False Confidence? A Closer Look at Sotheby’s 2nd-Quarter Report that Lifted Its Stock

The economic picture painted by Sotheby’s in its Form 10-Q second-quarter report (filed with the SEC on Monday) was not as rosy as stock traders seemed to have believed. Notwithstanding the uptick in its share price, Sotheby’s auction commission revenues declined by 11% and 17%, respectively, for the first three and six months of 2016, compared to the same periods in 2015.

What’s more, CEO Tad Smith told participants in Monday’s earnings conference call that the company’s “overall sales volume” this year was “down some 30%.” And CFO Mike Goss candidly revealed that “we expect the third quarter to be quite weak.”

Smith added:

What we face as the question is how long the art market will be in the doldrums. We did look back at this and it’s hard to see, based upon past 20 to 30 years of history, that it’s going much longer than 18 to 24 months. If you look at where the art market started tipping, I would say it was about 12 to 13 months ago.

That would take “the doldrums” into 2017. But despite what Smith described as “a softer market,” Sotheby’s closing stock price spurted from $32.28 at the close last Friday (before Monday morning’s quarterly report) to $40.00 yesterday. The six-month trajectory of its stock price (ticker symbol: BID) has been even more impressive, rising from $19.13 on Feb. 11:

Securities analysts participating in Monday’s conference call congratulated Sotheby’s on the good quarter, largely on the strength of its adjusted net income (profits) of $88.6 million—a 21% increase over the previous year. But in preparing analysts for the weak upcoming quarter, Goss urged them to focus on performance over six-month or twelve-month periods, “to get a better feel for the state of our business.”

Playing the game Goss’s way would dim the luster of the second-quarter results: This first six months of 2016 showed an 18% decrease in adjusted net income vs. the 21% increase for the second quarter alone. Part of that increase was merely a matter of timing: Contemporary sales in London, which boosted the second quarter’s net auction sales by approximately $80 million this year, were not held until the third quarter last year.

Adjusted earnings per share (EPS) for the second quarter were $1.51, compared to $1.04 last year—a 45% increase due, in large measure, to Sotheby’s share repurchase program: There are 55.1 million shares currently outstanding vs. 69.5 million a year ago, which means that earnings were divided by a smaller number of shares this year than last year in calculating the EPS.

In his prepared remarks, Smith took pride in the relatively high ratio of sold works to works that failed to sell in both the spring Contemporary sale in New York and the summer Impressionist/Modern and Contemporary sales in London. But other figures were more significant and less encouraging: The dollar amounts of net auction sales for the first three months and six months of 2016 declined by 10% and 21%, respectively, for contemporary art, and 47% and 45% for Impressionist/Modern.

Asian art showed increases in net auction sales of 31% and 16%. But Smith told analysts, “Early indicators are that consignments [from China] in the second half won’t be as strong as in the first half.”

Here’s the breakdown of the last quarter’s and first half’s net auction sales by category:

Auction commission margins, a somewhat meretricious metric, increased from 15.5% last year to 16.4% this year. A more telling indicator of financial health is auction commission revenue, which decreased $30.9 million (11%) and $68.2 million (17%), respectively, for the three and six months ending June 30, 2016. Sotheby’s reported that the decrease in commission revenue was “primarily due to a lower level of net auction sales during the current year periods.”

As I’ve repeatedly noted, auction commission margins (calculated by dividing commission revenue by hammer price) are, by definition, higher in the middle-to-low price range, because the commission percentage charged on the hammer price is higher for lower-priced goods. But at the lower end of the market, the profits per lot are counted in thousands, not millions.

“There was a deliberate position to say we only want to take in property we have confidence we can sell,” Allan Schwartzman, one of the principles in Art Agency, Partners, recently told Nate Freeman of ARTnews magazine. (Sotheby’s purchased AAP, an art advisory firm, in January.)

Schwartzman added:

I think it was very clear, shortly after we entered Sotheby’s, that everyone understood that it was more important to have successful sales than to have high numbers, and that the fight for winning property at any cost was not the approach….We have to make money for the company.

Smith promised a “more judicious use of guarantees”—the minimum amounts promised to some consignors, regardless of the level of bidding. Those promises had gotten out of hand, due to auction houses’ cutthroat competition for desirable property.

But the 10-Q revealed a recent bump in guarantees—from $3.3 million as of June 30 to $110.1 million as of July 29:

A substantial portion of the property related to these auction guarantees is being offered at auctions in the fourth quarter of 2016, with the remaining property scheduled to be offered in the first quarter of 2017.

That “substantial portion” is thought to be the Steven and Ann Ames Collection of contemporary art, scheduled to be sold in November and “estimated to fetch in excess of $100 million,” according to Sotheby’s announcement.

Here are the Ames Collection’s big two:

The elephants in the boardroom are activist investors whose chief preoccupation is shareholder value, not client service. Sotheby’s may have already heard from Taikang Life Insurance’s Chen Dongsheng about the changes he said he’d suggest as Sotheby’s new top investor—new board members and new initiatives to provide “alternatives for growth and exploration of commercial opportunities.”

The analysts’ conference call gave no insights into what specific Chen-driven changes may lie ahead.

[On a personal note: My planned busman’s holiday this week was postponed because of a death in my husband’s family.]