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Even a peek into



closet reveals some pretty ghoulish skeletons.

Facing doubts about the trustworthiness of its accounting after its former CEO and finance chief were charged earlier this year with looting the company, Tyco's new management, led by new CEO Ed Breen,

released a long-awaited review of past bookkeeping practices. While Monday's report said there was "no significant or systemic fraud" in past results, it did catalog a range of aggressive accounting maneuvers -- including the practice of manipulating the books of acquired companies -- to make Tyco's results look better.

Critical for investors to understand is that Tyco chose not to include the impact of its aggressive acquisition accounting in a $382 million cleanup charge. Instead, that pretax charge, taken in its 2002 fiscal year ended Sept. 30, covers audit adjustments for 2002, as well as corrections of what Tyco calls "errors" in prior years.

The report, conducted by David Boies, a well-known outside lawyer, concedes that its authors didn't look closely at many aspects of the company's accounts. It says Tyco did not seek "to go back and identify every accounting decision and every corporate act over a multiyear period that was wrong or questionable, or whether there was a preferable accounting treatment among the alternative accounting treatments available under Generally Accepted Accounting Principles."

But even a report of limited scope strongly suggests that the impressive profit margins posted under ex-CEO Dennis Kozlowski and former CFO Mark Swartz were artificial creations. That finding will cast serious doubt on whether Tyco can ever get back to those levels, or whether it is destined to show permanently lower profits.

The realization that Tyco's earnings may be structurally anemic will unnerve Tyco's creditors. The company may have to pay back obligations totaling $12 billion in 2003, and is talking with its bankers to find a way to pay back its debts.

Also Monday, the ailing conglomerate released its annual report for its fiscal year ended Sept. 30, 2002. The annual revealed that the Internal Revenue Service and other tax authorities have "raised issues and proposed tax deficiences."

reported earlier this month that Tyco, which has an extremely low tax rate compared with other corporations, was in discussions with the IRS to reach a settlement on back taxes that could result in Tyco paying out as much as $1.7 billion. The company denied the report at the time and the annual report says that it has provided in its income tax provision for any deficiencies and believes they will not have a "material adverse effect" on its results or financial position.


The key consideration for investors at this point is what Tyco can really make. In fiscal 2002, when many acquisitions were done and Kozlowski was still in charge, the company made earnings before interest, taxes and charges of $4.5 billion on revenue of $35.6 billion. That works out at an operating margin of 12.6%. In 2000, Tyco reported a margin close to 20%.

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Assuming the accounting games disappear and the acquisitions peter out, Tyco's margins could easily slip below 10%. That would mean Tyco does not deserve to have a capitalization (market worth plus debt minus cash) of more than one times sales, the level at which an average manufacturing company trades. Tyco has debt minus cash of $18 billion and sales of $36 billion. That means market worth has to be around $18 billion to get to a capitalization of one times sales.

The problem is that Tyco currently has a market worth of more than $30 billion. As a result, the stock would have to fall over 40%, to around $9, to get close to a reasonable valuation. This method is kind to Tyco because it leaves out off balance sheet debt and assumes 2002 sales were real and repeatable.

The decline in profitability means that Tyco's goodwill must be worth much less than the $26 billion stated on the balance sheet. Yet management and Tyco's auditors, PricewaterhouseCoopers, didn't use the opportunity of the annual report to mark down the goodwill. This may be because the reduction, when it comes, is going to be very large and would put the company in violation of a key debt-to-capitalization provision in its agreement with its bankers.

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Tyco's management will try to build on any positive sentiment arising from this report to get a debt restructuring done with its bank creditors, who are owed $3.9 billion in February. Tyco's Breen must convince the bankers that probes conducted by the

Securities and Exchange Commission

and the Manhattan district attorney, which are, no doubt, far more rigorous than the Boies report, will not turn up any further indications that Tyco's former profitability was a mirage.

Breen also must show confidence that 2003 earnings and cash flows won't be a disaster. The government probes and 2003 earnings will now become the main focus of investors. On Tyco's conference call, scheduled for Tuesday morning, expect canny investors to demand updated guidance on earnings and cash flows.

Possibly, questioners will focus on moves in the fourth quarter to boost cash flow. It appears the company has been selling receivables, or bills Tyco's customers have yet to pay, for cash. While this practice is widespread and fully legal, it appears that Tyco has been relying significantly on this practice.

On Sept. 30, Tyco sold $350 million of receivables to


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, a lender that Tyco disposed of through an IPO in July 2002. However, Tyco's fiscal fourth-quarter earnings release said that it did $53.9 million of receivables sales in the quarter, which was a net number, according to Tyco spokeswoman Elizabeth Mather. That implies that Tyco had a large outflow to offset the cash inflow of $350 million. Did the company buy back a significant amount of receivables? Mather didn't comment on that possibility.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to