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Bond Action Says Tyco's Still in the Woods

Investors continue to worry about the fate of an unloved split-up scheme.




roller coaster was inching its way uphill Thursday, but investors are clearly bracing for the heart-pounding action to resume.

Tyco's stock and bonds have recovered some ground since a wave of revelations about stock sales and payments to a director pushed them to 52-week lows. But investors clearly remain skeptical about the company, which has turned 180 degrees on its longtime growth-by-acquisition strategy without offering what the market deems a reasonable alternative.

"You buy into that, and then overnight they say they're going to do the exact opposite," says Brett Gallagher, head of U.S. stocks at Julius Baer Investment Management. Gallagher continues to own Tyco shares but he's using options strategies to hedge in accounts where he's allowed to. Tyco was up a dime at $34.95 Thursday.

Action in the fixed income market suggests that bond investors continue to worry that Tyco's plan to divide itself -- by selling one unit and splitting off three others via initial public offerings -- won't fly. Tyco billed the split-up as enabling the company to pay down debt and fetch premium valuations for its components; the plan assumed that Tyco itself owed its below-market multiple to a lack of financial transparency.

"Everybody was expecting some pop in the stock," says Patrick Kennedy, bond portfolio manager for

Pitcairn Trust

, who owns Tyco bonds. He notes that Tyco advertised the split-up as permitting its component pieces to garner premium valuations. But when Tyco's stock fell instead, "They started worrying what happens if these

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split-offs don't go through.'"

The failure of the split-up plan would hurt bondholders because Tyco had earmarked the proceeds to pay down some of its $23 billion debt.

During Wednesday's free-fall in Tyco stock, the spread between the 10-year Treasury and the comparable Tyco bond got as wide as 350 basis points. When Kozlowski and CFO Mark Swartz said that they would each buy 500,000 shares of Tyco on the open market, the stock rebounded and so did the bonds. They closed the day 250 basis points over the 10-year. But that spread is still as wide as it was before the break-up was announced.

Of course, even before the company submitted its breakup plan last week, Tyco bonds were suffering. When Tyco said it wouldn't meet its calendar first-quarter earnings target Jan. 15, bondholders began to worry that the company might have difficulty servicing its debt. Moreover, the sharp decline in the stock price -- in part due to the earnings forecast reduction and in part due to reports that some well-known short-sellers were saying the company was growing less rapidly than its accounting methods suggested -- meant that the company might have to turn to borrowed cash, rather than shares, to keep on buying new companies. Tyco stock has lost nearly half its value this year.

Shareholders flee Tyco

Kennedy believes the bond market's fears on Tyco are overdone and that the breakup will go forward. At this point, Tyco management's credibility has become so impaired that absent the split-offs, bondholders will begin to wonder whether they'll ever get paid. That would seriously damage Tyco's ability to raise capital in the credit markets, putting the company into a truly dire situation.

In effect, this turns Tyco into a forced seller. It's been reported that Tyco has shopped one of the proposed IPOs, finance arm Tyco Capital, to both GE Capital and


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. Knowing that Tyco must raise cash, any acquirer is likely to drive a hard bargain. Similarly, even if it doesn't appear that it will get fair prices spinning off divisions publicly, Tyco can't back away for fear of the bond market's wrath.

Nobody knows how the Tyco story will end, but at least we've found out the answer to the question of what happens when a company puts its fate in the hands of its bondholders: It suffers.