To understand the horns of the dilemma on which the Federal Reserve’s Open Market Committee finds itself in responding to inflation, I wanted to turn to a subject that I do not think is receiving sufficient attention: zombie companies. Simply defined, a “zombie company” is a company for which the interest payments on its corporate debt exceeds its revenue. The only way it can survive is by borrowing more.
How significant a problem is this? Extremely. Since 1980 the percent of zombie companies was 4%. Now it’s nearly 20%. And we’re not talking about “mom and pop” operations or just a couple of sectors:
From Bloomberg:
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. Almost a quarter of the index, or 739 companies, haven’t earned enough to meet their interest payments. That compares with 513 firms at the end of last year. The $1.98 trillion they collectively now owe dwarfs the $1.05 trillion of debt zombie firms reported before the pandemic laid waste to balance sheets. Boeing has seen its total obligations balloon by more than $32 billion this year, while Carnival’s debt burden has increased $14.8 billion, Delta has added $24.2 billion, Exxon $16.2 billion and Macy’s $1.2 billion, according to data compiled by Bloomberg.
See also here. These “zombie companies” include all four major airlines, Boeing, and Exxon-Mobil.
What’s the relation between inflation and these zombie companies? They’re highly dependent on ultra-low interest rates and interest rates are the Fed’s main tool for countering inflation.
If interest rates are raised some of them will be unable to raise enough additional borrowing to cover the increased interest payments.
I agree on the larger point — but the study seems off to me.
What sticks out is citing Exxon as a zombie company. In 2021; the company had free cash flow of $24 billion dollars. Yes, it had negative cash flow of -$2.5 billion in 2020 — but no one thinks the world will do a 3 month lockdown again. Positive free cash flow, positive earnings along with tangible assets like oil fields, equipment, would argue its very much not a zombie company.
Actually the relationship between zombie companies and inflation is symbiotic. Inflation messes with the market signal of prices (all stemming from the root one, the price of money). Resource allocation using market prices breaks down — creating zombie companies. The zombie companies drain resources that could be used more efficiently elsewhere, reducing aggregate supply in the economy. Which induces more inflation….
which is why the inevitable demands for bailouts will be so wrong-headed.
“What’s the relation between inflation and these zombie companies? They’re highly dependent on ultra-low interest rates and interest rates are the Fed’s main tool for countering inflation.”
https://www.federalreserve.gov/econres/notes/feds-notes/us-zombie-firms-how-many-and-how-consequential-20210730.htm
Pricing power, industry cycle effects, longer term secular trends and company stage of life/future prospects are all more important than a couple basis points in interest rates.
Just pencil to paper: $10 in revenue and 8% op-mgn means $.8 OP. If zombie means $.9 in interest, then debt at a 6% rate is .9/.06 = $15 in debt, a very high lvg ratio of 18x BTW. (An LBO might be 4-7x, which speaks to a transitory situation.) But you get to 1 to 1 interest coverage with a 2 % increase in rates and a price increase of 4%, respectively.
The Fed paper is better, but Bloomberg has to sell ad space……………
https://www.bloomberg.com/news/articles/2021-12-28/zombie-company-scorecard-declines-despite-inflation-covid-bites
The takeaway by the Fed paper authors is different than yours.
“Main Takeaways
In this note, we provide a panoramic view of the prevalence of zombie firms in the U.S. economy. Our main assessment is that zombie firms—defined as nonviable firms with low growth prospects that survive on cheap credit—are not an important feature of the U.S. economy, so far, and did not benefit disproportionally from the improvement in credit market conditions resulting from the unprecedented fiscal and monetary support following the outbreak of the COVID-19 pandemic.
Despite this assessment, it is too early to dismiss concerns that the current economic conditions may be breeding new zombie firms. The COVID-19 pandemic is an economic shock of unprecedented magnitude, and while its potential scarring effects on the economy are difficult to predict, it may severely damage some sectors of the economy, turning many firms into zombies. Whether this risk materializes can only be assessed as new data become available and will depend on the strength of the economic recovery post pandemic.”
Steve
Consider a simple question, steve. What would happen if American, United, Delta, and Southwest all defaulted? I think that not only outcome but the run-on effects from the likely policy response would be serious. Maybe the Fed thinks differently.
Also note the difference in meaning between “may” and “will”. I’m just pointing out that there are serious risks in the present situation not predicting a collapse.
I continue to have a strong sense of epistemological humility on this topic. In my view, we are in uncharted territory, so I’m skeptical of anyone making confident judgments about what will happen, particularly if they happen to be part of the pundit class (And that’s not a criticism of you, Dave, or this post – which is an important topic to consider).
As far as I’m aware, the US has never had the strange combinations of economic conditions that we currently have. And since so much of macroeconomics is really about the effects of aggregate public perceptions, I’m skeptical that anyone knows for sure where this is headed.
CO first hit the essential point. But I think others are losing sight.
No one wants an increase in costs, be they financing or operating. However, the point of the Fed study is that this phenomenon is longstanding, not pervasive and not remarkably different today than in the past. Further, as CO pointed out (and then me) the real issue is where is your operating income going (or, really, EBITDA if you contemplate curtailing capex), not your interest costs, especially if your op inc is affected by transitory issues. And that means that your industry, competitive or operating environment dwarf interest rate considerations.
For example, we have a company that serves mil and commercial aero. 2020 was a disaster for obvious reasons. The lender invoked a very standard 2% default penalty rate, far in excess of current Fed Reserve rate increase contemplations. No one on the board is talking about interest expense. Its all about how to move the op prof line, or how the op prof line will move simply through the passage of time, as I tried to show in the numerical.
The Fed really has a totally different consideration, especially the contagion one alluded to by Dave. The so called zombie company’s op profs will do what they do, depending on pricing policy, cost cutting etc. But the consumer has very little ability to alter its real purchasing power. Savings have been drawn down, and consumer credit costs are increasing. Financing of home mortgages and big ticket consumer durables will be affected.
Screw the zombie companies, where is consumer behavior going?
As I have been saying, we are in a box. Living on reds, Vitamin C and cocaine – oh, wait, that’s Sweet Jane – living on easy credit has finally let the inflation genie out. To fix it might mean 1980-1982 all over again.