Is It Safe to Buy Tyco Again?


By Amy Tsao After more than six months of testimony and deliberation in the case of former Tyco International (TYC) Chief Executive Dennis Kozlowski and Chief Financial Officer Mark Swartz, Judge Michael Obus declared a mistrial on Apr. 2. Even as it appeared in recent days that the jury was finally ready to come to a decision, Obus says his decision was neccessary as one of the jurors -- the now infamous Juror No. 4 -- was under overwhelming outside pressure. Kozlowski and Swartz were facing 32 charges, including grand larceny, conspiracy, and falsifying business records.

On Wall Street though, analysts and investors seem to be having an easier time reaching consensus on the turnaround efforts under way at Tyco. It's "in great shape," says Buckingham Research analyst Edward Wheeler. "It's a leader, it's executing, and it's generating a lot of cash." He rates the stock of the diversified conglomerate a buy, as do 13 out of 15 analysts, even though its shares have already run up over the past year, from a low of $11 to around $29 as of Apr. 2.

SHAKY GAINS. CEO Ed Breen, who succeeded Kozlowski almost two years ago, is getting high marks for the changes he has made. He has appointed an independent board, an element of corporate governance lacking under previous management. Breen has also promised to divest nonessential businesses by the end of 2004 and has shifted Tyco's focus to expanding profit margins via cost-cutting rather than acquisitions.

"Since the turmoil, new management is doing a good job of settling things down," says Standard & Poor's analyst Mike Jaffe. "The company is poised to move on."

Yet uncertainty may continue to plague Tyco in the aftermath of a high-profile courtroom drama over whether former execs pilfered $600 million from corporate coffers. Breen's turnaround efforts, though laudable, are still in the early stages. Lingering concerns include a mountain of debt and sky-high goodwill left over from a legacy of growth-through-mergers that will need to be charged against profits at some point. And shareholders want Tyco to pay in civil court for its alleged role in what happened while Kozlowski and Swartz ran the Bermuda-based conglomerate.

CURRENCY BOOST. "Given the uncertainties, I'd rather not attach a higher multiple to the stock," Jaffe says, rating the shares neutral. (Jaffe does not own Tyco shares, and S&P doesn't perform banking services.)

Tyco's earnings are up, but the gains aren't coming from stronger revenue growth. For its fiscal first quarter ended December 31, 2003, Tyco reported income growth of 27%, to $719 million, on revenues of $9.7 billion. The 8.7% rise in revenue was due in part to the weak dollar.

Sales for the fiscal year ending this September are expected to rise about 5% -- again, thanks largely to positive currency impact. Breen recently reaffirmed earnings guidance of $1.42 to $1.52 per share for the fiscal year ending Sept. 30, up from 52 cents for 2003. (Results for 2003 were hurt by a $390 million restructuring charge taken in the fourth quarter.)

"FAIRLY VALUED." Breen has promised better organic growth for Tyco's divisions, which include health-care, electronics, and security systems. But sales of many of its products and services have remained weak because of the lukewarm economic recovery.

Across the board, demand seems to have improved in the last two quarters, says Jeff Graff, analyst at Victory Capital Management. Graff applauds management's latest initiatives, but he figures the stock is "fairly valued" at a forward price-earnings ratio of 16 times consensus earnings per share of $1.81. He doesn't currently recommend the stock. (Graff doesn't personally own shares. His firm may own Tyco in its index funds.)

Revenue growth in fiscal 2004 likely will be led by the relatively strong electronics and health-care divisions. Weakness in other units, such as fire protection and security and engineered products, however, could hold Tyco back. S&P's Jaffe says revenues at these businesses could be under pressure from "soft" commercial construction markets. He notes that Tyco has been having a hard time retaining security customers in Europe.

LOGIC PROBLEM. "I wouldn't buy the shares, because it's grossly overvalued," says Peter Cohan, president of management-consulting and venture-capital firm Peter S. Cohan & Associates in Marlborough, Mass. Earnings growth of about 20% on single-digit sales growth isn't enticing, he says. "If you look at the growth rate, valuation, and debt, it's hard to see the logic of the stock being cheap at this point." (Cohan doesn't own shares in Tyco and does no business with it.)

Tyco predicts free cash flow in the current fiscal year will exceed $3.2 billion, about the same as in 2003. That's an adequate level to help pay down $18.2 billion in long-term debt as of the end of fiscal 2003, Jaffe says. However, nearly more than $26 billion in "goodwill can give you some nervousness," Jaffe says. Adds Graff: "It's definitely one of the risks to the story."

And over the longer term, shareholder lawsuits could have a financial impact. Tyco is "ultimately responsible for what those two were doing, despite the fact that current management had no involvement," says Aaron Skloff, an analyst at independent institutional research firm Pittsburgh Research. (Skloff doesn't own shares, and his firm doesn't do banking for Tyco.)

HEFTY DAMAGES? Outstanding shareholder lawsuits could take years to resolve, says Arthur Pinto, a professor at Brooklyn Law School. Tyco faces two main suits: A class action alleging that fraud occurred during Kozlowski's tenure and a derivative case, in which shareholders are suing former directors on the corporation's behalf.

"The defense [in the criminal trial] said the board knew what [Kozlowski and Swartz] were doing," says Sherrie Savett, an attorney at Berger & Montague in Philadelphia, the lead counsel in the derivative case. "If that's true...it goes a long way to making our case," Savett argues.

Much of the potential expense would likely be covered by insurance, though that's not a certainty, says Prudential Equity Group analyst Nicholas Heymann, who figures Tyco might have to pay up to $10 billion to $20 billion in damages to shareholders. Tyco declined to comment on its exposure to civil litigation. (Heymann doesn't own Tyco shares, and the firm has no other conflicts.)

After losing tens of millions of dollars worth of market cap as the alleged misdeeds of its former execs came to light, Tyco is gradually winning back Wall Street's favor. And though it seems to be doing the right things on the business front, the reign of Kozlowski & Co. may cloud Tyco's prospects for some time to come. Tsao covers the markets for BusinessWeek Online in New York


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