OPERATIONS

Sotheby's Business

Sotheby’s is a global art business whose operations are organized under three segments: Agency, Principal, and Finance. The Agency segment earns commissions by matching buyers and sellers of authenticated fine art, decorative art, and jewelry (collectively, “art” or “works of art” or “artwork” or "property") through the auction or private sale process. The Principal segment earns revenues from the sale of artworks that have been purchased opportunistically by Sotheby’s. The Finance segment earns interest income through art-related financing activities by making loans to certain collectors and dealers that are secured by works of art.

The global art market is influenced over time by the overall strength and stability of the global economy, the financial markets of various countries, geopolitical conditions and world events, all of which may impact the willingness of potential buyers and sellers to purchase and sell art. In addition, the amount and quality of art consigned for sale is influenced by other factors not within Sotheby’s control, and many consignments often become available as a result of the death or financial or marital difficulties of the owner. These factors cause the supply and demand for works of art to be unpredictable and may lead to significant variability in Sotheby's revenues from period to period.

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, a privately held, French-owned, auction house. In response to the competitive environment, Sotheby’s may offer consignors a variety of financial inducements such as auction commission sharing arrangements and auction guarantees as a means to secure high-value consignments. Although these inducements may lead to a higher level of auction consignments, they put pressure on auction commission margins, and auction guarantees introduce the possibility of incurring a loss on the transaction and reduced liquidity if the underlying property fails to sell at the minimum guaranteed price. To mitigate the pressure on auction commission margins, from time-to-time Sotheby’s adjusts its commission rate structures. In addition, Sotheby’s may reduce its financial exposure under auction guarantees through contractual risk and reward sharing arrangements such as irrevocable bids under which a counterparty commits to bid a predetermined price on the guaranteed property.

Sotheby's is a service business in which the ability of its employees to source high-value works of art and develop and maintain relationships with potential sellers and buyers of works of art is essential to its success. Sotheby's business is highly dependent upon attracting and retaining qualified personnel and employee compensation is its most substantial operating expense. Sotheby’s also incurs significant costs to promote, conduct, and complete its auctions, as well as general and administrative expenses to support its global operations. While a large portion of Sotheby’s expenses are fixed, certain categories of expense are variable, with sale marketing costs dependent upon the volume of auction activity and certain elements of employee compensation a function of Sotheby’s profitability.

Industry Trends

In late 2009, the global art market began a period of expansion that has resulted in some of the most profitable years in Sotheby’s history, and the art market has remained strong to date. A significant driver of the expansion of the global art market and Sotheby’s profitability during this period has been the growth of the Contemporary and Asian art markets, as well as increased demand for art from clients in China and other emerging markets across several collecting categories.

As the global art market has grown, the value of the property sold by Sotheby's has increased and the competitive environment between Sotheby’s and Christie’s has intensified. These factors have resulted in a decline in auction commission margins over the past few years, with the competitive environment for high-value consignments causing an increase in the use of auction commission sharing arrangements and an increase in the use of auction guarantees, sometimes without the protection of irrevocable bids.

To help mitigate the recent decline in auction commission margins, in March 2013 and again in February 2015, management enacted increases in Sotheby’s buyer’s premium rate structure. (See "Auction Commission Margin" within the discussion of Agency segment results below.)

To further leverage the growth of the global art market witnessed in recent years, Sotheby’s has developed its presence in emerging markets and implemented initiatives to grow private sales. In the emerging markets, Sotheby’s has deepened its relationships with Chinese art collectors by implementing regional marketing initiatives, investing in new staff with requisite skills to service Asian clients, and expanding its facilities in Hong Kong. Elsewhere, Sotheby’s has pursued opportunities in emerging markets such as Russia, the Middle East, and South America. In the private sales arena, over the past several years, Sotheby’s has committed additional management and specialist talent and opened dedicated private sale exhibition galleries in New York, London and Hong Kong, branded as S|2 and focused on selling Contemporary Art.

Along with the recent growth in the global art market and Sotheby’s revenues, operating expenses also increased. In response, in late 2013, management completed a review of its cost structure and identified opportunities for cost savings in 2014 across various categories of expense including auction direct costs, marketing expenses, professional fees and other categories of general and administrative expense. In addition, throughout 2014, management took other actions resulting in incremental cost savings within these categories of expense. Furthermore, in July 2014, Sotheby's announced a restructuring plan, which has resulted in staff reductions, the majority of savings from which are being reinvested through the addition of new staff in collecting categories and activities with the highest growth opportunity in the future. Management estimates that the reinvestment in various growth initiatives in 2015, along with expected increases in the cost of doing business, will result in a net increase in expenses when compared to 2014. (See "Management's Cost Control Programs" below and statement on Forward Looking Statements.)

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 represented 79% and 83% of total Net Auction Sales in 2014 and 2013, 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 the second and fourth quarters. Consequently, first and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters and, typically, a net loss 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 25 of Notes to Consolidated Financial Statements for Sotheby's quarterly results for the years ended December 31, 2014 and 2013.)

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.

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.)

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, and the timing of any such sale; (ii) 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 (iii) 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 Sotheby's commission. 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, 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. (See Note 5 of Notes to Consolidated Financial Statements for information related to accounts receivable.)

(3) 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 those related to the discount rate, the expected long-term rate of return on plan assets, future inflation, future annual compensation increases, and mortality, which are reviewed and updated, as appropriate, 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 as of December 31, 2013 that was used to calculate the $0.7 million net pension benefit recorded in 2014 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, 2014 , the discount rate used to calculate the $381.9 million benefit obligation was 3.5% . A hypothetical increase or decrease of 0.1% in this assumption would result in a decrease or increase in the benefit obligation of approximately $7.4 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 best estimate of annualized long-term 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. Where funds are actively managed, 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 $0.7 million net pension benefit recorded in 2014 was 6.1% . 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 $1 million.

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 $0.7 million net pension benefit recorded in 2014 was 4.6% . 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, 2014 , the assumption for future annual compensation increases used to calculate the $381.9 million benefit obligation was 4.1% . A hypothetical increase or decrease of 0.25% in this assumption would result in an increase or decrease in the benefit obligation of approximately $2.1 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% increase or decrease in life expectancies would result in an increase or decrease in net pension cost of approximately $0.6 million. Additionally, a hypothetical 5% increase or decrease in life expectancies would result in an increase or decrease in the benefit obligation of approximately $4.5 million.

As of December 31, 2014 and 2013 , 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 approximately ($44) million and ($38.6) 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 ($9.8) million after-tax net loss incurred in 2014 is the result of a decrease in the discount rate from 4.4% to 3.5%, partially offset by a better than expected return on plan assets and a decrease in the assumption for expected future inflation.

In periods when 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 over the average expected remaining service period of active plan participants, which is approximately 11.7 years. It is expected that approximately $3.2 million ($4 million, pre-tax) of the ($44) million after-tax net loss related to the U.K. Pension Plan will be recognized as a component of the net pension expense for the year ended December 31, 2015 . (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.)

As of December 31, 2014, Sotheby's had net deferred tax assets of $47.4 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 $2.2 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 could prove more difficult to support the realization of these deferred tax assets. As a result, an additional valuation allowance could 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.

Accounting for income taxes requires that incremental income taxes on the undistributed earnings of foreign subsidiaries be accounted for as a deferred tax liability unless management can assert that those earnings are indefinitely reinvested outside of the U.S. Beginning in 2014, the current earnings of Sotheby's foreign subsidiaries are not considered by management to be indefinitely reinvested outside of the U.S., and a deferred tax liability for incremental income taxes has been recorded on those earnings. However, Sotheby’s has not recognized a deferred tax liability for incremental income taxes on the undistributed foreign earnings generated prior to 2014 which management has determined to be indefinitely reinvested outside the U.S. The determination that foreign earnings are indefinitely reinvested is based on estimates and judgments of projected cash flow needs, as well as the working capital and investment requirements of Sotheby’s foreign and domestic subsidiaries. Material changes in Sotheby’s estimates of cash, working capital, and investment needs in the various jurisdictions in which it operates could require repatriation of foreign earnings previously considered to be indefinitely reinvested, which would be subject to incremental income taxes and applicable non-U.S. income and withholding taxes.

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, 2014, Sotheby’s liability for unrecognized tax benefits, excluding interest and penalties, was $22.8 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.

(See discussion of “Income Tax Expense” below, as well as Notes 10 and 11 of Notes to Consolidated Financial Statements.)

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013

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 2014 , Sotheby’s reported operating income of $226 million , which represents a $3.5 million ( 2% ) increase when compared to 2013, as current year results include $41.8 million in charges associated with shareholder activism, restructuring, and CEO transition. Excluding these items, Sotheby's reported Adjusted Operating Income ^* of $267.9 million , representing a $43.9 million ( 20% ) improvement over the prior year. The improvement in Adjusted Operating Income ^* reflects the continuing strength of the global art market, with Agency segment revenues improving $31.5 million ( 4% ). Also favorably impacting the comparison to the prior year are a number of cost reduction initiatives implemented by management throughout 2014. These initiatives resulted in a lower ratio of auction direct costs as a percentage of Net Auction Sales, savings in general and administrative and marketing expenses, and also helped contain full-time salary costs.

In 2014 , Sotheby’s reported net income of $117.8 million , which represents a $12.2 million (9%) decrease when compared to 2013, as current year results include the impact of the charges noted in the previous paragraph. Excluding these items, Sotheby's reported Adjusted Net Income ^* of $142.4 million , representing an $11.6 million ( 9% ) improvement over the prior year. As discussed in more detail below under "Income Tax Expense," the comparison of Sotheby's after-tax results to the prior year is significantly influenced by the effective income tax rate for the period, which increased from 30% to approximately 39%.

See the discussion below for greater detail on the significant factors impacting Sotheby’s 2014 results and the comparison to 2013 .

Outlook

The global art market continues to reflect strong demand and high prices. In this strong market, the competitive environment for high-value consignments is robust and auction commission margins remain under pressure.

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Results of Operations for the Years Ended December 31, 2014 and 2013

The table below presents a summary of Sotheby’s consolidated results of operations for 2014 and 2013 , as well as a comparison between the two years (in thousands of dollars):