By Yi-Wyn Yen
April 23, 2008

By Yi-Wyn Yen

It’s time for Microsoft to sweeten the bid.

Hours before Yahoo (YHOO) beat easy quarterly estimates on Tuesday, Microsoft CEO Steve Ballmer said his company wouldn’t raise its $43 billion offer no matter how well Yahoo performed. Nevertheless, Ballmer must up the ante if Microsoft (MSFT) intends to get a deal done with Yahoo.

In a call with analysts Tuesday, Yahoo CEO Jerry Yang signaled that his company wasn’t interested in a deal unless his company was offered more money. Microsoft’s No. 1 takeover target has until Saturday to accept the bid that would buy out Yahoo at slightly less than $30 a share or else face a proxy fight.

It took Yang a mere five minutes into Yahoo’s highly-anticipated earnings call to let Microsoft know he wasn’t going to be the first to back down. For the millionth time, Yang said the deal “substantially undervalues” his company.

Then he threw the ball back into Microsoft’s court. “Our board and management team continue to be open to any and all alternatives,” Yang said, “including a sale to Microsoft.”

Surely, Ballmer, who was halfway around the world in Morocco to launch the company’s MSN portal, is weighing his options: Go hostile or throw a few billion more at Yahoo, which has twice rejected its original offer. “We think we can accelerate our strategy by buying Yahoo and will pay what makes sense for our shareholders,” Ballmer said before the earnings Tuesday.

On Wednesday, Ballmer let Yang know he wasn’t going to be bullied around. “We know what Yahoo is worth. We offered a lot of money,” Ballmer said at a conference in Milan, according to Reuters. “If their board thinks that’s fair, great. If not, we’ll move forward.” Likely the move will be to┬ábegin a hostile takeover Saturday. Microsoft has hired Innisfree M&A to help it oust Yahoo’s 10-member board.

On the call, Yang and president Sue Decker insisted that the company is headed in the right direction. Yahoo offered its latest numbers as a final defense to its shareholders that it’s worth more than Microsoft is offering. Yahoo posted earnings per share of 11 cents, beating analyst forecasts by 2 cents. Its revenues, which exclude money it shares with advertising partners, climbed 14% to $1.35 billion, $20 million ahead of the consensus. Yang highlighted Yahoo’s display advertising revenues, which grew 25% from a year ago, and praised the company for its satisfactory quarter, calling it “impressive” under the circumstances.

But let’s face it. Those estimates weren’t too difficult to beat given that analysts had started with such low expectations. Yahoo also didn’t change its guidance for the year on annual revenues of $7.2 billion to $8 billion, which analysts considered a weak forecast when it was issued in January.

Yang said the company is still exploring “strategic alternatives” as Microsoft decides its next move. Yahoo ends its two-week test using Google’s search advertising on Wednesday and the company is in talks with Fortune’s parent Time Warner (TWX) to strike a partnership with AOL.

Analysts argue that Yahoo is playing for time. “Yahoo puts in numbers slightly better than expectations and wants a little more time to pursue alternatives. It’s time Microsoft doesn’t want [them to have], which means they will have to increase their offer to get investors over,” says Youssef Squali, an analyst with Jefferies.

As Google continues to gain online advertising share, Yahoo and Microsoft continue to fight with one another and fall further behind. The best way to quickly catch up is to start with Microsoft raising its bid. Analysts have suggested that an offer between $31 to $35 a share will make the deal possible. “If I’m a Yahoo shareholder looking at Yahoo’s performance and Microsoft as a potential buyer, I would think Microsoft is going to come in and sweeten the bid,” Squali says.

Expect that to happen or things will start to get ugly fast.

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