Zombie Companies: How can you identify them & avoid them like the plague?

Are you invested in zombie companies? You could well be without even knowing it and you need to get out if this is the case.

But what are zombie companies and how do you know if you’re invested in one?

What are Zombie companies?

Zombie companies are firms with core operations that are insolvent, but continue to operate with the help of lenders and creditors. In other words, companies that are able to stay afloat because they have enough cash, but they only have enough cash due to sources of capital other than from their core operations. This unsustainable business model is harmful for the company, their investors and even the economy as a whole.

For the economy, zombie companies can lead to reduced productivity, increased unemployment, and overall economic instability. For investors and other stakeholders, the worst part is that they will not realise they are invested in a zombie company and they stay in them. But eventually, things all fall apart and investors lose their money.

So how can you identify them?

4 key ways to spot zombie companies

Identifying zombie companies can be a challenging task, as they often appear to be functioning like any other company on a stock exchange like the ASX. However, there are some key indicators that can help identify these struggling firms. These include:

1. High levels of debt: Debt is not a problem in and of itself, but zombie companies typically have a high level of debt relative to their revenue and assets. This can be a red flag as it indicates that the company may not be generating enough income to cover its financial obligations and could soon be pursued by creditors. If they don’t have the money, things won’t end well.

2. Low or no profitability: Another sign of a zombie company is low profitability or negative earnings. This means that even though the company may be generating revenue, it is not making enough profit to sustain itself in the long term. The ASX automatically asks any company with less than 2 quarters worth of cash left if it expects things to change – either by raising capital or cutting cash burn.

3. Delayed payments: Zombie companies may also have a history of delaying payments to suppliers, employees, or other creditors. This can be a sign that the company is struggling to manage its cash flow and meet its financial obligations. Now, it can be hard to tell if listed stocks are delaying payments, it is not as if the bulk of them give a running commentary on their day to day operations. However, if they have to refinance a debt facility to longer terms, that can be a telling sign.

4. Lack of investment/R&D expenditure: Companies that are considered zombies often have limited investments in new projects or technologies. This lack of investment can hinder their growth potential and make them less competitive in the market, especially if they’re in a fast-moving industry like tech.

The extra indicator during COVID

During COVID, the JobKeeper scheme enabled plenty of these companies to survive long than they otherwise would have.

One example was Wellness & Beauty Solutions. This company was struggling even prior the pandemic, constantly bleeding cash without any sense of direction. Then it entered administration in March 2021, just 2 days after JobKeeper ended. Coincidence?

Keep in mind its clinics closed for some time during the pandemic, it had been suspended for 2 months prior pending ‘funding agreements’ and we again remind you it was bleeding cash. Of course, it is easy to say it was zombie company in hindsight, but it is much harder to spot them before they die.

Zombies still exist so watch out for them

The AFR estimated last year that up to 15% of all companies are zombie companies and this was up from 4-5% a decade ago. A decade or so of lower interest rates enabled companies to acquire cheaper finance. But the chickens are coming home to roost now that interest rates are higher and likely to stay so. Forget about near 0% interest rates coming back anytime soon.

The great investor Paul Samuelson once said,’ Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas’. In our view, zombie problems wouldn’t be as much of a problem as they were if investors took that piece of advice.

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