A Full Break-Up Of Yahoo Vs. Swift Completion Of The Aabaco Spin-Off

Summary

  • This week the board of Yahoo will consider whether to pursue a sale of the core business in place of or in addition to the spin-off of Aabaco.
  • The board should undertake a comprehensive breakup of Yahoo, or move swiftly to complete the Aabaco spin-off. The board faces issues of personal liability and must act now.
  • Yahoo Japan can be readily spun off even under more restrictive temporary IRS guidelines and Alibaba is faking disinterest in the purchase of Yahoo’s Alibaba stake (with good reason).

For readers familiar with Yahoo’s (NASDAQ:YHOO) planned spin-off of its 15% stake in Alibaba (NYSE:BABA), we begin with the conclusion. Those new to the subject would be advised to begin a little farther down the page with ‘Recent Events’.

Conclusion

While the tax-free nature of the Aabaco (AABAV) spin-off is virtually assured according to the company, the bulls (and even the bears), the Yahoo core remains stubbornly mispriced. In response, Starboard has threatened to remove the Yahoo board unless it sells the Yahoo core in place of the Aabaco spin-off. However, the board would be exposing itself to personal liability by taking such action.

Instead, we propose a middle way. Wall Street is waiting for Aabaco to spin so that Yahoo’s shares of Yahoo Japan can be spun and so that the Yahoo core can ultimately be sold. Instead of piece-mealing the process, the board ought to honestly recognize that the value maximizing choice is to associate a merger premium, rather than a tax discount, with each of its pieces.

The board should retain advisors and announce a comprehensive break-up plan including the spin of Yahoo Japan, the sale of the core and the sale of the residual Yahoo that would consist only of Alibaba shares and some cash. The board should do it all at once and do it now so one of the most storied and successful companies in the history of Silicon Valley can evolve out of its slump and prosper once more in a new incarnation. Otherwise, the board should get on with the business of the Aabaco spin-off.

Recent Events

On November 16th, Aabaco filed the third version of the SEC Form 10 related to Yahoo’s planned spin-off of its 15% stake in Alibaba. Three days after Yahoo filed the amended Form 10, on November 19th, Starboard Value LP published an open letter to the board of Yahoo, encouraging an outright taxable sale of the core Yahoo franchise, in place of the Aabaco spin-off. On November 19th, that same day, Yahoo responded through David Faber of CNBC (transcript), affirming that the tax-free treatment of the Aabaco spin-off was ‘virtually assured’.

Starboard is known for having removed the entire board at Darden Restaurants (NYSE:DRI), Olive Garden, Outback Steak House, Red Lobster etc.). Starboard’s letter represented a complete turnaround of their prior advocacy on behalf of the Aabaco spin and ostensibly threatened to remove the Yahoo board this coming spring. Starboard’s reason? The value of Yahoo, excluding Alibaba (YHOO – 0.4x BABA) reached $1.48 that day, even though the sum of its parts was worth $18.73.

Yahoo’s cash balance was worth $5.78/share, its Yahoo Japan public stock holding was worth $8.63/share and the core business was worth $4.32/share (assuming 5x $840mm of EBITDA). Yahoo net of its Alibaba stake, otherwise known as the Yahoo Stub, fell to as low as 11c on December 1st before rebounding to $1.30 as of the close last night.

The Yahoo share price has become a proxy for the Alibaba Share price, and IRS rules and precedent provide that a company gets tax relief if it decides to fix this kind of problem via a spin-off. However, no one seems to care because the IRS politely declined to rule on the question back in September. Never mind that well regarded tax expert Bob Willens believes the spin would be found to be tax free if ever contested (say five years from now) and that even the biggest bear on the Street, Bob Peck of Sun Trust, believes the spin has a 90% chance of never being contested. When the difference between the educated bull and the non-expert bear is only 10%, one has to wonder what’s still bugging Mr. Market. Starboard, sensing that the market was simply unwilling to bear even a vanishingly small tax risk, penned their letter. It worked.

On December 2nd, The Wall Street Journal (article 1, 2, 3) Recode (article 1,2, video), and CNBC (video) reported that this week, the Yahoo board will consider whether to undertake a sale of the Yahoo core in addition to or in place of the Aabaco spin (or undertake some other form of break up). The board was slated to make its final vote this week on the Aabaco spin-off in preparation for the definitive Form 10 filing. CNBC also reported on December 2nd that the board would be speaking with Jeff Smith of Starboard.

Starboard’s actions have improved in the pricing dynamics of the situation. Competing buyers may bid up the sum of the parts. Yahoo may now be in a position to charge a merger premium for its components, rather than see tax discounts applied. From a tax perspective, if Yahoo can attract bidders, then it would have the full body of M&A tax law at its disposal to achieve a tax-free break-up rather than just the part of the tax code governing spin-offs.

The Board’s Decision

Other than price gyration in the Yahoo stub, nothing material has actually happened with respect to the Aabaco spin-off from the time of the filing of the Nov. 16th Form 10. Back in September, the IRS indicated that it had not concluded that the proposed spin-off transaction was taxable and therefore was not ruling adversely on Yahoo’s private letter request. The board consulted its tax counsel (Skadden Arps) and reconsidered the core spin/sale scenario. Upon reflection, they decided to proceed with the spin-off.

What has actually happened is that both the CEO and CFO aggressively reaffirmed the spin on the 3Q call (CEO: “it’s a matter of when not if” CFO: “we can see the goal line”), and the Nov. 16th Form 10 includes a 2015 record date. The only reason to re-deliberate now is because Starboard has threatened to remove the board (similar to the removal of the Darden board) by saying it will “look to make significant changes to the Board if you continue to make decisions that destroy shareholder value.”

The board has no bona fide reason to stop the spin-off other than as an act of self-preservation to appease Starboard (unless of course the board undertakes a broader mandate to break up the business altogether). Yahoo cannot explain away a ‘will’ level tax opinion from Skadden and three Form 10/N-2 filings on fear of the taxman who has passed on three chances to nix the spin-off (no matter how worried one might be about Aabaco’s post spin-off discount).

To cancel the spin without a bid for the core or a comprehensive break-up plan in hand would guarantee the board members an otherwise indefensible legal position in a shareholder lawsuit. In that light, let’s take a quick recap of some of the key issues affecting the board’s decision.

The Tax-Free Treatment of Aabaco

The three main lines of thought in support of the tax-free treatment of Aabaco are as follows:

(1) The IRS has passed on three virtually costless opportunities to stop the transaction. They could have; (A) provided an adverse ruling instead of a ‘no rule,’ (B) issued a Notice of Proposed Rule-Making in September related to spin-offs (they issued a more gentle Revenue Procedure) and ((NYSE:C) the Revenue Procedure purposefully omitted a retroactive date for new rules (if any) that may or may not come to pass later next year after the spin-off is long done.

With these observations in hand, let’s step back and voice the market’s anxiety: The IRS plan is now to wait in the weeds for years so that they may later spend millions in a complex (and risky) multi-year litigation? So, that’s why Yahoo should confine shareholders to a certain $1bn cash cost by taxably selling the core franchise (as Starboard suggested in its open letter to the board)?

(2) The top transactional tax law firm in the country, Skadden Arps, has advised Yahoo that it will provide a ‘will’ level opinion (i.e. strongest) in support of the tax-free treatment of the Aabaco transaction. Recall that as a good corporate citizen, Yahoo has already paid billions in cash taxes related to the sale of BABA stock in Alibaba’s Sept. 2014 IPO. This is not the land of pharmaceutical inversion deals, and even if it were, the rule changes don’t seem to have fazed Pfizer (NYSE:PFE) and Allergan (NYSE:AGN), who just announced a multi-billion dollar inversion deal. We agree with Skadden for two reasons:

Yahoo’s 15% stake in Alibaba represents more than 98% of Yahoo’s market cap and is today inhibiting the company’s ability to compensate employees with options that relate to the performance of the US business. If this continues, nothing a Yahoo employee ever does can influence the Yahoo stock price to outweigh the effects of a change in the BABA share price. The IRS has ruled in published guidance that companies that suffer from this problem are entitled to tax relief.

This bloated Alibaba cross holding is also preventing the company from using its stock as merger currency (after all, an acquisition target would have to decide whether it likes BABA stock, not YHOO stock in a share for share deal). In terms of strategic M&A, Yahoo is the proverbial sitting duck. Here again, the IRS has ruled in published guidance that companies that suffer from this problem are entitled to tax relief.

(3) Independent tax expert Robert Willens thinks the spin-off will not be subject to taxation. We spoke with Mr. Willens last week and he reiterated this belief in the tax-free treatment of the Aabaco spin. His view is best captured in the following quote from him in September.

“I think the spin-off will proceed as planned and in the final analysis will be found to be tax-free.” Source

As an aside, when a whole company merges into another for stock consideration, the IRS does not charge a capital gains tax. With Alibaba comprising 98%+ of Yahoo’s market cap, one might argue Yahoo is making use of that same principal in reverse (with a stock de-merger instead of an all-stock merger).

A Word on a Tax -ree Spin-off of Yahoo Japan

The value of the Yahoo Japan ($8.5bn) cross holding is much smaller than the value of the Alibaba cross holding and therefore much more easily handled for tax purposes. The Yahoo Japan shares could be spun-off tax free if Yahoo contributed to a spin-co an active trade or business with roughly $85mm of EBITDA. At a multiple of 5x EBITDA, this active trade or business would be worth $425mm, or approximately 5% of $8.5bn. That would make a Yahoo Japan spin-co eligible for tax free treatment under even the more conservative temporary spin-off guidelines issued by the IRS. The spin-off could be part of a spin-merger, where the Yahoo core would be acquired and a Yahoo Japan vehicle spin-off commensurate with the close of the overall merger.

A Word on Alibaba’s Motivations

The FT reported in February of this year that Alibaba was deeply concerned about the emergence of a shadow market in their stock via the Aabaco spin-off. Alibaba cannot discuss the purchase of Aabaco or the Yahoo core with Yahoo or its advisors without triggering a law that would put a two-year delay on the acquisition of Aabaco by Alibaba. So, don’t be surprised if Alibaba feigns lack of interest in Aabaco, but be assured they are very interested.

While Jack Ma maintains effective control of the board, he doesn’t want the Wal-Marts and Amazons of the world to be able to take a 15% stake in his company without so much as placing a phone call to Alibaba headquarters in Hangzhou, China. That’s a real possibility if Aabaco remains outstanding. Lastly, Alibaba can freeze the tax liability inside Aabaco and watch its present value decline to zero over the next forty years through the mechanism of something called a preferred stock conversion.

So, don’t be fooled, Alibaba has big plans for Aabaco – they’d like us to believe they only care to buy it at a discount – but its very existence troubles them deeply and only they have the unique ability to truly eliminate all trace of the tax burden. While the spin-off itself will be tax-free, Aabaco will carry with it a capital gains tax liability – it is that liability that Alibaba can reduce with time and a preferred stock conversion.

Conclusion

While the tax free nature of the Aabaco spin-off is virtually assured according to the company, the bulls (and even the bears), the Yahoo Stub remains stubbornly mispriced. In response, Starboard has threatened to remove the Yahoo board unless it sells the Yahoo core in place of the Aabaco spin-off. However, the board would be exposing itself to personal liability by taking such action.

Instead, we propose a middle way. Wall Street is waiting for Aabaco to spin so that Yahoo’s shares of Yahoo Japan can be spun and so that the Yahoo core can ultimately be sold. Instead of piece-mealing the process, the board ought to honestly recognize that the value maximizing choice is to associate a merger premium, rather than a tax discount, with each of its pieces.

The board should retain advisors and announce a comprehensive break-up plan including the spin of Yahoo Japan, the sale of the core and the sale of the residual Yahoo that would consist only of Alibaba shares and some cash. The board should do it all at once and do it now so one of the most storied and successful companies in the history of Silicon Valley can get out of its slump and prosper once more in a new incarnation. Otherwise, the board should get on with the business of the Aabaco spin-off.

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