Merrill Note Massages Yahoo!

Updated from 1 p.m.

Yahoo! (YHOO Quote) rose 3% Friday after a Wall Street analyst fingered the struggling Internet stock as a prime takeout play.

Microsoft (MSFT Quote) should buy Yahoo! to give its struggling MSN Web unit a much-needed boost, according to a report issued by Merrill Lynch analyst Justin Post. Microsoft and Yahoo! declined to comment on the Merrill report.

Yahoo!, whose shares have declined more than 20% this year, currently has a market valuation of $43.9 billion. Microsoft could buy the Sunnyvale, Calif.-based company with $20 billion in cash with the remainder in debt, according to Post's analysis.

Merrill says the deal could trim Microsoft earnings next year by 5 cents a share. Analysts expect the software giant to make $1.40 a share in fiscal 2007.

Post arrives at the possible EPS hit by noting that the acquisition would reduce Microsoft's cash hoard, cutting its interest income. Issuing debt would boost interest expense. "The higher the price Microsoft has to pay the the acquisition, the more debt and interest expense necessary," he notes in an email.

Merrill has done non-investment-banking work for Microsoft in the past 12 months and expects to receive investment-banking work from the software company. It has neutral ratings on Microsoft and Yahoo!.

Buying Yahoo! might not be popular with Microsoft shareholders, who have criticized the Redmond, Wash.-based company for holding $34 billion in cash on its balance sheet. They also are angered by Microsoft's plans to spend as much as $2 billion to catch up to Google(GOOG Quote) in search.

"Even though Yahoo! and Google are competing for the Internet advertising dollar, Google is doing more by building software, and Yahoo! is doing it more by aggregating content," says Tony Ursillo, a software analyst with Loomis Sayles, which owns shares of Microsoft and Yahoo!. "Microsoft's focus is on building software, not aggregating content. I don't think it would be consistent with Microsoft's approach."