Yahoo: Nothing Left But The Shouting

| About: Yahoo! Inc. (YHOO)

Summary

I'm not sure why the Yahoo spin is receiving so much investor attention.

I think the market has it right here: there are way too many questions surrounding the spin.

There is certainly room for upside, but it's not as slam-dunk as many bulls seem to believe.

The Yahoo (NASDAQ:YHOO) story is well known at this point: the company is a pile of assets with a small core business attached that nobody in the investment community particularly cares about beyond what EBITDA multiple it would garner in a sale.

What's less clear, to me, is why anyone cares about the stock at these prices, when it's basically a straight-up bet on what the tax rate will be on whatever transaction eventually gets effected. It was a good value thesis when Dan Loeb first surfaced it years ago, but at this point it's been picked over by just about every buysider around. The dramatic fall in the price of Alibaba (NYSE:BABA) shares amidst the messiness in China makes it pretty clear that owning Yahoo only makes sense if you're shorting out the BABA exposure, and to a lesser extent, perhaps the Yahoo Japan (YAHOJ) exposure. Unless, of course, you actually want to own BABA, which would probably be more efficient to do by, well, just owning BABA. Notwithstanding whatever its fundamental value may be (I haven't even attempted to calculate that), it seems likely to trade with Chinese stock sentiment over the near to medium term.

With the caveat that I'm not an expert in tax matters, there are several reasons I think the YHOO trade is overrated.

1: Is Management Really Acting In Shareholders' Best Interests?

Part of the bull thesis related to the original tax-free spin plan was that it had been vetted by expensive lawyers. Yet the company's move away from the plan appears to have been precipitated by the lukewarm reaction from the market rather than actual primary analysis. Back in December, even as the company was hatching a new plan, CFO Ken Goldman explained that the forward spin plan made the most sense:

We engaged three leading investment banks, the country's top tax experts, Skadden Arps, and other experts over the past year. We believe this was the optimal structure with the highest probability of success to create value for our shareholders for the Company.

Chairman Maynard Webb followed up with the same sentiment on the call last week:

We did actively engage experts in looking at all the tax efficient structures. The reverse spin is a complex transaction. It's subject to third-party consents, prepared audited financial statements, shareholder approval, SEC filings and clearance, and work on the 1940's Act. Frankly, we believed that the forward spin optimized execution efficiency and minimized third-party involvement, and, frankly, could have provided more tax benefit to our shareholders.

Here's the important question: if the company was truly convinced that the original spinoff plan was in the best interests of shareholders - after spending a pretty penny on lots of input from high-paid advisors - then why did it cave to market reaction? Management's job is to maximize shareholder value, whether or not shareholders like it. This calls to mind the ongoing debate on long-term vs. short-term optimization - obviously the issue here isn't R&D spending versus cost-cutting, but it's the same general concept. If the original spin plan was the best way forward from a tax perspective, then why abandon it just because the market wasn't valuing it properly? Go ahead and do it, and if the spin-off really ends up being tax free like the lawyers said, then the market would have figured it out eventually and valued Aabaco properly.

The other alternative, of course, is that the market actually had it right and management had it wrong - which would be quite concerning for the outlook of the new plan.

2: Does Anyone Really Know About Taxes?

Following up on the above, it's concerning that nobody really appears to have any clarity on what exactly the tax implications of the reverse spin plan are. On the call last week, CFO Ken Goldman was very evasive in addressing the Morgan Stanley analyst's very reasonable question about the tax liability of spinning the core business:

In terms of, I don't want to go through the exact numbers on tax. Obviously we could do a reverse spin that would be basically tax free, more likely it will be taxable, so we understand that. We do have some basis for our core business, as well as basis for Yahoo Japan, but I'd rather not go through those numbers, because they are still being tuned a little bit, in terms of right now for public process.

This follows up on another evasive answer that Chairman Webb gave regarding tax implications for Yahoo Japan on the December call.

While the upcoming elections could change things, in the meanwhile we have an administration that is very clearly not a fan of corporations minimizing their tax bills (see: inversions). Whether or not such minimization is legal and permissible under existing tax code does not appear to be of great concern. Given the size of this transaction and the unfavorable optics - i.e. "not paying any taxes on Chinese assets while Warren Buffett's secretary pays XYZ% - I think the market is wise to price in uncertainty here.

3: Timing? ... what happens in the interim?

Unless you assume that literally everything goes right - i.e. zero taxes on the spins and a high multiple for the eventual sale of the Yahoo "core" business - then the magnitude of actual upside here is fairly small. While it looks large relative to your net exposure if you short out Alibaba, it's still pretty small relative to your gross exposure - and anyone who remembers LTCM should know better than to lever up on a supposedly riskless arbitrage. There's nothing saying that Yahoo's core business couldn't garner an even more negative valuation (if you assume that it is indeed negative today after accounting for taxes).

What is more concerning is this: what if the timeline extends? It's already been pushed out once. Worse, the core business isn't getting more valuable; in fact, it could get much less valuable. CEO Marissa Mayer signposted that the company was open to doing more acquisitions, even as the company is working on divesting some patents and other assets. While another big deal like Tumblr is probably not in the cards, some of the cash on the balance sheet (or cash generated in the interim) might not actually amount to anything. For all the acquisitions Yahoo has done over the past few years, it's basically treading water.

Conclusion

Sum of the parts stories rarely work out as nicely as they look on paper. Yahoo shareholders have been waiting a long time for value realization, yet we're seemingly back to square one, and things are even worse if you weren't hedging the Alibaba exposure.

Great investors jump over short hurdles. The Yahoo hurdle is very high - there is a lot of complexity and anyone who claims to know exactly what's going to happen here is grossly overstating things. Notwithstanding the presence of activist investors, I don't have any confidence in management to effectuate any transactions or spinoffs at an appropriate price, within an appropriate timeframe, with the appropriate tax protections. With the complexity of position structure that would be necessary to remove risk related to Yahoo! Japan and Alibaba ownership, it's well worth asking - why bother with Yahoo?

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