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AOL could benefit in Yahoo deal

Goal is for shares to exceed Microsoft's offer

Could the big winner in Microsoft’s increasingly hostile bid for Yahoo be Jeff Bewkes?

It started to look that way on Wednesday, as it came out that Yahoo has been contemplating a merger with AOL as a way out of getting acquired by Microsoft, a situation that Yahoo CEO Jerry Yang and chairman Roy Bostock seem almost desperate to avoid.

As contemplated, the deal would see Time Warner giving its troubled AOL unit’s content and advertising operations to Yahoo, along with some cash, in return for about 20% of the combined entity. Time Warner would keep AOL’s Internet access business, which Time Warner CEO Bewkes has already said he intends to spin off or sell.

The new Yahoo would then buy back some shares at more than $30 per share, exceeding the value of Microsoft’s approximately $29 per share offer. That would presumably incentivize shareholders to reject Microsoft’s bid, which the tech giant has threatened to turn hostile after it was rejected by Yahoo’s board.

Wall Street analysts still think that an AOL deal is somewhat less likely than an eventual purchase by Microsoft, particularly now that News Corp. is considering joining forces with Microsoft for a joint bid that could combine Yahoo, MySpace and MSN into one giant online entity.

Yahoo has also been flirting with Google, as it yesterday announced a trial partnership to use the search giant’s advertising against a small percentage of its search traffic. Analysts consider a long-term partnership between the two to be highly unlikely, however, and consider it more as a way to fend off Microsoft by showing it has alternative options.

Analysts noted that with some combination of Yahoo, Microsoft and Google looking likely, AOL and News Corp.’s Fox Interactive Media are eager to not be left out.

“While each firm’s motivations appear similar — avoiding third (or fourth) tier status on the net — the tactics are different,” Citi analyst Jason Bazinet wrote in a note. “Time Warner is hoping to scuttle a Microsoft bid for Yahoo, while News Corp. is hoping to get a slice of the pro forma Microhoo pie. We think both attempts make strategic sense. Who, after all, wants to compete as a sub-scale player — with a less than complete set of Internet assets — in a world dominated by Google and Microhoo?”

For both congloms, the race is on to make decisions and draft proposals for shareholder approval before Microsoft’s bid is scheduled to go hostile on April 26. But while News Corp. sources expressed caution about how tenuous talks are right now, those at Time Warner were more aggressive in making their case.

“From the Yahoo shareholder point of view, the question is going to be whether it’s better to take cash and then have Yahoo as you know it end, or whether a brighter future can be seen,” said a Time Warner insider. “If you put together the Google ad trial and our content, it’s an appealing alternative.”

AOL has been a particular albatross around the neck of Bewkes since he took over Time Warner last year. Though the CEO has made bold moves such as drastically downsizing New Line, he hasn’t yet figured out a winning strategy for AOL, which has been struggling for years to reinvent itself ever since its Internet access business started fading.

AOL recently has been re-thinking its approach to content with a focus on niche sites while beefing up its advertising operations under the rubric Platform A. Last month, it agreed to acquire British social-networking site Bebo for $850 million in order to better compete with MySpace and Facebook.

Amid all that, AOL’s advertising revenue has been growing at a healthy clip — 18% last year — but not nearly enough to make up for the huge losses in its subscription Internet access offering, which fell by 52% in 2007. Even the advertising growth is still far behind that of red hot competitors like Google.

Yahoo has also had its problems but is still performing better than AOL in most categories and could boost its performance and significantly reduce costs.

The two overlap in a number of traditional Web content areas, from movies to news to music, but would bring a few individual strengths such as AOL’s popular instant messenger and Bebo, along with Yahoo’s search technology. Together they would likely dominate the portal business, driven by display advertising, and possibly pose a stronger threat to Google and Facebook.

If nothing else, spinning off AOL should be a boon to Time Warner’s stock. Analysts noted that the online unit appears to be having virtually no impact on the conglom’s market cap.

“Given the market value for (Time Warner) and (Time Warner Cable) and our estimated fair value for Time Warner Content, the market is implicitly assigning nearly ZERO equity value to AOL,” noted Bernstein Research in a new report.

Despite such downbeat assessments of AOL’s future, the deal under discussion with Yahoo values AOL at about $10 billion.

Owning 20% of a separate public company that could be the cure Time Warner’s long-festering AOL problem, as it would take responsibility for its performance off of the hands of Bewkes and his lieutenants.

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