What a Tangled Web Yahoo! Weaves

Updated since 8:02 AM EST

SAN FRANCISCO -- Just when a merger between Microsoft(MSFT Quote) and Yahoo!(YHOO Quote) seemed inevitable, several new twists may now throw it off course, with talks involving Time Warner(TWX Quote), Google(GOOG Quote) and News Corp.(NWS Quote) all in play.

Yahoo! and Time Warner are reportedly close to merging their online operations as part of a three-pronged effort to rebuff Microsoft's merger offer. Under this strategy, Time Warner would fold AOL into Yahoo! and make a cash investment in Yahoo! for a 20% stake in the new structure. In turn, Yahoo! would take that cash and buy back several billion dollars of its own stock at a price between $30 and $40 a share, according to Wall Street Journal reports.

Control Your Ego, Yahoo!

Separately, Yahoo! has reached out to Google to outsource some of its search ads. Yahoo! said it will begin a limited test of Google's AdSense, which will deliver relevant Google ads alongside Yahoo!'s search results.

The test, which will last up to two weeks and will be limited to 3% of Yahoo!'s search queries, will apply only to the company's traffic in the U.S. and will not include its extended network of affiliate or premium publisher partners. The company noted that the testing "does not necessarily mean that Yahoo! will join the AdSense for Search program or that any further commercial relationship with Google will result."

In his research, analyst Jeetil Patel of Deutsche Bank wrote that either scenario will face considerable obstacles.

"We highlight regulatory issues may exist due to market share in instant messaging, e-mail, and 100% paid search share for Google should Yahoo! outsource its search," he said. "Integration issues would still remain between a Yahoo!-AOL combination."

At the same time, Patel pointed out that an arrangement between Yahoo!, AOL, and Google could be just as complicated as a deal with Microsoft, "rendering Yahoo!'s alternative strategy as merely a negotiating tactic."

Microsoft isn't exactly standing quietly on the sidelines as all these new developments unfold. The New York Times reported that the company is talking to News Corp. about joining its bid for Yahoo!, a move that would enable Microsoft to boost its bid without using more of its cash, which has been a sore spot for Microsoft shareholders. The Times says terms around a partnership offering "remain murky."

Early on, Yahoo! had been in discussions with News Corp., but hopes of a deal had been somewhat dashed when media mogul Rupert Murdoch dismissed the possibility, saying that he did not want to compete with Microsoft. Now it seems News Corp. might try to merge its social networking site, MySpace, with Microsoft's MSN, creating an Internet powerhouse if Microsoft manages to swallow Yahoo! as well.

Citigroup analyst Jason Bazinet pointed out in his research note Thursday morning that while Time Warner and News Corp. likely want to avoid tertiary status on the Web, they are both going about it in different ways.

"While Time Warner hopes to scuttle a Microhoo deal, News Corp. hopes to get a slice of the pro forma pie," he wrote.

Bazinet said that although he applauds Time Warner's efforts, he fears that Yahoo! shareholders won't want to give up cash and stock for what he called "a riskier, albeit potentially more lucrative, outcome."

"In this sort of market (recession, tepid ad market), we suspect Yahoo! shareholders want more cash, and fewer pro forma projections," he wrote.

Bazinet added that News Corp.'s chances of success are higher than Time Warner's. For one, News Corp. offers Microsoft and Yahoo! something they are both missing -- a social network. At the same time, News Corp. would be working with Microsoft instead of against. And lastly, Bazinet maintained that News Corp. may be more flexible when it comes time to negotiate.