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Monday, February 3, 2014

Consequences for Sothebys

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
many 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 over the years but they all backed off when the overhead was
explained to them.

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.

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.

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