• by Diane Mermigas , July 1, 2008

The only sure thing you can say about Yahoo's fate is that it is not over until it's over...and it's far from over.

Buzz persists about a possible alliance with Microsoft, and whether Yahoo's advertising service pact with Google will be approved by regulators. Now comes renewed speculation about a possible Yahoo-AOL merger that could yield $900 million in synergies and be worth up to $8 billion in incremental equity value to the pro forma entity, according to CitiGroup analyst Jason Bazinet.

Most of the synergies are in eliminating duplicate costs in content, payments, sales force, research and development and administration. While Time Warner's sale of AOL for as much as $12 billion (Bazinet assumes a low-end $8 billion price tag) would be considered by analysts to be a smart move, the sale would have mixed implications for Yahoo.

Combining their respective Internet advertising businesses would allow a merged Yahoo-AOL to gain sizable scale in the display market and pool their resources to tackle the search market. A change of control provision in the proposed Google-Yahoo pact would allow Yahoo to provide search functionality on AOL's properties and boost its search market share, the analyst said. In what would be a no-lose situation for Yahoo, Microsoft would be forced to pay a premium if it were to resume its pursuit of the search portal.

Bazinet's close examination of the 8-K filing reveals a quirk: Yahoo can terminate its search agreement with Google in the event of change of control--defined as any company owning more than 50% of Yahoo's voting power "except in the case of Time Warner and News Corp., in which case the percentage will be 35%." The provision suggests that Google and Yahoo have contemplated merger and acquisition activity beyond a possible tie-up with Microsoft, and that Yahoo especially is keeping its search options open.

It is less likely that Yahoo would seek an alliance or outright merger with News Corp.'s MySpace. AOL's recent acquisition of Bebo acts as a hedge either way--even at a lofty $850 million--as it gives Time Warner a portal, an ad network and a social network. Given Yahoo's perceived mishandling of Microsoft's acquisition overtures and the exodus of dozens of its most talented top and mid-level executives, it's clearly "a company in need of decisive new directions," Bazinet said.

However, the major stumbling block to any Internet deal could be valuations--just as it was with Microsoft's bid for Yahoo. Reestablishing valuation floors for companies is more challenging than ever in the wake of the economic crisis, credit crunch and continued digital transition. The $4 billion gap between a high-end (at $12 billion) and a low-end (at $8 billion) assumption for AOL's ad business represents one-half to one-third of its value. Bazinet says he uses an eight-times multiple of $812 million in estimated advertising earnings. The immediate value of an AOL deal to Yahoo shareholders is less clear-cut: from losing as much as $1.14 per share of equity to gaining as much as $1.18 per share in equity, as eliminating the Microsoft premium is offset by AOL merger synergies.

In an alternative to merging with AOL, Yahoo could shed its increasingly weakened search operations and move to bolster its stronger display advertising assets, including one of the world's three-largest user bases and some of the leading display ad networks solutions providers. Even in the case of a merger with AOL, Yahoo could sell its Asian off-balance sheet assets (such as Alibaba.com), more fully outsource its search business to Google and acquire other display advertising assets, Bazinet said.

One of the biggest challenges is trying to figure out what assets are worth against shifting economic tides. Although ZenithOptimedia is the latest to lower its North American and European ad growth forecast, it is sticking by its estimated 26.7% increase in online ad spending, to top 10% of all ad sales for the first time ever. But a continued unstable economy could adversely impact even online growth well into next year.

There are also ongoing general valuation problems with Internet properties. Facebook's valuation has been swinging away from the lofty $15 billion estimate prompted by Microsoft's $250 million investment in the private company last year. A federal court decision last week rejecting claims by the Winklevoss brothers to the Facebook concept, and efforts by some employees to unload their stock options, have suggested Facebook valuation as low as $5 billion. Facebook has indicated plans to go public in an improved stock market.

For now, Yahoo's reorganized senior management led by President Susan Decker, will be making its best case for continued autonomy and the Google alliance in a 30-slide presentation at the Aug. 1 shareholders' meeting, which essentially makes a financial and logistical argument for choosing the Google over Microsoft deal. Execution remains key, especially with an almost entirely new slate of senior managers.

Lehman Brothers analyst Douglas Anmuth figures Yahoo's current valuation is 9.8 times about $2 billion earnings, which is well off the valuation created by Microsoft's initial bid for the company. Even with the Google deal, he--and most of Wall Street--still consider Yahoo management's forecasts for 2009 and 2010 "a real stretch."