Yahoo (YHOO) stock has surged 12% in the days following its decision to move forward with its tax-free spinoff of the 384 million shares of Alibaba (BABA) that it owns.
This news comes despite Yahoo not receiving a favorable ruling from the IRS, which means YHOO might eventually get stuck with a tax bill after all. Nevertheless, Yahoo is wise to proceed with the spinoff, a move that will benefit shareholders in the long term.
What’s Going On?
A private letter ruling is a blessing from the IRS. Had YHOO been given one, it would attach the letter with its tax return and not have to worry about taxes on the 384 million shares of Alibaba that it plans to spin off.
Without the blessing, and with Yahoo moving forward anyways, investors anticipate a legal battle that has billions of dollars at stake.
With that said, there aren’t many investors or analysts who thought YHOO would have any trouble with this spinoff prior to this year. That’s because so many companies before Yahoo have used spinoffs as a way to eliminate taxes and create shareholder value. The taxes are still paid — but usually by investors rather than the companies themselves.
It wasn’t until this year, back in May, that Bloomberg reported that the IRS was considering certain changes regarding what qualifies as a tax-free spinoff. This report was the start of a multi-month slide where more than one-third of Yahoo’s stock value was wiped out, ending with the IRS decision recently.
However, Yahoo is choosing to move forward because it doesn’t technically need the IRS’s blessing for the spinoff. Sure, it may get stuck with the tax bill, but Yahoo has employed some of the best counsel whose opinions are strong enough to convince Yahoo that it can win this case.
While I am no lawyer, one must figure that Yahoo can look to historic spinoffs of similar nature and point to the fickleness of the IRS in making rule changes as reasons that YHOO should come out on top.
Regardless of how YHOO plans to fight the IRS’s ruling, the company has already spent boatloads of money and time associated with this spinoff, so it wouldn’t make financial sense to start all over.
While some analysts predict that $9 billion in tax payments could be at stake, Yahoo’s counsel continues to believe that Yahoo will not have to pay the tax bill, and, at the very least, Yahoo would likely settle on a much smaller payment after a long, drawn-out legal process that could take years to materialize.
In other words, Yahoo has 9 billion reasons to fight however long it needs to.
What About YHOO Stock?
When the dust finally settles and Yahoo’s Alibaba stake is spun off, YHOO will be a great investment opportunity. Here’s why:
Yahoo’s stake in Alibaba is currently worth $24.5 billion. YHOO also owns a 35% stake in Yahoo Japan that is valued upwards of $9 billion. Furthermore, Yahoo has $7 billion of cash and equivalents. Lastly, the core YHOO business is worth something. This year, the company is expected to generate $5 billion in revenue, so at one times sales, let’s assume that Yahoo’s core business is worth $5 billion.
Collectively, this equals $45.5 billion, but yet YHOO’s market capitalization right now is just $29 billion. That’s a huge disconnect.
For those unfamiliar, that $24.5 billion worth of Alibaba that Yahoo is about to spin off will be removed from Yahoo’s market cap. Therefore, if the spinoff were to happen today, YHOO’s new market capitalization would be $4.5 billion — its current market cap minus its BABA stake. That means Yahoo’s cash and Yahoo Japan stakes are completely unaccounted for, at about $16 billion.
Therefore, somewhere down the road, that valuation will reflect on YHOO stock. Perhaps Yahoo spins off Yahoo Japan stake to create shareholder value, makes a big acquisition, or maybe it launches a huge buyback program. Regardless, YHOO has a lot of options to drive shareholder value, but it needs to rid itself of a volatile BABA investment that has driven sentiment lower and has played a huge role in the underperforming stock price.
That fact alone makes YHOO wise to pursue the spinoff, and the fact that it has a good chance to win against the IRS makes it that much better.
As of this writing, Brian Nichols owned shares of Yahoo and Alibaba.
