Marcato Capital Places a Sotheby's Bid

 | Aug 02, 2013 | 2:00 PM EDT  | Comments
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Marcato Capital Management has reported owning a combination of shares and call options, giving it control of 6.6% of Sotheby's (BID), the $3.1 billion market cap auctioneer.

Marcato is a hedge fund founded by activist investor Richard McGuire in 2010. McGuire had previously worked at billionaire Bill Ackman's Pershing Square.

Marcato tends to manage a concentrated portfolio, with positions in only eight stocks in its most recent 13F filing (check out stocks that the fund owned). At the time, it did not own any shares of Sotheby's.

The firm has not indicated any particular activist plans related to the Sotheby's, saying only that it considers the stock undervalued. After having been about flat year-to-date going into May, Sotheby's has rallied about 25% since that time. BID closed Thursday at $44.63.

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Revenues decreased slightly in Sotheby's most recent quarterly report, compared with the first quarter of 2012. With many costs actually rising, including salaries and administrative costs, the company's operating losses more than doubled compared with the prior year period. While quarterly earnings numbers do tend to be highly volatile, adjusted losses per share of 33 cents were considerably worse than Wall Street analysts were expecting. In addition, cash flow from operations was negative for the quarter.

Combined with what have been low earnings on average over the past few quarters, the trailing price-to-earnings ratio is 32. The sell side is optimistic on earnings per share for Sotheby's for this year and for next year, placing the current price at 20x forward earnings estimates.

In order for the stock to be undervalued, either the business would have to outperform expectations, or Marcato would have to have a successful plan for increasing shareholder value. So far, Marcato has not shared any such plan publicly. Demand for the company's services is tied to the overall economy, as shown by the beta of 2.8.

Auction houses tend to not be publicly traded, but because Sotheby's is dependent on increasing global wealth and on the fortunes of the upper class in particular, it can be compared to Tiffany (TIF). The $10-billion market cap jewelry store carries trailing and forward price-to-earnings ratios of 24 and 20, respectively. It is priced about even with the auctioneer in terms of expected earnings for the next fiscal year.

In the first quarter of Tiffany's fiscal year, which ended in April, revenue rose by 9%, compared with the same period in the previous fiscal year. But with margins contracting a bit, earnings grew at a more modest rate.

As Sotheby's is currently operating, the stock has already priced in expectations from the financial community that earnings per share will significantly increase this year and next year. The moderately high forward P/E signifies that the company would have to continue to grow profits beyond that point.

It is difficult to call the stock undervalued, given current conditions. We would suspect that McGuire and his team are trying to get management to change their strategy.

Investors should also note that the fund has actually put little capital at risk so far by purchasing a large number of call options, rather than a full long position in the stock.

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