Yahoo's New Bedfellows: AOL and Google

With Microsoft at its neck, Yahoo is exploring tie-ups with the two giants

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by Catherine Holahan and Robert Hof

Yahoo is showing just how far it's willing to go in efforts to fend off an unwelcome takeover attempt from Microsoft—or at least extract a few more dollars from the software giant. Meantime, Microsoft (MSFT) is reportedly bringing in reinforcements to demonstrate it won't be beaten back.

Yahoo! (YHOO) Chief Executive Jerry Yang and his board are scrambling to cobble together a handful of tie-ups that would provide an alternative to Microsoft's offer. For its part, Microsoft is in talks with News Corp. (NWS) to make a joint offer for Yahoo, according to The New York Times.

AOL ploy

Step one in Yahoo's plan is a freshly announced test to team up with Google (GOOG) to make its Web-search business more profitable. Moreover, Yahoo is discussing a possible combination of operations with Time Warner's AOL (TWX). Under terms being considered, Time Warner would merge much of AOL's operations with Yahoo and make a cash investment in exchange for about 20% of the resulting company, according to a person familiar with the matter. As part of the arrangement, Yahoo would use the Time Warner cash and other funds to buy back its own stock at somewhere between $30 and $40 a share, according to the Wall Street Journal, which initially reported the discussions with AOL.

The discussions represent a scramble by Yahoo to come up with alternatives to Microsoft's $31-a-share offer, made public Feb. 1. Yahoo regards Microsoft's offer as insufficient, while Microsoft has indicated it's unwilling to sweeten the terms—and on Apr. 5 threatened to take its appeal straight to shareholders if Yahoo doesn't seriously negotiate. "It's fair to say that Microsoft's bid caused Yahoo to accelerate its exploration of its strategic alternatives," says a person familiar with the situation.

If approved by Yahoo's shareholders, the arrangement being discussed with Time Warner would scuttle Microsoft's acquisition attempt. But the combination is complicated, and would enmesh Yahoo with a business that Time Warner clearly wants to shed. AOL ranks fourth behind Google, Yahoo, and Microsoft in share of the lucrative Web-search market. Of the $27.5 billion expected to go toward online advertising this year, AOL is expected to snare about $1.5 billion, compared with $7.9 billion for Google, $3.6 billion for Yahoo, and $1.7 billion for Microsoft, according to market research firm eMarketer.

Google ad dominance

But the possible pairing with AOL isn't Yahoo's only Microsoft alternative. As part of a two-week trial unveiled Apr. 9, Google will handle advertising for a small sliver of the searches carried out on Yahoo. Under the arrangement, Google will place ads alongside 3% of the U.S. queries on Yahoo's site. Google has proven more adept than Yahoo at wringing a profit from search-related ads, so Yahoo wants to know whether it would make more sense to simply hand at least part of the business over to Google.

A successful test could give Yahoo a leg up in efforts to extract a higher price from Microsoft. For starters, pairing with Google could give Yahoo a way to cut costs and boost revenue—and demonstrate that it has options besides acquiescing to Microsoft. The trial may also give Microsoft an indication of how successful it might be in placing ads alongside Yahoo's search results. Microsoft considers its ad-placement technology superior (BusinessWeek, 2/06/08) to Yahoo's approach.