Yahoo May Be A Nice Way To Participate In The Alibaba IPO

| About: Yahoo! Inc. (YHOO)

Yahoo Alibaba

One of the most highly anticipated IPOs is Alibaba, the Chinese equivalent of a wholesaler's Amazon (NASDAQ:AMZN). Ever wonder where people get those HDMI cables that sell for $5.00 on AMZN? Or that must-have action figure of Psy, the South Korean rapper whose hit "Gangnam" style has taken the world by storm? You got it, Alibaba, the one-stop-shop for wholesalers. Yahoo (NASDAQ:YHOO) purchased 40% of Alibaba back in 2005 for $1 billion. Just recently they sold half of their holdings for $7.6 billion. That works out to be a compounded rate of return of 47.5% before tax, and values Alibaba at around $38 billion. YHOO, being subject to a 40% tax rate, will keep $4.3 billion, and has promised to return that money to shareholders. Unfortunately, depending on how the IPO is executed, most people may not have access to the IPO. Terms and date of the IPO have yet to be released, but it is never too early to start planning.

YHOO has retained a 20% share in Alibaba, and provides an investor a way to indirectly participate in the Alibaba IPO. Currently Alibaba is valued at $38 billion. YHOO is currently worth $23 billion; $8.3 billion or 36% of its capitalization is the after-tax worth of their Alibaba holdings and net cash from their recent sale. Remove the Alibaba contributions, and YHOO is really worth $14.7 billion. A solid IPO could easily move the stock price of YHOO.

How then would an investor take advantage of this situation?

1) Understand the valuations. Alibaba is currently valued at $38 billion. If the initial press releases regarding the IPO point to a higher valuation, expect the price of YHOO to respond accordingly. If the valuation is less than $38 billion, it may be best to wait until after the IPO and buy Alibaba in the open market.

2) If the investor is confident that the Alibaba IPO is going to be the next Chipotle (NYSE:CMG) or Google (NASDAQ:GOOG), they may want to either buy YHOO directly, or buy call options on YHOO.

3) If the investor thinks Alibaba is going to be the next Facebook (NASDAQ:FB), and collapse immediately after the IPO, one could sell short or buy puts on YHOO.

Assuming Alibaba is going to be the next GOOG, my preferred approach would be to buy out-of-the-money call options with an expiration date at or just past the IPO. Ideally the IPO would be on the expiration date of the option in order to minimize the wasting time value priced into the options. If one doesn't want to take delivery of YHOO stock in that situation, they would have to sell their options during the day before they expire. If Alibaba is getting a lot of press and/or IPO price is increased due to overwhelming demand, one may want to buy the options further in advance of the IPO in anticipation that YHOO will start to discount the optimism. If the press is quiet about the IPO, it is best to wait until shortly before the IPO to minimize the time value.

One additional note to set expectations. Just because YHOO holds 20% of Alibaba, don't expect a 10% move in Alibaba to move the price of YHOO by 2%, it most likely will be closer to 1.2%, the after tax net return YHOO would get if they sold their holdings of Alibaba. Using this metric however one can build expectations of the impact the IPO will have on YHOO's stock price. If Alibaba is priced at $10 for the IPO but opens at $20, one should expect YHOO to jump by 12%. At the time of this writing, YHOO trades at $19.66, and Feb13 $20 calls go for $0.06. A 12% move would result in a stock price of $22.02, and the call option would be worth $2.02. Not bad for a $0.06 investment a few days before the IPO.

Another way to analyze this would be by the book value. Right now the Alibaba holdings represent a net $4.3 billion to YHOO, or about $3.68 per share. Doubling that would theoretically add another $3.68 to the price of YHOO stock, making the above investment even more attractive.

A note of caution is that if this trade turns against YHOO, the investor would lose 100%, as their options would expire worthless. If that is too much risk to take, it is best to either buy YHOO stock or buy Alibaba in the open market.

If one wants to see how a stock performs based upon its holdings of another company,, they can track Rentech (NYSEMKT:RTK) and Rentech Nitrogen (NYSE:RNF). RTK holds 61% of RNF. RNF has a capitalization of $1.88 billion, 61% of which is $1.146 billion. RTK only has a capitalization of $680 billion, so it trades at a $466 million discount to its holdings of RNF. Clearly the tax treatment disrupts the $1 for $1 valuing of these companies. One can also run a comparative graph to see how the two stocks trend together.

In conclusion, it is never too early to start planning. The Alibaba IPO is almost certain to be one of the more high profile IPOs when it finally comes to fruition. This article highlights a strategy an investor can follow if they don't have access to the IPO. I plan to do a follow-up article once the IPO details are released. Until then, all we can do is plan and strategize on how best to approach this IPO... and have sweet dreams of riding a magic carpet ride all the way to the bank.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am long RTK. I do not own Yahoo, but may execute the discussed option strategy shortly before the IPO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.