Why Yahoo! Should Buy AOL

 | Jul 11, 2014 | 11:00 AM EDT
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A pair of Bloomberg and CNBC reporters covering Allen & Co.'s Sun Valley, Idaho, conference separately tweeted seeing Yahoo! (YHOO) CEO Marissa Mayer in "deep conversation" with AOL (AOL) CEO Tim Armstrong at a bar late last night.

Neither stock has really reacted, with both up marginally in morning trading. But these rumors focus everyone on the fact that Yahoo! will soon have lots of money thanks to the Alibaba Group's impending initial public offering, which most people -- myself included -- expect on Aug. 8. Victor Anthony of Topeka Capital Markets estimates that Yahoo! will net at least $9 billion from the IPO once it sells down its Alibaba stake.

Although many see Yahoo!'s current stock price as basically valuing its core business for nothing when you take into account its stakes in Alibaba and Yahoo! Japan, there is some logic behind investors "only" seeing Yahoo! worth the mid-$30s stock price. There is fear that once Mayer gets her hands on the Alibaba money, she will spend it in a value-destroying way on worthless mergers and acquisitions.

So far, Mayer and her lieutenants have pledged to be good stewards of shareholder capital, but investors are taking a wait-and-see attitude about that. In reality, I expect her to fulfill that pledge by using a majority of the Alibaba cash on stock repurchases.

But I also expect she'll use almost half of it to buy other companies. AOL is an acquisition target that makes a lot of sense for Yahoo! -- especially if Yahoo! were run by, say, a private-equity firm.

AOL and Yahoo! do lots of the same stuff. But Yahoo! has 13,000 employees and AOL has 5,000. If Yahoo! were to swallow AOL, it could very quickly eliminate a lot of duplicate staff and become a much more profitable entity. Beyond that, Armstrong has done a good job of steering AOL to have a strong collection of assets in the programmatic ad space. Yahoo! needs to move in this direction quickly and will need to do acquisitions. Buying AOL would help.

But will it happen? It's hard to predict because Marissa Mayer isn't a private-equity executive. She hasn't, to date, shown that she has a desire to lay off a lot of people. Instead, she's grown the headcount at Yahoo!. What's more, AOL is not a "cool" company among the Silicon Valley elite. Would she really be attracted to do a deal like this that many of her peers might turn up their noses to? Again, we haven't seen that in her past actions.

But you most certainly would expect Yahoo! to do deals in the months ahead on the scale of Tumblr. That won't necessarily hurt the stock, though. If Alibaba gets a rich valuation and Yahoo! does a lot of buybacks, Yahoo!'s stock should still go up, Tumblr deals or not.

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