Starboard, which recently went after Darden for wasting money at its Olive Garden restaurants, said a tie-up between the two firms could “offer synergies of up to $1 billion” and reduce corporate overhead cost.
AOL shares jumped more than 6 percent after the news, while Yahoo rose around 3 percent.
“[W]e believe a merger of AOL and Yahoo’s core business may be one of the best ways to both fully seize the cost reduction opportunity and also to tax efficiently monetize Yahoo’s noncore equity holdings,” the letter said.
Starboard said the deal could help the companies navigate the ongoing industry changes, such as the growth of programmatic advertising and migration to mobile.
The letter, which was signed by Starboard CEO Jeffrey Smith, described Yahoo as “deeply undervalued relative to the sum of its parts” and said the company must take immediate steps to “remedy this valuation discrepancy.”
Starboard said it had acquired a significant stake in Yahoo, adding that a possible AOL deal, along with other recommendations, would unlock tremendous value for shareholders.
While the proposed tie-up with AOL may not be “sexy,” there are a lot of reasons to think a combined company would work, said Colin Gillis, analyst at BGC Partners.
For one thing, AOL would bring original video and original content that Yahoo has been openly seeking, Gillis said.
There’s enough overlap that possibly significant cost savings could be found. And Yahoo clearly needs help gaining market share in the “raging bull market for online advertising,” Gillis said.
Yahoo currently has a market valuation of $40 billion, in comparison to industry leader Google’s nearly $200 billion market cap.
This is not the company’s first encounter with a high-profile hedge fund. In 2012, activist investor Daniel Loeb sent a letter to Yahoo’s board demanding that its then-CEO Scott Thompson be fired.
Loeb was a primary player in recruiting Mayer as Thompson’s successor, but the two reportedly had major differences in opinion about Yahoo’s strategy going forward, which eventually lead to Loeb’s departure from the board, the New York Post reported last year.
Disclosure: CNBC has a content sharing partnership with Yahoo’s finance site.