Spotting Zombies

There have been a few articles in The Economist lately about so-called Zombie companies. They refer to businesses which are kept alive on some form of life support system, but which are doomed to die. It is generally healthy that such firms are killed off quickly, so that subsidies are not wasted and so the staff can start the task of finding other jobs in more productive enterprises.

 

One of the disadvantages of furlough schemes is that they can freeze this healthy churn in economies by keeping Zombies alive. If these dying firms had to pay their staff they would go under, and they will have to give up once the furlough is ended, it is healthier that this happen sooner rather than later. Compared with Europe, the US has followed a balance of supporting its economy by paying citizens more than firms, and The Economist credits this for allowing fewer Zombies and a faster resumption of growth.

 

There seems to me to be some merit in this argument, although there must be many other factors involved in selecting the best policy, for example targeting the most needy, speed and avoiding abuse. Furloughs were lauded in the early weeks of the pandemic for being efficient in all these areas.

 

The concept of Zombie firms made me wonder just how many firms might be considered Zombies, even in normal times, and how to spot them. I can argue that I’ve worked in a few Zombie firms in my time and that large chunks of economies might be classed that way.

 

There are various ways to grow profits in businesses. The purest are to put new or improved products into the market in order to acquire new customers or earn more from existing customers. Firms can also grow revenue by charging more for existing products from existing customers. There are also many ways to reduce costs or to alter cash flow profiles by managing working capital or investment.

 

Growth is more imperative than it used to be, at least in publicly traded companies, because investors today demand a consistent high return on capital. The other important trend is the radical lowering of prevailing interest rates. This makes the future relatively more important than the present. With a 10% discount rate, the first ten years or so dominate a net present value calculation, but with a 5% rate, projections out to twenty-five years or more are relevant. In a high discount rate world, firms with legacy assets can squeeze the lemon for a long time to eke out an attractive value, via costs or incremental revenue gains. In a low discount rate world, it is hard to create a competitive value profile without pure growth. Mature sectors facing demographic headwinds are especially vulnerable.

 

This is the essence of there being so many Zombies now. Pure growth is hard to come by, especially with Amazon and China hovering up most of what is available. So firms have to resort to more and more desperate measures to be able to project a cash flow profile that keeps investors invested. These firms can be argued as disguising their death spiral, or Zombies.

 

 There are many Zombie survival moves available, even when governments aren’t distributing pandemic subsidies. My favourites are the retail ones, because that is my background. When marketing becomes all about promotion, it is a total giveaway. Look out for retailers who rely more and more on stamps and offers. These are the last resort to hold on to existing customers and to drag extra sales from them, even low margin sales, in order to bolster the short-term and delay defections. In the US, Marshalls, Bed Bath and Beyond and JC Penney are examples. Once a retailer has started down this road, there is no escape.

 

Linked to this are heavy promotional advertisers and channel stuffers. Why to car companies throw so much money down the toilet on TV adverts? It is because it is all they have. It brings sales forwards from existing customers, and stuffs their dealers with stock, but it is a slow death spiral. Financing plans fall into the same category.

 

Then there are business model tricks, much beloved by private equity. Moving from direct operation to franchises and then brand licenses effectively sells future upsides and dilutes brand value, but does generate cash. Lease and lease back deals on property are similar. Selling off parts of a portfolio does the same, as does restructuring pensions. This sort of financial and business model engineering nearly always spells doom next times there is a downturn.

 

Outsourcing, offshoring and cost cutting are at least more structural than the tricks above, but the problem is that they are one-off tricks. They can boost profitability for a while, but reduce upside and tend to lose impact once competitors have copied. These are a staple of private equity too: look at ABInBev, and its recent struggles now the playbook is becoming exhausted.

 

Other cost cutting is even more insidious. Zombie firms will often reduce R&D and defer maintenance investments. It can be argues that the entire US economy can be classified as this sort of zombie – just look at the state of the infrastructure. Share buy backs are a good acid test of this type of activity.

 

Other tricks involve mergers and regulation. A Zombie industry can extend its life by firms buying each other out and milking margins for a time. This can work even longer if the sector has barriers to entry or regulatory advantages. US pharmacies are good examples. One acid test is to compare prices with those in other markets. In the US, pharmacies telecoms and realtors have pulled these tricks for a long time, but Amazon and others will ensure an eventual comeuppance.

 

This is an extensive playbook. In the days of lazy investors and competitors, high interest rates, possible windfalls and one-off opportunities, firms could survive more or less forever using these moves. They can still last a long time. Banks hate bad debts and have a bias to existing clients, so they will keep lending long past the time they should. Passive investors stay in the game too long too, especially when dividends are high and when a stock lingers in an index (so must be retained by tracking investors).

 

I looked at the thirty firms currently in the Dow Jones index, and I think as many as half might be zombies if I am a tough judge. The department stores, car companies and industrial generalists like GE departed the Dow a while ago. But where do you see true growth in Boeing, or Caterpillar, IBM, Exxon, Dow Chemical, Amex or Walgreens? I can argue that even P&G, Coke, Nike or MacDonald’s might be vulnerable to Zombiefication in the medium term. Verizon and Disney have some strengths but are in dangerous sectors. Outside of healthcare and technology, there might be zombies everywhere.

 

The other side of this coin are the winners, notably Amazon. Zombies are perfect for winners. They prop up sector prices and margins and can be picked off gradually without ever posing any sort of threat. Facebook and Google will also hoover up the excessive desperation advertising of Zombie sectors for many years yet. There are also Chinese upstarts in many sectors that will be salivating at the prospects for taking business in the west, without having to resort to state subsidies or intellectual property theft.