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Summary

  • Alibaba IPO will be in mid September.
  • YHOO holds a large amount of Alibaba pre-IPO stock. More than half the value of YHOO is due to Alibaba. It is trading as a proxy for Alibaba.
  • YHOO call options are the best way to profit from the Alibaba IPO.

Alibaba Group (NYSE:BABA) owns several websites that have 45 percent of the rapidly growing e-commerce market in China. It is profitable (income was over $4 billion for fiscal year 2013) and rapidly growing both revenue and profit (more than doubling on an annual basis). Alibaba will have the largest IPO of the year, probably in mid September.

IPOs are usually underpriced and show a significant gain on the first day. Twitter (NYSE:TWTR) closed up 73% after the first day of trading. Several Chinese web site companies have gone public in the past year and saw significant first day gains: Qunar (QNR) up 89%, Autohome (NYSE:ATHM) up 75%, Weibo (NASDAQ:WB) up 19%. (Of course there is always an exception, Facebook (NASDAQ:FB) was down 10% in its first day of trading.)

Making money on options requires knowledge of two things: price and timing. IPOs offer a predictable timetable, so we just need to predict price. However, you cannot buy options on IPOs. Typically options don't start trading until a few weeks after the IPO.

Alibaba, however, is a unique case. In 2005, Yahoo (NASDAQ:YHOO) invested $1 billion in Alibaba. Yahoo now owns 524 million shares of Alibaba, and the value of Yahoo is dominated by its investment in Alibaba. YHOO trades as a tracking stock of Alibaba.

You can buy YHOO options, as a proxy for Alibaba!

Jeremy Raper laid out the details of how YHOO's value is dominated by Alibaba in this excellent article. The short story is that YHOO (about $35) is composed of Yahoo Japan ($9) (a publicly listed company), the core Yahoo business ($3), cash ($3), and its Alibaba holdings (about $20).

Yahoo owns 524 million shares of Alibaba. They are obligated to sell 140 million of these shares at the IPO price, but will hold the remaining 384 million shares. The sale of the 140 million IPO shares will trigger a tax bill (about 38% of the gain), but there should not be a tax on the remainder. (A number of way exist to avoid this tax, perhaps the simplest is splitting the company into two and directly giving the Alibaba shares to Yahoo shareholders.)

Bloomberg has been polling analysts on their estimate of Alibaba's valuation. In April they had it at $168 billion, up 10% from an estimate of $153 billion based on the previous quarter's numbers.

The most recent (July) poll had the post IPO valuation at $198 billion, with an IPO value of $154 billion.

Others estimate the value even higher. Bernstein analyst Carlos Kirjner projected a $245 billion valuation for Alibaba in April. Here is his reasoning:

We currently expect Alibaba's operating margins to grow 63% and 40% in FY14 and FY15, and believe this is still quite conservative. As a result, we are now forecasting materially higher net income for Alibaba in 2014 and 2015. We expect Taobao and Tmall will deliver 2016 net income of $9.5 billion ($7.4 billion in 2015), growing at 28% YoY (41% in 2015). As a result, we now value Taobao and Tmall at 25 times 2016 earnings (a 2016 PEG ratio of 0.9, below Tencent's current PEG ratio for 2016 earnings of 1.1x), to get $237 billion. We continue to value Alipay and Alibaba.com at around $7.5B combined, resulting in an Alibaba Group value of around $245B.

To estimate the possible return, I'll make some assumptions. The first set of assumptions, I'll call reasonable. Alibaba's IPO is priced at $65/share (about $150 billion market cap) and the first day it closes at $86 ($199 billion market cap). This price for Alibaba should put YHOO's share price at about $53.

Carlos Kirjner's numbers give an optimistic assumption. If the IPO is priced at $65/share and Alibaba rises up to $106/share ($245 billion market cap), then YHOO should be at $61/share.

The IPO date isn't fixed yet. The road show will probably start after Labor day. Alibaba will travel around the world talking about the offering, so I would expect it to take 1 to 2 weeks. September options might be cutting it close. To be safe, I'll concentrate on options expiring on October 18.

Let's see what kind of payoff we can get in the options market:

YHOO call options (October 18 expiration)

Strike Price

Friday's close

Reasonable Model (YHOO at $53)

Optimistic Model (YHOO at $61)

35

3.15

18.52

26.11

40

1.42

13.52

21.11

45

0.59

8.52

16.11

50

0.26

3.52

11.11

Percent gain from different YHOO call options.

Strike Price

Reasonable Model

Optimistic Model

35

587%

828%

40

951%

1486%

45

1443%

2730%

50

1352%

4273%

Of course, many things can go wrong here. The market could crash and the IPO could be delayed. Investors may not trust Yahoo management to return the post-IPO Alibaba holdings to shareholders, and apply a significant discount. Significant risks exist.

However, with the significant possible gains, even with a reasonable model, it's hard to see this as a losing bet.

That's why I'm long YHOO calls.

Disclosure: The author is long YHOO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Cashing In On The Alibaba IPO With Yahoo Call Options