$142 million for a Francis Bacon triptych. $120 million for a pastel by Edvard Munch. $106 million for an oil painting by Picasso.
After a slow 2012, the fine-art market is back. Stock market gains worldwide and growing wealth in Asia have lifted prices to new all-time highs. That includes the recent $142 million for the Francis Bacon triptych, eclipsing last year's record $120 million for Munch's "The Scream."
The fine-art market is trading just like the stock market. Buyers are stepping out and lifting the bid. That's putting a lot of cash into the pockets of investors with rare collections.
But art connoisseurs aren't the only ones cashing in. I want to tell you about a global leader in the auctioneer business that is also cashing in on these nine-figure masterpieces.
Not only does the company generate big commissions from conducting auctions for the world's rarest art and wealthiest individuals, it enjoys a duopoly with just one competitor, is protected by high barriers to entrance, is highly leveraged against growth in Asia and also pays a quarterly dividend.
That has fueled an outsize gain of 80% in the past two years. Take a look below.
Sotheby's (NYSE: BID) is the second-largest auctioneer in the world with a market cap of $3.6 billion. Along with industry rival Christie's (which is privately held), Sotheby's enjoys a virtual duopoly in the auctioneer business, with no other major competitors.
Sotheby's is a direct play on fine-art valuations. Just like a broker, Sotheby's charges commissions to buyers and sellers based on the value of the asset. Naturally, a $100 million piece generates a much bigger commission than a $50 million piece.
That's why record-setting sale prices have been fueling the company's share price. With a low-cost business model that can easily scale to higher volumes, revenue growth hits the bottom line hard, with operating margin coming in above 55% in recent third-quarter results.
Although Sotheby's is a direct play on the strength of the fine-art market, it's also an indirect play on a larger social trend: extreme wealth concentration. According to a recent study by the Boston Consulting Group, the wealthiest 1% of the global population controls 40% of the world's wealth.
|Sotheby's headquarters in New York City.|
While that extreme wealth disparity can lead to social unrest in the long run, there's no question it continues to fuel fine-art prices and valuations. Billionaires don't need or want to have all their cash parked in Treasurys. That kind of big money will be spread across a wide range of assets. That includes fine art not only because of its social status but also because a good purchase can produce big returns in a short amount of time.
Sotheby's also provides exposure to high-growth markets in Asia. The engine of the region's art industry has been China, where auction revenue totaled $8.9 billion last year. Not only is that a 900% increase from just 10 years ago, it also puts China's art market ahead of the United States' $8.1 billion.
Sotheby's has been making big investments in the region to cash in on that growth. In May 2012, it opened a 15,000-square-foot auction space in Hong Kong. In September 2012, it announced a $1.2 million investment and 10-year partnership with state-owned Beijing GeHua Art Company. That is a critical partnership for Sotheby's because non-Chinese companies are not allowed to conduct auctions in China without the assistance of a state-owned partner.
Sotheby's is already seeing those investments pay off. Auction results out of Hong Kong auctions in October came in ahead of expectations. During Asian Art Week, Sotheby's auction value rose 105% from the previous year, to $583, million on strong demand out of China. That has given Sotheby's a strong start to the fourth quarter and in position for a strong finish to the year.
In spite of Sotheby's success and market-leading position, it has also become an activist target, with hedge-fund billionaire and major shareholder Dan Loeb demanding operational improvements. In his recent profile of Sotheby's, my colleague Marshall Hargrave had an interesting insight about these activists' plans:
"The big news of late, in addition to the activist campaigns, is that Sotheby's is planning to sell its New York headquarters. Stifel Nicolaus has said that those real estate properties could hold unrealized value for Sotheby's, noting that the New York and London properties might be worth $300 million more than is carried on the balance sheet.
"It's no secret that one of the activists involved in Sotheby's, Marcato Capital, specializes in real estate investments. That firm may be looking to get its hands on any profits from Sotheby's real estate and return them to shareholders."
Activist demands for operational improvements have led to a new chief financial officer, a former senior investment banker at Goldman Sachs (NYSE: GS). They have also prompted Sotheby's to rethink its capital allocation strategies, currently moving away from the less profitable dealer business and on track to end its relationship with dealer Noortman Master Paintings by the end of the year.
The good news has the consensus estimate calling for 8% earnings growth in 2013, 21% in 2014 and average annual earnings growth of 18% in the next five years, ahead of the industry average of 15%.
Risks to Consider: Sotheby's biggest rival, Christie's, has made the strategic shift into lower-value markets to drive sales while Sotheby's has narrowed its focus on the high-end market. That has given Christie's a boost, selling $3.6 billion of fine art in the first half of 2013 against Sotheby's $3.1 billion. Over the long term Sotheby's has the flexibility to adjust to changing market conditions, but for the time being Christie's is leading the way into mid-level markets.
Action to Take --> In spite of the good news and recent gains, Sotheby's PEG (price-to-earnings growth) ratio of 1.3 is a discount to its industry average of 1.45. That discounted valuation will support shares in the short run. But as a market leader tapping into high-growth markets, Sotheby's still has plenty of room to grow while supporting shareholders with a small dividend.