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.

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.

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