On May 26, 2004, Standard & Poor's Ratings Services raised its corporate credit and senior unsecured ratings to 'BBB' from 'BBB-', as well as other ratings on Pembroke, Bermuda-based Tyco International (TYC), and related subsidiaries' debt. At the same time, Standard & Poor's raised its short-term corporate credit and commercial paper ratings to 'A-2' from 'A-3'. The outlook is now positive. At March 31, 2004, the global diversified industrial manufacturer had about $20.7 billion in total debt outstanding.
The rating actions reflect substantial recent and prospective improvement to Tyco's debt term structure, leverage, free cash flow generation, and access to the capital markets. Driving these ongoing improvements are management's strategies of strengthening operating efficiencies, divesting non-core units, and using improving and substantial free cash flow toward reducing debt. Standard & Poor's expects that Tyco will continue to use free cash flow mainly for debt reduction and pension funding. Standard & Poor's also expects that initiatives, particularly in the fire and security and electronics divisions, collectively will continue to improve operating performance and further strengthen Tyco's financial profile.
The upgrade also incorporates capacity for the possible resolution of several contingent liabilities, including open IRS tax audits and shareholder lawsuits that may require substantial funding. Although Standard & Poor's is not aware of any specific guidance Tyco has provided with regard to the possible cost of resolving these matters, Standard & Poor's has incorporated into its ratings and outlook the potential for up to $4 billion of funding, based on its view of Tyco's earnings and free cash flow generation and an assumption that Tyco would continue to maintain sufficient access to the capital markets. As such, within the scope of Standard & Poor's estimates, Tyco's contingent liability exposures are collectively viewed as something that could potentially restrain further improvement to the balance sheet, but for a relatively short period. Still, each contingency will be evaluated as it is resolved.
The ratings reflect Tyco's above-average business profile, its moderate financial policies, and its improving financial flexibility. The ratings incorporate tolerance for a prescribed level (up to $4 billion) of adverse developments relative to ongoing operational and litigation contingencies. Tyco International, with approximately $37 billion in revenues, is a diversified global manufacturer, with operations in five primary sectors: electronics, healthcare, fire and security, plastics, and the general industrial markets.
Competitive strengths for the company include good end-market, customer, and geographic diversity (over 40% of sales outside North America); leadership positions within several product lines; and a substantial base of recurring revenues, all of which provide a measure of earnings stability. Still, pricing pressures exist, particularly in the electronics business. This factor, which along with weakness in some general industrial markets and higher raw material prices, has somewhat tempered profit growth. To improve operating performance, Tyco has initiated a number of operating actions through its Six Sigma and lean manufacturing programs, including improved procurement and strengthening of working capital management. The company estimates that these initiatives could yield $3 billion in pretax cash flow in the next few years, a goal Standard & Poor's views as reasonable.
In sharp contrast to prior management, Tyco's strategy for the next couple of years is expected to be primarily focused on internal growth, with the company increasing its R&D spending (particularly in its healthcare operations) in an effort to increase its ability to generate new products. These actions, combined with reduced security dealer account acquisitions, should enable Tyco to generate meaningful free cash flow in the $3 billion to $4 billion range annually, and gradually strengthen its earnings, even without meaningful pickup in end-markets, although certain end markets, including commercial construction and general industrial are improving.
Members of prior management have been indicted on various charges, including misappropriating several hundred million dollars of corporate resources and violating securities laws. Numerous reviews and audits have also uncovered a pattern of aggressive accounting, leading to a spate of charges in excess of $1 billion. Tyco has taken several steps to strengthen its corporate governance, including a new management team and board of directors, updating reporting relationships, replacing certain senior managers, and beefing up its internal audit team. Still, several unresolved items remain credit concerns, including:
Investigations by the SEC's Enforcement division;
Open IRS tax audits;
Possible additional revisions to accounting practices;
Uncertainty as to the resolution of shareholder class action lawsuits;
Subpoenas by the District Attorney of New York County, U.S. Attorney for District of New Hampshire, among others; and
The magnitude of legal costs because of limited directors' and officers' (D&O) coverage.
Furthermore, on July 29, 2003, Tyco restated its historical financial statements for the previous five and a half years. In early August 2003, the company received a letter from the SEC's Division of Corporation Finance stating that it had completed its review of Tyco's periodic reports. The restatement has potentially strengthened the claims of the litigating shareholders. While Standard & Poor's is not aware of any estimate Tyco has made toward these contingent liabilities, it has factored into the current rating and outlook the possibility for up to $4 billion of cash payments based on its expectations of earnings and free cash flow for the company. Nonetheless, each contingency will need to be evaluated as to its impact on creditworthiness as specific resolutions are reached.
Tyco continues to improve its financial profile and liquidity position. As of March 31, 2004, Tyco had total debt to EBITDA (unadjusted for pension liabilities) of 2.7x and funds from operations to total debt of 27% on a trailing 12-month basis (excluding charges). There is ample room for improvement in profitability through improved purchasing leverage (Tyco spends about $16 billion in materials annually), lean manufacturing, and cost initiatives (particularly in fire and security and engineered products), and if pricing of metals and resins moderate. As a result, for the rating, Standard & Poor's expects funds flow to total debt to strengthen to the 30%-35% area and total debt to EBITDA to improve to no more than 2.5x. Nonetheless, Tyco's large intangible asset base limits capital structure quality and constrains pretax returns on permanent capital measures.
Tyco's FASB 142 review (goodwill impairment testing) for 2003 led to the company recording a $412 million charge across several business units. These charges did not meaningfully affect financial covenants, and Tyco is not expected to experience meaningful goodwill charges in the near future. Still, the company has ample room under its bank covenants if such a noncash goodwill charge must be taken.
The intercompany guarantee structure Tyco implemented in 2003 remains in effect and mitigates concerns that the claim of structural subordination for senior unsecured holding company creditors would be subordinate to those of operating company creditors in a bankruptcy. Over time, however, an increase in the percentage of priority liabilities to total assets, caused by lower holding company debt or higher subsidiary liabilities, could lead Standard & Poor's to differentiate between its corporate credit and senior unsecured ratings on Tyco.
At September 30, 2003, Tyco's pension plans were underfunded by $1.9 billion, and the firm had about $400 million of other postretirement liabilities. Treating these liabilities as debt-like, funds from operations to total debt would have been about 21% at fiscal year-end 2003, compared with 22% on an unadjusted basis. In 2003, Tyco made voluntary contributions in excess of $200 million and is expected to make additional voluntary contribution above the modest amount required in 2004. These liabilities should continue to not be a driver of ratings activity.
Short-term credit factors: Tyco's short-term rating is 'A-2'. At March 31, 2004, nonrestricted cash and cash equivalents were about $3.1 billion--Standard & Poor's views cash balances in the $1.5 billion-$2 billion range as a maintenance level of liquidity. Tyco is expected to generate free cash flow of more than $3.2 billion in 2004 (after security dealer program spending, outlays associated with restructuring and previous acquisitions, and cash contributions to defined-benefit pension plans). End-markets, including commercial construction and certain general industrial sectors, are starting to show signs of recovery, which could further enhance profitability and cash flow.
In addition, Tyco had just $125 million outstanding on its $2.5 billion unsecured bank credit facilities at March 31, 2004. Potential asset divestitures are another possible source of flexibility. Tyco's debt maturity schedule is meaningful (with approximately $1 billion and $826 million scheduled for calendar 2004 and 2005, respectively) but manageable. Short-term accounts receivable securitization programs totaled $783 million at March 31, 2004. Dividends are expected to remain steady at about $100 million per year, and no share repurchases are currently expected. Acquisition activity is expected to be limited in the near term.
Tyco has ample room under its bank loan covenants, providing a fair amount of capacity even if it needed to take additional asset write-downs and/or potential charges related to the contingent liabilities.
The company has a $175 million accounts receivable securitization program under which the purchaser could elect to discontinue purchasing receivables at the current ratings, another $350 million that could be terminated if the parent is rated below 'BBB-' by Standard & Poor's or 'Ba3' by Moody's, and an additional $350 million that could be terminated if ratings fall below Standard & Poor's 'BB-' rating or Moody's 'Ba3' rating.
Outlook: The outlook is positive. Tyco's strategy of improving internal operations and its commitments to using the majority of its substantial free cash flow toward reduction of debt and unfunded pension liabilities should lead to further strengthening of its credit profile, while contingent liabilities are currently viewed as doing no more than temporarily delaying further credit quality improvement. Ratings could be raised in about two years should the financial performance improve beyond Standard & Poor's expectations. Ratings could be raised sooner should contingencies be resolved for far less than expected and management's focus on improving credit quality continues. From Standard & Poor's RatingsDirect