Sotheby's

Sotheby's (BID) deals in the acquisition and selling of fine art, jewelry, and collectibles. Virtually all (nearly 95%) of revenues come from the Auction segment. Here, the company acts as the agent, conducting due diligence to verify the authenticity of the piece, building interest through marketing, setting up and conducting the auction, and handling collection and distribution of funds from buyer to seller. In exchange, both the buyer and seller pay a commission to the company, usually in the range of 16-19% of the selling price. Smaller contributors include a Finance segment (effectively a cash advance business), and Norrtman Master Paintings, a small art dealer. Sotheby's is a global company, conducting over 250 auctions a year across 40 countries, and earning close to 60% of sales outside of the U.S.

One of my favorite aspects of this company is its competitive position as a "big fish in a small pond". 2 players dominate the global fine art commercial market - Sotheby's and Christie's, each with about 50% market share. The firm has even faced monopolistic practice charges in the past. Considering both Sotheby's and Christie's have been in the business since the mid-1700's, the relatively small size of the market, and existing relationships with the few customers for these items (which routinely fetch tens of millions), the firm has an almost impenetrable economic moat against competition. This is a wide moat company, with a capital 'W'.

Another positive is business momentum. Put simply, the market for fine art is red hot, especially from China. Sotheby's recent show in Hong Kong generated over $400 million in net sales, second only to its April auction there. Q2 (ended June) was the firm's best quarter ever - and this is a firm with nearly 270 years of history! Fine art has been and will be an up-and-down market, but it is often difficult to predict the length of cycles here. This hot market could last for some time, and Sotheby's will benefit substantially from it.

The other fundamentals are solid. Cash on the balance sheet, at $666 (!) million, eclipses a debt load of about $477 million. Free cash flow can be lumpy depending on how long the firm holds inventory, but current trends are around $300 million annually. Profits cover interest an acceptable 8 times over.

Valuation, too, looks fairly attractive at $32. Sotheby's will always be a firm that experiences wild revenue swings from year to year, but over the long term the company has proven able to generate operating margins around 30% while growing sales at 5-7% annually. I don't see why this can't continue, given the multitude of new millionaires in developing countries and Asia's taste for fine art. At the same time, current valuation of about 2.5 times sales is below the firm's long-term average of about 3 times.

Given this, Sotheby's long-term value looks to be around $43 per share, about 35% above current trading levels. MagicDiligence rates BID as a solid Magic Formula purchase at current.

Contemplating a Bid on Sothebys

Oct 26, 2011