Modest Top Line Growth and Risk Profile Remain Areas of Concern
Artnet has reported its 2010 financial results, and they are in line with our prediction of the firm’s steady return to profitability. The company had been incurring losses in the last two years after shifting its strategic focus to an online auction business model in late 2007.
The biggest positive for 2010 is that Artnet is finally profitable again with a net profit of EUR 153,000 versus a loss of EUR 467,000 in 2009, although it should be noted that this profit comes with the help of historical tax liability release (see detailed discussion further in this report). Cash flow from operations also swung from a negative EUR 180,000 in 2009 to a positive EUR 651,000 in 2010. The cash position has grown nicely by 23% and, with the exception of a EUR 249,000 finance lease liability, the firm remains effectively unleveraged.
On the negative side, this lack of leverage actually translates into a lack of growth. Artnet has clearly identified a new business model centered on online art trading, and while the artworks that are being sold are small-ticket items for the art industry (below $10,000 in value), the average transaction sizes are wonderful in terms of online commerce in general. So far Artnet seems to be doing much better than eBay, Artfacts or any other rival in the online art trading space. In 2010, it achieved a volume of $13 mln, and, very importantly, the company has managed to avoid any public scandal surrounding the sale of fakes or inappropriately authenticated items through the system.
Despite the potential, Artnet’s management appears to have shied away from investing in faster growth and adopting the product more vigorously. As a result, top line growth was a disappointing 12%, and the firm continues to lose money in two out of its four business segments. Our updated financial model for Artnet suggests that the firm needs to achieve at least $35 mln in turnover for online sales art before it can break even (We discussed this number with Artnet, and the company’s management is convinced that they can break even with $27 mln in volume, i.e., double what they achieved in 2010. Our estimate is larger, as we expect Artnet’s costs to grow as it starts taking more consignments from outside its dealer network and its commission structure can also come under pressure once potential rivals like VIP Art Fair get their act together).
Instead of vigorous investment in the online auction platform, Artnet actually cut back on its capital expenditures by a factor of three in 2010, with overall investment in product development at just EUR 103,000 in 2010 versus EUR 328,000 in 2009. To be fair, however, Artnet’s investment levels were higher in 2009 due to the development of the Decorative Arts Price Database, which is now complete. Artnet’s management told us that the current system in place could easily handle the volume increase necessary for Artnet to operate a profitable online auction business. Yet, it remains to be seen whether current capabilities are enough to support the increased volume necessary to achieve sustainable profitability. Selling and marketing expenses remained effectively unchanged in 2010, going from EUR 2.97 mln in 2009 to EUR 3.07 mln in 2010. We believe that Artnet’s online model does work and that the firm should put significant capital into growing it even faster than it did in 2010 to retain its leadership position in online art trading space.
Artnet’s Business Model: From Art Industry Portal to Mass Consumer Art Retail Play
While Artnet’s management may still be pondering the revenue potential of its auction business, it appears to have made up its mind about the fundamental change to its business model. The firm is clearly migrating away from its traditional B2B focus on galleries, artist offices and art market intermediaries toward a model that focuses more on retail business. This decision seems evident in Artnet’s 2010 annual report and finds further support by the lack of growth in the company’s legacy business segments (see section “Core Statement”; the full annual report can be downloaded from the Artnet profile in the Skate’s Art Stocks & Funds section at www.skatepress.com).
Indeed, as Skate’s predicted a year ago, Artnet’s core B2B offering – “artnet Galleries Network” – produced virtually no top line growth in 2010 (0.4% growth in EUR terms to be precise) and plunged into losses, swinging from EUR 103,000 in earnings before taxes for the segment in 2009 to exactly the same EUR 103,000 in losses before taxes in 2010. While the segment remains the largest contributor to Artnet’s revenue mix and did better than we expected in 2010, it holds little growth potential given its current format and is being challenged by various other platforms through which galleries can communicate with each other and their customers. Artnet clearly recognizes this, and the company will need to review its gallery strategy in order to reverse loss-making trends for the segment.
The firm is responding by repositioning its primary moneymaker, the Price Database segment, to service both the business and retail market. It is also now presenting the Auction segment as a C2C model similar to eBay but with specialist market knowledge, data support and a product category focus in price levels (under $10,000 per work) that fall below the radar of Sotheby’s and Christie’s. All of these elements of Artnet’s retail strategy are clearly designed to pursue the objective of attracting more registered members and a greater level of site usage, which would make its marketplace more liquid and thus bring a second life to another struggling business segment at Artnet, namely Advertising, where profitability collapsed by 77% in 2010 due to stagnating revenues.
One striking takeaway from our analysis of Artnet’s 2010 financial results is that the company is actually not making money on EBT by segment basis. The EUR 739,000 provided by the Price Database cash cow, which is supplemented by a token EUR 61,000 EBT from Advertising, is still less than the losses before taxes generated by the Auctions segment and the losses from the Galleries segment. This all serves to put Artnet in the red by EUR 61,000 on an EBT basis. Apparently, the release from Artnet’s historical tax liabilities (EUR 335,000 in release of German tax liability for prior years (including related penalties)) enabled the firm to claim in its annual report that it “ultimately returned to profitability in 2010.”
That said, Artnet is now clearly on the path to profitability, and we expect the firm to return to positive EBT in 2011, especially given the EUR 700,000 cash flow that was generated in 2010, which was a EUR 800,000 improvement over the previous year. We expect that the still bleeding Auctions segment will begin to make money in 2013 (and possibly in 2012 if Artnet increases its sales and marketing expenses by at least 50% in 2011). It also seems as if Artnet has become even more attractive to its largest outside shareholder (i.e., not controlled by Mr. Neuendorf), as Artis Capital Management of San Francisco has apparently increased its stake in the company to 10.39%.
Risks of the C2C Model
Artnet is now betting that a C2C auction model will serve as a locomotive for growth and enjoy synergy with its Price Database and Advertising segments through more retail purchases and greater revenues from a growing audience base. This strategy creates a strong opportunity for growth. At the same time, it also opens up a Pandora’s Box of new risks, such as vendors using Artnet’s system to deal in fakes and wrongly attributed artworks. This would result in an increased percentage of charge backs and payment defaults. Certain worrisome signs are already there, as the firm’s trade receivable (accounts receivable net) grew by 20% to EUR 1.13 million in 2010 and its doubtful accounts increased by 26% in 2010.
These new risk areas can be mitigated, but they require adequate controls, and we are worried that Artnet may not have those in place. The firm is run by a three-member supervisory board (the German equivalent of a board of directors) but has no audit committee customary for US/UK public companies. In addition, Hans Neuendorf’s charisma as CEO and the fact that he remains the firm’s largest shareholder make for a powerful force that could cause Artnet to overlook red flags under certain circumstances. Although the small Hamburg-based firm that audits Artnet is part of Nexia International, a large and well-respected network of accounting and consulting firms, the absence of a Big 4 auditor does raise questions as to whether sufficient controls are in place to minimize exposure to payment, counterparty and fraud risk on Artnet’s growing C2C auction system. Under no circumstance are we implying that Artnet is experiencing any problems of this nature already or that the German audit firm has any conflicts or qualification handicaps that prevent it from doing a good job; rather, we are simply pointing out that the C2C model naturally increases Artnet’s risk exposure, which may require further implementation of best practice corporate governance at the firm including introduction of the audit committee chaired by an independent director.
These concerns aside, corporate governance at Artnet is rock solid in comparison to the less-than-impressive governance and reporting track record at Artnet’s listed art industry European peers. Artprice continues to produce quarterly reports without disclosing financial statements, instead publishing merely revenue and profit numbers. Camerawork has stopped making any public disclosure whatsoever. So if Artnet improves its corporate governance and reporting standards even further to match that of Sotheby’s and Collectors Universe, it will stand even higher above its European peers and go unchallenged as the only public investable company in the art market data world, for while we maintain coverage of Artprice, we do not view Artprice as an investable firm due to the poor quality of its reporting and governance.
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