Merrill Note Massages Yahoo!

Still, Post says the case for the acquisition, which has been rumored before, is more compelling than a Microsoft purchase of eBay(EBAY Quote).

"An acquisition could instantly vault Microsoft to the leading revenue position on the Internet," writes Post, who joined Merrill in 2004 from Deutsche Bank.

Post estimates that merging Yahoo! with Microsoft's MSN business would create $450 million in savings. He is forecasting that that MSN, which has recently introduced improvements to its advertising platform, will lose $800 million next year.

"A potential acquisition would significantly accelerate Microsoft's efforts in search," Post writes, adding that a deal would "build on both brands and extend Yahoo!'s lead in Internet traffic."

Selling such a deal to Wall Street could be tough.

Microsoft shares have dropped 12% this year, underperforming the Nasdaq Composite Index, which has declined 4%.

In addition, investors have high hopes that Yahoo! will improve its position in the search market and continue to benefit from the shift of advertising dollars online.

Plus, Ursillo and Post point out that Microsoft would face an exodus of key employees at Yahoo! if it bought the top Web site. Yahoo! executives have made similar arguments, and Post writes that he doesn't think that Yahoo! co-founders Jerry Yang and David Filo are interested in selling to Microsoft.

Shares of Microsoft fell 13 cents to $22.75, while Yahoo! rose 51 cents to $31.19.