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Amended Alibaba Agreement Makes Yahoo (YHOO) More Attractive

Yahoo (YHOO): Amended Agreement With Alibaba Should Prove Beneficial

Following yesterday’s closing bell, Yahoo (YHOO) reported their Q3 results and perhaps more importantly announced an amendment to their agreement with the Alibaba Group that reduces the maximum amount of shares Yahoo would be required to sell in the event of an Alibaba IPO. Under the original agreement Yahoo could have been forced to sell 261.5 million of their 523.6 million shares when Alibaba goes public, a move that appears imminent. After amending their agreement Yahoo can now only be required to sell 208 million shares. Shares of YHOO have more than doubled this year while operations have floundered, proving that at this point Yahoo is more of an Alibaba story than a Yahoo story per se. Yahoo’s 523.6 million shares of Alibaba represents an approximately 24% stake in the Chinese e-commerce group.

Alibaba is expected to file for a $15 billion IPO in 2014 that will valuing the company over $100 billion, expected by at least four analysts to command a valuation of at least $120 billion. At a valuation of $120 billion, Yahoo’s 24% stake would be worth $28.8 billion. One concern for YHOO shareholders stemming from the original arrangement regarding the IPO, was the notion that Alibaba might intentionally under-price their IPO, not needing to raise funds and force Yahoo to dump their shares at a low valuation. This becomes less likely with YHOO being required to unload 20% less shares. Yahoo also stands to benefit more from further appreciation in Alibaba’s valuation following their highly anticipated IPO. Alibaba’s revenue grew 61% to $1.74 billion in their most recent quarter while net income rose 159% to $707 million. They are by far the largest e-commerce player in China, one of the most lucrative markets you could possibly have a stranglehold on in the world.

YHOO is Undervalued at Current Levels

Given yesterday’s closing price of $33.38 per share, Yahoo currently has an enterprise value of $32.2 billion with about $2 billion in cash on their balance sheet. If Alibaba were to IPO tomorrow for $100 billion, less than many analysts anticipate, Yahoo’s total position would be worth $24 billion. They would be required to sell 40% of that position which would net YHOO $9.6 billion, or $6.25 billion assuming a 35% tax rate on their investment gain. For the purposes of our analysis lets assume they unload all of their shares at the time of the IPO, which would net $15.6 billion after taxes. In addition to their Alibaba stake Yahoo also owns 35% of Yahoo Japan, a position worth about $10.5 billion. If they were to liquidate that position as well and we assumed the same 35% tax rate, Yahoo Japan would carry a liquidation value of $6.8 billion. Subtracting this $22.4 billion in assets from Yahoo’s enterprise value, we can determine that the market is placing a value of about $9.8 billion on Yahoo’s core business. Including  yesterday’s results, Yahoo has generated net income of $1.29 billion over the past year. They have been aggressively acquiring companies this year, most notably Tumblr. While the effort to innovate is admirable, even if only through acquisitions, Yahoo’s core business continues to be stagnant. Revenues actually declined 5% year over year for Q3, so management needs to prove they  can start successfully implementing some of their acquisitions successfully to start fueling some growth before Yahoo can trade at multiples anywhere near its peers in the internet space. Taking this into account we will value Yahoo’s core business at only 12x trailing 12 months earnings, or about $15.5 billion. When taking into account all of Yahoo’s investments and placing a value upon their own operations, I believe YHOO should have an enterprise value of $37-$38 billion, a premium of 15%- 18% over yesterday’s closing price. Shares have the potential for even further upside should Alibaba continue to outperform as we anticipate they will, even more so now that they can retain an extra 10% of their stake following the impending IPO. YHOO is attractively priced at current levels.

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 have no business relationship with any company whose stock is mentioned in this article.

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