By John Foley
July 31, 2013


Alibaba is Yahoo’s best investment, and its most frustrating problem. The search giant’s 24% stake in China’s biggest online retailer is probably worth more than Yahoo’s entire booked assets of $16 billion. But a future initial public offering, in which Yahoo has promised to sell half its shares, may deliver much less. That’s because Alibaba holds most of the cards.

Yahoo acquired its Alibaba stake as part of a $1 billion investment made in 2005. In September 2012, Yahoo sold half of its holding in Alibaba for $7.1 billion before taxes. Under the terms of a May 2012 shareholder agreement, Yahoo will sell half of its shares in Alibaba if an initial public offering takes place before Dec. 31, 2015. Alibaba can choose whether to buy the shares or have Yahoo (YHOO) sell them in the offering. After that, Yahoo and other key shareholders will be prohibited from selling stock for one year.

A company raising growth funds typically wants a high IPO price, to raise the maximum proceeds for the sale of the fewest shares. But Alibaba is unlikely to raise new money in an IPO. It has plenty of cash, having recently borrowed $8 billion from banks at an interest rate of roughly 4%. If the only shares sold are Yahoo’s, Alibaba’s bosses could be less concerned about a high initial share price and more interested in strong stock performance thereafter.

MORE: What Google could learn from Yahoo’s acquisition strategy

There’s another reason to keep a lid on the price: Facebook’s (FB) experience. The U.S. social network priced its 2012 IPO at a twelve-digit dollar valuation, and then watched its shares fall precipitously. It took over a year and a big boost from this week’s earnings report to bring the stock back to its IPO price. Absolute numbers matter less than relative valuations, but the psychology counts.

Alibaba’s revenue increased 71% in the first quarter of 2013 from a year earlier to $1.4 billion, according to filings by Yahoo earlier this month. Earnings increased 189% year-on-year to $680 million in the quarter, according to the Yahoo presentation, with an operating margin of 51%, the highest since 2010. Yahoo discloses Alibaba’s headline financial results with a three-month delay.

Analyst estimates and market chatter of a valuation as low as $60 billion for Alibaba is already puzzling. Suppose the company can ramp up its roughly $1.4 billion of earnings last year by 50% this year and next. Apply Facebook’s lowest price-to-forward earnings ratio of 30 times, according to Eikon, and Alibaba should tip the scales at nearly $100 billion.

Yahoo has some influence. It has a representative on Alibaba’s board and the right to appoint an investment bank to help run any offering process. The 12% stake it would still own after an IPO also offers some comfort — albeit locked up for a year — if Alibaba shares shoot up after their market debut.

And with no IPO date set, there’s also time for compromise. Yahoo might, for example, be able to strike a deal to sell its entire stake while perhaps also sharing in future stock price gains over an agreed period. That would require tough negotiations, but Yahoo investors would probably appreciate the clean exit. After eight fractious years, Alibaba may even be prepared to pay up to get a clean break of its own.

Read more at Reuters Breakingviews.

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