artnet — Update 18 November 2015

artnet group is a coherent collection of businesses that improve the efficiency and transparency of the international art market. It has an online business model, in a market increasingly comfortable with virtual transactions and that is professionalising as an alternative investment asset class. Founded in 1989, artnet was an early entrant into the online art market. It has continued to develop its toolset using the cash raised at IPO in 1999 and the cash flow generated from its profitable businesses of the artnet Price Database (41% revenues) and artnet Galleries (36%), a subscription network. Reporting has been adjusted so that advertising revenues are split between the operations that they benefit. artnet News, where revenues are c 80% advertising driven, was established in 2014 and is now reported separately, accounting for 7% of group, with the balance (16%) attributable to the online Auctions business. These latter two categories represent the main growth potential for the group. The group is proprietor of the largest single accumulation of art market data (over ten million illustrated auction records), which it is seeking to monetise through more targeted analysis.

The share price took a sharp notch down in March 2015 after the news of a copyright court case in France (which judgement the group is appealing). Since then, the price has remained broadly unchanged, with little change in the trading outlook. When compared to other quoted businesses in the online space and to those specifically in the art segment, artnet’s shares trade at the significant discount of around 30%. This partly reflects disappointment in the market that the trading and financial performance has not lived up to earlier hopes. As the investment in new products and services starts to deliver improving returns, the valuation gap should start to close.

The markets for fine and decorative arts are truly global, with volumes and prices directly affected by the economic conditions in the main trading economies, with the presence and absence of the Chinese particularly pertinent. artnet’s business is also international and currency sensitivity has been highlighted in this year’s figures. There is a concerted shift to online trading, after initial resistance. Speed of adoption, particularly in the auction sector, will influence the financial outcome for artnet’s business. The group’s operating technology needs to be robust and secure to maintain client confidence. The market landscape is highly competitive with frequent start-ups, while existing operators can disrupt segments of the market through aggressive pricing. The group is currently appealing the judgement of a French court on a copyright case, for which financial provision has been made. Fraud and reputational issues are also a sectoral risk. Changes to the company’s Articles after 2012’s corporate action make further hostile bid activity unlikely.

artnet is an online resource provider for the global art market. It provides market participants – such as collectors, galleries, publishers, auction houses and enthusiasts – with the information and tools that they need to pursue their activities, from the research phase through newsflow to valuation and on to transaction. The group has its headquarters in Berlin, Germany and is listed in the Prime Standard segment of the Frankfurt Stock Exchange. The majority of its revenues are generated in the US (FY14: 56%), with its reporting currency being the euro.

artnet has a number of different activities and service offerings, all catering to the needs of the various constituent layers of the global art trade.

Historically, these have been reported in four segments; artnet Galleries, artnet Price Database, artnet Advertising and artnet Auctions. With the addition of the information service, artnet News, which went live in February 2014, these reporting arrangements have proved to lack clarity on the underlying performance of the business, with advertising revenues being generated across more than one activity. artnet News is set to become a high profile, key part of the group and identifying it separately will help demonstrate its importance. Therefore from Q115, and with comparative figures for the prior year equivalent period, artnet has reported its revenues and contribution margin in a new structure of four segments; artnet Galleries; artnet Price Database; artnet Auctions; and artnet News. Advertising revenues have been allocated to the underlying segments. These numbers have currently been published in US$ and not in euros, so we will not adjust our financial model under the new reporting arrangements until we have the detailed breakdown of costs in the reporting currency. For guidance, our estimates of full-year 2015 revenue by ‘old’ and ‘new’ reporting definitions are shown below. The implication is that advertising revenues were split very roughly evenly between News and Galleries, with a much smaller allocation to Price Database. We estimate that advertising accounts for around 20% of Galleries’ revenues.

The group employs 116 full-time and two part-time staff (roughly stable on prior year) and draws on the service of around 12 freelancers. Most are based in New York, the largest group operation, with a UK subsidiary providing sales and client support for its domestic market. The US market accounted for the largest percentage of group revenues in FY14 at 56%. With an online-driven business model, having local physical presence is less important than having a strong local reputation. Continuing investment in the sales and marketing functions in order to build brand awareness remains a clear group priority.

The integrity of the business and the success and market positioning of the various operations are all centred around the data and intelligence that artnet has accumulated over decades of collation (the auction records date back to 1985). We outline below the role of each segment, its historic performance and prospects.

artnet Price Database is the largest source of revenue (see Exhibits 1 and 2 above). It is subscribed to by a broad range of interested parties, ranging from dealers, auctioneers and valuers, private collectors, as well as interested ‘third parties’ such as the IRS and the FBI. It consists of over ten-million auction records, illustrated in colour, from more than 1,700 auction houses across 55 countries, with records dating back to 1985 in the fine art and decorative art categories. While plenty of other sources of data are available in the market, artnet purports to have the most comprehensive and longest-established archive. Price Database is provided to clients on a subscription basis, from one-day access to 12-month contracts, on volume-related fee per search and/or results.

Building the subscription base is predicated on improving the marketing. A recent targeted email recruitment campaign has had encouraging response rates. There is also considerable scope for analysing and presenting the data in ways that deliver greater value to its consumers. The group additionally offers derivative products; artnet Market Alert and artnet Analytics. Market Alert is a straightforward option for subscribers to be alerted by email if particular artists’ works are coming up for auction, are offered for sale within the gallery network or via the artnet Auction site, with pricing set in bands according to the number of artists monitored. Analytics was launched in May 2012 and offers a series of indices of segmented elements of the art market, by style, geography, era etc as demanded by the users, with pricing either set for a one-off report or for a batch of reports. Given the length of time that the main database has been running, trends and cycles can be monitored and identified in very specific segments of the market, with the database now covering over 600 artists and around 46,000 groups of comparable artworks. These can then be compared against other artworks or against financial indices unrelated to the art market. Customised analytics reports have had a particularly strong trading period over the latest nine months. Under the new reporting, we estimate that around 7% of Price Database revenues stem from advertising revenues.

As at the end of September 2015, artnet Galleries represented a network of around 1,300 galleries across 60 countries (2014: 1,400 galleries in 55 countries), enabling them to increase their reach and client bases, as well as keep tabs on market trends. The group has again carried out market research to identify the causes for the fall off in memberships and has been addressing the issues through greater collaboration with art fairs to increase its market presence. In order to turn the tide, best-in-class marketing and client interfaces are increasingly important given the backdrop. artnet has been investing in both aspects giving the potential to reverse the dip in the top line, alongside up- and cross-selling to the existing customer base. The group also offers a specific product to auction houses through its Auction House Partnership product, which enables them to link their own lots listed online with those listed on the artnet site, also referencing upcoming sales, thereby driving traffic to the auction house’s own site. This part of the group has grown well in 2015 and is becoming an increasingly important element of the Galleries segmental revenues.

Working back from the published figures between ‘new’ and ‘old’ reporting segments, we estimate that around 20% of the revenues attributable to the Galleries segment stem from online advertising

One of the newer activities has considerable potential. artnet Auctions undoubtedly presents an element of threat to some of the core customer base, with its B2C proposition. Presentation to the market is therefore key; maximising arguments on extending reach, while reassuring their customers that their client base will not be cannibalised. The initial fears that buyers and sellers would be reluctant to adopt online auctions, on the grounds that they would want physical access to examine lots on which they were bidding, has proved to be less of an issue than anticipated, particularly when offset by the convenience and speed of the process.

While the appetite has undoubtedly been growing for online auction capability, artnet’s auction activities initially failed to deliver a satisfactory return. The site was busy, but heavily weighted to low-value lots and a small number of active buyers. In 2014, the business was reoriented to drive up the gross and net margins through changes to the fee structure design, to promote a shift to higher-value lots. In the first nine months of 2015, buyers’ and sellers’ premiums were slightly lower at 22% vs 23% in the prior year, with the average price per lot broadly flat year-on-year, having risen in the previous year. However, volumes have increased, with the number of sold lots increasing by 5%. For the full year, the segment is likely to fall a little short of earlier ambitions on revenue growth, which management attributes to a number of unfilled specialist positions. It anticipates that Auctions will achieve breakeven once those vacancies have been filled with suitable applicants.

artnet News is the new segment under the restructuring of group reporting. It was launched in February 2014, with a view to providing regular compelling and authoritative content on a 24-hour rolling basis to drive website traffic. Visitors to artnet's main domain, artnet.com, have averaged over two million per month over 2015, an increase of 38% over the prior year. Traffic figures in Q4 are expected to benefit from a new co-operation agreement with Amazon, which will host artnet content on Amazon Art. The group is also in beta testing with a mobile app in the Apple iTunes store, which will be launched globally when the feedback from the trial is incorporated.

The bulk of artnet News revenues are generated from advertising, increasingly generating interest from luxury advertisers. This is particularly important in Q4, as those advertisers increase their seasonal spend. With the addition of mobile, further budgets will be accessible and the segment should be able to drive towards its initial break-even goal.

The art trade is peppered with high-profile individuals, often wealthy collectors, with vocal opinions on the industry structures and trends. Historically, artnet was effectively synonymous with Hans Neuendorf. He stepped down in 2012, but was later appointed deputy chairman in June 2013. His son, Jacob Pabst, took the reins as chairman and CEO, having joined the group in 2000. He has since been responsible for driving the technological aspects of the company, in particular the revamping of the website and its functionality, but also aspects such as product design and the launches of artnet Auctions, artnet Analytics and artnet News. Jacob is the sole member of the management board, but is supported by six VPs, segmental and functional. The supervisory board consists of chairman, lawyer John Hushon (a US citizen, US based), with extensive oil industry management experience, Hans Neuendorf, the founder, and Piroschka Dossi, a Ukrainian author, critic and curator specialising in the art market/finance interface, appointed in August 2013.

The global art market was estimated to be worth US$51bn in 2014, an increase of 7% on the prior year (TEFAF). Various estimates exist for the proportion now accounted for by online transactions, but the latest TEFAF report suggests that the figure was running at c 6% in 2014 at US$3.3bn, although it admits that this is probably a conservative estimate. The Hiscox Online Art Trade Report (2015) predicts growth in online sales from $1.57bn in 2013 to $6.3bn by 2019. Younger purchasers are (unsurprisingly) more prepared to transact online, with the ability to browse widely and transact deals on a click-and-buy basis particularly appealing. The primary frustrations centre around: the inability to see the works being purchased beforehand – which can be addressed in part through improved online presentation; and difficult and inconsistent returns’ policies.

The greater the amount of readily available relevant background information and continuing improvements in process are helping to increase the online proportion of the overall market. The potential prize obviously attracts new market participants, with the competitive landscape complex and in a continuous state of flux. New ventures, such as Sotheby's/eBay live auctions platform, are proliferating, with traditional auction houses also increasing their online presence. Other ventures, such as Etsy, have failed to live up to initial expectations. There are many companies in parts of the online art space addressed by artnet’s activities, but none with the same breadth.

The art market is complex, with many participants, all with differing business models and not all truly commercial enterprises. There continue to be many start-ups, disrupting the status quo, but conversely this may provide opportunities to expand and adopt new ideas and form strategic partnerships with other participants. Established business can also disrupt through changing their business models, for example by offering services for free that had previously been charged. Major online concerns are also increasing their exposure to the art market through alliances and bids.

The speed of adoption of online versus traditional trading will be a key sensitivity, mostly outside artnet’s control. Alongside more general economic trends and those in specific countries or markets, such as the presence or absence of the Chinese buyers in the market, these introduce a considerable element of uncertainty into the likely speed of growth of the group.

For any online business, systems integrity and security are crucial, particularly when dealing with high-value transactions and items and with client financial data. artnet’s upgraded IT provides an element of comfort on this front. Specific to the art market (and similar investment markets such as fine wine), there are perennial issues regarding fakes, fraudulent activity and money laundering, all of which constitute a reputational, as well as a commercial, risk.

The group has a global client base, but the bulk of the activity is carried out in US$, with the euro also an important trading currency and sterling also relevant. Results are formally reported in euros, but are also disclosed in US$, with the translational effects particularly significant in the current financial year, when exchange rates have undergone substantial shifts. The majority of the group’s assets are in US$, providing some degree of natural hedge.

In March 2015, the Paris Court of Appeal found against artnet, overturning the ruling of an earlier court, in a case of alleged copyright infringement of a French photographer whose photographs were used in the artnet Price Database. A provision of €0.95m to cover the payment and costs was taken in the 2014 accounts and in May 2015 the company lodged a further appeal to the French Court of Cassation.

Changes to the company’s Articles made in 2012 make further hostile bid approaches unlikely, given the founder’s substantial shareholding of 27.06%. Legal action that had been threatened at the time of the bid’s defeat did not materialise.

At the pre-tax level, artnet is currently trading a little over breakeven, as it builds towards sustainable and increasing profitability. The investment needed to drive this achievement has been considerable as the online art market has been developing, which has extended the timescale. This spend has also increased the operational gearing, making reliance on a traditional earnings or EV/EBITDA multiple metric unreliable. While the investment in software and IP is reflected in the balance sheet, accounting rules preclude the inclusion of the financial value of the historic art market data, which forms a key asset to the business and is responsible for generating considerable revenues – the equivalent to a backlist in a publishing concern, which might be valued on the basis of lists changing hands.

We have looked at the market valuation of artnet in comparison to both global online business ratings and to quoted business in the broader art space. The most commonly available valuation metrics are for trailing 12-month (TTM) and prospective 12-month (FTM) EV against revenues and against EBITDA.

Firstly, we compare metrics for artnet against online peers, based on quoted ecommerce businesses and also for web content businesses, the most directly relevant of the possible comparative categories for artnet’s trading model. Based on EV/Sales, the derived valuation is (understandably) considerably ahead of that based on EBITDA, reflecting the early-stage nature of many of the group’s activities, which have the greatest potential for delivering profits. Taking an average across the four measures, the suggested price is €2.99.

Looking at the quoted art sector, it is obvious that markets and business models are very disparate. Not all of the quoted companies operating in the sphere have available data, so there are some obvious omissions from our comparison table below. On average, they are valued more highly than for the general online businesses (but with very wide variations). Using the same valuation metrics as above, the average art sector valuation indicates a share price for artnet of €3.13.

We have also run a DCF model using various growth and WACC scenarios, using a terminal growth rate of 2%. The excerpt below shows the effect of different medium-term growth assumptions for the period beyond our detailed model.

The values derived for the share price under these conditions (and based on conservative growth assumptions), are broadly in line with those stemming from the peer comparisons.

We have adjusted our numbers on the back of the nine-month figures to end September 2015. The group’s proximity to breakeven means that the current-year figures are particularly susceptible to small changes in assumptions. Our figures fall within the range of company guidance.

artnet generates the majority of its revenues in US$, with a further 20% in euros and a proportion in sterling (exact percentages are not disclosed as there are elements of cross-charging, which complicate the picture). The substantial currency moves of the last few months have meant that the figures as reported in US$ and the figures as reported in euros appear to tell a very different story. The official reporting currency is the euro, as the group is headquartered in Berlin and quoted in Frankfurt and that is therefore the currency in which we have prepared our model. The key effect to note over recent reporting periods is that results when expressed in US$ have been broadly flat, whereas when expressed in euros, have been showing healthy growth. The segmental descriptions above are shown (and aggregated below) expressed in US$, as these are the figures currently available from the company.

Aggregate revenues for the first nine months of 2015 were up 1% in US$ terms; up 23% in €. Gross profits were ahead year-on-year as a result of mix, but also reflecting a smaller cohort of staff and non-filling of vacancies. Sales and marketing costs were ahead by 10% on a group basis, but lower for artnet News compared to the launch period in the comparative period. General and administrative costs were lower in the reported period, but product development costs were higher as further investment was made in the artnet Auctions platform and the cost of redesigning further product pages was also expensed. These changes are increasingly being effected in-house.

As with the group’s reporting currency, our model is in € and therefore shows the benefit of the translation in the top line in the current year. Our growth assumptions for future reporting periods make no allowance for currency impact from current levels, with growth stemming from organic developments within the group. The figures driving this exhibit are given in the financial summary, Exhibit 14. The build in advertising revenues across the various operations is the key to the improving margins that we anticipate in FY16 and FY17, alongside continuing close control of costs.

With reduced levels of product development and capitalised costs for the redevelopment of the website, the cash flow at the group is set to improve. In the first nine months of 2015, there was some absorption of working capital, but as advertising revenues step-up, this should unwind and we currently anticipate a stronger cash flow performance in 2016 and 2017.

Balance sheet remains cash positive

The group’s quoted fixed assets of €5.3m are equivalent to €0.42 per share, with fixed assets incorporating computer equipment, fixtures, leasehold improvements, website and software development and a €0.79m deferred tax asset. Despite net balance sheet liabilities of €0.02m as at the end of September 2015, net cash was €0.15m, which we estimate will have risen to just under €0.5m by the year end, with a further rise in the following financial year.