May 6 (Bloomberg) -- Bill Miller, the Legg Mason Inc. fund manager whose investments lost 20 percent in the first quarter, said Microsoft Corp. may return to buyout talks with Yahoo! Inc. after its $47.5 billion offer was rejected.

``I'm more puzzled by Microsoft's not going up to $37 than Yahoo's wanting to walk away,'' Miller said yesterday in an interview. Legg Mason is Yahoo's second-largest investor with 83.8 million shares as of December, or 6.3 percent of the total, Bloomberg data show.

Yahoo's demand for $5 billion more, or $37 a share compared with the offer of $33, equals 2 percent of Microsoft's market value -- little more than a daily fluctuation in its stock, Miller said. His $12.2 billion Legg Mason Value Trust in Baltimore posted its biggest quarterly drop since the period that ended in September 2001 on losses from Sprint Nextel Corp. and Bear Stearns Cos.

``If they want to be a viable competitor, I would expect them to come back,'' said Miller, 58, whose 15-year record of beating the Standard & Poor's 500 Index ended in 2006. ``Microsoft needs Yahoo much more than Yahoo needs Microsoft.''

Yahoo Chief Executive Officer Jerry Yang and his team now face more pressure to produce, said Miller, who was critical of the Sunnyvale, California-based Internet company's plan to work with Google Inc. on search advertising.

Yahoo fell the most in almost two years yesterday on the Nasdaq, after Redmond, Washington-based Microsoft dropped its offer. Today, the shares rose $1.35, or 5.5 percent, to $25.72 at 4 p.m. New York time, 34 percent above the $19.18 price before the bid.

Microsoft, the world's biggest software company, rose 62 cents to $29.70 while Google dropped $8.54 to $586.36.

Little to Lose

Abandoning the Yahoo bid was better for Microsoft than getting into a proxy fight, Miller said. A proxy battle would have resulted in internal chaos, he said.

``Microsoft loses very little by walking away for a while and seeing how much pressure, if any pressure, Yahoo's management might be under from shareholders,'' Miller said. ``If I'm sitting in their shoes, I'll go away and see what happens. I can come back and the worst case is, I'll pay six months more of my free cash flow.''

Together the two would be a ``more formidable'' rival to Google, the leader in Web search, Miller said. His $12.2 billion Value Trust is lagging behind the S&P 500 for a third straight year.

Sales Goals

In March, Yahoo laid out sales growth targets of $7.1 billion and $8.8 billion for 2009 and 2010, higher than analysts estimated, to justify its rejection of Microsoft's initial offer of $44.6 billion, or $31 a share. Yahoo pointed to operations in Asia, its No. 2 position in Web search and potential cost savings of the deal to show it was worth more.

Microsoft CEO Steve Ballmer said on May 3 he wasn't prepared to pay the $37 a share Yahoo executives demanded. Yahoo is in talks over a search-advertising arrangement with Mountain View, California-based Google, said two people familiar with the matter. An agreement could come as soon as this week, according to one of them.

Miller criticized Yang's decision to consider letting Google handle its search-advertising business. Yahoo introduced Project Panama last year to make search ads more relevant.

``That vitiates the Panama platform,'' Miller said. ``It would destroy the ecosystem of search.''

Miller also said a tie-up between Yahoo and Time Warner Inc.'s AOL, which Yang is considering, would have already happened if it were a compelling combination.

Now, it makes sense for Yahoo to use the $2 billion on its balance sheet to buy back shares, Miller said. The company announced a $3 billion repurchase in October 2006.

``It's a riskless transaction,'' he said. ``You have a couple billion of cash on your balance sheet and you generate a lot of free cash flow.''

To contact the reporter on this story: Gillian Wee in New York at gwee3@bloomberg.net.

Last Updated: May 6, 2008 16:15 EDT