Zombie companies: Latent or irrecoverable?

This does not mean these companies are headed for imminent failure, as countries such as the UAE have taken positive measures to strengthen and improve their business environment.

However, it does indicate a presence of some companies that may be operating as “zombies” in the region.

 A “zombie company,” a term originating in Japan, referred to companies that only generated enough cash to pay interest on their debts. Today, there is an increase in GCC-based companies unable to make their loan repayments that could be considered zombie companies. This is evidenced by the increasing rate of total non-performing loans and provisions across the region.

The impact of zombie companies

Research by the Organisation for Economic Co-operation and Development (OECD) states that:

“Zombies hamper productivity growth, diverting credit, investment and skills from flowing to more productive and successful firms. They also decelerate the diffusion of best practices and new technologies across an economy. At the company level, uncompetitive zombie companies can negatively impact pricing power, reduce return on equity, and lower market valuations of otherwise healthy companies.”

Furthermore, if a zombie company is not turned around at the right time, and collapses in a disorderly manner, it can prove to be a greater threat to immediate stakeholders, the wider economy and government development strategy. Such companies often only become visible when liquidity runs out and there is a cash crisis triggering a default on loans. However, a lack of liquidity is largely a symptom of distress, not the cause.

How do companies become zombies?

A downturn in the global economy, such as the one caused by the pandemic, pushes many businesses to failure. However, many of these businesses were already on their way to becoming zombies, with fundamental issues in their business models making them vulnerable to existential shock.

The root causes of zombie companies are often subtle, businesses can appear healthy and even profitable, right up until they run out of cash. Our study has highlighted some of the common causes in the GCC including:

• Incoherent strategy and operating models: Some groups expand over decades to cover disparate, non-complimentary sectors or fail to adjust their business model to changing market dynamics. Often, one core area of the business generates cash drained by other failing group companies.
• Centralisation of power and deference to seniority: Whilst a corporate hierarchy must be respected, the level of test and challenge required by a young workforce with diverse working cultures is sometimes not encouraged. Leading to slow decision making and inefficient processes that fail to react quickly to business needs.
• Duality, succession and lack of internal controls can cause issues that can then lead to a conflict of interest or lack of proper scrutiny of managements decisions.
• Low labour costs: Inefficient processes and a lack of investment in digitisation and IT are often masked by low labour costs. This can also impact reporting, in which case management may not have the level of information required in a timely manner to steer the business effectively.

Is this a latent zombie or irrecoverable?

While root causes can only be identified by gaining access into the inner workings of an organisation, there are questions that business owners, lenders and other stakeholders can ask such as to identify warning signs and whether this is a latent zombie in need of a turnaround, or one whose market has died and is now irrecoverable. Some of those questions are:

• What does the sales pipeline look like? How has the win/loss ratio evolved?
• What are customers saying?
• What are competitors doing?
• What do key operational KPIs look like compared to best practice?
• What is the business landscape expected to be in core markets in the long term and how should the business anticipate these changes?
• Are skilled management members leaving/are there gaps?
• Are there non-core parts of the business diverting attention?

The answers to these questions can help assess whether the zombie is latent or irrecoverable and anticipate what will be seen later in the financials: lower revenues, reduced margins, and reduced cash flows. A latent zombie has potential for turnaround even when existing conditions may appear to indicate no future for the business. By formulating a set of questions relevant to the type of business and asking them regularly, management can begin to shift from firefighting on an ongoing basis to developing a plan to turnaround a latent zombie. Zombies that don’t adopt this approach, in a formalized and recurring manner, have a heightened risk of becoming irrecoverable.

In the next article in this two-part series, we will examine key activities that a sustainable turnaround should include to successfully revive a latent zombie.

Said Al Sayyed, Director and James Murphy, Associate Director at Alvarez & Marsal (A&M).