Will Microsoft Buy Yahoo!?

Justin Post, a research analyst at Merrill Lynch, issued a report today indicating that Microsoft should consider buying another Internet Titan, specifically Yahoo! or eBay. The report, entitled "MSFT/Yahoo! combination: theory...for now," indicates that the current valuation of Yahoo! and eBay makes the acquisition attractive for Microsoft, and would immediately enhance their own internet offerings. "Worst case, an acquisition of eBay or Yahoo could cost Microsoft $5 a share if completely unsuccessful," wrote Mr. Post. With $34 billion in cash on hand, Microsoft could easily afford such a large acquisition. Post indicates that the likely acquisition scenario would be Microsoft paying $20 billion in cash, and funding the rest with debt.

The acquisition of Yahoo! would put Microsoft in a much stronger position to compete with Google in the online search and advertising markets. A combined Yahoo! and MSN would give Microsoft roughly a 41% marketshare of all U.S. search queries and 29% of worldwide search queries. Today, Google has 44% marketshare for U.S. search, and 61% share worldwide. Additionally, acquiring Yahoo! would eliminate one of Microsoft's largest Internet competitors. Post writes "We think the combined entity would realize operating synergies in product development, content licensing, S&M and G&A."

This all sounds well and good, but it is worth calling out the following:

Post doesn't own shares of Microsoft, Yahoo!, or eBay, but Merrill Lynch intends to seek an investment-banking relationship.

So what does this mean? I don't know, but a few possibilities come to my mind:

1. Discussions between Microsoft and Yahoo! are further along than what has been reported, and Merrill Lynch is releasing this report to see what type of reaction Wall Street and the public have to this type of acquisition.

2. Merrill Lynch is publicly courting Microsoft's business by providing data points that indicate this is a sound business move, and are, of course, ready to provide the investment-banking services if and when Microsoft is willing to proceed with this acquisition.

3. Merrill Lynch has no real evidence that Microsoft is interested in acquiring Yahoo! and this is just a publicity stunt.

I do think that Google is arguably Microsoft's biggest threat, and it is unclear if Microsoft has all the assets to compete effectively. The research I've done indicates that Google is having another strong quarter, and shows no signs of slowing growth.