Here's Why Yahoo And AOL Should Immediately Merge

Yahoo and AOL are both in a business that benefits greatly from scale. They're both basically media companies. By combining, they would achieve greater scale and reduce duplication.
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The two struggling Internet giants of the 1990s, Yahoo and AOL, should merge.


(In fact, it's ridiculous that they haven't already).

This idea isn't new -- we've been calling for it for three years, and, according to Kara Swisher, "big investors" are now calling for it, too.

"Big investors" want Yahoo and AOL to merge, AOL CEO Tim Armstrong to become CEO of the combined company, and Yahoo CEO Carol Bartz to become Chairman (which would be in keeping with what Yahoo's board is discussing anyway). We would certainly be open to that idea -- assuming Tim can persuade us that he is tough enough to quickly and efficiently make the big restructuring moves (and cuts) that the combination would require.

But the management structure isn't as important as the combination itself.

Here's why the companies should merge:

Yahoo and AOL are both in the same business, and it is a business that benefits greatly from scale. Yahoo and AOL are both basically media companies. They both use technology extensively, but their core competency is producing content to attract an audience and then selling display ads against that audience. They also both operate duplicative mail, instant-messaging, sports, finance, news, maps, and other services, all of which currently compete with each other. That is senseless. By combining, Yahoo and AOL would achieve greater scale and reduce duplication.

There are currently 4-6 big generalist destination web sites, and that's at least two more than there should be. The big destination sites are: Facebook, Google, Yahoo, Microsoft, and AOL (and, increasingly, Twitter). Facebook and Google have clearly differentiated businesses. Yahoo, Microsoft, and AOL don't -- they're still trying to be all things to all people. By investing hugely in Bing, Microsoft has picked its horse: It wants to compete with Google in search. Yahoo and AOL, meanwhile, have outsourced search to focus on content and display ads. That leaves Yahoo and AOL as the major competitors in content and display advertising. They both would be stronger -- and they both would eliminate a major competitor (in the US) -- if they combined forces.

There is huge and needless duplication of services at AOL and Yahoo: "Portal" page, finance, sports, entertainment, celebrity gossip, games, mail, instant-messaging, ad network, search window (outsourced), chat, etc. There is no reason for these services to be duplicated. And by splitting the market, Yahoo and AOL are splitting the market and thus losing more ground to their competitors. Take "mail," for example. Yahoo Mail and AOL Mail are critical traffic drivers to both company's content empires. They keep users coming back many times a day. But both Yahoo Mail and AOL Mail have lost ground to Gmail, Facebook, and Twitter, and Microsoft Outlook is still a major competitor. Left on its own, AOL Mail will die: AOL just doesn't have the resources to keep it competitive with the offerings of far-richer companies like Microsoft and Google. Yahoo Mail may survive, but it would have a better chance with the added scale and resources of being combined with AOL Mail. And the same can be said for instant-messaging, voice-chat, and all of the other areas above.

AOL is affordable, even for Yahoo. AOL's enterprise value is about $2.4 billion. Yahoo's is $16 billion. Yahoo could probably get AOL for $3 billion, maybe $3.5 billion. That's only 20% dilution. And if Yahoo didn't want to take the dilution, it could always buy AOL for cash. Yahoo doesn't know what to do with its cash anyway. (It might have to borrow a bit of money to pay cash, but money is free right now. Alternately, it could sell off its Alibaba stake and raise the cash that way. The stake adds no strategic value whatsoever.)

The combination would be instantly accretive for shareholders. In combining, Yahoo and AOL could not only boost revenues, but cut hundreds of millions of dollars of costs. Both companies are already gushing cash, so the combination would immediately goose cash flow.

The combination will eliminate a major competitor for both companies--both in display advertising and, importantly, in the consolidation of the burgeoning online content industry. AOL just bought TechCrunch for ~$40 million. Yahoo should also have bought TechCrunch -- and we suspect that AOL's move might just wake Yahoo's M&A team up. In future sales, therefore, AOL and Yahoo might be competing with each other for companies like TechCrunch. That will drive prices up... unless they're working together.

Combining AOL and Yahoo would make the combined platform a "must buy" for any display advertiser. The display market isn't growing as fast as the search market, but it's still a huge and fast-growing market. Right now, the two companies' sales forces are duplicated. They needn't be. And the combination would offer advertisers even greater reach, inventory, and targetability. This, in turn, would reduce content production costs as a percentage of revenue.

The combined search businesses would have (slightly) more leverage to get better terms with Google or Microsoft. AOL only owns 3 percent of the US search market, but that 3% is still worth ~$500 million a year. Search is an economy-of-scale business, so the added scale would likely allow the combined company to squeeze better terms out of Microsoft or Google.

The combined distribution business would have more leverage with Hollywood, the music industry, and other content creators. Why is the cable industry so powerful? Scale. Once again, the more people you reach, the more valuable you are as a distribution platform. This combination would bring more distribution scale.

AOL's New York media headquarters would give Yahoo an even stronger beachhead in the media and advertising capital of the world. New York still matters, especially in this industry.

Yes, putting the two companies together would be challenging and require painful cuts. But it's not rocket-science. And it also wouldn't involve combining enormously different cultures and businesses, the way, say, the disastrous AOL Time Warner merger did. These two companies are essentially in the same business. As long as management took a disciplined approach to the integration, the merger would stand a good chance of being very successful.

Unless it radically refines and focuses its business, AOL must combine with someone -- Yahoo or Microsoft. There is no way it can survive as a generalist all-things-to-all-people brand when it is so much smaller than everyone else in the business.

Yahoo has less need to do this deal -- Yahoo already has enough scale -- but the combination would help Yahoo. And, as discussed, it would also eliminate a major competitor.

Merging Yahoo and AOL is not "the answer" to both companies' woes. Once they combine, they'll still have to execute. But it's a good step toward for both companies.

They should do it immediately.

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