Restructuring Tyco
Edward Stavetski
02/01/06 - 07:09 PM EST
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When
Tyco(TYC) reports earnings Thursday before the market opens, many investors will be looking beyond the numbers and focusing on the company's restructuring plans. A spinoff could boost the stock.
All of this restructuring news will make for a complex call, and I'll be looking for signs that the restructuring will unlock value.
I'm a Tyco shareholder and I like the company's strong cash flow and the stock's attractive valuation.
Tyco is a conglomerate with sales of about $40 billion. The firm is divided into four segments: Electronics ($12 billion in sales), Health Care ($9.5 billion), Fire and Security (11.5 billion), and Engineered Products and Services ($6.5 billion). These segments have been built over the years through an aggressive acquisition program, and now management plans to break up the company. I estimate the sum-of-the-parts value of Tyco as $30 to $33 per share, broken down as follows: $15 to $16 for Health Care, $10 to $12 for Electronics, $5 to $8 for Fire/Security/Engineered products.
Tyco recently announced that it is splitting into two segments, with the long suspected spinoff of its Health Care and Electronics businesses. (This leaves Fire/Security/Engineered Products.) Tyco also announced in December that it has sold most of its plastic and adhesives business to Apollo Management for $975 million. Tyco's plastic coat hanger business ($175 million) was excluded from the sale, and is expected to be sold soon. When all is said and done, the company should receive about $1 billion in after-tax proceeds for this segment. The firm could use this to help reduce its $10 billion in debt.
Street expectations have been recently reduced to $9.81 billion in sales and $0.38 in EPS. I expect EPS guidance for 2006 to be $1.82-$1.90, down slightly from previous range. I believe that profits have been hurt by slow growth, distractions from the pending restructuring, and a higher tax rate due to the complexity of tax planning. Below I take a look at the results of each business segment.
To view Robert Martorana's video take of Tyco, click here.
Health Care: This business has 4%-5% growth but has been lacking a well supported research and development program. R&D outlays have been about 2.5% of sales, about half of the level of its competitors. An increase to R&D spending is needed, and this will pressure operating margins down to around 25%. Management already has increased R&D spending in its imaging, respiratory and surgical businesses. The underlying cash flows from this business make this segment worth $15-$16 per share.
Electronics: This segment includes the AMP and Rayco brands, and has growth of 4%-5% and margins of about 15%. While Tyco is a leader in electronics, the business is cyclical and subject to negative pricing pressures, which will moderate growth. The value of this segment is about $10 to $12 per share.
Fire and Security: Tyco's ADT brand dominates the field, and revenue dwarfs its competitors. And more than half of ADT's revenues are reoccurring. I value this business at $5 to $8 a share.
The costs of restructuring Tyco are large. Tyco announced a $250 million to $300 million pretax impairment charge related to the disposal of the Plastics unit. Tyco also announced $1 billion in spinoff charges relating to tax and debt-financing issues. The sale of various subsidiaries will trigger tax events based on the book value of assets sold. These will be after-tax charges, while refinancing and transaction costs will be pretax and unknown. Tyco is estimating there will also be a $1 billion hit to cash flow in 2006, in addition to the $500 million payout for legal issues. If management continues to divest the underperforming businesses, those charges could rise.
Tyco's cash is now expected to drop to around $2.5 billion in 2006. This is still strong, but down from approximately $4 billion in 2005. The debt of $10 billion may be refinanced and will be allocated among the entities. Each entity will pay a dividend to equal TYC's current dividend. Because Tyco expects this restructuring to take until 2007 to complete, the dividend will be frozen at this level.
As for current business trends, it's a mixed bag. Overall, the organic revenue growth rate has been about 4% to 5%, and future growth is also likely to be 4% to 5%. (Little benefit from foreign exchange is expected as the has strengthened against the euro.)
The Health Care segment experienced strong growth in international business. Unfortunately, this was more than offset by revenue and profit shortfalls in the Imaging and Respiratory business, which was hurt by product recalls and regulatory/compliance issues.
Limitations in capacity for the pharmaceutical business added to the shortfall. New capacity is expected in the second quarter of 2006, but charges for product recalls still persist. Elsewhere, revenue and margins in Fire and Security were hurt by weakness in Worldwide Fire Services and Commercial security. Finally, Electronics had strong growth of 7%-8%.
