Time to pivot?

Photographer: David Paul Morris/Bloomberg

Yahoo Is Looking for a New Way Around Alibaba Taxes

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Let's start with some dumb Yahoo math:

The left-hand column of numbers there is the obvious big embarrassment: Yahoo owns $32.6 billion worth of Alibaba stock and $8.7 billion worth of Yahoo Japan stock, it has $6.8 billion worth of cash and marketable securities, and it has only $1.4 billion of debt. Yet somehow when you add it all up, Yahoo is worth only $33.8 billion. If you just solve for the missing number, you are forced to conclude that Yahoo's actual core business of being Yahoo (and Tumblr and whatever) is worth negative $13 billion.

Which is an alarming number, but an explainable one: Yahoo's stakes in Alibaba and Yahoo Japan are highly appreciated, and Yahoo would have to pay tons of taxes if it ever sold them. So you can't count them at their full pretax value.

But the right-hand column is still pretty stark: Even after deducting 38 percent from the value of those stakes to account for taxes, you get a value for Yahoo's actual business of just $1.7 billion. This morning I mentioned the Yahoo senior vice president who was quoted, by name, on the record, in the New York Times, saying, "I just try to ship products that I'm not ashamed of," which feels like a level of ambition perfectly calibrated to that valuation.

That is probably not a fair value for Yahoo's core business, though. Here are some estimates that, if Yahoo sold its core business, it might fetch $3.4 to $4.1 billion. But what is much more shameful is that the whole point of Yahoo as a company right now is to not pay taxes on Alibaba. I realize that seems a bit hyperbolic, but just look at those numbers. Those Alibaba taxes are worth at least two and a half times the value of Yahoo's entire business. If there was a way to avoid paying taxes on the Alibaba shares that involved burning all of Yahoo's actual businesses to the ground, Yahoo should do that all day long, and then do it again the next day. It would still add shareholder value.

And the market, right now, is valuing Yahoo as though it will fail in that mission, which is its only mission.

Of course, the market recently thought that Yahoo had found a way to avoid paying taxes on Alibaba, and without even burning down its actual business. That way was to spin off the Alibaba shares into a new company called Aabaco, which could then proceed merrily on its way as an independent company consisting mostly of a chunk of Alibaba shares. This looks more in doubt than it used to, after the Internal Revenue Service refused to bless the Aabaco spinoff and has made extremely ominous noises about its opposition to the deal. If the IRS were to challenge the deal and win, the tax consequences would be pretty grotesque, and even if the IRS challenged the deal and lost it would take years and add lots of uncertainty.  There is good reason to think that Yahoo would win a challenge, but at this point no one seems to care, and the market is treating Yahoo's Alibaba stake as though it was fully taxable.

So now Yahoo seems to be considering a plan B that involves selling off the core Yahoo business, rather than spinning off the Alibaba shares. Yahoo would have to pay taxes on that sale, but, again, if that avoids paying taxes on the Alibaba shares, it would be worth it even if the taxes on the sale were 100 percent. Or 200 percent. 

Here, for instance, is an obvious sketch for a Plan B :

  1. Sell Yahoo's core business for cash. Pay taxes.
  2. Sell the Yahoo Japan stake for cash. Pay taxes.
  3. Now you have a shell, call it Yahoo Leftover Shell, consisting of (1) cash and (2) the Alibaba shares.
  4. Sell Yahoo Leftover Shell to Alibaba for cash plus Alibaba shares.

The trick in this plan is the only trick we've ever talked about for Yahoo, but it bears repeating over and over again, because it is the right trick. Alibaba, uniquely, shouldn't care about the tax liability on those Alibaba shares. Anyone who buys Yahoo Leftover Shell will face that big tax liability if it ever tries to take the Alibaba shares out of Yahoo Leftover Shell and do anything with them. (Like, sell them.) Alibaba, though, has no reason to take the shares out of Yahoo Leftover Shell. Alibaba can just hang out owning Yahoo Leftover Shell forever. Alibaba's purpose in owning Yahoo Leftover Shell would not be to sell the underlying Alibaba shares; it has all the Alibaba shares it needs. Its purpose is to retire them, to take them out of circulation (and out of its share count for earnings-per-share purposes), and to prevent anyone else (activists, competitors) from buying them. Just buying Yahoo Leftover Shell and hanging onto it forever should accomplish that; popping the shares out of Yahoo Leftover Shell and paying taxes on them should never be necessary. A schematic:

 

Obviously, Yahoo Leftover Shell would have to negotiate that trade with Alibaba. And Alibaba might say no. But it has more or less said yes already :

Asked about Alibaba’s interest in Yahoo’s stake, Executive Vice Chairman Joe Tsai said during an October call with analysts that Alibaba would buy back its shares “if it is very significantly accretive to our shareholders, and that’s the principle we operate on.”

If the transaction didn’t impose too much debt on its balance sheet, Alibaba would likely want its shares back, said Brendan Ahern, chief investment officer at KraneShares, a manager of China-focused exchange-traded funds that own Alibaba stock.

But you can do that transaction with no debt at all: Just buying Yahoo Leftover Shell for stock (plus cash for the cash on its balance sheet) would be accretive to Alibaba shareholders, as long as Alibaba buys Yahoo Leftover Shell at a discount to the value of its underlying Alibaba stock. If Alibaba issues 326 million shares of its own stock to buy back 384 million shares of its own stock, that is obviously accretive, and debt-free. And as long as that discount is less than, like, 38 percent, it's a win for Yahoo Leftover Shell shareholders, who right now are valuing Yahoo as though it will be paying the full tax bill on its Alibaba shares. Some extremely illustrative sample math, assuming that Yahoo sells its core business for $3.5 billion, sells its Yahoo Japan shares for their current market value (and pays taxes), and Alibaba then buys Yahoo Leftover Shell at a 15 percent discount (i.e. for about 326 million Alibaba shares):

 

That trade would add almost $7 billion of shareholder value. That might be too optimistic, but the margin for error here is large. What if Yahoo just gives away its core business for free, and then Alibaba buys Yahoo Leftover Shell at a 25 percent discount? It's still a good deal:

That's $1.5 billion better than the status quo. Again, the point here is less the specific math, and more that avoiding taxes on the Alibaba shares is colossally more important than anything else that Yahoo could do. Except, you know, make its core business worth tens of billions of dollars! But no one is particularly counting on that.

(Corrects value of Yahoo's marketable securities in second paragraph.)
  1. Sourcing on this table: 

    • Yahoo's Alibaba stake size comes from the Aabaco spinoff information statement.
    • Yahoo's Yahoo Japan stake size, as well as current market prices (as of Wednesday's close) and the dollar/yen exchange rate, come from Bloomberg.
    • Yahoo's cash and marketable short-term and long-term securities come from its most recent balance sheet.
    • The principal amount of Yahoo's convertible notes -- its only public debt -- comes from Note 11 in the 10Q. (Note that this doesn't match up with the number in the balance sheet because of weird non-cash accounting for convertibles.)

    Starboard Value LP, in a letter to Yahoo a few weeks ago, did similar math and reached similar conclusions.

  2. Except that Yahoo lists its cost basis in Alibaba ($2.7 billion) in Note 2 to the 10-Q, so I have deducted only 35 percent of the unrealized gain, not the full value. That is presumably an accounting basis, not a tax one, so it shouldn't be taken as exact. Yahoo discloses $9.1 billion of deferred tax liabilities relating to the Alibaba stake as of Sept. 30, 2015, which is a bit less than what I get, though also based on a lower valuation. Incidentally, the basis in the cash and securities is roughly equal to their carrying value, so I assume there's not much tax on selling them. Conversely, I assume a zero basis in Yahoo Japan, out of conservatism.

  3. And that uncertainty would make it harder for Alibaba to buy Aabaco, which is the sensible endgame for that spinoff, as we've discussed.

  4. Another big advantage of a taxable sale of core Yahoo is that it avoids the waiting period before anyone (viz., Alibaba) can buy whatever box the Alibaba shares are in, which would be required in the spinoff of Aabaco. (See footnote 8 here and accompanying text.)

  5. There are other possibilities that get a bit cleverer with the Yahoo Japan stake, but this is a good base case.

  6. And a convertible bond, but you can probably use some of the cash to buy that back. It's still pretty far out of the money.

  7. I believe that buying Yahoo Leftover Shell should accomplish retirement of the shares for EPS purposes; see footnote 5 here. More generally, as I said in that post:

    If you or I buy Alibaba stock, we want to have Alibaba stock; we want to be able to sell it one day, and generally have it be interchangeable with the other Alibaba stock in circulation. But if Alibaba buys Alibaba stock, it doesn't want Alibaba stock for trading or investing purposes. It has all the Alibaba stock it needs. It can actually print more Alibaba stock if it wants to. If Alibaba buys Alibaba stock, it's to retire it. It wants to take that stock out of circulation. If the stock sits in a U.S. subsidiary, and can't be extricated without paying taxes, that doesn't matter. From Alibaba's point of view -- particularly, from the point of view of measures like shares outstanding and earnings per share -- issuing 384 million shares to Yahoo, in order to acquire a corporate husk that owns 384 million Alibaba shares, is a nothing. 384 minus 384 is zero.

  8. That article says, "Alibaba buying the rest of Yahoo’s stake would require savvy deal making to avoid a huge tax bill on Yahoo’s gains from the Alibaba shares." But I think that deal making is actually ... pretty easy? Just keep the shares in the box?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Tobin Harshaw at tharshaw@bloomberg.net