Description

Tyco International Ltd. is an industrial conglomerate with four divisions: Fire & Security, Electronics, Healthcare, and Engineered Products. Tyco has been addressed on this board before, but not in very much detail and not with anything that could be used to evaluate what the company is actually worth today as it stands.

Our case for Tyco is built on the fact that the stock trades at less than 10x normalized EBIT for FY 2005 and there is still significant room for margin expansion from both cost-cutting and growth providing operating leverage. We think the reasons that the market is undervaluing Tyco include the dismissal of any potential for growth due to recent underperformance, the difficulty of analyzing the vast array of businesses under the Tyco umbrella, and the uncertainty leading up to next year’s Q1 spin-off of the electronics and healthcare business.

We’d like to go through Tyco’s different operating divisions to arrive at a sum-of-the parts valuation for the company as a whole. For each division, we estimate two values – one based on public market comparables and the other based on a simple model we developed that only has 4 inputs: normalized EBIT, cost of capital, expected growth rate, and expected ROIC. Basically, we take the normalized EBIT and figure out what level of investment the company needs to maintain the growth rate we expect given the projected ROIC. We then discount back the what's left after subtracting investment from normalized EBIT using the cost of capital that we input. (This is the approach taken by Bruce Greenwald in the book “Value Investing.”) We use this model to avoid the “Hubble problem” of terminal values in a DCF.

MODEL ASSUMPTIONS:
- Our cost of equity for Tyco is 10%, which we think is conservative given that at least 50% of cashflow is basically recurring revenue.
- Our pre-tax cost of debt is 7%, which is obviously conservative, but we make room for increases in long term bond yields. 7% means an after-tax rate of 5.2%.
- Given that Tyco’s enterprise value is composed of about 14% debt and 86% equity today, we estimate Tyco’s WACC at about 9.3%. For the purposes of our discussion, we use 9.5%.
- We use a 28% tax rate which is anywhere between 1 and 3% ABOVE Tyco’s long term tax rate.
We intend that these projections be conservative so that we can show that even on a conservative valuation, Tyco is a bargain.

TYCO ELECTRONICS:
Tyco Electronics stats:

FY 2005 FY 2004 FY 2003
Revenue: 12,196.00 11,822.00 10,492.00
EBIT: 1,852.00 1,749.00 1,241.00
EBIT Margin: 15.19% 14.79% 11.83%
ROA: 12.24% 11.40% 9.29%
Capex: 458.00 370.00 404.00
D&A: 559.00 540.00 484.00
EBITDA-Capex: 1,953.00 1,919.00 1,321.00

ROIC for each segment is hard to discern, but ROA is much easier to back out. The above ROAs are calculated using EBIT multiplied by (1 – tax rate). The ROA also uses total assets minus goodwill, but it does not subtract any other intangible assets. The rationale for excluding goodwill here was not to penalize management for overpaying on acquisitions that previous management was responsible for and also to understand what the true earnings power of the operating assets are.

Tyco Electronics is one of the world’s leading suppliers of passive electronic components. Its market position in the segments in which it operates is admirable, as it is #1 in connectors, heat shrink tubing, circuit protection devices, cable identification, network cabling, and relays. The fact that the segment is #1 or #2 in most of the products it sells means that Tyco has enormous scale advantages. In connectors, Tyco’s $5.5B in revenues dwarfs competitors Molex and Amphenol combined. To put this in perspective, the global market for electronic connectors is estimated to be at approximately $33.7B, which means that in this highly fragmented industry, Tyco’s 16.3% market share gives it enormous scale. This scale advantage also translates into a huge R&D advantage, as Tyco can spend more on R&D than competitors, but less as a percentage of sales. As a kicker, Tyco has some strong brands in its electronics portfolio, including AMP, Raychem, and Elo. We think normalized EBIT for Tyco Electronics is approximated by the EBITDA minus Capex figure of $1.95B.

Looking at what the public market valuations are on these businesses, they are found priced at above 15x EV/EBIT. Molex is priced at close to 20x EV/EBIT and APH at 16x. We think that these valuations are ridiculous given that these are cyclical companies at the top of the cycle. That said, we believe that operating margins at Tyco Electronics are sustainable for the future and could even be improved upon with a management team that is focused on the bottom line of that one entity (which will be the case once the spin-off is completed). There is also ample opportunity for Tyco Electronics to be an acquiring consolidator in some highly fragmented markets, giving the company a high return on capital on acquisitions. On a comparable basis, you can easily slap a 12x EV/EBIT multiple on Tyco Electronics and get a valuation of ~$23.5B.

For our Tyco Electronics model, we use the following assumptions:
1. Long Term ROIC: 15% - this is realistic given that Tyco is #1 in most of these areas, and can become a very efficient consolidator once the spin-off occurs.
2. Long Term Growth: 5% - this is conservative given acquisition potential and the fact that this business will probably grow faster than long term nominal GDP growth, given the upside of emerging economies.

Using the above assumptions, we get a fair value for the electronics division of $22.3B, which is about 11.5x EV/EBIT. This is still very conservative given where comps are trading and that Tyco is a much stronger company than those comps.

TYCO HEALTHCARE:
Tyco Healthcare stats:

FY 2005 FY 2004 FY 2003
Revenue: 9,543.00 9,110.00 8,420.00
EBIT: 2,563.00 2,365.00 2,104.00
EBIT Margin: 26.86% 25.96% 24.99%
ROA: 22.69% 23.93% 22.13%
Capex: 326.00 239.00 191.00
D&A: 319.00 327.00 310.00
R&D: 232.00 209.00 150.00
R&D Rate: 2.43% 2.29% 1.78%

ROA is calculated the same way as it was calculated for the electronics division, EBIT excludes a $277M charge for a legal settlement in Q4 for Tyco, and R&D is broken out specifically but it is also already included in the EBIT.

Tyco Healthcare makes medical, surgical, respiratory, imaging, pharmaceutical, and retail products in the healthcare field. These range from pulse oximetry instruments (machines that monitor oxygen content in the blood) to generic diapers for Wal-Mart. Beyond this information, you can open up Tyco’s annual report for a more detailed description of Tyco Healthcare.

If you read the descriptions of the different Healthcare segments, you know that Tyco Healthcare is by no means simple to understand. Fortunately, the ROA numbers speak for themselves. Tyco Healthcare has shown consistent ROAs above 20%, which means that ROIC is even higher (given that the ROA numbers do not subtract interest-free current liabilities from the denominator). These high ROA/ROIC numbers are typical in the healthcare segment given that for a large portion of Tyco’s revenue (imaging, respiratory, and surgical) the patent system ensures that returns to capital will be high as long as the R&D is productive (more on the R&D in a little bit).

Further, the fact that the ROA/ROIC of the healthcare segment is so high even with a good chunk of revenues coming from areas that do not traditionally provide high returns on capital (generic pharmaceuticals, retail, and medical) speaks to the fact that Tyco has leading market share, and thus economies of scale, in many of the products that these segments produce. While these segments can be subject to temporary shocks (like commodity prices for the Retail segment), we think Tyco’s market share and economies of scale will protect returns here in the long run and give Tyco pricing power.

Tyco Healthcare is the segment that has torpedoed Tyco recently and really underperformed in Q1. Some quality control issues, capacity constraints in the retail segment, and patent litigation have combined with generally slow revenue growth that has not been characteristic of this segment in the general economy. While the quality control issues, capacity constraints, and patent litigation are one-time issues, the market has unjustifiably extrapolated the slow growth far into the future.

We think the slow growth has come from a couple of sources. First, Tyco has underinvested drastically in R&D for this segment due to the fact that management has been concentrating on cost-cutting and dealing with the negative repercussions of business under Kozlowlski and Co. This has taken attention away from the core businesses at Tyco, and this has most negatively affected Healthcare, where R&D is the lifeblood of growth. Compare Tyco Healthcare’s R&D as a percentage of revenue (2.43% in 2005) to competitors like J&J (over 12%), St. Jude (over 12%), Medtronic (9.6%), or even Proctor & Gamble (3.3%) and you realize that Tyco woefully under-invests in this segment.

Second, Tyco Healthcare has been restricted from doing any acquisitions that could meaningfully grow the bottom line. If you look at its competition, say Colgate-Palmolive or Becton Dickinson, then you know that small bolt-on acquisitions and large acquisitions are very important to growing and investing operating cashflow. Large enterprises like Colagte, Becton, and Tyco can buy smaller companies and get a high return on capital by wringing out costs and plugging the products into a global distribution and sales force system. In the acquisition arena, just like in the R&D arena, Tyco has been held back by a conservative management that has been concentrating more on righting past wrongs than on engendering growth.

We think normalized EBIT for the healthcare segment is probably a bit lower than the FY 2005 number because Tyco will start investing more in R&D to jack up the growth rate. We think after increasing R&D a bit and cutting some more costs, Tyco Healthcare can churn out an EBIT margin of 25%. On last year’s sales of $9.54B, this comes out to normalized EBIT of ~$2.4B. (Given that capex and D&A are approximately equal, they do not have any effect on out normalized EBIT estimate.)

So how to value the Healthcare division? Looking at comps:
- Comparable medical device makers such as Smith & Nephew, Respironics, and Kinetic Concepts are trading at 22.3x, 17.5x, and 15.5x EV/EBIT, respectively.
- Comparable medical products companies such as Becton-Dickinson, Baxter International, and C.R. Bard trade at 15.8x, 16.9x, and 16.5x EV/EBIT, respectively.
- Comparable consumer healthcare companies such as Colgate Palmolive, Playtex Products, and Kimberly Clark trade at 14.5x, 13x, and 13.2x EV/EBIT, respectively.
- Generic drug manufacturers are trading at EV/EBIT multiples of well beyond 15 and sometimes well beyond 20, at the market anticipates their eating the major pharmaceuticals’ lunch.

We consider Tyco Healthcare part device-maker, part consumer healthcare manufacturer, part medical products manufacturer, and part pharmaceutical/generic drug-maker. Therefore, we think a 14-15x EV/EBIT multiple seems fairly conservative on a comps basis, which brings us to a $33-36B valuation for Tyco Healthcare.

For our model, we use the following assumptions:
1. Long Term ROIC of 20% - this is quite conservative for the healthcare segment given that ROAs, which are lower than the ROICs, have been well above the 20% mark for Tyco.
2. Long Term growth rate of 5.5% - on the conservative side given the tailwinds from the global demographic shifts and the jacking up of R&D and acquisitions once a properly incentivized and liberated management team is in place after the spin-off.

Using the above assumptions, we get a fair value for this segment of about $33.5B, which is about 14x EBIT – not very far from our comparable analysis.

TYCO ENGINEERED PRODUCTS & SERVICES:
Tyco Engineered Products stats:

FY 2005 FY 2004 FY 2003
Revenue: 6,456.00 6,007.00 4,498.00
EBIT: 672.00 620.00 362.00
EBIT Margin: 10.41% 10.32% 8.05%
ROA: 12.07% 11.28% 6.71%
Capex: 88.00 45.00 46.00
D&A: 108.00 116.00 103.00
EBITDA-Capex: 692.00 691.00 419.00

Tyco Engineered Products & Services, briefly, manufactures many different types of valves for various commercial and industrial uses; manufactures specialty steel products such as tubular goods and electrical raceway products; provides a range of consulting, engineering, and construction services for water, wastewater, environmental, and infrastructure markets; and manufactures and distributes fire safety parts used in fire protection systems.

This business has performed fairly decently for Tyco and has strong tailwinds behind it in the long run given the demand in emerging markets for the goods and services that Tyco provides. Tyco’s well-known name should be a big advantage when it comes to municipalities or businesses in emerging economies needing environmental and water-control products and services. Also, Tyco has strong market positions here, as it does in its other businesses, and is the world’s largest player in the steel conduit and valve markets. Even so, as evident from the ROAs above, this is the Tyco division that operates in the most competitive markets and subsequently gets the lowest returns on capital. We estimate normalized EBIT as the EBITDA minus Capex number given above – approximately $690M.

Looking at where comps trade on the open market: Dover Corporation, which does many of the same things that Tyco Engineered Products does, trades at around 15x EV/EBIT; Eaton Corp trades at 13x EV/EBIT; Parker Hannifin at 13.5x EV/EBIT; ITT Industries at 13.5x EV/EBIT; and Roper Industries trades at 19.5x EV/EBIT. On a conservative basis, if you value Tyco Engineered Products at 12x EV/EBIT, you get a value of about $8.4B.

For our model, we made the following assumptions:
1. Long Term ROIC of 12.5%, which is realistic and just a bit above the ROA for the last 2 years in this division.
2. Long term growth rate of 5.5%, which is quite conservative given the wind at the back of this business and its potential in emerging markets.

Using the above assumptions, we get a fair value for this segment of about $7.4B – about 10.8x EV/EBIT – ~$1B less than our comps analysis.

TYCO FIRE & SECURITY:
Tyco Fire & Security stats:

FY 2005 FY 2004 FY 2003
Revenue: 11,503.00 11,447.00 10,832.00
EBIT: 1,216.00 899.00 342.00
EBIT Margin: 10.57% 7.85% 3.16%
ROA: 8.40% 6.39% 2.33%
Capex: 389.00 335.00 509.00
D&A: 1,106.00 1,132.00 1,199.00
EBITDA-Capex: 1,933.00 1,696.00 1,032.00

Fire & Security is the true hidden gem in the Tyco empire. Tyco Fire & Security designs, manufactures, installs, and monitors electronic security systems and fire detection and suppression systems. The segment also manufactures products related to fire security, like firefighter breathing systems and specialized fire extinguishers. In addition, Tyco Fire & Security provides fully integrated systems for surveillance and control of public transportation systems, bridges, tunnels, and other public works and infrastructure.

This is by far and away the most dominating segment in the Tyco portfolio. ADT is the most widely known brand in the security industry. In North American residential security, Tyco’s revenues are more than seven times its largest competitor. In commercial security, which accounts for about 20% of this segment’s revenue, Tyco is over twenty times larger than its nearest North American competitor and is the only company that offers national coverage. About ninety percent of Fortune 500 companies use Tyco for security services.

The ROAs in this segment are misleading. If you take EBITDA minus capex, subtract 28% for taxes, and put it over total assets minus goodwill, ROA is closer to 15%. But this too is misleadingly low, as this is the segment with the largest amount of intangible assets due to the acquisition of dealer accounts that was done mostly before the present management team was in place. If those intangible assets are subtracted, you would get an ROTA (return on tangible assets) of close to 20%.

Customer attrition has been slowly decreasing at Tyco, as the company works off the dealer program instituted under previous management and will probably continue to decrease at least until the negative effects of that program have been totally worked off (Tyco is transitioning the business model from an independent dealer-based model to a larger and more highly trained sales force). The new sales-force model will lower customer acquisition costs, decrease the attrition rate, and will start increasing ARPU (average revenue per user) as a trained and incentivized sales force sells an increasing menu of security options to customers. We expect that once these developments are in place, ROIC will be well beyond the 20% that Tyco is seeing now.

We think normalized EBIT for Tyco is much higher than the $1.93B in EBITDA minus capex that was reported for FY 2005. First of all, management has stated that at present G&A expenses are 13.5% of sales and should be able to be scaled back to 10% in the future as incredibly inefficient back office operations are consolidated. On top of this, there is enormous operating leverage for the company, given that Tyco has recently made large investments in the sales force that are already showing up in the bottom line in terms of costs but have not yet shown up in terms of benefit. Another layer of increased margins will come from improvement in the fire business. At present, that business (32% of segment revenue) is earning 5% margins and management has stated that there is room for some drastic improvement. For our normalized EBIT number, we don’t even come close to incorporating all these improvements in the Fire & Security business. We simply assume that out of the 3.5% that Breen and company have identified in G&A efficiencies, they’ll be able to execute of 2.5% of that. That brings the EBIT margin to about 13%, which brings EBITDA minus Capex to approximately $2.21B for our normalized EBIT estimate.

How does that get valued? If you looked at comps, you’d see mid-cap Brinks and small-cap Protection One trading at far above 20x EV/EBIT. If you looked at a behemoth like Securitas, you’d see an EV/EBIT of 15.5x. Given the quality of Tyco’s business, we believe that on a comp basis, you’d value this segment at least at 15x EV/EBIT, bringing you to a valuation of $33B.

For our model, we made the following assumptions:
1. Long term ROIC of 20% - this is conservative if you account for operating leverage and, more importantly, the fact that incremental investment has a huge ROIC because of Tyco’s enviable market positions in this segment.
2. Long term growth rate of 5% - this is also conservative given the operating leverage that Tyco possesses and that even 4% revenue growth would bring with it much higher growth in EBIT.
Using the above assumptions, we get a fair value of about $28.3B for this segment – about 12.85x EV/EBIT, which is significantly below our $33B comps assessment.

CORPORATE EXPENSES:
Tyco had $468M in corporate expenses that were not allocated to any of the segments in 2005. We estimate that these expenses will grow slower than overall revenue, and apply a 12x multiple to it in order to arrive at a valuation. This gets us to about $5.5B that we lop off our sum-of-all-segments valuation.

SUM OF THE PARTS VALUATION:
Tyco’s enterprise Value at present is $53.5B in equity market cap plus about $8.5B in debt plus about $2B in unfunded pension and healthcare liabilities for a total of $64B.

Using the comps analysis in each of the segments and subtracting the valuation of the corporate expenses, you get a fair enterprise value for the entire company of about $93.5B. This implies an equity value of ~$83B, and a stock price of ~$41 – 52% higher than the current stock price.

Using our simple valuation model in each of the segments and subtracting the $5.5B for corporate expenses, you get a fair enterprise value for the entire company of ~$86B. This implies an equity value of ~$75.5B, and a stock price of ~$37.50 – 40% higher than the current stock price.

MARGIN OF SAFETY:
We think there are several sources of value in Tyco that we haven’t specifically mentioned which provide a margin of safety to our valuation:
1. Enormous FCF yield – Tyco is producing Free Cash Flow at a rate of over $4B annually. That is a FCF yield of over 7.5%. This free cash flow is being used to buy back shares, which we consider even better than a dividend given how undervalued Tyco’s shares are. Basically, investors are being paid very handsomely to wait for the market to revalue Tyco.
2. Depreciation tax shelter – we made the assumption that normalized EBIT basically equals EBITDA minus capex. This ignores the value of the depreciation to shareholders, as Tyco saves on its taxes. The depreciation over capex for 2005 was ~$800M. We don’t know how long this will last, but Tyco will save at least $200M a year as long as depreciation is larger than maintenance capex by that amount.
3. Further cost-cutting – management has stated that it believes there is another $650M in costs to cut from the present Tyco organization, with at least $350M of that coming from moving to low cost countries for electronics manufacturing. If you apply just a 10x multiple to that, that’s another $6.5B in market cap and more than $3/share.
4. Further leveraging/investor activism – Tyco is very underleveraged as it stands right now. 50% of Tyco’s sales are recurring revenue, and there’s no reason why debt to total EV should be only 14%. It can easily be increased to 30%. This would result in a large dividend or share buyback for shareholders, create a favorable tax effect from the interest, and lower the company’s WACC. If debt to EV was at 30%, we estimate that Tyco’s WACC would be closer to 8.5% than 9.5%. While that doesn’t seem like a lot, when a 30-year bond’s yield goes from 9.5% to 8.5%, the price rises dramatically. We estimate that such increased leverage could create an incremental $10B in value for shareholders. Luckily, there are some other big investors who think so too – Bill Miller has hinted that he will start pressing management on levering up to add value.
5. Conservative estimates in the first place:
- Our WACC was rounded upward, and thus was conservative even given the present capital structure.
- We assumed that all of capex was maintenance capex. While a large portion of it was certainly maintenance capex, if you assume that out of $1.3B in capex only $200M was “growth” capex, that would add an incremental $2B to our valuation if you applied at 10x multiple.
- We did not give Tyco equal valuation to our comparables in most instances – this is very conservative given that Tyco’s market positions in almost all of its segments should command premium valuations.
- We assumed a higher tax rate than Tyco will likely face in the long run. If Tyco’s tax rate were assumed at closer to the long run 25-26%, that would create an additional billion dollars in value.

In conclusion, we think that a $37-40 stock price is quite conservative given our different assumptions and comparisons. We would not at all be surprised to see Tyco at the post-spin-off-equivalent of $45-50 per share once the market catches on. Also, you’re not standing still if you hold the stock – you’re getting big share buybacks and continuous value creation from what we think is a valuation of $37-40/share right now. As time goes on and share count is decreased and value is created, we expect this $37-40 to grow accordingly.

RISKS:
- The risk that Tyco management in each segment will wait to break out the best possible performance only after the spin-off, where they will be rewarded accordingly in stock.
- Global economic slowdown that could derail the near-term growth prospects of the electronics and engineered products segments.
- Continued raw materials pricing pressure that would hit margins in the electronics segment very badly.

We consider these risks near term in nature and much more than accounted for in the stock price.

Catalyst

1. Spin-off in Q1 of 2007
2. Investor activism, hopefully from Bill Miller, who owns 4% of outstanding shares (other large value investors like Chris Davis have agreed with his analysis and we think they would support him if he took on the overly conservative management).
3. The Fire & Security business finally gaining traction