Now that Microsoft and Yahoo have ended talks, AOL (TWX) is in play. Not officially, perhaps, but certainly unofficially. The two most likely AOL buyers, moreover, are…Microsoft (MSFT) and Yahoo (YHOO). Yahoo is a better fit, but we expect a Microsoft-AOL deal to be announced within a couple of months.
Background: AOL needs to be combined with one of the Big Three (Google, Yahoo, or Microsoft). The industry needs this, AOL needs this, and Microsoft (MSFT) and/or Yahoo need this (Google doesn’t need it and wouldn’t risk antagonizing regulators by trying to buy it). The industry cannot support four big general players, and as long as Microsoft remains willing to lose billions on its web business, AOL will not be able to survive on its own. If Microsoft or Yahoo doesn’t buy AOL, the company should be chopped up and sold in pieces.
Yahoo is actually a better fit for AOL than Microsoft: AOL’s remaining content properties would complement Yahoo’s content business, Platform A would boost its dominance of display advertising (and help it compete with Google-DoubleClick), and the combination of AOL and Yahoo’s mail and instant-messaging systems would be powerful, especially now the the Google-Yahoo deal will allow interoperability between the Google and Yahoo two systems.
A Yahoo-AOL merger wouldn’t have helped Yahoo fend off Microsoft, but now that Yahoo has, in fact, fended off Microsoft, it should go ahead with negotiations to buy AOL. It shouldn’t devote too much energy to these negotiations, however, because…
Whatever Yahoo agrees to pay for AOL, Microsoft will pay $1 billion more. As Microsoft scrambles to come up with a post-Yahoo strategy, the usual acquisition suspects are being tossed around: Facebook, Digg, Ask, AOL, etc. The first three are either unlikely (Facebook) or irrelevant (Digg, Ask). A play for AOL (TWX), meanwhile, makes sense (Kara Swisher argues the same).
AOL’s Platform A would bring huge scale to Microsoft’s third-party display business. Microsoft might want to sell AOL’s content properties (it didn’t want to own Yahoo’s), but its mail and IM businesses would also benefit from the combination.
Most importantly, if Microsoft is serious about remaining in the web advertising business (which we don’t think it should be), it simply cannot let Yahoo buy AOL. Microsoft is already a marginal player in this business. A combination of AOL and Yahoo would make it an even more distant also-ran.
Conclusion: As we’ve said before, we think Microsoft should quit the online advertising business and focus on defending (and expanding) its corporate business. We think Microsoft is a long way from adopting this view itself, however, and we can’t imagine the company will let AOL end up in Yahoo’s hands.