NEW YORK AOL Inc (AOL.N) is actively exploring a breakup of the company in a complicated series of transactions that may lead to a merger with Yahoo Inc (YHOO.O), sources close to the plans told Reuters.
AOL has not yet made a formal proposal to Yahoo, these people say.
Shares of AOL rose 1.5 percent in afternoon trading, while Yahoo edged down 0.1 percent.
In many respects, the latest discussions derive from plans contemplated in 2008 and 2009 before Time Warner (TWX.N) spun off AOL to Time Warner shareholders.
At the time, the media conglomerate had explored the option of breaking apart AOL's two main businesses. The legacy dial-up Internet service would have been spun off or sold to EarthLink (ELNK.O) or United Online (UNTD.O), while the display advertising business would have been merged into Yahoo, the sources said.
Pushing ahead with plans to rid itself of a decade-long nightmare, Time Warner spun off AOL rather than face heavy tax liabilities that would have been associated with a breakup, said the sources.
The sources requested anonymity because they were not authorized to speak to the media.
AOL has continued to explore a breakup and other options since the December 2009 spinoff. "You can drive the pieces into people's hands that could pay top dollar for them and create value, or spin them off," said one of the sources.
This strategy depends on the buyers for the parts. Yahoo and EarthLink, for example, have changed direction since Time Warner first considered these plans, the sources said.
EarthLink was once a willing and capable buyer of AOL's cash-generating dial-up business. But because it is tying up most of its free cash in a deal to buy DeltaCom Inc for $516 million (328 million pounds), it is unlikely to pursue another big transaction for now, another source said.
Combining Yahoo and AOL's Web properties makes strategic sense, said Hudson Square Research Inc analyst Todd Rethemeier. Yahoo's home page attracts audiences to its sports, finance, general news and email, while AOL has strengths in maps and entertainment news, he said.
Yahoo, which analysts expect to generate $1.64 billion in earnings before interest, tax, depreciation and amortisation this year, could support AOL's display ad business. That could give AOL the confidence to shed the dial-up division.
AOL and Yahoo declined to comment. A source close to Yahoo reiterated that it is not seeking proposals or is in any buyout discussions with AOL.
AOL has been reluctant to shed its dial-up business, which remains a major source of revenue and whose 4 million customers remain a big contributor of traffic to the company's home page. Rethemeier expects the division to contribute a little over $1 billion of revenue out of $2.4 billion overall this year.
The dial-up business could fetch two or three times EBITDA, said UBS analyst Brian Pitz.
"I don't think as a stand-alone either Yahoo or AOL are going to be as competitive as they once were," Pitz said. "One plus one might equal two and a half."
To resolve the tax concerns, the dial-up and display businesses would need to be spun off rather than sold for cash, said one of the sources.
These plans come amid a painful turnaround strategy led by AOL Chief Executive Officer Tim Armstrong, who has quickly divested weak properties such as social networking website Bebo and bought high-profile blogging network site TechCrunch.
Still, the company's core operations remain weak. Rethemeier estimated revenue declines of almost 27 percent at the dial-up subscription business and 28 percent at the advertising business in 2010.
"AOL is down to a little over 4 million dial-up users," Rethemeier said. "That has been dropping by 200,000 to 300,000 every quarter."
One of the sources familiar with AOL's thinking called the company a declining business. "If you do nothing, your value just treads water at best, probably loses value," the source said. "That's the conundrum."
FOCUS ON YAHOO
"The issue is Yahoo has no interest in dial-up, and with the traffic flow between (AOL's two) businesses, it is not easy to sever," said one of the sources. But AOL's further investment in display advertising appears to be an attractive manoeuvre to Yahoo, said that source.
For now, AOL may have some time to weigh its options. It has about $600 million in cash and almost no debt on its balance sheet. With its asset disposals in the fourth quarter, the business is still cash-flow-positive, said Rethemeier.
The focus is now on what Yahoo does next. To complete a merger with AOL, Yahoo would need to take a series of steps to shrink in size, sources said.
The most plausible scenario, according to the sources, is Yahoo being broken up through a private equity buyout combined with a sale of the company's Asia assets to a strategic buyer, said two of the sources.
In one scenario, Yahoo would need to sell its stakes in China's Alibaba Group Holdings, of which Japan's SoftBank (9984.T) is the second-largest shareholder, and Yahoo Japan.
Since Yahoo made its investments in Alibaba and Yahoo Japan, the value of both of those entities has gone up dramatically, said one of the sources.
As a result, the tax consequences would make a deal "thorny and tough to make work," said one of the sources. "That strategy is the equivalent of throwing a basketball from underneath your own hoop -- it is not going to happen."
Yahoo shareholders could face a 38 percent in taxes on the price of the transaction, that source said.
AOL shares rose 1.5 percent to $25.57 on the New York Stock Exchange, while Yahoo was down 0.1 percent at $16.34 on Nasdaq.
(Reporting by Nadia Damouni in New York; Editing by Kenneth Li, Lisa Von Ahn and Dhara Ranasinghe)