| 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.
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.
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.
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.
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.
Peter Garnry is Saxo Bank’s Equity Strategist
