Scratch Tyco's Surface and You Might Not Like What You See

At first glance, investing in Tyco(TYC Quote) stock looks like a wonderful idea. It's hard not to salivate when looking at Tyco's historical growth in earnings and cash flow, which are both up an average of 30% a year over the past few years. The prudent investor, however, knows better than to take such impressive numbers at face value.

After taking a peek behind the numbers at Tyco, you'll want to run, not walk, away from this stock.

The Business Model

Growth via acquisitions is generally a loser's game -- and Tyco is growing principally through acquisitions. Last quarter, for instance, it boasted 29% year-over-year growth, but this growth was almost entirely due to acquisitions. Without acquisitions, Tyco's growth was a paltry 1%.

Why do I say growth via acquisitions is a loser's game? Because problems always develop, generally on multiple levels. It could be a simple case of overpaying, or integration problems or maybe an unforeseeable downturn in business. Whatever the reason, history is replete with examples of giant companies -- AT&T, Cisco and Lucent to name a few -- that were humbled after squandering billions to pursue growth via acquisitions.

Another reason to avoid Tyco stock is that this strategy of growing by acquisitions is, by definition, only possible if the acquiring company has a cheap currency to employ in acquiring companies.

In other words, either Tyco has an overvalued stock that it can use to acquire other companies, or Tyco has an undervalued stock that can't be used for acquisitions because it would be dilutive. If you look at the hundreds of acquisitions recently made using Tyco's stock, it's apparent that Tyco's management believes its stock is at least fully valued and certainly not undervalued, and investors should take notice.

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A final point: Investors should be careful not to look exclusively at earnings growth at companies such as Tyco that subscribe to a robust acquisition strategy for growth. A better way to evaluate Tyco's strategy is through an ROIC (return on invested capital) analysis. This calculation looks at earnings growth relative to balance-sheet growth. By my calculation, Tyco's average four-year ROIC is less than 10%, well below its cost of capital.

How Financially Strong Is Tyco?

To the extent you can find a reasonable margin of safety supporting the stock of Tyco -- and I certainly can't -- you aren't going to find it in the balance sheet.

A close examination of its balance sheet reveals there's not much "there" there. Assets are dominated by goodwill, which has ballooned fourfold between 1998 and today (from roughly $7 billion to $28 billion), because of all the acquisitions the company has made.

The problem with goodwill is that it is a phantom asset. You can't sell it, you can't spend it and you can't borrow against it. There is nothing there except an accounting entry to back up the asset that we call goodwill.

Tyco commands an enterprise value of about $131 billion (market cap of $105 billion plus net debt of $26 billion), but how much is backed up by tangible assets? Here it gets embarrassing. After deduction for goodwill, this $131 billion company has a tangible net book value of $3.5 billion, not much of a cushion for the prudent investor.

Only time will tell if Tyco is the exception to the growth-through-acquisition rule. Most of its acquisitions occurred in the last bull market, at the height of asset price inflation, meaning it probably overpaid for most of them. That fact alone, apart from all the other points I've raised, makes Tyco equity a gamble not worth taking.