Yahoo in Talks With Google
To Handle Some Search Ads

Yahoo Inc. is close to announcing that it plans to carry search advertising from Google Inc. as part of a test that could lead to a broader partnership, according to people familiar with the matter.

The short-term test, involving a very limited percentage of Yahoo's Web search queries, is designed for the two sides to evaluate the revenue potential of a broader search ad outsourcing arrangement. They have been discussing such an arrangement as part of Yahoo's pursuit of alternatives to Microsoft Corp.'s unsolicited acquisition offer, according to people familiar with the matter.

The test under discussion, given its short time frame and limited scope, shouldn't stand in the way of any eventual sale of Yahoo to Microsoft, says the person familiar with the matter. But it could factor into the dynamics of the ongoing deal standoff, as a way for Yahoo to signal to investors its alternatives to the Microsoft deal and potentially as an irritant for Microsoft, which views Google as a major rival.

Analysts have predicted outsourcing its search ads to Google would boost Yahoo's cash flow, since Google's system generates significantly more revenue for each search query than Yahoo does. Under such an arrangement, Yahoo would likely garner a majority of the revenue and Google keep the rest as a commission.

But antitrust experts say any broader ad pact between the two would likely face intense regulatory scrutiny, given Google's and Yahoo's significant shares of the Web-search and online-advertising markets.

Microsoft Chief Executive Steve Ballmer in a letter Saturday gave Yahoo directors a three-week ultimatum before Microsoft would go hostile, implying that Microsoft would lower its bid in that case. Yahoo's directors have rejected Microsoft's offer as too low, and in a letter responding to Mr. Ballmer Monday called his ultimatum "counterproductive." Some major Yahoo shareholders, including Legg Mason Inc. portfolio manager Bill Miller, have subsequently said they likely wouldn't support Microsoft in any hostile contest were it to lower its bid.

Prior to Microsoft's offer for Yahoo, Yahoo already had been in negotiations to outsource its Web-search advertising in Europe to Google, say people familiar with the matter. Since last year, some investors have called for Yahoo to abandon its own search advertising system as a quick way to boost its revenue.

Citigroup Global Markets analyst Mark Mahaney in a February research note had estimated that Yahoo could boost its cash flow more than 25% annually by outsourcing all its search advertising to Google. Yahoo executives had considered such a maneuver as part of a strategic review last year, according to people familiar with the matter, but Mr. Yang in October signaled that it had decided against it.

"We believe having a principal position in both search and display advertising is critical to creating...long-term shareholder value," Mr. Yang told analysts during Yahoo's earnings conference call in October.

Yahoo's search for alternatives to a Microsoft purchase and poor performance, including a sinking share price prior to Microsoft's bid and a 2008 revenue outlook considered tepid by many investors, possibly spurred the change of heart toward Google.