Part 1: Are 25% of S&P Companies at a High Risk of Bankruptcy?

By Charlie Strout, CFA

Professor Edward Altman recently warned of an impending spate of “mega” bankruptcies that will break all the records.[1] As the author of the well-known bankruptcy-predicting Z-Score, Altman knows a thing or two about financial distress, and he doesn’t like what he is seeing. Investors perk up when people start talking about bankruptcy—especially of big companies. Names like Enron and Lehman Brothers spring to mind and remind us the real damage mega-firm failures cause and some truly mammoth companies have that gone bust when the economy goes into a tailspin.  If Professor Altman is ringing the alarm, it is worth it to see what his Z-Score is telling him.

The Z-Score

The Z-Score has been around since 1968. There have been a variety of other methods developed since it was first published that seek to improve on its predictive results (Campbell, Hilscher, Szilagyi (CHS) Model, the Ohlson O-Score, and Merton’s Distance to Default) . Altman himself developed Zeta Analysis back in 1977.  However, despite these new methodologies—and more than a few analysts urging that we adopt them—the Z-Score is still widely used as an indicator of financial distress.

The original 5-parameter Z-Score was developed specifically for manufacturing companies.  Later, a 4-parameter score was developed for non-manufacturing and emerging-markets companies.  Each has a slightly different scale as follows:

Z-Score Parameters [2]

It is important to note that the data from the Z-Score is based mostly on companies’ SEC filings.  At the time of writing, most companies had only reported on Q1 2020.  This means that much of the really bad news may not be reflected in this analysis.  It will likely get worse, much worse. We will be releasing Part 2 of this analysis in August with the Q2 financial results. That should be interesting…

Methodology

For this analysis, I grabbed the list of S&P 500 tickers and divided it into three groups.  First, I removed all the companies where the Z-Score didn’t return a value when applied to my data set.  (Most of the companies were financial firms where the Z-Score isn’t appropriate.)  Then, I put all the companies listed in the manufacturing sector into the manufacturing group (164 firms) and all the remaining 276 firms into the non-manufacturing group.  I ran the appropriate Z-Score against each of these groups. Granted, this is a bit “best-effort.”  To really know which Z-Score is appropriate for an individual firm you would need to dive in deeper.  However, I am comfortable that this is a reasonable approach for a first pass.

Data

Manufacturing Companies

Distribution of Results for S&P 500 Manufacturing Companies

The 25 S&P 500 Manufacturing Companies with the Highest-Risk Z-Score

The 25 S&P 500 Manufacturing Companies with the Lowest-Risk Z-Score

Non-Manufacturing Companies

In the sample, the Z-Score rated the a full 35% (91 of 276) of non-manufacturing companies to high risk.  Fewer than half were rated low risk.

Distribution of Results for S&P 500 Manufacturing Companies

The 25 S&P 500 Non-Manufacturing Companies with the Highest-Risk Z-Score

 The 25 S&P 500 Non-Manufacturing Companies with the Lowest-Risk Z-Score

Additional Breakdowns

Not too surprising to find Facebook and Google on this list of companies at low risk of going bankrupt given all of the cash that they have stashed away. Just for the fun of it, I took a look at some selected retail companies and airlines.

Retail

Airlines

Results of Altman Non-Manufacturing Z-Score Analysis
Filings Data from Quarter Ending March 31, 2020

The full set of parameters can be found on the supporting Excel document in GitHub.

Analysis

As an initial step we are going to compare the five highest-risk manufacturing firms with the lowest risk.

Comparison of Low vs. High Risk Manufacturing

Review of the above chart shows how much influence X4 (market value of equity / book value of total liabilities) has.  This makes sense as it gives a view of what people think the company is worth vs. how much it owes.  However, also note that X1, X2, and X3 are also all consistently lower for the high-risk companies.  Notice both Ford and GM have made this list.  It may be worth digging into whether there is a particularity of in capital structure in the automotive industry that results in these high-risk scores.

Comparison of Low vs. High Risk Non-Manufacturing

For non-manufacturing companies the profitability measure (X2: retained earnings / total assets) drive the differences.  However, X4 also is a significant factor even though it is calculated differently for non-manufacturing companies.

Other items that show through is the large number of REITs that are listed as the highest risk companies.  This is particularly troubling given that the full impacts of COVID are likely not reflected in the filings data at this time.

Conclusion

Of the 440 companies analyzed, 112—a full 25%—were rated as high risk by the Altman Z-Score.  A full third of non-manufacturing companies rated as high risk.  This does give one pause. This analysis is just a first pass, but it certainly does explain why Professor Altman is ringing the alarms.  Research is always a journey where one analysis lead to more questions to explore.  The questions that come to mind when viewing the results of this quick Z-Score analysis are:

1. Do other measures of financial distress produce similar results?
2. If they do, is this information truly priced into the market?
3. What will this look like when the full set of second quarter earnings are in?
4. Where are the risks and opportunities?

More to come…

Data Provided by TagniFi.  More at https://tagnifi.com/.

Charlie Strout is founder of Seven Shadow LLC, and independent research and consulting firm.  More on Charlie can be found at https://charliestrout.com/.

DISCLAIMER: This article is for informational purposes only.  Nothing in it is intended as advice to buy or sell a security.