• by Diane Mermigas , October 7, 2008

A delayed regulatory approval of a search alliance between Yahoo and Google, declining ad revenues and asset values, and a dearth of recessionary growth options are making a resurrected Microhoo look attractive--although it could have negative ramifications for AOL.

There are compelling financial reasons why some combination of Yahoo and AOL would not be advantageous. There also are points at which market-depressed stock prices are irresistible to companies with plenty of cash reserves. With balance sheets and revenue forecasts getting squeezed, it behooves some larger players to retrench--often in unexpected ways.

The sale of AOL to Yahoo depends on how badly Time Warner wants to sell the search engine, and on what terms. A stock-based deal between AOL and Yahoo would only make sense for Yahoo shareholders at the company's own 6.5-times earnings multiple, or not more than $3.4 billion (without AOL's ISP business and before synergies). That is around half the $6 billion to $8 billion Time Warner seeks for AOL in a depressed market.

Yahoo would consider a $6 billion price tag if it could make up the difference of $2.65 billion in synergies with a hefty 35% reduction in AOL's cost base, according to Bernstein Research analysts Jeffrey Lindsay and Michael Nathanson. Even then, the post-merger cost reductions--which could involve eliminating more than 2,500 staffers to realize nearly $400 million in annual savings--would depend on Yahoo management, which has an "unimpressive track record" in such matters.

An AOL-Yahoo deal also could "trigger the dissolution of the existing AOL-Google paid search deal"--jeopardizing the 4.5% share of search queries currently handled as result of that pact, which generates $309 million in annual earnings. On the other hand, "expect further deterioration in AOL's portion" if a deal to sell to Yahoo does not materialize, Bernstein predicts.

Even with a new board of directors, fortified by the addition of activist investor Carl Icahn, Yahoo may not have the ammunition to pursue the deals it wants in a weak market. The delayed regulatory approval of a proposed paid search deal between Yahoo and Google only compounds the matter. The uncertainty of the arrangement, worth an estimated $3 per share to Yahoo, prompted Bernstein to reduce its 12-month valuation of Yahoo to $21 a share on Monday, when a record decline in the stock market pushed Yahoo's market capital to around $20 billion--about half what it was at Microsoft's initial bid earlier this year. None of Microsoft's other alternatives can prove quickly beneficial--from building its non-search applications and developing small start-up entities to attempting transformative acquisitions, such as eBay. Some deal with Microsoft also represents the best outcome for Yahoo shareholders at a potential $26 a share, compared with the proposed outsourcing deal with Google worth $3 per share, which would have boosted Yahoo's shares to $24 per share before the market collapse Monday. Without either outsourcing of Google or a Microsoft deal of any kind, Yahoo's future prospects "look bleak"--especially in a deteriorating economy, Bernstein analysts say.

Yahoo has a higher share of domestic revenues than its rivals, and will continue to see flat paid search in the U.S. while business deteriorate overseas. Yahoo could seek relief by selling Alibaba.com, YHOO Japan and others among its Asian assets at a premium to their majority owners.

The economic and advertising slowdown as a result of the ongoing financial malaise will weigh heavily on all advertising-supported businesses and even online giants such as Yahoo, AOL and Microsoft's MSN. Internet ad sales are still growing, but at much slower levels than originally forecast. That makes it more imperative for companies to continue pursuing their long-term growth and restructuring strategies.

Time Warner is in the throes of selling its AOL Access business to EarthLink and United Online for about $3 billion, which could be a double-edged sword, given the more than $600 million in profits it has generated so far in 2008 on a declining business. AOL and Yahoo are two of the biggest players in online display advertising based on their share of unique visitors. Their combination would be a one-stop leader in emerging media advertising sales.

All things considered, is it too farfetched to consider a three-way tie-up of sorts involving AOL, Yahoo and Microsoft in this climate? Depending on the financial structuring, such a deal could pose some interesting search and advertising competition for Google when the market heads north.