At first glance, investing in
stock looks like a wonderful idea.It's hard not to salivate when looking at Tyco's historical growth inearnings and cash flow, which are both up an average of 30% a year over the past few years. The prudent investor, however, knows better than totake such impressive numbers at face value.
After taking a peek behind the numbers at Tyco, you'll want torun, not walk, away from this stock.
The Business Model
Growth via acquisitions is generally a loser's game -- and Tyco is growing principally through acquisitions. Last quarter, for instance, it boasted 29% year-over-year growth, but this growth was almost entirely due to acquisitions. Without acquisitions, Tyco's growth was a paltry 1%.
Why do I say growth via acquisitions is a loser's game? Becauseproblems always develop, generally on multiple levels. It could be asimple case of overpaying, or integration problems or maybe anunforeseeable downturn in business. Whatever the reason, history isreplete with examples of giant companies --
to name a few -- that were humbled after squandering billions topursue growth via acquisitions.
Another reason to avoid Tyco stock is that this strategy of growing byacquisitions is, by definition, only possible if the acquiring company has acheap currency to employ in acquiring companies.
In other words, either Tyco has an overvalued stock that it can use toacquire other companies, or Tyco has an undervalued stock that can't beused for acquisitions because it would be dilutive. If you look at the hundredsof acquisitions recently made using Tyco's stock, it's apparent that Tyco's management believes its stock is at least fully valued and certainly not undervalued, and investors should take notice.
A final point: Investors should be careful not to look exclusively atearnings growth at companies such as Tyco that subscribe to a robustacquisition strategy for growth. A better way to evaluate Tyco's strategyis through an ROIC (return on invested capital) analysis. This calculationlooks at earnings growth relative to balance-sheet growth. By my calculation, Tyco's average four-year ROIC is less than 10%, well below its cost of capital.
How Financially Strong Is Tyco?
To the extent you can find a reasonable margin of safety supporting thestock of Tyco -- and I certainly can't -- you aren't going to find it in the balance sheet.
A close examination of its balance sheet reveals there's not much"there" there. Assets are dominated by goodwill, which has balloonedfourfold between 1998 and today (from roughly $7 billion to $28 billion), because of all the acquisitions the company has made.
The problem with goodwill is that it is a phantom asset. You can'tsell it, you can't spend it and you can't borrow against it. There isnothing there except an accounting entry to back up the asset that we callgoodwill.
Tyco commands an enterprise value of about $131 billion (
marketcap of $105 billion plus net debt of $26 billion), but how much is backed up bytangible assets? Here it gets embarrassing. After deduction forgoodwill, this $131 billion company has a tangible net book value of $3.5billion, not much of a cushion for the prudent investor.
Only time will tell if Tyco is the exception to the growth-through-acquisition rule. Most of its acquisitions occurred in the last bull market, at the height of asset price inflation, meaning it probably overpaid for most of them. That fact alone, apart from all the other points I've raised, makes Tyco equity a gamble not worth taking.
Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, Alsin and/or ACM had no positions in any of the stocks mentioned in this article, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to