Bidding Sotheby's Down

Robert Frank is worried about the accounts receivable at Sotheby's (BID), which more than doubled to $835 million in 2007. This means that the "clients of Sotheby's appear to be falling behind on their bills," he says - which could be bad news for the auction house.

What's fascinating to me is the contrast between Sotheby's share price, which has been declining pretty steadily for the past year or so, and its revenues, which keep on hitting new record highs.

Frank includes a pro forma paragraph to that effect, but he's clearly not convinced:

Bill Sheridan, Sotheby's chief financial officer, said the accounts receivables and guarantees aren't a problem. Receivables rose largely because the firm's sales increased, he said. Its consolidated sales -- a combination of auction, private and dealer sales -- rose 51% in 2007, while auction sales were up 44%.

Certainly the bears have been on the winning side of the argument since Sotheby's stock spiked up to $57 in October. The company is now trading at less than half that level, with its stock just over $24, and so far there's been no sign that the fall is over. But all of that is worries about the future, since the present is looking spectacular. An operating margin of over 30%, a return on equity of almost 50%, and diluted earnings of $3.25 per share in 2007, which puts the stock on a trailing p/e of less than 7.5.

It's also worth noting that Sotheby's hardly stands to lose $835 million if its buyers don't pay: As the middleman, in that event it doesn't pay the seller, and Sotheby's loses only its commission.

Still, as Frank explains, there's a lot of room for worry. We don't know when exactly the contemporary art bubble is going to burst, but we can be pretty sure that it will, at some point. And when that happens, Sotheby's is going to be left holding a vast number of guarantees on unsellable paintings. It all feels a bit like Citigroup (C) a year ago: The music is playing, the company is dancing, and no one likes to think about what's going to happen when the music stops.

Frank is also worried that Sotheby's is giving collectors three or four months to pay for their art - something which is cause for concern, to be sure, but which is also understandable in the context of financial markets which are more illiquid than at any time in living memory.

All the same, the number of rich collectors is not going to start falling any time soon, and many of them are salivating at the prospect that an economic downturn might force on-their-uppers old-money types to divest themselves of an heirloom or three. There's more to the auction business than just contemporary art, and the rest of the market doesn't look nearly as bubblicious.

I also wonder whether art collectors are shorting Sotheby's shares as a hedge against the art market collapsing. It's impossible to buy contemporary art at auction these days without worrying that you're overpaying, and there's no easy way to insure against your art falling in value. If shorting Sotheby's is the best way of doing that, then maybe the company's not in quite as much trouble as the depressed stock price might indicate.

Comments

[CrossProfit]

"I also wonder whether art collectors are shorting Sotheby's shares as a hedge against the art market collapsing."

BID works primarily on a percentage basis. What you are saying is that if the art 'bubble' bursts, revenue from sales will decrease, hence, commissions will decrease. So by shorting BID, an investor hedges against the loss in value of his/her art collection.

We find two flaws with this hypothesis.

First, who says that the shortfall in price per item will not be replaced with more items coming to market?

Second, collectors do NOT treat art as equities that need hedge protection. Insurance (theft and fire) yes, hedge, no way. Art is not 'hedge-able' as the time frame perceived by collectors is far too long.

Perhaps as an aside, this is similar to the average Joe who doesn't go out and hedge the house he is living in because it may go down in value. If it goes down and he has to sell and move, then the new house will cost less as well. In art, if the $10M painting went down to $5M and the collector MUST sell to raise some cash, the replacement art also went down from $4M to $2m. This however is very rare amongst the top collectors and is not a factor.

It is far more likely that the market is predicting a 'fad' change. In other words, if the U.S. officially heads into a recession, it will not be fashionable for the uber rich to flash money around while the masses are hurting, hence, the anticipated decline in overall auctions.

Less participants = less auctions = less commissions.

CrossProfit