Ok, Pollyannas... What next? Should we ignore more debt downgrades as well?
With Halloween a little more than a month away, stock investors may want to keep an eye out for zombies.
The coronavirus recession appears to have caused an outbreak of “zombie companies,” unprofitable and cash-poor firms that rely on financial markets to cover their costs, according to Principal Global Investors. As of the first quarter, the firm found that 18% of companies in the Bloomberg Total Return Index couldn’t cover their interest costs with last year’s pretax earnings, up from a little more than 10% a year ago.
“Unsurprisingly, zombie firms are usually bad investments, both as equities and credit exposures, and often carry excess volatility due to their distressed business models,” the firm wrote in a recent paper. “For many companies, [Covid-19] lockdowns caused their transition from living business interest to fundamentally doomed enterprise.”
When it comes to the broader economy, the consequences (and causes) of zombie companies are difficult to pin down. And the topic certainly isn’t new. The designation first found widespread use during Japan’s “Lost Decade” from the early 1990s to early 2000s, when that country’s banks were urged to extend loans to unprofitable firms at low interest rates to help them continue operating despite declining sales and a poor outlook for growth.
The outbreak appears to have spread steadily since then. A paper published by the Bank for International Settlements earlier this month warned that the rise of global publicly traded zombie companies has been going on for decades, rising to 15% in 2017 from 4% in the late 1980s.
And then came the pandemic and a new crop of zombies. In its paper on zombie companies, Principal Global Investors provides a five-step blueprint for identifying them:
• They can’t cover their interest costs twice over with last year’s pretax earnings.
• Their “return on common equity spread,” the gap between their return on equity and their cost of equity, is lower than 4 percentage points.
• Their one-year sales growth is below 3%.
• Their three-year average sales growth is below 3%.
• And their “Altman Z-Score”—a measure of liquidity, solvency, and profitability that is sometimes used to predict bankruptcy filings—is below 1.8.
Of course, when a firm can cover all of its interest costs for any given year, it should be able to refinance its debt at today’s low interest rates. That means its “zombie” status doesn’t add much risk to creditors, which are then less likely to force the company into bankruptcy or restructuring.
So for this screen, Barron’s looked for S&P 1500 companies that couldn’t cover their interest costs even once with last year’s earnings before interest and tax.
In its work, the BIS included global companies that couldn’t cover interest costs. And to ensure high-valuation and high-growth startups weren’t included, the BIS excluded companies whose assets command high market values compared to the cost of replacing those assets. To avoid unduly penalizing unpopular sectors, the researchers included companies whose ratio fell short of the median for the broader sector.
Barron’s took a simpler approach, and used price-to-book ratios. This screen includes only companies with price-to-book ratios below the median for their sector. The Altman Z-Score was also used as a measure of liquidity, solvency, and capital efficiency.
After screening for the three metrics chosen by Barron’s—an interest coverage ratio below 1, an Altman Z-Score below 1.8, and a price-to-book ratio below the sector median—36 companies were left for our list of potential zombies.
To be sure, this is just one way of many to screen for potential zombie companies. And more important, the significance of the designation is still up for debate.
Undervalued…or Undead?
The pandemic has expanded the ranks of zombie companies.
Name Sales (mil) Interest Coverage Ratio* Price/BookSector P/B Median Altman Z Score
Ford Motor $130,396.00 -4.3 1.1 1.9 0.9
The consequences for zombie companies’ shareholders aren’t easy to quantify. Only about 25% of the companies that were classified as zombies between 1980 and 2017 went on to exit the market, according to the BIS. And only some of those cases were liquidations, which are normally done to pay creditors (meaning shareholders get nothing). The BIS paper also counts mergers and takeovers as exiting the market, even though shareholders can limit their losses and even sometimes make money in those deals.
The BIS has another warning about that, however. The researchers found that once a company is designated a zombie under its methodology—again, not the method used by Barron’s—that company is more likely to become a zombie again in the future.
As of 2017, a “recovered zombie” company faced a roughly 17% chance that it would become a zombie in the next two-year period, the researchers found. That compares to a probability of around 3% for companies that have never been categorized as zombies by the BIS’s methodology.
So for now, investors should be on the lookout for zombies and tread cautiously when confronting them.