Tyco: Time for Radical Surgery?


Since taking the reins of Tyco International (TYC) last August, CEO Edward Breen has been striving to expose and expunge the flagrant accounting, ethical, and governance abuses of his predecessor, L. Dennis Kozlowski. Yet even as he has become the anti-Kozlowski, Breen has fallen in love with the $36 billion conglomerate built by the man some called "Deal-a-Day Dennis." In fact, Breen says he's willing to sell only some small units, accounting for no more than 10% of sales. "We have a heck of a foundation," he says.

In the face of continued accounting woes and weak earnings, critics are warning that more radical surgery -- including a sale of problem-plagued ADT Security Services Inc. -- may be needed. Tyco's Apr. 30 surprise announcement that it was taking more than $1.3 billion in accounting-related charges was only the latest sign that it's proving harder to root out abuses than Breen first hoped.

Certainly, investors applaud much of what Breen has accomplished, including replacing the board, cleaning out the executive suite, and getting debt due this year down to a manageable $4.4 billion. But his repeated insistence that Tyco's accounting problems are over -- only to come back with more write-offs -- has hurt his credibility.

PLUNGING MARGINS. Indeed, despite such assurances in the wake of the Apr. 30 charge, potentially costly hurdles still lie ahead. These include the resolution of shareholder lawsuits, an Internal Revenue Service audit of Tyco's tax-avoidance games, and a Securities & Exchange Commission ruling on Tyco's accounting. Meeting these challenges, says Nicholas P. Heymann, an analyst at Prudential Securities Inc., could require "the sale of significant assets" to raise cash. He's not alone: Lehman Brothers Inc. analyst Robert T. Cornell, a Tyco bull, believes selling ADT would boost Tyco's value.

Breen vehemently disagrees. Given Tyco's "ability to generate cash, it won't be necessary to sell off a major unit," he says. Breen predicts Tyco's earnings will grow at 10% to 12% annually, doubling cash flow, to nearly $3 billion, by 2005.

If so, he has a long way to go. First Call estimates of earnings from continuing operations for the current fiscal year have come down some 35% since Breen was appointed. Even after stripping out charges, Tyco's operating profit margin plunged to 12.9% in the first six months of the current fiscal year, down from 17.2% a year ago, figures Albert Meyer, who heads 2nd Opinion Research. Moreover, while Tyco reported strong cash flow of $1.1 billion in the latest quarter, much of that came from working capital improvements and capital-spending cuts.

And the accounting issues aren't about to go away. Some analysts predict the SEC may force Tyco to restate earnings for prior years, a step Breen is resisting. It also may force Tyco to write down the $26 billion of goodwill built up during the Kozlowski years. Why doesn't Breen just get it over with? Because earnings and goodwill restatements would bolster the case of shareholders seeking compensation for the approximately $90 billion drop in Tyco's market value since early 2002.

TIME FOR A RETHINK? Breen clearly hopes to keep the settlement tab for the lawsuits and IRS probe manageable. But if the bill for the shareholder suits exceeds $10 billion, as some fear, and if the IRS insists on a big payout, Tyco will need far more than the $4 billion it has in cash right now. "The sale of ADT is very logical," argues Heymann, since it could fetch $9 billion.

Even if Breen can limit the damages, getting rid of ADT might still be the right move. While Tyco's health-care and electronics units have solid prospects, ADT is Tyco's most troubled business. Operating margins have fallen to 9% from 15% a year ago.

Moreover, while holding Tyco's disparate parts together made sense when the mergers and acquisition machine was running full throttle, it may be time to rethink the conglomerate's holdings, says Mark L. Sirower, head of the M&A practice at Boston Consulting Group. With so many risks still looming, Breen can't close the door yet on dismantling this part of the Kozlowski legacy. By William C. Symonds in Boston


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