Could you be holding onto 'zombie' ASX shares hoping for new life?

Interesting economic landscape forming ahead of us.

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Key points

  • Interest rates are surging and this places additional stress on highly leveraged companies
  • The situation has gotten worse this year with the speed of hikes increasing 
  • It's important to check the balance sheet of a company to understand its ability to service debt

There's likely to be a corporate apocalypse should we head into a deep economic recession, as some experts are predicting. And ASX shares are right in the firing line.

That's a fitting appraisal for some entities already operating as so-called 'zombie companies' – businesses whose operating profits are persistently lower than their cost of debt.

Recent data suggests that a good chunk of global equities are backed by companies that fall under this criteria. Could you be holding one 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.

Typically, companies can raise money in two ways: via equity, that is through the issuance of shares; or via issuing debt.

Debt comes with a charge of interest on top of the principal repayments. Regardless of the route to seed capital, it is being spent to create an asset that will generate future economic benefits to pay back the debt.

Institute of International Finance managing director Sonja Gibbs noted on Bloomberg that global debt levels had "skyrocketed" over the past 10-15 years, spurred on by record low interest rates.

Add in record high commodity prices and input costs, and this has created a situation where many companies must continue borrowing to remain solvent.

Gibbs added:

What we mean by zombie companies is a company that essentially has to borrow to keep going. They are highly leveraged, not growing very fast and their revenues aren't up to par.

You [a company] don't earn enough revenue to cover your debt costs, and remain solvent.

Meanwhile, the OECD defines a zombie company as a business aged older than 10 years that has an interest coverage ratio of less than one for three consecutive years.

In a nutshell, a zombie company is unable to service the cost of its debt and maintain operations at the same time without having to borrow again.  

That's a no-no because, as mentioned, raising capital [debt, leverage] should be used to create additional economic value, not to simply get by.

Are we in zombie land?

We checked companies within the ASX 200 to see what names might fit the defined criteria. On a simple stock screen, five ASX 200 companies have an interest coverage ratio (earnings before interest and tax [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 these, with the exception of Block, is in a capital-intensive business that has high fixed costs just to maintain operations.

When opening up that criteria 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 levels of market cap included, it appears there are 955 names listed on the stock exchange with an interest coverage ratio of less than one.

As to how long these ASX shares have been operating and how long the ratio had been less than one, we weren't able to define in the stock screen. But it's something to think about nonetheless.

However, it does present interesting suppositions, especially relating back to what Sonja Gibbs said – that the corporate world is highly leveraged at the moment, and this is a large risk.

This sentiment has been 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.

Joyce posits that "hordes of zombie companies are about to die" after warning last year to "[b]e afraid [because] the zombie economy can't last".

With that in mind, interest rates are front of mind for many equity investors at the moment, and with no signs of the speed of rate hikes slowing down, we very might be heading into zombie land.

Motley Fool contributor Zach Bristow has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Block, Inc. The Motley Fool Australia has positions in and has recommended Block, Inc. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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