NEW YORK (CNNMoney.com) -- Microsoft, the world's largest software company, is reportedly in preliminary talks to buy onl ine search company Yahoo!. And if the two companies do decide to merge, they could create an Internet advertising powerhouse that would rival industry leader Google, analysts said.
According to reports in both The New York Post and The Wall Street Journal Friday, Microsoft (Charts, Fortune 500) is said to have approached Yahoo (Charts, Fortune 500) to discuss a possible combination.
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| According to reports, Microsoft's Bill Gates and Yahoo's Terry Semel may be discussing a merger. A combination would be a much tougher competitor to Google |
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Spokespeople from Yahoo and Microsoft both declined to comment on the reports, citing company policy that they don't discuss market speculation.
Shares of Yahoo surged 18 percent in late morning trading on Nasdaq Friday while Microsoft's stock slumped more than 1 percent. Google's stock dipped slightly.
David Garrity, director of research with Dinosaur Securities in New York, said a deal makes a lot of sense since it would allow the two companies to pool their resources in order to take on a common enemy -- Google (Charts, Fortune 500) -- as opposed to wasting money by competing against each other.
"There is a great deal of competitive logic here. Why not just set their sights on Google and go at it?" he said.
If Microsoft and Yahoo merged, their market share in search would still trail Google's but not by a wide amount.
According to figures from Web traffic tracking firm comScore, Yahoo-MSN combined had 38.4 percent of the search market in the U.S. in March. Google led the market with a 48.3 percent share.
Microsoft has struggled to make inroads in the rapidly growing onl ine advertising business. The company's MSN division ranks a distant third to Google and Yahoo in the onl ine search market.
Last week, Microsoft reported in its latest quarterly earnings report that revenues at its onl ine division grew onl y 10 percent, below the industry average, and that the unit posted an operating loss of $200 million.
Yahoo has fared better than Microsoft but has also found it difficult to compete with Google. Yahoo recently upgraded its search technology platform in order to make keyword search results more relevant for advertisers and users.
Analysts had hoped that the new system, dubbed Project Panama, would lead to market share gains and improved revenue and profits for Yahoo. But Yahoo released disappointing first quarter results last month and also issued tepid sales guidance for the second quarter.
Google, on the other hand, has continued to click, so to speak. The company posted first quarter results last month that far exceeded analysts' consensus estimates.
What's more, Google announced in April that it was buying onl ine ad placement firm DoubleClick for $3.1 billion, a deal that analysts think will bolster Google's prospects in the so-called branded advertising market, which include banners, videos and other onl ine graphical ads.
Google's purchase of onl ine video sharing site YouTube last year also is seen as a way for Google to extend its market lead beyond search.
The DoubleClick purchase was seen as a blow to Microsoft, which was also said to be considering an acquisition of DoubleClick and has prompted speculation that Microsoft could scoop up a DoubleClick rival such as 24/7 Real Media (Charts), ValueClick (Charts) or aQuantive (Charts).
But Yahoo currently is considered the leader in branded advertising and the company is also bulking up in this area. Earlier this week, Yahoo announced it was purchasing the 80 percent in onl ine ad exchange Right Media that it didn't already own for $680 million.
Marianne Wolk, an analyst with Susquehanna Financial Group, said a Microsoft-Yahoo deal merger would quickly trump Google's deal for DoubleClick.
She said a combination of Microsoft and Yahoo would give them a clear leg up on Google in the branded advertising business, a market that should see heady growth over the next few years as more marketers look to onl ine video as an advertising option.
"A deal would create a behemoth in onl ine branded display advertising and in my mind it would make Yahoo's Right Media exchange the standard for ad marketplaces," she said. "This is about the race to be the leader in branded advertising as video takes off."
And Dinosaur's Garrity said a marriage of Yahoo and Microsoft makes a formidable pair since it would match Microsoft's tech savvy, something Garrity feels Yahoo lacks, with Yahoo's media expertise.
Semel, after all, is more of a mainstream media guy, having worked for Warner Bros., which like CNNMoney.com is owned by Time Warner (Charts, Fortune 500), Walt Disney (Charts, Fortune 500) and CBS (Charts, Fortune 500) before joining Yahoo.
"Yahoo, relative to Google has not been seen as a technology firm per se and were a merger to take place between Microsoft and Yahoo, the combined entity's claims for technology leadership would be equal to if not better than Google," Garrity said. "Semel, coming out of Hollywood, may be cast as a technologist but he's not. He just plays one on TV."
Nonetheless, Wolk cautioned that there was no indication that Microsoft and Yahoo would definitely merge. She estimated chances of a deal at about 50/50 and said that instead of an acquisition, the two companies might wind up just forming a deeper strategic partnership.
Wolk added that if Microsoft and Yahoo are unable to work out a deal, Yahoo could also consider partnering, although probably not merging, with Barry Diller's IAC (Charts, Fortune 500), which owns Ask.com, or News Corp (Charts, Fortune 500)., which is increasing its presence onl ine through its Fox Interactive Media unit, which owns MySpace. (MySpace already has an ad sharing agreement with Google, however.)
Charlene Li, an analyst with Forrester Research who covers trends in onl ine advertising, is also doubtful that a merger will actually take place.
Li wrote in a Forrester blog Friday that "on paper, the deal makes sense ...but in the end it's going to be so hard that I don't think it will happen."
She added that a merger would bring a "limited benefit" to Yahoo and that a partnership that could be a prelude for an eventual merger down the road for the two companies was a wiser action to take.
"Tentative first steps to a merger would make a lot more sense, giving both companies the ability to "test the waters" before jumping into the deep end. But if I'm wrong and a merger does get announced, I wish the two companies good luck -- they are going to need a lot of it to pull it off." 
