Ryan Banerjee and Boris Hofmann recently reviewed the rise of zombie firms in advanced economes (BIS Quarterly Review, Sept 2018). Zombie firms are those that are unable to cover debt servicing costs from current profits over an extended period. Caballero et al (2008) coined the term in their analysis of the Japanese "lost decade" of the 1990s. More recently, Adalet McGowan et al (2017) have shown that the prevalence of such companies as a share of the total population of non-financial companies (the zombie share) has increased significantly in the wake of the Great Financial Crisis (GFC) across advanced economies.
When
is a company a zombie? Lack of profitability over an extended period is
obviously an important criterion, especially if the company cannot service its
debts. A second criterion is age: young companies may need more time for
investment projects to deliver returns. Finally, low expected profitability
should be important.
Profitability
today could be low because of a corporate restructuring or new investments that
may eventually increase profitability. Graph 1 shows that, for non-zombie firms, the median
interest coverage ratio (ICR) is over four times earnings. As the majority of
zombie firms make losses, the median ICRs are below minus 7 under the broad
measure (ICR below 1) and around minus 5 under the narrow one (ratio of assets
market value to replacement cost below median for that sector). A striking
difference between the broad and narrow zombie measure emerges, however, with
respect to expected future profitability, as measured by Tobin's q. Under the
broad measure, the median Tobin's q of zombie firms is higher than that of
non-zombies. Investors are therefore optimistic about the future prospects of
many of these zombie firms, more so than that for the non-zombies. By
definition the narrow measure, which is designed to purge the zombie measure
from this anomaly, has a lower median Tobin's q, slightly below one.
Both zombie
measures suggest that the prevalence of zombies has increased significantly
since the 1980s (Graph 2, red lines).
The rise of zombie firms has been driven by firms staying in the zombie state
for longer, rather than recovering or exiting through bankruptcy (Graph 2, blue lines).
Specifically, the probability of a zombie remaining a zombie in the following
year rose from 60% in the late 1980s to 85% in 2016 (broad measure) and from
40% to 70% (narrow measure).
How can corporate zombies survive for longer than in the past? They seem to face less pressure to reduce debt and cut back activity. And in contrast to what might be expected, the main change does not coincide with the GFC, but occurred in the early 2000s. The literature has identified weak banks as a potential key cause (Caballero et al (2008)). When their balance sheets are impaired, banks have incentives to roll over loans to non-viable firms rather than writing them off. Another potential, more general factor is the downward trend in interest rates. Mechanically, lower rates should reduce zombie firms as they improve ICRs by reducing interest expenses, all else equal.
Also note are the consequences - on average, labour productivity and total factor productivity of zombie firms are lower than those of their peers.
From Boeing Co, Carnival Corp and Delta Air Lines Inc to Exxon Mobil Corp and Macy’s Inc, many of U.S most iconic companies are not earning enough to cover their interest expense. Almost 200 corporations have joined the ranks of so-called zombie firms since the onset of the pandemic, according to a Bloomberg analysis of financial data from 3,000 of the country’s largest publicly-traded companies. In fact, zombies now account for nearly 20% of those firms.
Bloomberg’s analysis looked at the trailing 12-month operating income of firms in the Russell 3000 index relative to their interest expenses over the same period. The results paint a grim picture. More than a sixth of the index, or 527 companies, have not earned enough to meet their interest payments. That compares with 335 firms at the end of last year. The US$1.36 trillion they collectively now owe dwarfs the US$378 billion of debt that zombie firms reported before the pandemic laid waste to balance sheets.
There are plenty of comeback stories, from Boston Scientific Corp to Sprint Corp. 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. But the problem is some of the former zombies have a tendency to return to “zombiehood” when the economy turns south.
Key takeaways
- The prevalence of zombie firms has
ratcheted up since the late 1980s.
- This appears to be linked to reduced
financial pressure, reflecting in part the effects of lower interest
rates.
- Zombie firms are less productive and crowd
out investment in and employment at more productive firms.
- When identifying zombie firms, it appears
to be important to take into account expected future profitability in
addition to weak past performance.
- Zombies even after recovery are
underperforming and may fall back into zombie status when economy turns
negative.
References:
1. The rise
of zombie firms: causes and consequences, Ryan Banerjee, Boris Hofmann, BIS
Quarterly Review, September 2018
2. America’s zombie companies have racked up US$1.4 tri of debt, Lisa
Lee, Tom Contiliano and David Papadopoulos (Bloomberg), TheEdge CEO Morning
Brief, 18 Nov 2020
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