Sandeep Shroff recently wrote about burn rate zombie companies. I’ve worked with Sandeep and he is a very sharp guy. He defines a #burnratezombie as a firm that lacks the cash t
o go through the process of raising capital. A firm reaches this point when the burn rate is so high and the time left is so short that the company will have to sell itself or go bust. These companies are dead but don’t know it yet.
A zombie company is normally known as one that can pay interest, but doesn’t generate enough cash to pay off the loan balance. Their loans don’t go away and they survive by holding off the debtors. These firms aren’t dead yet, and they aren’t really alive.
The Economist in January 2017, wrote about the productivity slowdown due to zombie companies which have large amounts of invested capital, but don’t generate much profits. The invested assets should probably be liquidated and the business recapitalized, but instead they limp along, making enough to keep the doors open but not enough to upgrade the equipment. A company that is just covering marginal costs can price lower than a company that is seeking to make a profit. That competition lowers return on capital and limits new entries into the market. These zombies don’t eat people – they slime the market.
I think there is another class of zombie firms that isn’t spoken about often. I call these Dead End Zombies.
Dead End Zombies consist of firms that are stuck. Like a driver lost in suburbia they’ve turned into a cul-de-sac, and they can’t continue forward. Their returns are under the cost of capital so they can’t attract investment and grow their way out of the problem. The only good strategic direction is backwards. The invested capital in the business has to be restructured and the business has to be pared back to the profitable core.
Austrian business cycle theory says that low interest rates increase borrowing and investment. Too low of rate, too much borrowing and too much investment or “mal-investment”. Easy capital is invested too quickly and there is a correction because the resulting profits are just too low. The correction causes firms to restructure and reallocate the cash to better investments. If the capital isn’t reallocated and stays stuck in these underperformers it becomes “dead” money and a Dead End Zombie.
When I think about businesses that have low profitability I apply Seldon & Colvin’s approach from “Angel Customers & Demon Customers” and split the business into customer deciles. Some segment of the customer base generates good return – the top 10%. This implies there is some segment that is at low and perhaps negative profitability. These are Seldon & Colvin’s devil customers and one cause of the poor returns. For a CFO, marginal operations that don’t add to profits end up just driving down the return on capital. Recognizing this, cutting overhead and trimming marginal operations isn’t easy and it isn’t popular. For management, a shrinking operation means a less staff, lower pay and less power. Sales declines also upset boards and shareholders.
Private Zombies
Dead end zombies can be public or private, both have challenges. A private firm that is at a dead end stage has to conserve capital to execute the transition out of non-performing assets. Selling assets can be an option. However, cutting overhead may not be possible. A recent client had half of their assets invested in low return operations with weak profits. However, even minor profits helped since they helped cover overhead. The incentive was to “extend and pretend” rather than fix, since the fix basically meant lower paychecks for the CEO and the management team.
Public Zombies
Public Dead End Zombies are usually small caps and are under followed. There is a discount due to liquidity (ability for larger investors to buy and sell shares), so they suffer a low stock price too. Small stocks without a following are called “orphans”.
As I have noted before here, G. Bennett Stewart classified firms by ROIC and growth options. Low ROIC firms, that return less than the cost of capital, Stewart titled “X-Minus” firms. The proper valuation for a firm that earns its’ cost of capital is 1x book value (or a market/book ratio of 1.00). If the firm is an X-Minus, then they are valued at less than book value. Each additional $1 the management team invests in the business is discounted in the market. So the company invests $1 and the shareholder receives 80¢.
In a public dead end zombie, the shareholders and management aren’t on the same team. As long as there is cash in the business the management team will hold on and continue to re-invest hoping for better results. Public Dead End Zombies can’t grow out of their predicament, they can’t buy back their shares, and often they can’t decrease the sales or the management team would be fired. They are stuck.
There are a lot of these firms. I looked on the Mergent database and found that there are ~2,650 public firms (not including finance, insurance, real estate) with sales of $10m or more, and 38% earn less than 4% return on equity. The smaller the market cap, the greater the odds it has low return on equity, with more than half of the firms with less than $75m market cap have sub 4% ROE’s.
The direction forward for a lot of these firms is restructuring. In a different time we’d have seen investors buying these companies with borrowed money. Unfortunately, after the banking meltdown and the beating the bankers received, there isn’t much money chasing these opportunities. This is a very big opportunity for the right investor, and the LBO will come back as value is discovered lurking in these dead end firms.
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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, ora former student, colleague or would just like to connect – reach out.