________________________Please do not hesitate to direct all comments, questions, and inquiries to grahamarader@gmail.com_____________________________

Tuesday, February 4, 2014

An IRS agent weighs in on my article about Sothebys

Interesting information.  Thank you.

Robin M. Bonner
Art Appraiser

Note: All mail will be irradiated if not sent via Fed Ex or UPS.  Irradiation can destroy photographs and sensitive material.

Internal Revenue Services
Art Appraisal Services
C:AP  Suite 700
1111 Constitution Avenue, NW
Washington, DC  20224-0002

From: Graham Arader [mailto:grahamarader@gmail.com]
Sent: Tuesday, February 04, 2014 12:42 PM
To: Bonner Robin M
Subject: An Enjoyable Story

Dear Robin,
It is my opinion that Sothebys (BID) made a mistake last week offering their special dividend.

It is my belief that they have needlessly damaged themselves by giving up a substantial part of their cushion against the downturn that is sure to come.

The key number for anyone in the art business is the cost of sales percentage.  Every other measure pales in comparison.  The reason for this is that it is much higher than just about any other business. Not being cognizant of this measure is the reason that many art businesses

For 42 years it has cost me between 28 and 33 percent to sell a dollar's worth of goods.  No matter how I try or what I cut, getting below 28% has been impossible for me.

It costs a great deal of money to service the wealthy who buy most of the fine art in the world today.  If you don't spend lavishly, there is no way that you can get their attention and their business.  They expect grand gestures, deep and comprehensive research, full and genuine commitment to their personal charities, highly accurate descriptions noting all faults, an enduring cheerful countenance, magnificent catalogs and yes, a very expensive dinner now and then.

While I can buy $1,000,000 of stock on Ameritrade for $10 it costs me somewhere in the range of $280,000 IN OVERHEAD to make a $1,000,000 sale in my art business.

Sothebys charges in the range of 12% to 25% to the buyer of art work and 10% to 0% to the seller.  In the best possible scenario their gross margin is 35% in total but their overhead costs cannot be much less than 20%.  And this is with them doing everything perfectly.

There is no question that Sothebys does an amazing job but it is well known now that valued and powerful consignors not only pay a zero percent selling commission they are now getting back some of the buyers commission as well.  Sales over $2,000,000 only generate a reported 12% buyers commission to them.  When up to 50% of the buyers commission then goes to the
consignor, there simply is no mathematical way that transactions like this can be profitable after the cost of sales are taken out.  This is the key weakness of their model today.

During the last 40 years, the allure of the art business has pulled any people into taking parts or even full ownership of Sothebys.  I have watched one very rich collector after another decide that they want to be more involved with the company that was doing such an elegant job of selling them art using expertise, honesty, great style and magnificent women.    I remember how appalled Edmund Safra was that a parvenu like Al Taubman smoothly gained control of Sothebys in August of 1983.  Safra intensely felt that he, a supremely elegant, Sephardim descended from wealth, would have been a much more appropriate owner.  We had a number of meetings to explore starting an auction house but he backed off when I explained the punishing cost of doing business to him.  Many other people like Safra have approached me but all backed away when the high overhead of this industry was exposed.

The simple fact is that rich people - 200 people comprise 80% of Sotheby's business - demand a huge amount of service.  That insistence coupled with the firm belief that they are dealing with the absolute low cost producer who is completely honest and extremely knowledgeable is truly an impossible task that Sothebys team performs brilliantly. There is huge confidence in the value of art today primarily because of the great skills of Sotheby's management team and their experts.
Without their honest public auctions constantly giving confirmation of value, art prices and sales volumes would plummet worldwide.  BUT being low cost producer and having a crushing overhead is a very poor business model. One mistake and a year's profits disappear.  One serious mistake and a decade's profits disappear.

Sothebys succeeds at the impossible better than any other company in the world and they are doing this better now than at any other time in their history.  Finding people that have this amazing combination of skills who are willing to work for much less than they would on their
own is another impossible task that Sothebys succeeds at brilliantly.

It is my opinion based on my 42 years of experience that Bill Ruprecht and his executive team are being considerably underpaid for the splendid managerial task that they perform every day.  I have been in awe of their skills as managers until they recently gave up a key component of their financial structure with their special dividend.

For them to survive much less succeed they have to have a large cushion of cash for the downturns and art market busts that regularly occur.  A look at their chart confirms violent downswings in their stock price over the years.  Large drops have occurred in 1999 to 2000
going from $47 to $14.68 and again from 2008 to 2009 going from $61.40 to $6.05, and finally in  2011 to 2012 going from $52.95 to $27.53.

Bill Ruprecht and his team had done brilliantly preparing for the next crash by building up an appropriate cash cushion.  This was lost last week when they appeared to give into the wishes of some share holders who firmly suggested that they free up their cash cushion.

Also the cash that will be paid out will make it harder for Sothebys to take advantage of excellent opportunities like the Matisse Estate that they purchased in November 1990 for 143m where they subsequently made well over a 300% gross margin return on their investment. Significantly Sothebys was outbid for the Sonnebend estate in November of 2007 which has the potential to be even more profitable.

The simple fact is that an art dealer and auction house MUST be able to deal from a position of strength.  The very rich have a well developed nose for fear and flee from those whose glands excrete even the smallest quantities.  The Sothebys executive team have placed themselves back into the position of supplicants with this payout and the promise of payouts in the years to come.  They have forced themselves back into the role of an under capitalized market maker at the mercy of their consignors.  This has happened just at the point when they could have achieved the vast profits that accrue to those who take long positions and wait for the 400% percent returns that can and do occur every ten years for the very best works of art.  They will now continue to be a wonderful company sustaining confidence in the art market but that provides the overwhelming amount of the profits to their clients.  So they will continue to be loved by all (except Christies) but at punishing and dangerous expense.

They are now vulnerable to a severe art market correction or one US Attorney who starts an investigation into the manipulation of American, German, English and Chinese Contemporary Art Market prices by outsiders that Sothebys may have failed to detect, police, report and reject.
Very truly yours,

Graham Arader

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