Tyco: The Vise Grows Ever-Tighter

Half its debt is coming due--but where's the cash to pay it?

Since his arrival at scandal-scarred Tyco International Ltd. in late July, CEO Edward D. Breen Jr. has wasted little time sweeping out the now-notorious Kozlowski regime. On Sept. 17, Breen issued a report detailing how L. Dennis Kozlowski and his cronies allegedly looted more than $100 million from Tyco. He has recruited respected outsiders to begin rebuilding the executive suite, most notably Chief Financial Officer David J. FitzPatrick, who held the same job at United Technologies Corp. And he has gotten Tyco's discredited Kozlowski-era directors to agree to leave by early next year. Says Leon Cooperman, president of investor Omega Advisors Inc.: "He has been doing all the right things."

Good enough, as far as it goes. Now comes the much tougher challenge of cleaning up the financial mess. The $36 billion empire Kozlowski left behind is under siege on every front. Sales and margins are plunging, even as Tyco staggers under $26 billion of debt. And with its market value already down this year by some $90 billion, "it's getting awfully hot in the kitchen," says Nicholas P. Heymann, an analyst at Prudential Securities Inc.

Just how hot became more clear on Sept. 25, when Breen, in his first conference call with investors since taking charge, sharply cut earnings estimates issued in July by Tyco's former team. At the same time, Breen warned that Tyco would have to take yet another big write-off: this time, up to $2.5 billion for its disastrous foray into the underseas cable-telecom market. That's on top of a $6.7 billion write-down it took earlier this year on the sale of Tyco's CIT Group Inc. for $4.6 billion.

These latest disclosures only increase the urgency of Breen's immediate task: averting a liquidity crisis. While the sale of CIT helped boost Tyco's cash level to about $7 billion, nearly half of its debt comes due by the end of next year. And as previous estimates of cash flow continue to be ratcheted down, it now looks like Tyco could come up $3 billion short of what it needs. "There are still an awful lot of uncertainties," says Eric Ause, an analyst at Fitch Ratings, which is maintaining its junk-bond rating on Tyco's debt.

One critical problem is that Tyco's margins are crashing back to earth. Over the past five years, the aggressive accounting Kozlowski used in his incessant dealmaking helped push margins, before interest and taxes, from 12.5% in 1997 to 22.1% last year. But with the deals over and the economy weak, margins in the quarter ended June 30 fell across all four of Tyco's operating segments, including a nearly 50% plunge in its troubled electronics business, Tyco's largest unit. Moreover, as dealmaking dries up, so does Tyco's ability to avoid taxes by moving income to lower-tax overseas jurisdictions. As a result, Breen says, Tyco's tax rate will rise to 22%, from 18.5%.

Lower margins and higher tax rates will cut Tyco's earnings in the current quarter to $600 to $700 million. Compare that with $900 million predicted by the previous management team. Annual earnings, for the fiscal year starting Oct. 1, could fall as low as $3 billion, or 30% below earlier expectations, according to Breen.

To buy time, Breen is attempting to renegotiate Tyco's $3.9 billion line of credit, which expires next February. He also is considering selling more assets. While Breen has ruled out divesting an entire segment, such as health care, he could sell nonstrategic units, perhaps including plastics, that Kozlowski pulled from the block last spring.

In this market, though, Tyco may get only a fraction of the premium paid by Kozlowski during his bull-market binge. And deeply discounted sales would force further write-downs in the bloated $27 billion of goodwill Tyco still carries on its balance sheet. CIT, for instance, was sold for just 40% of what Tyco had invested in the unit.

The difficulty for Breen is that large write-offs would slash shareholder equity. That could put Tyco at risk of violating loan covenants requiring its ratio of total debt to total capitalization to remain below 52.5%. If that ratio--which stood at 49% as of June 30--is exceeded, Tyco would find itself in default, according to the company.

For now, that risk appears distant. It would take big write-downs--on the order of $11 billion--before Tyco is in danger of hitting its trigger. That's one reason Breen insists he's "very comfortable" with Tyco's ability to service its debt. Yet any nasty surprises from the ongoing forensic audit of Tyco's books, due in late fall, could quickly alter Breen's comfort level. Some observers worry that if Kozlowski looted the company, he could have cooked the books as well. And Tyco's banks are unlikely to renegotiate the bank lines until its ledgers are cleared.

Will Tyco's books pass muster? Breen says he isn't worried, and investors are beginning to agree. Following Breen's conference call with analysts, Tyco's shares rose 10%, to $15. If Breen is right, he would be left running a company with far slower, yet more reliable, growth. That may not sound like the sexiest job in the world. But changing Tyco back into the sleepy conglomerate it always should have been would sure beat the year of scandal and turmoil that the company and its long-suffering investors have just endured.

By William Symonds in Boston

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