One especially sensitive topic that has gotten renewed prominence in financial circles in recent weeks, is the fate of "zombie" companies in a low yield world where debt levels continue to jump to record highs quarter after quarter.
It started in December 2017, when the IMF published a blog discussing the "Walking Debt: China's Zombies" (a topic we first covered in October 2015 in "More Than Half Of China's Commodity Companies Can't Pay The Interest On Their Debt"). Slamming China’s “zombies”, the IMF said they "are non-viable firms that are adding to the country’s rising corporate debt problem, and are bad business. Zombie firms are highly indebted and incur persistent losses, but continue to operate with the support of local governments or soft loans by banks—adding very little value to economic prospects."
Of course, it's not just China: all the way back in April 2017, the IMF first looked at the US, and warned that a whopping 10% of US corporations are "zombies" - i.e., they can't cover their cash interest expenses with cash from operations - and are at risk of defaults should rates rise.
Unfortunately, since then the problem has only gotten worse as cash flows among this stressed corporate segment has remained flat or declined, while debt totals have risen, further accentuating the "zombie" problem. So much so that according to a Bloomberg analysis of the public companies in the Russell 3000, some 200 corporations have joined the ranks of zombie firms since the onset of the pandemic, bringing the total to over 500. As a result, "zombies" now account for nearly 20% of all large US public companies.
Even more stunning, there is now $1.4 trillion in zombie debt, an increase almost $1 trillion of debt since the pandemic struck, bringing total obligations to $1.36 trillion, a flood of new debt made possible by the Fed's direct backstopping of the corporate bond market. That’s more than double the roughly $500 billion zombie companies owed at the peak of the financial crisis.
From Boeing, Carnival Corp. and Delta Air Lines to Exxon Mobil and Macy’s, many of the nation’s most iconic companies aren’t earning enough to cover their interest expenses making them "zombies" as per the widely accepted definition (Bloomberg’s analysis looked at LTM operating income of firms in the Russell 3000 index relative to their interest expenses over the same period and screen for those whose interest coverage is below 1).
"We have come to the point that we should ask, ‘what are the unintended consequences?’" said Apollo chief economist Torsten Slok, even though we asked that very question back in 2017 and have yet to hear an answer. "The Fed, for stability reasons, decided to step in. They knew they were going to create zombies. Now the question becomes, "what about the companies that have been kept alive that otherwise would have gone out of business'?"
As Bloomberg puts it, repeating verbatim our own warning every time we bring up this topic, "the consequences for America’s economic recovery are profound"
The Federal Reserve’s effort to stave off a rash of bankruptcies by purchasing corporate bonds might very well have prevented another depression. But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come, according to economists.
Bloomberg raises another valid point: whereas zombie firms have historically been more commonly associated with 1990s Japan, post-crisis Europe or even China in recent years (our first coverage on Chinese commodity "zombies" was in 2015), their ranks in the U.S. have been soaring for over a decade, fueled primarily by catastrophic Fed policies.
Besides the strict definition of interest coverage < 1, there is another reason why zombie companies have that name: they have a tendency to limp along for years, and while they are unable to earn enough to dig out from under their obligations, they still have sufficient access to credit to roll over their debts. This is because every time the Fed cuts rates it creates a deflationary ponzi scheme, where companies that offer modestly higher yields (which, by definition, is all companies that are on verge of collapse) attract investor capital, which in turn prolongs their undead existence.
Meanwhile, even as they keep millions of workers employed in dead end jobs, they’re a huge drag on the economy because they keep assets tied up in companies that can’t afford to invest and build their businesses.
In fact, their very existence is the anthithesis of capitalism - whose core tenet is that productive capital will always go to those ventures that put it to best use - and confirms that Fed policies have unleashed corporate socialism (with elements of fascism in some very notable cases).
Of course, not every company that becomes a zombie is destined to stay one forever. There are a handful of successful comeback stories, from Boston Scientific to Sprint. In the case of the covid pandemic, many firms that have seen earnings wiped out due to the coronavirus outbreak are likely to rebound once a vaccine allows the global economy to return to a more normal footing, and may ultimately not need all the debt they raised, although it is most likely that the vast majority will never recover and end up defaulting anyway.
Bloomberg agrees and writes that the sheer amount of borrowing undertaken by struggling corporations in recent months will almost certainly limit the capacity of some to make capital expenditures and adapt to shifting consumer habits as Covid-19 alters how Americans spend their money.
Going back to Bloomberg analysis which was a screen of Russell 3000 companies, the results paint a grim picture: more than a sixth of the index, or 527 companies, haven’t earned enough to meet their interest payments. That is a 50% increase compared to the 335 firms at the end of last year. Worse, the $1.36 trillion they collectively now owe dwarfs the $378 billion of debt zombie firms reported before the pandemic laid waste to balance sheets.
The most prominent zombie is a company we have repeatedly flagged in the past: Boeing, which has seen its total debt explode by more than $32 billion this year, doubling to above $60BN, while Carnival’s debt burden has increased $14.8 billion, Delta has added $24.2 billion, Exxon $16.2 billion and Macy’s $1.2 billion.
And in another terrifying development, instead of mere zombie companies we now have entire zombie industries: following the covid pandemic shutdowns, all four major U.S. airlines, with a combined $128 billion of debt, have become zombies in 2020. A similar catastrophic trend was observed among movie theaters and other entertainment companies which grew from 2 last year to 10, accounting for nearly $28 billion of additional debt.
It's gotten so absurd, "analysts" now have gradations of undead: "We distinguish between the walking wounded and the walking dead," said Ken Monaghan, a portfolio manager at Amundi Pioneer. "The question is whether the business model has changed so significantly as a result of the pandemic that survival comes into question. Few sectors are likely to die, but some may require a radical transformation to survive and attract capital."
Meanwhile, as the Fed does everything in its power to keep zombies from collapsing - a form of cheap-debt funded socialist subsidy, as a wholesale decimation of the undead would lead to tens of millions of workers currently employed by these zombies getting laid off overnight -popular sentiment is increasingly turning against these companies.
While economists have recently started warning that zombies are less productive, spend less on physical and intangible capital and grow less in terms of employment and assets than their peers, new research from the Bank for International Settlements - the ironic central banks' central bank which repeatedly warns about the negative consequences of central bank actions and is routinely ignored - shows that zombies may be even more damaging to an economy than previously thought.
Not only are firms staying in a zombie state for longer than in years past, but of the roughly 60% of firms that do manage to ultimately exit zombie status, many nonetheless experience prolonged weakness in productivity, profitability and growth, leading to long-term underperformance. Moreover, recovered firms are three-times more likely to become zombies again compared to firms that have never been one, according to the September study, which examined companies in 14 advanced economies over three decades.
In other words, once you go dead, you don't go back.
"The zombie disease seems to cause long-term damage also on those that recover from it," the BIS’s Ryan Banerjee and Boris Hofmann wrote in the report. Therefore, “a firm’s viability should be an important criterion for its eligibility for government and central bank support."
To be sure, there is one industry that is delighted by the surge in zombies: those who charge 3% to keep issuing new debt for them year after year, collecting millions in exchange for allowing them to continue their miserable existence for another year.
One bank that couldn't get enough of zombies is UBS, which says that concerns over the spread of zombie companies is being over-hyped.
While they accounted for 41% of U.S. firms in a UBS Group AG analysis based on their interest-coverage ratios as of the second quarter, weighted by assets the percentage declined dramatically, to just 10%. And when using the bank’s preferred methodology, which looks at debt to enterprise value, the share fell to just 6%, close to average levels since the late 1990s.
"The zombie problem is fairly benign in the U.S.,” said Matthew Mish, a strategist at UBS. “I don’t think the problem looks any worse than the last two recessions."
He's wrong, and luckily others realize it: “The zombie question is one of the great open issues regarding the legacy of the pandemic,” said PGIM chief economist Nathan Sheets. "Will our economy coming out of the pandemic be as dynamic and flexible as before? I’m cautiously optimistic because competition is deeply embedded in the U.S. system.”
Correction Nathan: competition "was" embedded in the system. Now, it is every crony capitalist for themselves and survival is not a matter of being fit but having the best political connections.
In any case, if and when rates do rise again and companies have no choice but to cut debt, corporate deleveraging in the years ahead will result in slower growth, subdued inflation and low rates "for as long as the eye can see," he added.