The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.NEW YORK ( MagicDiligence.com) -- Sotheby's ( BID) deals in the acquisition and selling of fine art, jewelry and collectibles. Virtually all (nearly 95%) of Sotheby's revenue come from the auction segment. Here the company acts as the agent, conducting due diligence to verify the authenticity of the item being sold, building interest through marketing, setting up and conducting the auction, and handling collection and distribution of funds from buyer to seller. In exchange, both the buyer and seller pay a commission to the company. Smaller contributors to Sotheby's revenue include a Finance segment (effectively a cash advance business), and Noortman Master Paintings, a small art dealer. Sotheby's is a global company, conducting more than 250 auctions a year across 40 countries, and earning close to 60% of sales outside of the U.S. One of my favorite aspects of this company is its competitive position as a "big fish in a small pond." Two players dominate the global fine art commercial market: Sotheby's and Christie's, each with about a 50% market share. The firm has even faced monopolistic practice charges in the past. Considering that both Sotheby's and Christie's have been in business since the mid-1700s, that the market is relatively small, and the existing relationships with the few customers for these items (which routinely fetch tens of millions of dollars), the firm has an almost impenetrable economic moat against competition. This is a wide-moat company, with a capital "W." Another positive is business momentum. Put simply, the market for fine art is red hot, especially in China. Sotheby's recent show in Hong Kong generated more than $400 million in net sales, second only to its April auction there. The second quarter (which ended in June) was the firm's best quarter ever -- and this is a firm with nearly 270 years of history! Fine art has been and will be an up-and-down market, but it is often difficult to predict the length of cycles here. This hot market could last for some time, and Sotheby's will benefit substantially from it.
The other fundamentals are solid. Cash on the balance sheet, at $666 million, eclipses a debt load of about $477 million. Free cash flow can be lumpy depending on how long the firm holds inventory, but current trends are around $300 million annually. Profits cover interest by an acceptable 8 times. Valuation, too, looks fairly attractive at $32. Sotheby's will always be a firm that experiences wild revenue swings from year to year, but over the long term the company has proven able to generate operating margins around 30% while growing sales at 5%-7% annually. I don't see why this can't continue, given the multitude of new millionaires in developing countries and Asia's taste for fine art. At the same time, the current price-to-sales ratio of about 2.5 is less than the firm's long-term average of about 3. Given this, Sotheby's long-term value looks to be around $43 per share, about 35% greater than its current price. MagicDiligence rates BID as a solid Magic Formula purchase. At the time of publication, Alexander held no positions in stocks discussed in this article.