Yahoo’s History And The Alibaba Arbitrage Opportunity

Yahoo (YHOO) is one of the most criticized technology companies in the world. It is frequently seen as a step behind Apple and Google, and the haphazard growth in advertising dollars across its journalistic platforms (coupled with a non-intuitive interface) make the company an easy target for ridicule on the CNBC circuit.

While I agree that Yahoo is not a company I would put on my list of “100 Companies To Buy And Then Take A 50 Year Nap”, there are nevertheless many peripheral factors that make Yahoo far more intriguing than a superficial glance at the commentary or the news site would reveal.

David Filo and Jerry Yang hung out at student centers, bars, and coffee shops in the early 1990s while graduate students at Stanford, trying to figure out a way to get news stories and word searches to people across the United States in a more convenient manner than waiting for the morning newspaper to arrive. Talk about an ambitious side project while being a full-time student!

Although quite young, they nevertheless had some traditional sensibilities about running a company. They wanted diverse revenue streams. They wanted low, and ideally zero, debt. They were not starry-eyed inventors, but rather, ambitious men that also took care to read the footnotes. They had the heart of Silicon Valley with the mind of Depression-era A.G. Edwards.

Unlike most tech entrepreneurs that solely focused on metrics like user growth or technological innovation, Filo and Yang also had a keen eye for monetization. Growing something for free wasn’t their style–they wanted that growth to translate into cold, hard cash. As Yang said about the early days, “You can’t pay the rent with user stats.”

They incorporated in California in 1995, the same year they began selling online advertisement space on the new web-portal. They were not above the hustle. They called and called, convincing individual businesses that this would be a more efficient way to convert new customers than taking out an ad in the local paper.

Out of this disciplined history came great wealth. Even though the company is now known as the plaything of Marissa Mayer as profits have declined from $1.26 per share to $0.80 per share during her tenure as CEO, the company nevertheless has created significant wealth for long-term shareholders, maintained aspects of the original culture, and made a jackpot along the ride. It is these three things that are frequently neglected when the Yahoo brand comes up in discussion.

For instance, the Yahoo IPO is one of the most successful creations of American capitalism in the past quarter-century. If you purchased shares in September 18 years ago, you would have reaped a 21% annual compounding rate. Your $25,000 investment would be worth $1,000,000. Since Yahoo pays no dividend, you would have paid no dividend taxes, and you could borrow against the shares if you wanted to fund your lifestyle and continue enjoying the benefits of deferred taxation by leaving the ownership position intact.
The second element is the enduring aspect of Filo and Yang’s conservative culture for the company they founded. Yahoo has a much stronger balance sheet than most people would guess. It doesn’t have any pension plan that it must fund, and it is sitting on $5.2 billion in cash against $1.1 billion in debt. It continues to be the cash-rich company that Filo and Yang originally envisioned, having the balance sheet capacity to ride through an extended period of tough operating conditions.

But Yang’s greatest creation of shareholder value came when convinced Alibaba’s Jack Ma that Yahoo should take a $1 billion ownership position worth over 30% of Alibaba’ stock (and Yang was creating “Project Pebble” as part of an e-commerce rival gambit to force Ma’s hand into negotiating).

Eventually, Yang hustled and prevailed–golfing with Ma and his Alibaba deputies at Pebble Beach to develop personal relationships, and then convincing his own Board that the enigmatic Jack Ma was worthy of a $1 billion investment. That was no easy task, as Ma had recently ended his stint as a Chinese government tour guide at the Great Wall of China where he earned poverty wages.

The social signals that this man was worth a $1 billion investment was not evident if you make decisions based on the ornaments of success rather than measuring a man’s potential according to his intelligence, entrepreneurial IQ, and inner drive. Yang did the latter, and was richly rewarded for it.

That 30% stake, which cost $1 billion, eventually became a goldmine. The success of this investment was greatly diminished as Yang was forced at Yahoo and did not get to see the investment through. When Microsoft’s Steve Ballmer courted Yang in 2008 in an attempt to acquire Yahoo, Yang rejected the overture (much to the chagrin of shareholders who could have quickly tripled their investments).

Then, Yang failed to acquire Facebook two years before its IPO as he haggled over a $1 billion price tag. Suddenly, Yang found himself the cancer of Wall Street and Silicon Valley. Despite his first-mover status in the search world, he found his firm quickly overtaken by Google despite his own intelligent integrations of e-mail, opinion, news, and search. As Google thoroughly stole market share from Yahoo, Yang’s stature in Silicon Valley rapidly diminished. He was David Duval losing his halo for not matching the greatness of Google’s Tiger Woods.

The market share losses, inability to buy Facebook, and rejection of an acquisition from Microsoft eventually led to Yang’s overthrow. That is the dark side of taking your creation public. If you become unfashionable, you no longer get to water the tree you grew from a seedling.

But the new Yahoo team, led by Marissa Mayer, proved no more capable. In 2012, Yahoo decided to sell half of the Alibaba stake against Yang’s counsel back to Alibaba for $13 per share. Those shares, which peaked at $120 last year, and now trade at $60, offer a reminder to Yahoo’s current management that hindsight bias can be a cruel mistress–they have committed the same sin they drove out Yang for committing.

It is this Alibaba stake, however, that has caught my attention and led me to take Yahoo seriously as an investment for the first time in my life. There is a reason why Yahoo has been quietly popping up into the portfolios of value investors across the country.

Right now, the Alibaba stake on Yahoo’s balance sheet is worth $24 billion. Yahoo itself is worth $29.5 billion. Later this year, Yahoo will be spinning off the Alibaba stake in the form of Aabaco Holdings as a way to provide value to shareholders. This transaction is so shrewdly assembled that it will result in no capital gains taxes for Yahoo shareholders when they receive Aabaco as an independent indicator of the Alibaba investment.

The lawyers at Yahoo have been so clever at using the tax code to get Alibaba stock to existing shareholders that the SEC has released an advisory opinion indicating that it may change the rules for future companies that spin off large public investments in order to eliminate the possibility of mandatory capital gains taxes. It is Major League Baseball lowering the mound after Bob Gibson’s 1968 season all over again.

This is worthy of your own due diligence. Yahoo is currently valued at $5 billion. It makes $750 million in current profits, has a $5.2 billion balance sheet, and is about to repurchase $2.7 billion of its own stock. The business is valued according to the cash on its balance sheet–it as if Wall Street has marked down the Yahoo business to zero. And you also get Alibaba, which has grown profits from $1.56 to $2.10 in the past year and would likely become the fasting growing component of your overall portfolio.