Restructuring Tyco

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%.