Yahoo’s up 3.5% and AOL’s up 4% after  Jeffrey Smith’s activist hedge fund, Starboard Value, called for Yahoo to combine with AOL — and make other changes to “unlock” value for shareholders. A merger with AOL, he said in a letter today to Yahoo CEO Marissa Mayer, “could improve Yahoo’s competitive position, deliver cost synergies of up to $1 billion, and potentially facilitate the realization of value from Yahoo’s non-core equity stakes with minimal tax leakage.”  The letter asks Yahoo to “do the right thing for shareholders, even if this may mean accepting AOL as the surviving entity in a combination, should that be the best and most tax efficient structure.”

Something needs to be done, he says, because Yahoo’s 15% stake in Chinese e-retailer Alibaba “is currently worth more than the entire enterprise value of Yahoo. When adding [a 35.5% stake in] Yahoo Japan, these two minority equity interests are worth approximately $11 billion, or $11 per share more than the current enterprise value of the Company.”

In addition to a deal with AOL, Smith wants Yahoo CEO Marissa Mayer to sell some of its stock in the Asian companies, cut as much as $500M from Yahoo’s Display ad business, and stop buying assets. Since early 2012 the company has spent $1.3B in deals  — including$1.1B for Tumblr —  “while consolidated revenues have remained stagnant and EBITDA [cash flow] has materially decreased.” Yahoo’s shares are up 23.4% over the last 12 months, but Smith attributes increases to investor eagerness to indirectly profit from the growth of Alibaba — which they can do directly since last week when it went public.

Smith’s familiar with Internet media: Two years ago AOL beat back his effort to control three seats on the company’s board.  Starboard describes itself as “a deep value oriented investment firm that specializes in investing in underperforming companies and analyzing alternative strategies to unlock value for the benefit of all shareholders.” It’s currently embroiled in battles with several companies including Darden Restaurants, which owns Olive Garden.

Meanwhile Mayer is under the gun: Yahoo’s revenues have continued to decline despite splashy initiatives, including the hiring of former CBS anchor Katie Couric to be Yahoo News’ Global News Anchor.  The company seemed to be a likely target for activist investors even before last week, when Yahoo — apparently to protect itself — said it had signed a deal with Alibaba agreeing not to sell any more of its shares in the e-retailer for at least a year. Investors also are questioning AOL’s ability to compete with Google, Facebook, Twitter and others for Internet ads. AOL’s shares are down 5.5% so far in 2014.