SAN FRANCISCO -- A well-respected money manager for Legg Mason Capital Management is arguing that Microsoft ( MSFT) must up the ante if it wants the merger with Yahoo! ( YHOO) to happen.

Bill Miller of Legg Mason, Yahoo!'s second-largest shareholder with more than 80 million shares, wrote in his quarterly newsletter that the deal is "a strategic imperative for MSFT, and that YHOO is in a tough spot if it wishes to remain independent."

Yahoo! on Monday officially rejected Microsoft's $31-a-share bid for the company, calling it a substantial undervaluation of its brand name and growth potential. Yahoo! is reportedly holding out for a bigger payout of $40 a share.

Microsoft has not come back with a new price. Instead it simply said, "The Yahoo! response does not change our belief in the strategic and financial merits of our proposal." The Redmond, Wash., company also said it "reserves the right to pursue all necessary steps" toward the merger, setting the stage for a potentially ugly battle.

Miller put his own valuation of Yahoo! within the $40-a-share range, adding that "MSFT will need to enhance its offer if it wants to complete the deal."

At the same time, Miller wrote that Yahoo! will have a hard time coming up with an alternative to Microsoft's proposal. Potential suitors like News Corp. ( NWS) and Comcast ( CMCSA) have already said they are not interested in bidding for Yahoo!.

Shares of Yahoo! were down slightly, by less than 1%, or 18 cents, to $29.69 in afternoon trading. Microsoft was also down less than 1%, or 9 cents, to $28.30.