New Accounting Setback Knocks 6% Off Tyco

The big questions continue to hang over the company despite CEO Ed Breen's turnaround efforts.
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Tyco

(TYC)

investors, hoping for a rare yawn, may have a new reason to scream instead.

The scandal-plagued company is reportedly set to spring another big surprise on weary shareholders who had been crossing their fingers for a boring earnings report this week. According to a front-page article in Wednesday's

Wall Street Journal

, Tyco has uncovered $1.2 billion in new accounting problems -- on top of $325 million in accounting charges announced last month -- that the company could disclose with its second-quarter earnings report on Thursday.

Most of the fresh charges, stemming from Tyco's fire-and-security and engineering divisions, will apparently be triggered by the adoption of more conservative accounting rather than the correction of actual mistakes. The charges are not expected to hurt Tyco's future cash flow, perhaps the most crucial metric for the debt-laden conglomerate. But they will slice into earnings -- and, more importantly, could whack away at Tyco's already battered credibility.

The latest setback will also continue to vindicate short-sellers, who've been warning about major accounting problems for years.

"The beat goes on," one short-seller said. "Everything the shorts have been complaining about" is materializing."

Still, even some long-term Tyco bears were predicting a relatively quiet quarter before another storm hit. And the market -- generally optimistic right now, anyway -- was placing some bullish bets on Tyco's stock before the

Wall Street Journal's

report. Following a surge early this week, Tyco shares were trading above $15 for the first time since the company warned of fresh accounting troubles last month. But news of another big accounting blow immediately chopped $1 from Tyco's share price in Wednesday's pre-market session, to $14.34.

Long Road

For Tyco, the fresh accounting woes are just another bump in the road on the long, hard -- and, some believe, impossible -- journey to recovery.

Nicholas Heymann, the lone Wall Street analyst who's cautious on the stock, doubts Tyco can stage any meaningful rally until the company resolves regulatory and legal problems that could haunt it for at least another year. In the meantime, Heymann wouldn't be terribly surprised to see Tyco lower its full-year guidance -- already shaved by a dime or two last month -- once again.

"Tyco's just-reduced FY03 guidance could still prove over-optimistic," the Prudential analyst wrote last month. "We would not rule out the potential for further modest downward adjustments."

When issuing its profit warning in March, Tyco said it was on track to deliver full-year earnings of $1.30 to $1.40 a share -- well below the historical profits reported when acquisition-happy Dennis Kozlowski was at the helm of the company he's now accused of looting. But Ed Breen, Kozlowski's conservative replacement, has purposely set out to tone the company down.

"This is not an acquisition machine anymore," Breen said in March, during his first public appearance before analysts. "It's an operating company.

"This is the year to build the foundation, clean the ship up and get this thing moving down the road."

But Heymann, for one, isn't holding his breath for a quick turnaround.

"Tyco's rebuilding process is likely to be more complicated and take longer than what investors previously had anticipated," said Heymann, who has a hold recommendation and a $14 price target on the stock. "While Tyco may have numerous opportunities to pursue to improve performance, we feel none of the anticipated potential fundamental improvements should be viewed as 'light switches' in nature that are capable of immediately lifting the sustainable level of Tyco's earnings and true cash flow."

For now, the market is expecting Tyco to deliver second-quarter earnings of 32 cents a share -- matching last quarter's results -- then ramp-up profits during the second half to meet full-year guidance.

Clutter Buster

Investors are already braced for some clutter in Thursday's report.

Last month, Breen stunned Wall Street -- and sent Tyco shares into another skid -- by revealing that the company had just discovered new accounting problems in its fire and safety division. The new mistakes, expected to result in charges that will snatch 10 cents from this year's earnings, went undetected by a forensic audit launched by high-profile attorney David Boies last year.

The Boies audit essentially declared Tyco "fraud-free" and paved the way for a crucial securities offering just ahead of the latest accounting bombshell. While saying he was disgusted by the fresh accounting problems, Breen stopped short of declaring that Tyco's books are fully clean.

"Hopefully, there are not a lot of other things out there," he told analysts in March. "But I cannot commit that to you." Indeed, the

Wall Street Journal

quoted a person close to Tyco Wednesday saying the company might disclose an additional $1.2 billion in new accounting problems when it reports earnings.

Still, even Heymann isn't expecting a massive "big bath" charge that might allow Tyco to quickly clear the decks. Quite simply, he believes Tyco is in no position to take such a charge -- even if the company would like to do so. He says Tyco must resolve current investigations and show strong evidence of a cyclical recovery before it can simply take a big charge and put its past behind it.

But the company continues to struggle -- with more than accounting problems. Tyco's engineering and safety divisions, in particular, have weathered setbacks in the weakened economy. Still, Breen insists that Tyco has strong businesses well positioned for long-term growth.

"If I could recreate a portfolio, I don't think I would do too many things differently," he said recently. "These are businesses that look pretty exciting over the next five years."

But short-sellers are skeptical. They believe Tyco is weighted down with second-rate businesses picked up in a mindless acquisition spree. Even Heymann, who thinks Breen may be able to turn the company around, still isn't quite sure what to make of Tyco. He believes Tyco may sell off entire divisions -- and write off huge chunks of goodwill -- before the "new" Tyco can truly emerge. And he sees little opportunity for Tyco to reinvest in itself, creating new value for shareholders, until 2005.

In the meantime, he expects the stock to remain well below historic levels. The stock -- which fetched $60 at its peak -- hasn't traded above $20 in nearly a year.