Microsoft has withdrawn its unsolicited takeover bid for Yahoo. As Microsoft CEO Steve Ballmer wrote to Jerry Yang, CEO of Yahoo, on Saturday (see the whole letter here):

Also, after giving this week’s conversations further thought, it is clear to me that it is not sensible for Microsoft to take our offer directly to your shareholders. This approach would necessarily involve a protracted proxy contest and eventually an exchange offer. Our discussions with you have led us to conclude that, in the interim, you would take steps that would make Yahoo! undesirable as an acquisition for Microsoft.

We regard with particular concern your apparent planning to respond to a “hostile” bid by pursuing a new arrangement that would involve or lead to the outsourcing to Google of key paid Internet search terms offered by Yahoo! today. In our view, such an arrangement with the dominant search provider would make an acquisition of Yahoo! undesirable to us for a number of reasons.

Accordingly, your apparent plan to pursue such an arrangement in the event of a proxy contest or exchange offer leads me to the firm decision not to pursue such a path. Instead, I hereby formally withdraw Microsoft’s proposal to acquire Yahoo!.

Hostile takeovers just aren’t Microsoft’s style. I never expected Ballmer to go to the shareholders; Microsoft isn’t Oracle. He’s also not desperate. Microsoft wants Yahoo, but it doesn’t need Yahoo. While Ballmer was prepared to raise his offer from $31 to $33 per share, he simply wasn’t hungry enough for the $37 that Yang wanted.

But as Ballmer concludes,

I still believe even today that our offer remains the only alternative put forward that provides your stockholders full and fair value for their shares. By failing to reach an agreement with us, you and your stockholders have left significant value on the table.

What is Microsoft up to? I believe that Ballmer still wants Yahoo. I also believe that the past three months have demonstrated that Yahoo is unlikely to recover and to become an Internet powerhouse again; its days are numbered.

Thus, there are a small number of options:

1. Yahoo pulls itself together and continues as a viable company. Likelihood: low

2. Someone else makes a compelling offer for Yahoo. Likelihood: low

3. Yahoo approaches Microsoft at some time in the future, and tries to negotiate a good deal. Likelihood: reasonable.

4. Microsoft waits for Yahoo to tank, and then makes another offer — potentially back to the original $31 per share, but potentially even lower. Likelihood: reasonable.

Thus, one can conclude that Ballmer is prepared to wait. The story isn’t over.

The real losers here may be Yahoo’s shareholders. They’re unlikely to get a better offer than the $33/share that Ballmer offered.