On September 18, Deloitte released a new report which outlines a roadmap for the competitive business climate in Canada. Included in the report is a warning that "Canada may have a zombie problem." Luckily, Deloitte isn't raising concern about hordes of flesh-eating undead, but rather the relatively large number of "zombie companies" that exist on Canadian stock exchanges. The report identifies "zombie companies" as those who do not have enough earnings to cover their interest payments and found that out of the 2,274 companies listed on the Toronto Stock Exchange and the TSX Venture Exchange, 16% could be considered "zombies" compared to the OECD average of 10%. According to Deloitte, the reason to be concerned about these "zombie companies" is that they are locking up significant amounts of capital and talent to the detriment of more productive firms.
How did these companies come about?
The report suggests that management of Canadian companies tends to be more risk-averse and that attitude might be contributing to keeping low-productivity companies afloat. Out of the companies they surveyed, Deloitte found that only 22% are pursuing international expansion "to a great extent" and that 48% of companies "aren't exploring international opportunities at all" despite the obvious and well-known growth opportunities that exporting presents.
In addition to overly risk-averse management, there are two other factors that have been identified as partially contributing to this phenomenon. Most obviously, interest rates have been extraordinarily low for a decade. This can prop up low-productivity firms by reducing their debt carrying costs. Extremely low interest rates are also likely to discourage lenders from seeking more lucrative opportunities, since there are few opportunities to make money. Furthermore, in a study released in December 2017, the OECD ranked Canada's insolvency regime among the most cumbersome and inefficient. At the same time, the report found that insolvency reform can facilitate productivity growth.
There is also a possibility that Canada's outsize share of zombie companies is due in part to Canada's many exploratory resources firms who are not always expected to have positive working cash flow. Indeed, a KPMG study determined that mining and oil & gas companies make up 70% of zombies listed on the Australian Securities Exchange.
Is there an end in sight?
There are signs that there may be light at the end of the zombie invasion. According to Deutsche Bank, the incidence of zombie companies worldwide may be on the decline in 2018 due at least in part to rising interest rates. As monetary policy tightens in Canada, we may see some less productive firms pushed into the restructuring process which could free up resources for more productive firms and provide an opportunity for distressed investing.
Furthermore, Canada's junior resources sector has proven to be a hot commodity in the reverse takeover world, especially when it comes to the booming technology and cannabis industries. It would be welcome news for Canadian markets if Canada's glut of low-productivity zombie firms begun transforming into more innovative companies.
The author would like to thank Daniel Weiss, articling student, for his assistance in preparing this legal update.
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