The term ‘zombie company’ has seen increased usage, particularly over the last five years. Many definitions exist, but they all describe a company whose operating income is insufficient to cover debt service. The use of the term is growing because the number of companies with this problem is growing. As central characters in shows like The Walking Dead, zombie humans have a primary role. However, when it comes to zombie companies, they serve no purpose and should be avoided.
Creative destruction is an economic concept around innovation and the business cycle. Money losing or weaker companies should be starved of capital, shut down, or left to reorganize to become more competitive. On the other hand, investors should reward innovative and inventive companies with capital to seek additional profits for investors. Zombie companies continually lose money and struggle to compete yet continue gathering funds to service debt or try again to become competitive. There are always some zombie companies as the creative destruction of capitalism moves forward, but lately, their numbers are multiplying.
The Bank for International Settlements posted a recent working paper on corporate zombies that revealed several conclusions across 14 advanced economies. The number of zombie firms rose from 4% of all listed firms in the mid-1980s to 15% by 2015. The problem stems from low interest rates. When they are as low as they have been since 2008, highly levered companies have an increased ability to survive and hope for a better day.
Of the total number of zombie firms that emerged since the mid-1980s, about 25% have exited the market, and 60% have recovered. They did not mention the outcome of the remaining 15%. Presumably, their fate was not worth recording. Still, recovery is not permanent; those that recover have a 3x greater chance of returning to zombie status than the average company becoming a zombie in the first place. The Federal Reserve has lowered rates to zero again and provided massive support of the public markets debt. According to data compiled by Deutsche Bank Securities last summer, nearly one in five publicly traded U.S. companies is a zombie.
It happens in equity markets too. During the dot-com bubble in the late 90s, money-losing companies raised more money than their profitable counterparts, and it is happening again now. According to Bloomberg, over the trailing twelve months ending June 2021, about 1,000 companies issued secondary shares in the U.S., and nearly 750 were not making a profit. The shift that set this in motion took place since the financial crisis as investors became more tolerant of negative earnings and focused more on growth opportunities instead. While the absolute figures of equity issuance by unprofitable companies are not yet material compared to the entire market, it speaks to the environment that allows this to happen.
The growth in zombie firms matters for two reasons. First, it underscores the risks to blind acceptance of investing in benchmarks, through which investors intentionally accept exposure to the strong and the weak. Working to identify specific companies poised to grow more than others also offers the benefit of avoiding the more challenged competitors in any marketplace.
Second, it acts as a millstone to the momentum needed to get our economy back in gear and impedes the mechanisms of capitalism. To the extent that organizations that can barely cover debt service trap physical, human, and intellectual capital, those assets will never find their way towards innovative and more competitive uses to benefit more economic participants. Zombie companies are certainly undead, and they should be unloved too.