Why a Yahoo-AOL merger makes sense...maybe

Source: Starboard Value; Getty Images

There was a time when the notion of a Yahoo-AOL merger would have conjured up the image of an Internet giant poised to gain so much market control that regulators would be forced to weigh in. That was a long time ago.

Now, it sounds more like the desperate act of two companies from yesteryear that can't compete on their own. Of course, neither company is proposing such a deal. Rather, the chatter emerged from a letter that activist hedge fund Starboard Value sent to Yahoo's board and management on Friday.

Having taken a "significant" stake in the Web portal, Starboard is strongly suggesting that Sunnyvale, California-based Yahoo stop trying to grow via acquisition and instead explore a "strategic combination" with AOL that could result in cost savings of more than $1 billion. Starboard took an activist stake in AOL in 2012, but failed in its push to change the makeup of the board of directors.

Starboard takes aim at Yahoo
Starboard takes aim at Yahoo

Whether a Yahoo-AOL combination makes sense is very much up for debate. But what's clear from Starboard's letter is that Yahoo's current strategy isn't working for investors. Chief Executive Officer Marissa Mayer has spent $1.3 billion on acquisitions, including $1.1 billion on Tumblr, and there's been no growth to show for it.

"After two years and a myriad of acquisitions, the fundamentals of the business have not improved and arguably have deteriorated," said Laura Martin, an analyst at Needham & Co., who has a "buy" rating on New York-based AOL and a "hold" on Yahoo. "There's no proof point to date that the core business of Yahoo can be salvaged."

According to eMarketer, the combined companies would control 3.4 percent of the global digital advertising market this year, down from 5.1 percent in 2011.

Still, Martin says a merger between the laggards would make economic sense. In addition to the $1.2 billion in costs that Martin projects would be saved by bringing them together, the deal would allow AOL CEO Tim Armstrong to use his ad-selling expertise and history of acquiring content like Huffington Post to better monetize Yahoo's massive portfolio of sites and services, she said.

Yahoo shares rose 4.4 percent after the announcement on Friday, and AOL jumped 3.7 percent.

Marissa Mayer's 'moment of truth'
Marissa Mayer's 'moment of truth'

That's the optimistic take. But no matter the potential, both companies are battling for ad dollars in an increasingly competitive market with fast-growing players like Facebook and Twitter as well as the world's biggest Internet company by value, Google. Both are struggling to attract and retain talent, while salaries and perks across the industry go up and up.

Starboard's argument is purely financial. Yahoo's stakes in Alibaba and Yahoo Japan are worth more than its $40.4 billion stock market capitalization, even though the company is projected to record $4.4 billion in revenue and over $1 billion in net income this year.

The reason investors are so bearish on Yahoo, aside from all the competitive pressure, is because they expect the company to continue to be heavily taxed on its equity stakes and to spend a lot of cash searching for that elusive growth engine, Starboard said. If the New York-based investor has its way, a more tax-efficient mechanism will be put in place for the Asian investments and Yahoo will stop pretending to be a growth company.

Read MoreYahoo and its Alibaba stake

"Obviously, ascribing negative value to this large and profitable business is nonsensical, demonstrating to us the market's significant skepticism about the company's current strategy," Starboard said.

Yahoo isn't backing down. The company responded late Friday, saying that it would carefully review Starboard's letter. But it reiterated plans to find ways to put capital to work and said it will still be "investing in products that will drive sustainable growth: search, communications, digital magazines and video."

Furthermore, Yahoo is sending a substantial chunk of change back to investors. The company has repurchased more than $6 billion worth of shares since mid-2012, and has promised to return half of the after-tax cash from the sale of stock in Alibaba's IPO to shareholders.

According to Martin, Starboard's demands will at least serve as a reality check. Yahoo continues to pledge a turnaround, but more than two years into Mayer's term, investors aren't buying it, she said.

"Her board isn't hearing or isn't conveying the urgency that Wall Street feels," Martin said. "That changes once Starboard gets involved."