By Yi-Wyn Yen
April 10, 2008

By Yi-Wyn Yen

Yahoo and Time Warner’s AOL are negotiating a deal to combine their Internet operations, a source told Fortune.

The news was initially reported in the Wall Street Journal, which stated that Time Warner

would fold AOL into Yahoo and make a large cash investment for a 20% stake of the combined company. In return, Yahoo would repurchase several billions of its shares in the mid-$30 range. Time Warner is also the parent company of Fortune and CNNMoney.com.

For Microsoft, this means war. The Journal and New York Times have also reported that Microsoft (MSFT) is now in talks with News Corp. (NWS). Just hours before the news leaked of Yahoo’s advanced talks with AOL, the Internet portal announced that it would run a preliminary two-week test to run Google’s search advertising.

Yahoo, which has rejected Microsoft’s bid worth $31 a share, is hoping that a partnership with AOL and a possible advertising deal with Google, will be a more attractive offer to its shareholders. There’s no guarantee that Yahoo’s shareholders will go along with the deal if Microsoft comes back with a higher offer.

Many industry watchers continue to believe that accepting a deal with Microsoft is the best solution for Yahoo. “We continue to believe reaching a mutual agreement with Microsoft would be the best way for Yahoo to potentially extract a higher bid,” wrote UBS analyst Ben Schacter in a note late Wednesday. “The alternative would be for Yahoo shareholders to tender, although this process would not be as expeditious as if the two sides were to come to terms, and could involve a lower offer price, making the battle potentially even more protracted.”

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