Yahoo Inc. (YHOO) , one of the last remaining bastions of the 1990s tech boom, is all set to undergo some major changes as reportedly 40 companies look to bid on it. The company provides a multitude of services, including internet search, communication platforms and digital content. Yahoo delivers original content through Yahoo.com and its auxiliary sites, offers digital communication through Yahoo Mail, owns Flickr and Tumblr, and provides advertising technology. The company also owns significant stakes in Chinese e-commerce company Alibaba Group (BABA) and internet company Yahoo Japan.

Unfocused Strategy

Yahoo is one of the most popular internet companies, with a billion users visiting Yahoo sites (not including Alibaba or Yahoo Japan) every month. So what's not to like? Why has the company’s stock price been battered down repeatedly? Due to steadily declining sales since 2008, Yahoo has been categorized as a relic of the past: a declining internet giant with no competitive advantages, no recent innovations and an obscured future trajectory.

Furthermore, CEO Marissa Mayer has been pegged as a cash drain, buying up unprofitable shiny tech startups at oversized valuations, such as Tumblr for $1.1 billion, BrightRoll for $640 million, Flurry for $240 million and Qwiki for $50 million. Mayer contests that each one of these acquisitions fills a strategic void in Yahoo’s overall plan, but many analysts don’t share her view. Public opinion on the street is that Yahoo occupies a no man's land between being a cash cow, milking the stream of sure profits from its cash-generating businesses, and being an innovative disrupter focusing on growing top-line revenues.

Activist investors such as Jeff Smith from Starboard Value have recognized Yahoo’s unfocused strategy and have continuously pressured Mayer with numerous demands. In letters about increasing shareholder value, Starboard has made Yahoo proposals to stop making costly acquisitions, merge with AOL, repurchase shares, sell company patents and real estate, and cut down on questionable hiring. (See also, The Difference Between Amazon And Alibaba's Business Models.)

Core Business

Yahoo owns 384 million shares of Alibaba (15.4% of the company), valued somewhere in the range of $32 billion and 35.5% equity interest in Yahoo Japan, worth about $8.5 billion. Yahoo’s total market cap is less than the $40.5 billion, and after accounting for the cash on the company’s balance sheet, this means Yahoo’s core business is valued at less than $0. Now, this isn’t a new development that will disappear with some quick arbitrage. In fact, the value of Yahoo’s core business has been negatively valued for more than a year, so investors are seeing the value discrepancy measured by traditional means but just don’t believe in the company’s trajectory.

Yahoo’s core business has been slowly declining as the PC advertising and search engine space has come to be dominated by the likes of Google Inc. (GOOG) and Amazon (AMZN). Price-per-ad, PC advertising revenues, EBITDA margins and operating income have all declined year over year. On the other hand, Yahoo has been increasing its revenues in mobile, video, native and social advertising, but these revenue streams are miniscule compared to its legacy business and compared to the mobile advertising dominance of Facebook (FB) and Google. However, the hope is that by continually pumping talent and resources into these segments, they will eventually take off and become Yahoo’s primary cash generator. (See also, Alibaba's Goal: Supplant eBay, Amazon and Paypal.)

Alibaba Stake

Before Alibaba IPO’ed, many investors bought Yahoo only to gain access to Alibaba. So naturally after Alibaba went public, Yahoo crashed down from its peak of about $52 to where it currently trades, at roughly $43 per share.

In January of 2015, Yahoo announced its plan to spin-off the entire Alibaba stake tax-free in order to avoid a 40% tax bill that would cost shareholders upwards of $12 billion. Essentially, Yahoo would create a separate investment company called SpinCo, which would contain all of the Alibaba shares in addition to a small Yahoo division for legal reasons. Then, Yahoo would give investors shares of this new company pro rata, in proportion to the size of their Yahoo stock holdings. The plan was for Alibaba to eventually buy back the shares of SpinCo as a variation of a share repurchasing, paying SpinCo shareholders the full value of their shares.

However, in May of 2015 the IRS raised questions regarding the plan of spinning off Yahoo’s holdings in the Chinese firm, causing the stock to instantly plunge 7.5%. The issue was with respect to SpinCo not containing an “active trade or business,” which distinguishes real businesses from simply being investment vehicles. Only real businesses can be spun off tax-free, but thus far, the IRS has never imposed a size requirement for what constitutes a real business. Yahoo has reaffirmed its plans going forward and is confident in its spin-off, but the tax risk is a sticky situation for shareholders.

With these issues on the horizon, there has been speculation about Alibaba buying Yahoo. Advocates argue that by buying Yahoo, Alibaba can regain millions of its shares to satisfy shareholders, acquire stakes in Yahoo Japan and Yahoo’s core business, which still pumps out hundreds of millions in earnings in the worst case scenario. Based off of Yahoo’s current market valuation, this would give Alibaba a large margin of safety. Not only this, but Alibaba would also gain from acquiring stake in Yahoo Japan, since the two online ecommerce giants signed a partnership to bring Japanese merchants into Alibaba’s network. (See also, Don't Believe The Hype About A Yahoo Turnaround.)

Yahoo Japan Stake

Pressured by investors looking for Yahoo to return value to its shareholders, Mayer hired advisers to evaluate options to monetize the company’s stake in Yahoo Japan. Yahoo’s stake in Yahoo Japan is much harder to unload than Alibaba’s since Yahoo Japan hasn’t demonstrated any interest in buying back this 35.5% stake and it would be hard to unload the shares onto any other individual companies due to the size of the stake. Furthermore, with the haziness of the Alibaba and SpinCo situation, there is added doubt of a possible tax-avoiding technique to sell its shares and realize the full $8.5 billion value.

The Bottom Line

After conglomerate accounting trickery was used to boost earnings per share (EPS) in the 1960s and 1970s, conglomerates have had a hard time in the public eye. Many conglomerates are valued at less than the sum of their parts because investors view them as scattered and inefficient. It is very possible that, when Wall Street sees Mayer buying up startup companies left and right, it throws Yahoo into the same bucket as those failed conglomerates of yore, and thus applies the “conglomerate discount” to Yahoo, which would contribute to its undervaluation. However, this still does not explain how, after stripping away the Alibaba and Yahoo Japan stakes, the remaining business can be negatively valued by almost all metrics.