Say this for the folks at Ivory Investment Management: They've given this Yahoo-Microsoft thing a ton of thought. Of course, they have lots of reason to care -- holding 1.5 percent of Yahoo's outstanding shares, currently valued around $275 million but previously worth much more.

In an open letter to Yahoo's board this morning, the firm urged the company to strike a deal with Microsoft, describing in great detail the terms of a potential agreement. Read on for excerpts from the letter.

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"We envision a deal whereby Microsoft would acquire all of Yahoo's search assets and enter into a perpetual agreement for Microsoft to be the search provider for all Yahoo properties. In this deal, Microsoft would own and operate the combined search platform while Yahoo would become an affiliate that retains 80% of the revenues generated from the search traffic on its own sites. In addition, Microsoft would become the search engine for Yahoo's existing search affiliates. This deal would offer Microsoft the unique opportunity to immediately gain critical mass to better level the playing field with Google, while it would simultaneously allow Yahoo to both receive a sizable upfront cash payment and increase its prospective cash flow (i.e., EBITDA). There are two key reasons why we believe this proposed deal is extremely beneficial to both parties:

"1) Approximately $800 million of duplicate operating costs could be eliminated. This estimate is based upon benchmarking Yahoo's and Microsoft's Online Services Business' operating costs versus Google's cost structure. At the Microsoft analyst day earlier this year, Steve Ballmer described the cost structure in their search business: "I think you've got to think of it as sort of almost more of a fixed expense ... We won't have to be as high as Google's $2.3 billion because they're serving up so many more queries, but our COGS percentage will need to be quite a bit higher than theirs will, just to keep up in the ante to index the largest volume of documents on the Web."; and

"2) The combined search platform and marketplace would have a much greater "network" effect, resulting in 20% higher monetization rates. Again we quote Mr. Ballmer at the Microsoft analyst day: "We'd like to increase our revenue per search, and the way to do that is to get more queries. The more queries we get, the more advertisers we get, the more keywords they bid on, the higher they bid, you get the virtuous cycle flowing." Furthermore, based on Yahoo's past comments regarding differences in monetization rates between Yahoo and Google, we believe our 20% monetization rate estimate is conservative. On a June 12th conference call this year announcing a search relationship with Google, Jerry Yang described the monetization differential between Yahoo and Google: "At the current monetization rate, we believe there is an approximate $800 million in annual revenue opportunity in the U.S. and Canada on those queries where monetization upside exists." This $800 million represents a 47% increase relative to the $1.7 billion of search revenue from Yahoo's total owned properties. However, this $800 million applies only to a subset of Yahoo's owned properties, so the total monetization differential between Yahoo and Google is actually greater than 47%. Thus, we believe our assumption of a 20% improvement is less than half of the potential opportunity and could grow substantially over time.

"We believe the above factors could allow Yahoo to receive more than $15 billion upfront from Microsoft for its search business and increase EBITDA by nearly $500 million per annum. Post this transaction, Yahoo would lose annual search revenues of roughly $1.7 billion from its owned sites and another $450 million of revenues from affiliates (net of traffic acquisition or "TAC" payments). However, offsetting this shortfall would be over $1.6 billion of annual TAC payments received from Microsoft under the new search agreement. This payment stream assumes a TAC rate of 80% and that the combined search platform can garner 20% higher monetization. Finally, we estimate that Yahoo could eliminate over $1 billion in annual costs related to search. While Yahoo does not separately disclose the costs directly associated with its search business, sell-side analyst estimates for these costs range from $700 million to $1.4 billion. In total, we believe Yahoo's EBITDA could increase by approximately $500 million from this transaction. ...

"As for the benefits to Microsoft, this transaction could allow them to increase net search revenues by approximately $1 billion per annum, comprised of (i) $100 million of revenue synergies from its estimated $500 million of search revenue, (ii) over $400 million from the retained 20% share of the new Yahoo search arrangement assuming higher monetization rates, and (iii) $540 million of revenues from Yahoo's affiliates (120% of the $450 million that Yahoo currently earns). To earn these revenues, we assume Microsoft would have to additionally spend only 20% of Yahoo's current level of search expenses, or an incremental $200 million (due to current duplicative spending). The net effect is a pre-tax profit increase of over $800 million per year for Microsoft. Microsoft has tremendous cash resources (over $20 billion of cash as of the latest quarter) and the ability to borrow at exceptionally low rates (it just issued commercial paper at 1.42% last quarter). Assuming Microsoft earns 3% on current cash and pays a 30% tax rate, Microsoft could pay Yahoo over $15 billion upfront in this transaction and the deal would still be accretive to Microsoft's earnings per share. Over time, with this new critical mass, we expect Microsoft would be able to gain meaningful share from Google (as many advertisers could eagerly re-allocate their ad spending to a strong number two player), making this deal even more attractive in future years.

"What is the bottom line of this proposed deal for Yahoo's shareholders? On an after-tax basis, the $15 billion payment from Microsoft would be $9 billion for Yahoo shareholders, leaving Yahoo with $21.2 billion of cash and investments (up from $12.2 billion today) and annual EBITDA of $2.4 billion (up from the midpoint of current guidance of $1.9 billion). Applying a 5x EBITDA multiple on the "new Yahoo" would result in a value of $24 per share. If Yahoo were to go a step further and deploy the $9 billion in new cash to publicly tender for its own shares at a $16 offer price, it could reduce its share count by 40% which would leave the remaining shareholders with a stock value approaching $30 per share (amazingly close to the original bona fide bid from Microsoft)."