Yesterday, Standard & Poor’s (“S&P”) cut its unsolicited rating outlook on Yahoo! Inc. (YHOO - Analyst Report).

S&P cited two reasons — meager revenue growth and elevated costs for obtaining traffic — for lowering its outlook from stable to negative.

Unsolicited Rating Outlook

An unsolicited rating is an agency’s evaluation of a borrower’s creditworthiness without any participation of the borrower. Basically, the borrower does not pay for the rating assessment.

Currently, S&P has a BB+ rating on Yahoo, while its competitor, Microsoft Inc. (MSFT - Analyst Report), has a credit rating of AAA. Yahoo has lagged its competitors in terms of credit ratings due to elevated defections and increasing qualms over management's capability to turn the company around.

In a statement, S&P said, "We could lower our rating on Yahoo if the company's competitiveness in its display or search advertising businesses continues to decline and it is not able to reverse the negative operating trends affecting earnings before interest, tax, depreciation and amortization (EBITDA)."

Nearly a double-digit percentage decline in revenues, (excluding traffic acquisition costs), according to S&P, could point to a declining competitive position.

The credit rating agency also was quick to point out that any debt-funded scheme to gratify shareholders or acquire a company could also lead it to further lower Yahoo's credit rating.

However, S&P also mentioned that it might reconsider its position in the light of a few factors. These include the development and efficient accomplishment of a business plan which would result in Yahoo maintaining its market share; enhancement of the way it monetizes its assets, and reverse the slump in EBITDA.

To attain a revision, Yahoo will also have to exhibit its capability to improve its market share in search and display advertising.

Effect on Stock Prices

The impact that credit ratings have on equity prices is not clear. However, keeping up with the changes in a company’s creditworthiness often pays off for investors.

Over the years, several studies have shown that the three major rating agencies — Moody’s Investor Services, Standard & Poor’s and Fitch Ratings — often make available fresh data along with the publicly available information.

The European Central Bank (“ECB”), for instance, reported that Equity analysts lower their earnings expectations for the downgraded company. The extent depends on the initial rating as well as the amount of the downgraded debt.

ECB said, “The price reaction to rating changes, and in particular the effect on stock returns, is asymmetrical. The market reacts more strongly to rating downgrades than to rating upgrades, and ultimately this asymmetry appears less significant for bonds than for stocks.”

For now, just the warning was enough to push Yahoo! Japan shares down nearly 2% in Tokyo.

Conclusion

There is already a lot on Yahoo’s CEO Marissa Mayer’s plate.

This year witnesses two major developments. The first was the tax authorities' refusal to sign off on the Alibaba spinoff, meaning that shareholders are now exposed to the risk of paying several billion dollars in taxes if Yahoo goes through with the deal and it is assessed taxable. The second was the Microsoft search deal coming up for renewal that CEO Mayer adjusted to make it as favorable for Yahoo as possible.

Mayer’s growth strategy involved a focus on M-V-N-S (mobile, video, native and social). Critics have been highlighting the cost of her endeavors that yielded high double-digit growth in this segment off a small base (the segment is yet to reach quarterly revenues of half a billion dollars).

Will this warning by S&P cause equity analysts to downgrade Yahoo considerably? We will have to wait to know, but as of now Yahoo shares are down almost 35% year-to-date.

Yahoo has a Zacks Rank #3 (Hold). Investors can consider the stocks of Stamps.com Inc. (STMP - Snapshot Report) and Travelport Worldwide Limited (TVPT - Snapshot Report), both sporting a Zacks Rank #1 (Strong Buy).

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