No Microhoo. Now what?

After a week of intense takeover discussions with Yahoo that seemed increasingly likely to lead to a deal, Microsoft abruptly walked away Saturday. While Microsoft C.E.O. Steve Ballmer had been threatening to do just that, most analysts and observers were expecting either a deal to be done at a higher price or a hostile takeover to begin.

The proposed merger had drawn its share of critics, who charged that integration and cultural issues would outweigh potential benefits from combining the two. But now that the deal won't happen, the outlook for both companies is as dire as it was three months ago before the merger was proposed.

"Without Yahoo, Microsoft has no compelling means of becoming the No. 2 player in online advertising," said Sandeep Aggarwal, an analyst at Collins Stewart. "And without Microsoft, Yahoo has no magic wand to lift its stock back above the mid-20s."

This much is certain: Yahoo's stock will take a hard tumble this week as arbitrageurs and others counting on a Microsoft buyout relinquish their shares at a steep discount to last week's levels. "The word crater comes to mind," said Rob Enderle, president of tech advisory firm Enderle Group.

Yahoo had already been facing at least one shareholder lawsuit after it refused to accept Microsoft's proposal. It's likely to face more lawsuits, as well as other pressure from activist investors.

One of them, Eric Jackson of Ironfire Capital, is urging Yahoo shareholders to vote against all of Yahoo's board members when they are up for election later this year. Jackson says he's started hearing from more Yahoo shareholders since Microsoft dropped its bid.

"They're surprised and extremely frustrated," Jackson said. "They were certain a friendly deal was going to happen."

To appease those shareholders, Yahoo needs to improve its financial performance dramatically. The company unveiled a plan in March showing how a new search technology and an open-source approach to software development would help boost its revenue and cash flow. But analysts and investors have signaled that they aren't impressed.

The best short-term hope for Yahoo to increase its cash flow is to ally itself with the very company that has put it in dire straits—Google. Yahoo and Google may enter a limited ad partnership that will run Google ads on keywords where Yahoo makes less money.

That could help bring Yahoo new revenue in coming quarters. But it could also drive away advertisers who are on Yahoo precisely because its search engine, which is significantly less popular than Google's, charges less for keywords.

Microsoft's stock will likely fare much better in the near term. But longer-term threats to its profit growth remain. Vista software sales are slowing, Apple is gaining market share in desktops and laptops, and Google is pushing free versions of office-productivity software, threatening Microsoft's Office cash cow.

Microsoft has invested heavily in online advertising, only to see its share of the search market—like Yahoo's—decline steadily. The division that includes Microsoft's online-ad business has posted steadily growing operating losses for nine straight quarters. In aggregate, it's racked up $1.7 billion in losses since early 2006.

Such pressures drove Microsoft to pursue Yahoo. The $31-a-share bid Microsoft made in February offered a 62 percent premium over Yahoo's stock price at the time. But it also discounted 32 percent off the $41-a-share bid Microsoft had previously made for Yahoo, a bid that was also rebuffed by Yahoo's board.

Last week, Microsoft raised its offer to $33 a share, but Yahoo's board held out for $37.

"I think Yahoo misread Microsoft," said Enderle. "People usually bid low and then raise their bids. But Microsoft didn't want talks to drag on, so its strategy was to get the deal done as quickly as possible." Yahoo, however, sensed that protracted talks could strengthen its hand, and so it held firm on a higher bid. "Yahoo thought Microsoft was lowballing it," Enderle said, "and they missed the boat."

So like Yahoo, Microsoft must now scramble. Ballmer has outlined other possible acquisitions it could make if the Yahoo deal fell through: Facebook, Time Warner's AOL, and News Corp.'s MySpace. Facebook is also determined to remain independent, while AOL has talked with Yahoo about a deal. That leaves MySpace as the easiest partner for Microsoft.

Or Microsoft could simply bide its time and come back to Yahoo after its shareholders start screaming. In doing so, it would follow Larry Ellison's playbook in Oracle's acquisition of BEA Systems. Oracle walked away from BEA after its bid was rejected, then talked a lot about how hard it pushed for its bid. Once BEA investors complained, Oracle bought BEA at a lower price.

"Microsoft can come back again," said Aggarwal, "especially if Yahoo doesn't do very well on its own."

In that case, there may yet be a Microhoo. But whether the two companies combined can fend off Google better than they can on their own—well, that's another question entirely.