Behind Tyco's Accounting Alchemy
Last March, Tyco CEO L. Dennis Kozlowski stunned even some of his staunchest supporters by offering $9.5 billion to buy CIT Group, then the nation's largest independent commercial-finance company. Skeptics worried that Kozlowski's industrial conglomerate would get burned venturing into a risky area it knew nothing about. But Kozlowski scoffed, arguing that he would rev up CIT's growth. "I think CIT will be one of the best deals we've ever done," he told BusinessWeek just before the purchase was finalized.
Today, CIT looks like the worst deal Kozlowski ever closed. Rather than help transform Tyco International Ltd. (TYC ) into another General Electric Co. (GE ), as Kozlowski had hoped, CIT has become an albatross that is hastening its breakup. When Tyco's plunging stock price helped force a downgrade of CIT's credit rating, CIT was forced out of the commercial-paper market, its very lifeblood. The move caused CIT and Tyco to swap their $13 billion in commercial paper for pricier bank loans and heightened fears of a liquidity squeeze. Now Kozlowski is scrambling to cut CIT loose any way he can--through a sale or outright handover to shareholders--no later than June. "Nearly everyone accepts that they will take a multibillion-dollar loss" on a sale, says Barry Bannister, an analyst at Legg Mason Inc.
Even as Kozlowski moves to shed CIT, its financials are providing new insight into how Tyco itself operates. Critics say the CIT deal presents a rare glimpse into how Tyco has managed to "spring-load" its results--producing a huge pop in profits right after an acquisition closes. Alone among Tyco's major acquisitions, CIT continues to file financial reports with the U.S. Securities & Exchange Commission because of its reliance on the public debt markets. Those reports disclose that in its first four months under the Tyco umbrella--from June 2 to Sept. 30, 2001--CIT generated $252.5 million in net income. That's more than three times the $81.3 million CIT earned in its last five months as an independent public company, from Jan. 1 to June 1. "This is one of the most startling examples of financial engineering you can hope to find," says Albert J. Meyer, an analyst at David W. Tice & Associates and longtime critic of Tyco's accounting.
Tyco vehemently rejects this accusation, and in an interview with BusinessWeek, the company countered every charge leveled by Meyer and other critics. CIT CEO Albert R. Gamper Jr. maintains that thanks to Tyco's moves, his company is stronger today. Under the aegis of Kozlowski--a renowned cost-cutter whom Tyco recently rewarded with a rich retention package--CIT has slashed some 1,000 jobs while consolidating operations to save a total of $160 million a year in operating expenses, says J. Brad McGee, a Tyco executive vice-president who was dispatched to CIT after the deal closed. At the same time, Tyco prodded CIT to either sell or liquidate some $5 billion in poorly performing loans on recreational vehicles and other goods. McGee says these actions, along with falling interest rates, account for CIT's startling profits jump.
Even McGee concedes, though, that CIT made downward "adjustments" to income totaling $221.6 million last May, just before the deal closed. The result, disclosed in its 10-Q filed for the quarter ending June 30, is that CIT swung into the red in April and May, losing $78.8 million. Then, in June, CIT earned $71.2 million.
Several things look fishy about that $150 million turnabout, Tice's Meyer maintains. To start with, in that April-May period, CIT took a massive $148.1 million "provision for credit losses." That was well over twice the $68.3 million provision CIT took in the entire first quarter. McGee says the spike occurred after Tyco called in "at least half a dozen" firms to scrub CIT's books and then decided to pull back from lending to troubled telecoms. Tyco shakes up firms it acquires, he says, "and a non-recurring writedown is required when there is such a change in strategy." But the CEO of another major financial-services company says: "I would take this with a large grain of salt." CIT was "pretty well-run" he says. Meyer adds: "In effect, they're saying Gamper, whom they paid a big bonus to stick around, was turning a blind eye" to problem loans.
At the same time, CIT booked a $54 million charge for acquisition-related costs. McGee claims they were incurred by CIT only and that under generally accepted accounting principles, "they must be recorded prior to the close of the acquisition." However, Jack Ciesielski, publisher of the Accounting Observer, notes that CIT also adopted "a new basis of accounting" on June 2, allowing Tyco to "push down" deal costs to CIT. "That [shifts] some of Tyco's closing transactions into the CIT financials, making them appear as if they were CIT's own," he says. Together, McGee concedes, the provision for credit losses and the acquisition charge caused a $143.5 million spike in CIT's costs in April and May.
Meanwhile, some of CIT's revenues were unusually low during the two months before the deal closed. It recorded just $25.9 million in a category called "other revenue," down from $211.6 million in the first quarter, and $95.9 million in June alone. McGee says the apparent anomaly reflects a $78.1 million charge that CIT took in May. He adds that it was the result of a decision to write down "certain equity investments" in telecom and e-commerce--a decision supported by accounting rules. But Meyer argues the decision to book the charge against other revenue suggests that "all this might be in line with GAAP, but the rules allow for so much discretion that it becomes laughable."
Even if you accept Tyco's explanations for each of those items, the bottom-line impact is indisputable: The huge surge in charges taken by CIT just before the deal closed--combined with the drop in "other revenue"--helped produce a noticeable jump in CIT earnings just after the deal closed. Indeed, CIT was the major reason Tyco reported a 34% increase in per-share earnings for the quarter ending Sept. 30, just as profits were tanking throughout Corporate America.
Those surprising results soon made Tyco a magnet for critics looking for the next Enron. Those concerns, and Kozlowski's plan to split up the company, pushed Tyco's stock down to $22 by Feb. 5, just 37% of its price on Dec. 31. It rebounded to about $30 but took another 5% hit on Feb. 13, after Tyco issued another earnings warning.
Thanks partly to its drawdown of bank lines, CIT has enough liquidity to meet $12.5 billion in debt coming due through June. But "having access to the commercial-paper market is a fundamental premise of this business," says Robert Young, a senior vice-president at Moody's Investors Service. To regain that access, CIT must be cut loose fast.
Will Kozlowski get much for his once-prized asset? His preferred option is to sell CIT and raise cash to reduce Tyco's own debt load, which was $28.3 billion as of Dec. 31, according to S&P. Several potential bidders suggested by sources close to Tyco have already withdrawn, including GMAC, AIG, and UPS. That leaves GE and some big banks and insurance companies, figures Paul Scura, managing director of Scura, Rise & Partners, a boutique investment bank. But any bidders are unlikely to pay full price, he adds, especially since they know Tyco is on a tight timetable. Bannister expects Tyco to get no more than $7.7 billion, even though CIT is valued at $11.1 billion on its books.
Kozlowski's other option is to spin off most of CIT to Tyco shareholders. It might command a higher market value on its own than Tyco would get in a distress sale. Problem is, that wouldn't help Tyco raise cash anytime soon. Either way, a quick divorce is a fitting end to Kozlowski's worst merger ever.
By William C. Symonds in Boston, with Heather Timmons and Diane Brady in New York