity.


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