Skate's Art Investment Review

Parallel Reality for Global Art Market Emerges in China, Art Dealing Starts to Migrate Online
Artnet Downgraded, MCH Group (Art Basel Operator) Upgraded

In January, we published our customary outlook for the year and made seven predictions for 2011. Following Skate’s art industry workshop held in Venice on June 4 and on the eve of Art Basel we are reviewing our forecasts and introducing several important new trends to watch.

New trend: China’s art market increasingly a speculative playground for locals

The painting at the right, Eagle Standing on Pine Tree by Qi Baishi, is now the most valuable Chinese painting and world’s 15th most valuable work of art following its sale on May 22 for $65.5 million. Continuing this year’s new tradition of price records being set at second tier auctions (see Skate’s reports on MacDougall’s results from earlier this year), this top lot from the May auction sales was offered at the China Guardian Auction, the second largest local auction in China, which has been in operation since 1993. As a sign of the auction house’s quality, it was unable to attribute the year of creation to this artwork and did not publish pre-auction estimates.

A prolific artist who passed away in 1957 at the age of 80, Qi Baishi has emerged as China’s 47th most valuable artist in recent years and was the 10th most actively traded artist globally based on the data in Skate’s Top 5000. Baishi saw 11 sales exceeding $1.87 million per artwork in 2010.

The sale was the part of Chinese art market’s May extravaganza that saw 10 auction sales priced over $7 million per work and further established Zhang Daqian among the world’s most actively traded artists in the higher price category (half of the sales were his artworks). He was also the only Chinese name to be traded at major global auctions in this price range in May.

The Chinese art market is clearly living in a parallel reality at this point. Local auction houses trade local art that generally lacks a wide international ownership base and relies largely on domestic demand and art market infrastructure. The writing is on the wall: high-end Chinese art has virtually no repeat sales records to speak of, and not a single Chinese artwork was present in the Top 10 repeat sales in May. Investors entering the Chinese art market at current valuation levels are taking very significant liquidity and value destruction risks.

There are certain markets, such as those for works of Zhang Daqian, which are definitely worth following more closely. These works, which offer a must-have Chinese component for any global collection of 20th century art, are increasingly building international exposure and have Warhol-like elements in terms of liquidity.

New trend: art dealing starts to migrate online

Skate’s recently conducted extensive research on online art trading platforms for one of its clients, and the conclusions reveal a massive surge in both private equity investment in online art trading solutions and quick adoption of online marketing tools by the world’s most established galleries. Specifically, we estimate that the amount of private equity investment in global online trading platforms will grow from a mere $5 million in 2009 to over $30 million in 2011. At least 100 established global galleries will offer new online memberships in addition to the incumbent services of Artnet and Artprice. Acquiring and managing customers online is already becoming the #1 CRM (customer relationship management) channel for all artwork sales below $1 million as traditional location-based marketing aimed at cultivating a customer base around physical galleries is exhausting its growth potential in an over-saturated market. More importantly, investing in online marketing and CRM is increasingly a substitute to spending money on traditional art fairs – galleries and dealers apparently prefer to attend fewer fairs and focus their marketing efforts on more efficient online platforms.

It is still too early to tell which online art marketplace will emerge as the leader. At the moment, we are watching the beta launch of Art.sy at Art Basel this summer, anticipating second edition of VIP Art Fair in January and reviewing new product offerings and business plans from five other operators (in addition to existing players like Artfact, Artprice and Artnet).

Skate’s will publish an extensive review of the online art dealing platforms in February 2012, but we have already identified this segment as the quickest growing in the global art industry.

Art securitization: funds’ actual performance emerges as concern

We predicted that art securitization would be the most important trend to watch in 2011, and this has turned out to be true already. Our January forecast suggested that the total assets under management in art funds open to outside investors would grow from $300-400 million at the end of 2010 to over $1 billion in 2011. As of June 1, 2011, we estimate that the global art fund industry has at least $850 million in at least 15 art investment funds tracked by Skate’s. The inception of the FotoEffect fund, managed by Russia’s Agana, makes the largest contribution to this growth, but there are also new funds popping up in Brazil, Poland, Switzerland and Luxembourg, to name a few.

While we expect more art funds to arrive on the art market later this year (albeit none coming close to the size of Agana’s Fotoeffect), Skate’s believes that investors will become increasingly concerned about the new collective art investment vehicles’ ability to deliver satisfactory returns. The actual performance of art funds, liquidity of their ownership units (ease of redemption) and reliability of art funds’ performance data will take center stage, and fund managers might have a hard time addressing those issues in a convincing manner.

Underwhelming performance is already appearing at the capital raising stage. Brazil’s recently launched BGA Fund (Brazil Golden Art: BGA Private Equity Investment Fund is part of the Rio de Janeiro- and Sao Paulo-based firm Plural Capital and will invest largely in local contemporary art) raised BRL 40 million Brazilian (around $24 million), falling short of the initial target size of $50 million. The Art Collection Fund launched in Luxembourg this month by the duo of Stanislas Gokelaere, financier and collector, and the former head of Christie’s Europe, Bernard Steyaert, had given itself ample time until the year end to raise a mere EUR 20 million. Their fund also focuses on contemporary art as well as more exotic tribal art.

The first performance data that trickle in from the recently launched funds will not be helpful in the capital raising process either. The NAV (net asset value) of Agana’s FotoEffect shrank by RUB 33.5 million ($1.2 million or roughly 1% on an annualized basis) in 1Q 2011, which was largely due to partial management fee charges but also to the absence of reporting on notable sales that would allow marking up the fund’s NAV from what Skate’s saw as an already fully-priced valuation at launch. Russia’s other art fund, Atlanta, also reported an NAV decline of 2.11% in RUB terms for the first quarter, which translates into a 2.4% negative performance for the quarter in USD terms due to ruble appreciation for the same period.

While Russia’s regulated funds are listed on the local stock exchange and are naturally transparent with their performance data, the other global art funds are neither listed nor have any consistently transparent way of publishing performance data. The only exceptions are the Austrian and Swiss funds (for coverage of their ongoing performance, please visit the Art Stocks & Funds section). Complicating the interpretation of performance data even more is the fact that the art funds industry does not have a set of agreed-upon rules for data calculation and reporting. A few art industry trade bodies are only now beginning to develop international conventions for how art funds’ performance data should be calculated and published. As the number of art funds grows, their existing and potential investors struggle to obtain consistent and reliable performance data on those funds. The performance records that are available present a picture that is not altogether appealing.

We expect the inflow into art funds to slow and the industry to stagnate at around $1 billion in funds under management until it achieves a breakthrough with increasing credibility and consistency of performance data. Skate’s remains committed to the cause and continues to publish art fund profiles along with their performance data for all management companies that are willing to report their NAV and share their investment prospectuses with Skate’s.

Christie’s to go public barring sale to new owners, at least one new art industry IPO to take place

Our prediction of one new IPO came true; on May 5 we profiled the debut of Abbey House on the Warsaw Stock Exchange. Today Abbey is the smallest of the 12 constituent companies that make up Skate’s Art Stocks Index. Abbey House made its IPO just as Skate’s Art Stock Index peaked at 227 points at the end of April; since then, the index has retreated by more than 10%, closing below 200 points on June 1.

As of yet there is no credible news from Christie’s on a potential liquidity event for its existing owner, Francois Pinot’s Artemis group. If Christie’s really is considering an IPO, then it has clearly missed out on an extraordinary favorable spring window, which luxury goods peers like Prada went after and Sotheby’s insiders used extensively to sell down their stock.

Should Christie’s decide to go public, it will likely have a strong market ready for it this fall. A partial exit through an IPO might actually be a far better strategy for Artemis than selling to cash-rich owners whose art market agendas are unclear or questionable and who could make Christie’s business model vulnerable following an ownership change. In such a situation, Artemis could face claims under Representations & Warranties that Monsieur Pinot would be forced to provide as the seller in such a major transaction.

At this point Christie’s sale or IPO remains purely theoretical, as the firm itself has provided no credible signal that it is indeed working on exit options for its current owners.

Artnet as top performing stock in 2011

At the end of last year we banked on Artnet and suggested that it would be the best performing art stock for 2011. Accordingly, we raised our target price to $12 per share. With Skate’s Art Stocks Index at its peak in late April, we were almost there – the stock hovered around $11 per share and was among the best performers for the index at that time. When the art stocks market went down in May, Artnet was by far the worst performer of the month, losing a third of its market value. Unfortunately for Artnet’s management, the reasons are very straightforward. Following the release of very encouraging 2010 financial results and contrary to the firm’s guidance and to Skate’s expectations, Artnet’s disappointing 1Q 2011 financials show losses with online auctions and a failure to grow the business as quickly as the firm had anticipated. This is a very real concern given that Artnet no longer has the pioneer advantage in the field of online art dealing. VIP Art Fair is working on its second online edition for January 2012 and is expected to resolve its technical glitches from last January’s launch. The deep-pocketed Art.sy will unveil its pilot product at Art Basel next week. Finally, there are at least five online trading initiatives from less well-known players in the making.

Artnet’s ability to produce strong growth in the online auction market for the first six months of 2011, which can only be achieved through 2Q performance, will be decisive for the company’s outlook going forward. We have decided to put our $12 target price for Artnet under review for the time being, and we will publish a revised outlook for the firm once it releases its 1H results later this summer.

In all fairness, while we are disappointed with Artnet this year so far, we are truly bedeviled by Artprice. The Lyon-based art market data provider’s shares are up 245% (sic!) on a year-to-date basis. We see no rational reason behind this increase, especially since Artprice itself has not shared any news to warrant it. This marginally profitable company makes less than $10 million in annual sales, but today its valuation is virtually on par with Switzerland’s MCH Group, the Art Basel and Hong Kong International Art Fair owner that made a CHF 37 million (approximately $40 million) net profit in 2010. Our word of wisdom to all art stocks investors is to take current Artprice’s valuation with a massive grain of salt and prepare for a likely crashing nosedive of Artprice shares that would be triggered should anyone attempt to sell the stock in this illiquid and clearly inflated market environment.

MCH Group to be pressed to launch online strategy

At the end of last year we correctly sensed that MCH Group would need a new acquisition in the art industry to make a good use of the cash generated by its very successful Art Basel franchise. We were wrong on the company’s choice of priorities, however. The firm purchased the Hong Kong International Art Fair in May, yet its online strategy remains a mystery to this day.

We applaud to Hong Kong acquisition. Given the rise of China it was perfectly timed and focuses on a clear regional market leader. Skate’s is convinced that the deal will create significant value for MCH shareholders. While we look forward to MCH Group’s six months financials to ascertain the impact of the Chinese acquisition, we are already comfortable increasing our target price for MCH Group to $65 per share, which would imply a market capitalization of $300 million. Such a valuation would position MCH second behind Sotheby’s within Skate’s Art Stocks Index in terms of enterprise value.

That said, the time has come for MCH Group to think online. As the firm begins its incredibly successful offline Art Basel later this month, it will see the ambitious Art.sy start-up launch its beta online art-dealing product on MCH Group’s own territory. In parallel, VIP Art Fair will soon be closing acceptance to galleries for its second edition online fair this coming January with over 50 galleries now participating. We believe that MCH Group has another 12 months to decide its online strategy, which would involve either the development of an in-house product or an acquisition. The Chinese deal will definitely help to grow shareholder value between now and Art Basel 2012, but if MCH still has no credible online strategy at that point, the situation will start to look reminiscent of Borders doing battle with the Amazons of the world.

We know for a fact that there are more than a few stellar minds among MCH Group’s management who have always been able to get it right when it comes to art-related decisions. Skate’s looks forward to hearing more on MCH’s online move within the next nine months or so.

Value of Skate’s Top 5000 to exceed $30 billion, threshold price to reach $2 million

The June auctions have yet to take place, and the apparently strong fall 2011 auction season is still ahead, but we are already close to achieving these predictions. The combined market value of Skate’s Top 5000 stands at $28.9 billion as of May 31, 2011; the ranking’s threshold price (the auction price for the 5000th most valuable artwork) stands at $1.98 million. Both of our targets stand a very good chance of being reached already in June.

Warhol to overtake Monet

Andy Warhol is already there in terms of the number of works within Skate’s Top 5000 (213), but he has $360 million to go to catch up in market value and replace Claude Monet as Skate’s second most valuable artist after Pablo Picasso (Monet’s current market capitalization in Skate’s Top 5000 stands at $1.75 billion, Warhol’s is $1.39 billion). This value gap might take a bit more time to bridge than we originally anticipated, as Monet’s market is exceptionally strong. Art investors have realized that Monet’s premium market liquidity is second only to Picasso. The steady inflow of new funds into Monet’s high value art over the last six months has lifted the average ERR (effective rate of return) on repeat sales from practically negative values to a solid 9-10% (see page 3 of Skate’s Art Investment Report for June 2011).

More attention paid to photography

This prediction was largely based on Skate’s awareness of several new art funds scheduled to enter the art photography market in 2011, including Agana’s FotoEffect, which is dedicated entirely to photographic assets and is now the global art market leader in terms of NAV. Austria’s Photography Fund also reported fairly strong performance in 2011 and gained credibility as a clear benchmark for the art fund market segment.

Going forward, Skate’s does not expect any further allocation of investors’ funds to photography. We are revising our forecast and predicting that photography will remain at current levels as a visible but still fairly marginal area for art investment funds.

On May 5, Abbey House, a Polish firm that combines all known art business models, including a local arts & crafts auction, a local art magazine, a Polish market price database and a quasi-dealer business that promotes contemporary local artists, became the 12^th company to join Skate’s Art Stocks Index after its successful share flotation on the Warsaw Stock Exchange.

Abbey House (WSE:DAH) shares were trading at $1.37 as of publication on May 16, 2011.

On May 9, Sotheby’s also announced their quarterly results, reporting a 17% increase in revenues to $119.6 million and, perhaps most notably, an unusual first quarter profit of $2.4 million. Due to low auction-related revenues, the first quarter is traditionally a loss-making period for the firm.

Auction and related revenues, as well as dealer revenues, were the biggest winners, growing by 15.4% and 83.1% over the first quarter of 2010, respectively. Yet, increasing dealer revenues has come at a cost for Sotheby’s; dealer cost of sales skyrocketed from $1.8 million in the first quarter of 2010 to $5.9 million for 1Q 2011, or, as Sotheby’s calculates, an unfavorable change of -232%. Excluding the large increase in dealer cost of sales expenses, total operating expenses were up 11% over the same period of 2010, which is mainly due to significant increases in direct costs of services, marketing expenses and salaries and related costs.

Sotheby (NYSE:BID) shares are down -6.89% YTD as of May 16, 2011.

On May 9, Collectors Universe, a provider of authentication and grading services to dealers and collectors of high-value collectibles, released its third quarter results ending March 31, 2011. Among the highlights of the release were record revenues of nearly $12.82 million, up from $10.79 million for the same period last year. Likewise, the firm’s operating income increased to a record $3.31 million from $2.57 million in the third quarter of last year.

In his commentary and outlook, Collectors Universe CEO Michael McConnell expressed great satisfaction with the company’s results, stating, “Both industry fundamentals and internal efficiencies contributed to the strong performance.”

Judging by Collectors Universe quarterly release, the company’s efficiencies are indeed strong with selling and marketing expenses, as well as general and administrative expenses, under tight control at $1.58 million and $3.01 million, respectively. This is in stark contrast to many of the other firms in Skate’s Art Stocks Index where high operating expenses have served to hold down profitability or, in some cases, have resulted in losses.

Collectors Universe (NASDAQ:CLCT) shares are up 8.13% YTD as of May 16, 2011.

Sticking to its traditional reporting schedule, Artnet released its 1Q 2011 management report on April 29. While the company’s total revenue increased by 10% in euro terms (up to EUR 3,491,591 from EUR 3,178,513 in the first quarter of 2010), this increase was not enough to offset increasing costs, which meant that Artnet realized a EUR 70,733 net loss against a EUR 77,318 net profit for the same period last year.

Artnet’s loss for the quarter comes following the company’s report of a net profit of EUR 153,000 for all of 2010 (see Skate’s Market Notes #36, April 6, 2011). In its opening analysis to the 1Q 2011 report, the company states that its increased revenue in the first quarter was “offset by additional costs incurred by the Group for product development, consulting and payroll increases.” Furthermore, Artnet notes, “The Group continues to work with Simon-Kuchner & Partners to review pricing of its products and services.”

Looking at Artnet’s segment reporting, revenue from artnet Galleries was essentially flat at EUR 1,242,866 for 1Q 2011 vs. EUR 1,242,890 for the same period of 2010, although increased costs brought profit for this segment down significantly from EUR 73,103 to EUR 50,230. The artnet Price Database performed similarly with a slight growth in revenue hit by increased costs, thus resulting in a segment profit of EUR 194,350 that was down substantially from the EUR 360,581 profit for 1Q 2010. Such was also the case with the artnet Advertising segment, which saw profits shrink to just EUR 12,036 from EUR 69,741 in the same period last year, despite the hefty increase in revenue from EUR 315,955 to EUR 398,200.

artnet Auctions posted a modest EUR 85,602 loss for the first quarter, although revenue was up significantly from EUR 413,293 in 1Q 2010 to EUR 614,663 for the first quarter of this year, which indicates that the company is well on its way to making Auctions a profitable segment. artnet Magazine was listed as a new segment for the first quarter after previously being “considered primarily a marketing tool supporting the Group’s business activities”; it posted a EUR 224,925 loss on revenue of EUR 18,273, although Artnet states that artnet Magazine “will be developed into a full-fledged business.”

As the overall economy and the art market both continue their recovery, Artnet will need to be vigilant about redefining its business model and dealing with stagnant or loss-making segments. While we repeat our belief from last month that the artnet Auctions segment will begin to make money in the next couple of years, we remain concerned that artnet Galleries and to a lesser extent Advertising could pose challenges to the company’s finances. Though the economy has made a considerable recovery, the effects of the financial crisis and recession have made business owners much more conscious of costs, which will increasingly put the Galleries segment at risk given other platforms through which galleries can communicate with each other and their customers.

To their credit, Artnet does recognize the need to bring fresh life to the Galleries segment, stating, “The Group projects to offer a new plan to the gallery members in 2011, which is anticipated to increase revenue for this product in the coming year.” On May 16, Artnet also announced a new lower-priced subscription plan for its Database products, which it claims was made possible by reduced production costs associated with the segment. As the Price Database is traditionally a high-revenue segment for Artnet, more attractive pricing could bring additional subscribers and revive the company’s profitability in this segment.

Artnet (FRA:AYD) shares are up 0.94% YTD as of May 16, 2011.

On May 5, 2011, the Warsaw-based art auction Abbey House will float its shares on the Warsaw Stock Exchange.

With the firm’s pre-IPO pricing range suggesting a pre-money valuation of PLN 36 million (approximately $13 million) and a tiny capital increase of just 153,697 Series B shares at PLN 3.6 or USD 1.3 per share, the deal is small. Abbey House is a start up, having commenced operations in October 2010 and grossed only USD 0.5 million in sales for 2010. Its business model combines all known art business models, including a local arts & crafts auction, a local art magazine, a Polish market price database and a quasi-dealer business that promotes contemporary local artists. In a nutshell, Abbey House is telling potential investors that it will be a proxy for the Polish art market and thus be able to capture any growth experienced by this market in the foreseeable future.

Jakub Kokoszka, Vice President of Abbey House, estimates that the current size of the Polish art market is USD 100 million and could potentially increase 20-fold to USD 2 billion by 2021. This projection is based on a report by KPMG – The Luxury Goods Market in Poland – that places the overall value of the luxury goods market in Poland at approximately PLN 27 billion in 2009. Furthermore, Abbey House bases its estimates on a combined 100,000 high net worth individuals (HNWI – more than EUR 1 million in liquid assets), premium affluent citizens (EUR 500,000 or more in liquid assets) and core affluent citizens (EUR 2,000 or more in gross income per month). Based on the assumption that 20% of these 100,000 individuals can afford and will choose to purchase at least one work of art per year, Abbey House estimates that the total annual turnover in the Polish market will grow by a factor of more than 6.5 – from the current level of 3,000 artworks sold at auction to 20,000 works sold per year.

While Skate’s takes those projections with a large grain of salt and notes that Abbey’s business model thus far lacks focus and maturity, we are very happy to report on the upcoming IPO and will be delighted to follow Abbey House once it is successfully listed (i.e., once the IPO is underwritten). This is the first art industry IPO since Skate’s began publishing Skate’s Art Stock Index on September 1, 2005. Since then, most of the changes to the index have involved delisting firms as they went private or defunct (e.g., Italy’s Finarte Casa d’Aste or the Toronto-based Art-in-Motion Income Fund).

Developing the local auction business is perhaps the best thing that Abbey House can do in the next few years. The company’s listed peers in South Korea and Japan (Seoul Auctions, Shinwa Art Auctions and Art Vivant) have all managed to grow solid and profitable businesses locally (see Skate’s Art Stocks & Funds section). In addition, there are also excellent privately owned firms that have become notable operators (e.g., Polly in China, Safron in India and Russian-art focused MacDougall’s in London).

We have scheduled our due diligence visit to Abbey House on May 6 in Warsaw, and if all goes well, we will include the Polish firm in Skate’s Art Stocks Index as of May 10, 2011. This will expand the number of constituent stocks to 12 in the index. Abbey House will likely be the smallest firm in the index in terms of market capitalization and the only one to represent eastern Europe.

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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