Is there a cure for corporate zombies? Despite warnings about dead companies, a recent Wall Street study indicates they may not be as numerous as previously thought.
The pandemic has cut corporate cash flow, making it more difficult for companies to cover interest payments on their debt. This has led many commentators in and around Wall Street to warn of the preponderance of “zombie companies” – heavily leveraged, cash-strapped companies that, in theory, only survive on interest rates. low interest.
argued that last year, the proportion of American zombie companies reached its highest level in at least 40 years. Bank strategists warned of “a vicious loop of lower and lower defaults, more zombies, the need for more interventions and lower structural productivity.” They also argued that zombie companies interfere with the process of “creative destruction”, the theory of economist Joseph Schumpeter that in a capitalist system, old or weak companies are constantly destroyed as new, more innovative companies are created.
But other analysts are now digging into the data and saying corporate zombie ranks have shrunk significantly this year as the pandemic has subsided. Plus, there are real questions about how best to define them and whether the dreadful warnings about their increase in recent decades are valid in the first place.
The debate is important for investors as even the riskiest corporate bonds look expensive, with yields (and borrowing costs) hitting record highs earlier this month as bond prices rallied. If there really is a zombie problem in the high yield bond market, such low borrowing costs could help prop up dead companies – and that could mean that the market risks outweigh the prices. currently reflect.
Deutsche Bank’s warning was based on a screening of thousands of U.S. companies looking for companies with interest coverage ratios of less than one in the past three years, meaning they couldn’t fully cover their interest charges.
In contrast, seasoned bond analyst Marty Fridson and
painted a much more heartwarming picture in separate notes this week, both focused on high yield bond index companies. Goldman strategist Michael Puempel has focused on bond issuers with interest coverage ratios of less than one. But he also added two more criteria to make sure high-growth companies don’t make the list: above zero net debt and underperforming stock prices in recent years.
He found that by the end of 2020, the net debt levels of zombie companies had fallen to their lowest level since 2009. He attributes this to the increase in defaults during the pandemic, arguing that this shows that “Schumpeter’s creative destruction is alive and well in public corporate credit markets.
Fridson, chief investment officer of Lehmann Livian Fridson Advisors, took a different approach in his search for possible zombie companies. He also questioned the idea that corporate failures match Schumpeter’s idea of creative destruction; the concept “applies rather imperfectly to debt-induced bankruptcies in which the debtor settles with his creditors for pennies on the dollar and continues to operate as before,” he wrote in a June 22 note.
Instead of examining the past ability of companies to cover their interest costs – which could have been skewed by the disruption of cash flow during the pandemic – Fridson examines analysts’ earnings estimates to determine which companies should be in. able to cover their interest costs in the future.
He found only one company in the high yield bond index that should not be able to cover its interest costs in 2022, although he did not name it. But it introduces some problems according to the popular definition of zombie companies: If they only operate because interest rates are close to zero, they may not have a hard time paying interest charges today.
So Fridson took a different approach and looked for companies whose bonds were trading at troubled levels when interest rates were higher before the Covid-19 strike, but don’t appear to be troubled today now that the Federal Reserve has set its key rate near zero.
Within that group, he found nine publicly traded companies that are expected to be less profitable in 2022 than they were in 2019. He said Barron it does not make recommendations on the bonds of these companies, or whether their returns justify the risk of investing, but that they could be called zombies. They are:
Barron contacted all nine companies for comment. Laredo, for his part, pointed to a January 2020 note issued “at a coupon of around 10%” that is currently trading “at yields of around 7.5%, reflecting … improved fundamentals.” Others also defended their position, while others did not respond.
Since many high-yield issuers are private, forecasts were not available to everyone, so the number of zombie companies is likely over nine, Fridson said. Even then, he estimates that around 17 issuers could be zombies, representing around $ 8 billion, or 0.5% of the market, an estimate lower than the optimistic view of Goldman Sachs, which had around $ 30 billion in debt. zombie business at the end. from 2020.
More importantly perhaps, the recovery in equity markets and the rebound in oil prices have opened up funding options and improved cash positions for many of the above issuers.
AMC Entertainment, for example, got its credit rating improved after a rally in even stocks allowed it to raise more than $ 1.8 billion this year. If he’s able to use that money to pay down debt and improve post-pandemic performance, it could be a sign that money might have the power to heal corporate zombies.
Write to Alexandra Scaggs at [email protected]