SPCE - U.S. Zombie Firms With The Highest Potential Credit Risks
2023-03-15 12:22:49 ET
Summary
- The Federal Reserve commissioned a study in 2021 to evaluate, "How Many U.S. Zombie Firms and How Consequential?"
- In the wake of the largest banking collapses since 2008, this article evaluates which firms may most be at risk from a credit event.
- While there is no formal definition of a Zombie firm, this article reviews companies potentially at risk from the highest interest rates since 2008.
- In addition to Zombie measures used by the Federal Reserve study, additional forensic bankruptcy scores, debt ratios, and short floats are considered.
The U.S. Zombie Firms Study
In the wake of the Covid-19 pandemic, the Federal Reserve commissioned a study of Zombie firms to evaluate how many of these firms may "crowd out lending to productive firms and erode the strength of the U.S. economy."
A team of scholars evaluated the risks for the Federal Reserve and went about building a model to identify high-risk companies that are considered unable to generate enough profits to cover debt-servicing costs and must borrow to stay alive.
There is no formal definition of a zombie firm, but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets (Caballero, Hoshi, and Kashyap 2008). Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable. - (Favara, Minoiu, & Perez-Orive 2021).
A comprehensive list of more than 1,300 at risk stocks is available using the broader Federal Reserve measure from the study, but may be impractical for inclusion in this article. Many more zombie stocks are available to members of my investing community. In addition to the separate Federal Reserve study, I have applied forensic bankruptcy risk models by Altman and Ohlson to identify smaller sets of potential zombie firms. Many stocks that we may expect to be Zombie firms like research biotech companies with no revenues, may in fact not qualify to borrow and attain the required high debt levels. Instead many research firms rely almost exclusively on issuing shares to raise operational capital.
Methodology
Because there is no official standard to define a Zombie firm, scholars and analysts may have widely differing sets of high-risk firms. Rather than try to determine which model is best, I will provide a series of screens built on the Fed study parameters as well as long established forensic bankruptcy models from Altman (1968) and Ohlson (1980). We also want to consider which firms may be most at risk from the record high and rising interest rates. This requires a focus on firms with high debt levels, not just a focus on low profits at risk of not being able to cover debt-servicing costs.
The Federal Reserve study from Favara, Minoiu, & Perez-Orive, defined the parameters of a Zombie firm as:
We require that zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years. 4 High leverage and low ICR help identify firms that cannot cover their debt-servicing costs, while negative sales growth identifies firms with low growth prospects, as sales growth is a good predictor of firms' future performance.
In 2021 Goldman Sachs reported that some 13% of U.S.-listed companies “could be considered” zombies, which it called “firms that haven’t produced enough profit to service their debts.” The Federal Reserve study found that only roughly 10% of public firms were zombie companies in 2019. Finally, a Deutsche Bank study by Jim Reid in 2021 that found that over 25% of U.S. companies were zombies in 2020.
In my current screen for 2023 using Federal Reserve parameters I found that approximately 14% of public firms in the database met the standard, up from 10% in 2019.
Current Zombie Companies Based On Altman and Ohlson Bankruptcy Scores.
- The Ohlson model predicts bankruptcy risk using a multi-factor financial algorithm developed by Dr. James Ohlson in 1980. Any percentage values above 50% indicate the risk of a firm's bankruptcy within 2 years.
- The Altman model is used to predict whether a firm is likely to go into bankruptcy within 2 years and uses many variables from the income and balance sheets for this analysis. Distress is considered high with a value below 1.81.
The Debt Leverage ratio represents a company's ability to pay debt obligations from annualized EBITDA and all companies above a high 4x debt leverage ratio were included. Again keep in mind that companies unable to qualify to carry large debt levels may be zombie firms but would not be in this list.
Sorted by the highest negative Ohlson O-Score for probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These stocks also had to have a negative Altman score as well.
UncleStock
StockRover and Morningstar Grades
The stocks above are listed here with their associated scores in descending order by Financial Safety score.
Sorted by the highest negative Altman Z-score for probability of bankruptcy within 2 years with at least 4x debt leverage ratio. These stocks also had to have an adverse Ohlson score as well.
UncleStock
Stocks making the top 15 spots out of over 1,300 in both screens include:
USD Partners LP ( USDP ), HarborOne Bancorp, Inc. ( HONE ), Banc of California, Inc. ( BANC ), SB Financial Group, Inc. ( SBFG ), Dime Community Bancshares, Inc. ( DCOM ), First Financial Northwest, Inc. ( FFNW ), and Citizens Community Bancorp, Inc. ( CZWI ).
Current Zombie Companies Based On Federal Reserve parameters.
According to the Federal Reserve study:
"[A]mong publicly listed firms those in zombie status are smaller in size, have lower return on assets, hold less cash and have lower investment opportunities than their non-zombie counterparts."
The average size of a zombie firm is $374.6 million and has a negative -3.4 return on assets. The current list sorted in descending order from the worst interest coverage ratio is shown below:
UncleStock
StockRover and Morningstar Grades
The stocks above are listed here with their associated scores in descending order by Financial Safety score where available. Morningstar Profitability Grades also indicate the risk levels.
A few of the most at risk stocks in the screen include Culp, Inc. ( CULP ), trivago N.V. ( TRVG ), Royce Global Value Trust, Inc. ( RGT ), and Tri-Continental ( TY ).
Current Zombie Companies Based On Federal Reserve parameters and Forensic Algorithms.
Finally, the last screen uses a combination of the Federal Reserve parameters, and the forensic algorithms sorted along the Altman Z-score for bankruptcy risk. Selections are also limited to high debt leverage ratios for firms with over $1 billion market cap. Some of these names are familiar meme stocks like AMC Entertainment Holdings, Inc. ( AMC ) and Virgin Galactic Holdings, Inc. ( SPCE ) that also have very high short floats.
StockRover and Morningstar Grades
The stocks above are listed here with their associated scores in descending order by Financial Safety score where available. Morningstar Profitability Grades also indicate the risk levels.
Conclusion
These screens are intended to sort through over 1,300 high risk zombie companies with large exposure to rising interest rate risks. The data may have errors and companies are always finding new ways to improve their financial conditions that may not be reflected in these numbers.
You should continue to do your own due diligence in assessing which firms may be at risk. As I stated at the outset, there is no firm definition of a zombie company, but the Federal Reserve study asserts, "it is generally agreed that [zombie] firms are economically unviable and manage to survive by tapping banks and capital markets." (Caballero, Hoshi, and Kashyap 2008.)
I trust this research and stock selections will give you added value to your investment goals and returns in 2023!
JD Henning, PhD, MBA, CFE, CAMS
References
Altman, E. I. (1968). The Prediction of Corporate Bankruptcy: A Discriminant Analysis. The Journal of Finance, 23(1), 193–194. doi:10.1111/j.1540-6261.1968.tb03007.x
Caballero, Ricardo J., Hoshi, Takeo, and Kashyap, K. Anil. 2008. "Zombie lending and depressed restructuring in Japan." American Economic Review , 98(5): 1943-77.
Favara, Giovanni, Camelia Minoiu, and Ander Perez-Orive (2021). "U.S. Zombie Firms: How Many and How Consequential?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, July 30, 2021, U.S. Zombie Firms: How Many and How Consequential? .
Ohlson, J. A. (1980). Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research, 18(1), 109. doi:10.2307/2490395
For further details see:
U.S. Zombie Firms With The Highest Potential Credit Risks