Tyco Turnaround Makes Trial a Mere Curiosity

Tyco ( TYC) investors seem to be viewing this week's courtroom drama as a mere sideshow.

A combative jury, clashing over the fate of two former executives accused of looting the company, has left open a sordid chapter in Tyco's history. But Wall Street long ago skipped past the blank pages and gambled on a happy ending. With the suspense level high, fans plunged into Tyco's stock and, in some cases, managed to double their money and more in just a year.

Today, Tyco is no longer the high-powered acquisition machine that nearly skated over the cliff. It has instead evolved into a stable -- even boring -- company that makes a notable effort to operate firmly within the boundaries of good corporate governance. Certainly, its conservative leaders hardly resemble the characters currently on trial.

To be sure, CEO Edward Breen is well compensated. He picked up 600,000 restricted shares and 200,000 options just this week. But Breen has pocketed his big paychecks -- including $3.5 million in cash and bonuses last year -- while restoring billions of dollars in shareholder value. In contrast, former CEO Dennis Kozlowski and former CFO Mark Swartz stand accused of stealing $600 million from the company -- and nearly destroying this onetime Wall Street favorite in the process.

So there are those who believe that Breen has already moved Tyco's stock more than any jury verdict possibly could. After all, when Breen took over in the summer of 2002, there were plenty of bears speculating that the company was headed for dire straits. Now, Tyco has many more fans than critics.

"Regardless of the outcome of the trial ... we do not believe that the legal proceedings against the former management will have any meaningful fundamental impact on Tyco as a company today or its shares," Merrill Lynch analyst John Inch wrote on Monday. "We think that any attempt to connect the present trial and shareholder litigation is both speculative and, at minimum, unclear."

Tyco shares jumped 2% Monday to $27.96 as the jury continued deliberating.

Tyco's Tipping Point
Stock revives under CEO Breen's leadership

Road to Recovery

Inch, who replaced a Merrill Lynch analyst accused of pumping Tyco's stock, believes that fundamental improvements will continue to drive the company's share price.

He points to cash flow generation in particular. He predicts the company will deliver $4 billion in free cash flow -- well ahead of current estimates -- as it streamlines its operations and capitalizes on rebounding economic conditions this year.

Morgan Stanley analyst Stephen Volkmann, who initiated coverage on Tyco this month with an overweight rating, is similarly bullish. Volkmann says the company's solid cash flow has already strengthened a balance sheet that worried some investors in the past. He believes the company can now focus more on optimizing its assets and increasing its margins. But he also admits that "the easy money has probably been made" in the stock.

Meanwhile, Volkmann acknowledges that risks still exist. He says that proposed legislation could eliminate some of the tax benefits Tyco enjoys as a Bermuda-based corporation. He also says that huge goodwill impairments, while unlikely, could lead to covenant violations that raise the company's borrowing costs.

In the meantime, Tyco still faces shareholder lawsuits and remains under investigation by the Securities and Exchange Commission. And even Volkmann is waiting for the company's new management to really prove itself.

"The key still is to gain trust, which will only come through continued operational success, in our view," Volkmann wrote early this month. "The plan is in place, and the results thus far appear promising. But a positive track record is the ultimate end game."

Caution Ahead

One analyst has expressed more caution.

Barry Bannister of Legg Mason raised several concerns after Tyco's latest earnings report in February. He said that Tyco posted organic sales growth of only 2% in the first quarter. He also saw some weakness in the company's cash flow.

"Working capital free cash flow fell short of our view," wrote Bannister, who has a hold rating on the stock. "So Tyco is underspending depreciation and reducing acquisitions as offsets."

Still, Bannister expects Tyco to top its own guidance by generating $3.46 billion in free cash flow this year. But he also sees the potential for an earnings shortfall at a time when, he believes, the company needs to be delivering upside surprises just to justify its current stock price.

He isn't terribly optimistic, either. He says margins "are bouncing along rock bottom" in the construction business. They may have peaked in the health care division. And they are "struggling to maintain lift" in the electronics unit.

Ultimately, Bannister believes that Tyco is worth only $25 a share even with some of the company's biggest risks behind it. In contrast, Volkmann feels that Tyco's stock is worth a full $10 more.

"Legacy legal issues are still an overhang," Volkmann conceded. "We think this risk is real. But considering the outcomes of other high-profile suits, we think the overall effect on the company should be modest."

Inch downplayed the current fraud trial in particular.

"The realization of sustained cash generation, the success of business streamlining initiatives and leverage due to a rebounding electronics cycle should continue to drive the stock over time, in our view, rather than the outcome of the former management's trial," Inch wrote on Monday.

Stuck in Idle

So far, the judge presiding over the six-month fraud case has refused to declare a mistrial.

But in recent days, a sole juror appeared to be holding out for an acquittal. And at least one legal expert believes the jury could remain hung.

"When someone has refused to budge for this long, things are usually poisoned already," said Kirby Behre, an attorney who practices at the international law firm of Paul Hastings Janofsky & Walker. "Just one person can gum up the works. ... That's what makes criminal convictions so hard."

Behre, himself a former prosecutor, lays part of the blame on the government. He says the government has spent too long trying its case against the former Tyco executives -- and "familiarity can breed contempt" among jurors when that happens.

Still, Behre stops well short of declaring victory for the defense. He says a hung jury, with only one juror blocking a conviction, actually bodes well for the prosecution.

But he doubts that any jury decision -- now or later -- will really move Tyco's stock.

"These guys are not engaged in this conduct any more," Behre explained. "Typically, you see the stock impacted when these types of charges are announced -- long before any verdict" is delivered.

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