Executive Summary 

• The share of unprofitable firms (i.e., zombies) has remained elevated, representing about 17% of public companies but only ~2% of U.S. market capitalization.
• Companies at risk of cash shortfalls over the next two years are an even smaller share and as corporate borrowing costs decline, pressure on zombie companies may begin to ease on the margin.
• The majority of zombie companies sit in the healthcare sector, dominated by smaller biotechnology firms.
• A quality orientation in small cap equities can limit a portfolio’s exposure to zombie companies. 

There are a large number of zombie companies, but they represent a small share of total market value

U.S. Stock Market is represented by the Russell 3000 Index, which is a market capitalization weighted index of large, mid and small cap companies in the U.S. Zombies (EBITDA < Interest Expense) represent the subset of companies in the Russell 3000 whose earnings before interest, taxes, depreciation and amortization (i.e., EBITDA), have not covered their interest costs over the past three years. Zombies (Free Cash Flow < Interest Expense) adds an additional filter, including only those companies whose free cash flow have not covered their interest expense. Zombies (<2 yrs of Cash) adds another filter, including only those companies that have less than two years of cash on hand to cover projected expenses. Market value is represented by total market capitalization. Past performance may not be indicative of future results. One cannot invest directly in an index.

• Zombie companies, defined as those that do not have enough earnings to cover the cost of interest on their debt, account for about 17% of public companies, but only ~2% of U.S. market capitalization.
• Perhaps most important, only a fraction of zombie companies are in an even more difficult position, without enough cash on their balance sheet to cover their expected expenses over the next 2 years.

As corporate borrowing costs decline, pressure on companies may begin to ease on the margin

Data shown is the yield to worst on a market value weighted blend of the Bloomberg U.S. Aggregate Credit and Bloomberg U.S. Aggregate Credit High Yield indices, representing the publicly-traded investment grade and high yield corporate bond universes, respectively. Gray shaded regions represent periods of recession in the U.S. Past performance may not be indicative of future results. One cannot invest directly in an index.

• Some of the companies that fit these parameters can be newer firms, focused on establishing market presence before turning a profit, but many may be quite reliant on borrowing to remain afloat.
• The start of the Fed’s easing campaign could help reduce borrowing costs, offering relief to those facing near-term funding challenges.

Zombie companies are more prominent among smaller companies in particular sectors

Data shown is the share of market value in the Russell 3000 Index by sector that satisfy three conditions: 1) companies whose earnings before interest, taxes, depreciation and amortization (i.e., EBITDA) have not covered their interest costs over the past three years; 2) companies whose free cash flow have not covered their interest expenses; 3) companies that have less than two years of cash on hand to cover projected expenses. The Russell 3000 Index is a market capitalization weighted index of large, mid and small cap companies in the U.S. Past performance may not be indicative of future results. One cannot invest directly in an index.

• A large number of zombie companies are in the biotech and tech sectors, where early-stage unprofitability is common but risky due to aggressive growth business models with delayed monetization.
• Zombies that sit in more traditional sectors often exhibit the more typical serial lack of profitability, limping from year-to-year with additional costly borrowing to remain in business.

A quality-oriented approach to small cap equities largely avoids the zombie issue