• by Mark Walsh  @markfwal, April 8, 2008

Ratcheting up the tension in its takeover battle with Microsoft, Yahoo again rejected the software giant's acquisition offer Monday as too low.

Yahoo was responding to a letter from Microsoft on Saturday threatening to lower its bid and oust the Yahoo board unless the Web portal begins engaging in merger talks in the next three weeks.

Because of a drop in Microsoft's share price, its original offer two months ago has already fallen from $31 a share to about $29 a share.

Yahoo reiterated its position that Microsoft's unsolicited offer undervalues the company, setting the stage for a proxy battle.

"Our board's view of your proposal has not changed. We continue to believe that your proposal is not in the best interests of Yahoo and our stockholders," said Yahoo in a letter to Microsoft CEO Steven Ballmer. "Contrary to statements in your letter, stockholders representing a significant portion of our outstanding shares have indicated to us that your proposal substantially undervalues Yahoo."

In the letter to Yahoo's board of directors, Ballmer said a majority of Yahoo shareholders support Microsoft's view that its offer is even more generous today in light of deteriorating market conditions that have already affected Yahoo's business.

Since initially turning down Microsoft's bid on Feb. 11, Yahoo has explored alliances with Google, MySpace.com and Time Warner Inc.'s AOL, but no alternative to Microsoft's offer has surfaced. Citing those other negotiations in his letter, Ballmer questioned why--in the absence of another offer--Yahoo was still unwilling to negotiate with Microsoft.

Senior executives at the companies have met at least twice since Microsoft's Feb. 1 bid, but have not yet begun formal negotiations.

Highlighting how far apart the companies remain, Yahoo disputed Microsoft's characterization of their preliminary talks. "We have had constructive conversations together regarding a variety of topics, including integration and regulatory issues," said the company in a letter signed by CEO Jerry Yang and Chairman Roy Bostock.

To back up its demands for a higher offer, Yahoo last month outlined a bullish plan to double operating cash flow to $3.7 billion and increase revenue to $8.8 billion in the next three years.

As if to underscore its continued growth, the Web portal has continued to unveil new initiatives including its forthcoming AMP online ad platform announced Monday. Last week, it launched Yahoo Shine, its new property for women ages 25 to 54.

The release of Yahoo's first-quarter earnings on April 22 is likely to have a more significant impact on the progress of merger talks, coming just days before Microsoft's April 26 deadline.

Yahoo noted that it recently reaffirmed its forecast for the first quarter--"which is a testament to our ability to perform in line with our expectations despite the current economic environment."

Yahoo might have to blow away its earnings estimates, however, to make a strong case for Microsoft raising its bid.

Whether Yahoo comes in at the high or low end of its first-quarter guidance could even push Microsoft's $31-a-share bid up or down a few dollars, according to RBC Capital Markets analyst Ross Sandler. He estimates that Yahoo will come in near the midpoint of the company's projections of $1.28 billion to $1.38 billion in revenue and EBIDTA of $400 million to $450 million for the quarter.

In any case, he expects the companies to reach an agreement. "A deal needs to get done for Microsoft to be competitive with Google longer-term," Sandler said.

Yahoo isn't shutting the door on a possible deal. "We are open to all alternatives that maximize stockholder value," said Yahoo in its statement. "To be clear, this includes a transaction with Microsoft, is superior to other alternatives, and provides certainty of value and certainty of closing."

For its part, Microsoft declined to comment Monday on Yahoo's response to its ultimatum to conclude a merger deal in the next three weeks.

If Microsoft ends up initiating a proxy contest, it warned that it would have "an undesirable impact" on Yahoo's valuation.

Tim Bajarin, principal analyst at technology consultancy Creative Strategies, said he fully expects Microsoft to launch its promised proxy fight if Yahoo doesn't return to the bargaining table.

"I do believe that Microsoft really wants Yahoo, and in the end, will find a way to make it a part of their company," he said.