"Nations have their ego, just like individuals." - James Joyce, Irish novelist
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.
In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.
Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.
So you might be wondering why our chosen title on this specific topic? Well, (Who's Afraid Of?) The Art of Noise! was Art of Noise's debut full-length album, released in 1984, a called it a "techno-pop classic" and had a clear influence from German band "Kraftwerk". Given our fondness for electronic music from the 80s, we thought it be interesting to use this reference as in this particular conversation we would like to focus on the potential changing trends in the art market we are seeing. This additional indicators such as prices for classic cars as well, could be additional pointers to the lateness of this credit cycle we think.
- Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch
- Macro and Credit - Classic cars? Downshifting...
- Final chart: Classic cars have been "turbocharged"
- Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch
"Cyclical industry entering soft spot
The art market is entering a soft spot as a result of unfavorable changes in global exchange rates, a slowing economy and decelerated asset appreciation. Based upon lower art industry volumes, we believe that Sotheby’s Adjusted EBITDA will decline in FY16. However, the company has substantial liquidity to weather a more difficult environment.
Much to like
We believe that there are many attractive attributes of Sotheby’s business, including: (1) a strong brand name and positioning within the art auction industry; (2) the predominantly duopolistic nature of the art auction industry; (3) limited risk of substantially-levering acquisitions; (4) significant liquidity; (5) minimal maintenance capex; and (6) no near-term maturities. Sotheby’s has been engaged in the art auction industry since 1744 and over this tenure, has built a brand that would be challenging to replicate. Additionally, the duopolistic nature of the industry provides the company with the ability to increase price, as evidenced by a February 2015 increase. Despite small acquisitions over recent history, we believe that the company will not be a major participant in M&A activity in the future, limiting the risk of leveraging transactions. Financially, we estimate that maintenance capex is ~$10 million, which contributes to strong free cash flow and the company has no near-term maturities with which to contend.
FY16 EBITDA to decline, but free cash flow positive We estimate that Sotheby’s Adjusted EBITDA will decline 24% to $236 million in FY16.
However, we estimate that free cash flow will total $88 million, leaving net leverage only 0.4x higher at the end of FY16 (vs FY15).
Initiate at OverweightWe recognize that financial results could be soft in the immediate future. However, we believe that the rough period will be brief and that the company has adequate liquidity to operate through an extended downturn. Trading at a yield-to-worst of 7.3%, we believe that current trading levels are attractive, and initiate coverage on the BID 5.25% Sr Notes with an Overweight rating." - source Bank of America Merryll Lynch.Whereas tactically this recommendation paid handsomely given the bonds are trading back close to par, when it comes to assessing the viability of Sotheby's business in the long run as well as most recent fall in art trading volumes, we must confide that we do not share Bank of America Merrill Lynch's views on Sotheby's ability to survive in the long run.
First of all as per Bank of America Merrill Lynch's note, inventories are up, leverage is up but, thanks to "cheap credit", the loan portfolio balance is still increasing, meaning that from our perspective, Sotheby's is resorting increasingly to "vendor financing" thanks to "Cantillon effects" and the "generosity" of our central banking deities:
"Inventory sales increased 23% to $36 million with $3 million of losses on inventory sales. Finance revenues totaled $17 million, a $2 million increase from 4Q14. The loan portfolio balance was $682 million at the end of 4Q15 (an increase from $644 million at 4Q14).Secondly, we do not believe no matter how "dominant" Sotheby's position is, that its business as well as its financial position are secure. On that note, we read with interest Artemundi's note from the 10th of June entitled "Sotheby's with one step closer to the grave":
From an operating cost perspective, marketing expenses increased $1 million to $7 million. Salaries and related costs decreased $14 million to $75 million. G&A expenses decreased $4 million to $42 million. 4Q15 Adjusted EBITDA totaled $145 million vs $152 million in 4Q14. Based upon outstanding debt of $1.2 billion, total leverage was 3.8x at quarter end." - source Bank of America Merrill Lynch
"It has been a disastrous year for Sotheby’s, but the writing has been on the wall for a while. A series of unfortunate events has driven Sotheby’s to walk a tightrope, beginning with Bill Ruprecht stepping downin November 2014 -amid criticism- as CEO after being with the company for 34 years. His rookie successor, Tad Smith, and the new amateur directing board committee have exhibited their lack of experience within the art market, refocusing company ideals to make Sotheby’s a marketing brand that favors advertising and technology for online retail. The new management, forgetting that art remains a business where knowledge really matter, has adopted a new strategy limiting PR expenses. This has led to an unprecedented exodus of the company’s best asset: knowledgeable staffers with strong client relationships and more than 300 years of experience. Vicepresidents, Specialists, Worldwide Heads, Chairmen, and even CFOs have abandoned the sinking ship. The resulting feeling of an uncertainty and instability now pervades the glittering glass-and-granite-fronted building on Manhattan’s Upper East Side. Personally visiting the venue on Sunday, left us with the distressing feeling of a rundown business, just like a ghost with spiritual emptiness, or a phantasmagoric carcass of what once was one of the world’s largest brokers of fine art.
In a desperate effort to compensate for the auction house’s emptiness, the board of directors decided to overpay the private firm, Art Agency Partners, around $85 million on January 11th, 2016 to boost private sales. Thus, this auction season, all art market analysts’ eyes were on Sotheby’s expecting a miracle with Amy Cappellazzo as Sotheby’s triumphant savior. As expected, Post-War and Contemporary auctions developed smoothly with an astonishing 95% sell-through rate. It was a solid $242 million sale made extraordinary if we consider the context within which it was developed but a small sale nonetheless. Clearly the resulting revenue from this sector is not enough to cover the entire auction house’s expenses and debts. The failing 66% BI-rate for the Modern and Impressionist catalogue was a big downturn for Sotheby’s confidence. Excluding Post-War and Contemporary, the lack of talent on the other business sectors has deeply affected the quality and quantity of artistic offer.
To summarize, Sotheby’s total sales volume dropped almost by half: last year the house generated $748 million in sales, compared to this year’s $386 million. Furthermore, it seems that Sotheby’s own team tries to boycott its own selling process. The Latin American auction held on May 24th, suffered from serious technical problems for the morning online bidding, when the firm was unable to stream the live auction or place the selling results. The Latin American department surely worked very hard for six months, only to find themselves victims of the IT department’s inefficiencies.
As a result, the insufficient cashflow forces the company heavily depends on its credit facility. In fact, Sotheby’s has just announced that total sales revenue dropped 8%, suffering a $73M loss in 2015, which incremented $11M from last year’s forfeiture of $66M. In 2015, Sotheby’s gross margins narrowed from 47.25% to 43.72% compared to the same period last year, operating (EBITDA) margins now 27.19% from 30.75%.2 Narrowing of operating margins contributed to decline in earnings. As of today, Sotheby’s EBITDA margin keep falling, since on Friday 10th, the company’s EBITDA was of 14.58. This position had seriously affected Sotheby’s BID stock, which has crashed 54% over the past twelve months. Consequently, Sotheby’s current credit rating is at risk. That is to say, if Sotheby’s corporate credit rating from Standard & Poor Rating Services is downgraded to “BB-”, “B” or “B+”, the revolving credit line might be recalled and the auction house may be facing insolvency problems too frightening to even mention.
In addition to the current long-term debt of $603 million, Sotheby’s 25-year-mortgage originally had an initial annual rate of 5.6% has now increased to 10.6%. In fact, the possibility of relocating the business’ headquarters was presented at the New York Times in June of 2013. According to the New York Post, Sotheby's has retained Peter Riguardi of commercial real estate company JLL to help it search for a new location, possibly in the Hudson Yards development on Manhattan's far west side.
In what may be a "coup d’grace", a private, Singapore-based investment group called Shanda has just announced its ownership stake in Sotheby’s. Shanda originated as an online gaming company and is run by co-founders Tianqiao Chen and Chrissy Qian Qian Luo. They currently own two percent of Sotheby’s shares and could increase their stake to as much as 10 percent, raising the possibility that Sotheby’s could be acquired or taken private. According to Forbes, Chen, a self-made millionaire was a pioneer in China’s online game industry a decade ago and holds a Bachelor of Arts from Fudan University. As a collector himself, Tianqiao Chen might be acquiring prestige through the auction house’s purchase. In case you have not recalled this situation, the name Alfred Taubman might sound as a déjà vu. That is to say, Alfred Taubman took over the auction house in 1983, after he was object of ill treatment at Sotheby’s before he bought the business.8Would Chen’s money be just a tantrum or a fuel of fresh energy that Sotheby’s urgently needs? Let us hope that China’s 10th richest man truly understands the situation he is getting into." - source Artemundi - "Sotheby's with one step closer to the grave"Maybe Bank of America Merrill Lynch analysts and their loan officers aren't afraid of the "Noise of Art" but, when it comes to our assesment of the situation, increasing leverage and "vendor financing" is not a long term "good recipe". The credit facility due in 2020 is $541.5 million. If indeed the credit facility get recalled, it might be "game over" for this business founded in 1744.
Furthermore, there is an ongoing assymmetry in the art market particularly in contemporary art where only a few names are dominating sales as well as the auctions. This assummetry is well described in ArtAscent article from the 1st of February 2016 entitled "Market trends and reality: two examples":
"At a sale on March 7, 2014, Koons’ ceramic Balloon Dog (Red), number 131 of an edition of 2,300, sold for $22,500. This appears to be a good return on an investment held by the collector for 18 years. If one considers the transaction in a little more detail, the return on investment is not all that it might seem at first glance. The process of calculating a return on investment is a little complicated, but it is well worth understanding how it is done.
First the sale price must be discounted by the 25 percent buyer’s premium retained by the auction house. In this case of Koons’ Balloon Dog (Red), it was 25 percent of $22,500. So from the transaction, the seller’s account was credited with $18,000. From this was deducted the auction house seller’s premium or commission of 20 percent. Thus, the seller pocketed $14,400 from the sale. In calculating the return on investment we need to know the cost base or book value of the work. This is particularly difficult as commercial galleries are notoriously tight-lipped on sale prices. It is possible that the owner of the single piece from the large edition of Koons’ Balloon Dog (Red) acquired it for something in the range of $2,000. The return on the 18-year investment ($14,400 – $2,000) may have been around 34 percent per annum. But, there is another way of looking at this. If we put $14,400 actual return from the sale into a calculator at usinflationcalculator.com, we find that this sum equals $9,499 in 1996 dollars. Over 18 years, the real/uninflated annual rate of return for this investment, was about 26 percent. Koons’ Balloon Dog (Red) was a very good investment no matter how it is calculated, but not as stunning as it may first appear.
Only a few lucky investors had the foresight – or available cash – a couple of decades ago to invest in a work by Jeff Koons or one of his colleagues who now happen to top the art index. It is a question of predicting future demand for the works or a particular artist.
Currently, 68 percent of contemporary works sell at auction for under $7,000. They are not the works of so-called “market leaders.” Consider a single work, chosen more or less at random, as an example – a 10-inch X 96-inch oil on canvas, Lamay Bridge, (1987) by the American artist Woody Gwyn (b. 1944). In February 2010, it sold at auction in San Francisco from the collection of a law firm, fetching $4,575. Subtracting the 25 percent buyer’s premium, the return to the seller was $3,432. Because this work was part of a large consignment by the law firm, the auction house seller’s commission was probably discounted to around 10 percent. The law firm likely received in the vicinity of $3,089 from the sale of this work that was originally acquired in 1987 from a Santa Fe gallery. The price at the time might have been about $500. The difference between the book value of the artwork and the return from its sale ($3,089 – $500) shows a $2,589 capital gain. The annual rate of return on investment was in the range of 23 percent. But, when we put the $3,089 return from the sale of the work into an inflation calculator, this sum is equivalent to $1,609 in 1987 dollars. Subtract the cost of acquiring the work originally and the uninflated gains from the purchase are $1,109, or ($1,109/22 years) $50 per annum or 10 percent.
These two examples show the differences in return on investment. If a collector with a small budget is lucky – or clever enough – to acquire a work by an emerging artist who eventually rises to the top of the market, the rewards can be substantial. This applies equally to investment in works by skilled artists who do not achieve a mega-star status. In both cases, the risk must be considered in relation to a best guess at future demand and the potential rate of return.
The good news must be tempered with an important warning. All the statistics on which art market trends are calculated are based on actual public sales. No one reports on the huge number of works that are put up for auction and fail to find a buyer. Depending on the prevailing economic conditions it is not unknown, for as many as half the works in a sale to be bought in or remain unsold.
In the art market, statistical trends are an imperfect guide at best. They are not of much use in helping an art investor determine risk. In the case of the acquisition of art for investment purposes, the eye is invariably mightier than the math. Even if capital gains are not forthcoming, a well-chosen work will delight the owner. There is no way to put a monetary value on this, so it’s not subject to the vagaries of statistical analysis." - source ArtAscent, 1st of February 2016Furthermore there is even more distortion in the auction process particularly with Sotheby's not only engaging in "vendor financing" but, as well paying some buyers to bid on its artwork as reported by Bloomberg by Katya Kazakina on the 10th of June in her article entitled "Sotheby’s Is Paying Buyers to Bid on Its Artwork":
"Sotheby’s was in a bind. The auction house had won several top consignments for its bellwether spring auction, including a Jean-Michel Basquiat that sold for $7.4 million four years ago, by guaranteeing the sellers minimum prices.
But as volatile financial markets sent jitters through the art world, Sotheby’s faced the prospect of owning the work if it failed to sell. In the weeks leading up to its May 11 auction, the company began pitching a new perk to potential buyers: a fixed fee to those who agree, before the auction even starts, to make at least a minimum bid. The new incentive helped Sotheby’s find buyers for guaranteed pieces.
Sotheby’s is joining Christie’s in offering the fees to buyers, whose private deals sometimes undercut the notion of a public auction market. Sotheby’s previously resisted the incentive on concerns it would reduce profit and price transparency. The auction house’s change of heart comes after new Chief Executive Officer Tad Smith reshuffled the ranks of managers and specialists and brought in a former top Christie’s executive. The company’s shares have lost about a third of their value in the past year.
Sotheby’s change “makes them more competitive on the financial side with Christie’s,” said Thomas C. Danziger, a partner in Danziger, Danziger & Muro LLP. “In the current climate, every advantage that you can have helps the bottom line. Stupid money is not flowing in the ways it might have 12 to 18 months ago.” Sotheby’s declined to comment for this story.
The new perk in Sotheby’s arsenal of incentives, disclosed in catalogs in April, sweetens the deal for investors who agree to step in as buyers of last resort. In the past, so-called irrevocable bidders were compensated with a part of the auction house’s sales commission only if another buyer purchased the artwork that they had backed. Now, by opting for a fixed fee, they are guaranteed a payout and can get the artwork effectively at discount.
The new approach reduces the risk that Sotheby’s ends up with too much artwork in its inventory -- a concern particularly in a slowing market. But as the May 11 auction showed, the company can still lose money.
“Onion Gum” was one of four works in that sale consigned by hedge fund manager Daniel Sundheim. Sotheby’s gave him undisclosed guaranteed prices for the paintings, and in the weeks before the auction, it lined up irrevocable bidders for the four pieces.
The Basquiat sold for $6.6 million, net of the fee paid to the mystery buyer, who was the only bidder. That was less than the guarantee to Sundheim, according to a person familiar with the matter, leaving Sotheby’s with a loss on the painting.
Sotheby’s lists the price net of fees paid to such buyers, making it possible to estimate the fee that the company doesn’t disclose. The buyer of the Basquiat work received $258,000, based on Sotheby’s standard sales commission.
The company argues this form of disclosure is more transparent, because the fee paid to the irrevocable bidder works like a discount. Christie’s does not adjust for such fees in its reporting of final prices.
Christie’s declined to comment. The fees are “a separate transaction to the sale, reflecting the risk the third party has taken in relation to the minimum price guarantee,” the company says on its website.
Sotheby’s is offering the new incentive to investors after it took a loss on a $509 million guarantee on the collection of its former chairman A. Alfred Taubman and had to take possession of $33 million of unsold artworks last year.
Auction guarantees have proliferated since the financial crisis, covering half of the $2.1 billion of art in November’s semi-annual auctions in New York. Since then, the number of guarantees at Sotheby’s and Christie’s has fallen as the market slowed. Art adviser Todd Levin says guarantees act like "steroids" in the market by presetting bids often at artificially high levels.So if you think that only central banks are "manipulating" markets, think again. Having "auctions" rigged through this "new process" makes us indeed afraid of the "Noise of Art". We disagree with Bloomberg in the sense is that this new approach in no way reduces the risk that Sotheby’s ends up with too much artwork in its inventory - a concern particularly in a slowing market. On the contrary "rising leverage", "rising inventory levels", "rising vendor financing" in conjunction with this new process makes us even more worry of the consequences in a market where volumes have been falling significantly. Whereas it is difficult to "time" the consequences of "easy money" and "market manipulations" (even in the art market), we do not think it is different this time and the weaker credit rating of Sotheby's make us wonder if now the time is not right to start thinking again about shorting both the bond and the stock in the near future...
David Nash, a co-owner of Mitchell-Innes & Nash gallery in New York, says irrevocable bids are part of financial machinations that distort the art market. When highly valued works with prearranged bids come up for auction, in many cases there is no genuine bidding and they are bought by the guarantors, he said.
That’s what happened with Roy Lichtenstein’s "Nurse," which was purchased in November at Christie’s for $95.4 million -- an auction record for the artist that was 70 percent higher than the previous high two years earlier.
“It’s a sale agreed in private to take place in public and pretend it’s an auction,” said Nash." - source Bloomberg.
This brings us to the second point of our conversation, namely that not only the art market risk facing a "soft patch" but "classic cars" who have enjoyed "stellar returns" for the savy and wealthy investors are beginning to show sign of slow down and price revisions.
- Macro and Credit - Classic cars? Downshifting...
"How it Works:
Each individual component of the Hagerty Market Rating is comprised of a number of individual measures, with each measure being scored on a scale of 0-100. Each component’s individual measures are combined into a “weighted average” based on how indicative the measure is of market status, which results in the overall score for each component of the Hagerty Market Rating. Like the rating for the individual components, the overall Hagerty Market Rating is a weighted average of the eight components’ individual scores, with those measures that are a more correlative of the market’s status treated with more preference in the algorithm.
Therefore, in order to calculate the overall Hagerty Market Rating, each component’s score must be calculated, which in turn requires that each individual measure’s 0-100 score must first be determined. To do this, we calculate each measure’s current performance against its historic performance. Scores for any measures that are based on dollar amounts are calculated using inflation-adjusted values relative to 2014 dollars. The resulting scores are then combined according to their predetermined relative weights for a final number.
For all measures, components, and the overall Hagerty Market Rating, a “bell curve” type distribution is expected, with 0 falling on the far left, 100 falling on the far right, and 50 landing at the curve’s peak. Because of this, the rating is more fluid in 40-60 range, and much more difficult to move at the rating’s extremes." - source Hagerty
- Following a very slight increase last month, the Hagerty Market Rating is down to 69.01 for June.
- While last month marked the largest increase of 2016 in the auction channel, auction activity instead saw its largest decrease so far this year for June and is currently at a 33-month low.
- Private sales activity fell for the third consecutive month. Over the last 12 months, the average private sale price has fallen 10 percent and the percent of vehicles selling for above their insured values has fallen 1.4 percent.
- Requests for insured value increases for braod market vehicles declined for the ninth consecutive month.
- Requests for insured value increases for high-end vehicles fell for the second consecutive month and are at a 15-month low.
- Correlated instruments saw an increase for the second time this year, as the price of gold per ounce fell and the S&P 500 passed 2,100 forthe first time since November 2015.
- May's reported rating was revised from 69.35 to 69.17 due to newly released inflation numbers." - source Hagerty
"The Hagerty Price Guide Index of Ferraris is a stock market style index that averages the values of 13 of the most sought after street Ferraris of the 1950s-70s. The graph below shows this index’s average value over the past five years. Values are for #2 condition, or “excellent” cars.
As the top of the market moves, so moves the Hagerty Ferrari Index. This group of cars performed similarly to the Blue Chip Index in that it recorded its first drop since September 2009 and in that the drop was also a nominal 1% slip. None of the index’s 13 component cars increased in value—the first time since May 2009 that this has happened—which is remarkable considering Ferrari has hands down been the hottest part of the market for half a decade.Could the Dino retreat back to pre-2013? Us not suffering from "Optimism bias" and being as you know by now "contrarians" would beg to differ. So overall, not only are we afraid of the "Noise of Art" but we are also very wary of what the "Ferrari index" has been doing as of late.
In particular, softness was exhibited for some of the biggest movers of the past two years, as these models find new footing following a rapid run up. The Lusso dropped by 9%, the 275 GTB/4 fell by 8%, and the Daytona Spyder lost 9%. Over the past 12 months the 330 GTC is the loss leader with a 10% decline in value.
This may be bad news for anyone who bought a car in the last 6 months expecting to sell for a quick return, but will likely be of little concern to an end user. Looking through a longer lens, the most sluggish of the bunch over the past three years—the Dino—has still gained more than 50% in value and it is unlikely to retreat back to pre-2013 numbers. -Brian Rabold, May 2016" - source Hagerty
- Final chart: Classic cars have been "turbocharged"
"Classic cars were once again the top performing luxury asset on an annual basis, according to the latest figures from the Knight Frank Luxury Investment Index (KFLII).
While the overall value of KFLII increased by just 5% in the 12 months to the end of March 2016 – the lowest annual increase since the first quarter of 2010 – cars outperformed with a 17% surge.
Wine saw the second strongest growth, up 9%, with coins in third position, rising 6%. Art and furniture were the biggest losers, dropping by 5% and 6%, respectively." - source Knight Frank
"As most of our readers will know, modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn of the economic cycle. And interestingly, over the past couple of months, these assets have really been shooting up, breaking several records on the way" - source Gavekal, July 20th 2006.
"Usually, the last thing to go up in prices are rare automobiles" - source Gavekal Five corners, July 20th 2006.This time it's different? We don't think so.
"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Arthur FisherStay tuned!