Why Dan Loeb is targeting Sotheby'sOctober 7, 2013: 1:49 PM ET
The activist investor wants auction house Sotheby's to change its CEO and its strategy. He may have a point.
By Jeroen Ansink
FORTUNE -- How does a company that outperforms the S&P index by a factor of three become a target for an activist shareholder?
At first sight, the battle between auction house Sotheby's and Third Point, the hedge fund of financier Daniel Loeb, which has a 9.3% stake in Sotheby's (BID), seems puzzling. In a recent letter, Loeb demanded the immediate ouster of CEO and Chairman William Ruprecht, who in his 13-year reign has grown revenues at Sotheby's by almost 75%. Sotheby's shares are up more than 50% for the year.
Despite these successes, results could even have been better, says Oliver Chen, luxury analyst at Citigroup. Compared to its privately held competitor Christie's, Sotheby's is lagging behind in Asia and in the contemporary art market. "Those are the places where buyers from emerging markets are gravitating towards, and where the biggest opportunities are."
Sotheby's recent five-day, 3,571-lot auction in Hong Kong, which scored $23.3 million for an oil painting by Chinese artist Zeng Fanzhi on Saturday night, a record for Asian contemporary art, has done little to strengthen its market position, says Jeff Rabin of Artvest, a New York-based advisory firm. "Christie's is still absolutely dominant in Asia, both in the high end and the midlevel of the Chinese sector."
On top of that, Sotheby's made a "critical error" by not focusing on lower end art sales, says Rabin. While the 269-year old auctioneer has achieved some spectacular results in high-end art, including fetching $120 million for Edvard Munch's "The Scream" last year, margins in this market are under pressure. "A buyer's premium starts at 25% for sales up to $100,000, but drop to 20% for lots between $100,000 and $2 million, to 12% for anything above that," says Rabin.
To get prestigious works under the auction hammer, houses will often rebate a portion of the buyer's premium back to the seller, a practice known as an "enhanced hammer." Since Sotheby's and Christie's compete so aggressively at the high end of the market, margins are squeezed, says Rabin. "Whereas on the low end, there is no rebating, and auction houses are earning a full commission. That is the kind of business that keeps the lights on in difficult times. It is also a part of market that Sotheby's has virtually abandoned."
According to Rabin, Sotheby's has focused mainly on high-end properties. "It is a strategy that doesn't work."
A focus on lower end auctions will not cheapen Sotheby's brand, which is one of the oldest and most respected in the art world, says Rabin. "It didn't for Christie's, which has a sterling name as well. Focusing on cheaper lots is a good way of attracting new customers. Wealthy people don't start buying at the highest end, no matter how much money they have. They will have to develop a taste for collecting art first, for instance by starting at the $150,000 level and moving up from there. That's what makes Christie's so strong: It caters to every segment of the market place."
With the recent adoption of a poison pill that prevents an investor from acquiring more than 10% of its shares, the battle lines between Sotheby's and Third Point seem to have been drawn. "Ruprecht and his board of directors have bought themselves some time to align themselves with the other shareholders," says Citigroup's Oliver Chen. "The problem is that there is a variety of interests, both long-term and short-term, as well as starkly different views of the intrinsic value of the company. I don't know who is right, but Sotheby's should have probably been thinking about these challenges even without getting forced." Sotheby's declined to offer comment.
The poison pill has not deterred Third Point, which, in an official statement, called the move "a relic from the 1980s."
"Loeb is not the kind of guy who would pick a fight unless he is confident he can win," says Josh Black, an analyst at Activist Insight, a London-based research firm that tracks the performance and campaigns of nearly 200 activist shareholders. Black describes Loeb, who was instrumental in replacing former Yahoo (YHOO) CEO Scott Thompson with Marissa Mayer last year, as "a fine tuner."
"He intends to get on Sotheby's board with the intention of staying there for a significant period of time," Black says. "There is a distinct possibility he will look within Sotheby's and find an insider to take Ruprecht's place." Third Point declined to comment for this article.
By bringing Sotheby's challenges into the open, Loeb has already forced the auction house into the defensive position, says Rabin. "Collectors with a property for sale will still call Sotheby's and try to negotiate a deal, but they probably will feel not as confident about it as they used to be. The question of what is going on at Sotheby's, and what its future will be, will definitely linger in the back of their heads."
In the battle for control between Sotheby's and Third Point there is probably one sure winner though: the shareholder. "On the whole, the involvement of a shareholder activist does very well for the company's stock," says Josh Black from Activist Insight. "In these kinds of battles, the removal of a CEO leads to an average annualized share price increase of about 7%."
Citigroup's Chen has given the stock, which is at $50 as of Monday, a target of $55. "Regardless of the outcome, Loeb has brought up some valid things that need to be addressed. Now it's up to Sotheby's to make its case."