Microsoft-Yahoo! Is Only Mostly Dead

Microsoft investors applaud the company moving on, but Yahoo! may still be its best bet.
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SAN FRANCISCO -- Pundits have now written the obituary for the Microsoft (MSFT) - Get Report-Yahoo! (YHOO) merger. But is it really dead forever?

The deal that Yahoo! shareholders so desperately wanted -- and Microsoft shareholders hated -- seems to have entered no-chance territory after Microsoft announced Thursday that the two companies couldn't reach any sort of deal.

Yahoo! investors quickly showed their dismay. The stock dropped 10% to end Thursday's session and was down another 6% in Friday trading.

Microsoft investors welcomed the news that a potential deal, with its attendant integration costs, was no longer a looming threat, adding $1.21, or 4.3%, to $29.45 in recent trading, for a two-day gain of $2.33, or 8.6%.

Microsoft's decision to walk away is "good news" for its stock, says Nick Patience, analyst with the 451 Group. "The deal always looked slightly on the desperate side of things." He questioned the wisdom of buying a struggling online services company when its own wasn't able to grow in the face of

Google's

(GOOG) - Get Report

strength.

Microsoft has long maintained -- and correctly so, it appears -- that Yahoo!'s stock has been artificially inflated by the prospect that a merger between the two would happen. Many investors believed that if a deal didn't' happen -- and Yahoo! fell back to a realistic price -- Microsoft would be back knocking on the door.

But Microsoft is now sending a different message, saying Thursday that it "was not interested in rebidding for all of Yahoo!." Rather, "our alternative transaction remains available for discussion."

That alternative -- buying Yahoo!'s search business -- was more than just a way for Microsoft to boost its own online search-advertising market share. The company dreaded the prospect that Yahoo! would turn to Google to help it monetize its search share,

as it has now done

.

And that deal could be the impetus that would bring Microsoft back to the table, should Yahoo! shareholder Carl Icahn succeed in his bid to replace Yahoo!'s board this summer. The Yahoo!-Google arrangement contains a cancellation fee of up to $250 million -- probably insufficient to stop Microsoft from buying Yahoo! outright if it meant putting an end to the Google relationship.

"A deal is less likely than it was a few weeks ago, but not impossible," Cowen analyst Jim Friedland wrote in a note Friday. "Microsoft holds most of the cards and could hold out for a lower price."

But Forrester analyst Ray Wang disagrees. "I think the deal should be dead on the Microsoft side. The search business is still very important to Microsoft." But, he adds, the company will have to look for other partnerships or strategies to make a go of its online search-advertising aspirations.

Microsoft and Yahoo! combined have an eroding search market share of 27.2% to Google's 62%, according to Nielsen Online.

Yahoo! elaborated Thursday on Microsoft's determination not to buy Yahoo!, saying that at a meeting between Microsoft and Yahoo!'s chairman and independent board members on June 8, Microsoft representatives "stated unequivocally that Microsoft is not interested in pursuing an acquisition of all of Yahoo!, even at the price range it had previously suggested" of $33 a share.

But the alternative Microsoft was seeking -- a deal to buy Yahoo!'s search-based advertising -- though a good prospect for Microsoft, did not make sense for Yahoo!, Patience says. "If you take away search-based advertising, Yahoo! would be left with a shell of a company" consisting mostly of content-generation and display-based advertising. "That's not a particularly interesting business," he added.

Even after Microsoft abandoned buyout talks in early May, activist shareholders have pushed hard to force a deal on the two companies. Icahn has proposed an alternative slate of candidates to replace its current board and has advocated a full merger with Microsoft.

Icahn, who has yet to weigh in on Thursday's developments, appears to be going ahead with his proxy fight and remains the merger's wild card.

What hasn't changed since yesterday is Microsoft's interest in securing a bigger foothold in the Web business. With Yahoo! still offering the best chance to achieve that, it could be too early to say 'never.'