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What's The AOL/Google Deal?

Believe it or not, the rumored alliance between Google and AOL isn't all about Microsoft .

UPDATE: (Late Tuesday, Time Warner and Google officially confirmed previously reported details that Google was investing $1 billion for a five percent stake in AOL. The deal was first reported by the Wall Street Journal with the New York Times adding more details on Saturday).

"This agreement is key to fulfilling our commitment to realize the potential of AOL's very large online audience," Time Warner chairman and CEO Dick Parsons said in a statement. "As digital technologies continue to drive industries together, the great value and opportunity inherent in Time Warner's structure and array of premier businesses becomes increasingly clear. A critical piece of this strategic alliance will be our content, which we will be making more accessible to Google users."

A person close to the proceedings confirmed reports that Microsoft also had been in the running for a hook-up with AOL.

Such an alliance could have bolstered MSN's search share and provided a wider audience for its adCenter pay-per-click advertising platform set to roll out in 2006. But on Friday, Redmond got word that the engagement was off.

The $1 billion Google reportedly will pay for a 5 percent stake in AOL is actually spot on, according to Merrill Lynch analyst Jessica Reif Cohen, who values AOL at $19 to $20 billion.

AOL is struggling to jettison its image as a dial-up provider and become a true Internet portal. While its overall sales dipped 4 percent in the second quarter, advertising revenue made a 45 percent jump from a year ago and operating income increased by 33 percent.

So what exactly does Google get for that -- and what does it lose?

"I don't think the valuation will shock anybody, but $1 billion is still money where I come from," Victor Schnee, president of Probe Financial Associates, told internetnews.com. But there are significant questions to be answered, he said, about what Google gets in return for its small stake in the company owned by a traditional media conglomerate.

For example, would Google have priority on any future investments, or at least first right of refusal? Would it have any say on changes in control?

While the deal clearly has strategic value to Google as a way of keeping AOL's 7.2 percent search share away from MSN, it also could profit Google, according to John Battelle, author of "The Search."

In his blog, he pointed out that, should Time Warner decide to spin off AOL and take it public, that 5 percent could provide a serious return on the investment.

Moreover, Battelle wrote that his conversations with AOL executives led him to believe that they wanted to take the company public.

"And why would Google invest in a subsidiary of Time Warner, unless they were promised some kind of liquidity event?" he added.

Research analyst Henry Blodgett, principal of Cherry Hill Research, wrote that the partnership with AOL brings Google approximately $400 million in revenue and $50 million in gross profit "in exchange for some chump change from its cash hoard."

Blodgett said that placement within the AOL portal could give Google access to a different demographic from its own user base of tech-savvy professionals. Blodgett even saw synergy in communications.

"Properly exploited, AOL's IM and mail products could improve the outlook for Talk, Gmail, etc.," he wrote.

Upside for AOL

Aside from $1 billion more cash in hand, this agreement could give AOL a shot in the arm.

In a research note, Merrill Lynch's Cohen wrote, "The details of the agreement seem to satisfy the key requirements we laid out in a report last week; i.e. securing a long-term technology partner, driving additional traffic to AOL.com and improving the monetization of its current traffic through an improved sales effort.

She added that Google advertising could get AOL out of its rut.

"We have yet to see evidence of a pickup due to the opening of AOL.com to the general public. In addition, AOL will receive a white-label search solution that would allow it to sell a full advertising package to advertisers instead of being forced to direct them to purchase search through Google."

A Dangerous Liaison?

But the rumored union has its critics, as well.

Reportedly, Google will give AOL favored placement throughout Google search, while AOL's video content will be integrated into Google video search. Google will feature AOL video links on the search home page without marking them as advertising.

"Guaranteeing AOL ad position is in direct contradiction to the ad-rank system that helps level the playing field between deep-pocket marketers and small-business owners.

If, on top of that, AOL's video programming is integrated into its natural search results in any way different from other content, it would call into question Google's entire business model," wrote John Zappe, an analyst with Classified Intelligence.

Moreover, the pact might limit AOL's options too much.

"This deal is barely scratching the surface," Probe's Schnee said. "It seems like it's mainly a deal about selling advertising, and we don't think selling advertising is the be-all and end-all for AOL."

Investor Carl Icahn, who owns 3 percent of AOL and is fighting to take control of the board of directors, sent an open letter to Time Warner's board warning it about the deal. He was concerned about locking AOL into another five years of using Google search.

"I believe there are and will be major opportunities to enhance Time Warner's value in future combinations," he wrote. "However these transactions might not be achievable if Time Warner enters into long-term arrangements that preclude future flexibility such as an agreement regarding search functionality."

Icahn said he believed that some potential buyers had been or would be shut out by this deal.

"If, as is my belief, other suitors interested in transactions predicated on receipt of control of AOL have been foreclosed from entering into negotiations, the board's actions would be even more questionable," he wrote.

To Schnee, this is just the latest installment in "a business tragedy in several acts." What AOL really needs, he said, is to be released from Time Warner, which has let it wither.

"AOL was a pre-Internet company," he said. "It had to scramble to survive when the Internet came along, and it never became a full Internet culture."

Schnee believes that Google could give a technology boost to AOL, improving its user experience and helping it extend to mobile devices.

"You've got Gmail," perhaps?