Breaking: Yahoo, AOL Close In on Tie-Up Deal

http://online.wsj.com/article/SB120776803032602423.html

By MATTHEW KARNITSCHNIG, KEVIN DELANEY and MERISSA MARR
April 9, 2008 9:13 p.m.

Yahoo Inc. and Time Warner Inc.'s AOL are closing in on a deal to combine their Internet operations, a move that could thwart Microsoft Corp.'s effort to acquire Yahoo, people familiar with the matter said Wednesday.

The possible Yahoo-AOL tie-up is part of a threefold plan by Yahoo to present shareholders with an alternative to Microsoft's unsolicited offer. Yahoo would also propose repurchasing billions of dollars of its own shares and is negotiating with Google Inc. about an advertising tie-up. On Wednesday, Yahoo announced a short-term test under which it will carry search advertising from Google.
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At the least, Yahoo's plan may give it more leverage to negotiate a higher price from Microsoft. However, Yahoo might have difficulty convincing its shareholders that a Yahoo-AOL combination is attractive. Microsoft has threatened to take its offer directly to shareholders via a proxy fight.

If consummated, the Yahoo-AOL discussions would unite two of the Internet's largest Web sites. One person involved in the discussions cautioned that there was still "a lot of work to do" before a final agreement between AOL and Yahoo. Yet there is also incentive for Time Warner to complete a deal. It has been struggling to find a viable strategy for AOL for years. AOL has lost most of its value since it combined with Time Warner in 2000.

Under the terms being discussed, Time Warner would fold its AOL unit into Yahoo and make a cash investment in return for about 20% of the combined entity, the people said. The deal, which wouldn't include AOL's dial-up access business, would value AOL at about $10 billion. As part of the deal, Yahoo would use the Time Warner cash and additional funds to buy back several billion dollars worth of its own stock at a price somewhere in the middle of the range between $30 and $40 a share, the people said. Any deal would be taken to Yahoo shareholders for approval, the people said.

Microsoft has offered Yahoo shareholders a combination of cash and Microsoft shares currently valued at $42 billion, or $29.24 a share. Many analysts and investors believe that Microsoft will ultimately wind up acquiring Yahoo with a sweeter bid. Yahoo shares closed at $27.77, up seven cents, or 0.25%, in 4 p.m. trading on the Nasdaq Stock Exchange Wednesday.

The announcement of the Yahoo-Google test Wednesday turns up the pressure on Microsoft. A tie-up between Yahoo and AOL is not contingent on the success of the test, people close to the discussions said. Google already handles search advertising sales for AOL and owns a 5% AOL stake.

Yahoo and AOL are broadening their businesses to sell online advertising across other Web sites. Such efforts are in part a recognition that much of the growth momentum online has passed to younger players such as Facebook Inc.'s social-networking site and Google's YouTube video-sharing service.

Responding to such trends, Microsoft wants to combine with Yahoo to better challenge Google. Microsoft Chief Executive Steve Ballmer, in a letter Saturday, gave Yahoo directors three weeks to reach a friendly deal before Microsoft would go hostile, implying that Microsoft would lower its bid in that case.

Yahoo's directors have rejected Microsoft's current offer as too low. In a letter Monday responding to Mr. Ballmer, they called his ultimatum "counterproductive."

Some major Yahoo shareholders, including Legg Mason Inc. portfolio manager Bill Miller, have subsequently said they likely wouldn't support Microsoft in any hostile contest were it to lower its bid. At the same time, they're skeptical that Yahoo could come up with an alternative, such as a combination with AOL, that would be more palatable to shareholders than Microsoft's offer.

Yahoo's sites had the most U.S. visitors in February, with 137 million, while AOL's 109 million visitors put it fourth behind Google and Microsoft, according to research firm comScore Inc.

Yahoo said its test with Google will last up to two weeks and involve no more than 3% of Yahoo's Web search queries. It is designed for Google and Yahoo to evaluate the revenue potential of a broader search-ad sales outsourcing arrangement, according to people familiar with the matter. Yahoo views the latest test partly as a way to demonstrate its belief that it is worth more than Microsoft has offered, one of the people said.

"Yahoo will be testing Google's AdSense for Search service, which will deliver relevant ads alongside Yahoo's own natural search results," said Google in a statement. "This is only a limited test and does not necessarily mean that Yahoo will join the AdSense program."

Analysts have predicted outsourcing its search ads to Google would boost Yahoo's cash flow, since Google's system generates significantly more revenue for each search query than Yahoo does. Under such an arrangement, Yahoo would likely garner a majority of the revenue and Google would keep the rest as a commission.

But antitrust experts say any broader ad pact between the two would likely face intense regulatory scrutiny, given the companies' significant shares of the Web-search and online-advertising markets.

"Any definitive agreement between Yahoo and Google would consolidate over 90% of the search advertising market in Google's hands," said Microsoft in a statement. "This would make the market far less competitive."

Microsoft's statement added, "Our proposal remains the only alternative put forward that offers Yahoo shareholders full and fair value for their shares."

Citigroup Global Markets analyst Mark Mahaney, in a February research note, estimated that Yahoo could boost its cash flow more than 25% annually by outsourcing all its search advertising to Google. Yahoo executives considered such a maneuver as part of a strategic review last year, according to people familiar with the matter, but Yahoo Chief Executive Jerry Yang in October signaled that they had decided against it.

"We believe having a principal position in both search and display advertising is critical to creating...long-term shareholder value," Mr. Yang told analysts during Yahoo's earnings conference call in October.

Several factors may have spurred a change of heart toward Google, including the Microsoft offer and a 2008 revenue outlook considered tepid by many investors.
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Yahoo and aol????? I didn't think it was possible to be worse than merging with microsoft...until this.

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