Yahoo To Explore Sale Of Core Internet Business: Does It Make Sense?

  • Yahoo's board will soon meet to discuss Starboard's latest proposal to spinoff Yahoo's core instead of Alibaba, as earlier planned.
  • Spinning off Yahoo's core carries much less risk if the IRS decides to tax the transaction.
  • Will Starboard get its wish?

It’s about 2 weeks since activist investor Starboard urged Yahoo (NASDAQ:YHOO) to abandon plans to spin off Alibaba and instead sell its under-performing Internet business due to underlying tax implications.
Here is an excerpt from Starboard’s letter to Yahoo’s management:

Despite our continued belief that the proposed spin-off of Aabaco Holdings should be deemed tax free under current law, we believe it is important to note the market's assessment of the current strategy.  Irrespective of the impending tax-free spin-off, it is clear the market has a dim view of the Company's current strategy.  As shown on the table below, the market either discounts the tax benefits of the proposed spin-off and/or, worse, implies a significantly negative value for the Core Business based on a justifiable fear that the current turnaround efforts will fail and current management will continue to squander the Company's resources.  At best, the current stock price implies a meager ~2x consensus 2015 EBITDA multiple on the Core Business.

Starboard then worked out the valuation the market is assigning to Yahoo’s core Internet business as follows:

Implied value for Yahoo's Core Business
Current YHOO Enterprise Value $31,230
Less: Alibaba Group stake at 38% discount ($18,622)
Less: Yahoo Japan stake at 38% discount ($5,019)
Less: Net cash ($5,572)
Implied value of Core Business $2,017
2015E EBITDA $926
Implied 2015E EV/EBITDA multiple 2.2x
2016E EBITDA $838
Implied 2016E EV/EBITDA multiple 2.4x
Source: Company filings, Bloomberg, and Starboard Value estimates.
Note: As of November 17, 2015.

Source: PR Newswire

Starboard’s argument is that the market values Yahoo’s core business very poorly at just ~2x consensus 2015 EBITDA multiple-- and it has a point. After all, Verizon bought AOL for ~7 x EBITDA despite the fact AOL’s core dial-up business is almost moribund. Most Internet businesses receive a valuation of ~11 x EBITDA or more. Yahoo’s Internet business might be shrinking, but assigning it such a low valuation or a negative one at that is absurd at best.

Starboard’s crux of the argument is that given the uncertainty surrounding the question of whether or not the IRS will tax the planned Alibaba spinoff, the best thing to do is to prepare for the worst and simply spinoff Yahoo’s core business which, if taxed by the IRS, would be much less punishing for investors. And Starboard is right. Even assuming Yahoo’s core is lucky to receive a valuation of ~5x EBITDA, a 38% tax rate for the spinoff would mean a much lighter tax bill of ~$1.9 billion compared to ~$10 billion tax payable if the company was to spinoff its 15% stake in Alibaba instead.

The good news for Yahoo’s investors is that the company’s management has already indicated a willingness to deliberate on Starboard’s new proposal. Yahoo’s board will meet later this week to talk over the matter, though no one is sure when a verdict will be ready.

Valuation matters aside, is there any company that would really be interested in buying out Yahoo’s core Internet business?

Any takers for Yahoo?

That is the million dollar question. It’s not always that a company that puts itself up for sale ends up finding a buyer. Yelp (NYSE:YELP) is on record scouting for a buyer earlier this year, yet no bids came forth. A few tech names have been mentioned as possible Yahoo buyers namely Microsoft, Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), and Alphabet Inc-C (NASDAQ:GOOG).

Microsoft (NASDAQ:MSFT) is the only company here that’s on record wanting to buy Yahoo when it placed a $33/share bid for the company back in 2008. Although Yahoo turned down the offer, and Microsoft later said it would not be interested in pursuing the merger, Microsoft still remains the best candidate for a merger with Yahoo.

Microsoft and Yahoo have an ongoing search engine partnership where Yahoo depends on Microsoft’s Bing Search to power Yahoo’s search engine. The two companies had a similar deal dating back to 2010 which later turned acrimonious before the two made up and renewed the deal in 2014.

Now, Yahoo’s search engine deal with Bing is a revenue-sharing agreement where Microsoft gets a cut of all search revenues generated by Yahoo search. The earlier agreement involved Microsoft taking a 90% cut. Although no details are available for the new deal, it’s likely that Microsoft’s cut was lowered to maybe around 80%.

One thing that investors often neglect is the fact that Yahoo and Bing are almost evenly matched when it comes to global search engine share.

Yahoo-2

Source: Chinese Internet Watch

Microsoft has lately been indicating its intention to strengthen Bing, and I can’t think of a better way of doing it than by acquiring Yahoo. By merging with Yahoo, Microsoft would now take 100% of the revenue generated by Yahoo’s search engine and might even in future decide to integrate Yahoo’s search engine into Bing.

Now as to the question whether Yahoo’s management will rule in favor of spinning off Yahoo’s core instead of Alibaba as earlier planned? Yahoo’s management had previously said this in this 8-K report:

‘‘On September 23, 2015, Yahoo's Board of Directors authorized the Company to continue to pursue the plan for the Aabaco spin-off transaction as previously disclosed, except that completion of the spin-off will not be conditioned upon receipt of a favorable ruling from the IRS...

On September 28, 2015, Aabaco filed Amendment No.1 to its Registration Statement on Form N-2 which is available on the SEC's website at sec.gov using the name Aabaco Holdings, Inc.

Completion of the transaction is expected to occur in the fourth quarter of 2015, subject to the conditions described above.’’

But given the fact that management has already indicated a willingness to explore the new option, it won’t come as a surprise if Starboard gets what it wants.

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