By Alex Gavrish, Etalon Investment Research; author of “Wall Street: Back to Basics”
Income Inequality
Forbes magazine recently published an updated list of America’s 400 richest people. They now have a combined net worth of about $2.3 trillion dollars. According to TheHill.com, Sen. Bernie Sanders is demanding that Congress address the “obscene” level of wealth inequality in the United States: “Never before in the modern history of our country have so few had so much and so many had so little. This incredible and obscene level of wealth and income inequality is a grave danger to our economy and our political system”, Sanders said.
Social and political issues aside, if talking about investments, one may wonder what will “happen”, if at all, or what will be done with these tremendous amounts of money. It is obvious that neither government nor society at large will let such a small group of people to control so much capital and have so much power. Apart from channeling this capital back into existing, or new, businesses, there are four main possibilities. The first one is that this capital will be devalued: either through inflation or other currency and monetary system shocks. Or, the rich will have to give away: pay more taxes, donate it, or spend it. Speaking of spending, a fourth yacht, a third executive jet or another Ferrari will probably not be of great interest to people who have everything. And it is safe to assume that they might be interested to spend it on something that is the most eternal of all things material, such as art. In light of this, long-term investors might want to take a look at shares of Sothebys.
Company profile
[drizzle]Sothebys (NYSE:BID) is a global art business whose operations are organized under three segments: Agency, Principal, and Finance. The Agency segment matches buyers and sellers of authenticated fine art, decorative art, and high-end jewelry through the auction or private sale process. The activities of the Principal segment include the sale of artworks that have been purchased opportunistically by Sothebys and, to a lesser extent, retail wine sales and the activities of Acquavella Modern Art, an equity investee. The Finance segment conducts art-related financing activities by providing certain collectors and dealers with loans secured by works of art.
Activist funds’ investment thesis
Activist hedge fund Third Point LLC and Daniel Loeb initiated investment into shares of Sothebys (NYSE:BID) in 2013. According to the latest filing (6th of May, 2014), the fund owned 6.65 million shares or a 9.64% stake in the company. Third Point LLC’s April 2014 presentation explains that there are some important structural industry headwinds: global population of ultra high net worth individuals and their combined aggregate wealth have increased to record levels and luxury consumption across a variety of categories is on the rise. The art market, therefore, should reflect these positive trends, making Sothebys more profitable. A presentation filed in April 2014 by Marcato Capital Management which, as of 20th of August, 2014, owns a 9.5% stake in the company, emphasized that Sothebys needs to improve its capital allocation and capital structure. In particular, the activist fund stated that: (a) there are significant levels of unproductive capital; (b) inappropriate mix of debt and equity given business composition; (c) capital could be reallocated or returned to shareholders without affecting business operations; (d) improving the company’s capital allocation policies would unlock value and improve Sothebys cost-return relationship, increasing long-term shareholder value. Overall, according to Marcato estimates, Sothebys can unlock $1,069 million in excess capital after a special dividend payment (including $195 million in normalized free cash flow for 2014). To put these numbers in perspective, such amount represents 41% of company’s market capitalization.
Valuation summary
Based on a recent share price, Sothebys (NYSE:BID) had market capitalization of $2.6 billion and an enterprise value of $2.8 billion. Company has $511 million in notes receivable, located in the long-term assets part of the balance sheet. Adjusting for this amount, enterprise value equals $2.3 billion. Company is currently valued at an EV/EBITDA multiple of x9.3, based on EBITDA adjusted for notes receivable and full 2013 year results. P/E valuation ratio is currently x19.9, based on results for the same period. In 2013 Sothebys generated $214 million in free cash flow, implying a P/FCF multiple of x12. In January of 2014, company declared a special dividend of $300 million, or $4.34 per share (paid in March 2014), authorized a $150 million share repurchase program and stated that it intends to return any excess capital to shareholders on an annual basis, primarily through a special dividend.
Conclusion
Sothebys shares declined during 2014 from a high of $53.5 to current $37.6, a decline of 30%. Also, company made good progress since start of an activist investor campaign by Daniel Loeb and his hedge fund. Sothebys (NYSE:BID) signed shareholders agreement with Third Point, paid a special dividend of $4.34 per share in March, stated that it plans to return any excess capital to shareholders annually and announced that it will evaluate its real estate and the options for optimization of capital structure. Current valuation, recent share price weakness, potential for capital structure optimization and positive long-term industry trends make shares of Sothebys an attractive long-term holding.
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