Description

AABA is a liquidation security that currently trades ~$77 per share versus a pre-tax liquidation value of ~$103 and a conservative fully-taxed liquidation value of ~$82. This pre-tax liquidation value of ~$103 comprises ~$93 reflecting the current market value of AABA’s ~15% non-controlling stake in Alibaba (“BABA”), ~$9 reflecting the current market value of AABA’s ~35% non-controlling stake in Yahoo Japan (“Japan” or “4689 JT”), ~$9 in cash and other assets, and (~$8) in liabilities. AABA’s fully-taxed liquidation value of ~$82 embeds ~$21 in tax leakage on AABA’s stakes in BABA and Japan assuming a 22.8% effective tax rate, which the company has blessed and which could settle towards the federal corporate tax rate of 21.0% if AABA is successful in mitigating potential state taxes in New York and California. Hedged on BABA and Japan at the applicable tax-effected exchange ratios (see table below), we stand to make ~$5.50 to ~$10.50 (~7-14% on a gross spread basis) in a complete liquidation over the next 12-24 months. We are paid this ~7-14% to hold a call option on AABA realizing more tax savings than a conservative fully-taxed liquidation analysis would imply. At ~$77 AABA currently trades at a ~35% gross spread to its pre-tax liquidation value of ~$103 which we calculate as (~$103 – ~$77) / ~$77). Realizing the full ~35% is not a realistic scenario. But ultimately capturing an “all in” ~20% gross spread is a possibility if AABA reaches a tax-sharing deal-structural solution with BABA, whereby BABA would acquire AABA stock-for-stock in what would amount to a large, EPS-accretive de facto share repurchase for BABA. While this embedded return stream is hardly heroic, we believe it is attractive on an absolute risk-reward basis: we see little risk of realized capital loss given we are purchasing AABA at a ~7-14% discount to its simple Net Asset Value (“NAV”).

On AABA’s February 27 Business Update Call, CEO Thomas McInerney said that he would “be taking clear action right now over the coming couple of few months to enhance shareholder value while contemplating and determining next steps beyond those immediate actions. We will continue to mark out time and progress in weeks and months, not years.” In our view, this suggests AABA could provide the market with a clearer path forward sometime over the next several months which could tighten AABA’s discount to fully-taxed liquidation value on a more accelerated basis that the market currently contemplates. AABA’s CEO would seem to face some impetus to provide a compelling update by this summer. The prospect of shareholder activism at AABA would seem remote were it not for the company’s top holder, TCI Fund Management, publicly publishing a presentation (https://www.sec.gov/Archives/edgar/data/1011006/000090266418001639/exhibit99_3.htm) on March 15 recommending that AABA more clearly articulate and more quickly execute on a plan of liquidation to address its chronic discount to NAV. Assuming AABA’s Annual General Meeting will be held in October 2018 (AABA’s most recent such meeting was held on October 24, 2017), the company’s corporate governance documents state that shareholders may submit board director nominations 90 to 120 days before the first anniversary of this meeting which would mean June 26 to July 24, 2018. There is a clear activist path: AABA has an annually-elected, non-staggered, five-member board.

To this point, AABA has seemed content to simplify AABA down into a BABA “stock in a box” structure over time which, in theory, could bring BABA to the negotiating table. With Japan jettisoned (perhaps through open market sales, perhaps by selling the stake back to Japan itself), smaller non-core assets such as its patent portfolio (Excalibur) sold, and remaining liabilities paid down, AABA would basically be a shell containing BABA stock. As AABA’s CEO explained on February 27: “The bottom line is that even with our more complicated story today we trade with 0.99 correlation to Alibaba. If simplified further and if the entity were structurally designed to track only Alibaba and to protect investors from any modifications in the strategy, it ought to be an even closer proxy and this ought to further mitigate the trading discount.”

By contrast, TCI Fund Management seems to be urging AABA to initiate a parallel path process of value creation. TCI Fund Management seems to be saying: AABA should consider directly distributing its BABA shares to AABA shareholders because such an outcome would be economically positive due to tax savings (AABA would likely enjoy a blockage discount on the distribution of up to 15% of the value of the BABA shares) and because the initiation of such a process would not obviate the possibility of BABA coming to the negotiating table (to be sure, the introduction of such tension could conceivably catalyze this event). In our view, the math behind the blockage discount idea articulated by TCI Fund Management – and time-tested through legal precedents – remains underappreciated by the market.

AABA’s incentive compensation plan has potentially introduced a dynamic where shareholders’ view of time value of money is different from that of AABA management (which owns little stock). In June 2017 Verizon (“VZ”) completed its acquisition of Yahoo’s (“YHOO”) core business and AABA registered as an investment company. In August 2017 AABA filed its management incentive plan which sets as a baseline a 27.2% discount to pre-tax NAV for participants to achieve a multiplier to their compensation. The plan vests over three years but accelerates upon a change in control – for example, if BABA were to acquire AABA. AABA management stands to make ~$60 million if AABA’s discount to pre-tax NAV is narrowed to 12.5%. AABA’s pre-tax website NAV indicates that it currently trades at a ~26% discount. AABA calculates this discount as (~$77 / ~$103) – 1 whereas we have discussed the opportunity, consistent with other merger arbitrage and holding company collapse investments, on a gross spread basis of ~35% (~$103 – ~$77) / ~$77). AABA’s management team may be incentivized to hold out for a “home run” transaction with BABA down the line (which could deliver a ~20% gross spread return to shareholders over a longer period) than to consummate a more accelerated liquidation (which could deliver a ~7-14% gross spread return in the nearer term).

We lay out our AABA NAV scenario analysis below. Scenario #1 is our calculation of conservative fully-taxed liquidation value. It includes announced share repurchase activity through April 20 as well as a $235 million reserve for AABA’s share of the YHOO security breach liability based on analysis of data breach precedents where no payment card information, social security numbers, or other sensitive financial data were implicated (AABA is liable for 50% of post-closing cash liabilities with VZ liable for the other 50%). It assumes no blockage discount. Scenario #2 is our illustrative approximation of a fully-taxed direct distribution liquidation scenario incorporating a theoretical 15% blockage discount on AABA’s BABA and Japan stakes. It includes share repurchase activity through April 20 as well as a $235 million security breach reserve. It assumes an effective take rate of 21.0% versus 22.8% if AABA is successful in mitigating potential state taxes in New York and California. Scenario #3 is a summary of AABA’s published pre-tax website NAV (https://www.altaba.com/holdings.cfm). Since it uses AABA’s website inputs, it includes share repurchase activity only through quarter end, excludes the security breach reserve, and assumes no taxes.

Catalyst

* AABA announcement of and execution on clearer, potentially multi-pronged path to liquidation.