Since 2019, we’ve been warning about the rise of “zombie companies” kept alive by the care of constantly cheap money from near-zero interest rate and spendthrift central banks’ QE policies to infinity in the aftermath to the GFC. The concern is that as interest rates now normalize, many of these zombies may not survive, creating waves of corporate defaults the likes of which have not been seen since the 1991 recession in Australia and during the GFC in the US.
Therefore, we have updated our quantitative zombie detection models to cover both Australia and the US and have tested some of the definitions of what is and is not a zombie. The standard definition of a zombie is a business that meets two tests:
- They have been around for over 10 years, and
- Have an Interest Coverage Ratio (ICR) of less than 1 for 3 years in a row.
There are other more complex definitions that we employ, but this will suffice for our public inquiry. Therefore, ICR is defined as the ratio of a company’s earnings before interest and taxes (EBIT) relative to interest repayments (note, not principal) on its debt. If the company’s ICR is less than one, it is not earning enough income to pay the interest due on its debt. Hence the nickname “zombie”.
Using this definition, Coolabah finds that over 13% of all ASX companies are zombies, which is actually slightly higher than the number of zombies we find in the US, which is just under 10% of all companies. listed companies. Our US analysis includes all companies listed on the NYSE and NASDAQ.
The age restriction on a zombie doesn’t make much sense. Just because it’s a young, high-growth company, if it’s not making enough profit to pay off its debts, it’s technically still a zombie. So, in our first adjustment, we remove the 10-year minimum age criterion and simply focus on all companies that have reported ICRs less than one for 3 years in a row. The first panel of the following table summarizes the results.
In Australia, a whopping 34% of all ASX companies would be classified as zombies judging by their ability to produce enough EBIT to cover their interest payments. This is up from the 13% zombies we estimated in the table above, although it does impose a minimum age requirement of 10 years (i.e. taking into account businesses of all ages, zombie penetration jumps from 13% to 34% ). In the US there is also a jump in zombie market share from 9.6% to 18.9% once we remove the age criterion.
As a final exercise, when you classify companies as zombies only using data from their last financial year, instead of requiring them to have an ICR of less than one for three consecutive years. The final panel of the table below shows zombie participation increasing further to 39% in Australia and 37% in the US.
After identifying zombies, we study their spread across both industry sectors and by size or market capitalization. The tables below summarize the findings. This analysis reveals that zombies tend to be small and medium-sized businesses.
They are also found in greater numbers in the technology, energy, health, real estate and materials industry sectors. One last point is that if you spread out the companies by their ICRs, you will find that there are a lot of very risky zombies in contrast to a significant number of incredibly low risk companies, and not so much in between. It seems that in the corporate world, you are either good or bad! Or maybe what we’re saying is that there are a lot of great value stocks and also a lot of junk growth wannabes. Given the outlook for interest rates, it’s hard to imagine that there will be much global growth over the next year or two; recessions are more likely.
This has implications for the markets. As interest rates continue to rise, we are likely to see the first rate-driven default cycle in Australia since 1991. In the early 1990s, ANZ and Westpac nearly went bankrupt due to their credit exposures to the sector. commercial real estate.
Since the 1991 recession, we’ve also seen a huge rise in “non-bank” lenders, many of whom provide financing to zombies and don’t have the risk-management experience of lending during the 1991 recession, technological disaster or even the GFC.
While highly rated bond markets (eg, BBB to AAA rated securities) have generally appreciated substantially and are trading with credit spreads that are beginning to look quite cheap compared to historical benchmarks, high-yield and investment-grade debt markets still look expensive. or rich. As an example, consider the current credit spreads on US high yield bonds rated B and BB, as highlighted below. Note that current spreads remain within the much wider levels that emerged in all previous shocks, including 2020, 2015-2016, 2011-12, 2008, and 2002.
Coolabah has developed and uses automated global high yield bond default forecasting models, and they currently point to a substantial increase in high yield defaults. Our US recession forecast models also indicate a very high probability of a US recession, as they have been doing for many months. All of this means that high yield spreads are likely to have to go much higher, crushing many of their zombie companies…
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