10-K 1 bid-12312013x10k.htm 10-K BID-12.31.2013-10K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
 
 
 
 
 
FORM 10-K
(Mark One)
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2013.
 
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
FOR THE TRANSITION PERIOD FROM          TO
COMMISSION FILE NUMBER 1-9750
___________________________________________________________________
(Exact name of registrant as specified in its charter)
__________________________________________________________________
Delaware
38-2478409
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1334 York Avenue
10021
New York, New York
(Zip Code)
(Address of principal executive offices)
 
 
 
 
 
(212) 606-7000
 
 
(Registrant’s telephone number, including area code)
 
 
Securities registered pursuant to Section 12(b) of the Act:
 
 
 
 
 
 
 
 
 
Title of each class
 
 
Name of each exchange
on which registered
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Common Stock,
 
 
New York Stock Exchange
 
 
$0.01 Par Value
 
 
 
 
 
 
 
 
 
 
 
 
 
Securities registered pursuant to Section 12(g) of the Act: None
 
 
 
 
 
 
 
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Act. Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Act during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Act). Large accelerated filer þ Accelerated filer o Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act) Yes o No þ
As of June 30, 2013, the aggregate market value of the 67,470,498 shares of Common Stock held by non-affiliates of the registrant was $2,557,806,579 based upon the closing price ($37.91) on the New York Stock Exchange composite tape on such date for the Common Stock.
As of February 17, 2014, there were outstanding 69,152,590 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s proxy statement for the 2014 annual meeting of shareholders are incorporated by reference into Part III of this Form 10-K.
 




TABLE OF CONTENTS
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2



PART I

ITEM 1: DESCRIPTION OF BUSINESS
Overview
Sotheby’s (or, “the Company”) is a global art business whose operations are organized under three segments: Agency1, Principal2, and Finance. The Agency segment matches buyers and sellers of authenticated fine art, decorative art, and high-end jewelry (collectively, “art” or “works of art” or “artwork” or "property") through the auction or private sale process. The activities of the Principal segment include the sale of artworks that have been purchased opportunistically by Sotheby’s and, to a lesser extent, retail wine sales and the activities of Acquavella Modern Art (or “AMA”), an equity investee. The Finance segment conducts art-related financing activities by providing certain collectors and dealers with loans secured by works of art. To a lesser extent, Sotheby’s is also involved in brand licensing activities. A more detailed explanation of the activities of each of Sotheby’s segments, as well as its brand licensing activities, is provided below.
Sotheby's primary global competitor is Christie’s International, PLC, a privately held, French-owned, auction house. To a much lesser extent, Sotheby’s also faces competition from smaller auction houses such as Bonhams and Phillips, as well as regional auction houses and a variety of art dealers across all collecting categories. In the Chinese art market, Sotheby's also competes with Beijing Poly International Auction Co. Ltd., China Guardian Auctions Co. Ltd., and Beijing Hanhai Auction Co. Ltd. In 2013, Sotheby’s accounted for approximately $5.1 billion, or 47%, of the total aggregate auction sales of the two major auction houses within the global auction market.
Sotheby’s was initially incorporated in Michigan in August 1983. In October 1983, the Company acquired Sotheby Parke Bernet Group Limited, which was then a publicly held company listed on the International Stock Exchange of the United Kingdom and which, through its predecessors, had been engaged in the auction business since 1744. In 1988, Sotheby’s issued shares of common stock to the public. In June 2006, Sotheby’s reincorporated in the State of Delaware. Sotheby's common stock ("Common Stock") is listed on the New York Stock Exchange (the “NYSE”) and trades under the symbol “BID.” As successor to the business that began in 1744, Sotheby’s is the oldest company listed on the NYSE and is the only publicly traded investment opportunity in the art market.
Agency Segment
Description of Business
The sale of works of art in the international art market is primarily effected through the major auction houses, numerous art dealers, smaller auction houses, and also directly between collectors. Although art dealers and smaller auction houses generally do not report sales figures publicly, Sotheby’s believes that art dealers account for the majority of the volume of transactions in the international art market.
Through its Agency segment, Sotheby's accepts property on consignment, stimulates buyer interest through professional marketing techniques, and matches sellers (also known as consignors) to buyers through the auction or private sale process. Prior to offering a work of art for sale, Sotheby’s specialists perform significant due diligence activities to authenticate and determine the ownership history of the property being sold.
Following the sale, Sotheby's invoices the buyer for the purchase price of the property (including the commission owed by the buyer), collects payment from the buyer, and remits to the consignor the net sale proceeds after deducting its commissions, expenses and applicable taxes and royalties. Sotheby's auction commissions include those paid by the buyer ("buyer's premium") and those paid by the seller ("seller's commission") (collectively, "auction commission revenue"), both of which are calculated as a percentage of the hammer price of the property sold at auction. Sotheby's private sale commissions are stipulated in a legally binding agreement between Sotheby’s and the seller, which outlines the terms of the arrangement including the desired sale price and the amount or rate of commission to be earned. In certain situations, Sotheby’s may also execute a legally binding agreement with the buyer stipulating the terms of the private sale transaction. In 2013 and 2012, auction commission revenues and private sale commission revenues accounted for approximately 81% and 10%, respectively, of Sotheby’s consolidated revenues.
__________________
1 Formerly known as the Auction segment, see Note 4 of Notes to Consolidated Financial Statements.
2 Formerly known as the Dealer segment, see Note 4 of Notes to Consolidated Financial Statements.


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Under Sotheby’s standard auction payment terms, payments from buyers are due no more than 30 days from the sale date and payments to consignors are due 35 days from the sale date. For private sales, payment from the buyer is typically due on the sale date, with the net sale proceeds being due to the consignor shortly thereafter. Extended payment terms are sometimes provided to a buyer and, for auctions, can vary considerably from selling season to selling season. Such terms typically extend the payment due date to a date that is no longer than one year from the sale date. In limited circumstances, the payment due date may be extended to a date that is beyond one year from the sale date. Any changes from the standard auction and private sale payment terms are subject to management approval under Sotheby's policy. When providing extended payment terms, Sotheby’s attempts to match the timing of cash receipt from the buyer with the timing of payment to the consignor, but is not always successful in doing so.
Under the standard terms and conditions of its auction and private sales, Sotheby’s is not obligated to pay the consignor for property that has not been paid for by the buyer. If a buyer defaults on payment, the sale may be cancelled, and the property will be returned to the consignor. Alternatively, the consignor may reoffer the property at a future Sotheby's auction or negotiate a private sale with Sotheby's acting as its agent. In certain instances and subject to management approval under Sotheby’s policy, the consignor may be paid the net sale proceeds before payment is collected from the buyer and/or the buyer may be allowed to take possession of the property before making payment. In situations when the buyer takes possession of the property before making payment, Sotheby’s is liable to the seller for the net sale proceeds whether or not the buyer makes payment.
From time to time in the ordinary course of its business, Sotheby’s will guarantee to a consignor a minimum sale price in connection with the sale of property at auction (an “auction guarantee”). In the event that the property sells for less than the guaranteed price, Sotheby’s must perform under the auction guarantee by funding the difference between the sale price at auction and the amount of the auction guarantee. Sotheby’s is generally entitled to a share of the excess proceeds (the “overage”) if the property under the auction guarantee sells above the guaranteed price. If the property does not sell, the amount of the auction guarantee must be paid, but Sotheby’s has the right to recover such amount through the future sale of the property. In these situations, the guaranteed property is recorded as inventory on Sotheby's balance sheet at the lower of cost (i.e., the amount paid under the auction guarantee) or management’s estimate of the property's net realizable value (i.e., expected sale price upon disposition). The sale proceeds ultimately realized by Sotheby’s in these situations may equal, exceed or be less than the amount recorded as inventory on the balance sheet.
Sotheby’s may reduce its financial exposure under auction guarantees through contractual risk and reward sharing arrangements under which a counterparty commits to bid a predetermined price on the guaranteed property (an “irrevocable bid”). If the irrevocable bid is the winning bid, the counterparty purchases the property at the predetermined price plus the applicable buyer’s premium, which is the same amount that any other successful bidder would pay at that price. If the irrevocable bid is not the winning bid, the counterparty is generally entitled to receive a share of the auction commission earned on the sale and/or a share of any overage. Sotheby's irrevocable bid counterparties are typically major international art dealers or major art collectors. Sotheby’s could be exposed to losses in the event any of these counterparties do not perform according to the terms of these contractual arrangements.
Although irrevocable bids may be used to reduce the risk associated with auction guarantees, Sotheby's may also enter into auction guarantees without securing irrevocable bids. To the extent that auction guarantees are issued without securing irrevocable bids, auction commission margins and Sotheby's share of any auction guarantee overage could potentially improve, as the buyer's premium and any overage would not be shared with an irrevocable bid counterparty, but Sotheby's could also be exposed to auction guarantee losses and/or deterioration in auction commission margins if the underlying property fails to sell at the minimum guaranteed price. Furthermore, in such situations, Sotheby's liquidity could be reduced.
Sotheby's credit agreement has a covenant that imposes a $300 million limitation on net outstanding auction guarantees (i.e., auction guarantees less the impact of related risk and reward sharing arrangements). In addition to compliance with this covenant, Sotheby's use of auction guarantees is also subject to management and, in some cases, Board of Directors, approval.
(See Note 4 of Notes to Consolidated Financial Statements for financial information about the Agency segment. See Note 5 of Notes to Consolidated Financial Statements for information about auction and private sale receivables. See Note 18 of Notes to Consolidated Financial Statements for information about auction guarantees.)

4


Seasonality
The worldwide art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. In the aggregate, second and fourth quarter Net Auction Sales (as defined below) represented 83% and 84% of total Net Auction Sales in 2013 and 2012, respectively, with auction commission revenues comprising approximately 81% of Sotheby's total revenues in these years. Accordingly, Sotheby's financial results are seasonal, with peak revenues and operating income generally occurring in those quarters. Consequently, first and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters and, typically, net losses due to the fixed nature of many of Sotheby's operating expenses. Management believes that investors should focus on results for six and twelve month periods, which better reflect the business cycle of the art auction market. (See Note 22 of Notes to Consolidated Financial Statements for Sotheby's quarterly results for the years ended December 31, 2013 and 2012.)
The Art Market and Competition
Competition in the international art market is intense. A fundamental challenge facing any auctioneer or art dealer is to obtain high quality and valuable property for sale either as agent or as principal. Sotheby's primary global competitor is Christie’s International, PLC, a privately held, French-owned, auction house. To a much lesser extent, Sotheby’s also faces competition from smaller auction houses such as Bonhams and Phillips, as well as regional auction houses and a variety of art dealers across all collecting categories. In the Chinese art market, Sotheby's also competes with Beijing Poly International Auction Co. Ltd., China Guardian Auctions Co. Ltd. and Beijing Hanhai Auction Co. Ltd.
The owner of a work of art wishing to sell has four principal options: (i) sale or consignment to an art dealer; (ii) sale or consignment to an auction house; (iii) private sale to a collector or museum without the use of an intermediary; or (iv) for certain categories of property (in particular, collectibles), consignment to an internet-based service. The more valuable the property, the more likely it is that the owner will consider more than one option and will solicit proposals from more than one potential purchaser or agent, particularly if the seller is a fiduciary representing an estate or trust. A complex array of factors may influence the seller’s decision. These factors, which are not ranked in any particular order, include:
The level and breadth of expertise of the art dealer or auction house with respect to the property;
The extent of the prior relationship, if any, between the art dealer or auction house and its staff and the seller;
The reputation and historic level of achievement by the art dealer or auction house in attaining high sale prices in the property’s specialized category;
The client’s desire for privacy;
The amount of cash offered by an art dealer, auction house or other purchaser to purchase the property outright, which is greatly influenced by the amount and cost of capital resources available to such parties;
The availability and terms of financial options offered by auction houses including auction guarantees, short-term financing, and auction commission sharing arrangements;
The level of pre-sale estimates;
The desirability of a public auction in order to achieve the maximum possible price (a particular concern for fiduciary sellers, such as trustees and estate executors);
The amount of commission charged by art dealers or auction houses to sell a work on consignment;
The cost, style, and extent of pre-sale marketing and promotion to be undertaken by an art dealer or auction house;
Reputation and recommendations by third parties consulted by the seller;
The desire of clients to conduct business with a publicly traded company; and
The availability and extent of related services, such as tax or insurance appraisals.
It is not possible to measure with any particular accuracy the entire international art market or to reach any conclusions regarding overall competition because privately owned art dealers and auction houses frequently do not publicly report annual totals for auction sales, revenues, or profits, and the amounts reported may not be verifiable.

5


The Art Market and Regulation
Regulation of the art market varies from jurisdiction to jurisdiction. In many jurisdictions, Sotheby’s is subject to laws and regulations that are not directed solely toward the art market, including, but not limited to, import and export regulations, antitrust laws, cultural property ownership laws, endangered species laws, data protection and privacy laws, anti-money laundering laws, copyright and resale royalty laws, and laws and regulations involving sales, use, value-added and other indirect taxes. In addition, Sotheby’s is subject to local auction regulations, such as New York City Auction Regulations Subchapter M of Title 6 §§ 2-121–2-125, et. seq. Such regulations do not impose a material impediment to Sotheby’s business, but do affect the art market generally. A material adverse change in such regulations, such as the Equity for Visual Artists bill introduced in the U.S. Congress which would impose a 7% resale royalty only on sales of art through large auction houses, could materially affect Sotheby's business. Additionally, export and import laws and cultural property ownership laws could affect the availability of certain kinds of property for auction or private sale through Sotheby’s or could increase the cost of moving property to such locations. In addition, failure to comply with local laws and regulations could subject Sotheby’s to civil and/or criminal penalties in such jurisdictions, or expose Sotheby's to legal claims or government inquiries. Sotheby’s has a Compliance Department which, amongst other activities, develops and updates compliance policies and audits, monitors, and provides training to its employees on compliance with many of these laws and regulations.
Principal Segment
Description of Business
The activities of the Principal segment include the sale of artworks that have been purchased opportunistically and, to a lesser extent, retail wine sales and the activities of Acquavella Modern Art, an equity investee. Under certain circumstances, the Principal segment provides secured loans to certain art dealers to finance the purchase of works of art. In these situations, Sotheby's acquires a partial ownership interest in the purchased property in addition to providing the loan. Upon its eventual sale, the loan is repaid and any profit or loss is shared by Sotheby's and the art dealer according to their respective ownership interests.
The Principal segment also holds the remaining inventory of Noortman Master Paintings (or "NMP"), an art dealer that was acquired by Sotheby's in June 2006. In recent years, NMP was adversely impacted by shifts in the collecting tastes of its clients and faced increased challenges in sourcing and successfully selling the categories of Old Master Paintings that traditionally formed the heart of its business. In the third quarter of 2011, management initiated a plan to restructure NMP’s business and sales strategy, but those efforts were not successful in reversing this trend. As a result, on December 31, 2013, NMP’s remaining office in London was closed. Management is currently executing its sale plans for NMP’s remaining inventory. As of December 31, 2013, the carrying value of NMP's remaining inventory was $11.1 million.
(See Note 4 of Notes to Consolidated Financial Statements for financial information about the Principal segment. See Note 5 of Notes to Consolidated Financial Statements for information about Principal segment lending activities. See Note 7 of Notes to Consolidated Financial Statements for information about AMA.)
Principal Segment Market and Competition
The activities of the Principal segment are conducted in the same markets as the Agency segment and are impacted to varying degrees by many of the same competitive factors (as discussed above under “The Art Market and Competition”). The most prominent competitive factors impacting the Principal segment, which are not ranked in any particular order, include: (i)the ability to locate and purchase quality works of art for resale; (ii) the amount and cost of capital resources required to finance purchases of art; (iii) the level and breadth of expertise with respect to the works of art being purchased and sold; and (iv) the strength of relationships with various art market participants, which include art dealers and major art collectors.
Finance Segment
Description of Business
The Finance segment provides certain collectors and art dealers with financing secured by works of art that Sotheby's either has in its possession or permits borrowers to possess. The Finance segment generally makes two types of secured loans: (1) advances secured by consigned property where the borrowers are contractually committed, in the near term, to sell the property through Sotheby's (a “consignor advance”); and (2) general purpose term loans secured by property not presently intended for sale (a “term loan”).

6


A consignor advance allows a seller to receive funds upon consignment for an auction or private sale that will typically occur up to one year in the future. Consignor advances normally have maturities of up to six months and are often issued interest-free as an incentive to the consignor for entering into the consignment agreement. Such interest-free consignor advances can represent a significant portion of the Finance segment loan portfolio as of the end of certain quarterly reporting periods in advance of peak selling seasons. Interest bearing consignor advances typically carry a variable rate of interest.
Term loans allow Sotheby's to establish or enhance mutually beneficial relationships with borrowers and may generate future auction or private sale consignments and/or purchases. In certain situations, term loans are also made to refinance accounts receivable generated by clients' auction and private sale purchases. Term loans normally have initial maturities of up to two years and typically carry a variable market rate of interest.
In 2013 and 2012, auction and private sales of Finance segment loan collateral generated Agency commission revenues of approximately $26 million and $42 million, respectively.
The collection of secured loans can be adversely impacted by a decline in the art market in general or in the value of the particular collateral. In addition, in situations when there are competing claims on the collateral and/or when a borrower becomes subject to bankruptcy or insolvency laws, Sotheby’s ability to realize on its collateral may be limited or delayed.
Sotheby’s target loan-to-value (“LTV”) ratio, which is defined as the principal loan amount divided by the low auction estimate of the collateral, is 50% or lower. However, loans are also made at an initial LTV higher than 50%. In addition, as a result of the periodic revaluation of loan collateral, the LTV ratio of certain loans may increase above the 50% target due to decreases in the low auction estimates of the collateral. The revaluation of loan collateral is performed by Sotheby’s specialists on an annual basis or more frequently if there is a material change in circumstances related to the loan or the disposal plans for the collateral.
The lending activities of the Finance segment, which are conducted through Sotheby’s wholly-owned subsidiaries, have historically been funded by the operating cash flows of the Agency segment with the ability to supplement those cash flows with revolving credit facility borrowings. In January 2014, Sotheby's established a separate capital structure for the Finance segment through which the Finance segment will predominantly rely on revolving credit facility borrowings to fund client loans. The debt funding of loans will reduce the Finance segment's cost of capital and enhance returns. Cash balances will also be used to fund a portion of the Finance segment loan portfolio, as appropriate.
(See "Capital Allocation and Financial Policy Review" and “Liquidity and Capital Resources” under Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” See Note 4 of Notes to Consolidated Financial Statements for financial information about the Finance segment. See Note 5 of Notes to Consolidated Financial Statements for information about Finance segment loans. See Note 10 of Notes to Consolidated Financial Statements for information about the Finance segment's revolving credit facility.)
Finance Segment Market and Competition
A considerable number of traditional lending sources offer conventional loans at a lower cost to borrowers than the average cost of loans offered by the Finance segment. Additionally, many traditional lenders offer borrowers a variety of integrated financial services such as wealth management, which are not offered by Sotheby’s. Few lenders, however, are willing to accept works of art as sole collateral as they do not possess the ability to both appraise and sell works of art within a vertically integrated organization. Sotheby’s believes that through a combination of its art expertise and skills in international law and finance, it has the ability to tailor attractive financing packages for clients who wish to obtain immediate access to liquidity from their art assets.
Brand Licensing Activities
Prior to 2004, Sotheby’s engaged in the marketing and brokerage of luxury residential real estate sales through Sotheby’s International Realty (“SIR”). In 2004, Sotheby’s sold SIR to a subsidiary of Realogy Corporation (“Realogy”), formerly Cendant Corporation. In conjunction with the sale, Sotheby’s entered into an agreement with Realogy to license the SIR trademark and certain related trademarks for an initial 50-year term with a 50-year renewal option (the “Realogy License Agreement”). The Realogy License Agreement is applicable worldwide.
The Realogy License Agreement provides for an ongoing license fee during its term based on the volume of commerce transacted under the licensed trademarks. In 2013, 2012, and 2011, Sotheby’s earned $6 million, $5 million, and $3.9 million, respectively, in license fee revenue related to the Realogy License Agreement.
The Sotheby’s name is also licensed for use in connection with the art auction business in Australia, art education services in the U.S. and the United Kingdom (“U.K.”), and print management services. Management will consider additional opportunities to license the Sotheby’s brand in businesses where appropriate.

7


Strategic Initiatives
Investment in Sotheby’s Most Valuable Client Relationships
Sotheby’s focus on the high-end of the art market is an important contributor to its success and management dedicates significant time, energy, and resources to broadening and extending Sotheby’s relationships with major clients. In 2013, half of Sotheby's major clients transacted, representing more than a 20% increase in business from this client segment. Furthermore, in 2013, the number of first time buyers grew 17% and this group represented 30% of all bidders during the year. This illustrates the power of Sotheby's investments in client out-reach programs, both in acquiring new clients, as well as building loyal relationships with existing clients through repeat business.
Over the past several years, Sotheby’s has made substantial investments in its information technology infrastructure designed to significantly reengineer and improve the post-sale client experience. In particular, enhancements were made to improve client invoicing, facilitate the shipment and tracking of purchased property, and inform clients of important information such as bid confirmation, sale results, and payment confirmation.
Sotheby's also continues to invest in its digital media strategy via the sothebys.com website and its iPad† and Android† applications to facilitate Sotheby's accessibility to clients on mobile platforms. The website and BIDnowTM live auction bidding platform were both redesigned in 2013 to enable each to work across all tablet and mobile platforms, resulting in a significant increase in client usage, including a 45% increase in online bidding, a 50% increase in Asian client traffic, and a 25% increase in time spent on mobile devices. In addition, clients in the Sotheby's Preferred client loyalty program have doubled their visits to sothebys.com over the past year, illustrating both the reach of mobile technology and the impact of a more engaging online experience with multi-lingual (e.g., Chinese) content. The iPad† application was further enhanced with a “quick browse” experience to enable clients to peruse all upcoming auctions in an easy and expeditious way.
In addition to these technology investments, Sotheby's remains focused on consistently providing exceptional personalized service to its clients through the coordinated efforts of its world class team of management and specialists. Delivery of this level of service requires the retention and engagement of key personnel. Accordingly Sotheby’s has established active employee development programs and has aligned its compensation structure to reward the performance, behaviors, and values that are essential to outstanding client service.
Development of Sotheby's Presence in China and Other Emerging Markets
In recent years, Sotheby's has developed its presence in China by deepening its relationships with Chinese art collectors in a number of ways, including:
The implementation of regional marketing initiatives such as the publishing of Hong Kong sales catalogues in Chinese, the launching of a Chinese language website that includes e-catalogues for sales of Asian Art and Sotheby's major Impressionist and Contemporary sales, and the hosting of innovative private selling exhibitions.

The continued investment in new staff with the requisite skills to service Asian clients at Sotheby's Hong Kong, New York, and London locations, as well as to support the growth of the Chinese art market.

The expansion of Sotheby's facilities in Hong Kong to accommodate growth opportunities in the Chinese art market, with the addition of a state-of-the-art gallery with over 15,000 square feet of selling and exhibition space. This initiative has enabled Sotheby’s to host a greater number of private selling events and extend the Hong Kong auction calendar beyond the traditional sales held in April and October.

_______________________
iPAD and Android are third-party marks over which Sotheby's does not make any claims.


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In addition, recognizing that Beijing is the cultural and arts capital of China, Sotheby's Beijing was established in 2012 to provide Sotheby’s a platform for art-related auctions and private selling exhibitions of non-cultural relics, traveling exhibitions, and educational activities in mainland China. Management believes that Sotheby's Beijing will strategically enhance Sotheby's long-term presence in China and allow it to capitalize on the opportunities presented by the Chinese art market, which Sotheby's has traditionally served through its operations in Hong Kong. In late-2013, Sotheby's Beijing hosted a series of arts events that included selling exhibitions covering a diverse group of collecting categories, educational programs facilitated by Sotheby's Institute of Art, and a successful auction of Modern and Contemporary Chinese Art with over 750 attendees. Further auctions are planned for Sotheby's Beijing in June and December 2014. (See “Sotheby’s Beijing” within Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”)
Elsewhere, Sotheby’s has pursued opportunities in promising emerging markets such as Russia, the Middle East, South America and India. In 2013, Sotheby’s was once again the only global auction house to conduct an auction in Doha, Qatar. The sale achieved the highest total ever for an auction of Contemporary Art in the Middle East and is expected to become an annual event for Sotheby's. Management will carefully assess the potential returns on any future investments in these regions.
(See statement on Forward Looking Statements and Part I, Item 1A, "Risk Factors.")
Growth of Private Sales
Over the past several years, Sotheby’s has dedicated additional management and specialist talent to the private sales arena. Specially designed private sale exhibition galleries, branded as S|2 and focused on selling Contemporary Art, have been opened in New York, London, and Hong Kong. Sotheby's has hosted a number of new and innovative private selling exhibitions, at S|2 and for other collecting categories, in various locations around the world. In 2013, Sotheby's hosted nearly 30 private selling exhibitions, up from just four exhibitions in 2010. In 2014, Sotheby’s expects to further increase the number of selling exhibitions, as the London S|2 gallery, which opened in late 2013, will join New York and Hong Kong in hosting selling exhibitions throughout the year. A dedicated private sales website has also been established to promote S|2 and Sotheby's other private selling exhibitions.
In 2013, the volume of Sotheby's private sales grew 30% to $1.2 billion and the resulting revenues represented approximately 10% of total revenues. Prior to 2012, private sale commission revenues represented between 5% and 8% of total revenues during the five-year period between 2007 and 2011. Private sales have become an increasingly important contributor to Sotheby's overall financial performance.
(See statement on Forward Looking Statements and Part I, Item 1A, "Risk Factors.")
Leverage and Grow Finance Segment Client Loan Portfolio
Sotheby’s Finance segment is uniquely positioned as a niche lender with the ability to tailor attractive financing packages for clients who wish to obtain immediate access to liquidity from their art assets. Through its Finance segment, Sotheby’s deploys its unique combination of art expertise, skills in international law and finance, and access to capital. With these capabilities, management has been able to capitalize on an increased client demand for art-related financing, growing the loan portfolio by 113% since 2011 and 200% since 2009, while maintaining Sotheby's traditional high standards for loan underwriting.
Historically, the lending activities of the Finance segment have been funded by the operating cash flows of the Agency segment, supplemented when necessary with revolving credit facility borrowings. However, in January 2014, Sotheby's established a separate capital structure for the Finance segment through which client loans will be predominantly financed with revolving credit facility borrowings. The debt funding of loans will allow further growth of the loan portfolio, as well as reduce the Finance segment's cost of capital and enhance returns in support of efforts to achieve a targeted 20% return on equity.
(See statement on Forward Looking Statements and Part I, Item 1A, "Risk Factors." Also, see “Capital Allocation and Financial Policy Review” within Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”)
Financial and Geographical Information about Segments
See Note 4 of Notes to Consolidated Financial Statements for financial and geographical information about Sotheby’s segments.

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Employees
As of December 31, 2013, Sotheby’s had 1,577 employees with 618 located in North America and South America; 521 in the U.K.; 240 in Continental Europe; and 198 in Asia. Sotheby’s regards its relations with its employees as good. The table below provides a breakdown of Sotheby’s employees by segment as of December 31, 2013 and 2012.
December 31
 
2013
 
2012
Agency
 
1,371

 
1,302

Principal
 
3

 
3

Finance
 
7

 
7

All Other
 
196

 
189

Total
 
1,577

 
1,501

The three employees in the Principal segment as of December 31, 2013 relate to NMP and left employment on January 1, 2014 as a result of the closure of NMP's remaining office in London (see "Principal Segment" above.) Subsequent to January 1, 2014, Principal segment activities are conducted by employees of the Agency segment.
Employees classified within “All Other” principally relate to Sotheby’s central corporate and information technology departments.
Website Address
Sotheby’s makes available free of charge its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K through a hyperlink from its website, http://investor.shareholder.com/bid/index.cfm, a website maintained by an unaffiliated third-party service. Such reports are made available on the same day that they are electronically filed with or furnished to the Securities and Exchange Commission (the "SEC"). Information available on the website is not incorporated by reference and is not deemed to be part of this Form 10-K.
ITEM 1A: RISK FACTORS
Sotheby's operating results and liquidity are significantly influenced by a number of risk factors, many of which are not within its control. These factors, which are not ranked in any particular order, are discussed below.
The global economy and the financial markets and political conditions of various countries may negatively affect Sotheby's business and clients, as well as the supply of and demand for works of art.
The international art market is influenced over time by the overall strength and stability of the global economy and the financial markets of various countries, although this correlation may not be immediately evident. In addition, global political conditions and world events may affect Sotheby's business through their effect on the economies of various countries, as well as on the willingness of potential buyers and sellers to purchase and sell art in the wake of economic uncertainty. Sotheby's business can be particularly influenced by the economies, financial markets and political conditions of the U.S., the U.K., China and the other major countries or territories of Europe and Asia (including the Middle East). Accordingly, weakness in those economies and financial markets can adversely affect the supply of and demand for works of art and Sotheby's business. Furthermore, global political conditions may also influence the enactment of legislation that could adversely impact Sotheby's business.
Government laws and regulations may restrict or limit Sotheby's business or impact the value of its real estate assets.
Many of Sotheby's activities are subject to laws and regulations including, but not limited to, import and export regulations, cultural property ownership laws, data protection and privacy laws, anti-money laundering laws, antitrust laws, copyright and resale royalty laws, laws and regulations involving sales, use, value-added and other indirect taxes, and regulations related to the use of real estate. In addition, Sotheby's is subject to local auction regulations, such as New York City Auction Regulations Subchapter M of Title 6 §§ 2-121-2-125, et. seq. Such regulations currently do not impose a material impediment to the worldwide business of Sotheby's, but do affect the art market generally. A material adverse change in such regulations, such as the Equity for Visual Artists bill introduced in the U.S. Congress which would impose a 7% resale royalty on sales of art through large auction houses, could affect Sotheby's business. Additionally, export and import laws and cultural property ownership laws could affect the availability of certain kinds of property for sale at Sotheby's principal auction locations, increase the cost of moving property to such locations, or expose Sotheby's to legal claims or government inquiries.


10



Foreign currency exchange rate movements can significantly impact Sotheby's results of operations and financial condition.
Sotheby's has operations throughout the world, with approximately 59% of its revenues earned outside of the U.S. in 2013. Additionally, Sotheby's has significant assets and liabilities denominated in the Pound Sterling, the Euro, and the Swiss Franc. Revenues, expenses, gains, and losses recorded in foreign currencies are translated using the monthly average exchange rates prevailing during the period in which they are recognized. Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Accordingly, fluctuations in foreign currency exchange rates, particularly for the Pound Sterling, the Euro, and the Swiss Franc can significantly impact Sotheby's results of operations and financial condition.
Competition in the international art market is intense and may adversely impact Sotheby's results of operations.
Sotheby's competes with other auctioneers and art dealers to obtain valuable consignments to offer for sale either at auction or through private sale. The level of competition is intense and can adversely impact Sotheby's ability to obtain valuable consignments for sale, as well as the commission margins achieved on such consignments.
Sotheby's cannot be assured of the amount and quality of property consigned for sale, which may cause significant variability in its financial results.
The amount and quality of property consigned for sale is influenced by a number of factors not within Sotheby's control. Many major consignments, and specifically single-owner sale consignments, often become available as a result of the death or financial or marital difficulties of the owner, all of which are unpredictable and may cause significant variability in Sotheby's financial results from period to period.
The demand for art is unpredictable, which may cause significant variability in Sotheby's results of operations.
The demand for art is influenced not only by overall economic conditions, but also by changing trends in the art market as to which collecting categories and artists are most sought after and by the collecting preferences of individual collectors, all of which are difficult to predict and which may adversely impact the ability of Sotheby's to obtain and sell consigned property, potentially causing significant variability in Sotheby's results of operations from period to period.
The loss of key personnel could adversely impact Sotheby's ability to compete.
Sotheby's is largely a service business in which the ability of its employees to develop and maintain relationships with potential sellers and buyers of works of art is essential to its success. Moreover, Sotheby's business is unique, making it important to retain key specialists and members of management. Accordingly, Sotheby's business is highly dependent upon its success in attracting and retaining qualified personnel.
The strategic initiatives being implemented by Sotheby's may not succeed.
Sotheby's strategic initiatives are focused on extending the breadth and depth of its relationships with its most valuable clients, developing a presence in China and other emerging markets, growing private sales, and leveraging and growing the Finance segment client loan portfolio. Sotheby's future operating results are dependent, in part, on management's success in implementing these and other strategic initiatives. Furthermore, the inability of Sotheby's to successfully implement its strategic initiatives could result in, among other things, the loss of clients, the loss of key personnel, the impairment of assets, and inefficiencies from operating in new and emerging markets. Also, Sotheby's short-term operating results and liquidity could be unfavorably impacted by the implementation of its strategic plans. (See "Strategic Initiatives" within Item 1, "Description of Business," and statement on Forward Looking Statements.)

11



Sotheby's joint venture in China is a foreign-invested enterprise under Chinese law. As such, enforcement of certain of Sotheby's rights within the joint venture are subject to approval from the Chinese government, which could limit the ability of the joint venture to operate and succeed.
In September 2012, Sotheby's received approval from the Chinese government to form and operate a 10-year equity joint venture with Beijing GeHua Art Company in China, which management believes will strategically enhance Sotheby's long-term presence in mainland China and allow it to capitalize on the opportunities presented by the Chinese art market. (See "Sotheby's Beijing" within Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and statement on Forward Looking Statements.)
Because the joint venture is a foreign-invested enterprise under Chinese law, all changes in shareholding and constitution of the joint venture will be subject to approval by the Chinese government, including in the event Sotheby's is seeking to terminate the joint venture agreement, exercise its put option, or wind-up the joint venture. Accordingly, Sotheby's ability to successfully operate the joint venture and enforce the joint venture agreement provisions could be constrained by the Chinese government and other unforeseen circumstances.
Sotheby's is currently in negotiations with the Chinese government to obtain the license required to operate as a Foreign-Invested Commercial Enterprise in order to establish a wholly-owned subsidiary in China. Sotheby's negotiations to obtain the license required to operate as a Foreign-Invested Commercial Enterprise in China may not be successful.
Sotheby's establishment of a wholly-owned subsidiary in China is subject to the receipt of a license from the Chinese government. Sotheby's may not be successful in obtaining this license, which could delay or inhibit its ability to further implement its strategic initiatives in China. (See "Sotheby's Beijing" within Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and statement on Forward Looking Statements.)
Sotheby's capital allocation and financial policies may impact its liquidity, financial condition, market capitalization and business, and Sotheby's ongoing ability to return capital to its shareholders (and the size and timing of such return) is subject to ongoing business variables.
In September 2013, the Board of Directors announced a review of Sotheby's capital allocation and financial policies in an effort to evaluate ongoing ways to deliver value to its shareholders, including through balance sheet optimization and potential return of capital strategies. Key considerations with respect to such assessment included, but was not limited to, the potential use of incremental debt to fund segments of Sotheby’s operations, ongoing funding requirements for certain of Sotheby’s strategic initiatives, both announced and contemplated, the value of Sotheby’s real estate properties, and the potential tax implications of any of the actions considered. The actions taken by Sotheby’s based on its review of its capital allocation and financial policies may impact its current and future liquidity, financial condition, market capitalization and business. In addition, the amount and timing of Sotheby’s return of capital to shareholders depends on various factors, including the outcome of Sotheby’s review of strategies with respect to its real estate properties, the amount of excess cash generated by the business in the future, and the amount of capital that may be required to support Sotheby’s future liquidity needs, among other factors.
(See "Capital Allocation and Financial Policy Review" and “Liquidity and Capital Resources" within Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and statement on Forward Looking Statements.)
A small number of shareholders may ultimately impact Sotheby's business.
As of December 31, 2013, management believes that two of Sotheby’s largest shareholders control approximately 16% of Sotheby’s Common Stock. These two significant shareholders, either individually or acting together, may be able to exercise significant influence over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions.

12



A breach of the security measures protecting Sotheby's global network of information systems and those of certain third-party service providers utilized by Sotheby's may occur.
Sotheby's is dependent on a global network of information systems to conduct its business and is committed to maintaining a strong infrastructure to secure these systems. As part of its information systems infrastructure, Sotheby's relies, to a certain extent, upon third-party service providers to perform services related to BIDnowTM, retail wine e-commerce and website server hosting. While these third-party service providers offer unique and specialized information security measures, certain elements of Sotheby's global information system security are outside management's direct control due to the use of these service providers. These third-party service providers are contractually obligated to host and maintain the service in a professional manner, in accordance with the rules and standards generally accepted within the industry. This includes conventional security measures such as firewall, password and encryption protection, breach notification requirements, and PCI practices for credit card processing services. A breach of the security measures protecting Sotheby's information systems could adversely impact its operations, reputation, and brand.
Sotheby's business continuity plans may not be effective in addressing the impact of unexpected events that could impact its business.
Sotheby's inability to successfully implement its business continuity plans in the wake of an unexpected event, such as an act of God or a terrorist attack occurring near one of its major selling and/or sourcing offices and/or any other unexpected event, could disrupt its ability to operate and adversely impact its operations.
Sotheby's relies on a small number of clients who make a significant contribution to its revenues, profitability and operating cash flows.
Sotheby's relies on a small number of clients who make a significant contribution to its revenues, profitability, and operating cash flows. Accordingly, Sotheby's revenues, profitability, and operating cash flows are highly dependent upon its ability to develop and maintain relationships with this small group of clients, as well as the financial strength of these clients.
Subject to management approval under Sotheby's policy, Sotheby's may pay the consignor the net sale proceeds from an auction or private sale before payment is collected from the buyer and/or may allow the buyer to take possession of purchased property before payment is received. In these situations, Sotheby's is exposed to losses in the event the buyer does not make payment.
Under the standard terms and conditions of its auction and private sales, Sotheby's is not obligated to pay the consignor for property that has not been paid for by the buyer. However, in certain instances and subject to management approval under Sotheby's policy, the consignor may be paid the net sale proceeds before payment is collected from the buyer while Sotheby's retains possession of the property. In such situations, if the buyer does not make payment, Sotheby's will take title to the property, but could be exposed to losses if the value of the property declines. In certain other situations and subject to management approval under Sotheby's policy, the buyer is allowed to take possession of purchased property before making payment. In these situations, Sotheby's is liable to the seller for the net sale proceeds whether or not the buyer makes payment and would incur losses in the event of buyer default. (See Note 5 of Notes to Consolidated Financial Statements for information about auction and private sale receivables.)
Sotheby's ability to collect auction receivables may be adversely impacted by buyers from emerging markets, as well as by the banking and foreign currency laws and regulations, and judicial systems of the countries in which it operates and in which its clients reside.
Sotheby's operates in 40 countries and has a worldwide client base that has grown in recent years due in part to a dramatic increase in the activity of buyers from emerging markets, and in particular, China. The collection of auction receivables related to buyers from emerging markets may be adversely impacted by the buyer's lack of familiarity with the auction process and the buyer's financial condition. Sotheby's ability to collect auction receivables may also be adversely impacted by the banking and foreign currency laws and regulations regarding the movement of funds out of certain countries, as well as by Sotheby's ability to enforce its rights as a creditor in jurisdictions where the applicable laws and regulations may be less defined, particularly in emerging markets.
Demand for art-related financing is unpredictable, which may cause variability in Sotheby's results of operations.
Sotheby's business is, in part, dependent on the demand for art-related financing, which can be significantly influenced by overall economic conditions and by the often unpredictable financial requirements of owners of major art collections. Accordingly, the financial results of Sotheby's Finance segment are subject to variability from period to period.

13



The ability of Sotheby's to realize proceeds from the sale of collateral for Finance segment loans may be delayed or limited.
In situations when there are competing claims on the collateral for Finance segment loans and/or when a borrower becomes subject to bankruptcy or insolvency laws, Sotheby's ability to realize proceeds from the sale of its collateral may be limited or delayed.
The value of the property held in inventory and the property pledged as collateral for Finance segment loans is subjective and often fluctuates, exposing Sotheby's to losses and significant variability in its results of operations.
The market for fine art, decorative art, and high-end jewelry is not a highly liquid trading market. As a result, the valuation of these items is inherently subjective and their realizable value often fluctuates over time. Accordingly, Sotheby's is at risk both as to the realizable value of the property held in inventory and as to the realizable value of the property pledged as collateral for client loans. In estimating the realizable value of the property held in inventory and the property pledged as collateral for Finance segment loans, management relies on the opinions of Sotheby's specialists, who consider the following complex array of factors when valuing these items: (i) whether the property is expected to be offered at auction or sold privately, in the ordinary course of Sotheby's business; (ii) the supply and demand for the property, taking into account economic conditions and, when relevant, changing trends in the art market as to which collecting categories and artists are most sought after; and (iii) recent sale prices achieved for comparable items within a particular collecting category and/or by a particular artist. If there is evidence that the estimated realizable value of a specific item held in inventory is less than its carrying value, a loss is recorded to reflect management's revised estimate of realizable value. In addition, if the estimated realizable value of the property pledged as collateral for a client loan is less than the corresponding loan balance, management assesses whether it is necessary to record a loss to reduce the carrying value of the loan, after taking into account the ability of the borrower to repay any shortfall between the value of the collateral and the amount of the loan. These factors may cause significant variability in Sotheby's financial results from period to period.
Sotheby's could be exposed to losses and/or reputational harm as a result of various claims and lawsuits incidental to the ordinary course of its business.
Sotheby's becomes involved in various legal proceedings, lawsuits, and other claims incidental to the ordinary course of its business. Management is required to assess the likelihood of any adverse judgments or outcomes in these matters, as well as potential ranges of probable or reasonably possible losses. A determination of the amount of losses, if any, to be recorded or disclosed as a result of these contingencies is based on a careful analysis of each individual exposure with, in some cases, the assistance of outside legal counsel. The amount of losses recorded or disclosed for such contingencies may change in the future due to new developments in each matter or a change in settlement strategy.
Sotheby's could be exposed to reputational harm as a result of wrongful actions by certain third parties.
Sotheby's is involved in various business arrangements and ventures with unaffiliated third parties. Wrongful actions by such parties could harm Sotheby's brand and reputation.
Sotheby's could be exposed to losses in the event of title or authenticity claims.
The assessment of property offered for auction or private sale can involve potential claims regarding title and authenticity. Items sold by Sotheby's may be subject to statutory warranties as to title and to a limited guarantee as to authenticity under the Conditions of Sale and Terms of Guarantee that are published in Sotheby's auction sale catalogues and the terms stated in, and the laws applicable to, agreements governing private sale transactions. The authentication of the items offered by Sotheby's is based on scholarship and research, but necessarily requires a degree of judgment from Sotheby's specialists. In the event of a title or authenticity claim against Sotheby's, Sotheby's may have recourse against the seller of the property and may have the benefit of insurance, but a claim could nevertheless expose Sotheby's to losses and to reputational risk.
Auction guarantees create the risk of loss resulting from the potential inaccurate valuation of art.
As discussed above, the market for fine art, decorative art, and high-end jewelry is not a highly liquid trading market and, as a result, the valuation of these items is inherently subjective. Accordingly, Sotheby's is at risk with respect to management's ability to estimate the likely selling prices of property offered with auction guarantees. If management's judgments about the likely selling prices of property offered with auction guarantees prove to be inaccurate, there could be a significant adverse impact on Sotheby's results of operations, financial condition, and liquidity. (See Note 18 of Notes to Consolidated Financial Statements for information related to auction guarantees.)


14



Sotheby's could be exposed to losses in the event of nonperformance by its counterparties in auction guarantee risk and reward sharing arrangements.
In certain situations, Sotheby's reduces its financial exposure under auction guarantees through risk and reward sharing arrangements. Sotheby's counterparties to these risk and reward sharing arrangements are typically major international art dealers or major art collectors. Sotheby's could be exposed to losses in the event any of these counterparties do not perform according to the terms of these contractual arrangements. (See Note 18 of Notes to Consolidated Financial Statements for information related to auction guarantees.)
Future costs and obligations related to Sotheby's U.K. Pension Plan are dependent on unpredictable factors, which may cause significant variability in employee benefit costs.
Future costs and obligations related to Sotheby's defined benefit pension plan in the U.K. are heavily influenced by changes in interest rates, investment performance in the debt and equity markets, changes in statutory requirements in the U.K., and actuarial assumptions, each of which is unpredictable and may cause significant variability in Sotheby's employee benefit costs.
Tax matters may cause significant variability in Sotheby's financial results.
Sotheby's operates in many tax jurisdictions throughout the world and the provision for income taxes involves a significant amount of management judgment regarding interpretation of relevant facts and laws in the jurisdictions in which Sotheby's operates. Sotheby's effective income tax rate can vary significantly between periods due to a number of complex factors including, but not limited to: (i) future changes in applicable laws; (ii) projected levels of taxable income; (iii) pre-tax income being lower than anticipated in countries with lower statutory rates or higher than anticipated in countries with higher statutory rates; (iv) increases or decreases to valuation allowances recorded against deferred tax assets; (v) tax audits conducted by various tax authorities; (vi) adjustments to income taxes upon the finalization of income tax returns; (vii) the ability to claim foreign tax credits; (viii) the repatriation of foreign earnings for which Sotheby's has not previously provided income taxes; and (ix) tax planning strategies.
Sotheby's clients reside in various tax jurisdictions throughout the world. To the extent that there are changes to tax laws or tax reporting obligations in any of these jurisdictions, such changes could adversely impact the ability and/or willingness of clients to purchase or sell works of art through Sotheby's. Additionally, Sotheby's is subject to laws and regulations in many countries involving sales, use, value-added and other indirect taxes which are assessed by various governmental authorities and imposed on certain revenue-producing transactions between Sotheby's and its clients. The application of these laws and regulations to Sotheby's unique business and global client base, and the estimation of any related liabilities, is complex and requires a significant amount of judgment. These indirect tax liabilities are generally not those of Sotheby’s unless it fails to collect the correct amount of sales, use, value-added, or other indirect taxes. Failure to collect the correct amount of indirect tax on a transaction may expose Sotheby's to claims from tax authorities.
Insurance coverage for artwork may become more difficult to obtain, exposing Sotheby's to losses for artwork in Sotheby's possession.
Sotheby's maintains insurance coverage through brokers and underwriters for the works of art it owns and for works of art consigned to it by its clients, which are exhibited and stored at Sotheby's facilities around the world. An inability to adequately insure such works of art due to limited capacity of the global art insurance market could, in the future, have a material adverse impact on Sotheby's business.
Due to the nature of its business, valuable works of art are exhibited and stored at Sotheby's facilities around the world. Such works of art could be subject to damage or theft, which could have a material adverse effect on Sotheby's business and reputation.
Valuable works of art are exhibited and stored at Sotheby's facilities around the world. Although Sotheby's maintains state of the art security measures at its premises, valuable artworks may be subject to damage or theft. The damage or theft of valuable property despite Sotheby's security measures could have a material adverse impact on Sotheby's business and reputation. Sotheby's maintains insurance coverage for the works of art that are exhibited and stored at its facilities, which could significantly mitigate any potential losses resulting from the damage or theft of such works of art.
ITEM 1B: UNRESOLVED STAFF COMMENTS
None.


15



ITEM 2: PROPERTIES
Sotheby’s is headquartered at 1334 York Avenue, New York, New York (the “York Property”). The York Property contains approximately 439,000 square feet of building area and is home to Sotheby’s sole North American auction salesroom and principal North American exhibition space, including S|2, a private sale exhibition gallery. The York Property is also home to the U.S. operations of Sotheby's Finance segment, as well as its corporate offices. The York Property was purchased by Sotheby's on February 6, 2009 for $370 million and had a net book value of $272.2 million as of December 31, 2013. Prior to this purchase, Sotheby’s occupied the York Property subject to a 20-year lease which was entered into in conjunction with a sale-leaseback transaction in February 2003. Sotheby’s also leases office and exhibition space in several other major cities in North America and South America.
Sotheby’s U.K. operations are centered at New Bond Street, London, where the main salesrooms, exhibition spaces and administrative offices are located. As part of a multi-year refurbishment initiative, in 2012 and 2013, Sotheby's invested approximately $6 million to enhance the New Bond Street exhibition space and construct an S|2 private sales gallery. Management is expecting to invest an additional $3 million in 2014 to complete the final phase of this refurbishment project (see statement on Forward Looking Statements). Almost the entire New Bond Street complex is either owned or held under various long-term lease, freehold, and virtual freehold arrangements. (Freeholds are occupancy arrangements in which the property is owned outright by Sotheby’s. Virtual freeholds are occupancy arrangements in which there is a 2,000-year lease with nominal yearly rent payments that cannot be escalated during the term of the lease.) Sotheby's also leases 52,000 square feet for a warehouse facility in Greenford, West London under a lease that expires in 2030.
Below is a table summarizing Sotheby’s ownership, freehold and lease arrangements related to its London properties as of December 31, 2013 (in thousands of dollars, except for square footage):
 
Square
Footage
 
Net Book Value of Land
 
Net Book Value of Buildings and Building Improvements
 
Net Book Value of Leasehold Improvements
 
Total Net Book Value of London Premises
Freeholds and virtual freeholds
96,503

 
$
5,980

 
$
2,361

 
$
28,221

 
$
36,562

Leases with a remaining term greater than 10 Years
108,089

 

 

 
11,793

 
11,793

All other leases
30,309

 

 

 
3,853

 
3,853

Total
234,901

 
$
5,980

 
$
2,361

 
$
43,867

 
$
52,208

Sotheby's maintains salesrooms, exhibition space, and administrative offices in Hong Kong at One Pacific Place. In 2012, Sotheby's completed a $7.5 million expansion of this facility, which included the addition of a state-of-the-art gallery with over 15,000 square feet of selling and exhibition space, as well as significant enhancements to existing administrative offices.
Sotheby’s also leases space primarily for Agency operations in various locations throughout Continental Europe and Asia, including sales centers in Geneva and Zurich, Switzerland; Milan, Italy, Paris, France, and Beijing, China.
Management initiated a review of Sotheby’s real estate holdings in 2013, including a review of the York Property, that began in the second quarter, and a review of its New Bond Street premises, that began in the third quarter. As a result of the review of the York Property, management concluded that Sotheby’s business does not require the full square footage of the building and is evaluating relocation, as well as alternatives under which Sotheby’s would no longer occupy up to 50% of the York Property. Any future action relative to the York Property will only be taken after fully assessing all financial costs, including any potential lease costs and associated leverage, as well as operational challenges, and concluding that the incremental benefit will be meaningful and lasting, especially in consideration of the cyclical nature of Sotheby's business. Management expects to choose a course of action with respect to the York Property shortly and commence execution. In 2014, management will continue to evaluate the strategic and operating requirements for the New Bond Street premises and assess any feasible alternatives.
ITEM 3: LEGAL PROCEEDINGS
See Note 16 of Notes to Consolidated Financial Statements for information related to Legal Proceedings.
ITEM 4: MINE SAFETY DISCLOSURES
Not applicable.


16



PART II

ITEM 5: MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
Market Information
Quarterly Stock Prices—The principal market for Sotheby’s Common Stock is the NYSE (symbol: BID). As of February 14, 2014, there were 965 holders of record of Sotheby’s Common Stock. The quarterly price ranges on the NYSE of Sotheby’s Common Stock during 2013 and 2012 were as follows:
        
 
 
2013
 
2012
 
 
High
 
Low
 
High
 
Low
Quarter Ended
 
 
 
 
 
 
 
 
March 31
 
$
40.49

 
$
33.26

 
$
40.81

 
$
28.16

June 30
 
$
39.60

 
$
32.95

 
$
40.38

 
$
28.91

September 30
 
$
49.60

 
$
37.95

 
$
36.00

 
$
27.43

December 31
 
$
54.00

 
$
48.52

 
$
34.22

 
$
27.98

Quarterly Cash Dividends—The following table summarizes cash dividends declared and paid for each of the quarterly periods in 2013 and 2012 (in thousands of dollars, except per share amounts):    
 
 
2013
 
2012
 
 
Per Share
 
Amount
 
Per Share
 
Amount
Quarter Ended
 
 
 
 
 
 
 
 
March 31
 
$

 
$

 
$
0.08

 
$
5,519

June 30
 
$

 
$

 
$
0.08

 
$
5,432

September 30
 
$
0.10

 
$
6,841

 
$
0.08

 
$
5,438

December 31
 
$
0.10

 
$
6,913

 
$
0.28

 
$
18,834

Total
 
$
0.20

 
$
13,754

 
$
0.52

 
$
35,223

In December 2012, the Board of Directors declared and Sotheby's paid accelerated first and second quarter of 2013 cash dividends totaling $0.20 per share (approximately $13.6 million). This accelerated dividend was intended to be in lieu of quarterly dividends that would have otherwise been declared and paid in the first and second quarters of 2013.
On February 27, 2014, the Board of Directors declared a quarterly dividend of $0.10 per share (approximately $6.9 million), payable on March 17, 2014 to shareholders of record as of March 10, 2014. It is the intention of Sotheby’s to continue to pay quarterly dividends at a rate of $0.10 per share, subject to approval by the Board of Directors and depending on economic, financial, market, legal, and other conditions at the time.
Sotheby’s has credit agreements with an international syndicate of lenders led by General Electric Capital, Corporate Finance, under which there are no limitations on dividend payments provided that, both before and after giving effect thereto: (i) there are no Events of Default, as defined in the credit agreements, (ii) the Aggregate Borrowing Availability, as defined in the credit agreements, equals or exceeds $75 million, and (iii) the Liquidity Amount, as defined in the credit agreements, equals or exceeds $150 million. (See “Liquidity and Capital Resources” under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 10 of Notes to Consolidated Financial Statements for additional information related to Sotheby's credit agreements.)
Special Dividend and Common Stock Repurchase Program—On January 29, 2014, the Board of Directors declared a special dividend of $300 million (approximately $4.34 per share), payable on March 17, 2014 to shareholders of record as of February 12, 2014, and authorized a five-year, $150 million Common Stock repurchase program that management will implement principally to offset the annual vesting of employee share-based payments. Management expects that Common Stock repurchases of approximately $25 million will be made by the end of 2014. (See "Capital Allocation and Financial Policy Review" under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and statement on Forward Looking Statements.)


17



Shareholder Rights Plan—On October 4, 2013, the Board of Directors declared a dividend of one preferred share purchase right (a “Right”) for each outstanding share of Sotheby's Common Stock, par value $0.01 per share, and adopted a shareholder rights plan (the "Rights Agreement"). The dividend was paid on October 14, 2013 to the shareholders of record on that date. Each Right allows its holder to purchase from Sotheby's one one-hundredth of a share of Series A Junior Participating Preferred Stock (a “Preferred Share”) for $200 (the “Exercise Price”), once the Rights become exercisable. This portion of a Preferred Share will give the shareholder approximately the same dividend and liquidation rights as would one share of Sotheby's Common Stock.  Prior to exercise, the Right does not give its holder any dividend, voting, or liquidation rights.
The Rights will not be exercisable until 10 days after the public announcement that a person or group has become an “Acquiring Person” by obtaining beneficial ownership of 10% (or 20% in the case of a “13G Investor,” as such term is defined in the Rights Agreement) or more of Sotheby's outstanding Common Stock (the "Distribution Date"). If a person or group becomes an Acquiring Person, each Right will entitle its holder (other than such Acquiring Person) to purchase for $200, a number of Sotheby’s Common Stock shares having a market value of twice such price, based on the market price of Sotheby's Common Stock prior to such acquisition. In addition, if Sotheby’s is acquired in a merger or other business combination transaction after the Distribution Date, each Right will entitle its holder to purchase, at the Right’s then-current exercise price, a number of the acquiring company's common stock shares having a market value of twice such price, based on the market price of the acquiring company's stock prior to such transaction. In addition, at any time after a person or group becomes an Acquiring Person, but before such Acquiring Person or group owns 50% or more of Sotheby's Common Stock, the Board of Directors may exchange one share of Sotheby’s Common Stock for each outstanding Right (other than Rights owned by such Acquiring Person, which would have become void). An Acquiring Person will not be entitled to exercise the Rights.
The Rights Agreement also includes “qualifying offer” provisions, whereby the Rights will automatically expire concurrently with (but no earlier than 100 days after the commencement of such qualifying offer) the purchase of 50% (including any shares held by the offeror) of Sotheby's outstanding Common Stock on a fully diluted basis pursuant to a tender or exchange offer for all of the outstanding shares of Sotheby's Common Stock at the same price and for the same consideration, provided that the offeror irrevocably commits to purchase all remaining untendered shares at the same price and the same consideration actually paid pursuant to the offer. The Rights will expire on October 3, 2016; provided that if Sotheby's shareholders have not ratified the Rights Agreement by October 3, 2014, the Rights will expire on such date.  
On October 4, 2013, Sotheby's designated 2,000,000 shares of its Preferred Stock with a par value of $0.01 per share as Series A Junior Participating Preferred Stock.

18



Equity Compensation Plans
The following table provides information as of December 31, 2013 related to shares of Sotheby’s Common Stock that may be issued under its existing equity compensation plans, including the Sotheby’s 1997 Stock Option Plan (the “Stock Option Plan”), the Sotheby’s Restricted Stock Unit Plan (the “Restricted Stock Unit Plan”), and the Sotheby’s Amended and Restated Stock Compensation Plan for Non-Employee Directors (the “Directors Stock Plan”):
 
 
(A)
 
(B)
 
(C)
Plan Category (1)
 
Number of
Securities to be
Issued Upon
Exercise of
Outstanding
Options, Warrants
and Rights (2)
 
Weighted Average
Exercise Price of
Outstanding Options,
Warrants and Rights (3)
 
Number of Securities
Remaining Available for
Future Issuance Under
Equity Compensation Plans (4)
 
 
(In thousands, except per share data)
Equity compensation plans approved by shareholders
 
1,917

 
$
22.11

 
4,041

Equity compensation plans not approved by shareholders
 

 

 

Total
 
1,917

 
$
22.11

 
4,041

_____________________________________________________________
(1)
See Note 14 of Notes to Consolidated Financial Statements for a description of the material features of Sotheby’s equity compensation plans.
(2)
Includes 1,823,267 shares awarded under the Restricted Stock Unit Plan for which vesting is contingent upon future employee service and/or Sotheby’s achievement of certain profitability targets and 93,750 stock options for which vesting is contingent upon future employee service.
(3)
The weighted-average exercise price includes the exercise price of stock options, but does not take into account 1,823,267 shares awarded under the Restricted Stock Unit Plan, which have no exercise price.
(4)
Includes 3,906,095 shares available for future issuance under the Restricted Stock Unit Plan, 104,100 shares available for issuance under the Stock Option Plan, and 30,851 shares available for issuance under the Directors Stock Plan.

19



Performance Graph
The following graph compares the cumulative total shareholder return on Sotheby’s Common Stock for the five-year period from December 31, 2008 to December 31, 2013 with the cumulative return of the Standard & Poor’s Global Luxury Index ("S&P Global Luxury Index"), which is a line-of-business index largely composed of companies whose products and services appeal to a segment of the population consistent with Sotheby's clients, a peer group presented in prior years (the "Peer Group"), and the Standard & Poor's MidCap 400 Stock Index (“S&P MidCap 400”). The Peer Group consists of Nordstrom, Inc., Tiffany & Co., and Movado, Inc. Management has elected to replace the Peer Group with the S&P Global Luxury Index because it does not believe that the Peer Group constitutes an appropriate peer index, given the unique nature of Sotheby's business. No other auction house or business with the same characteristics of comparable market share or capitalization is publicly traded. As required by the relevant SEC regulations, Sotheby's is presenting the Peer Group on the graph, along with the S&P Global Luxury Index. In future years, Sotheby's will no longer include the Peer Group in this disclosure.
The graph reflects an investment of $100 in Sotheby’s Common Stock, the S&P Global Luxury Index, the Peer Group Index, and the S&P MidCap 400 on December 31, 2008, and a reinvestment of dividends at the average of the closing stock prices at the beginning and end of each quarter.
 
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
Sotheby's
$
100.00

$
259.70

$
523.31

$
333.88

$
399.62

$
635.05

S&P Global Luxury Index
$
100.00

$
152.25

$
220.31

$
216.41

$
273.60

$
370.97

Peer Group
$
100.00

$
193.86

$
261.15

$
298.41

$
350.64

$
485.49

S&P MidCap 400
$
100.00

$
137.37

$
173.98

$
170.98

$
201.53

$
269.09



20



ITEM 6: SELECTED FINANCIAL DATA
Year ended December 31
 
2013
 
2012
 
2011
 
2010
 
2009
 
 
(Thousands of dollars, except per share data)
Statistical Metric:
 
 

 
 

 
 

 
 

 
 

Net Auction Sales (a)
 
$
4,338,948

 
$
3,809,656

 
$
4,240,573

 
$
3,644,764

 
$
1,912,589

Income Statement Data:
 
 

 
 

 
 

 
 

 
 

Revenues:
 
 
 
 
 
 
 
 
 
 
Agency
 
$
793,639

 
$
717,231

 
$
791,738

 
$
731,021

 
$
448,768

Principal
 
30,638

 
26,180

 
21,790

 
29,092

 
22,339

Finance
 
21,277

 
17,707

 
12,038

 
9,685

 
9,073

License fees
 
6,902

 
6,124

 
5,228

 
3,682

 
3,270

Other
 
1,222

 
1,250

 
1,042

 
829

 
1,508

Total revenues
 
$
853,678

 
$
768,492

 
$
831,836

 
$
774,309

 
$
484,958

Net interest expense (b)
 
$
(39,911
)
 
$
(42,879
)
 
$
(37,496
)
 
$
(45,080
)
 
$
(40,351
)
Net income (loss)
 
$
130,006

 
$
108,292

 
$
171,416

 
$
160,950

 
$
(6,528
)
Basic earnings (loss) per share
 
$
1.90

 
$
1.59

 
$
2.52

 
$
2.37

 
$
(0.10
)
Diluted earnings (loss) per share
 
$
1.88

 
$
1.57

 
$
2.46

 
$
2.34

 
$
(0.10
)
Cash dividends declared per share
 
$
0.20

 
$
0.52

 
$
0.23

 
$
0.20

 
$
0.30

Balance Sheet Data:
 
 

 
 

 
 

 
 

 
 

Working capital
 
$
829,784

 
$
706,244

 
$
728,984

 
$
573,020

 
$
525,892

Total assets
 
$
2,893,546

 
$
2,575,095

 
$
2,399,414

 
$
2,178,628

 
$
1,586,123

Long-term debt, net
 
$
515,148

 
$
515,197

 
$
464,552

 
$
472,862

 
$
512,939

Total equity
 
$
1,139,665

 
$
992,826

 
$
903,667

 
$
771,508

 
$
576,985

(a)
Represents the hammer price of property sold at auction. (See "Results of Operations for the Years Ended December 31, 2013 and 2012" and "Results of Operations for the Years Ended December 31, 2012 and 2011" under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for other statistical metrics.)
(b)
Represents interest expense less interest income.


21



ITEM 7:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Seasonality
The worldwide art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. In the aggregate, second and fourth quarter Net Auction Sales (as defined below) represented 83% and 84% of total Net Auction Sales in 2013 and 2012, respectively, with auction commission revenues comprising approximately 81% of Sotheby's total revenues in these years. Accordingly, Sotheby's financial results are seasonal, with peak revenues and operating income generally occurring in those quarters. Consequently, first and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters and, typically, net losses due to the fixed nature of many of Sotheby's operating expenses. Management believes that investors should focus on results for six and twelve month periods, which better reflect the business cycle of the art auction market. (See Note 22 of Notes to Consolidated Financial Statements for Sotheby's quarterly results for the years ended December 31, 2013 and 2012.)
Use of Non-GAAP Financial Measures
GAAP refers to generally accepted accounting principles in the United States of America. Included in Management's Discussion and Analysis of Financial Condition and Results of Operations (or “MD&A”) are financial measures presented in accordance with GAAP and also on a non-GAAP basis. In MD&A, Sotheby’s presents EBITDA and EBITDA Margin, which are supplemental financial measures that are not required by or presented in accordance with GAAP.
Sotheby's defines EBITDA as net income (loss), excluding income tax expense (benefit), interest expense, interest income, and depreciation and amortization. Sotheby's defines EBITDA Margin as EBITDA as a percentage of total revenues. Management cautions users of Sotheby's financial statements that amounts presented in accordance with its definitions of EBITDA and EBITDA Margin may not be comparable to similar measures disclosed by other companies because not all companies and analysts calculate such measures in the same manner. Management believes that EBITDA and EBITDA Margin provide important supplemental measures of Sotheby's performance and that these measures may be used by securities analysts, investors, financial institutions, and other interested parties in the evaluation of Sotheby's. Management also utilizes EBITDA in analyzing Sotheby's performance and in the determination of annual incentive compensation. A reconciliation of EBITDA to net income derived in accordance with GAAP is presented under “Reconciliation of Non-GAAP Financial Measures.”
Critical Accounting Estimates
The preparation of financial statements and related disclosures in accordance with GAAP requires management to make judgments, assumptions, and estimates that affect the amounts reported in Sotheby's Consolidated Financial Statements and accompanying notes. Actual results may ultimately differ from management’s original estimates as future events and circumstances sometimes do not develop as expected. Note 2 of Notes to Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of Sotheby's Consolidated Financial Statements. In addition, management believes that the following are its most critical accounting estimates, which are not ranked in any particular order, that may affect Sotheby’s reported financial condition and/or results of operations.
(1)
Valuation of Inventory and Loan Collateral—The market for fine art, decorative art, and high-end jewelry is not a highly liquid trading market. As a result, the valuation of these items is inherently subjective and their realizable value often fluctuates over time.
If there is evidence that the estimated realizable value of a specific item held in inventory is less than its carrying value, a loss is recorded to reflect management's revised estimate of realizable value. (See Note 6 of Notes to Consolidated Financial Statements for information related to Sotheby's inventory.)
If the estimated realizable value of the property pledged as collateral for a Finance segment loan is less than the corresponding loan balance, management assesses whether it is necessary to record a loss to reduce the carrying value of the loan, after taking into account the ability of the borrower to repay any shortfall between the value of the collateral and the amount of the loan. (See Note 5 of Notes to Consolidated Financial Statements for information related to Finance segment loans.)

22



In estimating the realizable value of the property held in inventory and the property pledged as collateral for Finance segment loans, management relies on the opinions of Sotheby's specialists, who consider the following complex array of factors when valuing these items:
whether the property is expected to be offered at auction or sold privately, in the ordinary course of business;
the supply and demand for the property, taking into account economic conditions and, where relevant, changing trends in the art market as to which collecting categories and artists are most sought after; and
recent sale prices achieved for comparable items within a particular collecting category and/or by a particular artist.
Due to the inherent subjectivity involved in estimating the realizable value of the property held in inventory and the property pledged as collateral for Finance segment loans, management's estimates of realizable value may prove, with the benefit of hindsight, to be different than the amount ultimately realized upon sale.
(2) Accounts Receivable—Accounts receivable principally includes amounts due from buyers as a result of auction and private sale transactions. The recorded amount reflects the purchase price of the property, including the commission owed by the buyer. Under the standard terms and conditions of its auction sales, Sotheby’s is not obligated to pay the consignor for property that has not been paid for by the buyer, provided that the property has not been released to the buyer. If a buyer defaults on payment, the sale may be cancelled and the property will be returned to the consignor. Management continually evaluates the collectability of amounts due from individual buyers and, if management determines that it is probable that a buyer will default, a cancelled sale is recorded in the period in which that determination is made and the associated accounts receivable balance, including Sotheby's auction commission, is reversed. Management's judgments regarding the collectability of accounts receivable are based on an assessment of the buyer's payment history, discussions with the buyer, and the value of any property held as security against the buyer's payment obligation. Management's judgments with respect to the collectability of amounts due from buyers for auction and private sale purchases may prove, with the benefit of hindsight, to be incorrect. Historically, cancelled sales have not been material in relation to the aggregate hammer price of property sold at auction.
(3)
Legal Contingencies—Sotheby's becomes involved in various legal proceedings, lawsuits, and other claims incidental to the ordinary course of its business. Management is required to assess the likelihood of any adverse judgments or outcomes in these matters, as well as potential ranges of probable or reasonably possible losses. A determination of the amount of losses, if any, to be recorded or disclosed as a result of these contingencies is based on a careful analysis of each individual exposure with, in some cases, the assistance of outside legal counsel. The amount of losses recorded or disclosed for such contingencies may change in the future due to new developments in each matter or a change in management's settlement strategy. (See Note 16 of Notes to Consolidated Financial Statements for information related to legal contingencies.)
(4) Pension Obligations—The pension obligations related to Sotheby's U.K. defined benefit pension plan (the “U.K. Pension Plan”) are based on an actuarial valuation. Inherent in this valuation are key assumptions and estimates, including the discount rate, the expected long-term rate of return on plan assets, future inflation, future annual compensation increases, and mortality, which are updated on at least an annual basis. In developing these assumptions and estimates, management considers current market conditions, market indices, and other relevant data.
The discount rate represents the approximate weighted average rate at which the obligations of the U.K. Pension Plan could be effectively settled and is based on a yield curve for a selection of high-quality corporate bonds with maturity dates approximating the length of time remaining until individual benefit payment dates. The discount rate used to calculate the $1.2 million net pension benefit recorded in 2013 was 4.4%. A hypothetical increase or decrease of 0.1% in this assumption would result in a decrease or increase in net annual pension cost of approximately $0.6 million. As of December 31, 2013, the discount rate used to calculate the $360.2 million benefit obligation was 4.4%. A hypothetical increase or decrease of 0.1% in this assumption would result in a decrease or increase in the benefit obligation of approximately $6.9 million.
The expected long-term rate of return is weighted according to the composition of invested assets and is based on expected future appreciation, as well as dividend and interest yields currently available in the equity and bond markets. In particular, the expected rate of return for growth assets represents management's estimate of median annualized returns by asset class. The expected rate of return on debt securities is based on interest yields currently available on long-dated U.K. government bonds and highly-rated corporate bonds. No allowance is made in the expected rate of return for potential market out-performance by fund managers. The expected long-term rate of return on plan assets used to calculate the $1.2 million net pension benefit recorded in 2013 was 6.2%. A hypothetical increase or decrease of 0.25% in this assumption would result in a decrease or increase in net annual pension cost of approximately $0.9 million.

23



The assumption for future annual compensation increases is determined after considering historical salary data for Sotheby's U.K. employees and management's expectations for future salary growth, as well as current economic data for inflation. The assumption for future annual compensation increases used to calculate the $1.2 million net pension benefit recorded in 2013 was 4.2%. A hypothetical increase or decrease of 0.25% in this assumption would result in an increase or decrease in net annual pension cost of approximately $0.4 million. As of December 31, 2013, the assumption for future annual compensation increases used to calculate the $360.2 million benefit obligation was 4.6%. A hypothetical increase or decrease of 0.25% in this assumption would result in an increase or decrease in the benefit obligation of approximately $2.3 million.
Assumed mortality rates are based upon standardized data tables used by actuaries in the U.K., taking into account the demographics of U.K. Pension Plan members and allowances for longer future life expectancies. A hypothetical 5% decrease or increase in mortality rates would result in a decrease or increase in net pension cost of approximately $0.5 million. Additionally, a hypothetical 5% increase or decrease in life expectancies would result in an increase or decrease in the benefit obligation of approximately $3.9 million.
As of December 31, 2013 and 2012, the accumulated after-tax net loss related to the U.K. Pension Plan that has not yet been recognized in Sotheby's Consolidated Income Statements was ($38.6) million and ($34.8) million, respectively, and is reflected in the Shareholders' Equity section of Sotheby' Consolidated Balance Sheets within accumulated other comprehensive loss. Unrecognized pension losses are generally the result of (i) actual results being different from previous actuarial assumptions and/or (ii) changes in actuarial assumptions between balance sheet dates. The ($4.1) million after-tax net loss incurred in 2013 is the result of an increase in expected future inflation and updated mortality assumptions reflecting improved life expectancies.
If the unrecognized pre-tax loss reflected in Shareholders' Equity exceeds 10% of the greater of (i) the market-related value of plan assets or (ii) the benefit obligation, the excess amount is amortized as a component of future net pension cost or benefit over the average expected remaining service period of active plan participants, which is approximately 12.8 years. It is expected that approximately $1.9 million ($2.3 million, pre-tax) of the ($38.6) million after-tax net loss will be recognized as a component of the net pension benefit for the year ended December 31, 2014. (See statement on Forward Looking Statements.)
(See Note 17 of Notes to Consolidated Financial Statements for additional information related to the U.K. Pension Plan.)
(5)
Income Taxes and Indirect Taxes—The provision for income taxes involves a significant amount of management judgment regarding the interpretation of the relevant facts and laws in the many jurisdictions in which Sotheby's operates. Future changes in applicable laws, projected levels of taxable income and tax planning could change Sotheby's effective tax rate and recorded tax balances.
As of December 31, 2013, Sotheby's had net deferred tax assets of $52.4 million, primarily resulting from deductible temporary differences which will reduce taxable income in future periods over a number of years. Included in this net deferred tax asset is a valuation allowance of $3.2 million to reduce Sotheby's deferred tax assets to the amount that is more likely than not to be realized. In assessing the need for the valuation allowance, management considers, among other things, projections of future taxable income and ongoing prudent and feasible tax planning strategies. If management's projections of future taxable income and other positive evidence considered in evaluating the need for a valuation allowance prove, with the benefit of hindsight, to be inaccurate, it will be more difficult to support the realization of these deferred tax assets. As a result, an additional valuation allowance may be required, which would have an adverse impact on Sotheby's effective income tax rate and results. Conversely, should management determine that Sotheby's will be able to realize its deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would have a favorable impact on Sotheby's effective income tax rate and results in the period such determination was made.
Due to the global complexity of tax regulation, Sotheby's records liabilities to address potential exposures involving uncertain tax positions that management has taken, or expects to take, on income tax returns that could be challenged by taxing authorities. These potential exposures result from the varying applications and interpretations of income tax related statutes, rules, and regulations. As of December 31, 2013, Sotheby’s liability for unrecognized tax benefits, excluding interest and penalties, was $25.4 million. Management believes that Sotheby's recorded tax liabilities are adequate to cover all open years based on an assessment of the relevant facts and circumstances. This assessment involves assumptions and significant judgments about future events and potential actions by taxing authorities, as well as an evaluation of past experiences. The cost of the ultimate resolution of these matters may be greater or less than the liability that Sotheby's has recorded. To the extent that management's opinion as to the outcome of these matters changes, income tax expense will be adjusted accordingly in the period in which such a determination is made. Sotheby's recognizes interest and penalties related to income taxes as income tax expense.

24




Sotheby's is subject to laws and regulations in many countries involving sales, use, value-added and other indirect taxes which are assessed by various governmental authorities and imposed on certain revenue-producing transactions between Sotheby's and its clients. The application of these laws and regulations to Sotheby's unique business and global client base, and the estimation of any related liabilities, is complex and requires a significant amount of judgment. These indirect tax liabilities are generally not those of Sotheby’s unless it fails to collect the correct amount of sales, use, value-added, or other indirect taxes. Failure to collect the correct amount of indirect tax on a transaction may require Sotheby’s to record a liability and a corresponding charge to general and administrative expenses. The ultimate tax paid in respect of Sotheby's liability for sales, use, value-added and other indirect taxes may ultimately be higher or lower than the amount recorded on Sotheby's Consolidated Balance Sheets.
(See discussion of “Income Tax Expense” below, as well as Notes 11, 12, and 16 of Notes to Consolidated Financial Statements.)
(6)
Share-Based Payments—Sotheby's grants share-based payment awards as compensation to certain employees. The amount of compensation expense recognized for share-based payments is based on management’s estimate of the number of shares ultimately expected to vest as a result of employee service. A substantial portion of the share-based payment awards vest only if Sotheby's achieves established profitability targets. The amount and timing of compensation expense recognized for such performance-based awards is dependent upon management's quarterly assessment of the likelihood and timing of achieving these future profitability targets. Accordingly, if management's projections of future profitability prove, with the benefit of hindsight, to be inaccurate, the amount of life-to-date and future compensation expense related to share-based payments could significantly increase or decrease. (See Note 14 of Notes to Consolidated Financial Statements for information related to Sotheby's share-based payment programs.)
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2013 AND 2012
This discussion should be read in conjunction with Note 4 of Notes to Consolidated Financial Statements, which provides financial information about Sotheby's segments.
Overview
In 2013, Sotheby’s reported net income of $130 million, a $21.7 million (20%) increase when compared to the prior year. This improvement was made possible by a $24.7 million increase in fourth quarter net income as fourth quarter Net Auction Sales increased 28%, reflecting the continuing strength of the global art market as Sotheby’s autumn sales of Asian Art in Hong Kong and Impressionist Art in New York significantly exceeded prior year results.
The improvement in full year net income is primarily attributable to a $529.3 million (14%) increase in Net Auction Sales and a $272.5 million (30%) increase in Private Sales. However, these increases generated a smaller 11% growth in Agency segment revenues as the competitive environment for high value auction consignments remains robust and resulted in a decrease in Auction Commission Margin from 16.3% in 2012 to 15.9% in 2013. In addition, the improvement in revenues is partially offset by a higher level of operating expenses due to the cost of strategic investments, as well as inflationary pressures across most expense categories. As discussed below under "Outlook," management has recently completed a review of its cost structure and has identified opportunities for cost savings in 2014.
In addition to the operating factors discussed above, the comparison of Sotheby's results to the prior year is also favorably impacted by a non-operating bond redemption loss of $15 million ($8.3 million after taxes) incurred in the fourth quarter of 2012.
See the discussion below for greater detail on the significant factors impacting Sotheby’s 2013 results and the comparison to 2012.


25



Outlook
The global art market remains strong, as evidenced by the results of Sotheby's record-setting February 2014 auctions of Impressionist Art, which achieved aggregate auction sales of $345 million, the highest value achieved for any sales series ever held anywhere in London. In this strong market, the competitive environment for high value consignments is robust and auction commission margins continue to be under pressure.
Management has recently completed a review of its cost structure and has identified opportunities for cost savings in 2014 across various categories of expenses including professional fees and other general and administrative expenses, auction direct costs, and marketing expenses. (See "Agency Direct Costs," "Marketing Expenses," and "General and Administrative Expenses" below for additional information. Also, see statement on Forward Looking Statements.)


26



Results of Operations for the Years Ended December 31, 2013 and 2012
The table below presents a summary of Sotheby’s results of operations for 2013 and 2012, as well as a comparison between the two years (in thousands of dollars):
 
 
 
 
 
Favorable/(Unfavorable)
 
2013
 
2012
 
$ Change
 
% Change
Revenues:
 

 
 

 
 

 
 

Agency
$
793,639

 
$
717,231

 
$
76,408

 
11
%
Principal
30,638

 
26,180

 
4,458

 
17
%
Finance
21,277

 
17,707

 
3,570

 
20
%
License fees
6,902

 
6,124

 
778

 
13
%
Other
1,222

 
1,250

 
(28
)
 
(2
%)
Total revenues
853,678

 
768,492

 
85,186

 
11
%
Expenses
631,103

 
554,073

 
(77,030
)
 
(14
%)
Operating income
222,575

 
214,419

 
8,156

 
4
%
Net interest expense (a)
(39,911
)
 
(42,879
)
 
2,968

 
7
%
Extinguishment of debt

 
(15,020
)
 
15,020

 
100
%
Other income
3,029

 
2,916

 
113

 
4
%
Income before taxes
185,693

 
159,436

 
26,257

 
16
%
Equity in earnings of investees, net of taxes
15

 
251

 
(236
)
 
(94
%)
Income tax expense
55,702

 
51,395

 
(4,307
)
 
(8
%)
Net income
$
130,006

 
$
108,292

 
$
21,714

 
20
%
Statistical Metrics:
 

 
 

 
 

 


Aggregate Auction Sales (b)
$
5,127,155

 
$
4,473,625

 
$
653,530

 
15
%
Net Auction Sales (c)
$
4,338,948

 
$
3,809,656

 
$
529,292

 
14
%
Items sold at auction with a hammer price greater than $1 million
620

 
556

 
64

 
12
%
Total hammer price of items sold at auction with a price greater than $1 million
$
2,623,378

 
$
2,128,199

 
$
495,179

 
23
%
Auction Commission Margin (d)
15.9
%
 
16.3
%
 
N/A

 
(2
%)
Private Sales (e)
$
1,179,038

 
$
906,510

 
$
272,528

 
30
%
Consolidated Sales (f)
$
6,336,831

 
$
5,406,315

 
$
930,516

 
17
%
Average Loan Portfolio (g)
$
433,619

 
$
335,898

 
$
97,721

 
29
%
EBITDA (h)
$
245,066

 
$
220,640

 
$
24,426

 
11
%
EBITDA Margin (h)
28.7
%
 
28.7
%
 
N/A

 
%
 
 
Legend:
(a)
Represents interest expense less interest income.
(b)
Represents the total hammer price of property sold at auction plus buyer’s premium.
(c)
Represents the total hammer price of property sold at auction.
(d)
Represents total auction commission revenues as a percentage of Net Auction Sales.
(e)
Represents the total purchase price of property sold in private sales brokered by Sotheby’s, including its commissions.
(f)
Represents the sum of Aggregate Auction Sales, Private Sales, and Principal revenues.
(g)
Represents the average loan portfolio of Sotheby's Finance segment.
(h)
See “Use of Non-GAAP Financial Measures” and “Reconciliation of Non-GAAP Financial Measures” below.


27



Revenues
In 2013 and 2012, revenues consisted of the following (in thousands of dollars):
    
 
 
 
 
 
 
Favorable/(Unfavorable)
 
 
2013
 
2012
 
$ Change
 
% Change
Agency revenues:
 
 

 
 

 
 

 
 

Auction commissions
 
$
687,853

 
$
622,391

 
$
65,462

 
11
%
Private sale commissions
 
88,171

 
74,632

 
13,539

 
18
%
Auction guarantee and inventory activities
 
(2,186
)
 
(1,623
)
 
(563
)
 
(35
%)
Other Agency revenues*
 
19,801

 
21,831

 
(2,030
)
 
(9
%)
Total Agency revenues
 
793,639

 
717,231

 
76,408

 
11
%
Other revenues:
 
 

 
 

 
 

 
 

Principal
 
30,638

 
26,180

 
4,458

 
17
%
Finance
 
21,277

 
17,707

 
3,570

 
20
%
License fees
 
6,902

 
6,124

 
778

 
13
%
Other
 
1,222

 
1,250

 
(28
)
 
(2
%)
Total other revenues
 
60,039

 
51,261

 
8,778

 
17
%
Total revenues
 
$
853,678

 
$
768,492

 
$
85,186

 
11
%
*
Includes commissions and other fees earned by Sotheby's on sales brokered by third parties, fees charged to clients for catalogue production and insurance, catalogue subscription revenues, and advertising revenues.
Agency Revenues
Agency revenues increased $76.4 million (11%) in 2013 primarily due to a $65.5 million (11%) increase in auction commission revenues, as well as a $13.5 million (18%) increase in private sale commission revenues. See the discussion below for an explanation of the significant factors contributing to the increase in Agency revenues versus 2012.
Auction Commission Revenues—In its role as auctioneer, Sotheby’s accepts property on consignment and matches sellers (also known as consignors) to buyers through the auction process. Sotheby’s invoices the buyer for the purchase price of the property (including the commission owed by the buyer), collects payment from the buyer, and remits to the seller the net sale proceeds after deducting its commissions, expenses and applicable taxes and royalties. Sotheby’s auction commissions include those paid by the buyer (“buyer’s premium”) and those paid by the seller (“seller’s commission”) (collectively, “auction commission revenue”), both of which are calculated as a percentage of Net Auction Sales.
Auction commission revenues increased $65.5 million (11%) in 2013 due to a $529 million (14%) increase in Net Auction Sales offset by a decrease in Auction Commission Margin from 16.3% to 15.9%. See “Net Auction Sales” and “Auction Commission Margin” below for a more detailed discussion of these statistical metrics.
Net Auction Sales—Net Auction Sales increased $529.3 million (14%) in 2013 as a result of growth in a number of key collecting categories. Sales of Asian Art improved $257 million (44%) due to Sotheby's inaugural evening sale in Hong Kong, which took place in the fourth quarter of 2013 as part of the 40th anniversary celebration of Sotheby's Hong Kong, as well as an increase in other sales of Asian Art. Also contributing to the increase in Net Auction Sales versus the prior year are increased sales of Impressionist, Modern and Contemporary Art ($175 million) and Jewelry ($69 million).
 

28



Auction Commission Margin—Auction Commission Margin represents total auction commission revenues as a percentage of Net Auction Sales. Typically, Auction Commission Margin is higher for lower value works of art or collections, while higher valued property earns a lower Auction Commission Margin.
Auction Commission Margin may be adversely impacted by arrangements whereby Sotheby's shares its buyer's premium with a consignor in order to secure a high-value consignment. Auction Commission Margin may also be adversely impacted by the use of auction guarantees. For example, when issuing an auction guarantee, Sotheby's may enter into a risk and reward sharing arrangement with a counterparty whereby Sotheby's financial exposure under the auction guarantee is reduced in exchange for sharing its buyer's premium. Also, in situations when guaranteed property sells for less than the guaranteed price, Sotheby's buyer's premium from that sale is used to reduce the loss on the transaction. (See Note 18 of Notes to Consolidated Financial Statements for information related to Sotheby's use of auction guarantees.)
In order to enhance revenue and strengthen Auction Commission Margin, Sotheby's enacted a change to its buyer's premium rate structure that became effective on March 15, 2013. In salesrooms in the U.S., the buyer's premium was increased to 25% of the hammer price on the first $100,000; 20% of the hammer price above $100,000 up to and including $2,000,000; and 12% of any remaining amount over $2,000,000. In foreign salesrooms, with certain exceptions, these U.S. dollar thresholds were translated into an equivalent fixed local currency amount. Prior to March 15, 2013, in U.S. salesrooms, the buyer's premium rate structure was 25% of the first $50,000 of hammer price; 20% on the portion of hammer price above $50,000 up to and including $1 million; and 12% on any remaining amount over $1 million.
Auction Commission Margin decreased from 16.3% to 15.9% in 2013 principally due to competitive pressures which resulted in a higher level of buyer's premium shared with consignors. However, the impact of the competitive environment on Auction Commission Margin was mitigated to a large extent by the buyer's premium rate increase which contributed approximately $44.6 million in auction commission revenues.
Private Sale Commission Revenues—Private sale commission revenues are earned through the direct brokering of purchases and sales of art. Private sales are initiated either by a client wishing to sell property with Sotheby’s acting as its exclusive agent in the transaction, or by a prospective buyer who is interested in purchasing a certain work of art privately. Private sale commissions can vary from period to period, due in part to the timing of when sale transactions are initiated and completed. Private sale commission revenues increased $13.5 million (18%) in 2013 due to 30% growth in the aggregate value of transactions resulting from a higher volume of completed transactions and a higher average sales price per transaction.
Principal Revenues and Cost of Principal Revenues
Principal revenues includes proceeds from the sale of property that has been purchased opportunistically by Sotheby's, as well as revenues from the sale of Noortman Master Paintings (or "NMP") inventory. To a lesser extent, Principal revenues also include retail wine sales and commissions earned by NMP from the brokering of private art sales. The cost of Principal revenues includes the net book value of property sold during the period and any writedowns to the carrying value of Principal inventory.
In recent years, NMP was adversely impacted by shifts in the collecting tastes of its clients and faced increased challenges in sourcing and successfully selling the categories of Old Master Paintings that traditionally formed the heart of its business. In the third quarter of 2011, management initiated a plan to restructure NMP’s business and sales strategy, but those efforts were not successful in reversing this trend. As a result, on December 31, 2013, NMP’s remaining office in London was closed. Management is currently executing its sale plans for NMP’s remaining inventory. As of December 31, 2013, the carrying value of NMP's remaining inventory was $11.1 million.
The table below summarizes Principal revenues, the cost of Principal revenues, and the resulting gross profit for 2013 and 2012 (in thousands of dollars):
    
 
 
 
 
 
Favorable/(Unfavorable)
 
2013
 
2012
 
$ Change
 
% Change
Principal revenues
$
30,638

 
$
26,180

 
$
4,458

 
17
%
Cost of Principal revenues
(30,307
)
 
(21,118
)
 
(9,189
)
 
(44
%)
Principal gross profit
$
331

 
$
5,062

 
$
(4,731
)
 
(93
%)
In 2013, Principal segment results were significantly impacted by a $2.9 million increase in inventory writedowns largely resulting from $4.4 million in writedowns related to NMP. Also, although current year results include the sale of the most significant item in NMP's inventory, resulting in a gross profit of $1.6 million, the comparison of Principal segment results to the prior period is unfavorably impacted by a few significantly profitable sales of items purchased for investment purposes that were completed in the fourth quarter of 2012.

29



Finance Revenues
Finance revenues increased $3.6 million (20%) in 2013 due to a $97.7 million (29%) increase in the average loan portfolio balance, partially offset by a higher proportion of short-term non-interest bearing consignor advances outstanding during the period and a slight decrease in LIBOR, which is the base rate for interest-bearing loans. The growth in the loan portfolio is attributable to a number of factors, including an increase in client demand for art-related financing, the improved global reach of Sotheby's art-financing business, and an increase in term loans made to refinance clients' auction and private sale purchases. (See Note 5 of Notes to Consolidated Financial Statements for information related to Finance segment loans.)
(Note: For the purposes of MD&A, Finance revenues are presented on a consolidated basis and do not include intercompany revenues earned by the Finance segment from the Agency segment, which are eliminated in consolidation. See Note 4 of Notes to Consolidated Financial Statements.)
Expenses
In 2013 and 2012, expenses consisted of the following (in thousands of dollars):
 
2013
 
2012
 
Favorable / (Unfavorable)
 
$
 
% of total
 
$
 
% of total
 
$ Change
 
% Change
Agency direct costs
$
84,594

 
13
%
 
$
65,665

 
12
%
 
$
(18,929
)
 
(29
%)
Cost of Principal revenues
30,307

 
5
%
 
21,118

 
4
%
 
(9,189
)
 
(44
%)
Marketing
22,487

 
4
%
 
17,857

 
3
%
 
(4,630
)
 
(26
%)
Salaries and related
297,450

 
47
%
 
273,273

 
49
%
 
(24,177
)
 
(9
%)
General and administrative
176,830

 
28
%
 
158,220

 
29
%
 
(18,610
)
 
(12
%)
Depreciation and amortization
19,435

 
3
%
 
17,942

 
3
%
 
(1,493
)
 
(8
%)
Restructuring charges, net

 
%
 
(2
)
 
%
 
(2
)
 
100
%
Total expenses
$
631,103

 
 
 
$
554,073

 
 
 
$
(77,030
)
 
(14
%)
The increase in expenses in 2013 is largely due to an increase in the volume and the composition of Sotheby’s auction and private sales, costs associated with Sotheby’s multi-year strategic initiatives, and inflationary pressures across most expense categories. See the discussion below for an explanation of the significant factors impacting the comparison of each expense category between 2013 and 2012.
Management has recently completed a review of its cost structure and has identified opportunities for cost savings in 2014 across various categories of expenses including professional fees and other general and administrative expenses, auction direct costs, and marketing expenses. (See "Agency Direct Costs," "Marketing Expenses," and "General and Administrative Expenses" below for additional information. Also, see statement on Forward Looking Statements.)

30



Agency Direct Costs
In 2013 and 2012, Agency direct costs consisted of the following (in thousands of dollars):
 
 
2013
 
2012
Favorable/ (Unfavorable)
 
 
$
 
% of Net Auction Sales
 
$
 
% of Net Auction Sales
$ Change
 
% Change
Auction direct costs:
 
 
 
 
 
 
 
 
 
 
 
Sale marketing
 
$
32,946

 
0.76
%
 
$
26,160

 
0.69
%
$
(6,786
)
 
(26
%)
Shipping
 
12,912

 
0.30
%
 
10,816

 
0.28
%
(2,096
)
 
(19
%)
Sale venue
 
14,532

 
0.33
%
 
10,802

 
0.28
%
(3,730
)
 
(35
%)
Other
 
16,688

 
0.38
%
 
12,948

 
0.34
%
(3,740
)
 
(29
%)
Total auction direct costs
 
77,078

 
1.78
%
 
60,726

 
1.59
%
(16,352
)
 
(27
%)
Private sale expenses
 
7,516

 
 
 
4,939

 
 
(2,577
)
 
(52
%)
Total Agency direct costs
 
$
84,594

 
 
 
$
65,665

 
 
$
(18,929
)
 
(29
%)
See the discussion below for an explanation of the significant factors impacting the comparison of Agency direct costs between 2013 and 2012.
Auction Direct Costs—A large portion of auction direct costs relate to sale marketing expenses such as catalogue production and distribution, advertising and promotion costs, and traveling exhibition costs. To a lesser extent, auction direct costs also include the cost of shipping property, sale venue costs, and other direct costs such as debit and credit card processing fees. The level of auction direct costs incurred in a period is generally dependent upon the volume and composition of Sotheby's auction sale offerings. For example, direct costs attributable to auctions of single-owner or other high-value collections are typically higher than those associated with standard various-owner auctions, mainly due to higher promotional costs for catalogues, special events, and traveling exhibitions, as well as higher shipping expenses. Auction direct costs increased $16.4 million (27%) in 2013 primarily as a result of the level and composition of Sotheby's auction sales during the period.
Management expects to reduce auction direct costs as a percentage of Net Auction Sales by approximately 10 basis points in 2014 as a result of increased efficiencies and enhanced spending controls that will be implemented across all categories of spending. A reduction in the rate of spending of this magnitude would equate to approximately $5 million in savings, assuming a similar level of Net Auction Sales as 2013. (See statement on Forward Looking Statements.)
Private sale expenses—Private sale expenses consist largely of sale marketing and exhibition costs. Private sale expenses increased $2.6 million (52%) in 2013 due to an increase in the volume and value of transactions completed during the year, as well as an increase in the number of private sale exhibitions, due in part to the opening of Sotheby's S|2 gallery in London and exhibitions conducted in Beijing.
Marketing Expenses
Marketing expenses are costs related to the promotion of the Sotheby’s brand, consisting of costs associated with corporate marketing activities, client service initiatives, and strategic sponsorships of cultural institutions. Marketing expenses increased by $4.6 million (26%) in 2013 primarily due to an increase in sponsorships of museums and other cultural institutions, client engagement programs, and other brand promotion activities.
Management expects to reduce marketing expenses by approximately $4 million, or 17%, in 2014, reflecting a more targeted approach to spending on Sotheby’s core strategic priorities, including initiatives to engage its most important clients, outreach programs to clients in China and other new markets, museum sponsorships, and other donations. In addition, less strategic components of marketing expenses will be dramatically reduced or eliminated entirely. (See statement on Forward Looking Statements.)


31



Salaries and Related Costs
In 2013 and 2012, salaries and related costs consisted of the following (in thousands of dollars):
 
 
 
 
 
Favorable / (Unfavorable)
 
2013
 
2012
 
$ Change
 
% Change
Full-time salaries
$
142,503

 
$
133,214

 
$
(9,289
)
 
(7
%)
Incentive compensation expense
58,573

 
54,916

 
(3,657
)
 
(7
%)
Share-based payment expense
22,350

 
19,240

 
(3,110
)
 
(16
%)
Payroll taxes
21,992

 
20,319

 
(1,673
)
 
(8
%)
Employee benefits
32,415

 
24,541

 
(7,874
)
 
(32
%)
Labor union severance costs

 
4,375

 
4,375

 
100
%
Other compensation expense *
19,617

 
16,668

 
(2,949
)
 
(18
%)
Total salaries and related costs
$
297,450

 
$
273,273

 
$
(24,177
)
 
(9
%)
Statistical Metric:
 

 
 

 
 

 
 

Salaries and related costs as a % of revenues
34.8
%
 
35.6
%
 
N/A

 
2
%
*
Principally includes the cost of temporary labor and overtime, and expenses related to certain retention-based, new-hire, and other employment arrangements.
See the discussion below for an explanation of the significant factors impacting the comparison of the various elements of salaries and related costs between 2013 and 2012.
Full-Time Salaries—Full-time salaries increased $9.3 million (7%) in 2013 due to headcount and salary increases, which were implemented, in part, to support the growth of Sotheby's Hong Kong operations and the development of mainland China initiatives.
In 2014, management expects that full-time salaries will increase by approximately 7% to 8%, due to the full-year impact of mid-year strategic headcount and salary increases in 2013, as well as targeted salary increases that are expected to take effect in 2014. (See statement on Forward Looking Statements.)
Incentive Compensation—Incentive compensation principally includes the expense associated with cash payments made under Sotheby's incentive compensation program. The amount of incentive compensation awarded under this program is largely dependent upon the level of Sotheby's earnings, as measured by EBITDA, and is ultimately paid at the discretion of the Compensation Committee of the Board of Directors only after assessing Sotheby's full year financial results. In addition, incentive compensation includes amounts specifically awarded to employees for brokering certain eligible private sale transactions. Incentive compensation increased $3.7 million (7%) in 2013 due to the higher level of Sotheby's earnings relative to the prior year and an improvement in private sale commission revenues in the period.
Share-Based Payment Expense—Share-based payment expense consists of amortization expense related to performance-based equity compensation awards, restricted stock units, and stock options. Equity compensation awards are granted in the first quarter of the year principally in connection with Sotheby's incentive compensation program. Accordingly, the value awarded is generally dependent upon Sotheby’s financial results for the year prior to the grant date. The amount of compensation expense recognized for share-based payments is based on management’s estimate of the number of shares ultimately expected to vest as a result of employee service. In addition, for performance-based equity compensation awards, the amount and timing of expense recognition is significantly impacted by management’s quarterly assessment of the likelihood and timing of achieving certain profitability targets. Share-based payment expense increased $3.1 million (16%) in 2013, reflecting management's assessment of the likelihood that performance-based equity compensation awards will vest. (See Note 14 of Notes to Consolidated Financial Statements for additional information related to Sotheby’s share-based compensation programs.)

32



Employee Benefits—Employee benefits include the cost of Sotheby’s retirement plans and health and welfare programs, as well as certain employee severance costs. Sotheby’s material retirement plans include defined benefit and defined contribution pension plans for its employees in the U.K. and defined contribution and deferred compensation plans for its U.S. employees.
Generally, the amount of employee benefit costs recognized in a period is dependent upon headcount and overall compensation levels, as well as Sotheby’s financial performance. Additionally, the level of expense related to the U.K. Pension Plan, a defined benefit pension plan, is significantly influenced by interest rates, investment performance in the debt and equity markets, and various actuarial assumptions. Also, the amount recorded in a period for Sotheby’s Deferred Compensation Plan (the “DCP”) is dependent upon changes in the fair value of the DCP liability resulting from gains and losses in deemed participant investments. On a consolidated basis, the cost increases (decreases) related to the DCP liability are largely offset by market gains (losses) in the trust assets related to the DCP liability, which are reflected in the Consolidated Income Statements within other income (expense).
Employee benefit costs increased $7.9 million (32%) in 2013 due in part to a $3 million increase in non-union employee severance costs, which was primarily the result of the termination of certain senior employees during the year. The higher level of employee benefit costs is also attributable to the overall increase in headcount and compensation levels during the year, a $1.9 million improvement in DCP investment performance which increases employee benefit costs, and a $1.6 million decrease in the net credit associated with the U.K. Pension Plan due to the amortization of prior year actuarial losses.
In 2014, the net credit associated with the U.K. Pension Plan is expected to decrease by approximately $0.5 million primarily due to an increase in the required amortization of prior year actuarial losses. (See "Critical Accounting Estimates" above and statement on Forward Looking Statements.)
Labor Union Severance Costs—On May 31, 2012, Sotheby's and the union representing its property handlers agreed to a new collective bargaining agreement. In conjunction with the new collective bargaining agreement, Sotheby's offered severance benefits to the union members in exchange for the voluntary termination of their employment. The voluntary severance offer expired on July 20, 2012 with a total of 35 union members accepting, resulting in a charge of $4.4 million recognized in 2012. Management expects to recover a substantial portion of the total severance costs over the succeeding three years as a result of cost savings associated with the new labor agreement. (See statement on Forward Looking Statements.)
Other Compensation Expense—Other compensation expense typically includes the cost of temporary labor and overtime, as well as the amortization of expense related to certain retention-based, new-hire and other employment arrangements. Other compensation expense increased $2.9 million (18%) in 2013 primarily as a result of a higher level of expense associated with such employment arrangements.
General and Administrative Expenses
In 2013 and 2012, general and administrative expenses consisted of the following (in thousands of dollars):
 
 
 
 
 
 
Favorable / (Unfavorable)
 
 
2013
 
2012
 
$ Change
 
% Change
Professional fees
 
$
62,996

 
$
55,847

 
$
(7,149
)
 
(13
%)
Facilities-related expenses
 
46,920

 
45,127

 
(1,793
)
 
(4
%)
Travel and entertainment
 
30,788

 
27,706

 
(3,082
)
 
(11
%)
Telecommunication and technology
 
9,057

 
10,224

 
1,167

 
11
%
Insurance
 
6,252

 
5,832

 
(420
)
 
(7
%)
Other indirect expenses*
 
20,817

 
13,484

 
(7,333
)
 
(54
%)
Total general and administrative expenses
 
$
176,830

 
$
158,220

 
$
(18,610
)
 
(12
%)
* Other indirect expenses include costs related to client goodwill gestures and claims, uncollectible accounts, and other miscellaneous indirect costs.
See the discussion below for an explanation of the significant factors impacting the comparison of the various elements of general and administrative expenses between 2013 and 2012.



33



Professional fees—Professional fees principally include legal, audit and other compliance-related fees, Board of Director fees, and business consulting costs, as well as the costs associated with certain outsourced functions. Professional fees increased $7.1 million (13%) in 2013 largely due to a higher level of technology and other business consulting costs incurred in support of Sotheby's multi-year client service and business growth initiatives, most notably the enhancement of Sotheby's digital media offerings.
Management expects to reduce professional fees by approximately $9 million, or 15%, in 2014, principally as a result of negotiated reductions in rates and a reduced scope of services. Management also expects spending reductions of approximately $4 million across other categories of general and administrative expenses. (See statement on Forward Looking Statements.)
Facilities-related expenses—Facilities-related expenses principally include rent expense, real estate taxes and other costs related to the operation, security and maintenance of Sotheby's worldwide premises. Facilities-related expenses increased $1.8 million (4%) in 2013 primarily due to rent expense associated with Sotheby's new S|2 private sale exhibition gallery in London, as well as higher maintenance costs particularly for Sotheby's 1334 York Avenue headquarters in New York, where several significant repairs were necessary during the year. The increase in facilities-related expenses is partially offset by a $1 million decrease in security costs, as the prior year included costs incurred in order to minimize the business disruption associated with the lockout of Sotheby's unionized property handlers in New York, which ended on May 31, 2012.
Travel and entertainment—Travel and entertainment includes costs related to business travel by Sotheby's staff and client entertainment. Travel and entertainment expense increased $3.1 million (11%) in 2013 primarily due to increased travel in pursuit of business opportunities.
Other indirect expenses—Other indirect expenses include costs related to client goodwill gestures and claims, uncollectible accounts, and other miscellaneous indirect costs. Other indirect expenses increased $7.3 million (54%) in 2013 primarily due to a higher level of client goodwill gestures and claims, including a $1.7 million accommodation made to an irrevocable bid counterparty in the first quarter of 2013. The comparison to the prior year is also unfavorably impacted by a $1.4 million reduction to general and administrative expenses recorded in 2012 as a result of the reversal of a portion of Sotheby's liability for sales, use, and other indirect tax contingencies.
Net Interest Expense
Net interest expense decreased $3 million (7%) in 2013 primarily due to the repayment of Sotheby's 3.125% Convertible Notes (the "Convertible Notes") upon their maturity in June 2013, partially offset by incremental interest expense resulting from the September 2012 issuance of $300 million aggregate principal amount of 5.25% Senior Notes, due October 1, 2022 (the "2022 Senior Notes"). Also impacting the comparison of net interest expense to the prior period is $1 million of interest income recognized in the second quarter of 2013 upon the collection of a previously delinquent client account.
As part of its recently completed Capital Allocation and Financial Policy Review, management has established separate capital structures and financial policies for its Agency and Finance segments. The capital structure of the Finance segment will provide for the debt funding of loans through a dedicated revolving credit facility to reduce the cost of capital and enhance returns in support of efforts to achieve a targeted 20% return on equity. Accordingly, the level of interest charges that will be incurred in 2014 will be dependent, in part, on the level of debt funding of the Finance segment loan portfolio. (See "Capital Allocation and Financial Policy Review" and "Liquidity and Capital Resources." Also, see statement on Forward Looking Statements.)
Extinguishment of Debt
On November 23, 2012, Sotheby's redeemed all of its outstanding Senior Notes ($80 million) that were due in June 2015 (the "2015 Senior Notes") for a redemption price of $96.7 million, which included $2.7 million in accrued interest and a $14 million redemption premium. The redemption of the 2015 Senior Notes resulted in a loss of $15 million, which included the write-off of approximately $1 million in unamortized debt issuance costs and discounts. (See Note 10 of Notes to Consolidated Financial Statements for information related to Sotheby's long-term debt.)


34



Income Tax Expense
Sotheby's effective income tax rate was approximately 30% in 2013, compared to approximately 32.2% in 2012. The 2013 effective income tax rate was influenced by a number of factors. In the second quarter of 2013, a $6.8 million income tax benefit was recorded, net of a related liability recognized for uncertain tax benefits, for a worthless stock deduction Sotheby’s intends to claim on its 2013 U.S. federal income tax return related to the tax basis of a foreign subsidiary. Several developments occurred during 2013 that impacted the future value of this subsidiary, making it clear that Sotheby’s had met the criteria for claiming a worthless stock deduction in 2013. These developments included the revaluation of several significant items held in the subsidiary's inventory, as well as the decision to close the subsidiary’s remaining office. In addition, in the fourth quarter of 2013, net income tax expense of $8.7 million was recorded as a result of management’s decision to repatriate $250 million of accumulated foreign earnings of Sotheby’s subsidiaries in Switzerland ($120 million), the U.K. ($105 million), and Hong Kong ($25 million) to help fund a $300 million special dividend payable to shareholders in 2014. Management had intended that the $250 million in foreign earnings would be indefinitely reinvested outside of the U.S., and would therefore not be subject to U.S. income taxes, based on its projections and planned uses of foreign earnings. However, based on the conclusions reached in January 2014 as a result of the Capital Allocation and Financial Policy Review (see below), management and the Board of Directors determined that it is appropriate to repatriate these funds. The income tax expense that was recognized in the fourth quarter of 2013 as a result of this planned repatriation of foreign earnings was recorded net of the reversal of a valuation allowance against certain foreign tax credits which management determined were more likely than not to be realized as a result of the planned repatriation. (See Notes 11 and 12 of Notes to Consolidated Financial Statements.)
Based on current projections and planned uses of foreign earnings (including the planned repatriation discussed above), management believes that all other accumulated foreign earnings as of December 31, 2013 will be indefinitely reinvested outside of the U.S. and will not need to be repatriated to fund Sotheby’s U.S. operations or commitments. However, as a result of the Capital Allocation and Financial Policy Review concluded in January 2014 (see below) and current projections and planned uses of foreign cash balances, management has determined that, beginning in 2014, the current earnings of its foreign subsidiaries will not be indefinitely reinvested. As a result, the recognition of deferred taxes on such earnings will increase the 2014 effective income tax rate. (See statement on Forward Looking Statements.)
Sotheby's effective income tax rate is also influenced by the level and mix of earnings and losses by taxing jurisdiction in combination with the differences between the applicable U.S. and foreign tax rates. The impact of such changes could be meaningful in countries with statutory income tax rates that are significantly lower than the U.S. statutory income tax rate of 35%. This is particularly true in countries where Sotheby’s has significant auction operations, including the U.K., Hong Kong, and Switzerland, where the statutory income tax rates are approximately 23%, 17%, and 23%, respectively. In 2013, the pre-tax income related to the U.K., Hong Kong, and Switzerland was $28.8 million, $38.2 million, and $19.4 million, respectively, which cumulatively comprised 61% of foreign pre-tax income and 47% of consolidated pre-tax income. In 2012, pre-tax income related to the U.K., Hong Kong, and Switzerland was $55.3 million, $17.5 million, and $17.0 million, respectively, which cumulatively comprised 73% of foreign pre-tax income and 56% of consolidated pre-tax income.
American Taxpayer Relief Act of 2012—The American Taxpayer Relief Act of 2012 (the “U.S. Act”) was enacted on January 2, 2013. The U.S. Act, among other things, reinstated, retroactive to January 1, 2012, certain expired tax provisions relating to the U.S. tax treatment of deemed income earned by foreign subsidiaries. The change in tax law, including the retroactive effect, did not have a material impact on Sotheby’s 2013 results. The tax provisions relating to the U.S. tax treatment of deemed income earned by foreign subsidiaries have expired for all taxable years beginning after December 31, 2013. Unless extended retroactively, the expiration of these provisions could increase Sotheby’s effective tax rate beginning in 2014.
U.K. Finance Act 2013—The U.K. Finance Act 2013 (“the U.K. Act”) was enacted on July 17, 2013. The U.K. Act, among other things, reduced the U.K. statutory income tax rate from 23% to 21%, effective April 1, 2014, with a further reduction to 20% effective April 1, 2015. This legislation did not have a material impact on Sotheby's 2013 results and is not expected to have a material impact on Sotheby’s 2014 or 2015 results.
(See Part I, Item 1A, "Risk Factors," as well as Notes 11 and 12 of Notes to Consolidated Financial Statements)


35



Reconciliation of Non-GAAP Financial Measures
The following is a reconciliation of net income to EBITDA for 2013 and 2012 (in thousands of dollars):
 
2013
 
2012
Net income
$
130,006

 
$
108,292

Income tax expense
55,702

 
51,395

Income tax expense related to equity investees
12

 
132

Interest income
(2,801
)
 
(1,550
)
Interest expense
42,712

 
44,429

Depreciation and amortization
19,435

 
17,942

EBITDA
$
245,066

 
$
220,640

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011
This discussion should be read in conjunction with Note 4 of Notes to Consolidated Financial Statements, which provides financial information about Sotheby's segments.
Overview
In 2012, Sotheby’s reported net income of $108.3 million, a $63.1 million (37%) decrease when compared to 2011. This decrease was primarily attributable to a $79.4 million (11%) decline in auction commission revenues resulting from a 10% reduction in Net Auction Sales, as 2011 included an unprecedented level of sales from single-owner collections. The decline in auction commission revenues was partially offset by a $6.8 million (10%) improvement in private sale commission revenues due to higher transaction volume and a $5.7 million (47%) increase in Finance segment revenues attributable to increased demand for art-related financing and the improved global reach of Sotheby's art-financing business.
The comparison of 2012 net income to 2011 was also unfavorably impacted by a bond redemption loss of $15 million ($8.3 million after taxes) incurred in the fourth quarter of 2012, as well as a non-recurring $13.6 million tax benefit recognized in 2011 resulting from the reversal of a valuation allowance against certain of Sotheby's deferred tax assets.
See the discussion below for greater detail on the significant factors impacting Sotheby’s 2012 results and the comparison to 2011.

36



Results of Operations for the Years Ended December 31, 2012 and 2011
The table below presents a summary of Sotheby’s results of operations for 2012 and 2011, as well as a comparison between the two years (in thousands of dollars):
 
 
 
 
 
Favorable/(Unfavorable)
 
2012
 
2011
 
$ Change
 
% Change
Revenues:
 

 
 

 
 

 
 

Agency
$
717,231

 
$
791,738

 
$
(74,507
)
 
(9
%)
Principal
26,180

 
21,790

 
4,390

 
20
%
Finance
17,707

 
12,038

 
5,669

 
47
%
License fees
6,124

 
5,228

 
896

 
17
%
Other
1,250

 
1,042

 
208

 
20
%
Total revenues
768,492

 
831,836

 
(63,344
)
 
(8
%)
Expenses *
554,073

 
560,365

 
6,292

 
1
%
Operating income
214,419

 
271,471

 
(57,052
)
 
(21
%)
Net interest expense (a)
(42,879
)
 
(37,496
)
 
(5,383
)
 
(14
%)
Extinguishment of debt
(15,020
)
 
(1,529
)
 
(13,491
)
 
(882
%)
Other income (expense)
2,916

 
(1,057
)
 
3,973

 
N/A

Income before taxes
159,436

 
231,389

 
(71,953
)
 
(31
%)
Equity in earnings of investees, net of taxes
251

 
59

 
192

 
325
%
Income tax expense
51,395

 
60,032

 
8,637

 
14
%
Net income
$
108,292

 
$
171,416

 
$
(63,124
)
 
(37
%)
Statistical Metrics:
 

 
 

 
 

 
 
Aggregate Auction Sales (b)
$
4,473,625

 
$
4,986,639

 
$
(513,014
)
 
(10
%)
Net Auction Sales (c)
$
3,809,656

 
$
4,240,573

 
$
(430,917
)
 
(10
%)
Items sold at auction with a hammer price greater than $1 million
556

 
685

 
(129
)
 
(19
%)
Total hammer price of items sold at auction with a price greater than $1 million
$
2,128,199

 
$
2,307,648

 
$
(179,449
)
 
(8
%)
Auction Commission Margin (d)
16.3
%
 
16.6
%
 
N/A

 
(2
%)
Private Sales (e)
$
906,510

 
$
814,581

 
$
91,929

 
11
%
Consolidated Sales (f)
$
5,406,315

 
$
5,823,010

 
$
(416,695
)
 
(7
%)
Average Loan Portfolio (g)
$
335,898

 
$
219,785

 
$
116,113

 
53
%
EBITDA (h)
$
220,640

 
$
286,596

 
$
(65,956
)
 
(23
%)
EBITDA Margin (h)
28.7
%
 
34.5
%
 
N/A

 
(17
%)
 
 
Legend:
*
Expenses for 2011 include net restructuring charges of $4.8 million.
(a)
Represents interest expense less interest income.
(b)
Represents the total hammer price of property sold at auction plus buyer’s premium.
(c)
Represents the total hammer price of property sold at auction.
(d)
Represents total auction commission revenues as a percentage of Net Auction Sales.
(e)
Represents the total purchase price of property sold in private sales brokered by Sotheby’s, including its commissions.
(f)
Represents the sum of Aggregate Auction Sales, Private Sales, and Principal revenues.
(g)
Represents the average loan portfolio of Sotheby's Finance segment.
(h)
See “Use of Non-GAAP Financial Measures” and “Reconciliation of Non-GAAP Financial Measures” below.



37




Impact of Changes in Foreign Currency Exchange Rates
In 2012, changes in foreign currency exchange rates had a net unfavorable impact of approximately ($1.9) million on Sotheby's operating income principally due to a slight strengthening of the U.S. Dollar versus the Pound Sterling, as summarized in the following table (in thousands of dollars):
 
 
Favorable/(Unfavorable)
Total revenues
 
$
(9,608
)
Total expenses
 
7,721

Operating income
 
$
(1,887
)
Revenues
In 2012 and 2011, revenues consisted of the following (in thousands of dollars):
    
 
 
 
 
 
 
Favorable/(Unfavorable)
 
 
2012
 
2011
 
$ Change
 
% Change
Agency revenues:
 
 

 
 

 
 

 
 

Auction commissions
 
$
622,391

 
$
701,776

 
$
(79,385
)
 
(11
%)
Private sale commissions
 
74,632

 
67,848

 
6,784

 
10
%
Auction guarantee and inventory activities
 
(1,623
)
 
125

 
(1,748
)
 
N/A

Other Agency revenues *
 
21,831

 
21,989

 
(158
)
 
(1
%)
Total Agency revenues
 
717,231

 
791,738

 
(74,507
)
 
(9
%)
Other revenues:
 
 

 
 

 
 

 
 

Principal
 
26,180

 
21,790

 
4,390

 
20
%
Finance
 
17,707

 
12,038

 
5,669

 
47
%
License fees
 
6,124

 
5,228

 
896

 
17
%
Other
 
1,250

 
1,042

 
208

 
20
%
Total other revenues
 
51,261

 
40,098

 
11,163

 
28
%
Total revenues
 
$
768,492

 
$
831,836

 
$
(63,344
)
 
(8
%)
*
Includes commissions and other fees earned by Sotheby's on sales brokered by third parties, fees charged to clients for catalogue production and insurance, catalogue subscription revenues, and advertising revenues.
Agency Revenues
Agency revenues decreased $74.5 million (9%) in 2012 primarily due to a $79.4 million (11%) decline in auction commission revenues, partially offset by a $6.8 million (10%) increase in private sale commission revenues. See the discussion below for an explanation of the significant factors contributing to the decrease in Agency revenues versus 2011.
          Auction Commission Revenues—Auction commission revenues decreased $79.4 million (11%) due to a 10% decrease in Net Auction Sales and, to a much lesser extent, a decline in Auction Commission Margin. The decline in auction commission revenues in 2012 included the impact of unfavorable changes in foreign currency exchange rates, which contributed $8.1 million to the overall decrease. See “Net Auction Sales” and “Auction Commission Margin” below for a discussion of these statistical metrics.

38




Net Auction Sales—Net Auction Sales decreased $431 million (10%) in 2012 primarily due to a $464 million (58%) decline in sales attributable to single-owner collections, as 2011 included an unprecedented level of single-owner sales. Net Auction Sales were also unfavorably impacted by changes in foreign currency exchange rates, which contributed $42.8 million to the overall decrease. By major collecting category, the $431 million decrease in Net Auction Sales consisted of:
A $357 million (42%) decline in worldwide sales of Asian Art due to the decline in single-owner sales, as discussed above. The overall Net Auction Sales decrease in Asian Art was also likely influenced by a slowdown in the major economies of that region, in particular, China.
A $115 million (12%) improvement in sales of Contemporary Art. The auctions of Contemporary Art in New York in the fourth quarter of 2012 achieved $410 million, representing the highest two-day sale results ever at Sotheby's and an $85 million increase from the comparable sales conducted in the fourth quarter of 2011.
A $58 million (7%) improvement in sales of Impressionist and Modern Art. The auctions of Impressionist and Modern Art in New York in the second quarter of 2012 included the sale of Edvard Munch's The Scream for $107 million ($119.9 million, including buyer's premium).
A $193 million decline across a number of other collecting categories that included significant single-owner sales in 2011.
Auction Commission Margin—Auction Commission Margin decreased from 16.6% to 16.3% in 2012 principally due to sales mix, as there was a shift in the proportion of property sold in the various price bands of Sotheby's buyer's premium rate structure.
Private Sale Commission Revenues—Private sale commission revenues increased $6.8 million (10%) in 2012 due to an increase in the volume of sales transacted, particularly in the Contemporary Art collecting category.
Principal Revenues and Cost of Principal Revenues
The table below summarizes Principal revenues, the cost of Principal revenues, and the resulting gross profit (loss) for 2012 and 2011 (in thousands of dollars):
    
 
 
 
 
 
Favorable/(Unfavorable)
 
2012
 
2011
 
$ Change
 
% Change
Principal revenues
$
26,180

 
$
21,790

 
$
4,390

 
20
%
Cost of Principal revenues
(21,118
)
 
(23,738
)
 
2,620

 
11
%
Principal gross profit (loss)
$
5,062

 
$
(1,948
)
 
$
7,010

 
N/A

In 2012, Principal segment results improved significantly primarily due to a substantial decrease in the level of inventory writedowns, which totaled $1.9 million in 2012 and $8.4 million in 2011. The 2011 writedowns were almost entirely the result of a shift in the selling strategy of NMP, as well as a general weakening of the private dealer market for certain categories of lower valued Old Master Paintings and a shift in the collecting tastes of NMP's clients. Also contributing to the improvement in Principal segment results was a higher level of profitable sales of artwork purchased for investment purposes.
Finance Revenues
Finance revenues increased $5.7 million (47%) in 2012 due to a $116.1 million (53%) increase in the average loan portfolio balance. The growth in the loan portfolio was attributable to increased demand for art-related financing associated with client liquidity needs, the improved global reach of Sotheby's art-financing business, and an increase in loans made to refinance clients' auction and private sale purchases. (See Note 5 of Notes to Consolidated Financial Statements for information related to Finance segment loans.)
(Note: For the purposes of MD&A, Finance revenues are presented on a consolidated basis and do not include intercompany revenues earned by the Finance segment from the Agency segment, which are eliminated in consolidation. See Note 4 of Notes to Consolidated Financial Statements.)




39



License Fee Revenues
License fee revenues increased $0.9 million (17%) in 2012 primarily due to a $0.5 million brand development fee earned in the third quarter of 2012 in connection with a new master franchise agreement entered into by Realogy Corporation to develop the Sotheby's International Realty brand in Australia's New South Wales market.
Expenses
In 2012 and 2011, expenses consisted of the following (in thousands of dollars):
 
2012
 
2011
 
Favorable / (Unfavorable)
 
$
 
% of total
 
$
 
% of total
 
$ Change
 
% Change
Agency direct costs
$
65,665

 
12
%
 
$
69,507

 
12
%
 
$
3,842

 
6
%
Cost of Principal revenues
21,118

 
4
%
 
23,738

 
4
%
 
2,620

 
11
%
Marketing
17,857

 
3
%
 
15,059

 
3
%
 
(2,798
)
 
(19
%)
Salaries and related
273,273

 
49
%
 
268,530

 
48
%
 
(4,743
)
 
(2
%)
General and administrative
158,220

 
29
%
 
161,097

 
29
%
 
2,877

 
2
%
Depreciation and amortization
17,942

 
3
%
 
17,604

 
3
%
 
(338
)
 
(2
%)
Restructuring charges, net
(2
)
 
%
 
4,830

 
1
%
 
4,832

 
100
%
Total expenses
$
554,073

 
 
 
$
560,365

 
 
 
$
6,292

 
1
%
Agency Direct Costs
In 2012 and 2011, Agency direct costs consisted of the following (in thousands of dollars):
 
 
2012
 
2011
 
Favorable / (Unfavorable)
 
 
$
 
% of Net Auction Sales
 
$
 
% of Net Auction Sales
 
$ Change
 
% Change
Auction direct costs:
 
 
 
 
 
 
 
 
 
 
 
 
Sale marketing
 
$
26,160

 
0.69
%
 
$
27,425

 
0.65
%
 
$
1,265

 
5
%
Shipping
 
10,816

 
0.28
%
 
12,121

 
0.29
%
 
1,305

 
11
%
Sale venue
 
10,802

 
0.28
%
 
11,599

 
0.27
%
 
797

 
7
%
Other
 
12,948

 
0.34
%
 
14,273

 
0.34
%
 
1,325

 
9
%
Total auction direct costs
 
60,726

 
1.59
%
 
65,418

 
1.54
%
 
4,692

 
7
%
Private sale expenses
 
4,939

 
 
 
4,089

 
 
 
(850
)
 
(21
%)
Total Agency direct costs
 
$
65,665

 
 
 
$
69,507

 
 
 
$
3,842

 
6
%
Agency direct costs decreased $3.8 million (6%) in 2012, reflecting the level and composition of Sotheby's auction sales and changes in foreign currency exchange rates, which contributed $0.8 million to the overall decrease. The overall decrease in Agency direct costs was partially offset by a non-recurring $0.9 million recovery recognized in the second quarter of 2011 related to the sale of an object that was subject to a previous property loss claim, as well as a $0.9 million increase in private sale expenses that was mostly attributable to two selling exhibitions conducted in Hong Kong in 2012, for which there were no comparable costs in 2011.
Marketing Expenses
Marketing expenses increased $2.8 million (19%) in 2012 largely due to brand promotion and regional marketing activities in Asia. In particular, management continued to focus on developing the Sotheby's brand in China, where Sotheby's incurred marketing expenses of $1.2 million for a brand promotion campaign, $0.4 million for the promotion of its joint venture with Beijing GeHua Art Company prior to its formation, and $0.3 million to promote its new gallery and expanded premises in Hong Kong, which opened in the second quarter of 2012.

40



Salaries and Related Costs
In 2012 and 2011, salaries and related costs consisted of the following (in thousands of dollars):
    
 
 
 
 
 
Favorable / (Unfavorable)
 
2012