How to Play Yahoo Buyout Rumors

Connor is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yahoo (NASDAQ: YHOO) is in discussions to sell its Asian assets-- its 40% Alibaba and 35% Yahoo Japan stake. Rumors have this sale going for $17-18 billion dollars in a tax-free transaction for shareholders. The sale is far from certain -- and even if it goes through, it might not be as large as reported.

Read the following Wall Street Journal article for background information on the rumored deal: http://online.wsj.com/article/SB10001424052970204464404577112831114731306.html 

That being said, I do not think the exact details need to be known for this to highlight Yahoo's value at around $16.00. The fact that there is even discussion about selling these assets for $17 B should highlight the value in Yahoo shares. 

With a $20 B market cap, netting out the $17 B transaction from the Asian assets leaves $3 B for the core Yahoo business. Then, subtracting out the over $2 B in net cash they have on the balance sheet, you are left with a $1 B EV for Yahoo's core business.

This is a steal! Sure, Yahoo has underperformed over the last few years and faces significant competition (most notably from the monster in the industry, Google (NASDAQ: GOOG)), but $1 B would be paying around 2X ttm FCF. Even with their struggles, that's just too cheap. 

Even if the deal does not go through (or on different terms), Yahoo is dirty cheap. In fact, the Asian assets are extremely valuable and Yahoo may actually be better off in the long run holding them. However, I am hoping for a sale so that the value in Yahoo can be realized (a bird in the hand is worth two in the bush).

How to play this trade?

You could just buy the common stock and I think you would be getting a great deal. However, a trade I like even more is buying some deep in the money options. This allows you to "create the stock" with less capital up front and greater leverage. Because it is deep in the money, the options trade mostly in line with the stock (meaning the delta is close to 1).

Options are pretty liquid for Yahoo so you have plenty of choices for this trade. One I particularly like is buying the January 2013 $10 calls, which currently have an ask around $6.40. With the stock currently at $16.00, this allows you to "create the shares" at $16.40 (your breakeven on the trade). 

By using options, you create the stock 2.5% more expensive, but the advantages more than compensate you for this time value premium. You are able to “control” 100 shares of stock for only $640 with the option, rather than $1,640 buying the common stock. In other words, the capital requirement buying the common is 2.56X as great. Furthermore, this leverage will greatly enhance returns if Yahoo goes higher over the next year. If, for example, shares were to increase to $20, representing a 25% increase, the option would be worth at least $10 (stock price – strike price = intrinsic value). This represents a 56% gain on the option trade, versus just 25% in the common stock. There are certainly many other strikes and expiration dates to choose from in Yahoo, as their options are widely traded.

Whether they sell their Asian assets or not, Yahoo shares look cheap. I predict that they will outperform in 2012 and a major transaction will take place to appease activist investors and drive shareholder value (whether it is selling the Asian assets or an entire buyout). Consider deep in the money call options to play this thesis in 2012.

XMFConnor


Fool blogger Connor Haley is Long Yahoo (YHOO) and January 2013 $10 calls

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