ICR is defined as the ratio of a company’s earnings before interest and taxes (EBIT) relative to interest repayments (note, not principal) on 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 more than 13 percent of all ASX companies are zombies, which is actually slightly more than the number of zombies we find in the US (just under 10 percent of all ASX 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 of less than one for three years in a row.
In Australia, a whopping 34 percent 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 percent zombies we estimated by imposing a 10-year-old minimum age requirement. 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, we classify companies as zombies using only data from their last financial year, rather than requiring them to have an ICR of less than one for three consecutive years.
Using this definition, the proportion of zombies increases further to 39 percent in Australia and 37 percent in the US.
After identifying zombies, we study their spread across both industry sectors and by size or market capitalization.
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 industries.
Either a good boy or a bad boy
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-led default cycle in Australia since 1991.
In the early 1990s, ANZ and Westpac came close to bankruptcy due to their credit exposures to 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, markets high-yield, investment-grade debt still look rich.
As an example, consider credit spreads on US high yield bonds rated B and BB. These spreads remain well below the much broader levels that emerged in previous shocks, including 2020, 2015-2016, 2011-12, 2008 and 2002.
We have developed and use automated global high yield bond default forecasting models, and they point to a substantial increase in high yield defaults.
Our US recession forecast models also indicate a 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.
Another market where you’re likely to find zombies is Australian real estate, where about half of all borrowers are not more than a month ahead of their mortgage payments.
The Australian real estate crash is going to get worse
CoreLogic has just released its official housing data for August, confirming what we feared: both the five and eight capital city indices have posted their biggest monthly house price declines since 1983.
With the RBA poised to preemptively raise interest rates by 50 basis points for the fourth month in a row, imposing an extraordinary 225 basis point rate hike on unsuspecting borrowers, the great Australian housing crisis will only get much worse.
Individual capital losses in August have been impressive, though consistent with our highly contrarian October 2021 prediction of an unprecedented 15-25 percent decline in national home values. In fact, house prices fell in all of Australia’s capitals, with the sole exception of Darwin.
And, for the avoidance of doubt, the sole driver of the great Australian housing bust has been the record-breaking spate of interest rate hikes provided by the RBA, which risks another policy mistake.
These home price changes have nothing to do with employment, income, population growth, and/or building approvals. They simply represent a deep reduction in purchasing power as the RBA vastly increases the cost of borrowing.
Sydney losses to top 10% in months
After Sydney home values fell a staggering 2.2% in July, the biggest drop since 1983, losses accelerated in August, with the final monthly drop coming in at a staggering 2.3%.
Sydney house values are shrinking at an annualized rate of 19.7% based on the latest quarter of daily house price data (annualization of quarterly data is fairly common among central banks and credit bureaus). statistics).
Total peak-to-valley losses in Sydney are almost 8 per cent, which should exceed 10 per cent within a month or two.
The correction is a bit more orderly in Melbourne, where home values fell another 1.2 percent in August, a slower rate than the 1.5 percent loss in July.
Total peak-to-trough losses in Melbourne are approaching 5 per cent, with the annual pace of price declines exceeding 13 per cent based on data from the latest quarter.
The big news has been the complete capitulation of Brisbane property, which fell by 1.8 percent in August. That’s the largest monthly loss since CoreLogic records began 42 years ago in 1980.
As we had noted, the Adelaide market was likely to have finally turned around. Adelaide had been flat since May but lost 0.1 percent in August. While this may seem small, the change in direction is key: house prices in Adelaide are likely to start falling much faster.
Perth also apparently gave up the ghost in August with prices down 0.2 per cent. That said, Perth prices seem cheap compared to the other major cities. The median price of $562,000 is well below the Sydney and Melbourne averages of $1.1 million and $782,000, respectively.