By Yi-Wyn Yen
April 11, 2008

By Yi-Wyn Yen

Tick tock.

One week has passed since Microsoft CEO Steve Ballmer set a three-week deadline for Yahoo to accept the software giant’s $42 billion offer, yet the companies are no closer to reaching an agreement than they were last Saturday.

Should they fail to reach an agreement by April 26, Ballmer will mount a proxy fight to oust Yahoo’s board of directors. But before things get truly hostile, Microsoft MSFT , will find ways tighten the screws on Yahoo YHOO .

Analysts speculate that the most likely scenario is for executives from both parties to meet again for the first time since the letter went public and strike a deal.

While the software giant is debating bringing News Corp. NWS on as a bidding partner to buy Yahoo, the complexities of engaging three parties and reaching an agreement swiftly make that scenario unlikely. Despite all the numerous wheeling and dealing among Internet giants, “We still think Microsoft will prevail,” wrote UBS analysts Ben Schachter and Heather Bellini in a note to clients.

Yahoo, however, isn’t going down without a fight. The company publicly rejected Redmond’s initial offer to buy out the company at $31 a share because it is convinced the bid is too low. The shares are now valued at $29. In an effort to find white knights, Yahoo has sought a three-way alliance with Time Warner TWX (which owns Fortune and CNNMoney) and Google this week. Time Warner would offer cash and fold AOL into Yahoo in exchange for a stake. Yahoo meanwhile is testing Google’s search ad service.

Such an alliance is shaky at best. A Yahoo-Google combination may face regulatory problems. And Yahoo’s shareholders may not find a Yahoo-AOL deal nearly as attractive as a Microsoft-Yahoo offer.

Industry watchers believe that Yahoo’s latest efforts are pure posturing. “They are setting up a textbook case to attract a higher price from Microsoft. It’s a classic diversionary tactic,” says James Owers, a professor of corporate finance at Robinson College of Business at Georgia State. “They were probably very unhappy with Ballmer’s letter and raced off to have discussions with AOL. It’s an attempt to say, ‘Hey, don’t bully us and threaten us with a lower price.’ ”

Microsoft could attempt to walk away from the bid in an effort to make Yahoo’s shares drop dramatically. Oracle CEO Larry Ellison employed a similar tactic when he pursued PeopleSoft. Yahoo’s stock has traded 51% higher on average than when it last traded at $19.18 prior to Microsoft’s offer. Microsoft is offering a bid that’s worth a 62% premium of Yahoo’s shares. But a scenario to arm-twist Yahoo could backfire. “It’s the most aggressive move to walk away and come back with a lower bid. That would get the egos on the Yahoo side pretty enraged,” Owers says.

Ballmer is determined to buy Yahoo, and most likely, will get what he wants even if he ultimately pays a little bit more. Some Wall Street analysts expect Microsoft to offer Yahoo between $32 and $35 a share. Ballmer has been vocal about his intent to catch up with Google in the online advertising market, and firmly believes that combining forces with Yahoo is the only chance Redmond has to succeed. Much like the way the company poured billions into its Xbox gaming division to compete with Sony Playstation, Microsoft will do the same to go after Google. Microsoft has $21 billion in cash and is willing to issue debt to finance the deal that’s worth more than $40 billion.

“Ballmer offered a 62% premium. He wouldn’t have done that if he was just kicking the tires around,” Owers says. “That’s considered a blowout bid. And a blowout bid bid signals a determination to prevail.”

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