Tyco Blossoms as Drama Recedes

Investors applaud the latest strong quarter, but some worry about a rise in rates.
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Tyco

(TYC)

has followed former management's high-profile trial with a little drama of its own.

The giant conglomerate blew past second-quarter profit estimates and confidently raised full-year guidance, offering investors a sense of certainty that last month's mistrial of ousted CEO Dennis Kozlowski, may have denied them. Excluding special items, second-quarter profits jumped nearly sevenfold to 41 cents a share and beat the consensus estimate by a nickel. Free cash flow -- a metric closely monitored by the market -- surged 72% to $1.4 billion.

Tyco now expects to generate a full-year profit of $1.52 to $1.58 a share, at least a penny better than the highest analyst estimate, after reporting in-line results next quarter. More important, perhaps, the company raised its full-year cash flow target from above last year's $3.2 billion level to $5.7 billion.

"Since the beginning of our fiscal year, we have seen an improvement in our end markets, and we feel better about the global economy," CEO Ed Breen explained. "As a result of these improved business conditions and our operational progress, we are raising our outlook."

Tyco's stock jumped 95 cents to $28.93 following Tuesday's update. The stock is now just over $1 shy of the 52-week high it set in March, when Kozlowski was still on trial.

Swan Syndrome

Of course, Tyco had already won a big popularity contest on Wall Street ahead of its latest earnings release.

The company -- once a wallflower to be shunned -- has blossomed into a strong market performer fawned over by most analysts. It weathered its last major downgrade, from buy to hold, last summer. And it has now managed to top profit estimates every quarter since then.

Analysts were looking for another pretty financial update this time around. They predicted that Tyco -- helped by the strengthening economy -- might follow some other big conglomerates with a positive earnings surprise. And Breen himself told reporters in March that he was optimistic about the electronics division in particular, according to

Dow Jones

.

On Tuesday, the company clearly delivered.

"Obviously, they blew through their numbers and raised guidance -- which is great," said Peter Cohan, a Massachusetts investment strategist with no position in the stock. "I have no doubt the market will respond favorably."

Cohan was far more critical of the prior quarter's results. Still, he pointed out that Tyco continues to rely on favorable foreign exchange rates -- which could possibly disappear -- for much of its revenue growth.

Even so, he sees no immediate hurdles.

"I think that management's confidence in the economy for this year is probably well-placed," he said. "I'm more concerned about the longer-term factors that could arise. ... In theory, the stock price is a judgment of the future."

Cohan believes that Tyco's stock -- which he considered expensive until the company's latest report -- is now fairly valued at current levels.

Between the Lines

During the latest quarter, Tyco grew the top and bottom lines alike.

Although favorable currency exchange rates helped plenty, lifting first-quarter revenue 11% to $10 billion, the company also boasted a 3.4% jump in organic sales growth. Results in three key businesses -- engineered products and services, healthcare and electronics -- were particularly strong.

Engineered products posted a whopping 33% jump in revenue, which totaled $1.45 billion for the quarter, although half of that growth came from an accounting reclassification. The remaining half stemmed from an 8% jump in organic growth and an equivalent increase in favorable currency rates. Operating income surged 71% to $123 million due to improved business conditions and the absence of a year-ago charge. Operating margins climbed from 6.6% to 8.5%.

Health care -- perhaps Tyco's most stable business -- turned in another solid quarter even as the company invested new money into future growth opportunities. Revenue increased 9% to $2.28 billion, with organic growth accounting for just under half of that climb. Operating profits jumped 13% to $581 million, while margins widened from 24.5% to 25.4% in the latest period.

Electronics posted a strong quarter as well. Revenue grew by 12% to $2.85 billion, due to favorable exchange rates and a 5% increase in organic business. Still, profits and margins actually slid due to the effect of restructuring charges.

"Operationally," the company noted, "operating income improved due to higher volume and continued operating efficiencies partially offset by pricing pressure as well as higher copper and gold costs."

Tyco's plastics and adhesives division easily suffered the toughest quarter. The unit saw revenue slide 4% to $470 million despite a 2% increase in foreign exchange contributions. Operating income spiraled 76% to $9.9 million, due in part to a $24 million charge, and margins withered from 8.6% to 2.1%.

Tyco itself acknowledged the division's weak results.

"The decline in operating income was due to lower volume and tighter resin spreads that more than offset continued cost improvements," the company stated. And "revenue was lower in three of the four business units within this segment."

The company's final division, fire and security, is no longer struggling as it did. Granted, all but 1 point of its 8% jump in revenue stemmed from foreign currency. But the division swung to a $220 million profit due to increased efficiencies and the absence of a significant year-ago restructuring charge. The company said its continental European security business -- responsible for past problems -- continued to show improvement. However, the company's worldwide fire business is still suffering some weakness.

Overall, however, management was clearly upbeat.

"We're quite pleased with our results for the quarter," Breen stated. "They reflect continued progress in our efforts to build Tyco into a world-class operating company. We're continuing our focus on the fundamentals -- satisfying our customers, generating cash to reduce debt, running our operations more efficiently and increasing margins to produce earnings growth across the company."

Crowning Prize

Moody's could reward the company.

Just last week, Moody's indicated that it might actually raise Tyco's credit ratings -- cut to junk status nearly two years ago -- due to the company's "improved financial performance ... as well as Moody's expectation that Tyco will continue improving over the near to intermediate term." The ratings agency said it would be looking for signs of increased profitability, lower costs, continued asset sales and sustainable cash flow growth. It is also watching to see if Tyco can reduce its massive debt load -- which dropped $1.2 billion to $17.7 billion in the latest quarter -- and still maintain a strong liquidity position built of cash and unused credit.

In the meantime, Moody's continues to monitor some other risks as well. Specifically, it is still bracing for a possible writedown of Tyco's significant goodwill. And it views ongoing litigation risk -- outside the recent courtroom drama -- as a potential threat to liquidity. Tyco remains under investigation by multiple government agencies and still faces class action shareholder lawsuits that, some estimate, could trigger up to $3 billion in damages.

"Two things are driving the stock: litigation and earnings," Cohan said.

Cohan pointed out that Tyco recently peaked in anticipation of a jury verdict -- which could have brought some closure to the Kozlowski fiasco -- that never materialized. He said it then fell to the $27 level, where it see-sawed, as investors waited for the new financial report that is now fueling its shares.

Looking ahead, however, Cohan sees threats to the economic recovery that is lifting Tyco's results. He believes that inflation can grow, interest rates can rise and possible bubbles in the housing and Chinese markets can ultimately pop -- all of which could easily cool the steaming economy.

"At Tyco, there are a lot of very economically sensitive businesses," he pointed out. "My view on the economy is that is should be OK in the short-term. But I see some major overhangs -- some potential dark clouds -- a year or two out."