Being dead and being alive are mutually exclusive conditions. But with stocks, there are companies that to a large extent fit into this scheme. Now facing a heavily toxic cocktail of likely higher interest rates and a slowing economy, many of these businesses will be tested for their survivability. Even if they do survive as a whole business, it is nonetheless dangerous to invest into equities of heavily indebted zombies – no matter how high the temptation might be.

Summary and key takeaways from today’s Weekly
– First serious research about zombie companies started with the “lost decade” of Japan where factually dead companies were artificially kept alive.
– I show you what to look for at the minimum to get a feeling for the financial health of a company.
– In the final section, I show you some zombie companies and go through some figures to stress my points.

Have you ever thought about gobbling up some unloved shares at the cheap to make the next ten-bagger?

Often appraised by pretend bargain hunters, my experience is that the more rumble there is around a certain stock and the more know about this “secret” only the market allegedly doesn’t want to see, the higher the likelihood of it being a value-trap – i.e. a stock that looks cheap, but doesn’t return to its former glory.

If you find a company where the shares have dropped massively, in most cases you can be sure that it is not without a reason or two that the stock has fallen into a low earnings multiple. These stocks more often than not are not even cheep when factoring in debt and risky when looking at the interest coverage ratio.

Currently, the worst thinkable happens: After a decade of low- to no-cost debt, now a cooling economy and at the same time sharply rising interest rates pose a big challenge. Each of those would already be unfavorable for highly leveraged businesses. But both together are a dangerous, headache-creating cocktail for those companies that stand on weak legs. But those to suffer will be unsuspecting shareholders.

There is often a fundamental reason for a sluggish performance.

Many just look at the PE ratio which has its flaws. It does not take into account debt. High debt, however, massively raises the enterprise value (EV) and thus the whole valuation of the business.

And that’s why such stocks with low single-digit PE ratios usually are NOT cheap.

In today’s Weekly, we are going through the topic of zombie companies. Where does the term originate from? What to look for to not fall victim of such zombies? We’ll close with an overview of some zombie companies that should be avoided, because at the minimum their share prices could stay lower for longer and in the worst case current equity holders could get diluted.

Do not fall into temptation for pretend bargains!

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The origin: Big in Japan

A good read and interesting case study around this topic, as well as a basic overview of what happens with a zombified economy and such companies, is the example of Japan (see articles here, here and another source here).

Zombified, in easy words – although there is no official set in stone definition – describes an often unprofitable (but not only) company with excess use of debt, in many cases to push for growth.

At some point, a zombie starts to first slow down in growth or overall operations start to deteriorate. Finally, this can lead to stagnation and even bankruptcy. But what they all have in common is that at some point leverage starts to hurt. The reason is that the cost of debt becomes too high and requires too much of operating profits to be serviced – if there are any.

If debt repayments become unlikely and operating profits fall below interest payments, we are dealing with a zombie – that’s how I personally see it.

Actually dead, but somehow alive, only due to more lending that allows to further kick the can down the road without solving the root problem.

Japan was a success story that pulled worldwide capital and talent into the country.

An appreciating Yen and rising stock prices, together with other assets, led to a strong boom that overshot. Anyone with some interest in stock market history knows about the bubble in Japan that was inflated in the 1980s and peaked with the NIKKEI index exactly at the end of 1989.

The growth was accompanied by steadily growing public and private debt.

Unfortunately, when a leveraged asset bubble bursts, only the asset prices fall – the debt stays.

And this is what has crippled Japan’s economy and is also strangling other economic areas that cannot get enough of debt. Many know the above.

But what is not so widely known is that Japan had a debt to GDP ratio of only 50–70% during the 1980s:

In the chart above, you see a gradually rising level of public debt, relative to GDP.

But it really took off after the party of asset bubbles was over. Following the big crash after 1989, the Bank of Japan initiated big stimuli programs to reignite the fire.

However, without success. The only thing that went up was public debt.

The term “lost decade” describes well the period of the 1990s where economic growth came to a standstill. Some are even talking about three lost decades, as the policies continued with the same results.

The sclerotic Japanese economy could never be revived again.

Also, Japan was a decade ahead (in negative terms) when it comes to zero interest rates. They indeed tried them out during the 1990s, only to become more aggressive over time. If you accumulate ever more debt at barely any interest rates and still do not succeed in standing up again, time runs against you.

The former high in the NIKKEI at 38,915 points hasn’t been reached until today.

Over the next three years from the top, the NIKKEI plummeted by 60%. Bad enough, but the years after didn’t look that much better, even for long-term investors.

The NIKKEI index, however, like most indexes worldwide, only shows the pure price performance. To be fair, the total return index, i.e. including reinvested dividends, made a new all-time high.

But only in 2021 and thus 32 years after the former high.

What caused the forever-crisis?

In Japan – and likewise in Europe – the preferred way for a business to get loans is via bank lending, not bonds which is rather practiced in the USA. Especially among smaller companies that do not have any access to capital markets.

Economic growth in Japan came to a near-standstill because falling asset prices hurt the banking system. Bank loans are usually securitized by properties like houses or land. When the collateral falls massively in price, the lender has to either demand more securities or – if unsuccessful – to impair the loan portfolio.

This is what happened in Japan.

An impairment is first an accounting loss – not a true cash flow loss. But in case the borrower defaults, the “virtual” loss becomes a true loss.

Because the price drops were so massive, the ramifications for the lending banks were massive, either. Banks were unable to post operating profits for the subsequent ten years, due to their loan books suffering losses.

With losses, capital ratios deteriorate which in turn make it impossible to give out more credit, if the equity amount of a bank is not sufficient.

And this put a full break on overall economic activity.

What happened in response to the new situation was not a clean-up of the mess. It would have been short-term pain for long-term gain.

Quite the opposite happened.

Banks lent even more money to firms just in hope that some day the companies would come back and repay those loans. Unfortunately, among the borrowers were many financially unhealthy businesses that only borrowed money to repay older loans. As I said in another article, hope is no investment thesis to bank on.

I cannot imagine of a more unproductive way of using money.

According to a study that was cited in one of the articles I am referring to, an estimated 30% of business from different sectors like construction, manufacturing, real estate, retail and more were on life support from banks.

This is what led to the treading water situation and the zombification.

Denying the existence of a problem is seldom a good solution.

Banks have to comply with certain capital requirements and hold enough buffers to stay solvent. To further hold up this illusion, the new status quo became what I described above.

As long as you don’t recognize a loss, it is no “true” loss – this is one of the dumbest things you hear in investing.

This is also the mantra many individual investors believe in and practice. Not admitting mistakes is a big mistake in itself. If you haven’t already, please read my older article “Why you need to remove your portfolio losers regularly“.

The problem with these zombie firms is that they are blocking new entrants or more competitive firms from taking over their activities. It can go as far as that at some point even otherwise healthy businesses get caught in this strangle.

A quote from the article explains precisely why zombies are such a problem:

According to the theory of “creative destruction,” much of the progress in a market economy takes place through restructuring. Unproductive firms go out of business and new, more efficient firms replace them. Under normal conditions, zombie firms would have gone bankrupt and been replaced by new and better business ideas and models.

Chicago Booth Edu – see here

This didn’t happen in Japan.

Zombie firms directly and indirectly hold back economic activity from expanding:

• Directly due to operating though not fit and solvent enough anymore.
• Indirectly due to blocking expansion of better competitors or even new potential entrants.

For those who want to know more, I recommend reading the whole article.

But for this Weekly, this is a sufficient enough overview.

Let’s continue with how to spot such zombie firms in advance to stay away from them.

How to find and avoid zombie firms

For more information, see the sources here, here and here.

The above Japan-example was used as an introduction, because first serious research was done on the “lost decade” of Japan.

Of course, zombie firms can be found in many places.

According to a paper from the Bank for International Settlements (BIS, see here), it is estimated that until 2017 – when interest rates where still quasi-nonexistent, unlike now – the share of zombie firms was already 15% in 14 examined countries.

One can be sure that this percentage figure is not going to decline miraculously.

A study by the Federal Reserve resulted in roughly 10% publicly, respectively 5% privately held zombie firms – or also roughly 15%:

Zombie companies more likely than not will come to the surface more and more.

The current economical environment of higher and rapidly rising interest rates that could stay for longer (at least it should be expected for a defensive planning) paired with slowing economic activity (or even a recession) is toxic for these companies due to the following reasons:

• Revenues are breaking away due to less consumer spending. Not only due to higher interest rates that make consumer financing more expensive, but also due to focussing on necessities like food and energy which have risen among the most in price. Less revenue means less cash to service debt.
• Capital for businesses, too, is rapidly becoming more expensive. Indebted companies are facing higher refinancing costs for loans. Fresh debt has higher interest rates which will put pressure on profits.
• Likewise, equity raises become more difficult, because they will dilute shareholders more due to lower stock prices – especially highly indebted companies’ share prices have fallen much and make capital increases more unattractive.
• a rather seldom mentioned fact: higher interest rates means there are more safer options out there for lenders who become more cautious whom they give their capital.

Zombie firms don’t necessarily have to got bankrupt. But either way, they will likely become mediocre investments – at best.

What can happen is that they will be forced to sell assets just to raise cash to cover their debt. This would rather happen at lower or unfavorable asset prices, because the buyer will be in a better negotiating position.

Hence, look for financially strong businesses that could benefit from such situations.

The second point is, zombies will in many cases massively dilute shareholders at low prices to raise fresh equity, as described in one bullet point above.

These two risks are by no means worth it to put money into such companies.

Otherwise you could get caught up in a situation like this – fresh from yesterday:

The stock nosedived by nearly 14%, because many shareholders were surprised.

But it could have easily been avoided. The company has net debt of more than 7x its EBITDA, its cash flow per share hasn’t moved since 2018 (while revenues grew) and more or less all the operating cash flow was paid out in dividends.

It is easy to name zombies after they are in dire straits.

Our task as investors is to spot them while they are on the verge of becoming a zombie. Often, the underlying business sends out some signals that indicate unfavorable evolutions that the stock price does not necessarily.

This way, we can stay away from value-traps as well as check our current holdings for arising problems and limit the potential damage early enough.

Critical factors to look at are:

• operating problems
• net debt to FCF
• declining interest coverage ratio
• structure of debt over the next years

The first thing to look at is whether the company in question has any signs of operating issues.

If growth stopped – or worse, even went negative –, margins shrank, returns on capital went south and / or management suddenly started acquisition adventures that did not fit to the underlying operations, something does not smell right.

It is critical to find out whether there are temporary problems like cost pressure or durable and structural challenges like new emerging competitors.

Next point I like to look at is threefold: First the evolution of net debt, second the evolution of free cash flow and third the evolution of both in relation, as net debt to FCF.

It depends on the business model as well as the predictability and stability of cash flows how much debt becomes too much. Until now, for example tobacco companies were able to shoulder even 3x–4x of yearly FCF as net debt. Theoretically, they could have repaid all, if they suspended dividends (which they don’t intend to do). With higher interest rates, they will need to repay at least a portion.

Likewise, it is not a good sign when a company pays out nearly all of its free cash flows while having tons of debt. It will either have to cut on spending and thus harm its competitiveness or slash its shareholder returns – or in the worst case even both.

Third, the interest coverage ratio which answers the question whether a company is able to only pay interest for their debt out of operating earnings.

It is common to use EBIT (earnings before interest and taxes). However, there are also voices to adjust cash flow to a before interest paid status and compare this figure instead. I think, for a first overview it is sufficient to use EBIT. If you find a coverage of less than 3 or even 2, especially if debt was obtained with low interest rates, I’d be very cautious.

The interest coverage ratio can be pressured from both sides: declining cash flows and rising interest rates.

The last point to look at is the term structure of the debt. At least in their annual reports, sometimes also in between, companies show what portions of debt are due at which point in time in the future.

When the majority of a highly indebted company has to be refinanced over the next two years… You know.

In the last section for today, let’s have a look at some zombies that will have it very difficult down the road.

8 examples for current and emerging zombies

I structured this section into two groups:

• four companies where the problems cannot be covered anymore
• four companies, where one has to look a bit deeper into the numbers, but the problems are not less worrisome

Over the last weeks and months, you obviously heard at least once about:

• Carvana (ISIN: US1468691027, Ticker: CVNA)
• Electricité de France (ISIN: FR0010242511, Ticker: EDF)
• Bad Bath and Beyond (ISIN: US0758961009, Ticker: BBBY)
• Peloton Interactive (ISIN: US70614W1009, Ticker: PTON)

Let’s start with Carvana, the online auto dealer. During the 2020 and 2021 boom being a darling, now the share price is in the single digits, after the never profitable company started to face waning demand as well as refinancing risks:

Carvana has 7.4 bn. USD in net debt on its balance sheet. That is 9x its current equity value without generating positive cash flow. Short-term borrowings to be refinanced in under one year are already nearly 600 mn. USD or two thirds of its market cap. Rising fresh equity to cover this obligation would hurt investors massively.

Electricité de France, or in short EdF, is a different basket case and not so much followed. However, as I was looking last year over its numbers, I had a pretty bad feeling about arising challenges.

In short, EdF is the operator of the French nuclear reactors. It is not allowed to freely set market prices for electricity. This led to ever ballooning debt in a capital intensive and cash flow negative business. A few months ago during summer, the takeover by the government was announced.

Why? Hmm…

The stock jumped by nearly 50%.

The current market cap stands at 44 bn. EUR. Before the bid, it was less than 30 bn. EUR. Free cash flow was a negative 7.6 bn. EUR over the last twelve months. Going back even ten years, there was not a single year with a positive FCF.

A perpetual cash-burning machine.

A more recent example is Bad Bath & Beyond which isn’t even officially excluding bankruptcy, anymore.

The retailer had a net cash position ten years ago and healthy margins for a retailer. Now, net debt is 3.4 bn. USD, the market cap less than 200 mn. USD. In 2019 margins started to tank and cash flows went even negative recently. Since its fiscal year 2020, operating income is negative. At the same time, share repurchases – for cosmetic reasons – increased massively. How was that financed? With debt.

The last one of this first group is Peloton Interactive which hasn’t been ever profitable.

For a long time, PTON didn’t have debt, but financed its operations with equity raises. The share count increased by 50% since its IPO. Recently, the company also issued debt which now is 1.5 bn. USD. A big part of it is a convertible loan which could dilute shareholders. The business is also burning cash and recently even started to face growth challenges. Not a good sign…

Now, let’s have a look at some more companies where shareholders very likely will get hurt and where even realistically the whole businesses could face bankruptcy over the next years.

The first is Northwest Healthcare Properties (ISIN: CA6674951059, Ticker: NWH), a Canadian REIT that buys and leases medical facilities and pays monthly dividends. Big parts of the operating cash flow (before investments) already is used for the dividend.

Its aggressive acquisitions were financed by a mix of equity issuance and debt. The problem is it went too far. Over the last seven years, the share count went up nearly 5x while revenues only increased by 1.5x. Net debt stands at 3.4 bn. CAD which is 50% higher than the equity value.

With its most recent numbers as per Q3 2022, the interest coverage ratio – typically measured by EBITDA / interest payments at REITs – was only slightly a smidgen above 2x.

Now comes the really interesting stuff. In 2023 alone, around a third of NWHs debt is due for refinancing. This alone will be interesting. Another thing is that two thirds (yes, 2/3) of total debt a financed with variable interest rates. This will be very interesting, to say the least.

Number two, is MicroStrategy (ISIN: US5949724083, Ticker: MSTR) which I already rote a whole article about (see here).

Except that Bitcoin prices have dropped further and MSTR bought some more of them, nothing has changed – at least not for the better, because MSTR announced an equity raise program that will increase share count by 20%, if fully applied. Of course, this amount is high already, but it will not even be close to enough to deleverage their balance sheet.

The third company in danger is Unibail-Rodamco Westfield (ISIN: FR0013326246, Ticker: URW), a French owner of shopping malls and some offices in Europe, Australia and the USA. Europe is the key market, especially France.

URW also went on a shopping spree and bought properties for debt. Share count didn’t even increase that much, but net debt of 25 bn. EUR stands against an equity value of currently only 7.5 bn. EUR. Net debt to EBITDA (cash flow proxy) stands at nearly 18x. In Comparison to operating cash flow, the multiple is 12.5x.

In the last years, URW wanted to raise fresh equity, but shareholders voted against it and the dividend was cut for at least three years (see here and here). A REIT without dividends gives no reason to own it.

The only two slightly positive things for URW are that due to Europe’s crazy negative interest rates policy in the past, the company could secure financing for absurdly cheap conditions at fixed rates and it luckily stretched it over many years.

However, even under these circumstances, the interest coverage ratio to EBITDA is only 2.1x. I cannot imagine refinancing not to be linked to double or triple as high interest rates.

Closing the group is Bausch Health (ISIN: CA0717341071, Ticker: BHC) which I also wrote about, because it was a silly mistake in my personal portfolio last year (see here).

The 2.3 bn. market cap company with a PE of under 3x (remember that PE says nothing about debt?) has a debt load of 20.7 bn. USD. Operating cash flow was negative over the last twelve months due to some legal disputes.

But even without that, FCF cannot reach even 2 bn. USD which alone would be a 10x net debt to FCF multiple.

Interest coverage is just around one. In some years above, in others below. But new financing is more expensive. I am not sure this company makes it, especially as its spin-off plans are not working out as expected.

Conclusion

First serious research about zombie companies started with the example of the “lost decade” of Japan where factually dead companies were artificially kept alive.

I showed you what to look for at the minimum to get a feeling for the financial health of a company. Look at overall business developments, net debt to free cash flow, the interest coverage ratio and the structure of the debt.

In the final section, I showed you some zombie companies and went through some figures to stress my points.

In my research reports, exclusively for my Premium Members, I always look for sound financials and cheap valuations.

The last company I presented to my members:
– has a net cash position of more than 10% of its market cap
– is expected to pay a dividend with a 20% yield
– could buy back 10–15% of its stock – just in 2023
– has a low single digit FCF multiple

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