How to Identify a Zombie Company

“Zombie” firms can surface in any economy but particularly when rising interest rates and economic headwinds encircle cash-strapped, indebted companies. When such conditions accelerate—as they certainly did in 2022–23—such companies’ lifeblood can drain, sending them staggering toward investors, the government, or the courts for any chance at survival.  

Zombie companies can surface in any industry—from banks to bed linens.

In April 2023, Bed Bath & Beyond (BBBYQ) filed for bankruptcy after the home goods store couldn’t generate enough revenue to cover expenses after a lackluster holiday season. Yet for anyone paying attention years before, monsters were already circling.

The one-time Fortune 500 company had operated more than 1,000 stores at its zenith, but it would fall behind major chains like Amazon and Walmart even with the ubiquitous couponing that became part of its brand. COVID-19’s retail disruption would follow, contributing to BBBYQ becoming one of the most-shorted Wall Street meme stocks by 2021.

As interest rates began to escalate in March 2022, BBBYQ had $5.2 billion in debt and only $4.4 billion in assets by November. By March 2023, an attempted $1 billion stock offering would pull in only $360 million; a second $300 million stock offering would bring in only $48.5 million. By its April court filing, the chain projected a final closing date for the end of June.

The point: Zombie companies are always around, but it takes significant economic stress to bring them out in dangerous numbers.

According to Viraj Desai, director, portfolio manager at TD Ameritrade Investment Management, LLC, “Zombie companies always exist. A zombie company is merely any firm that can’t produce enough profit to service its debt. Economic downturns simply make us more conscious of them.”

A 2022 Goldman Sachs study reported 13% of U.S. companies were zombies, typically high-growth, technology-based companies. Yet firms with everyday names and longer competitive histories like BBBYQ have also found themselves in zombie territory.

Here’s how investors can see zombies coming before they infect their portfolio.

How to identify a zombie company

Problematic debt is likely the leading zombie company indicator. And the past decade has created two historic near-zero interest rate policy (ZIRP) environments (see figure 1) for such troubled firms to flourish before they start to fail.

“Zombie companies can keep operating during periods of low interest rates because the cost of carry for their debt is so small,” Desai explained. “When business is good, cash flow can cover those borrowings. And a lot of companies got used to that in recent years.” 

When good debt goes bad

“Many business models rely on debt at different points in their lifecycle,” Desai explained. Young firms may borrow heavily as they establish their products and services, but some established firms do as well to fit industry-specific cyclical needs or on a short-term basis when economic conditions change.

Sometimes poorly executed business strategies can lead to more borrowing as well.

“Over time, a company with high debt, low demand for its product, or other potential management mistakes might have to borrow more. If the economy starts to slow substantially in a rising rate environment, that can leave a company with few options to rescue itself,” said Desai.

According to the Federal Reserve’s definition for zombie companies, each has:

• More leverage—or debt—than the average company in its sector.
• Declining sales and/or earnings over its most recent three years.
• An interest coverage ratio (ICR) below one.
  

A closer look at the interest coverage ratio (ICR)

The ICR is considered a key calculation that can help identify a zombie company. It describes how successfully a company can pay the interest on its outstanding debt based on revenues.

Here’s the interest coverage ratio formula: 

• ICR = EBIT ÷ Interest expense
• EBIT* (earnings before income and taxes) is a measure of a company’s operating profit.
• Interest expense represents the interest the company pays on bonds, loans, lines of credit, and any other borrowings.

*Investors may also choose to use EBITDA (earnings before interest, taxes, depreciation, and amortization) as a substitute for EBIT. Some believe it gives a better picture of a company’s cash flow.

There are ways companies can improve their ICR, but these solutions can become more limited and extreme if rate and economic conditions deteriorate. They include:

• Finding ways to generate more revenue
• Raising capital through a stock offering or through some form of outside investment or strategic partnership
• Selling assets to reduce or repay debt
• Refinancing (if possible)
• Securing a government bailout (if available)
• Filing for Chapter 11 bankruptcy reorganization

Recent numbers suggest the most extreme solution for companies facing zombie status may be on the rise. In March 2023, S&P Global Market Intelligence said U.S. corporate bankruptcy filings hit a 12-year high during the first two months of 2023.

Can zombie companies survive—and possibly thrive?

It’s pretty tough, but it can be done. As of May 2023, Apple (AAPL) is the largest company in the world by market capitalization and is a global, cash-rich technology leader with established products.

But Apple was once on the verge of bankruptcy.

By the late 1980s, Apple had ousted early management as competition grew from rivals like Microsoft (MSFT) and IBM (IBM). Though there were other operational issues tied to the company’s fortunes at that time, Apple significantly didn’t license its software back then, a reasonably clear competitive disadvantage. By early 1996, the strategic consequences were clear. Standard & Poor’s and Moody’s downgraded Apple’s bonds to junk status, and by 1997, the company laid off about 30% of its workforce.

Poor strategy almost put Apple in a zombie state.

What saved Apple? A rival-turned-investor. Microsoft invested $150 million in Apple in August 1997 and agreed to a broad patent cross-licensing agreement to support each other’s businesses. Without that investment, Apple may not have survived.

The Bank for International Settlements (BIS) reported about 60% of zombie firms have recovered since the mid-1980s. But BIS added that when compared to companies that never reached that brink, ex-zombies were three times more likely to relapse.

A key weapon in the fight against zombie companies (Hint: It begins with a ‘d’)

That would be ‘d’ for diversification. Specifically, owning cash-rich companies may be the best protection when zombies start to rise.

Said Desai, “The more you diversify your holdings, the less concentrated in any one company you are. If you have a zombie within your portfolio, and it comes under stress, building a well-diversified portfolio should reduce the likelihood for widespread permanent loss of capital.”

How to get there? Consider:

• What healthy cash flow really means: The adage “cash is king” holds true any time you invest, but when zombies turn up in the markets, companies with solid cash flows and reserves will be in a better position to withstand an economic slowdown or impact from higher rates. Companies with cash can generally resist debt, safely cover expenses, and potentially invest more in products and services that can allow it to move ahead of any weaker competitor, zombie or not (see figure 2).

• Sector health: As you look to invest, consider sector risk. For example, commercial real estate (CRE) companies—and the lenders that serve them—fell under significant pressure as rates rose through 2023. Such companies typically refinance mortgages on their holdings every five to 10 years to satisfy balloon payments. (Commercial mortgages often have balloon payments to keep short-term costs lower so borrowers can allocate future earnings to finance that balloon payment.) That’s easier in healthy markets when commercial property can find tenants—but the COVID-19 pandemic reset that story.
  
  As workers went remote in 2020, CRE companies saw cash flow suffer as properties went unleased. And then as rates started to rise, loan underwriting standards began to tighten and interest costs on adjustable-rate loans began to increase—all the makings for a zombie environment.

• Moat size: Moats have the potential to protect companies—and investors—from attack. In investment terms, a company’s moat may be related to economies of scale or a leading, diverse product line or a service network that’s tough for any competitor to beat. Companies with wide moats often have strong earnings and significant cash reserves, which is another way of saying they’re cash-rich.

Finally, to learn more about zombie companies—or firms most likely to join their ranks—follow the news. In tough economies with rising rate environments, you’ll see certain types of firms make the headlines. Even if the news is bad, it’s a valuable opportunity to learn more about their fundamentals.