In a Microsoft internal e-mail that just “happened” to get out, Microsoft says it lost interest in acquiring all of Yahoo because of Yahoo’s foot-dragging and offered instead $1 billion for just Yahoo’s search operation and another $8 billion, the equivalent of $35 a share, for 16% of Yahoo, more per-share than Microsoft offered for all of Yahoo.

Yahoo rejected the offer, choosing instead to do a four-10-year advertising outsourcing deal with its worst rival Google for maybe $250 million- $450 million in incremental cash flow year one. Yahoo will still use its own search engine to place some ads and to process all search requests.

The alternative Yahoo-Google deal invites US antitrust scrutiny – the non-exclusive deal is limited to the US and Canada – and although the pair claims it’s outside of such oversight they are allowing three-and-a-half months for an investigation.

It also appears to have flummoxed corporate raider Carl Icahn, who started a proxy fight for control of Yahoo’s board to lure Microsoft back into a bid. He is now apparently backing off. He told Reuters Sunday that the Yahoo-Google deal “might have some merit.”

See, any change in Yahoo ownership – at least ownership of 35% of Yahoo for the next two years – could trigger a $250 million termination payment to Google minus whatever Google had earned.

Summing up much of the reaction, Deutsche Bank, which says Yahoo is virtually admitting it can’t compete in paid search – hence foreclosing its long-term future - called it “perhaps one of the worst strategic maneuvers seen in the Internet industry.”

Yahoo shares, however, continue to behavior as though some miracle is going to happen despite the assumption that advertisers will go directly to Google because of the pact.

Anyway, this is what Microsoft, which said in a public statement that it is still interested in a partial deal, told its own people:

From: Kevin Johnson
Sent: Friday, June 13, 2008 2:20 PM
To: Platforms & Services Division; APSP FTE - Adv & Pub Solutions Platform; Employees.all.corp
Cc: Executive Staff and Direct Reports
Subject: Update on our Yahoo! Discussions

I wanted to take an opportunity to provide my thoughts and perspective on the conclusion of our discussions with Yahoo!, and its announcement of a commercial agreement with Google.

As I shared in my mail on May 18, we have better options than a full combination with Yahoo! at the price it suggested, and we have moved forward on our strategy to grow our online business.

Let me share a little background with you. When we made our original proposal on February 1st to combine with Yahoo!, we offered a 62% premium that was based on a desire to reach an agreement in short order. The faster we could reach an agreement, the sooner we could begin the regulatory process and create value through this combination.

In a March 10th meeting in Palo Alto, we explained to Yahoo! management the importance of reaching an agreement by the end of April in order to have an opportunity to complete the regulatory process by the end of this calendar year. Because we could not come to an agreement on price by the end of April and given our concerns about Yahoo!’s business performance, we elected to withdraw our bid and pursue better options for Microsoft.

During the last few weeks, we spent a considerable amount of time with Yahoo! discussing an alternative proposal around search. Specifically, this search proposal had three components:

• Microsoft would have invested $8 billion in Yahoo! at $35/share
• Microsoft would have purchased Yahoo!’s search assets for $1 billion, and assumed the operations and R&D expense while returning data back to Yahoo! for use in their advertising business
• Microsoft and Yahoo! would have entered into a long-term search partnership, where Microsoft would have provided favorable economics to Yahoo! search, including a three-year guarantee of higher monetization than Yahoo!’s Panama paid search system currently provides
  

This partnership would have created a stronger competitor to Google, providing greater choice and innovation for advertisers, publishers and consumers. This approach could have been implemented quickly and would have simplified the integration process for both parties. It would have also established the basis for a long-term Internet partnership between Yahoo! and Microsoft.

We believe this proposal would have created compelling value for Yahoo! and its shareholders in at least three ways:

• New Transfer of Cash to Yahoo! Shareholders. This proposal would have transferred $9 billion from Microsoft to Yahoo!, which could have been used by Yahoo! to reward their shareholders.
• A More Profitable Ongoing Business. This proposal would have resulted in higher operating income on an annual basis for Yahoo!, with our projections more than doubling Yahoo!’s operating income in the first year of operation, and increasing it by more than $1 billion above its current operating income level.
• A More Compelling Search Offering. The combination of the search platforms would have unlocked new R&D innovation, eliminated redundant engineering efforts and allowed for greater scale in serving our customers.
  

Taken together, we believe that our proposal would have created total value for Yahoo!’s shareholders in excess of $33 per share.

Unfortunately Yahoo! has chosen a different course, and yesterday announced an agreement that would start to consolidate over 90% of the paid search advertising market in Google’s hands. This will make the market far less competitive. There are many experts who suggest that a host of legal and regulatory problems lie ahead for Google and Yahoo!.

Regardless of Yahoo!’s decision, we will continue to move forward on our strategy in online services and advertising.

Since my mail on May 18, we have been making great progress. At our advance08 conference, we announced Live Search cashback and Live Search Farecast, and the initial response to these user experience and business model innovations in search has been very positive. On June 2nd, we also announced a distribution deal with HP, the world’s largest PC manufacturer, to install a Live Search-enabled toolbar on all HP consumer PCs planned to ship in the United States and Canada, beginning in January 2009.

We look forward to sharing more milestones and details on our plans as we head to MGX and our Financial Analyst Meeting in July.

I remain confident in our assets, plans and people to succeed in building our online business. Thanks again for your commitment and focus.

Regards,

Kevin Johnson, president, Microsoft Platforms & Services Division