Yahoo gets desperate

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Yahoo officially rejects Microsoft's $44.6B bid Play video

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Yahoo's board rejected Microsoft's $44.6 billion bid, which could force the software maker to appeal directly to the search engine?s shareholders. Play video

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NEW YORK (CNNMoney.com) -- Oh silly Yahoo.

Not only has the company turned down Microsoft's takeover offer, but according to a report in The Times of London Monday, Yahoo (YHOO, Fortune 500) is said to be considering re-entering talks with my parent company, Time Warner (TWX, Fortune 500), to buy AOL.

I can understand if Yahoo is mulling alternatives to try and get Microsoft (MSFT, Fortune 500) to increase its $44.6 billion bid.

Microsoft's offer of $31 on Feb. 1 represented a 62% premium at the time - but Yahoo traded at $31 a share as recently as November.

Yahoo said in a statement Monday morning that it "believes that Microsoft's proposal substantially undervalues Yahoo!" and that "the proposal is not in the best interests of Yahoo! and our stockholders."

It's reasonable for Yahoo to try and extract a higher bid from Microsoft. This isn't like the News Corp.-Dow Jones takeover bid when Rupert Murdoch offered a price for Dow Jones that the stock hadn't traded at in more than five years.

But the thought of Yahoo trying to merge with AOL just smacks of desperation.

Sure, as our sister publication Fortune reported back in 2006, Yahoo and AOL were at one time in talks to merge. But a deal now is not something that would lead to a bigger, better Yahoo - it is merely a 2008 version of the old 1980s style of scorched earth takeover defenses.

Instead of adding debt, Yahoo would be purchasing a struggling asset that doesn't necessarily improve Yahoo's chances of surpassing industry leader Google (GOOG, Fortune 500).

When Time Warner announced last week that it was splitting AOL into two, the thought was that this would make it easier for Time Warner to eventually sell off the floundering access business of AOL. Adding this side of AOL to Yahoo would be the proverbial two wrongs not making a right.

The other side of AOL - the content and growing online advertising network business - could be attractive to Yahoo. Web sites like AOL-owned MapQuest and TMZ would complement Yahoo's content business.

And ad network Advertising.com as well as other AOL-owned advertising technology firms such as behavioral targeting company Tacoda and contextual advertising company Quigo would be a good fit with Yahoo's Right Media online ad exchange and BlueLithium ad network.

As such, Bernstein Research analyst Jeffrey Lindsay wrote in a report Monday morning that if Yahoo were to acquire the content and advertising businesses of AOL, that could make Yahoo worth $40 a share.

But would Time Warner want to sell this portion of AOL? That's debatable.

In addition, any deal that Yahoo made for AOL that valued AOL at more than $20 billion would only further enrich Google, which owns a 5% stake of AOL for which it paid $1 billion in 2006.

Finally, should Yahoo investors have any reason to trust that the company's management would do a better job of managing AOL than Time Warner has? After all, Yahoo is a company that has made numerous acquisitions in the past few years.

And despite having bought - take a deep breath - GeoCities, Broadcast.com, Inktomi, Overture Services, HotJobs, MusicMatch and Flickr, just to name a few, Yahoo still trails Google in the online advertising market.

Why should investors have any reason to believe that Yahoo-AOL (YAOL? AOL-hoo?) would be a more formidable competitor to Google?

I think that Yahoo's rejection of Microsoft and possible flirtation with AOL is simply a ploy to get Microsoft to raise its offer.

But as my colleague Colin Barr at Fortune pointed out last Friday, many large institutional investors that own Yahoo also own big stakes in Microsoft.

This means they may not be so eager to see Microsoft boost its bid since a higher offer for Yahoo would probably lead to a decline in the value of their Microsoft investment.

So Yahoo's best bet to fend off Microsoft doesn't lie with AOL but in finding a "white knight" bid to make a higher offer. But one may never materialize.

And in a couple of months, Yahoo may find, just as Dow Jones did, that there's only one logical move to make - taking the one offer that it has on the table.

How Now Dow? The other big news on Wall Street today besides the latest in the MicroHoo saga is the shake-up in the Dow Jones industrial average. Out goes Altria and Honeywell and in go Bank of America and Chevron.

It's an interesting move to say the least. The Dow is not a market index like the S&P 500. So unlike the S&P, most mutual fund managers don't really look at it as benchmark.

But the Dow does say something important about the U.S. economy. There were several other mega-cap firms that could have been chosen, such as Cisco Systems, PepsiCo and Apple. But the WSJ went with BofA.

So it is worth nothing that despite the doom and gloom pervading the financial services industry, the people at The Wall Street Journal who maintain the average have decided that adding a third bank and fifth financial services firm to the Dow made sense.

What do you think? Did Yahoo make a mistake by turning down Microsoft?