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Tyco's Tentative Turnaround


Three years after taking the helm at Tyco International Ltd. (TYC), Edward D. Breen has gone a long way toward cleaning up the mess left by his predecessor, L. Dennis Kozlowski, who was convicted on June 17 of 22 counts of securities fraud, conspiracy, and larceny. Today, Tyco sports a market capitalization of $62 billion, more than triple the bottom it hit shortly after Kozlowski left. As of Apr. 1, Breen had nearly halved its ruinous debt to $16.5 billion.

Now the question is whether Breen is running out of momentum. Shares in the conglomerate -- Tyco's businesses range from health care and electronics to home security -- have slipped 15% since January, as investors fret that a weak fiscal second quarter presages slower growth. Breen makes a strong case that his program to boost margins still has plenty of room to run. But critics are once again asking whether it makes sense to keep Tyco's disparate collection of relatively slow-growing units together now that Kozlowski's acquisition-fueled growth strategy has long been abandoned. Says Jeffrey A. Sonnenfeld, associate dean at the Yale School of Management: "There's no real synergy among Tyco's businesses."

ROUGH PATCH?

Investors' immediate concern is whether Breen's turnaround has hit a rough patch. For the fiscal year ended Sept. 30, Tyco's net income tripled as operating margins jumped to 13.2%, from 8.5% in 2003. That reflected a sweeping efficiency drive, in which Tyco closed over 600 facilities and saved some $600 million by consolidating sourcing and implementing a Six Sigma quality drive. But net income plunged nearly 75%, to $192 million, during the quarter ended Apr. 1. With big charges, including asset writedowns in the company's troubled plastics unit, largely responsible for the earnings hit, Tyco contends that the bad quarter was a temporary setback.

But the problems may be more far-reaching. Organic sales growth, which strips out exchange rates and the impact of divestitures and acquisitions, slowed to just 3.4%, well below Tyco's 4% to 6% target. Free cash flow fell 15%, and Tyco lowered its earnings guidance for the full year. Although sales surged a sizzling 15% in Tyco's diverse engineered products group, they were nearly flat in the fire and security division, which is still recovering from Kozlowski-era abuses. And the plastics business posted a $187 million loss, due to asset impairment charges. Tyco has been crimped by weakness in the European auto market and surging commodity prices.

Making matters worse, investors continue to have a hard time getting a handle on Tyco's performance. While Breen has greatly improved the conglomerate's financial reporting, it remains complex, and so many operations have been discontinued that comparing results from one year to the next is tough. As a result, it's difficult "to know what the sustainable operating performance of this company is," says Dan Mahoney, a senior analyst at the Center for Financial Research & Analysis. A Tyco executive responds: "We've gotten nice feedback from most investors on the level of disclosure (MHP)." As Breen continues to look for more efficiencies -- $600 million in cost cuts are targeted in fiscal 2006 -- he's also seeking to get rid of the worst-performing units. "He wants to sell the leaky boats before they take on too much water," says Nicholas P. Heymann, an analyst at Prudential Equity Group. For instance, Tyco's beleaguered plastics unit, which earned just $69 million on sales of $1.7 billion last year, is on the block. The company may prune the weak spots in its $12 billion electronics portfolio. These units, mostly in telecom-related areas, account for about $1 billion in sales, but they are barely breaking even, while the rest of electronics enjoys margins above 17%.

Still, with Tyco facing the prospect of relatively low sales growth, Breen may have to get more aggressive. Indeed, because the company sells at a comparatively low multiple of 16 times forward earnings, compared with 19 for its industrial peers. Heymann suggests Breen might create more value by selling one or more of Tyco's strong businesses, such as the ADT Security Services Inc. unit. One thing seems certain: Tyco will look less and less like the house that Dennis built.

By William C. Symonds in Boston


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