Could you hold onto ‘zombie’ ASX stocks in hopes of new life?
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There will likely be a corporate apocalypse if we head into a deep economic recession, as some experts predict. And ASX stocks are in the firing line.
It’s an appropriate valuation for some entities already operating as so-called “zombie corporations” – companies whose operating profits are consistently below their cost of debt.
Recent data suggests that a good portion of global equities are backed by companies that meet this criterion. Could you hold any of these names?
Capital structure matters
The percentage of debt and equity that make up a company’s assets and liabilities is known as its capital structure.
Generally, companies can raise funds in two ways: through equity, ie by issuing shares; or through debt issuance.
Debt bears interest in addition to principal repayments. Whatever the route to seed capital, it is spent to create an asset that will generate future economic benefits to repay debt.
The managing director of the Institute of International Finance, Sonja Gibbs, noted on Bloomberg that global debt levels had “skyrocketed” over the past 10 to 15 years, boosted by historically low interest rates.
Add to that record raw material prices and input costs, and it has created a situation where many companies must continue to borrow to stay solvent.
What we mean by zombie companies is a company that essentially has to borrow to keep running. They are very indebted, do not grow very quickly and their income is not up to par.
You [a company] don’t earn enough income to cover your debt costs and stay solvent.
During this time, the The OECD defines a zombie company such as a business over 10 years old that has an interest coverage ratio of less than one for three consecutive years.
In a nutshell, a zombie business is unable to repay the cost of its debt and maintain its operations at the same time without having to borrow again.
That’s a no-no because, as mentioned, raising capital [debt, leverage] must be used to create additional economic value, not simply to get away with it.
Are we in zombie land?
We checked the companies within the ASX 200 to see which names might fit the defined criteria. On a simple stock screen, five ASX 200 companies have an interest coverage ratio (earnings before interest and taxes [EBIT] divided by interest expense) less than one.
They are Block Inc CDI (ASX: SQ2), 5E Advanced Materials Inc (ASX: 5EA), Meridian Energy Ltd (ASX: MEZ), Auckland International Airport Ltd (ASX: AIA) and Origin Energy Ltd. (ASX:ORG).
Each of them except Block are in a capital-intensive business that has high fixed costs just to maintain operations.
When this criteria is opened up to the mid-cap space as well, the list grows to 27 names, including Australia’s flagship airline Qantas Airways Ltd (ASX: QAN).
And with all market capitalization levels included, there appear to be 955 publicly traded names with an interest coverage ratio of less than one.
As to how long these ASX stocks have been running and how long the ratio has been below one, we were unable to define in the stock screen. But it’s something to think about anyway.
However, it does present some interesting guesses, particularly with respect to what Sonja Gibbs said – that the corporate world is heavily in debt right now, and that’s a significant risk.
This sentiment was echoed by Christopher Joyce, portfolio manager at Coolabah Capital, in his column with The Australian Financial Review both in December last year and just last month.
With that in mind, interest rates are front and center for many equity investors right now, and absent any signs that the speed of rate hikes is slowing, we could very well be heading into zombie country.