Time is running out for unprofitable zombie companies as central bankers worldwide continue to raise interest rates and engage in quantitative tightening monetary policy. As access to easy and cheap capital evaporates, these companies are at risk of going bankrupt if they cannot raise cash through more debt or equity issuance. This paper seeks to define what makes up a zombie company and if the end of loose monetary policy signals their final demise.
WHAT IS A ZOMBIE COMPANY?
Zombie companies need to borrow money to stay alive. They must acquire new debt to continue operating to meet overhead expenses (wages, rent, interest payments, and debt) and have no capital to invest in growth. Zombie companies depend on banks or capital markets as they don’t have the profit to service their existing debts.
HOW MANY ZOMBIE COMPANIES ARE THERE?
Goldman Sachs has two estimates for zombie companies. Their broader estimate is that one in eight (13%) companies do not produce enough profit to service their debts (and are zombies).
This broader measure includes high-growth (and unprofitable) technology firms where investors are willing to forgo present-day profitability for outsized future earnings. When excluding these companies and only including those companies with underperforming broader market measures, the number of zombie companies drops to one in 25 (4%).
The United States Federal Reserve estimates that one in 10 (10%) of public companies and one in 20 (5%) of all private companies are zombies. In the Federal
Reserve’s estimate, Zombie firms are over-represented in the Retail Trade and the Mining, Oil & Gas Industry, with Retail Trade Zombies being especially prolific in private firms.
ZOMBIE COMPANY METRICS
The following are useful metrics to screen for zombie companies.
Negative interest ratio coverage (EBIT/Interest expense) – EBIT is a company’s operating profit (Earnings before interest and taxes). Interest expenses are the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
Negative Free Cash Flow (FCF) over the Trailing Twelve Months (TTM) – Free Cash Flow is the measure of money into and out of a company’s bank account.
It is the money left over after the company has paid all its expenses and capital expenditures. A negative value indicates the company cannot generate sufficient cash to support the business.
Burn Rate of less than 24 – This metric applies mostly to startups and means that a company has less than two years of cash on hand based on current spending.
A company can reduce its burn rate by cutting costs, such as reducing staff or cutting marketing expenditures.
ZOMBIE COMPANY HISTORY
Zombie companies live on debt, not on profits, and the 40-year decline in interest rates in the United States has been a necessary condition for these firms to exist. Following the Great Financial Crisis of 2008, central banks worldwide engaged in quantitative easing and even negative interest rates in a desperate bid to reignite economic growth. This distortion of capital markets has allowed these companies to borrow beyond their means, shuffling from one low-interest cash infusion to the next, seemingly in perpetuity.
ARE ZOMBIES DANGEROUS?
Zombie firms may crowd out lending that would otherwise go to more productive uses, eroding the long-term strength of the United States economy and the U.S. workforce–whose skills and talents are better spent at a firm generating real economic value. It’s evident that Zombie companies also invite speculation, which was apparent during the SPACs boom and meme-stocks that thrived in a financial system flooded with trillions in Covid-related economic relief money. Millions of Americans may even own zombie companies and not know it. In fact, if you own an index fund, chances are a zombie company lurks within!
Due to high inflation and low unemployment, central banks have shifted tactics by raising interest rates and ending quantitative easing regimes. Markets are on their own, and risk assets such as stocks and cryptocurrencies have cratered. If the Fed put is officially over, so too is the era of the zombie company, and the distinction between speculation and investment will be painfully apparent.
Download the full article here.
Thomas Galvin is the Director of Research for Stream Realty Partners’ Southwestern Region. He is a real estate economist with a focus on understanding and explaining macroeconomic trends through a commercial real estate lens.