YHOO - Yahoo Inc.

[alertmeipp]

Is the Spinoff fully approved by shareholders, etc...

 

Will gov come out and say yahoo needs to pay taxes for example?

[ni-co]

I'd value YHOO's core business at min. ~$5/share (~10x FCF) and $8/share in cash. Add to that ~$7 for Yahoo Japan and subtract ~$3 BABA spinoff discount. Adds up to $17 for the stub and you buy it for $8. The spinoff in Q4 is the catalyst and I don't expect the gap to be closed completely until then.

[thepupil]

Will gov come out and say yahoo needs to pay taxes for example?

 

that is definitely big kahuna tail risk, but let's say it happens and yahoo goes down 30%; it would then be trading at 56% of untaxed NAV, which would make for a hell of a share repurchase opportunity and a very cheap large cap stock. Shareholder approval is not a risk! Shareholders want their tax efficiency and don't want Yahoo to be tempted to use its BABA riches, separation is very shareholder friendly.

 

I'd value YHOO's core business at min. ~$5/share (~10x FCF) and $8/share in cash. Add to that ~$7 for Yahoo Japan and subtract ~$3 BABA spinoff discount. Adds up to $17 for the stub and you buy it for $8. The spinoff in Q4 is the catalyst and I don't expect the gap to be closed completely until then.

 

Per direct quote from management, there is $5.7B of net cash (just over $6 / share, not $8). Are you doing something like adjusting for converts?

[Guest Schwab711]

A lot have now been mentioned but I see:

1. Risk that the BABA short is undervalued and end up with lower ROC or borrowing costs increase

2. IV of Yahoo at $20 is too high and true value is lower

3. Spinoff doesn't occur due to shareholders or poor performance of BABA (or any other reasons)

4. Discount between SpinCo and BABA shares

5. Yahoo's core operations decrease or experience losses

6. Currency risk to Yen and Yuan (currently going in wrong direction with USD appreciation vs Yen)

7. Taxes on any Yahoo Japan transaction

8. Yahoo Japan remains owned by Yahoo and the resultant discount is greater than expected

9. Absolute and relative interest rate risks (hopefully is captured in currency risk but not always)

10. Reinvestment risk. This has a finite-duration. What is probability of future investments being available to make one pass on a current investment opportunity in a compounder or longer duration investment?

 

I'm sure I'm missing some but you have created a complicated investment product and there is generally risk added at each synthetic leg.

 

Basically, the stub is currently ~$8. If borrow cost of BABA is 7% then the stub now costs $10.42/sh + interest if you use margin + transaction costs (hopefully minimal). Also, the upside for the stub is highly dependent on the $6 + $7 valuation for Yahoo and Yahoo Japan, respectively. Finally, you also know a head of time that this is a finite-duration investment so you will have to pay capital gains. For the best annualized returns you will have to pay short-term capital returns. If this corrects too quickly you either lose 25% of profit to taxes or take on market risk. Your post-tax absolute return for  under 1 year is currently capped at 46.5% in absolute terms or 71% pre-tax. Many of the above can eat into that 71% or it may take longer than 1 year to realize.

 

In theory there is no difference between theory and practice. In practice there is.

[thepupil]

Thanks. Typing on iPad so excuse any errors.

 

A few of those can be resolved with a simple synthetic short position that is currently available at little or negative cost. If you are moving institutional money, this trade can be put on swap for about 2% on $100mm for a year, the last time I looked into it (know people that know people, got to love a self important swaps pricing drop to add to the arrogance that pours from my posts).

 

The risk of borrow costs is mitigated and the current options pricing allows one to benefit from it ( by being long yahoo and synthetic short baba, you basically create  a weird sort of conversion where borrow costs would reprice your put options in your favor, but you wouldn't benefit from the lend like you would in an actual conversion).

 

There will be no voluntary (from shareholders) stop of this spinoff. Barry O and crew will have to do that. This is shareholders' collective wet dream of tax efficient monetization. I don't understand why poor BABA performance would prevent it. If BABA is $200 or $20 it benefits everyone to get those millions of shares out of the yahoo holdco.

 

Risks 2, 5,6, 7,8 are all part of the simple questions of  "what value will remainco trade for?" "What is it worth?". As far as japan monetization, management has said they won't be complete idiots and given their track record so far so good.

 

Risk 10 applies to every single investment that is not for the "forever term". I admire your Mungerian purism and self righteousness, but I know even you might condescend to picking up a 50 cent dollar in liquidation if one presented itself. This is an 80 cent dollar with a large liquid high correlation hedge available, but a healthy heaping of basis risk and other factors. Perhaps you wish to not sully yourself with its short term nature and lack of care about business ownership and fundamentals, but if you do I promise not to tell Warren and Charlie :)

 

Taxes, schmaxes. A huge portion of the investment $s allocated give not one shit about taxes. This includes a large chunk of my personal savings and many a $ of potential employers, investors, etc.. I would love to limit myself to 71% pretax. I see this as a 25 % upside unlevered trade using the long leg  the long leg as the denominator or 50% if you want to go crazy and use 1/2 long leg as your "risk allocation" ( many would go far crazier in determining the actual capital requirement and leverage  but I don't want you to drop the LTCM bomb again). Can some stuff to wrong that knocks that 25% to ten or zero or negative? Yes. But if you take a look at my sexy excel conditional formatting chart, you need pretty hefty discounts to impair yourself (once again, assuming deal goes through, if deal breaks,maybe you lose 30% or so)

 

But if you want to chop japan to $5 / share and cash to 0 and yahoo to 3x ebitda, then the stub is fairly valued. I say this to illustrate the real risk is in SpinCo - BABA basis and the deal getting done. The stub (aka remainco) has a pretty big margin of safety. If you could avoid all the stub complications, Would you buy an $8B company that had $5.7B in net cash, and $7b in yahoo japan and owned the piece of shit known as yahoo? I know I would, so it's really all about getting there.

 

In short,  it is called risk arbitrage instead of "free money" for a reason. I think the returns compensate well for the risk and that the disaster scenario (spin not going thru or stub less discount being worth less than $8 if it does go through  are unlikely). I think it presents a great risk reward.  Even if the government stopped the spin, it is already at a decent 22% untaxed conglomerate discount. Can that go to 50%? Sure, but that's more Hong Kong conglomerate discount territory than US listed activist influenced super liquid and prominent stock territory. At a 50% discount masayoshi would be on Mayer and crew  like rice on white (I couldn't resist).

 

I personally don't think this trade is overly complex. You buy a stock and short a stock (preferably on swap or with options to lock in no to low borrow) and wait a year. You think about risks of a "deal break" (spinoff not happening) and what that might look like. You formulate a position on the appropriate SpinCo discount. You stress the remainco ( gigantic ally stupid acquisition, yahoo japan being down 40%, etc). It's not dissimilar to just buying a business / stock (risk, reward, scenarios, upside downside).

 

[ni-co]

 

I'd value YHOO's core business at min. ~$5/share (~10x FCF) and $8/share in cash. Add to that ~$7 for Yahoo Japan and subtract ~$3 BABA spinoff discount. Adds up to $17 for the stub and you buy it for $8. The spinoff in Q4 is the catalyst and I don't expect the gap to be closed completely until then.

 

Per direct quote from management, there is $5.7B of net cash (just over $6 / share, not $8). Are you doing something like adjusting for converts?

 

You're right. I was pulling the numbers out of my head. Looking it up I calculated: $6 net cash, $6.5 business (12x5.5 FCF – not 10x, sorry for that). Either way, the risk/reward is good enough.

 

With regards to the risks mentioned above:

1. Nobody said it was a risk-free trade. I said it was a no-brainer (from a risk/reward perspective)

 

2. Most of the arguments could be applied to any spinoff/special situation. I'm buying the dollar for roughly 50 cents and have a catalyst that will close most of the gap until January 2016. Of course, things can go wrong but I don't see myself losing all too much on this one. It's a heads I win, tails I don't lose all that much situation. It's not comparable to a "normal" merger arb where the risk of loss is substantially higher.

 

3. The tax risk is small in my opinion. Otherwise they wouldn't have announced it, and Malone – who has the best tax people I know of – has proven that this construction works (Matt Levine's excellent column on this).

[thepupil]

Perhaps consulting the sacred texts will help frame this opportunity.

 

(1) How likely is it that the promised event will indeed occur?

 

I'd say very likely as the bankers had months to figure this out, there is only 1 corporate making a decision (unless you think AliBaba is going to get up in Yahoo's grill about this but I imagine they consulted them). The structure has been utilized before and seems sound, although the 40 act fund is unique and without precedent as far as I know, so that could be a hitch. But all in all, I think chance of a break is low, would love to hear others' thoughts, particularly if less sanguine.

 

(2) How long will your money be tied up?

1-2 years. 1 year for the SpinCo to show up in your account at which point you can collapse the BABA - SpinCo leg (unless the discount is too big) and give it a year for RemainCo to get its stuff together to re-rate (figure out Japan, use of cash, etc.). This is a little long for an arbitrage type of trade, but the gross spread is commensurately wide for an arb (25% before SpinCo discount, this is a quirky spread in that you don't 100% know what the spread will be because of the SpinCo discount and RemainCo discount).

 

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

 

Low. I'm not counting on Yahoo turning around.

 

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

 

I'd like to hear others' thoughts but I think Yahoo would re-rate from an 80% NAV multiple to something like a 60-70% NAV multiple, call it 25% downside or so.

 

Arbitrage

 

    In past reports we have told you that our insurance

subsidiaries sometimes engage in arbitrage as an alternative to

holding short-term cash equivalents. We prefer, of course, to

make major long-term commitments, but we often have more cash

than good ideas.  At such times, arbitrage sometimes promises

much greater returns than Treasury Bills and, equally important,

cools any temptation we may have to relax our standards for long-

term investments.  (Charlie’s sign off after we’ve talked about

an arbitrage commitment is usually: “Okay, at least it will keep

you out of bars.”)

 

    During 1988 we made unusually large profits from arbitrage,

measured both by absolute dollars and rate of return.  Our pre-

tax gain was about $78 million on average invested funds of about

$147 million.

 

    This level of activity makes some detailed discussion of

arbitrage and our approach to it appropriate.  Once, the word

applied only to the simultaneous purchase and sale of securities

or foreign exchange in two different markets.  The goal was to

exploit tiny price differentials that might exist between, say,

Royal Dutch stock trading in guilders in Amsterdam, pounds in

London, and dollars in New York.  Some people might call this

scalping; it won’t surprise you that practitioners opted for the

French term, arbitrage.

 

    Since World War I the definition of arbitrage - or “risk

arbitrage,” as it is now sometimes called - has expanded to

include the pursuit of profits from an announced corporate event

such as sale of the company, merger, recapitalization,

reorganization, liquidation, self-tender, etc.  In most cases the

arbitrageur expects to profit regardless of the behavior of the

stock market.  The major risk he usually faces instead is that

the announced event won’t happen.

 

    Some offbeat opportunities occasionally arise in the

arbitrage field.  I participated in one of these when I was 24

and working in New York for Graham-Newman Corp. Rockwood & Co.,

a Brooklyn based chocolate products company of limited

profitability, had adopted LIFO inventory valuation in 1941

when cocoa was selling for 5¢ per pound.  In 1954 a

temporary shortage of cocoa caused the price to soar to over

60¢.  Consequently Rockwood wished to unload its valuable

inventory - quickly, before the price dropped.  But if the cocoa

had simply been sold off, the company would have owed close to

a 50% tax on the proceeds.

 

    The 1954 Tax Code came to the rescue.  It contained an

arcane provision that eliminated the tax otherwise due on LIFO

profits if inventory was distributed to shareholders as part of a

plan reducing the scope of a corporation’s business.  Rockwood

decided to terminate one of its businesses, the sale of cocoa

butter, and said 13 million pounds of its cocoa bean inventory

was attributable to that activity.  Accordingly, the company

offered to repurchase its stock in exchange for the cocoa beans

it no longer needed, paying 80 pounds of beans for each share. 

 

    For several weeks I busily bought shares, sold beans, and

made periodic stops at Schroeder Trust to exchange stock

certificates for warehouse receipts.  The profits were good and

my only expense was subway tokens.

 

    The architect of Rockwood’s restructuring was an unknown,

but brilliant Chicagoan, Jay Pritzker, then 32.  If you’re

familiar with Jay’s subsequent record, you won’t be surprised to

hear the action worked out rather well for Rockwood’s continuing

shareholders also.  From shortly before the tender until shortly

after it, Rockwood stock appreciated from 15 to 100, even though

the company was experiencing large operating losses.  Sometimes

there is more to stock valuation than price-earnings ratios.

 

    In recent years, most arbitrage operations have involved

takeovers, friendly and unfriendly.  With acquisition fever

rampant, with anti-trust challenges almost non-existent, and with

bids often ratcheting upward, arbitrageurs have prospered

mightily.  They have not needed special talents to do well; the

trick, a la Peter Sellers in the movie, has simply been “Being

There.” In Wall Street the old proverb has been reworded: “Give a

man a fish and you feed him for a day.  Teach him how to

arbitrage and you feed him forever.” (If, however, he studied at

the Ivan Boesky School of Arbitrage, it may be a state

institution that supplies his meals.)

 

    To evaluate arbitrage situations you must answer four

questions: (1) How likely is it that the promised event will

indeed occur? (2) How long will your money be tied up? (3) What

chance is there that something still better will transpire - a

competing takeover bid, for example? and (4) What will happen if

the event does not take place because of anti-trust action,

financing glitches, etc.?

 

    Arcata Corp., one of our more serendipitous arbitrage

experiences, illustrates the twists and turns of the business. 

On September 28, 1981 the directors of Arcata agreed in principle

to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),

then and now a major leveraged-buy out firm.  Arcata was in the

printing and forest products businesses and had one other thing

going for it: In 1978 the U.S. Government had taken title to

10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park.  The government had paid $97.9

million, in several installments, for this acreage, a sum Arcata

was contesting as grossly inadequate.  The parties also disputed

the interest rate that should apply to the period between the

taking of the property and final payment for it.  The enabling

legislation stipulated 6% simple interest; Arcata argued for a

much higher and compounded rate.

 

    Buying a company with a highly-speculative, large-sized

claim in litigation creates a negotiating problem, whether the

claim is on behalf of or against the company.  To solve this

problem, KKR offered $37.00 per Arcata share plus two-thirds of

any additional amounts paid by the government for the redwood

lands.

 

    Appraising this arbitrage opportunity, we had to ask

ourselves whether KKR would consummate the transaction since,

among other things, its offer was contingent upon its obtaining

“satisfactory financing.” A clause of this kind is always

dangerous for the seller: It offers an easy exit for a suitor

whose ardor fades between proposal and marriage.  However, we

were not particularly worried about this possibility because

KKR’s past record for closing had been good.

 

    We also had to ask ourselves what would happen if the KKR

deal did fall through, and here we also felt reasonably

comfortable: Arcata’s management and directors had been shopping

the company for some time and were clearly determined to sell. 

If KKR went away, Arcata would likely find another buyer, though

of course, the price might be lower.

 

    Finally, we had to ask ourselves what the redwood claim

might be worth.  Your Chairman, who can’t tell an elm from an

oak, had no trouble with that one: He coolly evaluated the claim

at somewhere between zero and a whole lot.

 

    We started buying Arcata stock, then around $33.50, on

September 30 and in eight weeks purchased about 400,000 shares,

or 5% of the company.  The initial announcement said that the

$37.00 would be paid in January, 1982.  Therefore, if everything

had gone perfectly, we would have achieved an annual rate of

return of about 40% - not counting the redwood claim, which would

have been frosting.

 

    All did not go perfectly.  In December it was announced that

the closing would be delayed a bit.  Nevertheless, a definitive

agreement was signed on January 4. Encouraged, we raised our

stake, buying at around $38.00 per share and increasing our

holdings to 655,000 shares, or over 7% of the company.  Our

willingness to pay up - even though the closing had been

postponed - reflected our leaning toward “a whole lot” rather

than “zero” for the redwoods.

 

    Then, on February 25 the lenders said they were taking a

“second look” at financing terms “ in view of the severely

depressed housing industry and its impact on Arcata’s outlook.”

The stockholders’ meeting was postponed again, to April.  An

Arcata spokesman said he “did not think the fate of the

acquisition itself was imperiled.” When arbitrageurs hear such

reassurances, their minds flash to the old saying: “He lied like

a finance minister on the eve of devaluation.”

 

    On March 12 KKR said its earlier deal wouldn’t work, first

cutting its offer to $33.50, then two days later raising it to

$35.00. On March 15, however, the directors turned this bid down

and accepted another group’s offer of $37.50 plus one-half of any

redwood recovery.  The shareholders okayed the deal, and the

$37.50 was paid on June 4.

 

    We received $24.6 million versus our cost of $22.9 million;

our average holding period was close to six months.  Considering

the trouble this transaction encountered, our 15% annual rate of

return excluding any value for the redwood claim - was more than

satisfactory.

 

    But the best was yet to come.  The trial judge appointed two

commissions, one to look at the timber’s value, the other to

consider the interest rate questions.  In January 1987, the first

commission said the redwoods were worth $275.7 million and the

second commission recommended a compounded, blended rate of

return working out to about 14%.

 

    In August 1987 the judge upheld these conclusions, which

meant a net amount of about $600 million would be due Arcata. 

The government then appealed.  In 1988, though, before this

appeal was heard, the claim was settled for $519 million. 

Consequently, we received an additional $29.48 per share, or

about $19.3 million.  We will get another $800,000 or so in 1989.

 

    Berkshire’s arbitrage activities differ from those of many

arbitrageurs.  First, we participate in only a few, and usually

very large, transactions each year.  Most practitioners buy into

a great many deals perhaps 50 or more per year.  With that many

irons in the fire, they must spend most of their time monitoring

both the progress of deals and the market movements of the

related stocks.  This is not how Charlie nor I wish to spend our

lives. (What’s the sense in getting rich just to stare at a

ticker tape all day?)

 

    Because we diversify so little, one particularly profitable

or unprofitable transaction will affect our yearly result from

arbitrage far more than it will the typical arbitrage operation. 

So far, Berkshire has not had a really bad experience.  But we

will - and when it happens we’ll report the gory details to you.

 

    The other way we differ from some arbitrage operations is

that we participate only in transactions that have been publicly

announced.  We do not trade on rumors or try to guess takeover

candidates.  We just read the newspapers, think about a few of

the big propositions, and go by our own sense of probabilities.

 

    At yearend, our only major arbitrage position was 3,342,000

shares of RJR Nabisco with a cost of $281.8 million and a market

value of $304.5 million.  In January we increased our holdings to

roughly four million shares and in February we eliminated our

position.  About three million shares were accepted when we

tendered our holdings to KKR, which acquired RJR, and the

returned shares were promptly sold in the market.  Our pre-tax

profit was a better-than-expected $64 million.

 

    Earlier, another familiar face turned up in the RJR bidding

contest: Jay Pritzker, who was part of a First Boston group that

made a tax-oriented offer.  To quote Yogi Berra; “It was deja vu

all over again.”

 

    During most of the time when we normally would have been

purchasers of RJR, our activities in the stock were restricted

because of Salomon’s participation in a bidding group. 

Customarily, Charlie and I, though we are directors of Salomon,

are walled off from information about its merger and acquisition

work.  We have asked that it be that way: The information would

do us no good and could, in fact, occasionally inhibit

Berkshire’s arbitrage operations.

 

    However, the unusually large commitment that Salomon

proposed to make in the RJR deal required that all directors be

fully informed and involved.  Therefore, Berkshire’s purchases of

RJR were made at only two times: first, in the few days

immediately following management’s announcement of buyout plans,

before Salomon became involved; and considerably later, after the

RJR board made its decision in favor of KKR.  Because we could

not buy at other times, our directorships cost Berkshire

significant money.

 

    Considering Berkshire’s good results in 1988, you might

expect us to pile into arbitrage during 1989.  Instead, we expect

to be on the sidelines.

 

    One pleasant reason is that our cash holdings are down -

because our position in equities that we expect to hold for a

very long time is substantially up.  As regular readers of this

report know, our new commitments are not based on a judgment

about short-term prospects for the stock market.  Rather, they

reflect an opinion about long-term business prospects for

specific companies.  We do not have, never have had, and never

will have an opinion about where the stock market, interest

rates, or business activity will be a year from now.

 

    Even if we had a lot of cash we probably would do little in

arbitrage in 1989.  Some extraordinary excesses have developed in

the takeover field.  As Dorothy says: “Toto, I have a feeling

we’re not in Kansas any more.”

 

    We have no idea how long the excesses will last, nor do we

know what will change the attitudes of government, lender and

buyer that fuel them.  But we do know that the less the prudence

with which others conduct their affairs, the greater the prudence

with which we should conduct our own affairs.  We have no desire

to arbitrage transactions that reflect the unbridled - and, in

our view, often unwarranted - optimism of both buyers and

lenders.  In our activities, we will heed the wisdom of Herb

Stein: “If something can’t go on forever, it will end.”

 

 

[Guest Schwab711]

Perhaps consulting the sacred texts will help frame this opportunity.

 

 

Haha, I probably deserve that! :)

 

I am very aware that Buffett and Munger like arbitrage, they both like it a lot more than I do. I've been burned and it takes a lot of successes to make up for one mistake. Though I am only thinking of merger arb and this is clearly a safer investment than most merger arb. The higher absolute returns lend to what you were saying about great risk/reward. Sadly, I might have passed on cocoa beans, not knowing what to do with them. I don't have much money and I have even less new money coming in so I feel the need to protect my capital to an obnoxious point (not that you don't but I truly mean overkill). Overkill is, I have bought 2 stocks in the last 24 months so re-investment risk is also a real fear of mine if I were to put on this position. I'm certainly not trying to do 20 punches but I was burned so badly when I first started that I am very cautious. Also, whether I'm playing blackjack, craps, poker, Draftkings, or stocks, I like to bet really big amounts. Sounds stupid, but for myself, if I took this deal I miss out on CLB or AXP or more ELDO. So really this babbling comes down to, I think I like the idea and I want to nit-pick it or play devil's advocate to make sure I do. Ultimately, I think I'm going to buy more ELDO but I thought about it last night/this morning and I think you've convinced me, I actually think this is a good deal now. Don't get used to this... I really like hating every investment idea!

 

Back to you, I think at minimum you have to find a way to get an equivalent to shorting BABA that guarantees a borrow cost for the entire period. This is the biggest risk to me (it may be a small risk and I'm over-blowing borrow cost increases) but I've heard horror stories and we both know that once you create the stub you are kind of pot-committed. At least this is more interesting than write-ups that try to convince you warm crap is high-grade fertilizer. I really like that you have extremely low expectations for future multiples and there is still a large gap for returns. Maybe I'll look back and think what an idiot I was to be so resistant to different strategies or methods of making $$.

 

So last question now that you have crystallized this investment for me, why is the market giving you this wonderful opportunity? Why isn't the stub fairly valued?

[thepupil]

thanks for being a good sport. I do actually admire your insistence on getting returns solely from growth in business value and earnings over very long periods of time and was making a a few jabs in good humor. The world needs more investors like you and I definitely have a little bit too much "sell to a greater fool, catalyst-event blah blah blah" in me. 

 

But I felt the need to contrast this with standard merger arb (where you are annualizing small gross spreads over a short period to juice IRR's) or the LTCM reference (which was off because LTCM employed a lot a lot more leverage). I agree, getting rid of borrow costs uncertainty is helpful, you can't totally get rid of it (early exercise on call leg risk). I think it does help this is a big liquid company with spread out ownership.

 

This isn't like Palm 3Com (http://www.chicagobooth.edu/capideas/win02/market.html) where you are shorting something that is very tightly held.

 

As far as why the market offers this opportunity I can only offer the following

 

1) duration, this is pretty long duration for dedicated event driven guys

 

2) not totally clean (the things we already discussed like the SpinCo discount), also this trade results in a long position in a company, it does not magically "close" like a merger arb

 

3) more traditional value guys probably want a bigger holdco discount than the current 20%, long onlies can't hedge out the BABA and those inclined to own a messy company like RemainCo are not the same as those inclined to own a beautiful clean story like BABA

 

Beyond that, I'm not sure. I would love to hear more explanations of "why this trade scares me" or "you think you're so smart pupil but you forgot about this".

[writser]

Thepupil: thanks for sharing your thoughts. I've been thinking about this idea last evening. A few bullet points (I love bullet points):

 

* I don't think the tail risks (the Japan blowup some of our forum members are expecting, the IRS making a stance against tax evasion, shareholders voting against the spinoff) are extremely relevant. Tail risks exist with every position bBut if your thesis is correct we expect this trade to be profitable enough to accept a small chance of things going horribly wrong.

 

* The Yahoo conglomerate will probably still trade at a discount after the spinoff because, well, it is Yahoo. I am also inclined to discount the cash on the balance sheet because I wouldn't be surprised if the board / MM feels they have 'earned' the right to spend a billion or two on crazy acquisitions after returning ~$40 billion to shareholders.

 

* Did your valuation of the Yahoo japan stake take possible taxes into account? (should it?)

 

* I don't understand Alibaba at all but it looks too expensive for my tastes and corporate governance is horrible. I really don't want any exposure to it so the only acceptable trade for me is buying YHOO and hedging my BABA exposure one way or another. Unfortunately this trade has a large margin requirements over a large timeframe to end up with a small position - making it slightly less attractive.

 

* As you correctly pointed out, the most important factor is: at what discount SpinCo will be trading after the spinoff? Ni-co is hedging with a Jan '16 synthetic, if I understand correctly. I think the risk with that strategy is that you are forced to sell your SpinCo stock at whatever discount it is trading at in January '16 (or roll through your hedge at bad prices). Given the size of the spinoff (both absolute and relative to the stub), the arbitrageurs involved etc. I can see Spinco trading at a considerable discount (15%+), especially right after the spinoff. Who would want to buy it at even money to BABA? So rather than playing the Jan '16 synthetic I think I'd rather short the stock itself (risky) or go short synthetically with a longer duration (haven't checked prices).

 

* Finally I am uncertain about the endgame. If BABA would acquire SpinCo in 2016 at fair value this would obviously be a super trade. But would that be in their best interest? Why shouldn't they play hardball, wait for a few years until SpinCo trades at a 20% discount and then commence a tender offer at a small premium? That would be hugely accretive to their own shareholders. And what other options are there to monetize SpinCo? Could the company dissolve itself and distribute BABA stock to its shareholders tax-free? SpinCo is so big that I don't see anybody else taking it over or something. Any insights about what could happen are appreciated.

 

Bottom line: until I have more knowledge about the possible endgame scenarios and their tax implications I am not extremely interested. My prediction is that SpinCo will trade at a 10% discount for a while, the stub will muddle through like it is doing now, also trading at a slight discount. Returns in this scenario are good but not great (as per thepupil's sheet), especially when taking into account the capital required.

 

 

Maybe another interesting idea would be to buy SpinCo instead if it is trading at a considerable discount to BABA. Have you considered that?

[ni-co]

* As you correctly pointed out, the most important factor is: at what discount SpinCo will be trading after the spinoff? Ni-co is hedging with a Jan '16 synthetic, if I understand correctly. I think the risk with that strategy is that you are forced to sell your SpinCo stock at whatever discount it is trading at in January '16 (or roll through your hedge at bad prices). Given the size of the spinoff (both absolute and relative to the stub), the arbitrageurs involved etc. I can see Spinco trading at a considerable discount (15%+), especially right after the spinoff. Who would want to buy it at even money to BABA? So rather than playing the Jan '16 synthetic I think I'd rather short the stock itself (risky) or go short synthetically with a longer duration (haven't checked prices).

 

I thought about longer durations for my synthetic short position, but this would increase margin requirements even further – so I chose the shortest reasonable duration for the short. I might roll it over to a slightly longer duration later this year if I get the chance to do it.

[thepupil]

writser, I agree with pretty much all your points.

 

- the tail risks are probably more of a distraction, but since this does require one to take a decent sized position, they should be considered.

 

- Regarding margin, I always seem to have plenty of room in my account (except when i go long 110% Safeway for one night lol), so I think of it in terms of "what I can make" and "what I may lose" and how should i size the position. My portfolio's capital requirements as dictated by IB have never been so high as to make me think about margin and capital reqs rather than risk of loss (which is always the main focus). i hold illiquids and OTC's primarily in my IRA's. The margin requirements on large liquid stocks are very low.  For thinking about return, i use the long leg (Yahoo) as the denominator. IF you use the stub, you see 100+% upside, which distorts the risk/reward because of the embedded leverage capital requirements ( i spoke to a respected money manager i know about this and I was saying the stub had 300% upside back when it was at $6 and he helped me see how that was an intellectually dishonest way of putting it).

 

- right now i'm only about 10% YHOO and 8% BABA btw, while I think it's a good trade, this isn't once in a lifetime opportunity and I think in my defense to Schwab I may come off as a little salesy and excited about it. I peaked at over 25% YHOO in december but actually sized down significantly when it briefly traded at 86% of NAV and December had a lot of my more long term less trade-y holdings selling off. 86% of NAV with no clarity on monetization was not as exciting as when i bought it in the low 70s. now we have clarity on BABA but a host of other issues to think about.

 

- No, Japan did not take into account taxes, and cash pile does not take into account potential future dumb acquisitions.

 

- Rather than focus on what the right discount is for the remaining company, I am choosing to see what price is that I am creating that company (at a range of SpinCo discounts) and judging whether or not I would pay that price. So if I am buying at $8, lose $3 to SpinCo discount and RemainCo is worth $19 or $20. I am happy because I will have created a very cheap and interesting company. I'll have positioned myself into a company with liquid assets equal to its market cap and positive (albeit falling) earnings and free cash flow.

 

-I see this as a backdoor way of buying RemainCo at a very cheap price. How long I will own RemainCo will be determined by where it trades.

 

- as far as endgame for SpinCo, I think it's important to realize that this is a 40 act fund, which means as a registered investment company (like a BDC, mutual fund or ETF) it will not be taxed at the entity level. So if a pension, IRA,  foundation, endowment (or a hedge fund with those types of investors) bought SpinCo and SpinCo liquidated, there would be no incidence of tax. I think this helps with the valuation of SpinCo. Large  non taxable investors can swap their BABA for SpinCo without fear if the discount gets too wide. One way to potentially put a ceiling on the discount would be to somehow offer investors the chance to redeem in kind at set intervals, which would give non taxable investors a way to play the discount (and raise the valuation for taxable investors to sell to those who could take advantage)

 

-But you're right, the real endgame is uncertain. 

 

 

[ni-co]

Ok. Tail risk is small – and potential upside is up to 100% annualized. If that is what I'm paid for by taking the remaining uncertainty I think it's a very good deal. BABA is available for shorting now. Borrowing rates are near zero.

[ni-co]

One more thing: like some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium discount small.

 

Two thumbs up for Marissa Meyer for being this smart and copyiing Malone's genius deal structure (and thereby even improving it).

[writser]

One more thing: as some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium small.

 

Yes, but the key question is whether it is in their best interest to acquire SpinCo shares at par immediately. I'm not sure about that.

[ni-co]

One more thing: as some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium small.

 

Yes, but the key question is whether it is in their best interest to acquire SpinCo shares at par immediately. I'm not sure about that.

 

I'm sorry. I realize that I wrote "premium" what I meant is discount! I fully agree that there has to be a discount. But the mere possibility and obvious reasonableness of this deal will keep the discount small.

[krazeenyc]

One more thing: as some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium small.

 

Yes, but the key question is whether it is in their best interest to acquire SpinCo shares at par immediately. I'm not sure about that.

 

I'm sorry. I realize that I wrote "premium" what I meant is discount! I fully agree that there has to be a discount. But the mere possibility and obvious reasonableness of this deal will keep the discount small.

 

SpinCo will presumably never ever sell any shares of Alibaba for tax reasons. People are suggesting that Alibaba issue new shares to the shareholders of SpinCo and make a small profit and end up with a bunch of SpinCo shareholders who are looking to dump Alibaba stock. If I'm Jack Ma -- I'd say no thanks.  I love that I have a long term shareholder that is unlikely to sell stock ever.  If I'm Jack Ma, why not let Spinco sit for years and years letting the discount grow wider and wider and buy back at a time of my choosing? He's not exactly a short term thinker looking to make a quick buck.

[writser]

My thoughts exactly. Apart from "being nice" I don't see any incentive for Jack Ma to buy back SpinCo.

 

I'm not sure about the tax implications of SpinCo selling BABA shares in the open market - what would be their cost basis? In fact I am not familiar with the US tax system at all. Any insights would be appreciated. You are saying that they can basically never sell / liquidate because they would have to pay the same taxes Yahoo would be paying now? That sounds reasonable.

[Picasso]

One more thing: as some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium small.

 

Yes, but the key question is whether it is in their best interest to acquire SpinCo shares at par immediately. I'm not sure about that.

 

I'm sorry. I realize that I wrote "premium" what I meant is discount! I fully agree that there has to be a discount. But the mere possibility and obvious reasonableness of this deal will keep the discount small.

 

SpinCo will presumably never ever sell any shares of Alibaba for tax reasons. People are suggesting that Alibaba issue new shares to the shareholders of SpinCo and make a small profit and end up with a bunch of SpinCo shareholders who are looking to dump Alibaba stock. If I'm Jack Ma -- I'd say no thanks.  I love that I have a long term shareholder that is unlikely to sell stock ever.  If I'm Jack Ma, why not let Spinco sit for years and years letting the discount grow wider and wider and buy back at a time of my choosing? He's not exactly a short term thinker looking to make a quick buck.

 

+1.  I don't see how there is any other probable outcome.

[ni-co]

One more thing: as some people pointed out in the comments section under Matt Levine's article: the obvious thing for BABA to do is acquiring spinco and paying with shares only. This is really a no-brainer. They receive the discount as a windfall and simplify their capital structure without even having to hand over cash. I think this mere possibility to do an all-share deal will contribute to keeping the premium small.

 

Yes, but the key question is whether it is in their best interest to acquire SpinCo shares at par immediately. I'm not sure about that.

 

I'm sorry. I realize that I wrote "premium" what I meant is discount! I fully agree that there has to be a discount. But the mere possibility and obvious reasonableness of this deal will keep the discount small.

 

SpinCo will presumably never ever sell any shares of Alibaba for tax reasons. People are suggesting that Alibaba issue new shares to the shareholders of SpinCo and make a small profit and end up with a bunch of SpinCo shareholders who are looking to dump Alibaba stock. If I'm Jack Ma -- I'd say no thanks.  I love that I have a long term shareholder that is unlikely to sell stock ever.  If I'm Jack Ma, why not let Spinco sit for years and years letting the discount grow wider and wider and buy back at a time of my choosing? He's not exactly a short term thinker looking to make a quick buck.

 

I'm not so sure about that:

 

The other weird thing about Yahoo's SpinCo is that it will be a registered investment company under the Investment Company Act of 1940. That is: It will be a mutual fund! With one stock. (Plus Nameless ATB.) Yahoo is proud of this innovation, calling it unique in the annals of spin-offs, and as far as I know it is. The basic trick is that if your company's assets consist mostly of "investment securities" (like Alibaba shares), and you don't control the issuer of those securities, then you have to register as an investment company. Registering as an investment company subjects you to some extra regulation, and somewhat restricts your business activities, which is why most issuers prefer to avoid it (thus SpinCo's uniqueness). However! SpinCo doesn't really care that much about its ability to operate other businesses (poor Nameless ATB!), and I guess the extra burden of '40 Act registration is worth it for the tax savings.

 

http://www.bloombergview.com/articles/2015-01-28/yahoo-would-rather-not-pay-taxes-on-its-alibaba-shares

 

As far as I know the innovation here is that spinco can just dividend out its BABA shares to a non taxable investor.

[thepupil]

yep, as far as i can tell this will be a RIC. If it is, then it's a pass through vehicle and taxes will be paid at the holder level. SpinCo may be able to just say "we will liquidate in 2 years so we suggest our shareholder base be of the non-taxable sort by then" and the discount would close as the IRA's 401ks, pensions, endowments, and foundations and all the mutual and hedge funds that don't care about taxes would swap BABA for SpinCo or go long and short (though shorting that much would be problematic).

 

The people that move big money are not tax sensitive. Look at mutual fund turnover. Look at who comprises hedge funds' LP base. Look at how the vast majority of ordinary americans invest (through 401k's).

 

http://www.investopedia.com/terms/r/ric.asp

 

If the discount is 20% (the largest i think is rational because that is the max LT cap gains at the moment) so it would be a full tax discount, then the SpinCo discount lost per Yahoo share will be: 0.2*0.39*(BABA Price).

 

At a price of $100, that would be $7.8 and you would be paying about $16 per share for RemainCo, which has a full value of about $20. You'd probably lose a little money because RemainCo might trade for an even lower multiple of NAV, but it wouldn't be catastrophic either.

 

If BABA really skyrockets, and you layer on a fat SpinCo discount, then you can start to get impaired by the trade.

 

For example

 

YHOO $43.54

BABA $87.00 (0.39) = $33.93

$9.61 per share paid for stub

 

BABA triples and SpinCo trades at 20% discount

 

You would be short  $102 of BABA per Yahoo share bought

You would receive    $81 of SpinCo value

 

You would lose $21 per Yahoo share which would put your cost of the stub at close to $30. It is arguably worth $20 and will probably trade at a discount to its value so you could really lose a lot.

 

So you see how you are effectively short a far OTM BABA call with this trade. There are ways to mitigate this, but it's something to be aware of.

 

 

 

 

[ni-co]

Yes. This is a risk to keep in mind. Anyway, this is a brilliant way to do it – even improving on Malone's advisors' clever idea. I can only hope that other companies take this as an example and start thinking more about tax consequences of their actions. 

[fareastwarriors]

A Deep Discount on Yahoo’s Alibaba Stake Spinoff

 

http://dealbook.nytimes.com/2015/02/12/a-deep-discount-on-yahoos-alibaba-stake-spinoff/?module=BlogPost-Title&version=Blog Main&contentCollection=Breakingviews&action=Click&pgtype=Blogs&region=Body

[yitech]

Yahoo's Incredible Shrinking Profitability In Its Core Business

http://www.forbes.com/sites/ericjackson/2015/03/01/yahoos-incredible-shrinking-profitability-in-its-core-business

 

Eric Jackson argues that core business does only $590M of recurring EBITDA (or $190M if stripped away $400M stock-compensation costs) rather than $1.1B.

[ni-co]

I have to admit that I pulled out of this special situation investment. As a 10% position it simply demanded too much leverage for my taste.