Yahoo enlists AOL to counter joint Murdoch-Microsoft offer

After 24 hours in which the hostile takeover battle between Microsoft and Yahoo took several dramatic twists, with internet rival AOL and Rupert Murdoch's MySpace both said to be getting involved, investors were last night making exactly the same bet – Microsoft's existing bid will be successful.

Yahoo is "closing in" on an alternative deal to merge with AOL, the pioneering internet company whose purchase by Time Warner marked the peak of the dotcom boom in 2000, sources indicated. The mooted deal would involve Time Warner paying cash to top up its stake in the joint venture to 20 per cent – money which would be used to buy back Yahoo shares at a price higher than the $29.34-per-share value of the Microsoft bid, it emerged yesterday.

Meanwhile, on the other side of the stand-off, Microsoft is believed to have opened talks with Rupert Murdoch's News Corporation, which owns the social networking site MySpace and a network of other internet sites, about the possibility of working together on the bid for Yahoo.

Those talks, reported in US newspapers, are said to be at an early stage and it remains unclear what form any deal would take. However, an alliance that brought Yahoo, Microsoft's MSN and MySpace under one roof would certainly create a powerful network of websites to rival Google for the affections of advertisers. News of the AOL-Yahoo plan came just hours after Yahoo had said it was testing the idea of outsourcing the sale of advertising on its search engine to Google, a proposal which – though fraught with competition concerns – would most likely improve Yahoo's profits from search-based advertising after years when its in-house advertising technology has underperformed that employed by Google.

All the big internet players have been brainstorming ideas for the future of the industry since Microsoft launched its audacious bid for Yahoo on 1 February. The cash-and-shares deal was valued then, before Microsoft's share price slid, at $31 per share, or $44bn (£22.3bn). Yahoo shares have never traded above the level of that bid, despite Yahoo's claims that the offer undervalued the company, and intense pressure from Yahoo investors, who have been demanding that Microsoft sweeten the deal. In New York yesterday, Yahoo shares were up 3 per cent to $28.59 – almost a dollar below the level of the Microsoft offer.

Laura Martin, an analyst at Soleil Media, dismissed Yahoo's dealings with Google and AOL as "delay tactics". Their emergence on the front pages of newspapers comes after the Microsoft chief executive, Steve Ballmer, gave Yahoo three weeks to agree to his original offer or face an attempt to unseat the board. So far, Mr Ballmer has resisted the temptation to bid against himself. In his most recent letter to Yahoo's chief executive, Jerry Yang, he threatened to reduce the bid to reflect the damage a boardroom fight would do to Yahoo morale, and to reflect the worsening economy.

Mark Mahaney, of Citigroup, said Yahoo genuinely had alternative options that would force Microsoft to raise its offer, adding: "We believe Yahoo is more 'in play' than its stock price and its discount to the Microsoft offer imply. It has more strategic options than the market has believed.

"A combined News Corp-Microsoft bid very likely means a higher bid for Yahoo. An AOL-Yahoo strategic deal that involves the repurchase of Yahoo shares at a higher price than $31 very likely forces a higher bid. And a full Google search outsource deal – with over $1bn in accretive cashflow – almost certainly forces a higher bid."

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