It’s no secret that one of the activists involved in Sotheby’s, Marcato Capital, specializes in real estate investments. That firm may be looking to get its hands on any profits from Sotheby’s real estate and return them to shareholders.
Margin Expansion
Loeb and his activist buddies may believe Sotheby’s can expand its margins to historic levels. The company’s trailing 12-month margin on earnings before taxes (EBT) is 18.4%, while in previous years it has had margins between 27% and 30%. If we think about where earnings would be if the EBT margin were 27%, there is definitely upside here. With a 27% EBT margin, earnings could easily be nearly 50% higher than current levels; assuming Sotheby’s keeps its premium 31 P/E multiple, the price target would be $68.
Boosting Shareholder Value
The activists could also be looking at Sotheby’s cash on hand. The company has more than $10 in cash per share and could increase its modest 0.8% dividend yield or boost share repurchases. Its debt-to-equity ratio is down to 0.5 as of last quarter, compared with 0.9 in 2009. Sotheby’s recently said it was exploring new ways to boost shareholder value, which could include a higher dividend or share buybacks.
Whatever the reasoning behind Loeb’s investment, you’d better believe the upside will be realized in a short period. Loeb isn’t necessary a long-term investor, rather an opportunist. So the question remains whether he’ll treat this like a short-term investment, as was the case with Yahoo! Inc. (NASDAQ:YHOO), or an ultra-short-term investment, like his stake in Herbalife Ltd. (NYSE:HLF).
Sotheby’s has only five analysts following it — compared with the 48 following Apple Inc. (NASDAQ:AAPL) — so it can be tough to get information on the company. But investors can use this to their advantage: Despite the fact that Sotheby’s has three activist investors collectively owning 15% of the company, the stock is flat since Loeb’s involvement.
Sotheby’s also offers investors downside protection given its inherent moat as the only major publicly traded auction house. The other major player in the $8 billion art dealership industry, Christie’s International, is private. Sotheby’s other moatlike characteristics include its cash-generating capabilities and strong liquidity. Over the trailing 12 months, Sotheby’s managed to generate $237 million in free cash flow. That’s $6.50 a share, or an 8.7% free cash flow yield.
Risks to consider: The biggest risk is another pullback in the economy. Investors should also consider the risk that the activist investors announce a sound strategy for unlocking value, sending the stock surging, but ultimately their plans fail, sending the stock plunging.
Action to take –> Get into Sotheby’s before the real bidding process begins. If the activists get their way, there could easily be more than 50% upside to the stock over the next couple of years. The stock has a solid moat and business model that makes the downside limited. The company’s balance sheet and free cash flow are both relatively solid.
P.S. — Activist investing is a bit different from buy and hold, and isn’t suitable for every investor. Owning “Forever” stocks is, however, for everyone. These companies have large moats that allow them to dominate their industries and as a result, you can add them to your portfolio and simply forget about them. To learn the names and ticker symbols of these stocks — click here.
– Marshall Hargrave
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