How Yahoo may finally be sold: Why March 2015 is key

Dreams of a merger between AOL and Yahoo haven't vanished, but investors will likely need to wait for a series of events in 2015 to unfold before getting their Christmas wish.

Several large Yahoo shareholders interviewed by CNBC say they are effectively in a negotiation with CEO Marissa Mayer over what she will concede and when. The ideal outcome, those shareholders say, would be similar to something envisioned by activist investor Starboard Value, which took a stake in Yahoo earlier this year.

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Yahoo! President and CEO Marissa Mayer delivers a keynote address at the 2014 International CES in Las Vegas, Jan. 7, 2014.
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Starboard's suggestion was to kill three birds with one stone: Divest Yahoo's valuable stakes in Alibaba Group and Yahoo Japan in a tax-free manner while simultaneously merging the core Yahoo business with rival AOL. Such a move could allow for roughly $20 billion in tax savings from the divestitures while also capturing enormous synergies from the merger. Yahoo, AOL and Starboard all declined to comment.

But shareholders say Mayer is resistant to such a deal. One big reason: If Yahoo divests those stakes, its market capitalization would shrink considerably. Using a multiple of six times the company's estimated earnings before interest taxes, depreciation and amortization—as recently suggested by analysts at Citigroup—the core Yahoo business is worth $7.8 billion. By contrast, Yahoo currently has a market capitalization of about $48 billion.

Why does that matter? One good reason is that it arguably makes it easier for Mayer to acquire large companies that don't make much money when your company is bigger. After all, the $640 million acquisition of advertising platform Brightroll last month would look a lot bigger if Yahoo had a market capitalization of $7.8 billion. The same goes for social blogging site Tumblr, which was bought last year for $1.1 billion.

Not surprisingly, some shareholders hate those deals because those companies have little or no earnings and were acquired at multiples far above what core Yahoo would likely command.

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But Mayer can't ignore shareholder pressure forever. Indeed, Yahoo has essentially indicated it will deliver a plan for a tax-efficient divestment of Alibaba before it reports earnings at the end of January or early February. According to one large shareholder, "there would be a riot" if Mayer didn't come through with a plan to divest the Alibaba stake before the next earnings report.

Some shareholders say an Alibaba divestment won't be enough. Based on current prices and Yahoo's disclosed financials, the tax savings from an efficient divestment of the Alibaba stake is about $17 billion, or $17 a share. But there's another $3 billion, or $3 per share, in benefits from a tax-free divestment of the Yahoo Japan stake. (At the moment Yahoo's share price doesn't fully reflect those potential tax savings, as the market isn't fully convinced this scenario will play out.)

Once again, Mayer would probably like to delay the Yahoo Japan divestment as long as possible. If Yahoo sheds Alibaba, its market capitalization might shrink to, say, $15 billion based on the current value of Yahoo Japan, which trades in Tokyo (assuming $7.8 billion for the core business and about $7 billion for the Yahoo Japan stake). That's probably still enough size to prevent Yahoo from being a target for AOL or other medium-sized companies that might take interest.

But the pressure to then move on Yahoo Japan could come fast. Some shareholders say there is a potential for frustrated investors to nominate a slate of directors if a plan for Yahoo Japan doesn't materialize. The deadline for those nominations: March 27, 2015—just over three months from now.

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Mayer, who is focused on improving Yahoo's faltering advertising business, would probably prefer to avoid engaging in a proxy fight. That will be especially true if there hasn't been meaningful improvement by late March. Yahoo's 2015 consensus EBITDA estimate has fallen to the current $1.3 billion from about $1.6 billion at the beginning of 2014, according to FactSet.

The good news for Mayer is that she will probably buy herself some time by delaying the divestments. In coming months, she will have a chance to prove that she can revive core Yahoo, which has fallen behind rival AOL as advertisers embrace new technologies.

Even if Yahoo's performance improves, it will still be an obvious merger candidate with AOL. Unlike the acquisitions Yahoo has pursued so far, a merger with AOL would probably please shareholders on both sides.

To illustrate, AOL trades around 6.4 times consensus EBITDA. Even assuming a generous 50 percent takeover premium, Yahoo might buy it for around $5.2 billion. Given the hefty $1 billion of cost savings a deal could easily create, such a deal would be a winner for Yahoo shareholders as well.

The transaction would likely work if Yahoo is the target, with cost benefits being split either way.The question is who would run the show—Yahoo's Mayer or AOL CEO Tim Armstrong. For now, Mayer is the one with more to prove.

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