The recent surge in so-called zombie companies seems haunting, but concerns might be overblown.
A zombie company is one that expects its operating income to come in below its interest expense for a given time period. Since it is unprofitable, the company relies on capital markets to stay afloat. Healthy companies, on the other hand, have operating income that far surpasses their interest expense.
The number of zombie companies has exploded because of Covid-19s economic impact. Before the pandemic, there were about 400 zombie companies out of a pool of 3,000 large U.S. public companies screened by Bloomberg. The total has since risen 50% to hit 600 companiesone-fifth of the 3,000 screened companies overall. And some recent additions to the group are household names like Marriott International and Carnival. With $1.36 trillion of total debt now, U.S. zombie companies have increased their total debt levels by almost 280% since before the pandemic, according to Bloomberg.
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The issue of zombies companies isnt new, however. The International Monetary Fund, in a report cited by Yardeni Research, feared in October 2019 that zombie companies debt could soon rise to $19 trillion, or 40% of all corporate debt in major economies. The percentage of all global public companies that are zombies has risen to almost 16% currently from 4% in 1980, according to DataTrek Research. The firm says that 85% of zombie companies globally will remain in the category a year from now, compared with 75% in 2015.
Investors are generally worried, and for good reason. The pandemic put the U.S. economy in a recession earlier this year, decimating the most economically-sensitive companies. It has made it incredibly challenging for travel- and consumer-focused companiesincluding cruise lines, airlines, restaurants, and hotelsto do business because of social distancing and infection risks, turning many of them into zombies.
Seated dining in the U.S., for instance, is still at roughly 40% below pre-pandemic levels, according to Citigroup data, while airlines are still seeing roughly 60% less air traffic than pre-pandemic levels.
While the S&P 500 has already surpassed its pre-pandemic record high, many zombie stocks are still struggling. Carnival is still 66% below its 2020 high, and its average analyst price target is $16, more than 5% below its current level. Marriott International is 20% below its 2020 high, while United Airlines Holdings (UAL) is 55% below.
However, some of the companies turned into zombies by the pandemicparticularly travel and restaurant stocksshould come back to life as a vaccine helps the world move past Covid-19.
Earnings are expected to see a sharp rebound in the next one to two years, which would allow some current zombie companies to be able to cover their interest expense and become healthy again. That would mean their interest coverage ratiotheir operating income divided by their interest expensewould return to above one. (Healthy companies typically have operating income that is multiple times the size of their interest expense.)
Marriott, for example, is estimated to post a net loss for 2020, but an operating profit of $394 million, according to FactSet. With a 2020 interest expense of roughly $450 million, the interest coverage ratio would be 0.87meaning the companys earnings are insufficient for servicing its debt. But as vaccines seem likely to emerge and consumer and labor market data drastically improve from the pandemic doldrums, analysts are looking for a 2021 operating profit of $1.4 billion. If interest expenses remain roughly the same, Marriotts interest coverage ratio would move to 3.2 times.
Until people go back to cruising and flying, these most Covid-19-sensitive companies may have to tap the capital markets againmade easier by the Federal Reserves ultralow interest rates. Zombies refinancing debt at record-low interest rates get to live to die another day, analysts at Yardeni Research wrote.
So wouldnt these dynamics make some of these battered stocks a good pick? The worlds emergence out of the pandemic will reduce the zombie count after all, but just because a company isnt a zombie anymore doesnt automatically make it a good long-term bet. So investors could have fun picking stocks, but they might not want to hold on to them for too long.
The lesson for value investors: Zombies dont tend to fully recover, so while deep cyclical stocks should work fine just remember they are more trade than investment, DataTrek said.
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More Zombie Companies Have Cropped Up During the Pandemic - Barron's
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