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Article / 22 September 2014 at 12:05 GMT

Yahoo grotesquely mispriced after Alibaba IPO

Head of Equity Strategy / Saxo Bank
Denmark
  • Yahoo price doesn't make sense if markets are rational
  • Yahoo shares could be used to short Alibaba
  • Shorting Yahoo could be hazardous 

By Peter Garnry

What is clear post the Alibaba IPO is that the market is presumably mispricing Yahoo. Basically, it does not make sense if we assume markets are rational. Yahoo closed at $40.93 last Friday but based on a sum-of-the-parts (SOTP) analysis the stock should trade closer to $45.

Around 11% upside in Yahoo

The table below outlines the SOTP analysis behind Yahoo's fair value. The company has $3,408 million in cash and short-term securities. Its Yahoo Japan stake is worth $5,191 million on an after-tax basis. The proceeds from the Alibaba IPO are $5,381 million on an after-tax basis. 

The Q3 balance sheet will reflect the full amount not adjusted for taxes, but the liabilities will also shown an increased tax provision related to capital gains tax on the stake sold. Yahoo's remaining post-Alibaba IPO stake is worth $22,071 million on an after-tax basis and assuming a 10% discount for selling the entire stake over-the-counter to an interested party. 

Finally we apply a free-cash-flow multiple of 15x on Yahoo's expected stable $600 million of free cash flow. In earnings terms this translates into a P/E ratio of around 7x.

Yahoo sum-of-the-parts
















The combined SOTP fair value is $45,051 million which divided on 994,603,788 shares translates into a fair value of $45.30 or 10.7% higher than Friday's closing price. As a result the market is either not pricing Yahoo correctly or the SOTP reflects negative expectations on its holdings in Yahoo Japan and Alibaba.

The optimal trade reflecting this apparent arbitrage situation is long Yahoo and short Yahoo Japan and Alibaba with the right weights reflecting the holdings share of Yahoo's total market value. The only issue with this strategy is that locating shares for shorting in Alibaba will be constrained in the short term.

yahoo
Are the sum of Yahoo's parts really only worth $40.93 a share? Photo: Getty Images News

Use Yahoo shares to short Alibaba?

For investors with a negative view on Alibaba (and there are likely a lot of them), Yahoo shares are a possible way to short Alibaba. Yahoo's stake in Alibaba is currently half of their market value so declines in Alibaba should be reflected in Yahoo's share price (1% decline in Alibaba should lead to 0.5% decline in Yahoo's share price) given the assumption of no arbitrage.

The declines last Friday in Yahoo shares (see price chart) were likely a combination of short selling intensifying and long-term investors selling out as the investment theme in Yahoo has been predicated on the Alibaba IPO event.

Yahoo share price
Yahoo share price
















Source: Saxo Bank

The problem with shorting Yahoo at the current market price is that traders are already close to 11% out-of-the-money relative to the fair value of Yahoo given all the assumptions above. This is a dangerous residual an unknown factor against you. If traders put on shorts now they could end up in a situation where Alibaba declines 20% but the Yahoo share price stays flat; because in that scenario the SOTP fair value would equal the market price. It is this unknown variable that is a major risk in a short Yahoo strategy.

Softbank shows similar discount

It is not only Yahoo that is currently being mispriced under certain assumptions. Softbank, Alibaba's largest shareholder with a 32% stake, is also valued on a SOTP basis as the market is not placing any value on its Japanese telecommunication business and largest investment portfolio. 

The combined value of Softbank's stake in Alibaba with a 20% discount and investments in publicly traded stocks such as Sprint, Yahoo Japan and GungHo Online Entertainment is currently exceeding Softbank's market value of around $92 billion. Applying a modest valuation multiple on the Japanese telecommunication assets and adjusting the holding for corporate taxes then Softbank reflects a similar discount as in the Yahoo case.

-- Edited by Clare MacCarthy

Peter Garnry is head of equity strategy at Saxo Bank
4y
Peter Garnry Peter Garnry
The mispricing got even more distorted yesterday as Yahoo fell 5.6% The media spun it as short sellers are using it to short Alibaba, but at this point it is only speculation as the official short interest data is always two weeks delayed.

The spread between Yahoo's share price and SOTP fair value is now 15% (see table)
4y
Winfield Tuck Winfield Tuck
I have followed your Idea of buying yahoo on September 17th.Now I am down 10% and ready to leave this deal. In Juli 2014 yahoo was by 34.- -36.- therefore enough to take some profit. but I heard of it too late.I take my lesson..
4y
Peter Garnry Peter Garnry
Sorry to hear that. Yes, in hindsight you should jumped the bandwagon when we highlighted this trade months ago. I cannot give you individual advice but just refer to our general view which is stated above. You have to decide whether you agree or not. The latest quote in pre-market trading is $37.89 down 2% from yesterday's close. The current declines in Yahoo's share price do not reflect the underlying declines in the values of Alibaba or Yahoo Japan. The only logically explanation for the decline in the share price is either long-term investors closing their positions following the Alibaba IPO event (which was their investment theme) or aggressive short selling - however if the latter then these sellers are starting way out-of-the-money (knowingly or not)...
4y
Jazzy Jazzy
@ Winfield. I think it is never smart to enter a stock that is so high overpriced, you only give the longer's more money...
4y
peter peter
@ Winfield.
Since yesterday BAC/ML has price target approx. 45USD based on market close of Baba at 92USD basically similar to Peter´s valuation.
Today´s trade of Yahoo is quite promissing, I am thinking and waiting for comming back to Yahoo due to the arbitrage. I sold some yahoo shares before IPO. If Winfield is not able to hold the position from September 17, the problem is somewhere else (too high margin?).
Anyway: “The market can stay irrational longer than you can stay solvent.” J.M. Keyness. In translation, the price gap in arbitrage trade must be always big enough to cover part of the risk.

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