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Sotheby's (NYSE:BID)

Q2 2012 Earnings Call

August 07, 2012 04:45 p.m. ET

Executives

Bill Ruprecht – President & CEO

Bill Sheridan – CFO

Analysts

Oliver Chen – Citigroup

George Sutton – Craig-Hallum

Rommel Dionisio – Wedbush Securities

Nick Hiller – Stephens

Marc Riddick – Williams Capital

Operator

Good afternoon, ladies and gentlemen, and welcome to Sotheby’s Second Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, ladies and gentlemen, this conference is being recorded.

During the course of the call, the company may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such projections and statements are only predictions and involve risks and uncertainties resulting in the possibility that the actual events or performance will differ materially from such predictions. We refer you to the documents the company files periodically with the Securities and Exchange Commission, specifically the company’s most recently filed Form 10-Q and 10-K. These documents identify important factors that could cause the actual results to differ materially from those contained in the projections or forward-looking statements.

At this time, I would like to introduce you to Bill Ruprecht, President and Chief Executive Officer, and Bill Sheridan, Chief Financial Officer. Mr. Ruprecht, please go ahead.

Bill Ruprecht

Thank you, Karen, and welcome, everybody to this summer call. Appreciate your interest in Sotheby’s.

Our results reflect the global economy, which we’re all experiencing. In the second quarter of this year, 2012, revenues decreased 18% and net income decreased $41.8 million, from the record level of the prior second quarter, which was the best quarterly result in our 265-year history.

These decreases are primarily due to lower auction commission revenues resulting from a $247 million, or 13% decline in net auction sales, the shortfall which is attributable to a historically unprecedented level of single-owner unique one-off sales in 2011, a $250 million decrease in single-owner sales in the second quarter of 2012 alone.

This is a quarter with unfavorable top line comparisons. We sold materially less in Q2 2012 than we did a year ago, and that’s the story. Income is down, largely because sales are down. The overall health of the business is very much intact and we’re optimistic about our opportunities.

Asian business has slowed, as has the economy there, but it remains very profitable and a source of substantial opportunity with new wealthy collectors. Luxury good companies have largely posted first half increases in 2012 in Asia, which is reassuring.

There are some notable bright spots in our numbers. Our lending business is very strong with revenues up more than 44% in the quarter, reflecting what may be a trend by the wealthy to turn to their art for liquidity, having exhausted other resources over perhaps the last four years of volatility. And private sales remain robust and have contributed both growth and more than $40 million in revenues in the first six months. Offsetting the overall decline in revenues is over $13.6 million, 8% improvement in the operating expenses in the quarter.

While we’re still in the early stages of property gathering for the autumn fourth quarter sales, we are pretty confident in the current state of the art market and in the number of meaningful opportunities that we see for the autumn season. I’ll have a bit more to say on that later in the call.

Bill Sheridan, take over.

Bill Sheridan

Thank you, Bill. If you refer to Appendix A or page six of the press release, I’ll be referring to the three and six-months number there. On an overall basis, net income for the quarter is $85.4 million, or $1.24 per diluted share and $74.8 million, or $1.09 per diluted share for the first six months. This compares to our 2011 second quarter net income of $127.2 million, or $1.81 per diluted share, and first half net income of $129.7 million, or $1.85 per diluted share from a year ago. Clearly, year ago was a tough comparable and great results for the company.

Turning to total revenues for three and six months ended June 30, total revenues declined $65.8 million, or 18% and $80.5 million, or 16% respectively, when compared to the same periods in the prior year. As Bill commented on, this deterioration stems principally from single-owner sales and Bill quoted those amounts. Our Hong Kong sales were down about $131 million versus the prior year, again, principally, from single-owner sales in Hong Kong.

For the three and six months ended June 30, our auction commission margins, which are highlighted in our MD&A, declined from 16.4% to 15.3% and from 16.4% to 15.8% respectively. These declines were attributable to competitive pressures to win high-value consignments, which resulted in a lower level of shared auction commission, and also was a result of our sales mix.

Offsetting the revenue shortfall in the first half is a 9% increase in private sales commission stemming from the 15% growth in aggregate private sales volume over the period, which grew to $514 million.

Turning to the direct costs line, direct costs of services increased $1 million, or 4% in the second quarter and remains relatively unchanged for the first half of the year.

Moving to salaries and related costs, for the second quarter and first half, salaries and related costs declined $11.6 million or 12% and $7.4 million, or 5% respectively, primarily due to a decline in incentive compensation and share-based payment costs due to the lower level of Sotheby’s earnings relative to the prior year periods and reflecting the company’s ongoing commitment to a variability in our compensation structure.

A couple other points on salaries. In conjunction with the new collective bargaining agreement with the union representing our New York property handlers, Sotheby’s offered severance benefits to the union members in exchange for the voluntary termination of their employment, which resulted in a charge of $4.1 million in the second quarter. We anticipate that the cost of these severance buy-outs will largely be recovered by cost savings over the initial three-year labor agreement with the union, and we expect to see more favorable labor economics thereafter.

On the G&A line, general and administrative costs for the second quarter were flat with the prior year. For the first half, G&A expenses increased $5.4 million, or 7%. The biggest increase was a $3.3 million or 17% increase in facilities-related expenses, due to a $2 million increase in our rent expense for the expansion of Sotheby’s premises in Hong Kong. And we’re hopeful to see a fourth quarter benefit with respect to that investment.

There is a 13% or $3.2 million increase in professional fees due to a higher level of consulting to support our strategic and corporate initiatives as well as a higher level of legal fees. Lastly, a $1.3 million increase in travel and entertainment expenses were incurred.

Turning to net interest expense. For the second quarter, net interest expense remained largely flat when compared to the same period in the prior year.

Moving to income tax expense, which is always complicated, Sotheby’s effective income tax rate for the three and six months ended June 30 is approximately 32% compared to 29% in the prior year. This is principally due to a shift in the mix of earnings between our overseas and U.S. locations. We currently anticipate that our effective income tax expense rate for 2012, excluding discrete items, will approximate 31%.

Lastly, I’d just like to comment on our balance sheet. Our balance sheet is strong. If you look at our liquidity and capital resources, we continue to have significant cash balances and strong liquidity. However, in consideration of the historically low interest rate environment as well as our potential future operational and capital needs, management is currently assessing, among other options, a refinancing of the convertible notes as well as our high yield senior notes.

Sotheby’s operational and capital needs include the potential domestic and international growth of the Finance segment and the loan portfolio therein and possible future expenditures related to international growth in markets such as China. As Bill mentioned earlier, Sotheby’s Financial Services loan portfolio is up 49% year-to-date.

Additionally, should business operations and liquidity remain strong, management will continue to evaluate traditional corporate finance alternatives, including repurchases of shares, stock and/or a combination of those actions as well as dividend increases. At the end of June 30, we had approximately $583 million in cash on the balance sheet.

At this time, I’ll turn things back over to Bill Ruprecht.

Bill Ruprecht

Thank you, Bill. A quick recap of some of the things that have happened of late and some of the things upcoming. Late May in London, we sold Gunter Sachs estate material, which was a remarkable success. That brought $65 million, double its presale estimate, and we had bidders from 17 countries across four continents, a terrific success.

Our London June sales brought some very strong prices for high-end works, Joan Miró’s Blue Star sold for almost $37 million, a record for the artist at auction. Our Impressionist and Modern Art series brought a total of $140 million. Contemporary sales brought $130 million, a very strong price for Basquiat at $8.7 million, nearly double what the same picture sold for four to five years ago.

More recently in July, in Old Master and British Paintings in London, the market overall, aggregate results were robust. The highlight of our Evening Sale was a naval scene by Willem van de Velde the Younger, we sold for $8.3 million, bought by a Dutch collector returning the painting to its home in the Netherlands.

We see the famous story being repeated again and again in this environment. We secure great rarities and present them well to the world. There is remarkable demand. The demand side really is not deteriorated throughout the volatility of this economic cycle. Supply of art does experience volatility and we currently are enjoying some substantial deal flow opportunities for the autumn season and beyond.

Upcoming, we’ve got some interesting things. In September, among the first major sales we have are the Asian Art series here in New York. We’ve got Chinese Ceramics being led by a Celadon Jade and an important Fish Jar and Cover. The 400-lot sale has a presale estimate of $15 million at the low end.

Towards the end of September, the 24 and the 25, Sotheby’s also in New York will sell auction property from the estate of the loved philanthropist and society figure, Brooke Astor. The sale offers fine and decorative arts from Mrs. Astor’s New York City apartment, as well as her Westchester estate, as well as the wonderful selection of jewelry from her personal collection. Proceeds from that sale will benefit a number of charities, including The New York Public Library, The Metropolitan Museum of Art, and The Animal Medical Center of New York.

In October, from the 5 to 9 in Hong Kong, we have a wonderful group of things being put together for that seg group of sales. There’s a Qing Imperial court painting by Giuseppe Castiglione whose paintings have rarely ever come to market, as well as some important Qianlong vases. The painting by Castiglione has a presale estimate of just under $20 million and the double-gourd vases approximately $5 million.

We have a – as we do annually, a major exhibition of sculpture. It’s a selling show outside at Chatsworth called Beyond Limits this autumn beginning on September 7 going through October. It’s outside at the grounds of the Chatsworth House in Derbyshire. And there you will see this year the work of a single artist, Barry Flanagan, following his recent retrospective exhibition at the Tate Britain. We’ve got a rich selection of the artist’s critically acclaimed, monumental late works.

Another fascinating exhibition we’re holding this autumn in London called, Unfolding Landscape, our selling exhibition of works by graduates at the School of Design of the China Central Academy of Fine Arts, which is Chinese premier fine art academy. That’s early November in London. It’s the first western exhibition of the work by graduates of this. I think you’ll see exciting furniture, ceramics, jewelry and photography from the next generation of China’s unique creative talents.

As I mentioned earlier on the call, last quarter we expected first half auction sales to be lower than the levels that we achieved in the first half of 2011, as we indicated, due to the record number of significant single-owner sales in the first half a year ago. We also said that the climate for most high value consignments is competitive, with these consignments often earning fractional margins, our second quarter reflects these results. We’re focused on stabilizing margins and on generating revenues.

As we monitor the developments in the broader world around us, China, Eurozone sovereign risks and the so-called U.S. fiscal cliff, it may well be that others are thinking of selling in addition to borrowing, having seen their margin of liquidity eroded over the last four years of volatility.

So, I remain confident in the global art market. Demand and prices continue to be strong, especially at the high end of the business. And I can report, as I already indicated, that the consignment pipeline for the autumn season appears to be active at the moment.

As we move forward, we’ll continue to look to ways to broaden and deepen our relationship with major clients while staying focused on costs even as continue to invest in our business and in opportunities where we think we’ll see real payback.

I know you all will have a few questions and we look forward to them. Karen, if you’ll moderate the questions for us, please. That concludes our prepared remarks.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from the line of Oliver Chen from Citigroup.

Oliver Chen – Citigroup

Hi, Bill and Bill. Thank you for your time. Regarding the single-owner sales and single-owner impact, what is the back half looking like in terms of anniversarying single owners last year versus your visibility on what you have in the pipeline for single owner sales this year?

Bill Ruprecht

Well I think all I can comment on really is last year, Andrew, where we had a front-weighted year which was unusual for the organization. And the fourth quarter of last year was not all that exciting or robust a fourth quarter. So I think the comparables shift quite differently in terms of the challenges for beating the best quarter in the history in the second quarter. I would only say in context the second quarter this year is in the top five of the company’s history ever in terms of our quarters. So, we don’t think that the second quarter this year was anything to be embarrassed by. Typically we generated a very significant profit for shareholders.

In terms of the fourth quarter, Andrew, I talked about supply. I can’t uncouple or de-chunk that for you yet. We’ll make announcements as we make announcements. But we’re seeing deal flow that’s rewarding and encouraging.

Oliver Chen – Citigroup

Thanks a lot. It’s Oliver Chen from Citi, by the way. Regarding the auction commission margin, it’s been a little volatile. You posted impressive 18% in 1Q, and it looks like it was 15.3% in 2Q. How should we think about the back half for that margin? Do you think we should think about it as being potentially somewhere in between those? Or is the lower end the good run rate?

Bill Ruprecht

I apologize, Oliver, in the first instance. I had a brain cramp and called you Andrew, I did know who you were.

Bill Sheridan

Oliver, it’s Bill Sheridan. Each – our margins are negotiated on a deal by deal basis. We don’t have visibility, so we’re hoping they’re higher than the current quarter. But we’ll wait and see what the competitive pressures bring and what success fees we can negotiate. And we can’t really provide any other guidance.

Oliver Chen – Citigroup

Okay. And your expense control was impressive in a tough quarter, a tough quarter in terms of the top line. Is that a kind of – is the back half, in terms of salaries and related costs, is there any visibility? Will they continue to be a contraction potentially at that fixed cost line item?

Bill Sheridan

As we say, it’s the bonus pool. The discretionary bonus is the key driver of that. And unless the world falls apart, that will probably drive the second half of the year. But we really have no guidance on that.

Bill Ruprecht

It’s responsive to our results in the end of the day, Oliver. So when you tell me what our year end numbers are going to be, I’ll be then in a position to press negotiation with our Compensation Committee, and then detail for you what we’re able to share as reward systems for employees. As Bill said, what we’ve done is embed a lot of variability into our comp.

Bill Sheridan

As our proxy says, it’s a formula that’s not disclosed. But the comp committee looks to EBITDA and EBITDA growth.

Oliver Chen – Citigroup

Okay. Okay. Thank you very much. And finally, I’m encouraged by the opening of the year-round facility in Hong Kong. Should we think about how that may impact your Asian aggregate auction revenues in some fashion? Do you have any kind of insight into how we should think about that?

Bill Ruprecht

Well, we’ve taken on more cost, because we thought we’d be able to, over time generate more revenue. I think the facility is spectacular. It’s clearly the best of breed in the marketplace. We’ve already had a – in the second quarter, significant show there of Kusama’s work. That was a considerable success. Our challenge in the next 12 months is to make sure that we present a number of exciting opportunities outside of the auction cycle that represents real value for our clients to engage with us and not just come see us a couple of times a year and generate some revenue for the firm.

I think in the next several months, those new facilities are part of a bridging process as we renovate our old facilities in that same Pacific Place building. So you’re not getting full utility out of those new spaces for the next couple of months, Andrew until we finish the renovation on the 31st floor in that building. Most of our staff are in the gallery space as we speak. That will be returned to galleries and marginal revenue development opportunities come to fourth quarter. So we’ll see how fast we can get that work finished. But I think that the real message for us and for you in that is, we took on cost because we expect and anticipate revenue growth in the future. I can’t calendarize that for you. That’s a longer term strategy and direction for the business.

Oliver Chen – Citigroup

Okay. Thanks so much for your time.

Operator

Thank you. And our next question comes from the line of George Sutton from Craig-Hallum.

George Sutton – Craig-Hallum

Thank you. Good afternoon, guys. So we’ve talked for many, many years about death, divorce and debt driving the auction market. And I think what you’re suggesting in part, Bill is that as we look at some of the challenges in the market that is actually starting to create some supply which would ostensibly be the debt part of that argument. Is that effectively what you’re saying? Because it hasn’t been something we’ve seen for quite some time.

Bill Ruprecht

I suggested George to be completely transparent, which I know you’ll think is rare for me, my – I never entirely understand the full range of motivation of the seller. In other words, people don’t come to me and say, I’m out of cash. I would like to do x, y, and z. They simply say I’d like to sell this. And the broadest range of their motivations are not something or other that we always understand. But because of the nature of our loan book, it’s growth.

Because of the number of inquiries that we’ve had about selling significant groups of property, I posit as a guess, not as a fact, that there is significant need for liquidity across, not insignificant number of collectors, who may not have the number of avenues that they have historically to access significant liquidity. That’s a lot of words, but I’m trying to be fulsome in my response. We’re certainly encouraged at this point in the cycle by the number of discussions that are going on.

George Sutton – Craig-Hallum

And it’s fair to say six months ago, you might not have posited that takeaway?

Bill Ruprecht

I would think that is a conclusion that you might draw that most people would think was accurate.

George Sutton – Craig-Hallum

Okay. One other question relative to your growth in professional fees and travel and entertainment expense relative to some of these strategic initiatives; obviously – it’s no secret you’re doing a lot of work in China. Are you able to give us a little bit more of a sense of what the focus has been and what the conclusions might be? Or what the range of conclusions might be?

Bill Ruprecht

What I’d like to, George, I think what you find with the luxury goods companies and we’re not the same. We’re selling works of art at a fundamentally different price point, but you’re looking at a complete shift in the mix of our business. Asia and greater China critical to understand and engage with people of wealth in that part of the world. So it’s not an optional thing for us anymore. It’s an obligation for us to engage as many wealthy Chinese and greater Chinese as we can.

And we probably have lower levels of penetration among that population of great wealth than we do among other parts of the world in terms of engaging those people as collectors. So apart from having the goal and the commitment to engage those clients wherever and however we can, subject to the constraints of law, subject to the constraints of cultural patrimony, subject to the limitations of legal systems in different corners of the world, we keep probing and testing and considering a bunch of alternatives. And when we’ve concluded on that, I’m sure we’ll make some announcements.

George Sutton – Craig-Hallum

Thank you.

Operator

Thank you. And our next question comes from the line of Rommel Dionisio from Wedbush Securities.

Rommel Dionisio – Wedbush Securities

Yes. Thank you. Bill, in your comments, you noted that the demand, you believe is still fairly robust on a global basis, but cited some weakness in Asia. Could you talk about which geographic markets are picking up the slack?

Bill Ruprecht

Well, I don’t want to, again, misrepresent our numbers. Our sales were down 13% in the second quarter. So they weren’t up. Big drivers to the deterioration of our sales were $120 some odd million decline in Asia in sales and the single owner sales decline that we had. Geographically, I think it’s still pretty fair to characterize our business as a three-legged stool where you’ve got strong Asian demand, strong North American demand and spotty European demand in the business. I think that’s a same story we’ve been seeing and continue to see.

Bill Sheridan

Rommel, it’s Bill Sheridan. Single owner sales are opportunistic for us. When we get them, they’re great. I think we saw deterioration in single owner sales in Europe, Asia and North America and that’s really the story of the second quarter and the first half. I mean we had a $100 million single owner sale in Asia in the spring of Chinese paintings by one artist. So Asian demand goes – Asian buying goes down, but it went down because we didn’t have the product which they would have bought. So I don’t think of us as experiencing like a – the lights are out in a certain part of the world or anything like that.

Rommel Dionisio – Wedbush Securities

Okay. Fair enough. And a follow-up question, if I may. I think you noted that there’s some pressure, and you’ve noted this before, certainly there’s some pressure on auction commission margins as a result of competitive pressures. Is that coming from your traditional competitors in New York and London? Or is that also coming from some of your emerging mainland competitors in the Far East? Or both?

Bill Ruprecht

I think it’s really hard to unpick that. I guess, I’m not going to answer your question exactly. I am going to say, while our Asian business is down given the diversity of revenues that we have with revenues down about 18%, I’d a whole lot rather be Sotheby’s this week than I would be a mainland Chinese auctioneer whose revenues are down 60% to 70% quarter-on-quarter, because they’ve got a very large exposure to a very narrow market segment. That’s a market segment which has gone straight north.

And as they’ve seen comparables in sales in the mainland of 50% decline year-on-year in the second quarter, you’re looking at organizations that are, and this is a speculative rather than a knowledgeable comment, they’ve got to be gasping for revenue under those circumstances. You can’t see those kinds of declines. We’ve only experienced them once in my 32-year history at the firm in the winter of 2008 and early 2009. So, clearly that’s impacting their business, impacted to some extent, ours. But I wouldn’t say that it was particularly driving a deterioration in margins. I’d say it’s probably more from the traditional competitors.

Rommel Dionisio – Wedbush Securities

Okay. That’s very helpful. Thank you, Bill.

Operator

Thank you. And our next question comes from the line of Nick Hiller from Stephens.

Nick Hiller – Stephens

Hi. Thanks for taking my call. I just wanted to quick check my numbers here. The hit to EPS from the severance charges was about $0.04, right?

Bill Sheridan

Nick, why don’t you follow-up with Jennifer Park or me with a call?

Nick Hiller – Stephens

Okay. Thanks.

Bill Sheridan

We can do the math offline.

Nick Hiller – Stephens

Okay.

Operator

Thank you. And our final question comes from the line of Marc Riddick from Williams Capital.

Marc Riddick – Williams Capital

Hi. Good afternoon. I was wondering as far as the decline of auction commission margins, I know that mix can often have a lot to do with it. But I was wondering if the difference in the decline for this particular quarter was that primarily more a function of mix or whether it was competition or maybe half of each?

Bill Sheridan

It’s a combination of both.

Bill Ruprecht

I think it’s...

Bill Sheridan

If you look at the MD&A, you’ll get more details with respect to that. But it’s quarter-to-quarter, it’s competitive at the high-end and the math works at above $1 million. Commission falls to 12%, so...

Marc Riddick – Williams Capital

Right. I understand that. But I guess maybe a better way maybe to ask it, if we’re looking at for the second quarter, the margin declined in the second quarter, would you say that the contribution between mix versus competition was similar to what took place in the fourth quarter of 2011? Is that a similar type of effect from each? Or would you say that one was more of a factor than the other?

Bill Ruprecht

I can’t do the math for you on those two different quarters. I can tell you that if you look at the MD&A, you’ll get some color on this. And I would also say to you that both were a factor, both mix and competitive pressures in the second quarter of 2012. And I wouldn’t overly weight one issue versus the other.

Marc Riddick – Williams Capital

Good. Thank you very much.

Operator

Thank you and I have no further questions.

Bill Ruprecht

Karen, without any further questions, I have one more job, which is to wish you all happy remainder to the summer. Thank you very much for your interest in Sotheby’s, and we’ll look forward to sharing with you the details on our business come November.

Bill Sheridan

Thanks very much.

Bill Ruprecht

Good bye.

Operator

Thank you, sir. Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may now disconnect. Everyone, have a good day.

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