Yahoo's Alibaba Holdings Should Make For An Interesting 2014

| About: Yahoo! Inc. (YHOO)

The very first article I wrote for Seeking Alpha was about Yahoo's (NASDAQ:YHOO) Alibaba holding, and how it would likely affect YHOO's stock price as more data came to light. Talk about beginner's luck, that article couldn't have been more prophetic. At the time I wrote the article, YHOO was trading at $19.66/share and Alibaba was being valued at $38 billion.

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...At the time of this writing, YHOO trades at $19.66

YHOO currently trades at $41.23, having gained more than 100% since last February when I wrote the original article. The original thesis was that the markets were grossly undervaluing Alibaba, and that over time, as more analysts looked into the issue, the estimates of Alibaba would increase.

I did a followup article in March, and estimates for YHOO and Alibaba were already on the rise.

"The analysts raised their target price for YHOO to $26 from $21, after adjusting the Alibaba/YHOO Japan valuation on new disclosures."...Alibaba's valuation has probably risen to $55 billion from the $40 billion at which the company raised capital back in Q3 of last year, writes DiClemente, increasing the value to YHOO! by $2.23 billion to $8.98 billion.

The trend of increasing estimates for YHOO and Alibaba continued throughout the entire year. By October, valuations for Alibaba were scratching $120 billion.

Yahoo Inc's plan to keep a larger-than-expected stake in e-commerce giant Alibaba after the Chinese company's IPO prompted at least seven brokerages to raise their stock price targets on the U.S. company." ..The amended sale agreement with Alibaba ... coupled with our view that the IPO will price closer to our previously assigned $120 billion value (for Alibaba).

By October the estimates were between $100 and $200 billion dollars.

Instead, it's the stake in Asian Internet businesses that have YHOO investors excited. Most speculate the Alibaba IPO will unleash a $100 billion internet giant - with some valuing the company as high as $200 billion by the end of 2014.

In December the Wall Street Journal highlighted how Alibaba and YHOO Japan were basically all the value in YHOO. Without those "glitzy" assets, YHOO was more like an old-technology print media company.

But when Alibaba completes its initial public offering, expected next year, investors must ask whether Yahoo still is worth owning without its glitzy wardrobe...Analysts say Yahoo's core business should be valued at around four to six times 2014 Ebitda-more like a print media asset.

The WSJ also reports estimates between $100 and $190 Billion.

It is difficult to say where that business trades now because so much rests on Alibaba's IPO. Estimates of Alibaba's value range from $100 billion to $190 billion. To complicate calculations, Yahoo must sell 40% of its stake at the IPO, with the rest to be sold at its discretion, theoretically for more if Alibaba's stock rises...In one scenario, UBS estimates Alibaba will list at a $100 billion valuation, which will then climb to $160 billion.

It is the last part of that quote that makes this trade/investment so interesting. Back when I wrote my first article, the estimates for Alibaba were $38 billion, now the estimates are over 2.5x higher for the IPO, with an expected 60% gain once it hits the secondary market. The high end of the estimates would have a 100% pop post IPO. The uncertainty this creates presents a trading opportunity. The trading opportunity remains unchanged from the time I detailed it in the first article.

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.

I should have said "assuming Alibaba is going to be the next Amazon (NASDAQ:AMZN)" not Google (NASDAQ:GOOG), but the concept remains unchanged. The market will start to discount the price of Alibaba's IPO into the price of YHOO. That has been occurring all last year. The problem is, all that can be discounted are estimates, there are no hard and fast numbers to analyze yet. Once the preliminary IPO numbers are released, the markets will have more visibility, and the price of YHOO will adjust accordingly.

My expectation is that the first trial balloon will place the Alibaba IPO around $100 billion, which seems to be the market's expectation right now. Like FB, I would expect the initial offer to get substantially oversubscribed, and the IPO price will be boosted with the next trial balloon.

Facebook Inc's record initial public offering is already oversubscribed,...Analysts say the company, which is seeking to raise about $10.6 billion by selling more than 337 million shares at $28 to $35 apiece, may raise that price range if demand turns out to be healthy enough.

Even after a few adjustments to the IPO price, I would still expect Alibaba to go public at a discount. The reason is simple, Alibaba has a worldwide following. Almost anyone that has an internet store is aware of Alibaba. If you want to open a store on AMZN and sell HDMI cables for $3.99, the first place to look for a supplier is Alibaba. Most small internet business owners won't have access to the IPO, unless Alibaba does a Facebook (NASDAQ:FB), which I doubt. Besides the upward revisions of the IPO price, the FB case study is one on what not to do, and is unlikely to be repeated. Twitter's IPO (NYSE:TWTR) is most likely to be copied, not FB. I would expect a large number of people that want Alibaba will not have access to the IPO, and will have to buy it in the secondary market.

"The only reason Facebook would ever authorize E*Trade as an underwriter is because it wants broad retail distribution of its IPO," said Scott Sweet, senior managing partner at IPO Boutique, a research firm tracking new offerings.

Because I expect upward revisions to the initial IPO pricing efforts, the trading opportunity would be to buy out-of-the-money calls after the first IPO pricing trial balloon. YHOO price will adjust, but I would expect that to be the low starting point. As the IPO price is adjusted upward, the price of YHOO will follow. When the IPO does hit, I would expect a sizable pop in the stock price of Alibaba, and once again, YHOO should follow. What I like about this kind of trade is that you have a definitive endpoint, and clearly defined events to confirm or refute the theory.

1) The initial IPO price trial offer will be oversubscribed, and require upward revisions.

2) YHOO price should trade higher with the upward IPO revisions.

3) The Alibaba IPO should go public at a steep discount, resulting in a 40% to 60% or more pop on the first day of trading.

Using TWTR as a case study may give insight into how Alibaba may go public. TWTR's first estimates started at $17-$20/share, then up to $23-$25/share and set the final price at $26/share.

Twitter priced its initial public offering at $26 a share late Wednesday, a move that clears the way for the stock to start trading Thursday.

Twitter ended up pricing its IPO above the range of $23-$25 a share that the company set earlier this week -- which was already an increase from the initial $17-$20 range. The announcement came via -- what else?

Once TWTR hit the secondary market, the stock price exploded, opening up 74% and at one time gaining 80% on its first day of trading. The stock closed up 70%.

beginning trading at $45.10. That's about a 74% premium to Twitter's IPO price of $26, which was kept low despite a lot of demand for the shares. Right after making its debut at 10:50 a.m. ET, Twitter's shares shot up to near $50, an 80% premium on the IPO pricing

In conclusion, the Alibaba IPO should present an interesting investment opportunity when it happens. People that want to participate in the Alibaba IPO but can't, can indirectly participate through YHOO. YHOO currently owns 24% of Alibaba, and plans to sell a maximum of 40% of their holdings. A solid performance of the IPO should translate into a solid performance of YHOO.

Yahoo, which owns 24 percent of Alibaba, cut the maximum amount it planned to sell to 40 percent of its stake from a previous sale of half.

In mid-October, Alibaba and Yahoo Japan were estimated to account for 86% of the value of YHOO, with Alibaba representing the majority of that 86%. Even after selling 40%, the remaining Alibaba holdings will still represent a significant portion of YHOO's valuation.

The brokerage, which has a "buy" rating on Yahoo, valued the company's Asian assets, which include Alibaba and Yahoo Japan, at about $29 per share on a fully taxed bases.

That is 86 percent of Yahoo's Tuesday closing price of $33.38.

That would be a conservative way to play the Alibaba IPO. Another way to do it would be to buy out-of-the-money calls with expiration dates near, but past the IPO. If the IPO is on the second Friday in June and YHOO is trading at $40, the trade would be to buy the June $45 call. If the IPO was in June but past the 3rd Friday in June when options expire, one would buy the July call.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please 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 have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.