Pandemic leads to the rise of the zombies

The strength of the recovery in the economy has taken many people by surprise. The UK is on course to post its fastest annual economic growth since World War II as it rebounds from the lows of early 2020.

However, look beneath the surface and lots of UK companies bear the scars of a year when businesses were forced to shut and sales dried to a trickle. Companies took on considerable debts to keep their businesses ticking over during the lockdown. While for some that proved an abundance of caution, for others it’s a burden that will hang around their necks for years to come.

Enter the zombie company.

What is a zombie company?

A zombie company is a business which is able to pay the interest on its debt but has no possibility of repaying the principle without turning to shareholders for extra cash.

More technically: a zombie company might have positive operating profit, with sales greater than costs like wages and inventory, but all of that profit is absorbed paying the interest of its debt pile.

As you can see from the graph below, the number of zombie companies, as measured by companies whose interest expense is equal to or greater than operating profit, rose substantially in 2020. In fact, in 2020 over a quarter of companies in the FTSE 350 index (excluding investment trusts) were officially in the zombie zone according to data from Refinitiv.

Number of current FTSE 350 companies in the zombie zone

Source: Refinitiv, 02/06/21.

What makes a zombie company?

The dramatic increase in the number of companies that meet the zombie definition reflects the increase in FTSE 350 companies reporting an operating loss in 2020, up from 25 in 2019 to 63 in 2020. Unsurprisingly those names are clustered in the sectors hit hardest by the pandemic.

Energy and Travel & Leisure companies made up nearly 30% of all zombie companies in 2020 – far more than their share of the wider index would imply.

Zombie companies by sector against the FTSE 350 index (%)

Scroll across to see the full chart.

Source: Refinitiv, 02/06/21.

Both sectors have had an abnormally terrible year and managers and investors will be hoping they enjoy a rebound in 2021, although there are no guarantees. With share prices in the worst affected industries still well below where they started 2020, that could tempt investors into some zombie stocks. But should it?

Should zombies be avoided?

The challenge a zombie company faces is that it lacks the cash to invest in future growth. Significant debts and no way to build up spare cash can also leave superficially healthy companies very vulnerable to unpleasant surprises.

Put those two things together and a company stuck in the zombie zone for any length of time will struggle to turn itself around without either a dramatic change of market conditions or turning to investors for extra cash. Hoping for a shift in market conditions is risky, and the latter is potentially painful – as new shares are issued at lower prices which then dilutes existing shareholdings, meaning they own a smaller proportion of the company overall.

Investors also shouldn’t assume companies hit hard by the pandemic will make a rapid return to their former performance even if conditions improve.

British Airways owner International Consolidated Airlines Group (IAG) saw net debt rise from €7.6bn in 2019 to €9.8bn at the end of 2020, a 28.9% increase year-on-year. Over the same period, the group reduced the number of planes it owned or leased by 10.9%. The company that emerges from the current crisis will be smaller and carrying more debt than it was in 2019.

IAG isn’t alone though. Nearly half of FTSE 350 companies saw net debt rise (or net cash fall) between 2019 and 2020, with debt up more than 50% at 62 companies. These companies will emerge from the pandemic with balance sheets that need urgent repair, hampering investment and shareholder returns for some time. Put that in the context of a zombie company and the outlook isn’t good.

This article isn't personal advice. All investments rise and fall in value, so you could get back less than you invest. If you're not sure if an investment is right for you, ask for financial advice.

How should investors respond?

In normal times investors tend to pay lots of attention to operating profit, sometimes called earnings before interest and tax (EBIT), but less to profit before tax.

Read our understanding income statements articles for more detail on different types of profit

The dramatic changes to corporate balance sheets over the last year means investors can’t afford to be complacent. As the economy reopens, companies that stay stuck in zombie mode should need a very good reason to make it onto your investment list.

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.