Tyco Really Is That Good

Tyco(TYC) is one of those stocks that just seem too good to be true.

Here's a diversified industrial company, involved in the manufacture of such unsexy product lines as electronic connectors and fire alarms, which in the midst of one of the toughest economic environments in a decade just posted year-over-year earnings growth of 34% in the September quarter.

I can't deny that the stock makes me nervous, particularly because it seems every sell-side analyst who covers Tyco absolutely loves it. (Not surprisingly, Tyco is very active in the mergers and acquisitions department, creating lots of lucrative investment banking business that those analysts' firms are probably eyeing.)

And it's not as though Tyco hasn't scared the daylights out of me before. My former firm, Ark Asset Management, owned the stock back on Dec. 9, 1999, when Tyco announced that the Securities and Exchange Commission was conducting a "non-public formal inquiry" into the company's financial statements. I thought my worst fears about Tyco's numbers being too good to be true had finally materialized. The stock plunged 22% that day.

But what initially appeared to be a disaster turned out to be an incredible buying opportunity for Tyco's shares. By June 26, 2000, when the inquiry was over, the stock was up 71% from its low. Tyco had to restate its financials for fiscal year 1999 and for the first six months of 2000, but the adjustments were insignificant and had no impact on cash flow.

In the meantime, Tyco just keeps delivering, and not just earnings growth but strong cash flow as well. So with the stock selling at a price-to-earnings ratio of just 15.5 times fiscal 2002 estimates of $3.64 a share, I have to be interested. At this price, Tyco is cheaper than other diversified industrials such as Illinois Tool Works(ITW) (P/E of 22), Emerson(EMR) (a P/E of 18) and United Technologies(UTX) (P/E of 15.7).

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Tyco is an amalgamation of many acquisitions made since Dennis Kozlowski became CEO in 1992. Since the end of that year, the company has expanded revenue and earnings at compounded annual rates of 32% and 50%, respectively. It has focused these acquisitions on sectors that it perceives to be ripe for consolidation, and that have solid top-line growth and opportunities to expand margins. These include electronic components and connectors, fire and safety systems and medical products. If there's one criticism one can levy at Tyco, it's that because of a voracious appetite for acquisitions, the company's return on invested capital has averaged just 9.5% over the past decade, and there's certainly room for improvement.

But cash-flow generation is strong, indicating that earnings quality is relatively high at Tyco. For example, in fiscal 2001 (which just ended in September), free cash flow was $4.75 billion, or 92% of income. And compared with other industrial companies, Tyco's free cash flow as a percentage of sales, at 13%, is well above average. Just for comparison, Emerson's and ITW's comparable numbers are about 8%.

Over the next couple of weeks, Tyco will be in the news a lot, and I suspect the coverage will be favorable. The company is appearing at four broker-sponsored conferences this month and also will have its own analyst meeting today (you can listen in on a simultaneous Webcast by going to www.tyco.com starting at 8 a.m.). My bet is that management will give a very upbeat presentation to the investment community, including confirmation of analysts' estimates for next year. That could help the stock.

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