Beware fake arbitrages on Yahoo - Alibaba!

For an arbitrage opportunity to exist, asset classes need to be fungible (deliverable against each other), so anyone selling you a scheme to "arbitrage" an apparent pricing disparity between related, but non-fungible, assets maybe selling you a dud.

When I see investor research by banks, who should know better, promoting "the Yahoo arbitrage trade" whereby the muppets are advised to short Yahoo Japan and Alibaba against a long Yahoo Inc (ie generating 3 trades and 3 commissions), alarm bells ring.  The logic may seem sound enough in that Yahoo Inc's shareholding in Yahoo Japan (35%) and Alibaba (16.3%) offer an indirect economic interest in these entities as well as a possible valuation implication on the rump Yahoo inc businesses if these assets are backed out. The problem however is this is a spurious argument if  Yahoo inc shareholders are unable to get direct access to the underlying assets or cash flows and is therefore sensitive to the assumed tax on disposal as well as conglomorate discount which the market would almost certainly also apply.

OK, so let's look at some numbers on this supposed arbitrage opportunity. At first sight, the Yahoo market cap of approx $40bn drops to nearer $36bn EV after backing out the approx $4bn of net cash (MV and cash assuming the 50% Alibaba IPO proceeds are returned to shareholders via a share buy-back). Against a current MV of its remaining interests in Alibaba (16.3%) and Yahoo Japan (35%) of almost $44bn this might suggest a negative EV is being priced in to the rump Yahoo operations. However, Yahoo's book values on these are marginal which implies a possible gains tax liability on disposal of over 30%, which would bring the net investment valuation down to nearer $31bn and therefore bring the implied EV of the Yahoo rump up to just over $5bn.  Against a prospective 2016 EBITA of $675m (consensus) and Op FCF of approx $473m, this would not be unreasonable; reflecting a prospective Op FCF yield of 9.0% and an implied growth rating of approx +3.0% CAGR.

But hang on, isn't Yahoo inc talking about splashing the Alibaba cash on other acquisitions? What this does is remind us that Yahoo management still stands between investors and the underlying Yahoo assets. Jerry Yang may have played a blinder with Yahoo Japan and Alibaba, but are investors as confident with new girl Marisa Mayer's ability to spot a bargain on investors behalf?  If AOL is the great new play, perhaps not, which just re-enforces the perception that a conglomorate discount will also be applied by markets as we've seen with the likes of Vivendi, Lagardere and countless other groups in the recent past.

If the implied valuation of the Yahoo rump is only just about OK when the post tax valuations of its investments are backed out, then applying a conglomorate discount of anywhere between 10-20% on these is going to make the whole 'arbitrage' deal a rather pointless and possibly expensive exercise, at least for the investor rather than the promoter, who stands to gain possibly 3 commissions and possibly also a spread or two!


Yahoo valuation (sum of parts)
 

See more here
wyt-i blog article

Post IPO: Market valuing Alibaba as if it were a normal US tech Co!

I am surprised! Having cleaned up the reported numbers a little (eg including stock comp and intangible amortisation - excl goodwill), and applied a broadly average growth discount trend, the Alibaba NPV on the WYT growth discount model comes within 5% of the post IPO price - nb this already adjusts for forward valuation horizon based on the rate of organic revenue delivery - for those with the growth rater service see the 'Horizons' tab.



So why the surprise?  - Because this suggests that markets in their hunt for growth are valuing Alibaba pretty much the same as they would an Amazon, LinkedIn, Ebay or Facebook. While the Alibaba that investors are buying may ape the business models of these, the instrument that is providing them with the exposure is entirely different.  In effect, what is being bought is a Caymans Island holding company (the "foreign owned enterprise") with the right to participate in a non-existent dividend from the Alibaba companies (the "variable interest entities"), but without a direct interest in these assets. Although a complex structure theoretically allows a conversion into many,but not all, the underlying economic entities, this is not actually legal at present under Chinese ownership rules unless by another PRC entity and indeed may never be permitted. In addition to that, there seems little to stop these options being re-assigned to other entities.

So what does the prospectus say about these "Exclusive call option agreements" that the foreign owned enterprise has over the variable interest entities

What is says on Exercise price: "Equal to the higher of  (i) the registered capital in the variable interest entity; and (ii) the minimum price as permitted by applicable PRC laws. Each relevant variable interest entity has further granted the relevant wholly-owned enterprise an exclusive call option to purchase its assets at an exercise price equal to the book value of the assets or the minimum price as permitted by PRC law, whichever is higher"
Interpretation: OK, so this seems to enable the foreign entity to buy some of the underlying Alibaba companies at book value, which is low and therefore attractive, or at some unknown "minimum" price that may be determined by PRC law. Perhaps a Gweilo pays more law!

What it says on conversion: "Each call option is exercisable subject to the condition that applicable PRC laws,rules and regulations do not prohibit completion of the transfer of the equity interest or assets pursuant to the call options."

Interpretation:  This is of course a big 'IF'. Investors may hope that either the future bar on direct overseas investment will be lifted or that the entities can be parked into another vehicle that might hoodwink the PRC that it was still PRC owned. Many states however have long-standing 'look-through' legislation (such as the HMRC in the UK after 'Dawson v Furness') and one might also expect the PRC to exercise similar action. Indeed, the Alibaba prospectus warns
"However, we have been further advised by our PRC legal counsel, Fangda Partners, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the opinion of our PRC counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our internet-based business do not comply with PRC government restrictions on foreign investment in the aforesaid business we engage in, we could be subject to severe penalties including being prohibited from continuing operations"

This however, may be the least of ones worries. Check the small print of the options and you find
"The wholly-foreign owned enterprise may nominate another entity or individual to purchase the equity interest or assets, if applicable, under the call options".

Naturally, one might have thought that this is part of the wheeze that would enable the Gweilo investors to park the assets into a PRC friendly vehicle and no doubt this was its intention, but wait a moment and think about this. The foreign owned entity will still be substantially controlled by Jack Ma and Simon Xie, who are also the 'owners of the variable interest entities and as such they will also be able to "nominate" the "entity or individual" to exercise these options. As a shareholder in a Cayman Island holding company which has a right to a dividend for which there is no intention to pay and an option to buy the underlying assets at perhaps book value, that might be all it gets should someone else be "nominated" to exercise it, do you feel lucky? Well do ya?
   

Finally, a memorable and relevant financial services advert

With marketing infatuated with big data, social media, mobile and any other nerdy technology where they can bamboozle the client with techno-babble, it is a pleasure to see a good creative advert. I may have been 'exposed' to a thousand marketing messages from the financial services industry, and for which someone has paid good money, but there is only one I not only recall, but actually enjoyed watching. This is the new advert for Direct Line by Saatchi & Saatchi who recently won the account from their namesake, M&C Saatchi. In it Harvey Keitel reprises his role as Wolf from Pulp Fiction, but in this instance as a fixer for a couple who have been burgled rather than for a couple of hoodlums.

Well done Saatchi & Saatchi



https://www.youtube.com/watch?v=ir791xwvOP4

Correlation <> causation, but sometimes maybe!

When I was but a nipper, a wise old Chairman of a large and successful financial information business gave me a valuable piece of advice:  That mediators extract better margins in poor information environments and when price discovery is obscured. As his business, amongst others, picked off and commoditised market after market with real-time pricing, newsflow and data, spreads narrowed and the mediators were increasingly forced in the opaque areas of finance where clients could still be bamboozled into chasing a higher return without appreciating the often killer tail end risk.  While plain vanilla equity broking was being crushed, derivative margins soared as any old sows ears were packaged together and sold as silk purses, with a whole industry supporting the illusion.  The key of course, as the Chairman knew, was the ability to withhold the relevant data from those on the other side of the trade; yes, the muppets.  Raw data however without insight is not a solution. The 'casino' owners are not dumb and know how to bury the truth under a ton of information; hidden in plain sight. To better democtratize the investment process therefore needs insight and context to be applied to the content.

At WYT, our aim is to provide insight to what drives valuations and includes a search for systematic relationships, both internal (relating a company's ability to grow with its 'growth rating') and external.

A feature we have recently added to our 'growth rater' analysis suite includes an auto-correlator which searches for the best correlation fit for a wide range of external macro factors against 5 company related factors to test for relationships in the way the shares perform (actual and relative), the possible impact to trading (organic revenues and margins) and the possible effects on valuation (via growth rating).  Yes, we appreciate that correlation does not necessarily imply causation, but without such a perspective an investor is truly blind.

Often a correlation analysis confirms an obvious relationship, sometimes it reveals an absence of one that was expected and very occasionally offers that much desired WTF experience.

The obvious ones:
Yes, Royal Dutch Shell's share price is tightly correlated to oil/energy prices

The interesting with hind-sight
Perhaps its more a reflection of a broader economic sensitively, but for an oil major to make better margins when there are more vehicles about is not totally without merit!

 



The yes, of course, but only if you already know that gas is the largest cost component for a chemicals group such as LyondellBassell.
Yes, its margins are negatively correlated with the gas price.

Another obvious one? A consumer staple with a share price that correlates with real personal income.
More income = more spending = higher share price?

Another consumer major with a high share price to consumption correlation
Wow, this investing business is getting easier!

Err, hang-on. A cyclical sensitivity to consumption ought not to imply a structural re-rating to a higher growth rating into the cyclical up-swing.
Perhaps, PepsiCo is just doing better in exploiting new and higher growth areas?

Er, nope. Actually this company's organic revenue growth is negatively correlated to actual real retail & food sales.

So what have we got here?  A share price that follows personal income, but this is not reflected in its sales and trading and therefore as a consequence its valuation (as measured by the growth rate that the shares are discounting - the 'growth rating') has to rise. Indeed, rise to well above its ability to grow its revenues.

My conclusion? Markets are clearly being inefficient and possibly lazy by using PepsiCo as a proxy for broader consumption. The principal culprit of poor pricing in current markets however is not too difficult to find - financial repression. In these dull days of command economics and crushed yields, a big mature business that can borrow cheap and payout big (85-90% of net income into share buy-backs and dividends over the last 5 years) is going to appeal to the muppets these days.  Will it last? No, of course it won't and if you think you'll be the smart one to get out before the rush, then that's what they all think!

Are there more such stocks out there?  You bet! you just need to know how to find them. Good hunting.