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Investing in Yahoo! Inc. (NASDAQ: YHOO)

Written By Briton Ryle

Posted January 27, 2015

While most traders look to make money during the trading session, savvier investors often make a good chunk of their profits after the session ends – specifically on after-hours earnings reports.

The plan is simple. Scout a stock that is expected to report stellar upside earnings growth, or even atrocious downside earnings misses, and buy either long calls or long puts as the case may warrant. Earnings periods offer some of the highest profit potential for the shortest amount of time.

For instance, take today’s scheduled earnings report for Yahoo! (NASDAQ: YHOO) due out shortly after the closing bell. What makes Yahoo! such a stand-out today isn’t so much its regular quarterly report, but some extra news regarding additional profit distributions which could cause its stock to rise some 19% to as much as 35% higher – overnight.

Let’s first review what the hoo-ha over Yahoo is all about, and then consider some trades to capitalize on the report.

Business Before Pleasure

There are two main pieces of news traders will be looking for in Yahoo’s quarterly report due out after the market closes at 4 pm eastern time today. First, there is the rather mundane earnings and revenue figures at the heart of all quarterly reports.

For the quarter ending December 31, 2014, Yahoo is expected to report earnings of 29 cents per share on revenues of $1.19 billion. When compared to previous quarters and even Q4 of a year prior, these figures are not really that great.

Including today’s expected 29 cents, the quarterly average for 2014 would be 39.75 cents, making today’s report below average in earnings terms. When compared to last year’s Q4 of 2013 when earnings were 46 cents per share, this year’s Q4 will show an earnings shrinkage year-over-year of 17 cents, or 36.96% less than last Q4’s earnings. That is pretty bad.

Revenues, however, are expected to be a little better. Including today’s $1.19 billion, the quarterly average revenues for 2014 would be $1.1025 billion, making today’s report above average in revenue terms. When compared to last year’s Q4 of 2013 when revenues were $1.2 billion, this year’s Q4 will be only a shade less, showing a shrinkage of only $10 million, or 0.833% less than last Q4’s revenues. That’s pretty much flat year-over-year, and so not bad.

Of course, investors don’t look only at the last quarter’s results when deciding whether to buy or sell a stock, but will also consider the next quarter’s estimates. Next quarter’s earnings for Q1 of 2015 are expected to continue shrinking, down to 25 cents per share, down 13 cents from Q1 of 2014’s 38 cents for a drop of 34.21% year-over-year.

Meanwhile, next quarter’s revenues are expected to continue shrinking as well, down to $1.1 billion. Yet they are expected to be up slightly from Q1 of 2014’s $1.09 billion, for a rise of 0.917% year-over-year. So here again, revenues are expected to remain relatively flat.

These figure taken alone should put some downward pressure on Yahoo’s stock tomorrow as traders anticipate a rather disappointing report after hours, given its shrinking earnings and relatively flat revenues.

But don’t run off just yet. There’s a little something extra expected in today’s report which could turn the entire table upside down.

Possible Major Distribution Announcement

As many investors are already aware, Yahoo has long been one of the largest shareholders of Alibaba stock (NYSE: BABA) – the largest e-commerce company in the world. According to Barron’s, Yahoo held some 523 million shares of Alibaba when it debuted in September of 2014, having sold some 140 million shares shortly after the IPO according to Forbes, leaving Yahoo with some 383 million BABA shares, currently worth some $39.828 billion.

This represents a substantial profit, seeing as Yahoo paid a mere $1 billion for its Alibaba stake back in 2005. What investors will be looking for in today’s after-hours report is an announcement on how Yahoo plans to distribute this nearly $39 billion profit to its shareholders.

There are several options on the table. One possibility, according to Barron’s, “would be for Yahoo to take its 383 million shares of Alibaba and create a new company that would hold that stake plus another Yahoo business and spin off that company to Yahoo [shareholders] on a tax-free basis. Yahoo is subject to a one-year lockup on that 383-million share stake in Alibaba, but it’s unclear whether any spinoff would be subject to lockup since the Alibaba stock wouldn’t be sold.” In this case, existing Yahoo shareholders would receive free shares of the new company’s stock.

Another possibility “would be for Alibaba to execute a cash-rich split-off in which Alibaba would include cash and an operating business into a company that would [be] swapped for Yahoo’s Alibaba stake,” Barron’s explains. “That also would be tax-efficient for Yahoo but would require the cooperation of Alibaba.”

Of course, there still exists the simplest but costliest option of simply selling its 383 million BABA shares on the market, which would incur a substantial tax. “The tax bite on the sale of the remaining Alibaba stake could be $10 billion or more assuming a 35% tax rate,” Barron’s tabulates. “That’s why Wall Street is eager to see if Yahoo can dispose of that Alibaba stake in a tax-efficient way.”

Whatever Yahoo’s plan for divesting of its remaining Alibaba shares is, the announcement this late-afternoon could move Yahoo’s stock substantially overnight, as projected by brokerage firm MKM Partners. “According to MKM Partners,” Barron’s reports, Yahoo’s stock “would rise to $59 if half of the [BABA] distribution is tax free. If 85% of the distribution is sheltered, the stock would rise to $67.”

Thus, there exists a strong potential for Yahoo’s stock – which closed yesterday at $49.44 – could rise to $59 for a gain of more than 19%, or even as high as $67 for a gain of more than 35%. Of course, the timing of the disposition of BABA stock would also need to be factored in, since Yahoo has a one-year selling restriction which extends into September of this year.

Just keep in mind that it isn’t necessarily the distribution of the proceeds from a BABA sale that would cause Yahoo’s stock to rise, since the profit in Yahoo’s BABA shares are already on Yahoo’s books. Rather, a rise in Yahoo’s stock to $59 or higher would come as a result of any tax savings from the disposition of its BABA shares. The more tax Yahoo manages to save in its disposition of BABA shares, the more Yahoo’s stock will rise – all based on the amount of tax saved.

3 Ways to Capitalize on a Potential Move Higher

The possibility for a rapid move in Yahoo’s stock price over a short period of time is the ideal condition for options trading, since buying options costs you a premium which erodes with each passing day.

To structure the right options trade we first need to estimate the amount of the move. In this case, let’s go with the more conservative of MKM Partners’ two estimates, that of $59 per share.

1) The simplest strategy is to just buy a call option. Given Yahoo’s current price in the mid-$49 range with our target set at $59, we could purchase a March call option halfway in between, say the $55 strike, for just $122. The stock would need to rise to $56.22 for this trade to break-even. Then, for every $1 it rises above $56.22 we would earn $100 in profit, scoring $278 if it reaches $59, for a total return of more than 227%. Of course, the more it rises the more we earn, with potentially unlimited upside potential for a maximum risk of just $122 plus commissions.

2) If we wanted to earn a profit sooner instead of having to wait until it reaches $56.22, we could structure a covered-call, which is a combination of long Yahoo stock plus a short call out-of-the-money. If our target is $59 per share, we could sell a March call option with a strike price of $60, collecting $43 in premium. We would also need to purchase 100 Yahoo shares which would cost $4,944 as of yesterday’s closing price. Our maximum upside potential if the stock rises to $60 would be $1,056 from the shares plus the $43 from the short call for a total of $1,099, or just over 22% of our investment (excluding commissions). The percentage return is not quite as great as the long call option explained above, but then we are earning a profit from the 100 shares right away instead of having to wait until reaching $56.22 in the prior strategy. Of course, this strategy has downside risk if Yahoo’s stock falls.

3) If we don’t like the idea of buying 100 shares which exposes us to downside loss should Yahoos report be decidedly negative, we could protect our stock position by adding a long put option into the mix. The combined position would then be a “collar spread”, which is composed of our covered call above (100 stock shares plus a short out-of-the-money call option) with an out-of-money long put option tossed in for protection. Since we are selling our call about $10 out of the money ($60 call), we could choose a long put option that is equally $10 out of the money ($39 put), which costs $30. Hence, the premium collected from selling the $60-strike call (which pays $43) would pay for the $39-strike put (which costs $30), with a few dollars left over to cover the commissions we’re paying. In this case, our maximum upside potential would be $1,056 from the shares plus $13 from the net option premium for a total of $1,069 (excluding commissions). But our maximum downside loss would be much lower than before at just $1,044 minus the $13 net premium, or $1,031. This is far better than the maximum loss potential of just the covered call without the protective put, which would be $4,944 minus the $43 short call premium, or $4,901.

Of course, it is unlikely Yahoo’s stock would fall to zero, so you might not think you need a put option. Still, for just $30, a long put would be wise since you could always sell it tomorrow after the earnings report if the announcement is positive.

Joseph Cafariello