By Steven M. Sears
November 24th, 2015
Yahoo's pain can be your gain.
Shares of the troubled Internet company are down sharply this year, even as Yahoo (ticker: YHOO) attempts to monetize a massive, valuable stake in Alibaba Group Holdings (NYSE:BABA). Yahoo's slide, not coincidentally, has closely tracked the trajectory of Alibaba's stock.
Last week, an activist investor emerged to challenge Yahoo's proposed Alibaba spin-off. The activist involvement suggests Yahoo's weak stock will steady, and could even advance before the year is up. While we have previously recommended investors initiate an April upside call trade on Yahoo, recent developments suggest a shorter-dated approach is merited.
With Yahoo's shares at $33.11, aggressive investors can sell the December $31 put that expires Dec. 24 for 79 cents, and buy the December $34 call with the same expiration for $1.21. The risk reversal strategy - selling a downside put and buying an upside call with the same expiration - is often used to bullishly take advantage of investor fear.
If Yahoo declines, investors are obligated to buy the stock at the put strike price, or cover the put. Owning the stock at this level is desirable. Something definitive will eventually make clear what will happen with the Alibaba stake, reinforcing perceptions that Yahoo's stock, down 34% this year, seems primed to rise on the least bit of good news. Should shares rally above the call strike price, the call will increase in value. If the stock were to hit $40, the call would be worth $6.
The risk reversal puts investors in the middle of a contentious moment in Yahoo's history. Other investors share our bullish bias. In recent trading, an investor bought 5,500 Yahoo December $36.50 calls that expire Dec. 24. Last week, an investor traded a package of 21,000 January call options in anticipation the stock climbs to $38.
All of the trading seems pegged to Yahoo's Alibaba stake.
Robert Peck, a SunTrust analyst, is telling clients that Yahoo's Alibaba position is worth $24 a share. He is 90% positive Yahoo will be able to separate Alibaba without paying taxes, which is the crux of the debate about Yahoo.
Starboard Value, a key Yahoo shareholder, is unsure about the tax contours of the Alibaba spin. The fund is urging Marissa Mayer, Yahoo's embattled chief executive, to turn Yahoo into an Alibaba Holding company. Starboard wants Yahoo to sell its non-Alibaba assets, and keep Alibaba because it is not clear a spin will be tax-free.
Yahoo has previously indicated it could spin off Alibaba in a tax-free transaction, but some investors worry the transaction could generate a tax bill exceeding $20 billion. The Internal Revenue Service told Yahoo in early September that it would not indicate if the Alibaba spinoff would be tax free, which did not help Yahoo investors sleep at night.
To be sure, Yahoo would be of little value, or interest, if not for the Alibaba stake and Starboard Value's interest in shaking up the company. At minimum, the next month should be interesting for Yahoo, which is why investors should consider using options to wager on a bullish outcome.
Disclosure: I am/we are long YHOO.