Takung Art Co — A piece of the art action

Takung’s mission statement states: “We aim to become the premier shared ownership brand for art and culture investment in the world”. This is obviously ambitious, but should inform the trajectory of the group’s development.

Based in Hong Kong, the business is effectively transacted in mainland China. The NYSE American listing adds credibility and reflects the broader global ambitions. Meanwhile, there is a very large market to address within the existing remit, with a proven and growing appetite for:

Takung has put together an IT platform for trading fractionalised ownerships (comparable to units in a mutual fund), which enables investors to buy and sell units on a matched-bargain basis.

The group has invested to build a robust and scalable platform. It has also moved onto a second iteration of its business model emphasising higher quality portfolios that should give it greater scope to scale up the number of retail investors and increase liquidity on the platform – which in turn should attract more (and more valuable) business. It also has put in place strategic partnerships with trade bodies and associations that give an important credibility endorsement.

The changes to the business model invoked to build a more sustainable business with greater growth potential caused inevitable upheaval but also had secondary impacts. There was churn in the authorised agent base, as they were encouraged to shift the type of portfolio being offered up-market and become more commercial, and some were unable to comply with the new requirements. Many clients of those agents paid monthly fees that covered all commission from trades and once the related agents no longer dealt with Takung, these clients no longer paid their dues, leading to a $1.8m bad debt provision. The upheaval pushed the group into loss for FY17.

Takung has net cash on the balance sheet, albeit reduced by the changes described above. Our modelling shows net cash at end FY18 of US$11.7m (from $12.5m at end FY17), building in FY19 to $12.9m based on the existing business model. This is, however, a young company, with ambition and determination and may make further changes along the way.

Applying traditional metrics to a business still at an early stage of development can be distortive, but it is clear that other businesses with some overlapping characteristics trade at more than double Takung’s current valuation. Our DCF modelling (details below) suggests a less ambitious valuation. An average of peer-based valuation (year one and year two EV/EBITDA estimates) and DCF suggests a level of around $3.63. The group will need to demonstrate that its reconfigured business model can deliver the promised growth and margin improvements to justify a rating at these levels.

Takung Art has three elements to its business; Takung Unit, which is an online trading and shared ownership platform for units in Asian and international fine artworks; Collectibles (Unit+), which is a trading platform featuring portfolios comprising multiple copies of sports memorabilia and other collectibles, both Asian and international; and Takung Online, which is a more ‘traditional’ eCommerce platform for artists to sell directly to the buying market. Takung Unit is the original business and contributed 98% of FY17 revenues.

Takung is based in Hong Kong, with wholly owned subsidiaries in Shanghai and Tianjin and was founded in 2012. A further office was opened in Hangzhou in FY17 and technology development is based there. The group listed on the NYSE American in March 2017, having reversed into a public shell in October 2014.

Takung Unit is the core of the business and is an online platform that allows items or portfolios of fine art to be listed and shares in their ownership to be traded. This allows the original owners the opportunity to share in the future increase in value of their portfolio.

The group appointed a number of authorised agents whose role was (and is) to identify artworks and art portfolios, to get them professionally appraised and then bring them to Takung with a view to listing them on the platform. Takung’s own staff then carry out a further appraisal to determine of the work or works are suitable for marketing and are likely to appreciate in value. If these conditions are met, then, subject to all the necessary paperwork being in order, Takung will list the artwork on its website and divide the ownership into shares of equal value, based on its view of the underlying value. These are valued at HK$1, so a work valued at HK$1m would have one million HK$1 shares. Their subsequent value is determined by the supply and demand for those shares when listed on the platform.

Takung has three sources of revenue:

The artworks that are listed remain in secure storage for 10 years, after which they are sold and the proceeds paid to the unit holders in proportion to the number of units held. The first such realisation will be in FY23, 10 years after the first artwork was listed. The value of the units in trading should give strong guidance to the level of demand which will in turn determine the realisation price. One of the key attractions for the owner of an artwork is that they can opt to retain a proportion of the ownership, up to 20%. Other routes, such as private sale or sale by auction, inevitably involve a complete disposal, which may be a less attractive proposition to an owner who anticipates that a work will increase in value.

Fractional ownership and trading is a new concept in this context, although obviously very well established in financial markets. There have been some recent moves to trade fractional ownerships in real estate, but we are not aware of any existing or planned other operators in the art and collectibles markets. We would conclude that the IT platform is replicable. Establishing the necessary relationships with the relevant stakeholders (artists, agents and traders) would be more of an issue.

Client access to the platform is via an app that is available for download from the company's commercial website.

Takung has negotiated a number of important partnerships that function both as introducers of business and as external validation for the credibility of the offering. These include; China National Arts and Crafts Society/Huangshan Arts Association; Russian Artists’ Society; Union of Mongolian Artists; China Cultural Heritage Foundation on the art side. In sports memorabilia, it has partnerships with PNH Group, a manufacturer and distributor of sportswear (football in particular) that in turn has partnerships with major clubs such as Juventus, Manchester City and Paris St. Germain and organisations such as the FA and FIFA. It also partners with 5USports, the exclusive partner of Icons.com in Asia and an online sports portal and sports marketing organisation that took a 60% stake in Northampton Town FC during 2017.

Access to the platform was extended to residents of Russia, Mongolia, Australia and New Zealand in 2016 and three Russian portfolios of paintings and 15 Mongolian paintings are now listed on the platform.

As of December 31, 2017, Takung had 241 art listings trading on its platform, with an aggregate initial listing value of US$58.0m. Management attests that most of the listed pieces and portfolios have traded actively and shown significant appreciation since their introduction on the site. The purchase and sale of ownership units of Takung's listed artwork generated a total transaction value of US$17.3bn in FY17 versus US$9.4bn transacted in the prior year, with over 2bn units traded per month in 2017. The trader population registered with site exceeds 170k.

During FY17, Takung carried out an appraisal of the business as it had developed to identify the drivers of profitable growth. The group had grown its revenue base fast over the years since inception but the income was not necessarily of particularly high quality, with the average value/listing having been in decline. Liquidity of certain portfolios on the platform was a particular issue. To address this, management has put into place a strategy to attract a larger and more diverse user base to the platform. This has involved a degree of churn in the user base as it has adjusted to the new priorities.

These two elements (Unit/‘A’ Tier and Unit+) give Takung a strong proposition to cater for investors and traders in high value items.

Having offers at different price points should allow Takung to appeal to a wider range of people of different demographics and build out its user base, which will enable it to scale and increase its market visibility.

Takung’s long-term aspiration is to become the ‘go to’ web site for art and collectibles.

The management team is headed up Di Xiao, who has been in the art investment and consulting industry since 2008 and has considerable experience across different trading models and potential pitfalls in the industry. He joined Takung Art Company as CEO in January 2013. Previously he had been general manager at Hangzhou LuxTimes Culture and Art Company, for four years, again in China. Before that he had worked as a director of an electronics company, specialising in marketing development.

The CFO is Leslie Chow, who is a qualified certified public accountant in the US, having trained at Deloitte & Touche LLP in the US. He joined Albeck Financial Services in 2009, becoming an MD in 2011 and a partner in 2014. Since 2015, Leslie Chow has been an NED for two Hong Kong-listed companies, PPS International and Golden Power Group. He acted as a consultant to Takung Art from 2015 before being appointed CFO in February 2016.

Management holds 1.9% of the equity. The largest (and only substantial) shareholder is listed as Sun Yan, who holds 33.4%.

There are four key drivers of consumption in China: economic growth; demographic changes; technology; and consumer attitudes. All these factors are very pertinent to the backdrop for Takung Art to build a significant business.

The key constituency for Takung’s offering as it now stands is the growing Chinese middle classes. As the Chinese economy has developed, the growth in per capita GDP has grown at a faster pace than the population, as shown in the exhibit above. This accompanies a growing urbanisation of the population and a different set of spending priorities. World Economic Forum figures suggest that over the next decade, consumption will grow at a CAGR of 6% and that the middle class will consist of 65% of all households.

The process of urbanisation in the population has led to a squeeze on the availability of some resources and a consequent growth in sharing applications, boosted by advances in accessible technology. This is already well established in terms of transport, but has been spreading across to other areas of the economy. Extending the concept to art looks logical in a context where full ownership of assets is less of a cultural objective.

Chinese investors have long been a major influence on the art market, with their presence or absence driving valuations across Europe and North America in particular. The regular Art Basel/UBS/Arts Economics review of the Art Market shows that Chinese investors participating in art auctions globally vacillate, coming second or third by value behind the US and the UK. In 2017, China accounted for 21% by value of the documented art market, behind the US at 42%, but ahead of the UK at 20%. Transactions amounted to $13.2bn, boosted by the performance at auctions, with Poly Auctions and China Guardian the third and fourth largest global players after Sotheby’s and Christies.

Gambling is illegal in mainland China and in Hong Kong, barring state-run lotteries, but permitted in Macau and with current proposals being put together for Hainan Island. Trading, on the other hand, is enthusiastic. Futures trading in the commodities markets was heavy, with record volumes, but volatile in 2016. In December 2016, regulators approved the first commodities options. Regulators have been compelled to raise exchange fees in order to clamp down on speculators.

Chinese President Xi Jingping has a well-attested enthusiasm for football and the government has set goals for the country to become a major force in the global game by 2050, starting at grass roots level. Basketball is long-established and also very popular in China. In 2015, the NBA signed a c $700m, five-year deal worth with Tencent for the Chinese digital streaming rights to its games. This compares with a three-year deal for the Chinese television rights to the English Premier League in 2016, which cost $650m.

There are a number of sensitivities to the financial performance, both external and company-specific. We particularly identify:

Population. Takung is providing a service that caters to a particular segment of the population, currently in Hong Kong and mainland China. The dynamics of this audience are described above. Their discretionary income will be dependent on economic and political factors, which may influence their willingness to participate in the ownership of art.

Currency. Takung Art is based in Hong Kong and its core customer base is in that territory and in mainland China. The group is listed in New York, US, and the financial results are reported in US dollars. There are both transactional and translational impacts on the reported numbers, which may be significant.

Market issues: for many years the international art market (and those for other tradable collectibles, such as fine wine) has suffered from the presence of a large number of fakes, with fraud regularly uncovered. China has been particularly highlighted in this respect, alongside prevalent issues such as last payment and non-payment to auction houses. Takung Art seeks to avoid issues of doubtful authenticity through using its authorised agents with their market experience and expertise, with the additional scrutiny of works in-house before they are listed on the platform, with provenance and accompanying paperwork thoroughly checked prior to acceptance.

Art as an asset class: Takung Art’s ambition is for art to build as an alternative investment asset class. To some extent this has been established already, but the limited liquidity in the market has been a significant handicap to its gaining traction. Takung’s approach of fractionalised ownership may prove to be the solution to the liquidity hurdle.

Platform risk: the platform has been built out and has proved that it is fit for purpose. Maintaining a fully functional platform with negligible downtime is crucial to Takung’s business proposition.

Data security: all web-based businesses accumulate large quantities of data, but there are added risks when a platform is using individual clients’ financial details for them to trade. Exemplary data handling practices will be essential to maintain the necessary trust between Takung and its clients.

Managing balance between the interests of traders, agents and artists: the group has a number of stakeholders, whose interests may not necessarily align. This has been clearly shown with the move to shift agents to delivery of higher-value portfolios in the ‘A’ Tier, which disrupted both the agent and the client base.

Risk of reputational damage: high standards of protocol for assessing the authenticity of listed works and items are essential to avoid reputational damage that might undermine trust from participants.

Ensuring good flow of listings to maintain site traffic: Takung has to drive both the level of trade carried out on the platform, which it has addressed by changing the type of portfolios listed, and the number of new listings. This is essential to driving listing fee revenue, but also to keep the level of interest from the market at a high level to attract new traders.

Success of new ventures: the group has made its first moves into memorabilia with the listings of signed replica sports shirts and with facsimiles of early, important newspapers. Continued success in this Unit+ area is the main driver of revenue growth in our model.

Obtaining relevant authorisations: for Takung to succeed in other markets and to make the transition to a genuine alternative investment asset class, it will need to gain authorisation from the relevant financial market authorities. There are no guarantees that an application of this sort would be successful. If it was, however, this would be a genuinely transformative opportunity. It should be borne in mind in this context that Takung Art had to undergo certain due diligence to list on NYSE.

An externally validated valuation for Takung Art is complicated by the lack of genuine comparators quoted on the world’s stock markets. Given that the business model has changed considerably over the last year, it is effectively very early stage in its current form, with the associated risks. Its business model represents a combination of interests that are partially represented across a range of different peer groups. We have looked at the valuation in the context of three types of quoted companies: art-related stocks; online gaming; and investment/trading platform stocks.

The connection with the art stocks is self-evident, although the degree of overlap is limited. The other clear issue with valuing Takung by comparison with the quoted art-based peers is the paucity of financial information and forecasts in the sector, making the ratings unreliable. The inclusion of Etsy, which trades at a significant premium, is also a distorting factor.

We also feel it is appropriate to look at Takung in the context of online gaming and online casino. This is not because we regard trading in art as a direct alternative but rather that there are similarities in driving large numbers of retail traders (or gamers, in this context) to the platform to participate regularly. Since there are a very large number of quoted companies in this market segment, we have not listed them here but have shown the average rating on these metrics.

Takung also has aspects of its business that are far more akin to retail financial platforms. We have included Autotrader in this bracket as an information and matched bargain trading business.

We have discounted the average by 30% to reflect the comparatively short trading record and the small relative size of the group. As can be seen above, the conclusions are very different according to which metric is used, with a considerable discount opening up when looked at on a year two basis. A 10.9x Y1 EV/EBITDA multiple would indicate a share price of $2.78 while the average Y2 EV/EBITDA of 11.2x indicates an equivalent value of $5.95 (note, EV/EBITDA for the average art stocks increases in year two as Redbubble contributes to the average, to the extent that the three-sector average also rises). These two values themselves average out at $4.37. This exercise demonstrates that the current price is factoring in a high element of execution risk and relatively low earnings visibility.

We have looked at two different types of DCF; a traditional calculation and a reverse version that varies mid-term FY20-27 EBITDA margin and growth rate.

Taking a WACC of 12% and a terminal growth rate of 2% and our using our short-term forecasts prior to the mid-range assumptions, of 10% revenue growth and an EBITDA margin of 25%, the DCF model indicates a share price of $2.89, a 32% premium to the current price. We show below how this varies if different assumptions are made about mid-term revenue growth and EBITDA margin.

The mid-point between the two derived share prices of $4.37 from the peer comparison and $2.89 from the DCF is $3.63.

Takung Art reports its financial results quarterly.

Takung Art derives its revenues from three core sources:

Listing fees will typically be between 22.5% and 48.5% of the offer price and become due when the shares start trading on the platform.

In 2015, there were 43 new listings; in FY16 the number rose to 132. In FY17, however, the number was scaled back to 58 within the traditional Unit business as the focus of the business was set to higher-value portfolios that would generate greater sustainable trader interest. There were also two listings in H217 in the Unit+ collectibles category – one of football jerseys and one of vintage newspapers. The initial football jersey offering of a replica Steven Gerrard shirt gained strong market traction and by mid-January 2018 had traded over $650k by value. Subsequently, Takung has listed replica jerseys from Lionel Messi and Cristiano Ronaldo, which have also stimulated very high levels of interest.

Our model anticipates that listing fee revenue resumes its progress in FY18, with the bulk of the growth coming from further offerings of collectibles, particularly of sport-related memorabilia in Unit+, as shown by the exhibits below. Management indicates a good pipeline. The changes are already having a positive impact on the result, with listing fees in January 2018 168% higher year-on-year at $790k. This includes the Messi and Ronaldo jerseys, along with eight art portfolios with an average listing value of $220k.

Commission revenue should naturally increase if the number of portfolios listed increases, provided that traders are sufficiently interested in the works or items on offer (still to be demonstrated). This relationship should become more transparent with the shift in the user base that has been actioned over the last year. Historically the commission revenues were biased towards the VIP traders associated with the authorised agents. These individuals would pay a monthly subscription that allowed them to trade as frequently as they liked. The revised emphasis on portfolios of greater importance and financial worth was put in place to build the retail trade. This underlies the forecast growth in commissions over the remainder of FY18 and FY19. The trader population registered with the platform is now more than 180k.

The changes to the remit of the authorised agents over H217 resulted in some not continuing their relationships with Takung Art, either from choice or from not being in a position to offer the type of portfolio that is now being accepted for listing. A minority of the VIP traders who were associated with these agents then stopped paying their monthly subscriptions and at the year-end the outstanding balance had reached c $1.8m, which had previously been recognised on billing and included in total revenue figures reported for earlier quarters. This sum has now been written off the uncollected receivables and the revenue recognition policy has been changed to avoid any repetition. Revenue from retail traders continues to be recognised on its collection.

Management fees simply reflect the number of total listings on the platform, with some slight variations in the charges depending on the nature of those works or items.

Two further initiatives may stimulate revenues for FY18 but are not sufficiently certain to yet be built into our forecasts. These are:

The cost of sales line includes the internet service fee, but also the depreciation and amortisation of the hardware and software of the trading platform. Gross margin was 90% in FY17, down from 93% in FY15 and 94% in FY16. We model a modest recovery in FY18 to 92%, then maintaining that level.

In terms of costs, FY17 saw a shift in emphasis from sales and marketing to general and administrative expenses, primarily consisting of salaries. With the new market strategy now in place, we would expect the sales and marketing figure to increase as the group looks to recruit new participants (agents and retail investors) onto the platform. The forecast revenue growth built into our model more than covers the increase in overhead, with normalised operating margins recovering from the -8.4% delivered in FY17 to 4.5% in FY18e and 19.7% in FY19e. The operating margins achieved in FY15 and FY16 were at a higher level but were clearly unsustainable.

Total revenues for Q118 are expected by management to be around $4.0m, compared to the $2.3m generated in Q417. It also expects to return a profit on this turnover for the quarter. We have not attempted to make adjustment in our figures for future currency movements and have used a tax charge of 25% for both FY18 and FY19 (the PR China corporate tax rate). This results in forecast earnings per share (adjusted, diluted) of 8 cents for FY18 rising strongly to 29 cents for FY19.

With the peak of spending on building the business infrastructure past, we anticipate that there will be a modest net cash outflow in FY18 before the group turning net cash flow positive in FY19.

Takung Art had $12.5m of net cash on its balance sheet at the end of FY17. This figure does not include restricted cash of $25.3m, up from $21.7m at end FY16 (matched with equivalent liabilities). The short-term borrowings from third parties are there to ensure that the Hong Kong-based company has sufficient US dollar currency available to meet its working capital obligations, secured by equivalent RMB loans (shown on the balance sheet as Loan Receivables), which are repaid in parallel. The $12.5m net cash figure comprises cash and cash equivalents of $11.9m plus loan receivables of $7.8m less short-term borrowings of $7.2m (there being timing differences with the loan matching across the FY17 year-end). For future years we assume that the loan receivables and the short-term borrowings are equal sums. Our model indicates a small net cash outflow in the current financial year, to end FY18 with a net cash position of $11.7m, rising to $12.9m by end FY19, equivalent to 50 cents per share.