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Get Four
|  | JANUARY 13, 2006
By William C. Symonds The Trouble with TycoInvestors hammered the stock after the breakup plan was announced. That's because carrying it out -- and making it work -- will be devilishly complicatedTyco International (TYC ) offers a classic case of the conundrum faced by investors every day: Should you focus on the long run or the short term? In a conference call with investors on Jan. 13, Tyco CEO Edward D. Breen made a compelling case for the plan he was announcing to break his $40 billion conglomerate into three pieces. After explaining that he and his board had spent months mulling over every conceivable strategic option before settling on the breakup, he argued: "I'm absolutely convinced that we did the right thing to create value over time." Maybe so. But Breen's carefully crafted long-term logic was overwhelmed by some short-term storms. Not only did Tyco surprise investors by tucking an earnings warning into the press release unveiling its breakup plan but there are mounting concerns over the cost and complexity of the breakup (see BW Online, 1/11/06, "Tyco: The Case Against a Breakup"). Instead of rising as Breen had no doubt dreamt they would, Tyco's shares were hammered in extraordinarily heavy trading on Friday, Jan. 13, losing nearly 11% of their value, or $6 billion. "DEAD MONEY." Worse, troubles look likely to linger at the struggling conglomerate. It was bad enough that Tyco warned that fiscal first-quarter results, which will be unveiled on Feb. 2, will come in some 10% below the high end of its previous guidance. Breen also warned that the company will enjoy little or no earnings growth in its 2006 fiscal year, which ends Sept. 30. He also cautioned that Tyco won't be able to complete its breakup until sometime "during the first quarter of calendar 2007," possibly more than a year from now. Given these clouds, "I expect the stock to be dead money for much of this year," says an analyst at a major institutional investor. "Tyco is worth more than its current price," adds Ronald W. Beasley, a Tyco bull who heads a Houston investment advisory firm. "But my reaction is not positive. I'm not saying I will sell all my Tyco holdings, but I may reduce them." BACK IN GEAR. At the very least, Tyco is a cautionary tale for those who believe that a breakup is the best way to boost a conglomerate's market cap (see BW Online, 11/3/05, "Spin Off, Buy Up, Cash In"). The theory is that because most conglomerates trade at a discount to the market, the sum of the parts resulting from a breakup will be worth more than the behemoth was as a whole. Over time, that could still happen at Tyco. But this year, the impending breakup could become more of a distraction than a salvation. Indeed, the most pressing problem at Tyco is getting its earning engine back in gear (see BW Online, 11/3/05 "Tyco's Tentative Turnaround"). The first-quarter earnings miss stems from problems in two of Tyco's four key units. TRICKY TASK. The $9.5 billion health-care business has been hurt by product recalls and regulatory issues, while margins in the $11.5 billion fire and security business have been crimped by weakness in its commercial security and worldwide fire services units. The big issue for investors is that this is becoming a recurring refrain. "They keep saying the problems will be fixed," says Beasley, "but we've had downward revisions in each of the last two quarters, and now it looks like 2006 earnings will be about the same as 2005." Executing a breakup in this environment will be tricky under the best of circumstances. First, "the concern everyone has is that [Tyco managers] will take their eye off the ball on operations," says Joel Levington, a credit analyst at Standards & Poor's Ratings Services (like BW Online, a unit of The McGraw-Hill Companies). Second, each of the three units set to emerge from the breakup will be headed by essentially the same management teams as they are now. "It doesn't seem like Tyco is being managed all that effectively," worries Beasley. "It's a bit of a quandary to see how they will execute better" when the same people are running separate companies. ELABORATE MACHINE. Even if Tyco was firing on all cylinders, the breakup would be devilishly complicated. Tyco was put together by one of the most aggressive dealmaking campaigns in corporate history, in which now-jailed former CEO Dennis Kozlowski swallowed up hundreds of companies. Along the way, he moved Tyco to Bermuda, then set up an elaborate machine to finance his empire, in which most debt was issued by a Tyco subsidiary based in Luxembourg. It was an intricate but legal scheme to shave Tyco's tax bills to an absolute minimum. In fact, this tax-avoidance mechanism continues to be one of Tyco's most powerful competitive advantages. Breen hopes to take this empire apart, even while keeping as much of the tax-avoidance mechanism as possible. But he'll have to refinance or reassign much of Tyco's $15 billion in total debt, redistributing it among the three resulting companies, which will remain based in Bermuda. Then he plans to issue tax-free stock dividends to Tyco's shareholders, after which they'll own 100% of the stock in all three companies. That may sound straightforward, but it's complex and costly. Even Breen admits it'll cost $1 billion and take at least a year. FORK OVER. On top of this, Tyco must figure out how to divide up the liabilities it faces from the lawsuits filed by shareholders who lost billions after Tyco's stock collapsed in 2002, at the end of Kozlowski's reign. Levington estimates that Tyco -- or its three surviving offspring -- may have to fork over $3.5 billion to settle these suits. Yet, for all these problems, Breen's plan has a strong strategic rationale to Breen's plan. "There are minimal synergies among our businesses,' Breen argues. And equally important, the three units face different challenges going forward. Take health care, the crown jewel of the Tyco empire. One reason it has been so profitable is that it has skimped on R&D compared with other health-care giants. To grow, it must build a robust R&D culture, a process that could take several years. Conversely, the electronics business faces a mix problem. It's heavily weighted toward the cutthroat and mature auto industry. To offset that, "they need to build more of a presence in consumer electronics and on the military side,' says Levington. That will likely require acquisitions. In addition, electronics is a highly cyclical business, which arguably would do better as a stand-alone unit in which investors accepted that cyclicality as a fact of life. HUGE TASK. Finally, there's the $18 billion combination of fire and security and engineered products, which Breen says he plans to run. Here the paramount challenge is operational efficiency. In the $2 billion valve business, for instance, Levington estimates Tyco still has about 100 plants, dating from Kozlowski's buying spree. Breen's job will be to prune such operations to boost margins, which now badly trail those in electronics and health care. On paper, it seems to make a lot of sense. The problem is that achieving Breen's vision will take a while. And "there won't be any quick fixes to the problems at any of these three companies,' warns Levington. To his credit, Breen has accomplished one huge task. Since taking the helm at Tyco in August, 2002, he cleaned up the scandal and liquidity crisis left by Kozlowski, while more than doubling the stock price. Now he's embarking on what he calls phase two of the Tyco turnaround. But just as phase one took several years, this won't be a quick fix. Investors likely will need their fair share of patience during the difficult months ahead.  Symonds is BusinessWeek's Boston bureau chief
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