After the dust settles and Microsoft likely acquires Yahoo, everyone will still be fixed on competing with Google. While Microsoft, Yahoo and AOL scramble for an expanded user base and more powerful ad search mechanisms, all will need a monetized social network. That is why Microsoft's hostile pursuit of Yahoo has suddenly morphed into a strategic brawl that involves MySpace, AOL and their corporate parents. To that end, trying to value any of these companies--let alone track their incestuous ties to each other--is like playing darts in the dark. Although Google, the Darth Vader of the Digital Age, ironically lacks its own social networking component, everyone is reacting to its force.
Microsoft and Yahoo need to merge to form a more potent No. 2. But even after Microsoft likely acquires Yahoo for slightly more than its $31-a-share bid--through a shareholder proxy vote or direct tender if it must--it faces 18 months of integration, streamlining and cultural clashes. That gives Google (and its newly acquired DoubleClick) 18 months to make inroads into Internet display ads, where Yahoo enjoys the lead.
In fact, Google has a pony in nearly every digital media race these days. In addition to dominating more than 60% of search advertising, Google has a 5% stake in AOL, for which it paid Time Warner $1 billion (now worth $500 million) and won an ad search service arrangement. Yahoo this week surprisingly revived plans to test the outsourcing of its search ad business to Google, although Yahoo has invested $1 billion trying to become a more competitive online ad player.
While a permanent pact with Google would boost Yahoo's earnings by 25%, it would likely prompt an antitrust furor by affording Google 90%-plus of the online search market and Yahoo's dominant share of Internet display advertising.
Complicating things further, Yahoo has instigated wild press speculation about an imminent deal with Time Warner's AOL--which, through its proposed acquisition of Bebo, could provide Yahoo with a social network tie. Both of Yahoo's logical moves are perceived as a desperate attempt to thwart or boost the price of Microsoft's bid, which is good until April 26.
Microsoft's unexpected move to fortify its bid by reaching out to News Corp.'s MySpace as an ally actually provides the software giant with the critical social-networking tie it also lacks. The kicker will be the equity alliances these players have with each other. Google has a $900 million Internet ad search deal in place with MySpace, which would be a critical social-networking partner to Microsoft-Yahoo. Microsoft recently paid $240 million for a 1.6% stake and a broader marketing relationship with Facebook, which values the social network rival at $15 billion. The prospects of a mind-boggling alliance of Yahoo, Microsoft, MySpace and Facebook to battle Google would be irresistible to the staunchest institutional Yahoo shareholder.
However, the most profound element in all of this is how these double-edged ties will unwind or tangle as consolidation and fluctuating valuations intensify competition.
Certainly Time Warner never expected to lose about half of AOL's initial $20 billion-plus market cap seven years after its failed merger. Fortifying AOL with the $850 million acquisition of Bebo will only work if Time Warner knows what to do with the combined asset, which is why a new owner-partner is crucial. As the battle for Internet dollars swiftly moves past portals to social networks, every major player will need user engagement, e-commerce and targeted analytics to monetize digital interactivity. So far, Bebo, Facebook and MySpace have not been able to crack the monetization code.
Bernstein Research analyst Michael Nathanson insists that Time Warner can no longer afford to keep AOL, as the continuing decline in subscriber revenues needs to be offset by some combination of more massive cost cuts (another $640 million or 30% of its $2.1 billion cost base) or a huge increase in advertising growth. A projected $48 million in incremental revenues will not offset an estimated $131 million decline in ISP profits at AOL in 2008. "Time Warner must act now to divest AOL...and that should not be contingent on a hail-Mary Yahoo deal," Nathanson said.
Yet another of the many ironies in this mess is that the valuation that Microsoft's premium $45 billion bid places on Yahoo dictates a $21 billion equity value for AOL, based on the same 18.9 times multiple of 2008 earnings. That would give Time Warner the benefit of a higher valuation as it proposes to fold AOL into Yahoo and retain a 20% stake in the combined entity. It is a stark contrast to the zero equity value many analysts assign to AOL in their break-up valuations for Time Warner.
The increasingly influential social networks have their own valuation issues, defined by the successful monetization of their special interest communities, communications and target users. The $1 billion Google paid for a 5% stake in AOL, while worth half as much today, could be worth more tomorrow if it successfully breaks the Bebo social network spell. MySpace could be worth $6 billion to $10 billion, and Facebook could be worth $15 billion, based on the equity stakes purchased by Google and Microsoft respectively--if their social scales can be monetized.
The only valuation that Wall Street and investors appear sure of is the downward spiral of Yahoo if its founding CEO Jerry Yang is left to his own devices. Announcing more bad news about its latest quarterly earnings April 17 would certainly dash his hopes for autonomy. The same fate awaits popular social networks from MySpace to Facebook, if they cannot crack the monetization code. News Corp. Chairman and CEO Rupert Murdoch understands this.
Although Microsoft has not proven to be much more savvy about managing and growing its MSN portal than Time Warner has with AOL, MySpace would be a unique growth catalyst to a Microsoft-Yahoo partnership. Under pressure to transform MySpace into an ad-driven profit center (its new music merchandising notwithstanding), Murdoch was rebuffed by Yahoo's Yang when he offered to do a deal several months ago.
CitiGroup analyst Jason Bazinet says if News Corp. and Time Warner are left out in the cold, MySpace eventually could join forces with AOL. "Facing a more daunting long-term battle for relevancy than even AOL, News Corp. executives may be willing to be more flexible in its negotiating posture," Bazinet said. Someone who knows how to monetize an Internet portal will snatch up AOL when the dust settles. MySpace will find a partner. And then, the next round of battles for Internet supremacy begins.