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Search engine giant Google (Nasdaq: GOOG) has walked away from a proposed ad-sharing deal 
with Internet portal Yahoo (Nasdaq: YHOO) after the U.S. Department of Justice made it clear that it would seek to block the agreement in court.
Google's decision is a profound setback for Yahoo, which has struggled to maintain its share in the online advertising market. The proposed deal, first announced last June, would have allowed Yahoo to display ads from Google and then take a portion of the revenue. The pact would have pumped hundreds of millions of dollars into Yahoo's coffers.
Yahoo made it clear early Wednesday that scuttling the deal was Google's decision, and it expressed disappointment in the move.
"Google has terminated the advertising services agreement the companies announced in June," Yahoo said. "Yahoo continues to believe in the benefits of the agreement and is disappointed that Google has elected to withdraw from the agreement rather than defend it in court."
Whither Microsoft?
The prevailing question now is this: What's next for Yahoo?
The company has struggled mightily of late, announcing in October that it would lay off 10 percent of its 15,000-employee workforce and posting a whopping 64 percent year-over-year drop in profit during the third quarter.
Despite the recent tough financial news and Wednesday's announcement of the end of the deal with Google, Yahoo stock was up .7 percent to US$14.05 per share in mid-day trading on the Nasdaq National Market.
"Why is Yahoo's stock up today? Because there is speculation that Microsoft (Nasdaq: MSFT) will swoop in and buy them," Colin Gillis, managing partner at Click Capital Research, told the E-Commerce Times.
Yahoo's board has three new members that are friendly to the idea of a deal with Microsoft, which made a $33 per share buyout offer to Yahoo in February, Gillis noted. Yahoo's stock was trading at $14 per share at the time, yet Yahoo's board turned the deal down because it said the offer significantly undervalued the company.
"Given the new board members and where the share price is today, Microsoft might be able to come back with a lower bid and a smoother process," Gillis said. "The expectation is that Microsoft will get involved somehow. There are very few options for Yahoo right now aside from going it alone."
The idea that Microsoft may revisit a deal with Yahoo is gaining some traction.
"Certainly, Microsoft is interested in Yahoo's search business," Matt Rosoff, an analyst at Directions on Microsoft, told the E-Commerce Times. "It's just a question of price and what other parts of the deal will look like. Microsoft is pretty dedicated to taking on Google in search. Yahoo would increase Microsoft's user base and make their ads more relevant."
However, both Gillis and Rosoff find the prospects of an outright buyout of Yahoo by Microsoft dim.
"I don't think they're interested in a full-scale acquisition," Rosoff said.
What's Next for Yahoo?
Yahoo must now decide whether to go it alone or team up with another major Internet player such as Microsoft or AOL, said Click Capital's Gillis.
The former is not an impossible -- or even improbable -- scenario, he said.
"Yahoo has an enviable and deep worldwide reach to users," Gillis noted. "It will take time to turn itself around. They need to make some core decisions. They need to leverage their position in display advertising. [Display advertising] is weak now, but it won't be forever."
Yahoo must continue its focus on its new APT platform -- a technology designed to make it more efficient for marketers to reach their audiences with display advertising, he said.
At the same time, it shouldn't be lost on Wall Street that Yahoo's two-year-old Panama search technology has actually produced a modest boost to the company's revenue per search metrics.
"Yahoo's moving in the right direction," Gillis said.
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