In 2015, Yahoo! Inc. (NASDAQ: YHOO) saw its earnings decline from $7.45 per share in mid-December 2014 to negative $4.64 per share in mid-December 2015. In the first quarter of 2016, Yahoo's year-over-year earnings were down from two cents per share to eight cents per share. The company has developed a trend of declining earnings, and this trend is bound to place pressure on the company's capital structure.
Capital structure refers to the way in which a company funds itself. A company must pay back debt in hard times, even if earnings are negative. This is why debt is considered riskier than equity. Equity gives investors a claim on future earnings, but it does not need to be paid back. By contrast, equity tends to cost more than debt, especially in periods of low interest rates. In difficult times, companies with access to the capital markets may become overleveraged, which decreases earnings, increases the cost of capital and lowers the intrinsic value of the stock.
When given a chance, most companies prefer a more balanced approach to capital structure, referred to as the optimal level of debt and equity. This allows a company to take advantage of the tax advantages of debt without increasing the risk associated with future earnings.
Debt and Equity Capital
Debt at Yahoo is comprised primarily of bonds. Total debt for Yahoo remained relatively flat from December 2014 to December 2015, rising slightly from $1.110 billion to $1.233 billion, meanwhile the number of shares outstanding decreased slightly from 983.3 million to 977.4 million. Market capitalization declined from $49.7 billion to $32.5 billion over the same period. The price of YHOO declined from approximately $50 per share in mid-December 2014 to $32 per share in mid-December 2015, which means the issue is a decline in stock price more so than share count.
Another way to analyze a company’s capital structure is with enterprise value. The enterprise value, like market capitalization, is a measure of the firm's total cost or value in the market. It represents the theoretical takeover price of the company, and is calculated by adding the market value of preferred equity and the market value of debt and minority interest to market capitalization, and then subtracting cash and investments from the sum. Enterprise value can increase due to an increase in debt, market price or shares outstanding. However, it can go down based on the amount of cash a company holds because the buyer can use this cash to finance the acquisition. A company could be highly capitalized, but would remain a viable acquisition target if it had a lot of cash on hand.
Yahoo’s enterprise value is comprised of market capitalization, total debt, cash and investments, investments in unconsolidated subsidiaries, and non-controlling interests. The company's market capitalization was $32.5 billion on December 2015, and its total debt was $1.23 billion. Cash and investments decreased from $8.1 billion in December 2014 to $6.0 billion in December 2015. Investments in unconsolidated subsidiaries increased slightly from $2.489 billion to $2.503 billion, and noncontrolling interest decreased from $43.8 billion to $35.9 billion. In total, enterprise value decreased from $40.3 billion to $25.2 billion, due almost entirely to the drop in market capitalization, which, in turn, was caused by the drop in market price. Total debt remained flat, but the company is using up its cash reserve. At some point, it may need to return to the capital markets.
As of December 2015, Yahoo's market debt-to-equity ratio was 3.7%, compared to the general market as a whole at 67.7%. The good news is that the company has room to carry additional leverage without jeopardizing its risk profile. The bad news is that leverage can't make an unprofitable company profitable. If 2016 is like 2015, Yahoo will have to find a way to fund declining operations with more than cash.