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Tyco's
Feeling the Wind at Its Back
After learning of massive new charges last quarter -- identified just months earlier by the supposedly exhaustive probe led by David Boies -- Tyco investors are headed toward another earnings date that could bring more unpleasant surprises. Specifically, the company may finally reveal how it plans to address the staggering $26 billion in goodwill listed on its books. And that decision, guided by strict accounting tests, could tip the company's balance sheet into risky territory.
If there's a significant impairment -- which is not out of the realm of possibility, given the company's acquisition binge and questionable accounting under [former CEO Dennis] Kozlowski -- it could take them over some debt covenants," said John Boland, a portfolio manager at NI Capital Management whose fund owns 800,000 shares of Tyco and some Tyco debt. "That's not necessarily going to bankrupt the company, but it will drive up borrowing costs. ... And it would certainly bring into question management's credibility, which is probably where the bigger impact would be."
While skittish, Boland is hoping instead for a positive surprise like the one Tyco coupled with last quarter's $1.3 billion accounting blow. He would like to see Tyco again post strong cash flow, which toppled analysts' highest expectations last quarter by coming in at $833 million. He's looking for another $1 billion worth of cash flow this quarter -- and wouldn't mind seeing more -- so that Tyco can easily meet its full-year target of $3 billion.
"They are a cash-flow machine," Boland said. "That's really the crown jewel at Tyco. You can manipulate earnings, but it's hard to fudge cash flow."
Still, Boland admits that the quality of that cash is important. And Legg Mason analyst Barry Bannister has already raised concerns about Tyco's cash generation so far.
"Tyco has relied on underspending, depreciation, deferred taxes and various working capital measures," Bannister wrote last month, when reducing Tyco from buy to hold primarily due to valuation reasons
At the same time, Bannister pointed to weaknesses in Tyco's fundamental businesses. He said the "sluggish" electronics division, which once generated 43% of the company's profits, may contribute no more than 26% to this year's bottom line. Meanwhile, he's still struggling to value Tyco's problematic fire and safety division in the wake of massive restatements.
On average, Wall Street analysts are looking for Tyco to report third-quarter earnings of 35 cents a share. Bannister has projected full-year profits of $1.34 to $1.42 a share, a range that encompasses the consensus estimate of $1.38.
Fencing
Meanwhile, as the heated battle between the bulls and the bears continues to rage, Bannister has taken a unique position on the fence.
"We believe that many of the statements regarding the previous management's tenure and the current management's obstacles have been overstated," he said. "Nevertheless, we find it difficult to quantify the ammunition a financial restatement may give to lawsuits or to inquiries by [government] authorities."
Bannister is the only mainstream analyst who recommends holding, rather than buying, Tyco shares. Prudential's Nicholas Heymann, long the sole Wall Street bear, recently upgraded Tyco to buy because he believes the stock will become attractive to investors hoping to capitalize on the "best prospects for a sustainable [economic] recovery" in years.
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"We don't anticipate any significant signs of a fundamental recovery in Tyco ... until late this year or early in 2004," Heymann said. But "the desire to participate in Tyco's expected eventual fundamental turnaround could result in the stock coming under significant accumulation by new investors near term, which could act to lift the shares -- possibly significantly (25% or more) -- from current levels over the next six to 12 months.