Tyco Totters Toward 2003

Crawling out from under that mountain of debt isn't getting any easier for Tyco ( TYC).

Detox took a close look at Tyco's debt problem last month, but recent developments suggest the company is struggling to find a satisfactory solution.

After a long year punctuated by a sputtering economy, a softening operating performance and the high-profile fraud indictments of ex-CEO Dennis Kozlowski and ex-CFO Mark Swartz, the stakes are rising at the conglomerate. Tyco, which declined to comment for this piece, continues to be weighed down by some $12 billion of debt and debt-like obligations that fall due in 2003. The company will likely need to pursue some kind of new financing to meet those repayments, and that financing may whack Tyco's stock.

Though 72% below its 52-week high, the stock has rallied sharply since the naming of a new management team that investors hope will clear Tyco's name. And since Tyco's fortunes rest with regulators combing its books and banks checking its ledgers, there's plenty of cause yet for anxiety -- including big potential writedowns and shareholder dilution. The stock jumped 38 cents Tuesday to $17.08.

Riding the Convertible

Since last month's Detox piece, The Wall Street Journal has reported that the company is thinking of raising cash by doing a large issue of securities that convert into Tyco stock. In another report, the paper said that the Securities and Exchange Commission, which is probing Tyco's books, is taking another look at the accounting for a large acquisition done in 1998.

In a previous investigation from 1999 to 2000, the SEC reviewed the deal, but the agency only recently acquired new documents relating to it, prompting this second examination, the Journal reported. Tyco critics have long said the earlier probe was insufficient and claims earnings and cash flow have been goosed by acquisition accounting.


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Reports of the convertible debt deal had Tyco raising as much as $4 billion before February, when $3.9 billion of bank debt comes due and when holders of a convertible bond issue can demand repayment of $2.3 billion in stock or cash. News of the new deal was received positively, but it's hard to see why.

First, it suggests that the banks are reluctant to roll over much of their debt, and that cash flows are anemic. Second, large convertible issues by distressed companies often cause the issuer's stock to tank. That happens because the holders protect themselves against a drop in the common stock by selling it short. That was Calpine's experience after it issued convertible debt earlier this year.

Open Arms?

One way that Tyco might be able to avoid a crushing wave of shorting around a convertible deal would be to sell a large chunk of it to investors who don't short, like mutual funds. However, mutual funds typically buy only SEC-registered deals, and it's hard to see the SEC rushing to sign off on a $4 billion convertible offering before it completes its own probe and before Tyco releases an audited annual report, which is due by the end of the year. Tyco's latest fiscal year ended Sept. 30, 2002.

Failure to do a sizable convertible may force Tyco back into the arms of its bankers. But the bankers must also be nervous about the SEC inquiry, as well as the investigation being carried out by the Manhattan district attorney. No doubt, the bankers -- J.P. Morgan Chase, Citigroup and Bank of America -- also eagerly await an audited annual report, so that they can get a clearer picture of Tyco's health.

Some investors expect the annual report to contain a large writedown of goodwill, which is an asset on the balance sheet that represents the estimated value of an intangible item. In Tyco's case, most of the goodwill reflects the difference between the price Tyco paid for its acquisitions and their book value. Up until a year ago, Tyco was a voracious acquirer that overpaid for its purchases. If, as is almost certainly the case, the operating performance of the bought firms has deteriorated, the goodwill associated with them must be marked down heavily.

Indeed, Tyco may have to take a goodwill writedown of over $2 billion, and maybe as much as $3 billion, just on Lucent Power Systems, which it bought from Lucent in the fourth quarter of 2000. And there are plenty other problematic deals.

Banking On It

If a goodwill charge is big enough, it could put Tyco in violation of a key provision in its bank debt covenant that says its debt must not exceed 52.5% of its capital, defined as debt plus stockholders' equity. At the end of September, Tyco was $3 billion away from going over that ratio. Of course, Tyco could use its $6.5 billion of cash to pay down debt to stay well below the ratio. And it's almost impossible to conceive of the banks forcing Tyco into a default over a breach. However, because it would raise big questions about the soundness of Tyco's balance sheet items, a big asset writedown would lead creditors to be extremely demanding in any new loans they grant.

And some investors wonder whether the balance sheet total for Tyco's debt includes all the debt the company owes. The balance sheet says Tyco has $24.2 billion of debt. A comprehensive calculation that totals the company's public debt and two large bank credits comes extremely close to that balance sheet number. In fact, Detox gets to a slightly higher total of $24.4 billion.

Therefore, there seems to be no room in the balance sheet total for the bank debt that Tyco would've assumed when it was scooping up hundreds of companies, many of which were in debt-intensive industries like manufacturing. Maybe Tyco paid a lot of the acquired debt off when it had more cash, but it's hard to believe all of it has gone. If Tyco still holds this debt, the company could possibly be booking it in a liability item that is not debt.

The SEC's decision to replumb Tyco's 1998 purchase of Surgical Devices also doesn't bode well for the company's efforts to pay off next year's obligations. If the SEC inquiry turns up that Tyco did goose earnings with deal accounting on this transaction and others, investors would assume that true profit margins and cash flows were much lower than the company reported. As a result, creditors may also ratchet down their projections for these items and make Tyco's cost of borrowing higher.

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