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Quantifying Uncertainty In Yahoo!

|Includes: Altaba, Inc. (AABA)

If you're a frequent reader of this account (and you should be), you're likely well-aware of the events surrounding Yahoo!'s Alibaba SpinOff situation. If you've been living under a financial rock for the past year, Yahoo! was an early investor in Chinese e-commerce giant, Alibaba. Now that Alibaba is publicly traded, Yahoo!'s 384 million share position is valued at $31.62 billion (using this morning's $BABA price). This holding represents roughly $33.69 for every share of Yahoo! (nearly 86% of YHOO's current $39.40 per share market value).

Investors with access to Yahoo!'s balance sheet and a calculator soon figured out that YHOO trades at a discount to its Sum-Of-The-Parts (SOTP) value, and activists hedge funds like Starboard Value have taken positions in the Silicon Valley internet search company in hopes of forcing a tax-efficient asset spinoff.

Yahoo! CEO, Marissa Mayer, announced just that in the form of a SpinCo which would allow Yahoo! to spin off its 384 million shares of Alibaba - along with a smaller ancillary business - to Yahoo! shareholders completely tax free at the corporate level. Since then, speculation has arisen regarding the likelihood of this spinoff occurring - especially after an offhanded comment by an IRS official regarding spinoffs in general appeared to be specifically targeting Yahoo!'s SpinCo proposal. Yahoo! has remained confident in the eventual success in the proposal as planned, but statements by the company and the CEO herself have done little to sway market skepticism.

As I am neither an employee of Yahoo! nor the IRS, nor am I a corporate tax attorney, I'll be the first to admit that I don't know what the likelihood of success is for Yahoo! Accordingly, some form of uncertainty discount in Yahoo!'s share price is expected, but what level of uncertainty is warranted? Let's find out.


The Worst-Case Scenario

The best start to examining an investment is by determining a worst-case scenario. Here's how I see the worst-case scenario happening for Yahoo!:

  • Alibaba holding fully-taxed at 40% with a $0 cost basis
  • Yahoo! Japan holding fully-taxed at 40% with a $0 cost basis
  • Resulting after-tax funds of each holding are misappropriated

In this scenario, here's how the SOTP valuation plays out:

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Assets:

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Liabilities:

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Discounts:

Now I apply certain discounts. In this worst-case scenario, I assume that the resulting after-tax funds are misappropriated (overpaying for acquisitions, inefficient expansion efforts, etc.). Accordingly, I discount each by 15%. Cash remains par, and all other assets - which includes the intangible assets, other investments, property, etc. - are discounted by 33%.

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Valuation:

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Worst-Case Scenario Results:

Assuming we apply a Forward P/E multiple of 8x a conservative FY2016 EPS estimate of $0.57, we see that today's market price of $39.40 reflects my suggested worst-case scenario! As my Fund's holding is hedged against Alibaba risk through an open short position on BABA, my prediction is that even if this worst-case scenario were to play out, the position would remain flat. Put another way, I see the downside of an Alibaba-hedged holding in Yahoo! as de minimis.


The Moderate Scenario

The moderate scenario - in my mind - is this:

  • Alibaba holding is spun off tax-free
  • Yahoo! Japan holding is fully-taxed at 40% with a $0 cost basis
  • Moderate discounts applied to remaining assets

In this scenario, here's how the valuation plays out:

Assets:

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Liabilities:

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Discounts:

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Valuation:

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Moderate Scenario Results:

Again assuming an 8x FY16 P/E multiple, I see the moderate scenario has 34% upside from today's price.


The Best-Case Scenario:

The best-case scenario - in my mind - is this:

  • Alibaba holding is spun off tax free
  • Yahoo! Japan holding is spun off tax free
  • Moderate discounts applied to remaining assets
  • Yahoo! core trades at a forward P/E multiple that is comparable to that of the S&P 500 Index, 17

Assets:

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Liabilities:

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Discounts:

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Valuation:

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In the Best-Case Scenario, I see Yahoo! having 55% upside.


Takeaway:

As far as your holding is hedged against Alibaba risk, I see the downside of owning Yahoo! as almost negligible, as the market is currently fully factoring in the worst-case scenario. Should Yahoo! successfully spinoff its Asian holdings, however, the potential upside could be as high as $61 per share, a gain of 55%.

The risk-reward here looks good.

Disclosure: The Prosperity Active Yield Fund is long YHOO and short BABA

Disclosure: I am/we are long YHOO.