Google-AOL deal on the cards?

Google may pay $1bn for a five per cent stake in AOL as part of an exclusive deal with Time Warner that would strengthen ties with the search giant instead of dumping Google for Microsoft.

As part of the current negotiations with Google, AOL would be able to sell additional ads for its search engine also powered by Google on top of those provided by Google, according to a report Friday in The Wall Street Journal Online. Google could also promote AOL websites among sponsored links in search results, according to an unidentified source in the report. The report said the deal would not be finalised until after Time Warner's board meets on Wednesday.

Representatives at AOL, AOL parent company Time Warner and Google did not return calls seeking comment. A Microsoft representative declined to comment.

AOL was in talks with Microsoft this year about forming a strategic partnership, with negotiations at one point touching on a potential buyout or a Microsoft investment in AOL, according to a person familiar with the negotiations who asked not to be identified.

The talks escalated in recent months to focus on a broad, long-term partnership which the source described as a "game-changing deal for the media business". Under the proposal, AOL and Microsoft would have combined their advertising forces to form a massive global advertising network, selling multimedia, brand- and search-related ads for their own websites and third-party sites on the internet. The deal would also have included joint promotions and content-sharing between the sites.

Then, AOL suddenly told Microsoft early on Friday that the deal was off the table, opting to forge stronger ties with its current advertising partner, Google. The Dulles, Virginia-based media company has been interested in selling its own search-related ads, which are currently provided exclusively by Google, the source said.

The shifting negotiations apparently put an end to a heated and closely watched contest between Google and Microsoft over a key source of Google's advertising revenue. According to filings with the Securities and Exchange Commission, Google derives as much as 10 per cent of its advertising revenue and traffic from its partnership with AOL through sponsored listings within its search engine. And although that percentage has dropped from 12 per cent a year ago and is likely to continue to fall, the estimated $400m in revenue isn't likely to be easy for Google to give up.

The reported Google-AOL deal would give AOL a valuation of $20bn. Time Warner shares closed at $18, giving it a market capitalisation of nearly $84bn, compared with Google's $430.15 per share close and more than $127bn market cap. Microsoft, meanwhile, saw its stock close at $26.90, giving it a market cap of more than $286bn.

Google had 48 per cent search market share in October, compared with 22 per cent for Yahoo!, 11 per cent for Microsoft's MSN and 7.2 per cent for AOL, according to Nielsen/NetRatings.

JPMorgan analyst Imran Khan predicted the deal would have a slightly positive or neutral impact on Google's profits and would make it harder for MSN to have a strong advertising network.

Khan wrote in a research report: "We believe this deal makes it more difficult for MSN to develop a strong advertising network as scale is very important in order to attract [advertisers]. By tying up AOL, Google has made it more difficult for MSN's ad network to reach critical mass."

Piper Jaffray analyst Safa Rashtchy said the proposed deal delivers the most benefit to Google, as opposed to AOL. If the deal goes through, Google will retain its search relationship with AOL, as well as its revenue source, and stave off Microsoft in its quest to acquire AOL as a partner. Finally, Google will be able to use AOL's network as a test lab for new services, such as its banner and display advertising sales. Google, for example, could sell a display ad for AOL pages and maintain its search engine's signature spare look.

In contrast, the deal doesn't necessarily help AOL greatly, Rashtchy said.

He said "AOL's biggest challenge is still to reposition the company" as a player in the web content business. "This would be more of a cash infusion for that than anything else."

Yahoo! and Comcast were reportedly in talks with AOL at one point too but dropped out of the race, leaving heavyweights Google and Microsoft to fight it out.

AOL was initially a huge success, bringing millions of Americans online with its ubiquitous subscriber CDs and internet-made-easy campaigns. After Time Warner and AOL's $109bn merger in 2001, AOL began weighing on the old media company's stock as AOL lost dial-up internet subscribers to faster broadband connections.

AOL recently had a makeover and a huge shift in its business model, launching a new AOL.com portal and opening up its formerly walled-off content to the internet at large. The move was designed to help grab some of the dollars going toward Google and others in the fast-growing internet advertising market.

The changes weren't fast enough to suit billionaire Carl Icahn, who directly and indirectly controls three per cent of Time Warner shares. Icahn has been organising a proxy battle for control of the company and wants to split AOL off.

Stefanie Olsen and Elinor Mills write for CNET News.com