Zombie companies, a term that originated in Japan post the 1991 Japanese asset price bubble, and regained popularity post the 2008 financial crisis. The term "Zombie" refers to young companies aged at least 10 years and cannot cover their debt serving costs from profits and are characterized with an interest coverage ratio of less than 1 for at least 3 consecutive years which measures the ability of a company to repay the interest on its outstanding debt. The interest coverage ratio is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expenses. The probability of becoming a zombie triples if a company was previously categorized as so, according to the Bank of International Settlements (BIS).
The number of listed zombie firms almost tripled from 2010 to 2020, and as shown below, the percentage of US zombie companies in Russell 3000 in 2020 is around 15 %. Their aggregate value increased by 200 % in 2020 compared to 2019 due to the Covid-19 pandemic, exceeding USD 6 Trillion. In 2020, a record of 66 % of the zombie companies' loans had the lowest quality segment with an S&P rating of a single B or less. Examples of zombie companies are Boeing (BA), Bloom Energy Corporation (BE), Sunrun Inc. (RUN) with annual interest coverage ratios of less than one for the past 3 years.
Percentage of US Zombie companies in Russell3000 Equivalent Index| Source: Financial Times (September, 2020)
Since those companies survive on low-interest rates to finance their debt rather than borrowing for new investments, they are highly sensitive to changes in monetary policy. It is expected that if interest rates double, the number of zombie firms could increase by nearly 40% bringing it to the fore concern. Therefore, there's a trade-off for central banks when adopting monetary policy; an easing monetary policy might support the emergence of new zombie firms and sustain existing ones through low-interest rates, while a tightening monetary policy could worsen their case with the increased cost of debt.
The charts of some of these companies can show the effect of the US Federal Reserve signaling an increase in interest rates for the first time since 2018 in early December 2020. The chart below shows the market price of Sunrun Inc., with an interest rate average ratio of -1.9 for the past 3 years due to negative EBIT, decreased by almost 56 % since early Jan 2022.
Sunrun Inc. Stock chart| Source: Trading View (March 2022)
However, it's worth mentioning that although there are some companies that end up exiting the market, others recover from such status by enhancing their debt structure. Therefore, it doesn’t necessarily mean that if it’s a zombie company, it should be excluded.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.