Yahoo is one of the weirdest companies in the world. That's because it appears to be worth less than nothing.
Here's the best way to see this: Yahoo passively owns large swathes of two Asian internet companies — Chinese e-commerce giant Alibaba and a Japanese firm called Yahoo Japan. Add up the value of 15 percent of Alibaba and the value of 35.5 percent of Yahoo Japan, and you have $45 billion* — which is more than the total price of all the shares of Yahoo stock outstanding. That implies that Yahoo's main business is worth less than nothing.
That's odd. And what makes it particularly odd is that Yahoo's core business, though shrinking, is profitable.
So why is Yahoo worth less than nothing? According to Starboard Value LLP, an activist investment fund that has bought up a bunch of Yahoo shares, it's because markets think that Yahoo will destroy the value of its holdings in Yahoo Japan and Alibaba by paying corporate income taxes after selling them, and then squander the proceeds by buying unprofitable startups.
Starboard, by contrast, has a plan to make Yahoo more valuable:
- Stop buying startups
- Slash $250 million to $500 million in current spending
- Sell the Yahoo Japan and Alibaba shares
- Buy AOL
The most intriguing thing, however, is that Starboard is suggesting that Yahoo can sell the shares without paying a hefty capital gains tax bill on the proceeds. In investor-speak "with the assistance of tax counsel and independent tax advisors, we have explored a number of alternative structures that, if implemented, could deliver value for these minority equity investments directly to the shareholders of Yahoo with limited tax leakage."
How would that work? One likely scenario involves the AOL purchase.
The cash-rich split-off
One way for a company to sell shares in another company while minimizing taxes is what's known as a cash-rich split-off.
Alibaba can form a new subsidiary called SplitCo that includes both some business assets and some cash. Then Yahoo could trade 100% of SplitCo to Yahoo, in exchange for Yahoo giving Alibaba some or all of the shares of Alibaba stock that Yahoo owns. Yahoo would, in effect, be trading Alibaba shares for cash just as if it had sold them. But for tax purposes it doesn't count as a sale that would trigger capital gains taxes.
That said there are limits on how far companies can go in executing these splits. One limitation is that cash can't be more than 66 percent of the value of the spun-off enterprise. It needs to include some real business assets. Another limitation is that Yahoo would have to continue operating that business for at least two years. It's a tax dodge, but it can't be a pure tax dodge.
So that's where AOL comes in. Right now it's unlikely that Alibaba has any subsidiaries that it would want to spin off in this way. But Alibaba could buy AOL, then load AOL up with cash, and then swap the newly cash-rich AOL to Yahoo for Alibaba shares. Then that newly obtained cash could be paid out to Yahoo shareholders as buybacks or dividends.
Why would AOL and Alibaba do this?
Of course to make the deal work would require not just Yahoo to go along with Starboard's thinking, but cooperation from AOL and Alibaba as well.
The AOL part should be easy enough. Selling to Yahoo at a modest premium over AOL's current valuation seems to be the only real long-term strategy AOL CEO Tim Armstrong has for his company. The synergy between the two firms would be real, as they could combine ad sales forces and other corporate functions at a minimum. Normally the biggest obstacle to this kind of takeover is ego on the part of the smaller company's top executives, and that's not an issue here.
For Yahoo shareholders and Alibaba the key point is simply the enormous scale of the tax avoidance this would facilitate. Yahoo is looking at paying a 38 percent tax rate on its capital gains if it sells Alibaba shares. That means that if Alibaba were able to facilitate a tax-free transaction, it could reasonably demand a discount from Yahoo on the price paid for Yahoo's Alibaba shares.
Buying those shares at a discount and then retiring them will boost the value of the shares owned by Alibaba's other shareholders. It's a win-win-win for shareholders of Alibaba, Yahoo, and AOL.
Why might this deal not happen?
The American taxpayer, naturally, might have reason to reject an enormous tax arbitrage on this scale. But a cash-rich split in the context of an AOL purchase would also, in its way, be a defeat for Yahoo CEO Marissa Mayer.
When Mayer left Google to take the top job at Yahoo, her idea was to turn the company around in the sense of making it a dynamic, vibrant, growing company again. That means taking Yahoo's financial assets and investing them in new things. Mayer's signature moves — from buying Tumblr to hiring Katie Couric to making a spiffy new weather app with no clear revenue model — have all been about this vision of Yahoo as a dynamic firm.
The AOL spinoff-acquisition idea would be the opposite of that. Part of the idea is to transform the Alibaba shares into cash in shareholders' pockets, and part of the idea is to enhance the profitability of the declining Yahoo/AOL display advertising businesses by cutting costs and combining functions. This sort of value creation through financial engineering is what most activist investment funds specialize in. But it's not the kind of vision that brought Mayer to the company in the first place and likely a vision she'll resist implementing.
Correction: This article originally misstated the combined value of Yahoo's stakes in Alibaba and Yahoo Japan.