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Turnaround CEOs aren't supposed to lose their credibility this quickly.

After

Tyco

(TYC)

revealed a whole new set of bookkeeping issues Wednesday evening, though, expect investors to start questioning the judgment and ethics of Tyco's new-broom CEO, Ed Breen. Not to mention the company's new CFO, auditor PricewaterhouseCoopers and the prominent law firm that oversaw a recent accounting probe.

Moreover, doubts about Tyco's operating performance are likely to increase after a cut in earnings guidance and what appears to be a slyly timed change in the company's definition of cash flow. Though the company continues to make optimistic statements about its future, Tyco stock plunged $1.74, or 12%, to $12.29 Thursday, reaching its lowest level in six months. Tyco didn't reply to an email and a call seeking comment.

Clean Slate?

To quickly recap, last July Breen joined Tyco, a shaky conglomerate built through frenetic acquisitions, soon after the departure of long-term CEO Dennis Kozlowski, who was later charged with looting the company. Investors had long suspected that Tyco's bookkeeping wasn't clean, but a company probe conducted under Breen and overseen by high-profile attorney David Boies claimed that Tyco had committed only relatively minor missteps. The internal inquiry resulted in a $382 million pretax charge. This may sound like a lot, but after the multibillion-dollar accounting ruses allegedly carried out at

WorldCom

and

Enron

, the report was seen as a relatively clean bill of health.

Relief that the probe didn't turn up evidence of substantial fraud helped Tyco raise $4.5 billion in January through the sale of securities. That money-raising exercise enabled the company to avert a life-threatening cash shortfall. At the time, skeptics believed the probe to be woefully inadequate, mainly because it said Tyco's past acquisition accounting, where most abuses appear to have taken place, was within generally accepted principles.

But soon enough, Tyco began to

change its tune about the Boies report. In February it released a quarterly filing that said the report resulting from the probe had "limitations." Indeed, the report must've been much more limited than Tyco said at the time, because, across the company, Breen and his team are now conducting what he called "aggressive audits" at an analysts meeting Thursday.

It appears that it was one of these audits that turned up the issues in Tyco's fire and security business, which will result in a charge of up to $325 million in the quarter ending March 31. Tyco's CFO, David Fitzpatrick, said Thursday at the analyst meeting that the issues arose from fire and security entities' "lack of adherence to company procedures." He said these included overly long amortization periods, which meant expenses were understated, and the inappropriate use of reserves set up by acquisition accounting. Tyco also said it had terminated the president of the fire and security business, Jerry Boggess.

PricewaterhouseCoopers may also feel some heat for signing off on Tyco's fiscal 2002 books, if, as is likely, the accounting issues at fire and security extend back to that year. The accounting firm declined to comment on Tyco. The lead PricewaterhouseCoopers partner who signed off on Tyco's 2002 audit was removed from the account,

Reuters

reported last week.

Checking the Timing

The

Securities and Exchange Commission

gets particularly incensed when a company raises fresh money from markets just weeks before announcing negative developments. Thus, it would not be surprising if the SEC's ongoing probe of Tyco looks at how long Breen knew of the fire and security problems and whether the Boies probe deliberately made no effort to address them. The Boies report did say that Tyco had used aggressive accounting for its acquisitions, but claimed it was within accepted practices. The SEC may be taking a different view. And investors should bargain on more nasty accounting disclosures like this.

Tyco also cut its earnings guidance for its 2003 fiscal year, ending Sept. 30, but not by much. Of course, in the Tyco saga, most focus is on cash-flow generation. Tyco marginally raised the floor of its cash-flow guidance for fiscal 2003 to $2.6 billion from $2.5 billion, with $3 billion remaining the upper number in the range.

Tyco is also changing its definition of free cash flow. Previously, free cash flow was actual greenbacks it took in from core operations adjusted for inflows and outflows of cash for items such as capital expenditures. The new definition includes two outflows: cash spent to acquire fire and security clients from dealers, and cash paid out as part of acquisitions. Company critics had long calculated free cash flow with these two hefty outflows.

Under the new definition, Tyco expects to make free cash flow of $1.45 billion to $1.85 billion in fiscal 2003, and $2.1 billion to $2.3 billion next year. If we take a multiple of eight times -- equivalent to a return of 12.5% on an investor's capital, about right for a company as risky as Tyco -- and apply it to 2004's free cash flow, we end up with a market valuation of about $18 billion. To get there, Tyco's stock would have to fall another 25% to around $9.15.

Ball of Confusion

Hold on, Tyco bulls will say -- what about the massive upside potential to 2004 free cash flow that CFO Fitzpatrick spoke about Thursday? The executive, curiously lacking in explanatory powers, seemed to suggest during the last question-and-answer session of the analyst day that Tyco could add an extra $1.93 billion to its free cash flow in 2004. He made this apparent point when referring to a slide titled "'04 Free Cash Flow Incremental Opportunity." Fitzpatrick appeared to say the $1.93 billion of upside -- from various items, including reductions in working capital and dealer payments -- was not included in the base projection of $2.1 billion to $2.3 billion.

If that is true, it is an enormous bull point, since the CFO is effectively saying free cash flow could be almost twice the base number if things go well. Unfortunately, it's all but impossible for an investor to determine whether this promise actually stacks up.

By definition, Tyco must already have factored cash outflows from areas such as working capital and dealer outlays into its base free cash flow forecast for 2004. But, critically, it did not say what these amounts were. If we don't know these base numbers, it is impossible for an outsider to gauge whether such large amounts of extra cash really can be milked from these areas.

A brokerage analyst who attended the analyst day probably sums it up best: "People left this meeting way more confused about Tyco than when they went in."

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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

peter.eavis@thestreet.com.