Did Yahoo! Just Learn a Lesson About China?

Yahoo! (Nasdaq: YHOO  ) stock was off sharply yesterday, and this time it wasn't due to poor results in search or advertising or CEO Carol Bartz dropping the f-bomb. Rather, it was because analysts feared Yahoo! had lost its ownership interest in Alipay, an online payments processor in China that is arguably one of the company's most valuable assets.

It all started with this disclosure in Yahoo!'s most recent 10-Q, one that probably should have started with something like "See, here's what happened ... ":

To expedite obtaining an essential regulatory license, the ownership of Alibaba Group's online payment business, Alipay, was restructured so that 100 percent of its outstanding shares are held by a Chinese domestic company which is majority owned by Alibaba Group's chief executive officer. Alibaba Group's management and its principal shareholders, Yahoo! and Softbank Corporation, are engaged in ongoing discussions regarding the terms of the restructuring and the appropriate commercial arrangements related to the online payment business.

The reason this matters is because it's recently become fashionable to claim that Yahoo! stock is undervalued relative to the value of its assets in Asia. I laid out this investment case in Motley Fool Global Gains last January, estimating that Yahoo! was worth at least $20 per share -- and potentially much more -- after you add up its nearly $3 per share in cash and securities, value its U.S. business at about $5 share, add about a $4-per-share after-tax value for its stake in publicly listed Yahoo! Japan, and then value out its stake in Alibaba Group, which includes Alibaba.com, Taobao.com, and Alipay to be approximately $8.

That valuation, which values Alibaba Group overall at about $30 billion, is largely based on a discounted cash flow model and may turn out to be conservative. Using a run rate of Q4 results, in which Alibaba Group's sales were up 99% to $545 million and earnings turned from a $157 million loss to a $33 million profit (the bright side here is that the Yahoo! 10Q also revealed that Alibaba Group is doing great), a $30 billion valuation is just 14 times annual sales and 234 times annual earnings. While that sounds expensive, it's well within the realm of what top Chinese Internet companies are currently worth on the market.

Company

P/S

P/E

Baidu (Nasdaq: BIDU  )

35.6

78.2

Youku (Nasdaq: YOKU  )

80.4

Negative

Tencent

14.7

35.0

Renren (NYSE: RENN  )

57.4

Negative

SINA (Nasdaq: SINA  )

18.3

Negative

Sohu (Nasdaq: SOHU  )

5.6

22.4

Ctrip (Nasdaq: CTRP  )

15.7

43.4

Source: Capital IQ.

And I'm not the only analyst who has observed this. David Einhorn of Greenlight Capital wrote recently to shareholders that he, too, was buying shares of Yahoo!:

YHOO currently has $3 per share of net cash on its balance sheet and has approximately another $8 per share of value in its two minority equity stakes of publicly traded companies in Asia...Assigning a conservative valuation (5x current year EBITDA) implies $18 per share for just the core businesses and publicly traded securities and cash. We believe that Yahoo's most valuable asset is its 40% stake in Alibaba Group's still-private holdings, which are separate and distinct from its ownership in the publicly traded Alibaba.com, which we are essentially getting for free.

Those still-private holdings are Taobao, China's top business-to-consumer and consumer-to-consumer e-commerce website, and Alipay, the platform that makes it all run. Of course, if Alibaba Group no longer owns Alipay, then my thesis, Einhorn's, and many others have been undermined.

So the stock drops
That, at least, was the view of Stifel Nicolaus analyst Jordan Rohan, as reported by Forbes. He wrote to clients:

Investors valuing Yahoo on its sum of the parts will have to remove Alipay from the equation ...The worst case scenario is that payment rates on Alipay creep upward, while Taobao rates are lowered, thus diverting economic profit away from the Alibaba Group (and Yahoo) into the new entity. The animosity between the Alibaba Group and Yahoo management has been well documented.

The conspiracy theory here is that because Alibaba Group Chairman and CEO Jack Ma and Yahoo! no longer like each other -- a well-documented fact in Chinese and American tech circles -- he would seek to defraud it of its ownership stake in Alipay. I don't think that's correct. The risk that the Chinese government would view Alipay as a banking instrument and therefore restrict foreign ownership of it -- as it does in other so-called strategic sectors such as defense, media, and telecommunications -- has long been known. And while it is disheartening that Alibaba Group ceded ownership of the asset before working out a deal whereby it maintains its economic interest, I believe such a deal is not only possible, but likely.

Why it's not so bad

There are a few reasons for this. First, remember there is a third party present to the negotiations here, and that's SoftBank, the massive and influential Japanese investment bank that also owns a significant stake in Alibaba Group. Ma is a director at Softbank. If he manages to steal away Yahoo!'s economic interest in Alipay, he will also steal it away from SoftBank -- an unlikely scenario.

Second, Ma has a lot to lose from a reputational standpoint if he were to stiff Yahoo!. Ma is China's most high-profile entrepreneur and has received numerous awards for his ethics, philanthropy, and acumen. Manipulating Alipay away from Yahoo! would damage his image; trust lost is not soon regained.

Third, there's an easy solution to the ownership structure here, and it's one that's been used over and over by Chinese companies to circumvent these regulations. That solution is an operating contract, and it was used most recently by Renren, which has been deemed a telecommunications company in the eyes of the Chinese government, to let foreigners have an economic interest in the company. The way it works is that the operating company owned by Chinese in China agrees with a holding company outside of China to allow the economic benefits of the operations in China to accrue to the holding company even as control is exercised by the Chinese management. There are some issues with this arrangement, but so long as you trust your counterparty and the management team to run the show, there is minimal difference to Yahoo! from an economic standpoint.

The global view
When it comes to putting money to work in China, there are many unique risks that investors, whether individual like you and me or large and professional like Yahoo!, need to get comfortable with. And while Yahoo! is learning a lesson today about China's legal and regulatory frameworks, I believe a solution is in the works and that it will be protected by the fact that it has a reputable business partner (even if the two sides don't like each other on a personal level).

All told, the investment case for Yahoo! is still intact despite this week's revelation, and the stock is a buy below $17.

Get Tim Hanson's top global stock picks by joining Motley Fool Global Gains. Tim's "Global View" column appears every Thursday on Fool.com.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. The Fool owns shares of Yahoo!. Yahoo! is a Global Gains recommendation. SINA is a Stock Advisor choice. Baidu is a Rule Breakers recommendation. Ctrip is a Motley Fool Hidden Gems choice. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (20)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2011, at 1:37 PM, WisRealtor wrote:

    Ok, I really like this article, but not so much the headline.

    No doubt Yahoo learned that being proactive about a future story, on an event they new would be coming, is important.

    More important with yesterday's 'event' with trading was the media portrayal of what may be going on.

    I appreciate the detailed nature of this story, as it talks about multiple angles of this story...and that's something worthwhile in itself!

    Thanks again!

  • Report this Comment On May 12, 2011, at 1:58 PM, Gonzhouse wrote:

    I agree the analysis is factual (and I am a subscriber and long-time fan of TMF Global Gains team). But lately I keep coming back to a central question with regard to Chinese companies: are they worth the hassle?

    On the Yes side is the irrefutable fact that the growing economic impact and power of China will be reflected in the value of Chinese companies. The emphasis in the acronym BRIC is on the 'C', no question.

    On the No side is a litany of concerns: questionable financials with auditors walking off the job, short-sellers pummeling the stock (even if unwarranted), lack of transparancy on dealings, and now with Yahoo's Alipay situation, the possibility that if we don't like you we'll just cut you out of the picture.

    While this worse-case is not proven, how many other shoes are going to drop? And how much worry do I want with a stock?

    Again, I'm a big supporter of Tim H and the GG team. But the drama around Chinese companies is not where I need to be spending my energy. I'm done.

  • Report this Comment On May 12, 2011, at 3:18 PM, TMFMmbop wrote:

    Thanks, Gonzhouse. To be honest, I don't think you're irrational to be thinking that way. Long-term, I think the returns will be worth the hassle, but the near-term stress may mean I don't live long enough to appreciate them anyway.

    Is that morbid?

    Best,

    Tim

  • Report this Comment On May 12, 2011, at 4:15 PM, Gonzhouse wrote:

    Tim,

    If "what doesn't kill you, makes you stronger", I'll be seeing you on The World's Strongest Man show pretty soon.

    As a member of the GG team, I know you can't plausibly blacklist companies with significant exposure to the largest country in the world. (In fact, companies that don't have exposure to China should be questioned.) But the Yahoo situation is different: the exposure is non-management ownership of a Chinese company, not operational (like YumBrands).

    Terminating Yahoo's ownership of part or all of Alibaba will not have any operational impact on the Alibaba (hopefully there would be legal ramifications). Compare that to Yum Brands, where the supply chain is at least moderately dependent upon the parent.

    I'm just pointing out that Yahoo is in a very unique risk situation.

  • Report this Comment On May 12, 2011, at 4:46 PM, samwise7 wrote:
  • Report this Comment On May 13, 2011, at 5:51 AM, ershler wrote:

    It isn't like China cutting off US companies access to the Chinese market is a new thing. It happens in some degree to most US companies that do business there.

  • Report this Comment On May 13, 2011, at 7:19 AM, outlawnyc1 wrote:

    Your take on the situation regarding alibaba and alipay is exactly the same as mine -- in particular regarding Jack Ma's reputation.

    What is interesting to me is Yahoo's statement. I do believe that Yahoo needed to come out with a public statement to assure its investors, but the statement does not do this. In fact, I believe the Yahoo statement simply creates more confusion.

  • Report this Comment On May 13, 2011, at 9:28 AM, TMFMmbop wrote:

    It's not shocking to me that Yahoo could mishandle PR. Down below $16 I think this gets very interesting.

    Tim

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