How to Profit While These Zombie Companies Still Roam the Earth

Janet Yellen chickened out, so these “living dead” firms will go on, but they might not make it past December…

What a shock - the Fed didn't raise interest rates last week. Its next chance is in December - we'll see if it chickens out then, too.

You can count on markets to obsess over the possibility of a rate hike for the rest of the year. Anything to keep the free money hose on full blast.

But this obsession with rate hikes means the markets are missing a critical component of the big picture - corporate credit quality. It's really in horrible shape, but eight years of zero interest rates have helped to disguise that fact, and these companies aren't advertising it to shareholders.

Now that the Fed is contemplating raising interest rates, their disguise could be ripped off.

The truth is, "Corporate America" is far more leveraged now than it was on the cusp of the financial crisis.

That isn't even their biggest problem, but it could be a huge opportunity for investors with the intestinal fortitude to follow through on this...

Why We're Not Seeing a Flood of Defaults... Yet

zombie companies

Even if the Fed chickens out and doesn't raise rates, these leveraged "zombie companies" are still in big trouble - maybe even bigger trouble. Because if the Fed doesn't raise rates, it means that it believes the economy is too weak to handle even a tiny 25-basis-point rate increase. And that's downright pathetic.

Right now, there are a number of zombie companies that are still haunting the landscape solely because of low interest rates. These companies carry huge debt loads but the cost of servicing that debt is very low due to the fecklessness of the Federal Reserve.

They are losing tons of money in their businesses but have been able to borrow (or extend their existing borrowings) due to complacent financial markets. Remember - bond and bank loan investors don't want to report defaults to their investors if they don't have to. So they are perfectly content to allow borrowers to "extend and pretend" their loans until some future date when they are forced to face the music.

Thus far in 2016, 122 companies have defaulted around the world. The tally would be much higher if interest rates were anywhere near normalized.

Shorting These Companies Could Be Very Profitable

These companies will join this list if interest rates begin to rise, either because the Fed gets aggressive (which is highly unlikely) or because investors wake up to the fact that their businesses are weak and incapable of repaying these debts.

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Zombie No. 1: Sears Holdings Corp.

Sears Holdings Corp. (Nasdaq: SHLD) reported net losses of $398 million in Q2 and is set to close 64 more Kmarts within the next year (in addition to the 68 that it announced were closing back in April). Sears has about $3.5 billion in long-term debt, and the company is limping along propped up by loans from CEO Eddie Lampert's hedge fund, ESL Investments. As Kmart employees follow orders to move all merchandise onto the sales floor, it would seem that their parent company is preparing for liquidation. The question is whether Sears will even live to see Christmas.

As a whole, the retail industry is in crisis. Buffeted by structural changes such as the explosion of e-commerce, weak consumers, and an increasingly selective consumer base, there's been an epidemic of mall-based retailer bankruptcies lately (Sports Authority, RadioShack, Aeropostale, American Apparel, Pacific Sunwear...), and it's only going to get worse. This segment is ripe for shorting.

Zombie No. 2: iHeartMedia Inc.

 IHeartMedia Inc. (OTCMKTS: IHRT), formerly Clear Channel Communications Inc., is the largest traditional radio station operator in America, and is $20.6 billion in the hole, struggling to keep its head above water in an era of streaming media. It hasn't reported a profit since 2007, hemorrhaging between $219.5 million and $4 billion every year. It's also the victim of another leveraged buyout, struggling to pay back the debt it took on in its acquisition by Bain Capital Partners LLC and Thomas H. Lee Partners LP back in 2008. (The way private-equity firms loot these companies, as I've written before, is shameful). IHeart has been holding on: refinancing, restructuring, pushing back payments, and cannibalizing its healthier divisions to create more cash (a move Bloomberg Intelligence described as "burning up your sofa to heat your house"). But if rates go up, it's in big trouble.

Zombie No. 3: Valeant Pharmaceuticals International Inc.

Fund manager Bill Miller recently recommended Valeant Pharmaceuticals International Inc. (NYSE: VRX) stock. Miller famously beat the S&P 500 for the 15 years heading into the financial crisis by taking huge risks. Then, he blew up and lost most of the money he made over the previous 15 years because he ignored the value of risk-adjusted returns. VRX is heavily leveraged, has negative tangible net worth, is under investigation by multiple government agencies, and offers far more risk than reward. The stock is overvalued and the company is not out of the woods. Ignore Bill Miller and go short.

I could go on, but my blood pressure is rising.

Suffice it to say that each of these stocks is toxic and headed for disaster no matter when (or if) Janet Yellen raises rates.

But when (or if) she does, that day of reckoning may come a little sooner.

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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