We have been wrong about this company in the past. In the context of a collapsing art market during the spring of 2009, we looked at Mallett’s financial performance for 2008 and predicted that this UK-listed art dealer would either go bankrupt or at least cease trading as a public company. Neither of these scenarios turned out to be true. While Mallett continues to report a negative cash position period after period, it is still listed (albeit as one of the least valuable stocks in Skate’s Art Stocks Index). It has just reported its six months financial results for 2010 and remains a going concern for now. In other words, Mallett is clearly a survivor. As we take a look at what has helped the firm to stay afloat, we will try to ascertain whether Mallet is indeed a going concern (in accounting speak).
Artprice, the French art market information provider, has disclosed its six months financial results for 2010, staying true to the signature Artprice financial data publishing fashion – four pages of words and three lines of numbers.
Artprice, which prides itself as the world leader in art market information and transparency, is very cagey about its own financials – the firm does not publish a balance sheet, cash flow statement, or notes to the financial statements, and its financial disclosure is limited to revenue numbers (with an essentially meaningless revenue breakdown and no costs and profits (losses) disclosed). No auditor statement, of course. The firm, however, provides several pages of French language prose to read on top of the laconic financial disclosure it makes…
On August 9, we erroneously reported that Christie’s had decided to divest itself of its Haunch of Venison dealer business. According to Toby Usnik of Christie’s Public Relations, however, “Christie’s remains committed to HoV.” We apologize for this inaccuracy in our report and have issued a correction to the story linked in the post below.
When we published our last major Sotheby’s story on March 5 of this year, we praised the company for its progress with turnaround and increased our target price to $32 per share. Sotheby’s financial results disclosed last week did not disappoint and were in line with our projections. The firm achieved a 73% growth in sales and 26% growth in net income for the first six months of 2010 compared to the same period a year earlier. The share price, which fluctuated wildly throughout the spring, has climbed back above the $30 mark, gaining 6.4% on the single day of August 6, 2010 following the release of the company’s financial statement. The firm also devoted a significant portion of its press release to reporting on a robust pipeline of auctions lined up for the remainder of the year.
As the market knew of Sotheby’s auction results for the first half of the year ($2.2bln in combined volume, more than twice the size of the auction trade in depressed 2009), strong topline growth was expected. This growth is not big news; the interesting news stories are found elsewhere in Sotheby’s disclosure.
Artnet published its six months results on Friday, July 30. True to its German fashion, the firm quietly published its accounts without releasing a major media statement. This would have been understandable over the last couple of years when, quarter after quarter, Artnet’s financial disclosures carried news of yet more losses and more declining revenue.
But not this time – the firm reached positive cash flow from operations, ended six months with net income and even managed to reverse top-line decline, achieving a modest but symbolic increase in sales. We would not call it a turnaround as of yet, but we definitely see light at the end of the tunnel and applaud Mr. Neuendorf and his team in their commitment to build an online auction business to compensate for the lack of growth and outright decline in the core business of data and gallery services.
General Financial Performance – Artnet Makes Progress and is Strong Enough to Continue with Its Major Bet on the Auction Business
Artnet revenues were up in the first half of the year by 7% in Euro terms (the firm’s principal reporting currency, they were up by 6.5% in USD terms). The only reason for this increase is the performance of the company’s online auctions, which we analyze in detail below. Auction revenue more than tripled for the period (compared to the first six months of 2009, albeit from a small base of EUR 316,000 (USD 421,000) a year ago), making the segment a more significant contributor to the group’s top line than advertising sales. Revenue from every other business segment at Artnet continues to be in decline, from a 10% drop in advertising sales to a 1.3% sales decline for the core database product (all in USD terms calculated for six months of 2010 over six months of 2009).
With auction revenues not yet achieving the EUR 1 million mark for the first half of the year, Artnet has nevertheless managed to cure its overall group economics (at least for now). It reduced losses from the auction segment significantly enough so that profits made elsewhere in the company would not have to pay for that loss. As a result, Artnet is finally net income positive for the period (after two long years of loss making on the group level). This is definitely a symbolic achievement after two years of heavy investment in the auction segment – we specifically observe notable improvement in the economics of Artnet’s auction trade and solid discipline in related working capital management (see further discussion in the auction focused section below).
These positive developments are encouraging, but Artnet is not out of the woods yet as it faces several important challenges. First and most importantly is the continued cannibalization of its core business, particularly of the gallery network’s revenues and profits. Secondly, Artnet has yet to demonstrate a profitable auction business model – yes, the firm is turning more volume and loses less money in the segment, but for the auction case to work it must see significantly more volume and firm profitability before it can be called a success. In a way, given Artnet’s lack of interest in modernizing its information and gallery offerings (at least based on an historical lack of progress in those two segments over the last several years), those two challenges come to just one question – can the firm grow its auction segment quickly enough to achieve a size and level of profitability that would compensate for what now seems like an inevitable decline (at best — stagnation) of data and gallery network-related revenues and profits?
This is the first time we are prepared to make this assertion – yes, based on the first six months results of 2010 we believe Artnet can do it, and here is why:
- Artnet’s auction product is gaining proper momentum (see below) and the company has learned how to grow the auction business without growing its losses at the same time;
- The firm continues to be essentially debt free – with the exception of EUR 366,000 (USD 447,000) in finance lease obligations, the firm has no debt and can access more capital if needed for further expansion of the auction business model by taking leverage; and
There are other ways Artnet can finance its further efforts to turn the auction segment into a sustainable, profitable endeavor. Now that it has achieved a profitable reporting period, Artnet has preserved and increased its cash position, from USD 3.14 million on December 31, 2009 to USD 3.49 million as of June 30, 2010. The firm also has 78,081 of its shares on the books (roughly 1.4% of shares outstanding) that it can use to raise an additional USD 500,000 in equity capital fairly quickly.
All in all, we conservatively estimate that Artnet can access at least USD 7 million worth of capital, including its own cash and treasury stock, to continue pushing along with its online auctions (assuming zero net profits going forward and USD 3 million in max allowed net debt position). With these resources available to Artnet and provided the company continues with its discipline in cost and working capital management, the firm can definitely scale its auction business to achieve a sustainable, profitable online auction house business model, thereby making it a core business for Artnet in all senses within the next two to four years.
Now let’s take a closer look at Artnet on a segment-by-segment basis.
Online Auctions – Volumes Still Tiny, but Trends are Strongly Positive
Based on the first six months of 2010, Artnet is firmly on the way to changing its product mix – revenues from auctions went from 4.9% of total sales a year ago to 14.5%, becoming the third most important contributor to the firm’s top line after the Gallery Network and the Price Database segments. At the same time, auctions continue to be the largest loss maker for the group, albeit at a smaller level than in 2009 – Artnet lost EUR 422,000 in the segment for the first six months of 2010 (EUR 675,000 a year earlier).
We are encouraged that the firm achieved a narrower loss by growing its top line, which confirms the assumption that as Artnet scales the business it would become a more profitable operation. In the notes to the financial statements, Artnet CEO Hans Neuendorf confirmed the original guidance for doubling auction volumes and commissions for 2010 over 2009, as the firm not only grew revenue by more than three times for the first six months of 2010 but indeed moved toward greater profitability by increasing the buyer’s premium (commission) from 10% to 15% as of March 1, 2010.
In terms of timing, the online auction offering is showing strong momentum. The art market continues to attract more buyers – many of whom start with relatively lower value lots such as those offered at Artnet auctions. They appreciate the ease of use and access to information that Artnet offers. However, the overall quick art market recovery observed in the first half of 2010 helped tremendously. Launched in the spring of 2008, Artnet’s auctions arrived at a very difficult time for the art market, whose period of troubles now seems to be history following an impressive start this year.
As the auction segment is clearly becoming a core business for Artnet, it is important that the firm treat it this way in its disclosures. We hope that Artnet adopts the best practice used by Sotheby’s, the largest listed auction business (there are also two other listed art auction houses based in Japan and South Korea –for more details, see Skate’s Art Stocks section of www.skatepress.com). Specifically, we would like Artnet to separately disclose auction volumes, commissions charged, inventory carried and guarantees made. The firm should also publish its revenue recognition standards. So far the company has limited its disclosure and does not publish any of this information, which makes it difficult to conduct sufficiently reliable analysis of its auction volumes, profitability and working capital requirements.
However, all the signs offered by Artnet’s consolidated balance sheet so far point to a healthy picture. While tripling sales from the auction segment, Artnet had no major changes to its balance sheet structure, as we specifically see no spike in debt, receivables, payables or inventory, which suggests that new volumes are handled without Artnet involving any of its capital to do so and without the company taking new risks in managing receivables or inventory caused by the auction segment’s growth. As this seems to be the case, it creates an even stronger argument for Artnet to publish related disclosures. Clearly, such disclosures could be a strong positive differentiator of Artnet’s online auction business model from the traditional balance sheet structure of well established auction operators like Sotheby’s (specifically against the backdrop of their recent expansion into the working capital-heavy dealer business).
Gallery Network – Artnet Seems to Have No Response to Continued Cannibalization of this Segment
The Gallery Network has historically been the largest revenue source for Artnet. It remains so, but on a much lower scale with Artnet’s shift in priorities clearly taking a toll on the company’s ability to preserve the Gallery Network business model from cannibalization via the numerous other avenues where galleries can list and market their stock (i.e., their art). Following a 5.4% revenue decline (in EUR terms), gallery membership income is now responsible for 38% of the firm’s revenue, down from 43% a year ago.
Our model company for generating revenues from sales to galleries is Swiss MCH Group, the operator of the flagship Art Basel and Art Basel Miami shows. We expect that when MCH Group publishes its six months financial results later this month, we will actually see more revenue and more revenue per gallery at MCH, in complete contrast with the eroding profitability of Artnet’s Gallery Network model. The first six months of 2010 is the first time since we began covering Artnet in 2005 that its Gallery Network has gone into a net loss for the period – the company lost EUR 38,000 on EUR 2,608,000 in revenues, suggesting even faster decline in profitability than in sales in the segment. The Gallery Network business model faces challenges from all sides – galleries launch and market their own increasingly more sophisticated websites, art fairs provide them with an increasingly better way of generating business than a passive listing presence at sites of the Artnet / Artprice style, and mobile applications are becoming increasingly en vogue among galleries as a way to convert digital traffic into actual visits to galleries. Artnet has been deaf to those threats for years, and the company is now paying the price. We actually believe that the Gallery Network will overtake Advertising as the fastest declining segment at Artnet. We also believe that it is currently the weakest segment in the company’s business portfolio, and unless Artnet finds a clever way to address this threat, the business model appears poised for destruction within a few years (or faster if someone like MCH Group launches an online offering for its galleries).
Price Database – the Crown Jewel, for Now…
On the surface, Artnet Price Database is what makes the company tick – contributing just 34% of the firm’s revenues, the segment is responsible for virtually all of its profits and operates at a 21.9% EBIT margin. Artnet so far remains the market standard for art price data and clearly has an edge over its archrival Artprice, whose credibility has been recently damaged by a massive legal battle with Christie’s.
A closer look reveals some signs of trouble, however. First of all, there is an issue of transparency with respect to financial reporting. Artnet does not publish detailed notes to its financial statements, which is why it is difficult to explain some of the policies that the company uses. One area of concern is that the apparently brilliant profitability of the Price Database segment may be partially a product of certain accounting policies employed by the firm. In its segment reporting, where Artnet discloses the profitability of its business units, it has no “other segment” reported (p.17), while in its revenue structure disclosed on p.11 contains a line “other Artnet products” not attributed to any segment. Doing some basic forensic accounting, we discovered that most of the revenues from “other Artnet products” have been added to the Price Database revenues for segment reporting purposes, thus giving a significant boost to the segment’s bottom line. Hence, while there is definitely a positive trend in the growing profitability of the Price Database, the question remains how much of the EBIT margin improvement from 9.1% in the first six months of 2009 to 21.9% for the same period in 2010 is due to operational improvements or to accounting policies employed by the firm.
Secondly, an evolving market environment persists wherein auction price data are increasingly becoming a commodity. LBM’s Artinfo went so far earlier this year to offer historical auction prices free of charge, and the number of data providers is growing, with some of them offering pricing plans and mobile distribution platforms clearly superior to what is available from Artnet today. This expanding competition is clearly responsible for Artnet’s inability to grow revenues in the segment (again declined 1.3% in USD terms in the first six months of the year) where the firm has historical leadership but is increasingly looking like a vulnerable incumbent.
While its Price Database will continue to provide a cushion for the firm’s financials for years to come, we question the sustainability of a 20%+ EBIT profit margin for the segment and expect it to come down significantly in the near future. Growing revenue for the segment will remain a challenge for Artnet.
Relative Performance and Outlook for 2010
With its portfolio of four business segments – a strongly profitable and so far market leading Price Database, quickly growing but still loss-making Auctions and a declining Gallery Network and Advertising – Artnet is definitely one of the strongest constituents of Skate’s Art Stocks Index and will remain most interesting to watch.
Based on seven months performance this year, both art market information providers Artnet and Artprice are significantly lagging behind the Skate’s Art Stock Index. While performing better than Artprice (Artnet’s stock is up 4.6% on a year to date basis while Artprice’s is down by 2.6%), Artnet is underperforming Skate’s Art Stock Index by almost 2000 basis points. As demonstrated by Sotheby’s (up 22.3% year to date), investors have a lot of confidence in successful art auction models, but they are not certain if Artnet is making it there yet. We believe there is good reason for this uncertainty, but it is worthwhile to watch Artnet in its endeavors to reinvent itself as an art auction company.
We have a positive outlook for Artnet for the balance of 2010, and raise our target price to EUR 6.5.