Why the Alibaba Spin-Off Is Under Attack from This Activist Investor

Activist hedge fund and key Yahoo! Inc. (Nasdaq: YHOO) shareholder Starboard Value LP has thrown a major snag in the company's Alibaba spin-off plans.

Starboard is pressuring Yahoo to halt the $20 billion Alibaba spin-off and instead sell its sputtering Internet business.

"If you stay on the current path, we believe the potential penalty for being wrong is just too great," Starboard wrote in a letter sent to Yahoo.

yahoo-signThe potential penalty Starboard referred to is a massive tax bill for Yahoo shareholders.

Starboard initially supported Yahoo's plan to sell its Alibaba Group Holding Ltd. (NYSE: BABA) stake. But that was before the IRS denied Yahoo's request for a private letter ruling on whether the Alibaba spin-off would be considered tax-free. Going forward without the IRS tax-free status approval raises the risk the agency could challenge the spin-off in a future audit.

It also means shareholders could be responsible for as much as $9 billion in taxes from the Alibaba spin-off.

Earlier this week, SunTrust analyst Robert Peck said he still believes the transaction will not incur taxes. Yet he cautioned that if taxed, the taxes "could equate to more than the full value" of the Alibaba stake.

In September, Yahoo said it would proceed with the planned Alibaba spin-off even after the IRS denied its request. And last month, Yahoo said it expected the spin-off to be completed in January.

Since Yahoo is already far along in the process and has communicated confidence about the outcome, it's unclear if Yahoo will reverse course and bow to Starboard's demands.

Here's what Starboard recommends Yahoo officials do instead of pursuing the Alibaba spin-off...

Alibaba Spin-Off Creates a Smaller Yahoo

"Selling the Core Business now is the best outcome for Yahoo shareholders," Starboard maintains.

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The activist investor added it will "look to make significant changes to the board if you (Yahoo) continue to make decisions that destroy shareholder value."

Starboard estimates Yahoo's enterprise value is $31.2 billion. But Yahoo's core business is valued at about $2 billion, Starboard said.

When Starboard first amassed its significant Yahoo position last fall, its loudest call was for CEO Marissa Mayer to find a tax-free way to sell its Alibaba stake and share the proceeds with shareholders.

Since then, Starboard has been an active investor. In September 2014, Starboard urged Yahoo to merge with AOL. That plan fell through when Verizon Communications Inc. (NYSE: VZ) bought AOL in May for $4.4 billion.

When Mayer took the helm at Yahoo in July 2012, hopes ran high that the former Google executive would turn around struggling Yahoo. But during her three years at Yahoo, the company's core business has dwindled.

Upon Mayer's arrival in 2012, Yahoo sales totaled $4.5 billion. In 2014, the tally was $4.4 billion.

Yahoo's slice of digital ad spending worldwide is expected to dip to 2.0% in 2015. That's down from a 3.4% share in 2012, according to eMarketer Inc.

At $33.28, Yahoo shares are down 34.1% year to date. According to Starboard, selling the core business and not pursuing the Alibaba spin-off is the only way to revive the stock.

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