AOL May Be Plan B For Microsoft, But Yahoo Still In Focus

SAN FRANCISCO -(Dow Jones)- As Microsoft Corp.'s (MSFT) pursuit of Internet portal Yahoo Inc. (YHOO) drags on, Wall Street analysts are increasingly speculating the software giant may be focusing on a Plan B: Tying up with internet service provider AOL.

The speculation was revived on Wednesday when The Wall Street Journal reported Microsoft executives met with representatives of Time Warner Inc. (TWX), AOL's parent company, to discuss a possible union. Microsoft has reportedly been in informal discussions in recent months to explore an AOL deal, which the Redmond, Wash.-based company sees as a potential way to boost its Internet presence.

The talks come against a backdrop of mounting pressure on Microsoft to boost the proportion of revenue it gets from the Internet. A combination of Microsoft and AOL would immediately position Microsoft as an online powerhouse by bringing it significant online traffic and scale to its display advertising, both of which could help it monetize its own Web properties. In 2007, AOL had about 11% of total U.S. online advertising revenue, according to eMarketer, an Internet research firm. Microsoft also had around 11%.

Whether a deal with AOL will happen remains an open question. Among the reasons for skepticism about such a deal is the fact that acquiring AOL would do little to turn around Microsoft's currently weak position in Internet search advertising, the largest and fastest growing segment of the online advertising economy. AOL's search advertising is outsourced to Google Inc. (GOOG), the market leader, and it's unclear whether Google would continue to support this arrangement if AOL was owned by Microsoft, arguably the Mountain View, Calif.- based Internet company's biggest rival.

Still, many analysts increasingly see the benefits of combining the two company's online operations. The combined Web properties of the two companies, which would include AOL's celebrity gossip site TMZ and social networking company Bebo, several online display advertising networks including Advertising.com and Tacoda.com, as well as Microsoft's Hotmail email service, would be larger than industry leader Google Inc.'s, in terms of unique users, according to ComScore, another Internet market research firm.

"It's a deal worth doing" at a reasonable price, said Charles Di Bona, an analyst with Bernstein Research. "It would bring some search and some significant display advertising assets." Bernstein's parent company, Alliance Bernstein, owns shares in both Microsoft and Time Warner.

Microsoft declined to comment. AOL representatives didn't return phone calls seeking comment.

J.P. Morgan values AOL's advertising business - excluding the company's declining Internet subscription business - at $8.7 billion. Earlier this year, Bear Stearns wrote that AOL's combined operations could be worth as much as $13 billion.

To be sure, an AOL deal wouldn't immediately help Microsoft gain in search advertising, its biggest concern. About 40% of U.S. online advertising revenue is generated by search advertising, in which companies pay search services for terms that lead to links to their Web sites when entered by users. Google has almost 80% of the search advertising market, according to ComScore. AOL's share of the U.S. Internet advertising market has declined every year since 2004, according to Credit Suisse.

Earlier this year, Microsoft extended a $44.7 billion offer to buy Sunnyvale, Calif.-based Yahoo, the No. 2 Internet search advertising company after Yahoo, in a deal which would have significantly boosted Microsoft's ability to compete with Google. That deal was rejected, although talks have continued on and off and a proxy battle, led by billionaire activist investor Carl Icahn, means Yahoo remains in Microsoft's crosshairs.

Despite increasing acrimony between the managements of both firms, observers believe Microsoft will ultimately acquire Yahoo, either in its entirety, or through a deal giving it control of Yahoo's search business.

"We believe that Microsoft will eventually at least acquire Yahoo's search assets, given that acquiring Yahoo represents the only way for Microsoft to effectively narrow the gap with Google in the Internet search market," Philip Winslow, with Credit Suisse, said in a recent research note.

Shares in Microsoft closed up 4.24% Wednesday at $27.26. Shares in Time Warner closed up 5.24% at $14.65.

Source: money.cnn.com