Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Johnson Controls, once America's biggest car-parts supplier, took another step toward reinventing itself by striking a deal with Tyco International.  Its valuation may take a while to catch up to the transformation.

The new Johnson Controls is going to be a much different company going forward with higher margins, less volatility -- and a lower tax bill,  thanks to a plan to adopt Tyco's headquarters in Ireland, where rates are lower. A scheduled spinoff of Johnson Controls' automotive-interiors business later this year means the remaining company will primarily be focused on building-control technologies such as air conditioners and fire systems.

Bargain Hunting
Before news of the Johnson Controls merger, Tyco's valuation had dropped to its lowest level since a 2012 break-up.

Sure, Johnson Controls is getting Tyco for a relative bargain. The implied exchange ratio suggests a valuation of about $34 a share, based on Friday's closing prices. That's a roughly 11 percent premium to where Tyco was trading. Big industrial targets of the last five years have tended to command twice that. Not to mention the fact that analysts were projecting Tyco would reach a higher price on its own over the next year after bouncing along near its lowest valuation since a 2012 breakup.

And Johnson Controls stands to reap as much as $150 million in tax savings via its move to Ireland, on top of $500 million in potential cost synergies.

But tax savings and bargains aside, the primary goal of this transaction is to make Johnson Controls a true multi-industrial company and tap into the higher valuation that goes along with that classification.

On the face of it, adding Tyco's businesses should help the $23 billion company. Despite the recent slump in Tyco's shares amid slower-growth and the strong U.S. dollar, the company's average Ebitda multiple over the last three years was about 17, higher than Johnson Controls':   

Valuation Gap
Tyco has traditionally commanded a steeper valuation relative to Ebitda than Johnson Controls.
Source: Bloomberg

But there's precedent for this strategy -- with mixed results -- in Eaton, as Bloomberg Intelligence's Joel Levington has noted.  Like Johnson Controls, Eaton was once primarily an auto-parts maker before CEO Sandy Cutler started trying to diversify. The effort culminated in the 2012 purchase of lighting and electrical-equipment maker Cooper Industries (also an inversion). That deal shifted a greater proportion of Eaton's revenue toward less volatile businesses. Analysts said at the time it should help lift Eaton's valuation.

Falling Back
Eaton's Ebitda multiple has dropped back to its range before the company announced the Cooper Industries deal.
Source: Bloomberg

Initially, that was true. Eaton's Ebitda multiple spiked, reaching a high of about 19 in 2013. But now, it's trading for about 9 times its Ebitda in the last year -- roughly where it was before announcing the Cooper Industries purchase. The valuation has been weighed down by the parts of the auto-parts business that Eaton kept around, which are more sensitive to swings in the economy and require higher fixed costs (more on that here).

Like Eaton, Johnson Controls is saddled with a potential weight on its valuation. The spinoff of the auto-interiors business will go a long way toward separating the company from its lower-margin past, but it’s still holding on to a battery business that can be volatile. The air conditioner and heating businesses also may not have the margins to command a top valuation.  Using rough, back-of-the-envelope math based on Johnson Control's estimated pro-forma revenue and Ebitda before synergies, the combined company's Ebitda margin may be in the range of 14 percent, versus a typical 17 percent for investment-grade multi-industrials tracked by Bloomberg Intelligence. Johnson Controls also will likely be burdened with higher leverage than most of its desired peer group.

For Johnson Controls, reaping the benefits of its transformation will require some more work -- just like the U.S. government's efforts to curb inversion transactions. Monday's deal is just the latest slap in the face for lawmakers who have sought to curb an inversion trend that many deem tax evasion. So far, their efforts haven't been very effective. While the Treasury has made it modestly harder to structure inversions and removed some of the economic benefits, these deals are still possible and still very attractive. Trash-collectors Waste Connections and Progressive Waste struck an inversion deal earlier this month. And of course there's Pfizer's $160 billion takeover of Allergan and planned move to Ireland. More will come.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Tyco last week settled a suit with the U.S. government that centered on the use of earnings stripping, a tactic used by inverted firms to effectively shift profit to lower-tax countries via intercompany loans. As much as $9.5 billion in deductions were at issue here, with a potential tax bill of about $3.25 billion, according to estimates by tax consultant Robert Willens. In an apparent victory, Tyco and its former subsidiaries agreed to pay just $475 million to $525 million to the government. The small payout is further evidence of how difficult it is for regulators to curb the use of earnings stripping, one of the primary benefits of inversions.

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