Sustaining the unsustainable is now an inflection point for an economy hell-bent on saving jobs.
At a glance
- One in seven ASX-listed companies trades in “zombie” territory, where there is very low capacity to service debt and a high likelihood of going bust.
- In “normal” circumstances, stimulus initiatives would not be enough to save these companies, but current government provisions have been a lifeline.
- While the endgame is to stem unemployment, analysts are concerned that certain initiatives to prop up struggling companies could cause further problems in the long term.
It can be argued that a healthy ratio of earnings before interest and tax (EBIT) to interest expenses is to a company what a heartbeat is to a human being.
When this ratio falls to below one, but the company continues to operate, the company is thought of as walking dead – a zombie – according to BIS Oxford Economics. The lower the ratio is below one, the greater the likelihood of the company going bust.
According to a November 2019 report by KPMG Australia (Distance to Default: A Default Indicator for Australian-listed Companies Vol. 6), about one in seven ASX-listed companies is trading in zombie territory.
Amid the economic slowdown and prolonged revenue uncertainty that has prompted the Australian Government’s rollout of the JobKeeper scheme, this number is likely to have risen.
In addition to being laden with debt, the other attributes that such zombie companies share include high share price volatility, rapidly declining market value and negative cash flow, which make them vulnerable to external shocks.
In a normal trading environment, neither historically low interest rates nor capital injections by long suffering shareholders would be able to save zombie companies from the knock-out blow to revenue and income caused by the COVID-19 shutdown.
However, rather than landing the final blow, leaving them to either collapse or enter administration, Australian Government-led provisions to help businesses navigate their way through, plus a light touch approach by the Australian Taxation Office (ATO), have inadvertently thrown zombie companies a life line.
Out with the rule book
There is significant pressure from the federal government on banks to join their efforts to backstop companies during these challenging economic times. That means offering credit to businesses that normally wouldn’t qualify.
In many ways, the rule book has had to be thrown out the window, just as it was during the global financial crisis (GFC).
Observing this response, Nathan Bell, analyst with InvestSMART, comments that the government’s message to banks appears to be, “don’t let them collapse, even if it means extending credit to companies against your better judgement”.
One recent example is National Australia Bank’s decision to waive its covenant breaches and offer a bridging loan to distressed dental group Smiles Inclusive, despite 16 dentists terminating their service agreements on insolvency grounds. It is questionable loans like these that are forcing Australia’s four largest banks to raise their provisions (estimated at about A$20 billion) for loans going bad, with the bulk expected to come from the education, tourism and commercial property sectors.
"While it's clearly within a Government's playbook to save as many jobs as possible, they're prepetuating old business models and creating a debt noose that will still be there in five years." Martin North, Digital Financial Analytics
The end game, Bell says, is to staunch unemployment, which some economists fear could rise above 10 per cent. “In addition to having a highly indebted consumer sector, it’s become politically acceptable to have a highly indebted government balance sheet, with taxpayers now sustaining highly unsustainable businesses,” Bell says. “Unlike during the GFC, when credit lines were instantly cut, the government wants banks to continue lending and spread bad debts over three-plus years.”
SME companies – good, bad or otherwise – are also benefiting from mandatory codes of conduct (rent relief), which require landlords to share the pain of declining revenue with tenants. As a result, companies can expect future leases to be a lot cheaper.
Also artificially propping up some companies is the temporary exemption for directors trading while insolvent. In addition to pushing more companies further into zombie territory, Martin North, principal of Digital Financial Analytics, fears this provision may encourage some overly aggressive directors to take even greater risks, believing their own necks aren’t on the line.
Broader economic impacts
In the meantime, Bell says the great unknown is whether remedies to help low-growth, high-debt and poorly managed businesses will do little more than kick the can down the road and result in the extinction of these companies further down the line, while increasing the chance of more companies falling victim to the same fate.
Admittedly, while listed zombie companies only represent an estimated 0.25 per cent of total (share) market value, Bell says it’s important to recognise their negative impact on the overall performance of an economy.
Research by the Organisation for Economic Co-operation and Development (OECD) reveals that zombies hamper productivity growth, diverting credit, investment and skills from flowing to more productive and successful firms. They also decelerate the diffusion of best practices and new technologies across an economy.
In Australia, zombie companies are estimated to hold A$5 billion in shareholders’ capital. In a perfect world, Bell says, this capital should be reinvested more effectively elsewhere in the market.
“At the company level, uncompetitive zombie companies can negatively impact pricing power, reduce return on equity, and lower market valuations of otherwise healthy companies,” Bell says.
With SMEs having virtually been granted the licence to enter zombie territory courtesy of the exemption for directors trading while insolvent, North suggests companies take greater stock of who they are trading with. Within an environment where the need to act responsibly is removed, he warns against taking rating agencies at face value.
Whether they’re saving jobs or not, Bell says current stimulus provisions are perpetuating business models that are no longer fit for purpose.
Instead of being myopic about their direct interactions, now’s the time, suggests North, for SMEs to assess their entire value chain for pressure points. He also urges companies to ask the right questions and build risk scenarios across the value chain. “Instead of propping up unsustainable companies, we should look at the quality of the jobs being saved,” North advises.
“While it’s clearly within a government’s playbook to save as many jobs as possible, they’re perpetuating old business models, and creating a debt noose that will still be there in five years.”