* AOL mulling split of dial up from display ad businesses
* Plans still in exploratory stage
* Yahoo not contacted on combination of business
By Nadia Damouni
NEW YORK, Dec 5 AOL Inc AOL.N, undergoing a radical transformation into the king of content on the Internet, is actively exploring a breakup involving a complicated series of transactions that may lead to a merger with Yahoo Inc (YHOO.O), sources close to the plans told Reuters.
The plans are still in the exploratory stage and Yahoo has not been contacted, the sources said. The plans are also fraught with complications involving myriad moving pieces.
In many respects, the latest discussions are derivative of 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. Its legacy dial-up Internet service would have been sold to or spun off into EarthLink ELNK.O or United Online UNTD.O. Its display advertising business would have been merged into Yahoo, the sources said.
To avoid complication and to push 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 break up, said the sources.
The sources declined to be named because they were not authorised to speak to the media.
AOL has continued to explore a break up option since the December 2009 spin off. "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 is dependant on the buyers for the parts, including Yahoo and EarthLink, whose directions have changed since Time Warner first considered these plans, said the sources.
EarthLink, for instance, was once a willing and capable buyer of AOL's cash-generating dial-up business. But it has agreed to buy DeltaCom Inc for $516 million, tying up most of its free cash and is unlikely to pursue another big transaction for now, another source said.
Combining Yahoo and AOL's web properties makes strategic sense, said Todd Rethemeier, analyst at Hudson Square Research, Inc. Yahoo's home page attracts audience to its sports, finance, general news and email, while AOL, has strengths in maps, and entertainment news, Rethemeier said.
Yahoo, which is expected to generate $1.64 billion in Ebitda this year, could support AOL's display ad business, giving AOL the confidence to shed the dial up division, a big financial engine at the company.
AOL declined to comment.
A spokesperson for Yahoo also declined to comment, but a source close to the company reiterated that it is not seeking proposals or in any buy-out discussions with AOL.
AOL has been reluctant to shed its dial-up business as it remains a major source of revenue and its existing 4 million customers remain a big contributor of traffic to AOL's homepage. The division is expected to contribute a little over $1 billion of revenue out of $2.4 billion overall revenue this year, according to Rethemeier's estimate.
The dial up business could fetch two or three times earnings before interest, tax, depreciation and amortization, said Brian Pitz, an analyst at UBS.
"I don't think as a standalone either Yahoo or AOL are going to be as competitive as they once were. One plus one might equal two and a half," said Pitz.
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 turn-around strategy led by AOL CEO Tim Armstrong, who has quickly divested weak properties such as social networking website Bebo, and buying high profile blogging network site TechCrunch.
Still, the company's core operations remain weak. Revenue for its dial up subscription business for full year 2010 dropped almost 27 percent, while the advertising business has not fared better, said Rethemeier, declining 28 percent over the same period. "AOL is down to a little over 4 million dial up users That has been dropping by 200,000 to 300,000 every quarter."
"AOL is a stagnant to declining business," said one of the sources, close to AOL's thinking. "If you do nothing, your value just treads water at best, probably loses value. That's the conundrum," the source said.
FOCUS ON YAHOO
"The issue is Yahoo has no interest in dial up, and with the traffic flow between the 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 maneuver to Yahoo, said that source.
For now AOL may have some time to weigh its options. It has about $600 million in cash, almost no debt on the balance sheet and 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. In the grand plan of breaking up AOL, the sources said ultimately there are a number of stages that need to occur, including the slimming down of Yahoo.
Yahoo could well be on the receiving end of financial sponsors and strategic companies that are modeling it and trying to figure out if it comes into play, what they can do, said a another person familiar with the situation.
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 order to complete a merger of AOL and Yahoo, Yahoo would also need to shrink in size, sources said.
Yahoo owns a 40 percent stake in China's Alibaba Group Holdings, of which Japan's SoftBank (9984.T) is the second largest shareholder. In one scenario, Yahoo would need to sell the Yahoo Japan and Alibaba business stakes. But the tax issues 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," said that source.
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. How you structure something that minimizes the taxes, is a major hurdle.
Yahoo shareholders could face a 38 percent in taxes on the price of the transaction, that source said.
(Reporting by Nadia Damouni in New York; Editing by Kenneth Li and Dhara Ranasinghe)
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