Many have used the term "zombie" to describe certain financial institutions with questionable assets and overwhelming liabilities, essentially insolvent banks that continue to live on despite their permanently impaired position. As I ponder the potential for a year of negative GDP (nominal) in 2009, something we haven't experienced in my lifetime of 44 years, I wonder by what process the market will soon begin to value companies that have low or no earnings.
While I am aware that many investors discuss the concept of "earnings power", the challenge will be to incorporate margins and costs of capital that might be quite different from the past decade in the event we are in a protracted period of slow or negative growth. In other words, the last 18 years or so have seen relatively steady and somewhat strong real growth and a massive expansion of debt.
If the economy shrinks in 2009 and earnings implode, I believe that investors will migrate to valuation techniques that incorporate book value. I have written about how many of the S&P 500 companies trade "below book value" (151 currently) and shared the pitfalls with that metric: Lots of goodwill or intangibles, bloated inventories, overvalued factories, equipment and land and uncollectable receivables can render that metric unreliable at best. Even using "price to tangible book" suffers from asset quality issues, so investors will have to dig a little deeper and discount, if necessary, certain components of the balance sheet.
In the environment that I am describing, investors will avoid companies that are burdened by high levels of debt (or other liabilities that are claims on assets) and whose market value is high relative to the value of the underlying net assets, especially in competitive industries that could endure price wars. We could see the term "zombie" applied to non-financials that have high levels of debt, especially if it is due within 3 years.
While it is one task to identify a zombie, the more important job is to identify an expensive one, as it isn't likely to fare well at all in a prolonged recession with limited capital. There is no exact delineation for "too much" debt. As I mentioned before, sometimes liabilities aren't classified as debt, so we need to include them. Also, it makes sense to adjust liabilities by crediting the company for cash. In my screening of the S&P 500 for potential zombies, I have created a new metric that I hope allows the quick identification of companies that could be at risk: Tangible Leverage. Here is the definition:
(Total Assets less Goodwill/Intangibles) / (Common Equity less Goodwill/Intangibles)
What I have attempted to do is determine a "lights-out" ratio for valuing a company that strips intangibles from the balance sheet. While it is a rather harsh way to look at a company, I expect that increasingly investors will discount intangibles and goodwill. The goal, then, is to identify companies with high Liabilities (Assets less Equity) relative to the "worth" of the companies. These are the companies that could face problems rolling over their debt.
The table below (click to enlarge) on the S&P 500 Industrials includes this ratio. Note that interpreting the ratio is not as simple as I would like it to be, as 1.0 is a great number (all assets, zero liabilities). Negative numbers imply no tangible equity (and perhaps no equity either), while "high" numbers would imply a lot of debt.
I don't know how high is too high, but I have highlighted all of those that are negative or greater than 5. This ratio gives the investor a measure of risk, while the "price to tangible book" gives investors a measure of value. All things equal (they never are!), one would expect that the riskier the company in this environment, the closer the stock would be priced to its tangible book value. As you can see, that isn't necessarily the case.
The stocks are ranked by traditional leverage, so the ones at the top have low financial leverage (Assets/Equity) relative to the ones at the bottom, though note that the first one has negative equity and should thus be at the bottom of the list. I have highlighted the adjusted ratio that I described above in cases where it is negative or above 5 (arbitrary). I have also highlighted high P/TB ratios as well as a few other metrics, including high levels of short-term debt, high debt-to-capital (the negative numbers indicate more cash than debt) as well as a few PE ratios that seem high.
So, how can we use this information? As I stated before, companies with high levels of debt, lots of intangibles and a high price/tangible book ratio could be very vulnerable to a protracted downturn. While the last 6 companies have high traditional leverage ratios (all above 5), their adjusted leverage ratios are in cases substantially higher. While the traditional Price/Book ratio ranges from 1 to 13, Pitney Bowes (NYSE:PBI) actually has a negative Price/Tangible Book ratio. The other 5 range from 2x to 12X.
There are some real surprises, though, as one looks at companies that theoretically don't have so much leverage. While I haven't done any work on these, consider the following:
- Eaton (NYSE:ETN): 2.6X Leverage, 39% net debt to capital, 1.1X BV and 7 PE
- Emerson (NYSE:EMR): 2.3X Leverage, 22% net debt to capital, 2.7X BV and 11 PE
- ITT (NYSE:ITT): 3X Leverage, 24% net debt to capital, 1.8X BV and 10 PE
By traditional metrics, these three stocks appear to be cheap on a PE and BV basis (historically and compared to the entire sector) and have "average" leverage and net debt to capital for the entire Industrial sector. By excluding intangibles, though, we see an entirely different picture, as ETN has negative tangible equity (and $1.4 billion of short-term debt to roll), EMR has an adjusted leverage ratio of 8X and a P/TB of 14X, and ITT has negative tangible equity (with $1.7 billion of short-term debt to roll).
While the market seems to be on to ETN looking like a zombie, I wonder if investors in EMR or ITT look at the company that way. If the companies have any problems addressing liquidity issues, they could be forced to sell equity into a market that isn't exactly embracing stock issuance. Additionally, as companies will most likely be writing down intangibles, the low P/B ratios will rise, removing what could be an artificial valuation floor.
FedEx (NYSE:FDX), on the other hand, has an above average PE (13.6X), but it has little net debt, low leverage (1.8X, 2.0X adjusted for intangibles) and a modest P/B and P/TB ratio. Contrast that with United Parcel Service (NYSE:UPS), which is down slightly less in 2008. The PE is slightly higher (14.7X), and the leverage ratios and P/B and P/TB are all higher. Grainger (NYSE:GWW) and Precision Castparts (BATS:PCP) stand out as relatively low valuation and strong balance sheet.
This discussion isn't intended to suggest that you buy or sell any of the stocks mentioned, but rather it serves to introduce or elaborate upon a metric that I expect to become increasingly popular in this uncharted territory in which we find ourselves. 2008 has seen stocks sold off en masse, with little differentiation. As the credit crunch continues into 2009, I would expect to see less reliance upon PE and more of a reliance upon balance-sheet-related valuation metrics. While I shared examples from large-cap industrials, this type of analysis applies to all sectors and to all market capitalizations. Until credit is more readily available, it is wise to avoid potential zombies.
Disclosure: Long CTAS and long CTAS and ITW in one or more of my model portfolios