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Tyco Silences Shorts With Breakup Plan

Some bulls worry that the company may regret its split-in-four strategy.

Investors apparently like Tyco's (TYC) decision to split itself into four, but not so much that they are offering anything more than muted applause at this point.

Tyco, the recent target of a vocal group of short-sellers who say the company is growing less rapidly than its accounting methods suggest, announced Tuesday morning that it would divide itself into four publicly traded companies. The units will focus on security and electronics, health care, fire protection and flow control, and financial services. The action, Tyco said, would "unlock tens of billions of dollars of shareholder value."

Tyco jumped as high as $52 at the open, up strongly from Friday's close of $46.45, but closed at $47.55. The company's stock remains well below where it was at the beginning of the year. On a

market capitalization basis, it's worth about $94.9 billion -- $2.2 billion more than what it was worth Friday. Apparently, the tens of billions of dollars of unlocked value are going to come later.

Credibility

"Certainly in the near term I'm quite happy to see the stock going up," says Brett Gallagher, head of U.S. equities at Julius Baer Investment Management, which owns Tyco shares. "The breakup reflects the frustration of management in not being able to get the credibility that they think they deserve. They tried to create a GE-type entity, and they weren't accorded anything like a GE multiple."

General Electric

(GE) - Get Report

, the vast conglomerate that Tyco management aspired to be, trades at about 23 times this year's expected earnings. Tyco, in contrast, trades at about 13 times calendar 2002 expected earnings.

Part of that credibility gap between Tyco and GE is related to the accusations of too-aggressive accounting that have dogged Tyco. During an analyst meeting outlining the plan this morning, CEO Dennis Kozlowski also recited a litany of other rumors, all untrue, that he said have recently dogged the stock: that Tyco planned to buy

Honeywell

(HON) - Get Report

, that the company was heavily exposed to

Enron

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, that the company was heavily exposed to

Kmart

(KM)

, that its CFO was stepping down.

These rumors are in effect straw men, having nothing to do with the accounting concerns raised by various short-sellers, who benefit if Tyco's share price goes down.

Shorts contend that the company has used its many acquisitions to boost earnings. They say Tyco has undervalued the tangible assets of the companies it has acquired, allowing it to classify most of the price it paid as goodwill -- the intangible assets of a company, such as its good name, strong customer relations and the trust that investors put in it. The company then writes down that goodwill, as accounting rules say it must, and this later gives it an earnings boost by clearing nagging expenses out of the way.

Jim Chanos, president of the hedge fund Kynikos and a vocal Tyco short, has said the company should show the financial statements for the target companies in the months prior to acquisition as well as their consolidated balance sheets on the day of acquisition -- something Tyco has so far not done.

He again asked for this information at Tyco's analyst meeting this morning. Mark Swartz, the company's CFO, said in effect that public companies made up the bulk of Tyco's recent acquisitions, and that investors need only look at their quarterly financial statements prior to acquisition to get the information they need. In other words, Chanos still isn't going to get what he asked for.

Sum of the Parts

For his part, Julius Baer's Gallagher thinks Tyco's breakup plan suggests that the shorts' concerns are unfounded. Spinning the company into four parts will force a careful scrutiny of its books -- not the sort of thing the company would do if it were worried about investors digging too deep. Even so, he was surprised that the company that often got dubbed "the next GE" was changing tactics so quickly. "I hope they're not being so defensive that they're doing something they're going to regret," he says.

As for the notion that Tyco would be worth far more broken up than it is now, Gallagher wasn't so sure. He noted that in the morning, Merrill Lynch's analysts said the company could be worth $70 to $80 a share on breakup -- an exercise that entailed giving a higher-than-20

price-to-earnings ratio for three of the four units. Tyco's Kozlowski was happy to point out that J.P. Morgan analyst Don MacDougall, in a note published just hours before Tyco's breakup announcement, had suggested that the sum of Tyco's parts was worth $90 a share.

Gallagher said he would consider beginning to scale out of his Tyco position if it hit $60, and that if it hit $90 he'd be laughing all the way to the bank.

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