For the three and nine months ended September 30, 2005 and 2004, salaries and related costs consisted of the following (in thousands of dollars):
* Represents a change in excess of 100%.
** Principally includes the cost of temporary labor and overtime.
For the three months ended September 30, 2005, salaries and related costs are relatively unchanged when compared to the same period in the prior year, as higher costs for full-time salaries, payroll taxes, stock compensation, short-term labor and incentive bonus were almost entirely offset by reduced employee benefit costs and lower costs related to the Option Exchange program.
For the nine months ended September 30, 2005, salaries and related costs increased $4.7 million, or 4%, to $130.3 million, when compared to the same period in the prior year. This increase is largely attributable to higher full-time salaries and stock compensation expense, as well as increased incentive bonus and employee benefit costs. The increase in salaries and related costs for the period is partially offset by lower costs related to the Option Exchange program.
See discussion below for a more detailed explanation of each of these factors.
Full-Time Salaries—For the three and nine months ended September 30, 2005, full-time salaries increased $0.9 million, or 4%, to $24.7 million, and $2.5 million, or 3%, to $75.3 million, respectively, when compared to the same periods in the prior year. These increases are principally due to limited salary and headcount increases in 2005. Also impacting the comparison to the prior year is the unfavorable impact of foreign currency translations, which increased full-time salaries by $0.8 million for the nine months ended September 30, 2005.
Incentive Bonus Costs—For the three and nine months ended September 30, 2005, incentive bonus costs increased approximately $0.4 million to $0.8 million, and $1.3 million, or 9%, to $15.9 million, respectively, when compared to the same periods in the prior year. The increase in incentive bonus costs for the three months ended September 30, 2005 is attributable to the higher level of private sale activity during the current quarter. The increase in incentive bonus costs for the nine months ended September 30, 2005 is attributable to the Company’s financial performance through the first nine months of the year.
Employee Benefit Costs—For the three months ended September 30, 2005, employee benefit costs decreased $1.3 million, or 22%, to $4.5 million, when compared to the same period in the prior year. This decrease is primarily due to approximately $1.4 million in severance costs incurred in the third quarter of 2004 for which there was no comparable event in the current period, partially offset by an increase of $0.3 million in costs related to the Company’s U.K. defined benefit pension plan (see Note 9 of Notes to Consolidated Financial Statements under Part I, Item 1 “Financial Statements”).
For the nine months ended September 30, 2005, employee benefit costs increased $0.3 million, or 2%, to $15.1 million, when compared to the same period in the prior year. The higher level of employee benefit costs for the period is primarily due to an increase of $1.4 million in costs related to the Company’s U.K. defined benefit pension plan (see Note 9 of Notes to Consolidated Financial Statements under Part I, Item 1 “Financial Statements”). To a lesser extent, the increases in employee benefit costs are attributable to incremental profit-sharing costs of $0.6 million related to the Company’s U.S. pension plans, reflecting the Company’s financial performance for the first nine months of 2005. In the prior year, certain contributions to the Company’s U.S. pension plans were determined as a fixed percentage of an employee’s eligible compensation rather than via a profit-sharing formula. Also unfavorably impacting the comparison to the prior year are increased health and welfare benefit costs in the U.K. and increased headcount. The overall increase in employee benefit costs for the period is largely offset by a $2.0 million decrease in severance costs primarily related to headcount reductions in Continental Europe in 2004, for which there were no comparable events in the current period.
As disclosed in the Company’s Form 10-K for the year ended December 31, 2004, during the three-year period from 2000 to 2002, actual asset returns earned by the U.K. defined benefit pension plan were less than management’s assumed rate of return on plan assets, principally contributing to unrecognized net losses of approximately $77.5 million as of December 31, 2004. These unrecognized losses are being systematically recognized as an increase in future net periodic pension expense in accordance with Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions.” In 2006, management anticipates an increase in the range of $1.3 million to $2.3 million in costs related to the U.K. defined benefit pension plan principally due to higher amortization of such unrecognized losses. (See statement on Forward Looking Statements.)
Stock Compensation Expense—For the three and nine months ended September 30, 2005, stock compensation expense related to restricted stock shares granted pursuant to the Sotheby’s Holdings, Inc. 2003 Restricted Stock Plan (excluding shares issued in conjunction with the Exchange Offer discussed below) increased $0.7 million and $2 million, respectively, when compared to the same periods in the prior year. These increases are primarily due to the amortization of stock compensation expense associated with grants of 276,000 and 33,250 restricted shares on February 7, 2005 and August 2, 2005, respectively. Stock compensation expense related to restricted stock shares granted pursuant to the Sotheby’s Holdings, Inc. 2003 Restricted Stock Plan (excluding shares issued in conjunction with the Exchange Offer discussed below) is expected to be approximately $3.7 million for the year ended December 31, 2005.
33
Option Exchange Program—In February 2003, the Compensation Committee approved an exchange offer of cash or restricted stock for certain stock options held by eligible employees under the 1997 Stock Option Plan (the “Exchange Offer”). The Exchange Offer was tendered during the first half of 2004.
Compensation expense related to the Exchange Offer decreased $0.9 million, or 48%, to $0.9 million, and $2.3 million, or 39%, to $3.6 million, for the three and nine months ended September 30, 2005, respectively, when compared to the same periods in the prior year. For the three months ended September 30, 2005, the decrease in compensation expense related to the Exchange Offer is principally attributable to lower amortization of stock compensation expense related to the issuance of approximately 1.1 million shares as a result of the Exchange Offer, the expense relating to which is being amortized over a graded four-year vesting period. For the nine months ended September 30, 2005, the comparison of compensation expense related to the Exchange Offer to the prior year is also significantly influenced by $2.2 million of expense recognized in the first quarter of 2004 representing the full cash payment made to employees upon acceptance of the Exchange Offer on March 31, 2004, for which there is no comparable event in the current period.
The amortization of stock compensation expense related to the Exchange Offer is expected to be approximately $4.6 million, $2.5 million and $1.2 million for the years ended December 31, 2005, 2006 and 2007, respectively.
General and Administrative Expenses
For the three months ended September 30, 2005, general and administrative expenses decreased $1.4 million, or 5%, to $27.4 million. This decrease is largely attributable to a $1 million reduction in professional fees and a $0.6 million reduction in insurance premiums as a result of a favorable claims history. The comparison of general and administrative expenses to the prior year is also favorably impacted by improved bad debt experience, as well as $0.5 million in settlement costs related to a legal claim recognized in the third quarter of 2004 for which there was no comparable event in the current period. The overall decrease in general and administrative expenses for the period is partially offset by a $1 million recovery of previously paid U.K. real estate taxes recognized in the third quarter of 2004, for which there was no comparable event in the current period.
For the nine months ended September 30, 2005, general and administrative expenses increased $6.1 million, or 8%, to $85.2 million. This increase is largely attributable to the following factors:
| • | An insurance recovery of approximately $4 million recorded in the second quarter of 2004, for which there was no comparable event in 2005. |
| • | An increase of $1.2 million in property taxes related to the Company’s headquarters building at 1334 York Avenue in New York as a result of a tax reassessment that became effective on July 1, 2004. |
| • | An increase of $1.2 million in travel and entertainment costs principally due to the higher level of travel for pursuing business opportunities during 2005. |
| • | An increase of $1.1 million in professional fees principally related to the timing of the Company’s compliance efforts for Section 404 of the Sarbanes-Oxley Act. |
| • | An increase of $1.1 million in other professional fees partially due to fees incurred as a result of outsourcing management of the Company’s catalogue production operations in the U.S. |
| • | The $1 million recovery of previously paid U.K. real estate taxes recognized in the third quarter of 2004, for which there was no comparable event in the current period (as discussed above). |
| • | An increase of $0.8 million in facilities related costs. |
34
The overall increase in general and administrative expenses for the nine-month period is partially offset by the following factors:
| • | A $0.8 million reduction in insurance premiums, as discussed above. |
| • | A $0.8 million decrease in settlement administration costs and legal fees associated with certain civil antitrust litigation (see Notes 1 and 12 of Notes to Consolidated Financial Statements in Part I, Item 1, “Financial Statements”). |
| • | $0.5 million in settlement costs related to a legal claim in the third quarter of 2004, for which there was no comparable event in the current period (as discussed above). |
For the nine months ended September 30, 2005, general and administrative expenses were also favorably influenced by $2.2 million in transaction costs incurred in 2004 related to the consummation of the Company’s agreement with Cendant to license the Sotheby’s International Realty trademark (see Note 4 of Notes to Consolidated Financial Statements in Part I, Item 1, “Financial Statements”). There were no comparable fees incurred in the current year.
Depreciation Expense
Depreciation and amortization expense decreased $0.6 million, or 10%, to $5.5 million and $0.8 million, or 5%, to $16.7 million for the three and nine months ended September 30, 2005, respectively, when compared to the same periods in the prior year principally due to accelerated depreciation recognized in the third quarter of 2004 for assets retired as a result of the consolidation of the Company’s New York warehouse space into its headquarters building at 1334 York Avenue in New York. To a lesser extent, these decreases are also related to the timing of capital spending.
Net Interest Expense
For the three and nine months ended September 30, 2005, net interest expense decreased $0.8 million, or 11%, to $7.1 million, and $3.6 million, or 15%, to $20 million, respectively, when compared to the same periods in the prior year. These improvements are largely attributable to increases of $0.7 million and $2.8 million, respectively, in interest income resulting from significantly higher average cash balances and short-term investments, as well as higher interest rates due in part to a change in investment composition. To a lesser extent, the decrease in net interest expense versus the prior periods is attributable to lower amortization of the discount related to the Antitrust fine and settlement (see Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”).
The overall decrease in net interest expense for the third quarter of 2005 was partially offset by $0.4 million in interest expense associated with borrowings outstanding during the period under the Company’s revolving credit facility. The Company had no outstanding credit facility borrowings during the third quarter of 2004.
(See “Liquidity and Capital Resources” below.)
Termination of GE Capital Credit Agreement
As discussed in more detail under “Liquidity and Capital Resources” below, on September 7, 2005, in connection with the Transaction described above under “Recapitalization Transaction,” the Company terminated its senior secured credit agreement with General Electric Capital Corporation (the “GE Capital Credit Agreement”). As a result of the termination of the GE Capital Credit Agreement, the Company incurred a $1 million termination fee and wrote off approximately $1.9 million in arrangement fees and other direct costs related to the GE Capital Credit Agreement, which were previously being amortized over the term of the agreement. These charges are combined and reflected as a separate caption in the Consolidated Income Statements for the three and nine months ended September 30, 2005. (See Note 8 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
35
Provision for Income Taxes
The effective tax rate related to continuing operations for the third quarter of 2005 and 2004 is approximately 33%. The effective tax rates related to continuing operations for the first nine months of 2005 and 2004 are approximately 32% and approximately 35%, respectively. The overall decrease in the effective tax rate in 2005 from 2004 is primarily driven by the tax rate differential between the U.S. and foreign jurisdictions as more of the Company’s earnings arose overseas in jurisdictions with tax rates lower than the U.S., as well as a $3.9 million benefit arising from the release of the valuation allowance related to the Company’s U.S. Federal tax operating loss carryovers during the third quarter of 2005. These items are partially offset by an additional provision of $2.9 million related to foreign and state and local tax matters. (See Note 16 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
In October 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act creates a temporary incentive for the Company to repatriate earnings accumulated outside the U.S. by allowing the Company to reduce its taxable income by 85% of certain eligible dividends received from non-U.S. subsidiaries by the end of 2005 at an effective tax rate of 5.25%.
As of September 30, 2005, the Company had not yet finalized its plan for repatriation of foreign earnings. Accordingly, the Company has not yet adjusted its income tax expense and balance sheet as of September 30, 2005 to reflect the effect of the new repatriation provision.
On November 7, 2005, the Company’s Chief Executive Officer and Board of Directors approved a domestic reinvestment plan to repatriate up to $72 million of foreign earnings under the Act during the fourth quarter of 2005. The Company will determine the amount to be repatriated and the associated tax cost of such repatriation during the fourth quarter of 2005. The repatriation will conclude by December 31, 2005. Planned uses of the repatriated funds include domestic expenditures relating to capital asset costs and investments, as well as other permitted activities.
Discontinued Operations
For information related to Discontinued Operations, see Note 4 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”
FINANCIAL CONDITION AS OF SEPTEMBER 30, 2005
This discussion should be read in conjunction with the Company’s Consolidated Statements of Cash Flows (see Part I, Item 1, “Financial Statements”).
For the nine months ended September 30, 2005, total cash and cash equivalents decreased $107.9 million primarily due to the factors discussed below.
Net cash used by operations of $133.9 million for the nine months ended September 30, 2005 is due in part to:
| • | A $28.6 million decrease in accounts payable, accrued liabilities and other liabilities. |
| • | A $15.6 million net increase in inventory principally due to investments made during the first nine months of 2005 ($13.7 million), partially offset by the impact of sales during the period. Also contributing to the overall increase in inventory was property relating to auction guarantees that did not sell at auction during the spring 2005 auction season ($5.8 million). |
| • | The funding of a $15 million discretionary contribution to the Company’s U.K. defined benefit pension plan in May 2005 (see Note 9 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”). |
| • | The funding of $12 million of the fine payable to the DOJ in February 2005 and the redemption of $4.3 million in vendor’s commission discount certificates (see Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”). |
Net cash used by operations was significantly influenced by a $320.5 million decrease in amounts due to consignors, partially offset by a $222.8 million decrease in accounts receivable, both principally due to the timing and settlement of auction sales in the fourth quarter of 2004 and first nine months of 2005. The impact of these net cash outflows from operations is also partially offset by the collection of $12.5 million in cash due from the Company’s partner in an auction guarantee as well as the Company’s income from continuing operations of $11 million during the period.
Net cash provided by investing activities of $72.1 million for the nine months ended September 30, 2005 is largely due to $433.2 million in proceeds received from the maturity of short-term investments during the period and, to a lesser extent, the collection of $105.9 million in client loans, a $12 million decrease in restricted cash and $3.4 million in distributions received from an equity investee. These investing cash inflows are partially offset by the funding of $323.2 million in short-term investments, the funding of $152.7 million in new client loans and $6.6 million in capital expenditures.
Net cash used by financing activities of $45.6 million for the nine months ended September 30, 2005 is principally due to the purchase by the Company of 6,934,158 shares of Class B Stock for $168.4 million in cash in connection with the transaction described under “Recapitalization” above and in Note 3 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”. The impact of this transaction on cash outflows from financing activities is partially offset by $120 million of credit facility borrowings (of which $100 million was used to fund a portion of the stock purchase described in the previous sentence) and, to a much lesser extent, $4.8 million in proceeds received from the exercise of stock options.
36
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The following table summarizes the Company’s material contractual obligations and commitments as of September 30, 2005:
| | Payments Due by Period | |
| | Total | | Less Than
One Year | | 1 to 3
Years | | 3 to 5
Years | | After
5 Years | |
| | (Thousands of dollars) | |
Principal payments on borrowings: | | | | | | | | | | | | | | | | |
Credit facility borrowings (1) | | $ | 120,000 | | $ | – | | $ | – | | $ | 120,000 | | $ | – | |
Long-term debt (2) | | | 100,000 | | | – | | | – | | | 100,000 | | | – | |
Sub-total | | | 220,000 | | | – | | | – | | | 220,000 | | | – | |
| | | | | | | | | | | | | | | | |
Interest payments on borrowings: | | | | | | | | | | | | | | | | |
Credit facility borrowings (1) | | | 408 | | | 408 | | | – | | | – | | | – | |
Long-term debt (2) | | | 23,490 | | | 6,875 | | | 13,750 | | | 2,865 | | | – | |
Sub-total | | | 23,898 | | | 7,283 | | | 13,750 | | | 2,865 | | | – | |
| | | | | | | | | | | | | | | | |
Other commitments: | | | | | | | | | | | | | | | | |
York Property capital lease | | | 393,441 | | | 18,949 | | | 38,574 | | | 40,912 | | | 295,006 | |
Operating lease obligations | | | 81,468 | | | 14,097 | | | 23,603 | | | 13,755 | | | 30,013 | |
DOJ antitrust fine (3) | | | 15,000 | | | 15,000 | | | – | | | – | | | – | |
Employment agreements (4) | | | 4,271 | | | 3,214 | | | 1,057 | | | – | | | – | |
Sub-total | | | 494,180 | | | 51,260 | | | 63,234 | | | 54,667 | | | 325,019 | |
Total | | $ | 738,078 | | $ | 58,543 | | $ | 76,984 | | $ | 277,532 | | $ | 325,019 | |
(1) | Represents the outstanding principal and approximate interest payments related to the Company’s credit facility borrowings. Interest payments are due at short-term intervals. (See Note 8 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”) |
(2) | Represents the aggregate outstanding principal and semi-annual interest payments due on the Company’s long-term debt. (See Note 8 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”) |
(3) | Represents the remaining fine payable to the Antitrust Division of the U.S. Department of Justice (the “DOJ”). (See Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”) |
(4) | Represents the remaining commitment for future salaries as of September 30, 2005 related to employment agreements with a number of employees, excluding incentive bonuses. (See Note 10 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”) |
The vendor’s commission discount certificates (the “Discount Certificates”) that were distributed in conjunction with the settlement of certain civil antitrust litigation (see Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”) are fully redeemable in connection with any auction that is conducted by the Company or Christie’s International, PLC (“Christie’s”) in the U.S. or in the U.K. The Discount Certificates may be used to satisfy consignment charges involving vendor’s commission, risk of loss and/or catalogue illustration. The Discount Certificates will expire on May 14, 2008 and cannot be redeemed subsequent to that date; however, any unused Discount Certificates may be redeemed for cash at their face value at any time between May 15, 2007 and May 14, 2008. As of September 30, 2005, the outstanding face value of unused Discount Certificates that the Company could be required to redeem was $52.6 million.
37
(See “Off-Balance Sheet Arrangements” below for information on auction guarantees and lending commitments.)
OFF-BALANCE SHEET ARRANGEMENTS
Auction Guarantees
From time to time in the ordinary course of business, the Company will guarantee to consignors a minimum price in connection with the sale of property at auction. The Company must perform under its auction guarantee only in the event that the property sells for less than the minimum price and, therefore, the Company must pay the difference between the sale price at auction and the amount of the auction guarantee. If the property does not sell, the amount of the auction guarantee must be paid, but the Company has the right to recover such amount through future sale of the property. Generally, the Company is entitled to a share of the excess proceeds if the property under the auction guarantee sells above a minimum price. In addition, the Company is obligated under the terms of certain guarantees to advance a portion of the guaranteed amount prior to the auction. In certain situations, the Company reduces its financial exposure under auction guarantees through sharing arrangements with unaffiliated third parties.
As of September 30, 2005, the Company had outstanding auction guarantees totaling $73.1 million, the property relating to which had a mid-estimate sales price (1) of $79.6 million. The Company’s financial exposure under these auction guarantees is reduced by $8 million as a result of sharing arrangements with unaffiliated third parties. The property related to such auction guarantees is being offered at auctions in the fourth quarter of 2005 and the first quarter of 2006. As of September 30, 2005, $36.2 million of the guaranteed amount had been advanced by the Company and its partners, of which the Company has recorded its $34 million share of these advances within notes receivable and consignor advances and $2.2 million within other assets representing amounts funded by the Company on behalf of its partners. (See Note 6 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
As of November 4, 2005, the Company had outstanding auction guarantees totaling $62.4 million, the property relating to which had a mid-estimate sales price (1) of $67.1 million. The Company’s financial exposure under these auction guarantees is reduced by $13.3 million as a result of sharing arrangements with unaffiliated third parties. The property related to such auction guarantees is being offered at auctions in the fourth quarter of 2005 and the first half of 2006. As of November 4, 2005, $30.6 million of the guaranteed amount had been advanced by the Company and its partners, of which the Company will record its $28.4 million share of these advances within Notes Receivable and Consignor Advances and $2.2 million within Other Assets representing amounts funded by the Company on behalf of its partners.
| (1) | The mid-estimate sales price is calculated as the average of the low and high pre-sale auction estimates for the property under the auction guarantee. Pre-sale estimates are not always accurate predictions of auction sale results. |
(See Note 11 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
Lending Commitments
In certain situations, the Company’s Finance segment enters into legally binding arrangements to lend, primarily on a collateralized basis and subject to certain limitations and conditions, to potential consignors and other individuals who have collections of fine art or other objects. Unfunded commitments to extend additional credit were approximately $11.6 million at September 30, 2005. (See Note 10 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
38
DERIVATIVE INSTRUMENTS
The Company utilizes forward exchange contracts to manage exposures related to foreign currency risks, which primarily arise from short-term foreign currency denominated intercompany balances. Generally, such intercompany balances are centrally managed by the Company’s global treasury function. The Company’s objective for holding derivative instruments is to minimize foreign currency risks using the most effective methods to eliminate or reduce the impacts of these exposures.
The forward exchange contracts entered into by the Company are used as economic cash flow hedges of the Company’s exposure to short-term foreign currency denominated intercompany balances. Such forward exchange contracts are typically short-term with settlement dates no more than one month from their inception. These contracts are not designated as hedging instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, and are recorded in the Consolidated Balance Sheets at fair value, which is based on referenced market rates. Changes in the fair value of the Company’s forward exchange contracts are recognized currently in earnings and are generally offset by the revaluation of the underlying intercompany balances in accordance with SFAS No. 52, “Foreign Currency Translation.”
CONTINGENCIES
Legal Actions—The Canadian Competition Bureau is continuing to conduct an investigation regarding anti-competitive practices relating to commissions charged by the Company and Christie’s for auction services during the period 1993 to 2000. The Company also becomes involved, from time to time, in various claims and lawsuits incidental to the ordinary course of its business.
Management does not believe that the outcome of any of the pending claims or proceedings described above will have a material adverse effect on the Company’s business, results of operations, financial condition and/or liquidity.
Gain Contingency — During the third quarter of 2004, the Company signed an agreement for the sale of land and buildings at Billingshurst, West Sussex in the U.K. (the “Sussex Property”). The completion of the sale is conditional upon the receipt of planning permission for redevelopment of part of the site. If completed, the sale of the Sussex Property would result in a pre-tax gain of approximately $5 million. The Company is not certain when this contingency will be resolved.
(See Note 10 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
39
LIQUIDITY AND CAPITAL RESOURCES
On September 7, 2005, in connection with the Transaction described under “Recapitalization” above, the Company terminated the GE Capital Credit Agreement, which provided for borrowings of up to $200 million through an international syndicate of lenders and was originally available through March 4, 2007.
As a result of the termination of the GE Capital Credit Agreement, the Company incurred a $1 million termination fee and wrote off approximately $1.9 million in arrangement fees and other direct costs related to the GE Capital Credit Agreement, which were previously being amortized over the term of the agreement. These charges are combined and reflected as a separate caption in the Consolidated Income Statements for the three and nine months ended September 30, 2005.
On September 7, 2005, also in connection with the Transaction described under “Recapitalization” above, the Company entered into a new senior secured credit agreement with an international syndicate of lenders arranged by Banc of America Securities LLC (“BofA”) and LaSalle Bank N.A. (the “BofA Credit Agreement”). The BofA Credit Agreement provides for borrowings of up to $200 million through a revolving credit facility. The BofA Credit Agreement also provides for the ability to increase the amount of available borrowings by $50 million to $250 million on a one-time basis. As of October 31, 2005, the Company received commitments from new lenders for an additional $40 million and expects to close on the full $50 million of additional commitments by the end of November 2005. The amount of borrowings available at any time under the BofA Credit Agreement is limited to a borrowing base, which is generally equal to 100% of eligible loans made by the Company (i.e., notes receivable and consignor advances) plus 15% of the Company’s net tangible assets (calculated as total assets less current liabilities, goodwill, unamortized debt discount and eligible loans). As of September 30, 2005, the amount of unused borrowing capacity available under the BofA Credit Agreement was $25.8 million, consisting of a borrowing base of $145.8 million less $120 million in borrowings outstanding on that date. Such outstanding borrowings are classified as long-term liabilities in the Consolidated Balance Sheet as of September 30, 2005. As of October 31, 2005, the amount of unused borrowing capacity available under the BofA Credit Agreement was $70 million, consisting of a borrowing base of $200 million less $130 million in borrowings outstanding on that date.
The BofA Credit Agreement is available through September 7, 2010; provided that in the event that any of the $100 million in long-term debt securities (the “Notes”) issued by the Company in February 1999 (as discussed in more detail in Note 8 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”) are still outstanding on July 1, 2008, then either: (a) the Company shall deposit cash in an amount equal to the aggregate outstanding principal amount of the Notes on such date into an account in the sole control and dominion of BofA for the benefit of the lenders and the holders of the Notes or (b) the Company shall have otherwise demonstrated its ability to redeem and pay in full the Notes; otherwise the BofA Credit Agreement shall terminate and all amounts outstanding thereunder shall be due and payable in full on July 1, 2008.
Borrowings under the BofA Credit Agreement are available to be used to: (a) finance in part the Transaction and related fees and expenses and (b) provide ongoing working capital and for other general corporate purposes of the Company.
The Company’s obligations under the BofA Credit Agreement are secured by substantially all of the assets of the Company, as well as the assets of its subsidiaries in the U.S. and the U.K.
The BofA Credit Agreement contains financial covenants requiring the Company not to exceed a maximum level of capital expenditures and dividend payments (as discussed in more detail below) and to have a quarterly interest coverage ratio of not less than 2.0 and a quarterly leverage ratio of not more than: (i) 4.0 for quarters ending September 30, 2005 to September 30, 2006, (ii) 3.5 for quarters ending December 31, 2006 to September 30, 2007 and (iii) 3.0 for quarters ending December 31, 2007 and thereafter. The maximum level of annual capital expenditures permitted under the BofA Credit Agreement is $15 million through 2007 and $20 million thereafter with any unused amounts carried forward to the following year. Dividend payments, if any, must be paid solely out of 40% of the Company’s net income arising after June 30, 2005 and computed on a cumulative basis. The BofA
40
Credit Agreement also has certain non-financial covenants and restrictions. The Company is in compliance with its covenants.
At the option of the Company, any borrowings under the BofA Credit Agreement generally bear interest equal to: (i) LIBOR plus 1.75%, or (ii) 0.5% plus the higher of the Prime Rate or the Federal Funds Rate plus 0.5%. During the three months ended September 30, 2005, no amounts were outstanding under the GE Capital Credit Agreement, and the weighted average interest rate charged on outstanding borrowings under the BofA Credit Agreement was approximately 5.5%.
The Company paid underwriting and structuring fees of $2.6 million related to the BofA Credit Agreement, which are being amortized on a straight-line basis to interest expense over the term of the facility.
The Company generally relies on operating cash flows supplemented by borrowings to meet its liquidity requirements. The Company currently believes that operating cash flows, current cash balances and borrowings available under the BofA Credit Agreement will be adequate to meet its presently contemplated or anticipated short-term and long-term commitments, operating needs and capital requirements through September 7, 2010. Additionally, as a result of the liquidity provided by the BofA Credit Agreement, management expects to continue to look for opportunities to expand the client loan portfolio of the Company’s Finance segment. (See statement on Forward Looking Statements.)
Due to potential funding requirements for new client loans, as well as decreased cash balances resulting from funding the Transaction described under “Recapitalization” above, the Company expects to have a higher level of outstanding revolving credit facility borrowings in the foreseeable future, when compared to recent past periods. Therefore, the Company expects to periodically borrow amounts under the BofA Credit Agreement in order to potentially fund new client loans and meet peak seasonal working capital requirements. As a result of these factors, management anticipates an increased level of net interest expense for the fourth quarter of 2005 and for 2006. (See statement on Forward Looking Statements.)
The Company’s short-term operating needs and capital requirements include peak seasonal working capital requirements, other short-term commitments to consignors, the funding of the Finance segment’s client loan portfolio and the funding of capital expenditures, as well as the short-term commitments to be funded prior to October 1, 2006 included in the table of contractual obligations above.
The Company’s long-term operating needs and capital requirements include peak seasonal working capital requirements, the funding of the Finance segment’s client loan portfolio and the funding of capital expenditures, as well as the funding of the Company’s presently contemplated or anticipated long-term contractual obligations and commitments included in the table of contractual obligations above through September 7, 2010.
In addition to the short-term and long-term operating needs and capital requirements described above, the Company is obligated to fund the redemption of the Discount Certificates distributed in conjunction with the settlement of certain civil litigation related to the investigation by the DOJ (see Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”). As discussed above, the Discount Certificates are fully redeemable in connection with any auction that is conducted by the Company or Christie’s in the U.S. or the U.K. The Discount Certificates may be used to satisfy consignment charges involving vendor’s commission, risk of loss and/or catalogue illustration. The Discount Certificates will expire on May 14, 2008 and cannot be redeemed subsequent to that date; however, any unused Discount Certificates may be redeemed for cash at their face value at any time between May 15, 2007 and May 14, 2008. As of September 30, 2005, the outstanding face value of unused Discount Certificates that the Company could be required to redeem was approximately $52.6 million.
41
FACTORS AFFECTING OPERATING RESULTS AND LIQUIDITY
Operating results from the Company’s Auction and Finance segments, as well as the Company’s liquidity, are significantly influenced by a number of factors, many of which are not within the Company’s control. These factors, which are not ranked in any particular order, include:
| • | The overall strength of the international economy and financial markets and, in particular, the economies of the U.S., the U.K., and the major countries or territories of Continental Europe and Asia (principally Japan and China); |
| • | Interest rates, particularly with respect to the Finance segment’s client loan portfolio and the Company’s credit facility borrowings; |
| • | The impact of political conditions in various nations on the international economy and financial markets; |
| • | Government laws and regulations which the Company is subject to, including, but not limited to, import and export regulations, cultural patrimony laws and value added taxes; |
| • | The effects of foreign currency exchange rate movements; |
| • | The seasonality of the Company’s auction business; |
| • | Competition with other auctioneers and art dealers, specifically in relation to the following factors: |
| (a) | The level and breadth of expertise of the dealer or auction house with respect to the property; |
| (b) | The extent of the prior relationship, if any, between the seller and the firm; |
| (c) | The reputation and historic level of achievement by a firm in attaining high sale prices in the property’s specialized category; |
| (d) | The desire for privacy on the part of sellers and buyers; |
| (e) | The amount of cash offered by a dealer, auction house or other purchaser to purchase the property outright; |
| (f) | The level of auction guarantees or the terms of other financial options offered by auction houses or dealers; |
| (g) | The level of pre-sale estimates offered by auction houses; |
| (h) | The desirability of a public auction in order to achieve the maximum possible price; |
| (i) | The amount of commission proposed by dealers or auction houses to sell a work on consignment; |
| (j) | The cost, style and extent of presale marketing and promotion to be undertaken by a firm; |
| (k) | Recommendations by third parties consulted by the seller; |
| (l) | Relationships and personal interaction between the seller and the firm’s staff; and |
| (m) | The availability and extent of related services, such as tax or insurance appraisal and short-term financing; |
| • | The amount of quality property being consigned to art auction houses (and, in particular, the number of single-owner sale consignments), as well as the ability of the Company to sell such property, both of which factors can cause auction and related revenues to be highly variable from period-to-period; |
| • | The demand for fine arts, decorative arts and collectibles; |
42
| • | The success of the Company in attracting and retaining qualified personnel, who have or can develop relationships with certain potential sellers and buyers; |
| • | The success of the Company in retaining key members of management; |
| • | The demand for art-related financing; |
| • | The value of the Company’s inventory; |
| • | The uncertainty in future costs related to the Company’s U.K. defined benefit pension plan, as well as the impact of any decline in the equity markets or unfavorable changes in interest rates on plan assets and obligations; and |
| • | The impact of the variability in taxable income between the various jurisdictions where the Company does business on its effective tax rate. |
FUTURE IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2004, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 123(R), “Share-Based Payment.” SFAS No. 123(R) requires the recognition of compensation expense equal to the fair value of stock options or other share-based payments. Under SFAS No. 123(R), the Company would have been required to implement the standard as of July 1, 2005. In April 2005, the Securities and Exchange Commission (the “SEC”) announced the adoption of a new rule that amended the compliance date for SFAS No. 123(R). The new rule will allow the Company to implement SFAS No. 123(R) as of January 1, 2006. The Company will adopt SFAS No. 123(R) using the modified prospective method, which will result in the amortization of stock compensation expense related to unvested stock options outstanding on the date of adoption, as well as any stock options granted subsequent to that date. The Company expects the adoption of SFAS No. 123(R) to result in the recording of compensation expense in the range of $0.5 million to $1.2 million in 2006 related to unvested stock options outstanding on the date of adoption.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting and reporting of a change in accounting principle and error corrections. SFAS No. 154 applies to all voluntary changes in accounting principle, as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Starting in 2006, the Company will apply the provisions of SFAS No. 154 on a prospective basis when applicable.
The Company has adopted the provisions of FASB Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” According to FSP No. 109-2, the Company is allowed time beyond the financial reporting period of enactment to evaluate the effects of the Act on its plan for repatriation of foreign earnings for purposes of applying SFAS No. 109, “Accounting for Income Taxes.” As of September 30, 2005, the Company had not yet finalized its plan for repatriation of foreign earnings. Accordingly, as provided for in FSP No. 109-2, the Company had not yet adjusted its income tax expense and balance sheet as of September 30, 2005 to reflect the effect of the new repatriation provision. As discussed in more detail above under “Provision for Income Taxes,” on November 7, 2005, the Company’s Chief Executive Officer and Board of Directors approved a domestic reinvestment plan to repatriate up to $72 million of foreign earnings under the Act during the fourth quarter of 2005.
OTHER MATTERS
On November 7, 2005, the Company amended Sections 1.03 and 1.07 of its Amended and Restated By-Laws to: (1) eliminate the ability of shareholders holding at least 25% of the Company’s outstanding stock to call special meetings of shareholders and (2) to provide that the Chairman, rather than a majority of the shareholders present at a shareholder meeting, may adjourn the meeting. The amendments also include certain technical corrections that primarily reflect the elimination of all outstanding shares of Class B Stock as part of the Transaction discussed under “Recapitalization” above. A copy of the Company’s Amended and Restated By-Laws reflecting the foregoing amendments is filed as Exhibit 3.1 to this Form 10-Q.
43
FORWARD LOOKING STATEMENTS
This Form 10-Q contains certain forward looking statements, as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended, relating to future events and the financial performance of the Company. Such statements are only predictions and involve risks and uncertainties, resulting in the possibility that the actual events or performance will differ materially from such predictions. Major factors which the Company believes could cause the actual results to differ materially from the predicted results in the forward looking statements include, but are not limited to, the factors listed above under “Factors Affecting Operating Results and Liquidity”, which are not ranked in any particular order.
44
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company continually evaluates its market risk associated with its financial instruments and forward exchange contracts during the course of its business. The Company’s financial instruments include cash and cash equivalents, restricted cash, notes receivable, consignor advances, revolving credit facility borrowings, long-term debt, the fine payable to the DOJ and the settlement liability related to the Discount Certificates issued in connection with certain civil antitrust litigation (see Note 12 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements”).
At September 30, 2005, a hypothetical 10% strengthening or weakening of the U.S. dollar relative to all other currencies would result in a decrease or increase in cash flow of approximately $6.6 million. Excluding the potential impact of this hypothetical strengthening or weakening of the U.S. dollar, the market risk of the Company’s financial instruments has not changed significantly as of September 30, 2005 from that set forth in the Company’s Form 10-K for the year ended December 31, 2004.
At September 30, 2005, the Company had $104.4 million of notional value forward exchange contracts outstanding. Notional amounts do not quantify risk or represent assets or liabilities of the Company, but are used in the calculation of cash settlements under such contracts. The Company is exposed to credit-related losses in the event of nonperformance by the two counterparties to its forward exchange contracts, but the Company does not expect any counterparties to fail to meet their obligations given their high credit ratings.
ITEM 4: CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of September 30, 2005, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) were effective as of September 30, 2005.
Changes in Internal Control over Financial Reporting
There was no change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
45
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
The Canadian Competition Bureau is continuing to conduct an investigation regarding anti-competitive practices relating to commissions charged by the Company and Christie’s for auction services during the period 1993 to 2000.
The Company also becomes involved, from time to time, in various claims and lawsuits incidental to the ordinary course of its business.
Management does not believe that the outcome of any of the pending claims or proceedings described above will have a material adverse effect on the Company’s business, results of operations, financial condition and/or liquidity.
(See Note 10 of Notes to Consolidated Financial Statements under Part I, Item 1, “Financial Statements.”)
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
| 3.1 | Amended and Restated By-Laws of Sotheby’s Holdings, Inc., as amended through November 7, 2005 |
| 10.1 | Transaction Agreement by and among Sotheby’s Holdings, Inc., and The Investors, dated as of September 7, 2005 |
| 10.2 | Credit Agreement, dated as of September 7, 2005, among Sotheby’s, Inc., as the Company, Sotheby’s Holdings, Inc., as Holdings, Certain U.K. Subsidiaries of Holdings, Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, LaSalle Bank N.A., as Syndication Agent, and The Other Lenders Party Hereto, Banc of America Securities LLC and LaSalle Bank N.A., as Joint Lead Arrangers and Joint Book Managers |
| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| (i) | On August 8, 2005, the Company filed a current report on Form 8-K under Item 2.02, “Results of Operations and Financial Condition,” and Item 9.01, “Financial Statements and Exhibits.” |
| (ii) | On September 8, 2005, the Company filed a current report on Form 8-K under Item 1.01, “Entry into a Material Definitive Agreement,” Item 1.02 “Termination of a Material Definitive Agreement,” Item 2.03 “Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement of a Registrant,” and Item 5.02, “Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers.” |
| (iii) | On September 13, 2005, the Company filed a current report on Form 8-K under Item 3.01, “Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing” and Item 5.03, “Amendments to Articles of Incorporation or By-Laws; Change in Fiscal Year.” |
46
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | SOTHEBY’S HOLDINGS, INC. |
| | By: |
/s/ Michael L. Gillis
|
| | | Michael L. Gillis
Senior Vice President,
Controller and Chief
Accounting Officer |
| | | |
| | Date: | November 7, 2005 |
47
Exhibit Index
Exhibit No. | | Description |
3.1 | | Amended and Restated By-Laws of Sotheby’s Holdings, Inc., as amended through November 7, 2005 |
10.1 | | Transaction Agreement by and among Sotheby’s Holdings, Inc., and The Investors, dated as of September 7, 2005 |
10.2 | | Credit Agreement, dated as of September 7, 2005 among Sotheby’s, Inc., as the Company, Sotheby’s Holdings, Inc., as Holdings, Certain U.K. Subsidiaries of Holdings, Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, LaSalle Bank N.A., as Syndication Agent, and The Other Lenders Party Hereto, Banc of America Securities LLC and LaSalle Bank N.A., as Joint Lead Arrangers and Joint Book Managers |
31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
32.1 | | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
32.2 | | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
48
