The Breakdown - The Decade of the Living Dead: How Zombie Companies Are Robbing Tomorrow’s Economy

Episode Date: September 16, 2020

Today on the Brief: MicroStrategy increases its bitcoin reserves by $175 million  The Oracle-TikTok deal starts to smell fishy The SEC is investigating claims of fraud involving Nikola Corp. Our main discussion: The rise of zombie firms.  A zombie firm is a company that can’t afford to service its debt from operating income. These companies are made possible by artificially low interest rates, and they drain resources from the economy.  On today’s episode, NLW explains: Why there are more zombie companies than ever The negative impact they have on the economy How they could drive a new financial crisis

In short, banks can't really afford to let these zombie companies fail either because of the potential cascade effect. It's not hard to see how with so much of this bad debt on their books, a number of defaults all at the same time could trigger that sort of cascade, where all of a sudden banks don't have the reserves to cover those losses and certainly can't keep loaning out money to good companies. All of a sudden, then, zombie companies aren't just draining resources, by disallowing them to flow where they would be more economically productive, but they're actually cutting off the opportunities for those other companies that exist as well.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. The breakdown is sponsored by Crypto.com, BitStamp, and nexo.io. And produced and distributed by CoinDes. What's going on, guys? Tuesday, September 15th, and today we are talking about zombie companies and the threat they pose to real growth, the real economy, and the potential for them to be at the center of a new financial crisis. First, however, let's do the brief. The brief today is actually a number of follow-ups to

stories we've been following, so we're going to look at micro-strategy upping its Bitcoin allocation, the real deal with the Oracle deal, and fraud accusations at Nicola. Let's start with Micro Strategy. CEO Michael Saylor tweeted this morning on September 14, 2020, Micro Strategy completed its acquisition of 16,796 additional Bitcoins at an aggregate purchase price of 175 million. To date, we have purchased a total of 38,250 Bitcoin's at an aggregate purchase price of 425 million inclusive of fees and expenses. So what does this mean?

To me, the only way that I think you can read this is as an extra doubling down on this strategy of moving cash reserves into Bitcoin. To me, this suggests that the initial market feedback to their original plan has been positive. When they initially made this announcement, they were only intending to buy $250 million worth of Bitcoin, not the $425 million that they've ended up with.

And as much as I'd like to think that it's just because us and the Bitcoin crowd liked it, they wouldn't have done this. They wouldn't have allocated an additional $175 million unless the actual traditional financial markets liked it as well. Vijay Boyapati made a really interesting point and said that as Bitcoin's price continues to rise, micro strategy essentially becomes like a Bitcoin ETF. the majority of its market cap coming from its BTC holdings. Investor Arjun Bilaji simply said,

micro strategy? More like macro strategy, am I right? Next up on the brief, what is this Oracle deal really? You guys know that I've been following the TikTok US saga pretty closely. I think that there are significant geopolitical implications of this. I think it says a lot about the state of the U.S.-China trade war, and potentially, according to some, the U.S.-China New Cold War, I think that it could set precedent for future deals. And as the show went in depth on yesterday, it seems like after months of thinking that it was going to be Microsoft

that got this deal done, it ended up going to Oracle. Some of the reactions, as we profiled on yesterday's show, basically argued that these were such weird deals that it's not necessarily a good thing for Oracle and it's not necessarily a bad thing for Microsoft that they missed out. That was sort of the day one narrative. The day two narrative is digging a lot deeper on what the actual deal was and whether it smells kind of fishy. We still don't have a lot of information, but what it appears is that Microsoft wanted to do the deal fully, right? They wanted to actually acquire the algorithm behind TikTok. They wanted to move everything over, completely separate the company from ByteDance, its parent. In so doing, they would actually address the national security concerns theoretically

at the heart of this whole hullabaloo. Mike Maznick and TechDirt, however, have put together all the info we have, and it doesn't really seem like Oracle is actually buying TikTok. Instead, they're simply going to be hosting TikTok on their cloud platform. This cloud platform is, of course, behind major competitors like Microsoft and Amazon. And the important thing, thing is that this deal, if it is in fact just this hosting deal, would do effectively nothing to actually address the concerns. Alex Stamos, the former security head at Facebook, tweeted, a deal where Oracle takes over hosting without source code and significant operational changes would not address any of the legitimate concerns about TikTok, and the White House accepting

such a deal would demonstrate that this exercise was pure grift. The pure grift that Stamos and many, many others are accusing the Trump administration of is that Larry Ellison and Oracle have been huge supporters of the administration. Without getting into politics, it would be very disappointing to me to see this, as Stamos puts it, legitimate set of concerns about TikTok and the national security apparatus be reduced to yet another blustery backroom deal-making session. The precedent for future administrations, which I've expressed concerned with before, would be even worse than we'd seen. Instead of instilling trust in an administration to actually address legitimate national security issues that intersect with business, we would instead have a precedent where those national

security issues were just used as cloud cover to make a nice deal for someone who is pleasant to that administration. Whoever you like in office, whatever party you're affiliated with, that doesn't serve anyone in the long run. Last up on the brief today, let's look at fraud accusations with Nicola. Nicola is one of the companies that have been at the heart of the SPAC revolution. Spacks are, again, special purpose acquisition companies. They are an alternative to IPO, where basically a blank check company IPOs, with the mandate to then go out and acquire a company effectively taking them public through the acquisition, through the merger. Nicola, as you might guess from the very original name, is in the electric vehicle space and has had

a ton of hype both from the electric vehicle side as well as from the SPAC side. Just recently, however, Hindenberg Research made accusations of fraud in a report that kicked up an absolute ton of dust. As Bloomberg put it, the report alleges that the maker of electric and hydrogen fuel cell heavy-duty vehicles made non-working products appear as fully functional. The report also alleges that Nicola staged misleading videos and told, quote, dozens of lives about its capabilities, partnerships or products, among other issues. As you might expect, the CEO of Nicola called the report a hit job by incentive-aligned short-sellers, but the SEC has now said that it is examining the accusations and markets are

responding. I think that there are, of course, implications for SPACs as a whole and whether we like that vehicle and we continue to like that vehicle for taking companies public. Again, part of the whole idea is that it's a workaround to the very strict and difficult set of standards and due diligence processes that come with an IPO. But still, to me, the best point about this came from Nick Carter, who wrote, The crypto industry is a constant source of wacky capers, but not a lot surpasses Nicola rolling a non-functional truck down a hill and implying that it was a working prototype. With that, however, let's shift to our main conversation, why zombie companies are robbing tomorrow's economy. If you listen to the breakdown frequently, you know I have a concept called

a narrative watch, and a narrative watch is basically when I notice that a lot of people are talking about a similar thing at the same time. Right now, zombie company, zombie firms, and the crisis that they may propagate are 100% in my radar as a huge narrative watch. To get a sense of that, here are some related headlines from the last couple months, with most of these, frankly, being in the last couple weeks. The Washington Post writes, Here's one more economic problem the government's response to the virus has unleashed, zombie firms. The Financial Times has two. Pandemic debt binge creates new generation of zombie companies, and Germany haunted by specter of zombie companies.

Market Watch says zombie companies are multiplying in the UK, and that is bad news for the economy. The Philadelphia Inquirer says Fed's J. Powell creating zombie firms, says noted Fed Watcher. A Korean Daily writes, number of zombie companies in Korea is growing, and the Japan Times writes, Bank of Japan coronavirus loans may ensure zombie firms limp on.

So clearly this is a global problem. This is a clear type of company, and it seems to be getting worse in the context of the coronavirus response. So what is a zombie company? A zombie company is a company whose operating income isn't enough to service their debt. In other words, that income is lower not than their debt, but then the interest on their debt. Usually, if we're being technical about it, it requires about three years of operating income failing to cover debt to be considered as a zone. zombie company. The term itself was first recognized in Japan after the collapse of the 1990s bubble economy. But to give you an example that's a little bit closer to home, let's look at Oasis

Petroleum, a shale mining company. In 2019, operating income was 154 million, but interest on debt for Oasis was 176 million. Meanwhile, back in 2014, Oasis was trading at $56 a share, while today, shares are around $1. So the question is, how does a company like this get more money? And in a quote-unquote normal, healthy economy, the answer is they wouldn't. They would go out of business. They would go through an insolvency process. They would go through bankruptcy protection.

They would change, right? They would shut down in some way and be reborn or sold off for parts or basically the normal process of creative destruction would transpire. In the economy that we have, however, where public market investors have passed these companies beyond. The way that a company like this gets more money is only through banks, i.e. more debt, or corporate bond investors, specifically junk bond investors. The reason that that money is available is the fact that interest rates have been capped ultra-low, making money effectively free. What's going on, guys? I'm excited to share that one of

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with interest rates starting from only 5.9% APR. NXO also lets you earn up to 10% annually on your Fiat and digital assets. What's more, interest is paid out daily, and you can add or withdraw funds at any time. Get started at nexo.io. Now, to get a sense of how big a phenomenon this is, let's look at some stats. First, let's look at some debt stats and then we'll look at zombie companies specifically. Non-financial business debt grew 19% in quarter one, which was the biggest percentage jump in 40 years. In that same quarter, businesses took on $3 trillion in new debt,

which was 10 times the previous three months. In the first half of August, there were $56 billion in junk bonds and leverage loans, which was 50% higher than prior records for the same period in 2012 and 2016, and more than double the amount for the entire August of last year. In the 1980s, less than 3% of publicly listed companies in the U.S. were zombies, but according to Deutsche Bank securities, one in five publicly traded companies today is a zombie. According to the Russell 3,000 at the end of last year, 13% were zombies up from 8% in 2008, and now that's past 15% at a minimum. In the UK, 1 in 5,000, 4%. firms is estimated to be a zombie, and people are terrified that this is coming to Germany as well.

Around 550,000 German companies, one in six, risk becoming a zombie firm. So this is clearly a worldwide problem. It is clearly rooted in this incredibly low interest rate world, this artificially low interest rate world that has been created on the backs of these crises. But what is the actual problem in practice? These companies, these zombies, are a huge drag on the economy. These are companies that don't grow because they literally can't. All they can do is service their debt. That means they don't reinvest.

They don't hire new people. They don't add value other than continuing to exist and giving some people jobs. In fact, it's not overzealous to call these companies leeches. They sap capital that could go to more productive uses. They sap time and talent that would go to. to more productive uses. Discussing the role of the Fed in this and why it's a problem, Danielle Di Martino Booth said, the optics are so damning. The Fed has placed itself in between the financial markets and the process of capitalism. In a capitalist framework, there's Chapter 11

filings and corporate reorganizations. Now, the Fed steps in and forces the market to continue funding these companies. Instead of permitting winners and losers to emerge, the Fed creates a zombie company today robbing growth from tomorrow. Once a recovery returns, the economy expands, there's not enough room for new entrants, and the dead wood was allowed to survive. There's an important spiral here. It's not just that these companies are individually bad and crowd out some potentially good companies. It's that they create an entire downward spiral. Here's how that looks. Weak growth leads to lower interest rates, right? That's how monetary policy responds to weak growth is they try to make the capital flow more easily. But lower interest rates also have the net

impact of expanding the number of zombies. In other words, when interest rates are really low, it's not just good companies that can get capital, but bad companies as well. More zombies means an overall weaker economy and less growth. And then all of a sudden, we're back to the start of this weak growth cycle all over again. Let's look at a few numbers that reinforce this idea that more zombies lead to a weaker economy and less growth. From a UK think tank that just put out a report on this, they estimate that it could reduce business investment by 42 billion pounds a year. The quote from the report was,

slower employment growth could mean over 400,000 fewer jobs created in a recovery that takes over twice as long, and lower productivity leading to at least 41 billion pounds of lost growth over five years. Now let's go over to Japan from that article I was mentioning earlier from the Japan Times. The term zombie company was coined during the nation's so-called lost decade in the 1990s, when banks continued support for unprofitable businesses crowded out investment in healthier firms. The legacy of that lives on, with the nation's labor productivity ranked 21st among the members of the OECD, according to the Japan Productivity Center.

If this spiral sounds bad, there are two other things. that happen two other areas of very negative self-fulfilling prophecy. One is that the more zombies there are, the harder it is for politicians to actually let them die. Going back to the article I mentioned before about Germany's looming zombie company crisis, basically Germany created an insolvency moratorium at the beginning of the coronavirus crisis that effectively had it so that companies that otherwise would file for bankruptcy wouldn't in this time. They wrote, however, about how difficult this is as it relates to governance. Quote, the logic of extending the insolvency moratorium

is clear. 2021 is an election year and neither of the government parties want to see a wave of bankruptcies sweeping over the countries just as voters go to the polls, pushing up unemployment and sapping economic growth. I might put this a little bit differently. Politicians are only as long-term as their next election, and these business cycles can take more than one election cycle to play out, meaning that politicians always have an incentive to not let bad companies die if the initial impact is going to be things that don't look pleasant in the headlines, i.e. bankruptcy numbers, i.e. jobless numbers, etc. However, as difficult and self-reinforcing as the political dimension of zombie companies are, an even bigger issue has to do with the potential

for cascading banking crisis. In short, banks can't really afford to let these zombie companies fail either because of the potential cascade effect. It's not hard to see how with so much of this bad debt on their books, a number of defaults all at the same time could trigger that sort of cascade, where all of a sudden banks don't have the reserves to cover those losses and certainly can't keep loaning out money to good companies. All of a sudden then, zombie companies aren't just draining resources by disallowing them to flow where they would be more economically productive, but they're actually cutting off the opportunities for those other companies that exist as well. What you have then, like so many other parts of the economy that we've examined on this show,

is a house of cards, a game of musical chairs that needs everyone to keep playing and keep playing even more extremely, because the consequences of stopping would be so severe. Or at least that's one narrative. So, will zombie companies lead to the next financial crisis? I'm not sure, but I know it's an important phenomenon and something we have to keep paying attention to because the implications both short-term and long-term are not good. Anyways, guys, thank you for listening. I appreciate you spending some time here. And until tomorrow, guys, be safe and take care of each other. Peace.