If

Tyco's

(TYC)

a value stock, then Dennis Kozlowski is a prime candidate to become the next tax secretary.

The troubled conglomerate's fiscal third-quarter financial results, issued Tuesday, offered a wealth of evidence why Tyco stock has dropped more than 80% from its 52-week high -- and why, in Detox's view, it is unlikely to rebound anytime soon.

The company trimmed fiscal 2003 earnings targets and posted divisional profit margins that were mostly pathetic. More to the point, by any rigorous standard Tyco's free cash flow -- an ardently watched indicator of financial health -- is looking rather sickly. This weakness appears to have forced the company to cut acquisition spending, which in turn will hit revenue generation.

Also disconcerting was the central role played in the Tuesday conference call by CFO Mark Swartz. Swartz was a close associate of former CEO Kozlowski, who left in June amid tax-evasion charges. For all its recent changes, Tyco remains under a cloud as investors worry a hard-hit stock could go lower still.

Searching for Upside

Let's be clear: Tyco now has breathing room. In raising $4.4 billion by selling the

CIT

(CIT) - Get Report

finance arm, the company has dealt with its most pressing liquidity issues. But investors now must decide how much upside there is in the stock. Very little, going by third-quarter numbers. In selling CIT, Tyco holders are left with an uninspiring hodge-podge of businesses, with only one division showing any strength at all: the health care operations.

Tyco execs were eager to point to future cash flow generation on the conference call. The company is shooting for a hearty $4 billion to $4.5 billion of free cash flow in 2003, which would be about $2.13 per share. Giving that a 10 times multiple gets $21 per share, which is almost double the current stock price. So why aren't Tyco shares soaring?

The short answer is that Tyco's version of its free cash flow appears to overstate the true cash-generative abilities of its operations. In fact, a strict reading of the accounts suggests the company may in fact be churning out just $2 billion of free cash a year, going by third-quarter numbers. Such a reading would value Tyco at $10 a share, a discount even to today's heavily beaten levels. Tuesday afternoon, Tyco was trading at $11.25, down 60 cents, or 5.1%.

Methods

¿

Tyco said it generated $1.2 billion of cash from operations in the third quarter. It's not clear if Tyco arrives at that number by using the methodology dictated by generally accepted accounting principles. Even so, we can use that as a base to work off. To get to free cash, we should subtract two items: $423 million of general capital expenditures and $184 million of capital spending at its telecom operation, Tyco Global Network. That would leave Tyco with $590 million of free cash.

However, Tyco spends huge sums each quarter on acquiring so-called dealer accounts for its security division. Arguably, this outflow -- $396 million in the third quarter -- is another form of capex. If Tyco didn't use the dealer method, it'd have to amass the accounts in such a way that would add to the regular capex total. When asked why the dealer account spending doesn't get included in Tyco's free cash flow, a company spokesman responds: "This is how we have consistently calculated free cash flow, and, for comparison's sake, it's accurate."

In addition, to be safe, investors should also include the amounts spent on acquisition-related costs that don't get included in operating cash flow. These expenses, which are a recurring item at Tyco, are called purchase accounting liabilities, and totaled $63 million in the third quarter. Subtract those two items and we get to $131 million of free cash -- which projects to just over $500 million a year.

Adjusting

Out of fairness, we need to make a couple of adjustments in Tyco's favor. One would be to assume a lower Tyco Global Networks capex bill, since the company won't be spending so much in coming quarters. Let's say Tyco spends $40 million per quarter instead of the $184 million of the third quarter. And we could also add back the $178 million of cash charges in the third quarter. That gets to $450 million of "normalized" Detox free cash flow -- being generous, around $2 billion a year. Giving that a 10x multiple produces a market cap of $20 billion, or a stock price of around $10.

The next obvious step is to ask how long a company producing only $2 billion of free cash flow on $71 billion of assets can go without a big writedown to its $33.6 billion of intangible assets. How big might that writedown be? As much as $5 billion, if we use what the market is telling us as a yardstick. Tyco's current market cap is $22 billion, $5 billion lower than its goodwill total -- and, notably, its book value. In other words, the market is intimating that assets have to be written down by $5 billion for book value to be in line with the market valuation.

Another potential complication is that a big writedown could put Tyco in violation of the debt-to-capital provision of its bank covenants, assuming debt remains at current levels. A spokesman didn't comment on any possible goodwill writedown. But clearly any big charge could stick Tyco back in the liquidity squeeze it was trying to wriggle out of with the CIT deal -- and the liquidity worries were among the biggest fears of investors who sold the stock so heavily earlier this year.¿

Regardless of how the balance sheet issues are worked out, Tyco's just not generating enough cash to be a value stock.