January 23, 2002


Tyco Plans to Split Into Four Companies

Amid Accounting Questions, Stock Slide







As the collapse of Enron Corp. triggers widespread investor anxiety about companies with inscrutable finances, giant Tyco International Ltd. -- its stock price depressed amid persistent questions about its books -- announced a surprise plan to split into four separate companies.


The breakup represents a sharp departure from nearly a decade of acquisition-fueled growth that transformed Tyco from an obscure maker of fire-protection devices into one of the world's biggest conglomerates, with $38 billion in annual revenue and a stock-market value of about $95 billion.


The move is an about-face for L. Dennis Kozlowski, Tyco's ambitious chairman and chief executive, who last year said he was aiming for $100 billion in revenues by 2006. Now, Tyco is worth at least 50% more broken up than as a whole, he said. While saying that Tyco's accounting practices are spotless, Mr. Kozlowski told investors that separating the company into smaller, independent entities will offer investors "greatly increased simplicity, clarity and transparency."


Mr. Kozlowski declared: "A lot of companies are going to suffer for Enron's sins." But he said his spinoff wasn't planned in reaction to the recent drop in Tyco's stock price. Rather, he said, for the past 18 months or so, Tyco executives have been frustrated by the low ratio of the company's stock price to its earnings, even as the company has continued to deliver strong earnings growth.


Transparency was exactly what some investors believed was lacking at Tyco, whose chief businesses include security gear, medical products, and financial services. The company's acquisitions, while generally regarded as well executed, made its financial statements increasingly difficult to analyze. Acquired companies disappeared into much bigger Tyco units, making their subsequent performance impossible to track. Some smaller acquisitions were never even announced.


Tyco's breakup marks the latest sign that investors and regulators are demanding more clarity from companies' disclosures to the public. In the wake of the Enron debacle, jittery investors have been fleeing any stock with even a whiff of accounting controversy. When a wave of fresh accounting rumors about Tyco started soon after Jan. 1, the company's shares tumbled nearly 25% in less than three weeks, wiping almost $30 billion from its market value. That created profits for short sellers, whose trading strategy bets on a stock's decline.


"Enron and others have really shaken things up, and it's provided fuel for shorts who have been all over [Tyco] for years," said Bruce Bartlett, director of growth investing at Oppenheimer Funds, which owns about 5.5 million shares of Tyco in eight different mutual funds. Mr. Bartlett said he doesn't believe any of the buzz about possible accounting problems at Tyco. But investors, he said, "hate stories that don't have accounting transparency."


The Securities and Exchange Commission Tuesday reminded public companies of the need to clearly disclose financial transactions, including off-balance-sheet financings, in their forthcoming annual reports. Enron used such arrangements to keep large amounts of debt off of its books. There is no suggestion, even from Tyco's critics, that it has employed off-balance-sheet financing or secret partnerships.


Moody's Investors Service, the big credit-rating agency, has made an unusual demand of more than 4,000 bond issuers: to provide new information on any off-balance-sheet arrangements that could pose financial risks.


"We need better disclosure about these matters in this reporting season," SEC Chief Accountant Robert K. Herdman said in the commission's statement. He urged companies to exceed minimum legal disclosure requirements and also said the SEC is continuing to study how it can improve disclosure of esoteric financial arrangements.


Auditing firms also are clearly feeling pressure from the very public pillorying of Enron auditor Arthur Andersen LLP. That harsh spotlight is "stiffening the spines of auditors in other companies," said James Gipson, lead manager of Clipper Fund, a mutual fund with about $2.5 billion in assets. "Audits taking place right now are likely to be very diligent, much more so than they were a year or two ago," he said. "In the long run, investors will be well served by that."


Professional investors say they are stepping up their own vigilance because of the Enron meltdown. "We are paying more attention to" companies' more complex financial engineering, said Steve Fossel, a portfolio manager and vice president with Berger LLC, a unit of Stilwell Financial Inc. While Berger has always made an effort to analyze such arrangements, recent events have moved that "more toward the front of your mind," he said.


Tyco's announcement last week of results for its fiscal first quarter, which ended Dec. 31, provided a prime example of what some investors have called the company's preference for baffling disclosures. The results featured three separate changes in accounting practices and a "pro forma" section on hypothetical year-earlier earnings. There were also numerous charges and credits Tyco treated as extraordinary, even though some are considered part of operating results under generally accepted accounting principles.


Although the accounting-practice changes were adopted to conform with recent changes in general standards, even some accounting professors were left shaking their heads at the complexity of the results.


Meanwhile, the Bermuda-registered Tyco has also been lowering its taxes and interest costs through a complex international structure that, in part, involves issuing debt through a Luxembourg subsidiary. Befuddled investors have found themselves wading through numerous lengthy footnotes in an attempt to decipher all of this. Some wonder how Tyco has been able to report 40% average annual growth in per-share earnings over the last five years with a grab-bag collection of businesses, ranging from disposable diapers to home-alarm systems.


Tyco's response has been that it chooses the right businesses to acquire, cuts costs to maximize efficiency and provides generous incentives to keep its managers at the top of their game. It has also said that its free cash flow -- which it put at $4.8 billion last year -- demonstrates the integrity and authenticity of its earning power.


Until the Enron scandal, questions about Tyco's accounting seemed to have subsided. An SEC investigation of its merger-related accounting ended in 2000, when the SEC essentially cleared the company, and the stock had recovered.


Mr. Kozlowski said Tyco executives began seriously considering a breakup more than a year ago but didn't move forward with it until he began informally approaching some directors last month. The company then engaged Goldman Sachs & Co. to analyze a potential breakup. The final decision took place at a two-day board meeting in Bermuda that ended Monday. "We didn't just wake up a week ago and say, 'Hey, the stock is going down. Let's break up the company,'" the Tyco chief said.


Under the plan to separate the company into four parts, the security and electronics units, with $17.6 billion in 2001 revenue, will form the core of a slimmed-down Tyco run by Mr. Kozlowski. Three other units -- a finance subsidiary, a health-care business, and a unit making fire-protection devices and "flow-control" equipment, such as valves and pipes -- will each be split off into a new company. As much as 20% of each new company will be sold in initial public offerings.


After the IPOs, Mr. Kozlowski said Tyco plans to spin the remainder of the three companies out to shareholders by the end of 2002. In addition, Tyco plans to sell its plastics unit, which Mr. Kozlowski predicted could bring $3 billion to $4 billion. If all goes as planned, Tyco plans to eliminate $11 billion of its $23 billion in debt, excluding obligations of its finance arm.


Investors reacted cautiously to the breakup plan, pushing Tyco shares up just $1.10, to $47.55, in 4 p.m. New York Stock Exchange composite trading Tuesday. That's still far below the nearly $59 level at which Tyco started 2002, and well short of Mr. Kozlowski's prediction that the breakup plan would add 50% in value for investors.


Don MacDougall, an analyst with J.P. Morgan, praised Tyco's plan, estimating the breakup value of the company at $90 a share. Mr. MacDougall said investors will be eager to snap up shares in the IPOs, especially of the company's health-care business, a Wall Street favorite these days. That business makes medical products such as sutures, syringes, and diagnostic-imaging supplies.


Mr. MacDougall said dividing the company into smaller pieces should allay investor suspicion about Tyco's complexity, because each segment will disclose far more detailed information. "Acquisitions at Tyco created financial statements that are far more complex than the average company's," he said. That depressed Tyco's share price, he added. "We've long felt that discount is inappropriate."


But some investors reacted more skeptically. Kevin McCloskey, a portfolio manager at Federated Investors Inc. in Pittsburgh, which owns 4.3 million Tyco shares, said the plan could deliver higher share prices, but he added, "I have to question whether this is the time to give up on their [prior] strategy." He said he suspects that Tyco executives were afraid they wouldn't be able to meet their own earnings projections, and with the stock price so low, couldn't make new acquisitions. "So they come up with Plan C, which is split up the company," he said.


Piloting the audacious breakup plan through his board in just a month is characteristic behavior for Mr. Kozlowski, the son of a Newark, N.J., detective who joined Tyco as assistant controller in 1976. After running three divisions, he took the reins as chief executive in 1992. The company then had $3 billion in annual revenue from such operations as valves, pipes and fire-sprinkler systems. By last year, he had expanded revenue 12-fold, gobbling up scores of companies along the way, including ADT alarm systems, AMP electrical connectors and U.S. Surgical.


In making deals, Mr. Kozlowski insists on a simple formula: Tyco doesn't do hostile deals, and every acquisition has to add to earnings immediately. Once Tyco acquires a firm, it cuts costs, sometimes ruthlessly. On the same day in 1999 it bought Batts Inc., a family-run maker of plastic hangers, Tyco executives stunned the company's employees by announcing the closure of all three factories in its Michigan hometown. Tyco executives said the closures helped integrate Batts into its other hanger operations.

Tyco Hopes to Increase Shareholder Value With Breakup, but Wall Street Is Skeptical


Tyco is highly decentralized, run from a simple, two-story wooden building in Exeter, N.H., staffed with top executives and a few dozen accountants, lawyers and acquisition specialists. Unit managers are given considerable leeway -- and paid handsomely for delivering results. During much of the 1990s, the formula was a spectacular success, with the stock rising more than 12-fold between the day Mr. Kozlowski took the helm and early October 1999.


That was about the time the first serious questions about Tyco's accounting arose. The concerns were aired in a newsletter, published by Dallas money manager David Tice. Mr. Tice claimed that Tyco had a history of taking huge acquisition-related charges that could be used to pump up profits later. He also warned that investors weren't paying enough attention to the charges, which he said were obscuring the company's actual results.


Tyco executives hotly disputed the allegations, but its stock took a steep fall after the SEC began an informal inquiry into the company's accounting practices. In mid-2000, after Tyco made some minor adjustments in restating its books, the SEC ended its inquiry without taking any action. Bullish investors saw that as vindication of Tyco's bookkeeping.


After the SEC inquiry ended, Tyco kept chugging along, delivering a 42% increase in per-share earnings in fiscal 2000, before what Tyco called restructuring and other "non-recurring" items, and another 29% increase on a similar basis last year. But the stock didn't take off as Tyco executives hoped. Instead, it bounced up and down with the market. It closed Tuesday below its October 1999 level, prior to Mr. Tice's report.


Tyco executives believe they have been victimized, in part, by short sellers, who try to profit from a stock's decline by selling borrowed shares in hopes of replacing them with shares bought later at a lower price. The company has been a favorite of the shorts, who have contended that Tyco's numbers are simply too good to be believed.


For starters, Tyco critics have said the company has been improving its performance by having acquired companies take inflated write-offs and otherwise manipulate their books in their last few months of independence before being gobbled up by Tyco. This period typically isn't subject to any scrutiny by outsiders because the acquired company usually doesn't file financial statements for the period.


For example, some cite a series of charges by finance company CIT Group Inc. last year in the two months before it was acquired by Tyco. CIT posted a net loss of $78.8 million in its final two months of independence, when investors didn't much care. Then, after being absorbed by Tyco, it posted net income of $71.2 million in the remaining month of its June quarter. Tyco executives have said the accounting was proper, and that they told investors that CIT's one-month results were artificially high owing in part to large quarter-end revenue.


Others have noted Tyco's seemingly uncanny ability to keep lowering its tax rate, especially in quarters in which it needs extra income. In last year's fourth quarter, the company reported a tax rate of just 19.2%, down from 24.7% for the first nine months, and 24.2% in the year-earlier period. Tyco has said it had overestimated its tax rate earlier in the year and had to adjust it in the fourth quarter. The lower rate added about five cents per share to earnings in a quarter in which it beat analysts' expectations by two cents.


Even many veteran money managers have said Tyco's financial statements have been so complex that they didn't understand them fully. Alfred Harrison, a manager of Alliance Premier Growth Fund in New York, which has $12 billion in assets, including Tyco shares, said recently that "nobody knows how they put it together, but they do." Mr. Harrison likened Tyco's complexity in some senses to Enron, saying "to some degree, they become faith stocks."


When that faith started to diminish in recent weeks, Mr. Kozlowski vowed that he would no longer use Tyco stock to make acquisitions. With the company shouldering $23 billion in debt -- mostly from prior deals -- many wondered how Tyco would be able to keep gobbling up companies. The fear was that without dealmaking, the company's growth would begin to falter.


Mr. Tice, the Dallas money manager, said Tuesday's announcement suggested a repudiation of the company' strategy of growing through serial acquisitions, financed with a rising stock price and growing debt levels. "This is essentially Tyco's dream exploding," he said. "The company always wanted to get big -- to grow -- not break up."


About a month and half ago, Mr. Tice also started shorting Tyco shares in his Prudent Bear mutual fund. He said he did so in part because he believed investors were starting to grow more skeptical of companies with obscure financial statements. "We just felt like earnings would slow down and that there would be more concern about accounting issues after Enron," he said.


Mr. Kozlowski denied any "defensive" reason for the breakup plan, saying the company was on track to make its earnings targets for this year. He said Tyco would deliver $5.5 billion next year in free cash flow -- a measure tracked by many Tyco analysts and investors, who consider it a key indicator of earnings quality. Mr. Kozlowski also said Tyco had no reason to be concerned about its debt, which was low considering the size of its total balance sheet.


But at some point, the Tyco chief said, investors were going to start clamoring for a breakup. Instead of waiting two or three years to prove to skeptical investors that its model works, he decided on the breakup plan. Sometimes, he added, "you just have to pull the trigger and do it."


Write to Mark Maremont at mark.maremont@wsj.com, John Hechinger at john.hechinger@wsj.com and Karen Damato at karen.damato@wsj.com





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