First Yahoo, is AOL next?

Interesting take from Portfolio.com:

The news that Microsoft finally put a formal offer on the table for Yahoo places new emphasis on an oft-asked question: What will happen to AOL?

Speculation that Time Warner would spin off the troubled internet unit it merged with seven years ago has persisted since shortly after the deal closed. The $124 billion merger, reached at the very peak of the tech bubble, is widely regarded as one of the worst corporate combinations ever.

Time Warner could seek a buyer for all or part of AOL, or it could spin it out in an initial public offering. Today's news that Microsoft values Yahoo at a 60 percent premium to what the market values it is great news for Time Warner brass looking to unlock shareholder value.

David Katz, a Time Warner shareholder and chief investment officer at Matrix Asset Advisors, believes that AOL is worth 60 percent more today than it was yesterday. "It puts significantly different valuation metrics on the business," he says.

Only that's not how the market is viewing it. Time Warner shares surged more than 9 percent before the market opened, but they've since settled down to trade about 1 percent higher.

This makes an I.P.O. look like a challenge for AOL. Even though the cash-rich Microsoft values Yahoo at a premium, there's no guarantee that investors will do the same for AOL.

The company is in the midst of a turnaround as it shifts from a subscription-based business model to an advertising-based one. As a result, AOL's subscriber numbers have fallen off a cliff in recent quarters. But the advertising side has yet to pick up the slack: During the last quarterly earnings conference call in November, Time Warner said it expected advertising revenue growth to slow in the fourth quarter, and it believed its pageviews would be flat.

Instead, the company is focused on growing profits by slashing costs—not exactly the kind of show to take on the road. They could spin it as a separate entity for Time Warner shareholders, but the sales pitch might still be challenging.

An alternative scenario would be that another major media player takes Time Warner's problem off of its hands by acquiring it. Google took a $1 billion stake in AOL, in a deal that valued the company at $20 billion.

But that was two years ago. Yahoo's market value has been cut in half since then (as of yesterday's close), so it's hard to argue that AOL's has fared much better. At the time Google made the deal, AOL accounted for 10 percent of its advertising revenues. Now it accounts for half that.

Perhaps a better option for Jeff Bewkes, who took the helm at Time Warner last month and who has pledged to focus on shareholders, is to use Microsoft's lofty valuation of Yahoo to sell AOL for a deal.

It's hard to imagine Google swooping in and coughing up a 60 percent premium for a company in which it's already realized a loss. Another potential acquirer, News Corp., already paid that eye-popping premium for Dow Jones last year, so it might be tough to pull off two years in a row, even for Rupert Murdoch.

But Matrix Advisor's Katz does have a point. Valuation metrics in the online advertising industry are changing with today's news. If Microsoft is willing to buy Yahoo for a 60 percent premium, then AOL at a 20 or 30 percent premium looks like a steal.

But a premium to what? A clearer answer should emerge next week, when more is revealed about just how bad things are at AOL during Time Warner's fourth-quarter earnings call on Tuesday.