Can Tyco Survive the CEO's Math?

Its problems will worsen if CIT triggers a huge writedown

As case No. 63, indictment 3418, was called before New York Supreme Court Judge Arlene Goldberg on June 4, it was easy to pick the defendant out from the petty criminals also in appearance. L. Dennis Kozlowski was the one in the blue suit and tie--standard dress for a man who made $332 million over the past three years running Tyco International Ltd. (TYC )

Despite allegations by Manhattan District Attorney Robert M. Morgenthau that Kozlowski may have used funds from a Tyco executive-loan program to buy several paintings, company officials insisted that CEO Kozlowski's resignation just before his criminal indictment on charges that he evaded New York taxes on his art purchases was strictly "personal." But Tyco is still stuck with Kozlowski's troubling legacy: the aggressive accounting he used to supercharge growth. With Tyco shares down over 70% this year, the question is whether interim CEO John F. Fort III and his board can reverse the slide before Tyco faces a liquidity crisis.

Tyco executives argue that their restructuring plans are on track. Still, the coming weeks could shape up as a desperate race to stabilize the company. Tyco must try to avert a massive writedown of the bloated $34.5 billion worth of goodwill on its balance sheet. Such a writedown would reflect the fact that many of Tyco's assets are now worth far less than what Kozlowski paid during his bull-market acquisition binge. And a big write-off could put Tyco in violation of its debt covenants.

Amidst all this, Fort is likely to have an even harder time finding a buyer for Tyco's huge finance unit, CIT Group Inc. Plus, the board--packed with Koz-lowski's long-term associates--must find a CEO to restore integrity. "Current management has pretty much lost their crediblity," complains David Dreman, CEO of Dreman Value Management LLC, which owns more than 6 million shares. Rob Plaza, an analyst at Morningstar Inc., believes that if the CIT sale goes badly, "there is a very real risk of a Chapter 11 filing."

Tyco Executive Vice-President J. Brad McGee argues that Tyco has the wherewithal to handle its $27.4 billion debt load. "The concept of Chapter 11 is very remote," he says. But critics worry that will no longer be the case if Tyco is forced to take a huge haircut on the value of its assets. Since mid-2000, Tyco has spent some $24 billion on acquisitions. The amount of goodwill on Tyco's balance sheet, meanwhile, grew from $13.7 billion in September, 2000, to $34.5 billion on Mar. 31--a rise of $20.8 billion. In other words, Tyco spent $24 billion on companies it deemed to have less than $4 billion in tangible value.

Abraham J. Briloff, an accounting professor emeritus at Baruch College in New York, argues that Tyco's accounting was clearly designed to produce "extraordinary earnings growth." Why? Since most of Tyco's growth came through acquisitions, most of the cost of buying this growth was booked to the balance sheet in the form of goodwill, he says.

In part, that's because Tyco massively overpaid for the companies it bought. But what set Tyco apart from other acquirers is that it also directed newly acquired companies to take big writedowns before the deals closed. That further increased the value that was attributable to goodwill--and in some cases helped springload earnings. CIT, for instance, generated $252.5 million in net income during its first four months with Tyco--three times what it earned during its last five months of independence. Tyco says its accounting was appropriate and that the charges were warranted.

The problem is, with the decline in Tyco's stock, the goodwill it has recorded on its books is clearly overvalued. Now, under new accounting rules, it must write down that "impaired" goodwill to reflect its true current value. But in doing so, Tyco must be careful not to trigger its debt covenants, which require that debt-to-total-capital rise no higher than 52.5%. It's at 45% now.

McGee denies there's a problem. Other than CIT, "the goodwill on our books is more than supported by the value of our businesses," he says. But CIT is a big issue. If Tyco can't sell CIT and has to spin it off to shareholders, for example, it will have to write off its entire $11.3 billion investment--which would bring it perilously close to triggering the covenants. Moreover, Tyco may have to take a big writedown of its industrial businesses, too. "Given the facts that they used stock to make acquisitions and that their stock is now down almost 75%, goodwill is clearly impaired," argues Albert J. Meyer, an analyst at short-seller David W. Tice & Associates Inc.

The most immediate challenge for Fort is to sell CIT. In late April, Kozlowski predicted that he would raise $6.5 billion in a CIT public offering--enough to resolve the liquidity concerns. However, that price was undercut by one of Tyco's own bankers, Lehman Brothers Inc., when it withdrew a $5 billion bid on May 24.

Now, many commercial-finance companies believe an IPO won't fly at all. As a result, Tyco could get as little as $4 billion selling CIT to an outside buyer, says Nicholas P. Heymann, an analyst at Prudential Securities Inc. Spinning it off to shareholders for no cash would be a disaster--and not just because of the writedown. By Tyco's own calculations, it needs to raise at least $3 billion to cover the $8.9 billion worth of debt coming due through next March. Kozlowski may be gone, but the problems he has left behind are getting worse.

By William C. Symonds in Boston, with Nanette Byrnes in New York

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