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Google and Yahoo have made major concessions in their proposed search advertising deal in hopes of getting the Justice Department to go along with it, according to a Wall Street Journal story. People “familiar with the matter” say the new proposal, submitted over the weekend, shortens the term of the deal from 10 years to two years and places a limit on the revenue Yahoo can generate from Google to 25% of Yahoo’s search revenue. Also, Google advertisers can opt not to have their ads shown on Yahoo.

It’s unclear how deep these concessions are. For one, Yahoo has always said it would start slowly on the deal and see how it goes before deciding whether or how much to increase the ratio of Google ads on its pages. Moreover, Yahoo’s search revenues on its own site in the third quarter alone were $438 million; 25% of that, annualized, still adds up to a fairly large number—not the $800 million revenue opportunity Yahoo has floated, but probably more than half of that. So while that would likely be a significant concession, it’s also still significant. And in the Internet age, I wonder if a 10-year deal meant much of anything.

But the bigger issue is whether Justice’s antitrust division will be mollified, or if it prefers to make a statement about Google’s growing power by either demanding even more stringent concessions or blocking the deal entirely. It doesn’t seem out of the question that the two sides can come to some agreement, though from a story in TheDeal.com reprinted here, Assistant U.S. Attorney General Thomas Barnett told the companies a final proposal must come by Tuesday. Clearly Google and Yahoo want this deal. And according to many antitrust experts, how antitrust law applies to this deal is far from clear, since it’s not a merger and Yahoo retains control over when, where, and how many Google ads to run. So those experts think Justice would have a tough time winning a lawsuit that seeks to block the deal outright.

If Justice continues to balk, at some point—probably not much further than this latest proposal—the deal will no longer be worthwhile for Google, which doesn’t want heavy regulatory oversight of its business. If the amount of revenue Yahoo gets from the deal is too limited, even Yahoo may find it unattractive, despite the fact that any deal is probably better for Yahoo than nothing. Although I would be surprised to see an agreement in Election Day, when some current Justice officials become lame-duck by definition and whatever they announce would get buried by other political news, I also suspect it won’t be long before this gets resolved.

UPDATE: After talking with other people, I suspect there’s some positioning by Google and perhaps Yahoo going on here that transcends the actual negotiations with the Justice Department. According to one person knowledgeable with the situation, it’s unlikely Google and Yahoo would leak these details if things were going swimmingly with Justice. Surely these are options that Justice attorneys have been aware of, and examined, for many weeks now. Indeed, one person close to the situation says Justice has asked potential witnesses about what they think of potential remedies. Bottom line: If talks with the antitrust regulators were fruitful, it seems likely we wouldn’t hear much until an agreement were announced.

Google and Yahoo could be hoping to put some pressure on regulators by showing they are willing to compromise. Or they could be sending a signal to worried advertisers that they’re trying to deal with their concerns.

If so, the tactic seems like a long shot—as the deal itself is looking with each passing day.

According to a just-posted story in the Journal, the likelihood that Google and Yahoo will walk away from their controversial search advertising deal has risen, as talks with the Justice Department have not produced an agreement on terms the companies and the government can both live with.

This isn’t very surprising, since the fact that talks have gone on this long—more than four months after the two companies proposed the deal for Yahoo to run Google search ads on some of its pages—has suggested in recent weeks that it might not happen after all. But according to sources at both companies I talked to late yesterday, talks were continuing. And according to Google just minutes ago, they are still going. Spokesman Adam Kovacevich issued this statement: “We are continuing to have cooperative discussions with the Department of Justice about this arrangement and agreed to a brief delay in implementing the agreement while those discussions continue. We are confident that the arrangement is beneficial to competition, but we are not going to discuss the details of the process.”

Still, it seems pretty certain the issue will come to a head quite soon. Between a new administration likely to result in changes in personnel at Justice, Google’s desire to either do the deal or go on, and struggling Yahoo’s immediate need for the revenues that would come from it, it would seem none of the parties wants to delay this much longer.

The deal has become a political hot potato, pitting Microsoft and its extensive and experienced lobbying force in Washington against smaller teams at Google and Yahoo. By many accounts of antitrust experts I’ve talked to, Justice would have a hard case to win outright. But neither Yahoo nor Google likely wants this to come to a lawsuit at all. For Google, especially, already under increasing regulatory scrutiny, such a battle could have much worse consequences than the loss of what is for it a fairly small amount of revenues compared with its overall sales.

For Yahoo, however, the deal was not only a significant profit boost—up to $450 million annually in operating cash flow—but it was a bargaining chip vs. Microsoft potentially coming back with an acquisition offer for far less than the $33 a share, or $47 billion, it offered earlier this year to buy Yahoo. Sources indicate there are no talks between the two companies currently. Yahoo has a bigger stake in making this happen, even with restrictions the government might demand.

So the longer this stalemate goes on, indeed, the less likely the deal will happen. I suspect we’ll know very soon.

Not surprisingly, Yahoo just reported third-quarter earnings that were weak but not as awful as some might have expected. However, the company said layoffs of at least 10% of the staff of 14,300 will begin in the fourth quarter—about what reports had anticipated.

They will be part, but not all, of a sweeping cost-cutting effort that is intended to reduce its annual costs of $3.9 billion by about $400 million before the end of this year. “Now we are conducting a deep review of our cost structure to identify more opportunities to enhance efficiency and build a stronger and more profitable Yahoo!,” president Sue Decker said in a statement.

Net profit fell 64% to $54.3 million, or 4 cents a share, from $151.3 million, or 11 cents a share, a year ago. Excluding special items such as stock option expenses, profit fell from 11 cents a year ago to 9 cents a share in the third quarter, precisely what analysts were expecting. However, net revenues, after payments to partners for traffic, rose just 3%, to $1.33 billion, slightly short of the $1.37 billion analysts had forecast.

Yahoo lowered its 2008 revenue outlook to between $7.18 billion and $7.38 billion, from its previous forecast of $7.35 billion to $7.85 billion.

Yahoo Chief Financial Office Blake Jorgensen cited “an increasingly challenging economic climate and softening advertising demand” for Yahoo’s results coming in at the low end of the range it had forecast. Although he said in a statement that Yahoo was “disappointed” in the results, he said cost-cutting during the year so far had helped cushion the economy’s impact on operating cash flow. Free cash flow, after capital expenses, fell 31%, to $151 million, from a year ago.

You can view the results and then listen to the conference call online here. After the jump is my pre-earnings analysis of the many issues facing Yahoo as it reports results and provides an outlook on coming quarters:

UPDATE: Investors so far seem relatively pleased, with the stock up 5% after-hours.

And the call begins with Jerry Yang. He says Yahoo saw “mixed trends,” with search and performance-oriented display ads showing strong growth but “demand for branded display advertising weakened.” So the company is reducing full-year revenue outlook but keeping its operating cash flow outlook thanks to cost cuts, which will be not only layoffs but cuts in real estate, standardization of its technology platform, and other methods.

He says he remains optimistic about Yahoo’s future because the downturn likely will drive advertisers to reliable venues. The latter, at least, is what I’ve been hearing from advertisers and agencies, but the question will be to what extent Yahoo’s entire ad offering will be the most compelling.

“This is in many ways an unprecedented operating environment,” Yang says. “We believe the online ad market will emerge strong, with Yahoo well-positioned to take share.”

Now President Sue Decker comes on to talk about fairly familiar Yahoo products and features, though one detail—page views up 17%—is a positive sign. But she says overall monetization of pages was lower than expected, especially commitments to branded campaigns. Despite strength in search revenues from its own sites, up 17%, display ad revenues on its own sites was up only 3%, much less than double-digit gains in previous quarters.

Decker’s now talking up APT, its new display-ad platform.

Now it’s on to Jorgensen: Two main themes in quarter, already apparent in previous comments: worsening economic environment coupled with greater cost cuts. “We are cautious about the advertising market in Q4. But we feel we are well-positioned to weather the downturn.” Mentions the Asian properties are valued at $7 billion or so, or more than $5 a share—a clear attempt to point out that Yahoo’s stock is undervalued in his view.

Now, the analysts’ questions:

* How is Yahoo going to improve monetization on its own sites? Decker says mainly the display ad platform, APT.

* Any lift in ad rates thanks to APT? Decker says no data yet.

* Where were the cost cuts in the quarter? Jorgensen: All year, actually. Slower hiring, but mainly hiring in lower-cost areas like India, Eastern Europe, and Southeast Asia.

* Any deadline on the Google-Yahoo deal? Yang can’t say, though I’ve gathered from people close to this that the Oct. 22 deadline mentioned widely isn’t actually a deadline. Talking with the Justice Department and others.

* How confident are you in the revenue forecast? Decker: watching weakness in Asia, but she mentions some “stability” in the U.S. despite some ad cancellations in travel and other areas.

* Could there be more consolidation among companies online, and what would Yahoo’s role be? Yang: Says there are opportunities, especially since ad spending isn’t increasing much, so it’s hard to grow that way. But he offers no specifics.

* How do you see your growth rate vs. Google? Yang: “There continues to be a flight to quality with regard to consumer behavior and advertiser behavior.” Decker more specifically acknowledges the obvious, that Google’s growth rate is faster than Yahoo’s, and talks about various ways Yahoo hopes to improve its search offerings for consumers and its search ad system for advertisers.

* Was there a sharp downturn in September? Decker: “The trends weakened in the latter part of August.” First Europe, then Asia. Also weakened in the U.S. but not as much as the rest of the world.

* What’s the ‘09 outlook? Yang, with a hint of a rueful laugh: “I don’t think we have any visibility into ‘09.”

* What’s the impact of acquisitions on revenue? Jorgensen says acquisitions contributed 1% to GAAP revenue.

* In what departments or functions is Yahoo making cuts? Yang doesn’t provide specifics, just the usual things like real estate.

* How will Yahoo unlock shareholder value? Yang says one way is cutting costs. Conservative on share buybacks, though, so that looks unlikely.

* How much of the weak 3% display-ad growth is due to the economy and how much to losing share to ad networks and niche sites? Decker: Can’t really say yet, but says Yahoo is outgrowing the ad networks.

* How sensitive will Yahoo be to diluting shareholders if and when it does acquisitions? Jorgensen: “We’ll clearly be very sensitive to dilution.”

* Last question: Have you considered hedging out exchange risks in various international markets? Jorgensen: Yes, but doesn’t sound like Yahoo plans to do much on that.

And that’s it for the call. The stock’s now up about 7% in extended trading, so if anything, the details from the call reassured investors—at least to the mild extent that they can be reassured about a company facing this many challenges.

Analysts are expecting a profit of 9 cents a share on net revenues, after payments to partners for traffic, of $1.37 billion. But some analysts, who have already cut their estimates for the fourth quarter and next year, think Yahoo could miss those numbers. Yahoo’s stock closed down about 6%, to just over $12 a share, in trading Oct. 21 before the earnings announcement.

Investors also will be looking to see if Yahoo announces layoffs, as recent reports have indicated it might, and how many. Several reports indicated it could cut about 1,500 people out of its staff of 14,300, though it wasn’t clear when and where the cuts would be made inside the company. Yahoo has hired consultant Bain & Co. to help suggest various cost-cutting measures, which could go beyond layoffs.

Like Google’s earnings last week, Yahoo’s will be closely watched for signs of how badly online advertising will be hit by the deepening economic downturn. Google, however, which reported better-than-expected results, was not a good industry bellwether because of its dominance in relatively well-performing search ads.

By contrast, Yahoo is more representative of the broader online advertising market, in particular display ads that are likely to bear the brunt of cutbacks by large brand advertisers. In particular, Yahoo’s heavy reliance on financial services and automobile advertising could hurt it as the effects of the credit crunch worsen. “Their business has been hurting,” says John Aiken of Majestic Research. “The real miss looks like it’s coming on the branded display ads.”

And those cutbacks were already starting even before the market meltdown began about a month ago. According to recently released figures from the Interactive Advertising Bureau and PricewaterhouseCoopers, display advertising declined from the fourth quarter of 2007 to the first quarter of 2008, and also fell again slightly from the first to the second quarter. That hasn’t happened since 2002. “If clients have to cut, digital budgets are not going to escape scrutiny,” says Clark Kokich, CEO of Razorfish, an online ad agency owned by Microsoft. “You’re going to see a softness we haven’t seen for the last few years.”

At the same time, Yahoo faces many other challenges. Since Microsoft walked away from offers to buy the entire company and then only its search business, Yahoo’s stock has fallen—especially after the market meltdown. It’s now trading a little under $13 a share, a small fraction of Microsoft’s original $31-a-share offer. And while Microsoft CEO Steve Ballmer recently appeared to hint that the company is still interested in Yahoo, Microsoft officially quashed that notion.

Yahoo has been discussing a combination with AOL, which parent Time Warner has been shopping for months. The agreement is believed to involve Yahoo taking over AOL for something under $10 billion and Time Warner taking a minority stake in Yahoo. According to people familiar with the companies, Yahoo, bolstered on the media front with AOL, might then be willing to do a search deal with Microsoft from a position of more strength.

However, it’s not clear that such a combination would help Yahoo regain ground lost to fast-growing social networking sites such as Facebook and News Corp.’s MySpace, let alone Google. Despite a monthly audience of 500 million people worldwide, Yahoo has been unable to break into social networking, a key potential growth area.

That’s not all the drama surrounding Yahoo. Its proposed deal to run Google search ads on some of its pages is under intense scrutiny by the Justice Department, which is expected to make a decision soon. Although few people expect the deal to be opposed outright, many legal observers think limits could be placed that would make the deal—which Yahoo said could contribute $250 million to $450 million in cash flow annually—less lucrative.

Not least, Yahoo’s plight also has been sending a steady stream of talent out the door, from engineers to executives. And the layoffs being considered now no doubt would hurt morale even further. That’s especially likely if Yahoo doesn’t announce specific jobs to be cut until later in the year.

The only upside for Yahoo is that its difficulties could be priced into the stock already, leaving relatively little downside. However, few people expected Yahoo’s stock to fall this far. So for now, all bets are off.

Executives from Silicon Valley to Madison Avenue are keeping a wary eye on the Justice Department this week as it nears a decision on whether to try to block an Internet advertising partnership between Google Inc. and Yahoo Inc.

After months of studying the arrangement, government antitrust attorneys could move any day now to sue to stop it from taking effect -- or they could abandon a potential court challenge and allow the partnership to proceed.

Under the terms of the deal, Google will sell some of the online advertisements displayed alongside search results on Yahoo's site. Yahoo entered the partnership in June after rebuffing a $47.5 billion takeover offer from Microsoft Corp. -- sparking a shareholder backlash.

With the Justice Department investigation shrouded in secrecy, it is unclear when a decision could come. But after Google and Yahoo agreed this month to a "brief delay" in launching their deal to allow the government to complete its probe -- and perhaps to try to reach a settlement -- many observers expect an announcement by midweek.

The stakes are high. The Justice Department investigation has pitted Google and Yahoo against not only their archrival Microsoft but also many of the advertisers that are their primary sources of revenue.

In a letter to Justice Department officials last month, the Association of National Advertisers warned that the Google/Yahoo partnership would leave advertisers with fewer options for placing online ads, raise the cost of online advertising and further cement Google's control over the search advertising market. The Association of National Advertisers represents such large companies as Kellogg Co., Johnson & Johnson, American Express Co., Walt Disney Co., Kraft Foods Inc. and McDonald's Corp.

For their part, Google and Yahoo argue that the deal will benefit both advertisers and consumers by delivering more targeted, more relevant ads.

They also maintain that because Google's system for identifying and displaying ads is more lucrative than Yahoo's approach, the deal will generate additional revenue for Yahoo that will it make it a more formidable competitor to both Google and Microsoft. When it first announced the deal, Yahoo projected the agreement would increase its operating cash flow by $250 million to $450 million in the first year.

The Justice Department review could play out in one of several ways for Google and Yahoo.

If the department does not make its intentions clear soon, the two companies could simply move ahead with their partnership and wait to see whether the government acts. While a court case would be unpleasant and cumbersome, there is no guarantee that a lawsuit would succeed -- leading some to speculate that the Justice Department may just be bluffing in threatening to sue.

If the department does bring a court challenge, Google and Yahoo could fight, or they could simply walk away from the deal.

Or, to play it safe, the companies could offer up voluntary conditions -- limiting the volume of ads subject to the agreement, for instance -- in order to head off a possible lawsuit.

Still, that approach risks exposing Google to accusations that the partnership would have in fact crossed the line into anticompetitive behavior. Many people in the industry are doubtful that the two sides can agree on concessions that would enable the deal to pass antitrust muster, still make the partnership worthwhile for Google and Yahoo and not taint the companies.

Melissa Maxman, head of the antitrust practice group at Baker & Hostetler LLP, said Justice Department attorneys must answer a series of critical questions in determining whether to intervene in a deal such as the Google/Yahoo partnership. Those include: How much market share does each party have? Would the agreement further concentrate the market? How would the deal affect consumers, competitors and other players, such as advertisers in this case?

The challenge, Maxman noted, is applying standard antitrust measures to a deal like this. For example, the department will often measure market share geographically, but Internet companies have a global reach. And precisely delineating "product" market share is hard to do in online advertising.

Microsoft, for one, argues that the deal should be blocked because Google already controls more than 70 percent of the market for search-related advertising. If it teams with Yahoo, which controls as much as 20 percent of the market, the two companies could together have a 90 percent share, Microsoft has warned.

The nature of the Internet advertising business also complicates things. Both Google and Yahoo use auctions to sell the ads that run alongside search results on their sites. The companies maintain that even if they partner, the marketplace will still determine online advertising prices through separate auctions.

The Association of National Advertisers is unconvinced. In its letter to the Justice Department, the group warned that the agreement will effectively drive up prices for ads sold through Yahoo's auctions since Yahoo will have access to ads sold by Google at a higher price.

Ultimately the battle over the Google/Yahoo partnership is about more than just the online advertising business. It's about the survival of Yahoo as an independent company, and whether Microsoft or Google has more of a say in the future of the Internet and computing.

That war extends far beyond Washington and the tug-of-war over Yahoo. But for now, the Justice Department could help shape the outcome.