First Wall Street flipped out when Microsoft decided to spend a billion or so fighting Google. Now one analyst is saying Microsoft should spend $44 billion buying Yahoo! or perhaps eBay.

Merrill Lynch analyst Justin Post pushed the Yahoo! acquisition in a research note this morning that contributed to YHOO's 2.4 percent gain today.

Yahoo! plus MSN still wouldn't equal Google's market share. But MSN plus eBay's Skype would help Microsoft grab the nascent VoIP market that seems more important than the current Internet advertising bubble. Post doesn't talk much about eBay and instead runs with the idea that ad sales could eclipse Windows.

"Microsoft's goal is to make advertising a significant new revenue stream -- possibly even larger than the
core operating system business (per recent quote from MSN executive in
Mediapost.com)," he wrote. "A potential acquisition would significantly accelerate
Microsoft's efforts in search. A Yahoo!/MSN-Microsoft combination would
have garnered approximately 41% share in the U.S. of search queries and
29% worldwide in April versus Google with 44% and 61% share, respectively."

Here's the meat of Post's note:

Trends support increasing acquisition probability Following on recent press speculation on Microsoft Internet acquisition strategy, we consider that continued query share gains by Google, a growing Internet focus from Microsoft and pressure on large cap. Internet valuations (down 20%+ YTD) support Microsoft's opportunity to make a large cap. Internet acquisition. While Microsoft is likely to wait on an acquisition until the company can evaluate results of their a "go-big" investment in their MSN search platform, Google's ongoing traffic share gains and greater focus on building a software platform (recent spreadsheet launch and Adobe partnership) increase acquisition probability, in our view. We think takeout valuation analysis could begin to support eBay and Yahoo! stock valuations.

Weighing acquisitions versus buybacks Microsoft's $34bn cash balance and roughly $12bn/year cash generation argues for more aggressive share buybacks and/or higher dividend yield from a financial perspective. However, the possible acquisition of Yahoo! would be a strategic positive, in our view. Although likely dilutive to EPS by up to $0.05 in C07E (excluding deal related amortization), we think the strategic value of a deal would far outweigh dilution. A potential acquisition of Yahoo! would reduce the risks and the time horizon for Microsoft to drive market share and profitability of its MSN business unit relative to its internal efforts.

Can Microsoft afford not to take the risk? Worst case, an acquisition of eBay (C-1-9) or Yahoo! (C-2-9) could cost Microsoft $5/share if completely unsuccessful (we could argue increasing Internet investment spending has already impacted MSFT stock by $3-5/share); however, Google's potential encroachment on Microsoft's core software market, using Internet profitability to fund software investment, represents a long-term business risk. An acquisition could instantly vault Microsoft to the leading revenue position on the Internet.

Acquisition economics = potential Yahoo! valuation support Based on acquisition premiums ranging from 30-47%, our analysis suggests that Microsoft can acquire Yahoo! (from $40-45/share) using cash and debt as acquisition currencies and suffer minimal EPS dilution ($0.01-0.04). We estimate the same range of dilution for an eBay acquisition, although acquisition would have less strategic benefits, in our view. Yahoo! seems a better strategic fit based on: 1) Microsoft's search/advertising focus across the PC, mobile devices and video game consoles, 2) natural ad platform and cost synergies and 3) elimination of a top competitor.