Description

Tyco International Ltd. (NYSE: TYC)

 

Date:                            3/23/07

Price:                            $32.00

F/d Market Cap:          $67 billion

F/d Enterprise Value:    $72 billion

 

 

Thesis

 

Tyco is a conglomerate of great businesses that have the opportunity for margin and revenue improvement over the next 3 years. While management has done an excellent job on addressing liquidity concerns and stabilizing the company after the Kozlowski-era, there remains a significant opportunity to improve the profitability of each business.

 

With the company now conservatively capitalized and most issues stemming from the Kozlowski-era addressed, management is spinning-off the Healthcare and Electronics divisions so that there will now be 3 separate publicly-traded companies (Fire & Security and Engineered Products is the remainco).

 

With the spin-offs to be completed within the next 2 months, management of each company will have a renewed focus and incentive to fix the various operational issues at each company.

 

Tyco currently trades at 16x consensus 2007 earnings. However, we believe that within 3 years each company will have substantially improved profitability resulting in Tyco trading at only 9x our expected 2010 earnings.

 

Specifically, we believe that in 3 years the individual divisions will be worth the following:

 

Healthcare:                   $20.00/share

Electronics:                   $18.50/share

Fire and Security:          $21.00/share

Engineered Products:    $6.50/share

Current Net Debt:         ($6.00/share)

TYC Total:                   $60.00

 

This valuation implies that the total combined intrinsic value of TYC in 2010 will be $60/share or roughly double the current price. Importantly, this valuation uses estimates that we believe are conservative, and ignores what is currently too little leverage in the capital structure. There is upside to our valuation in a high case outcome.

 

Due to the size of the company and our desire to keep this write-up short, we are going to forego describing the businesses (read coda’s excellent write-up from last year) and list our assumptions for what we think will happen to the profitability of the 3 businesses over the next 3 years. We are more than happy to dive deeper into our assumptions and the competitive positioning of each business in the Q&A.

 

Tyco Healthcare

 

We expect at least 25% operating margins and 4% revenue growth to 2010 which will result in $1.00/share of eps. At 18x earnings and cash build Healthcare will be worth at least $20/share on 2010 numbers. Key assumptions driving these estimates are:

 

• Normalizing current operations for one-time issues in 2006. Lower operating margins were a result of product recalls, production capacity issues, and cost issues in Retail.
• Lowering the costs of goods sold through rationalization of their real estate footprint, specifically moving manufacturing capacity from the U.S. to lower-cost regions. 40% of sales are international but very little production is done outside of the U.S.
• Increasing operational efficiency through Six Sigma, Strategic Sourcing, and lean manufacturing. These programs have been in place for several years but management continues to see opportunities for improvement.
• Increasing the productivity of their global sales platform. Management has restructured the sales and marketing and business development groups to the value of maximize Tyco Healthcare’s size and scale. The effort is primarily centered around increasing the spending on R&D and ramping up acquisitions of single-product or development stage companies. Tyco Healthcare can realize high returns on investment in these activities because they possess a global platform that allows them to distribute a new product to a larger aggregate amount of demand than competitors.

 

 

Tyco Electronics

 

We expect 17.4% operating margins and 6% revenue growth to 2010 which will result in $1.00/share of eps. At 17x earnings and cash build Electronics should be worth around $18.50/share on 2010 numbers. Key assumptions driving these estimates are:

 

• Due to high raw material costs and product mix, operating margins and organic growth rates are well-below normalized levels.
• Growth in in the consumer electronics market to diversify away from their position in auto.  Tyco’s overweight in auto versus peers is slowing revenue growth and also impacting margins due to the longer nature of contracts in the automotive end market.
• Management will be able to focus on maximizing the value of the franchise through portfolio changes (more emphasis on consumer, divestitures of low margin businesses)
• Management will reduce the high cost footprint by moving manufacturing facilities from North America to low cost countries.
• As margins expand and revenue growth rates increase, the market will attribute a higher multiple for the business than it does currently.          

 

Tyco Fire and Security

 

We expect $13.7 billion of revenues and a 25% EBITDA margin to drive earnings of $1.05/share by 2010. At 18x earnings and cash build Fire and Security should be worth $20/share on 2010 numbers. Key assumptions driving these estimates are:

 

• Attrition declining from 14% to 11%.
• SG&A declining from 16% to 13%.
• Organic growth increasing from 2% to 4%.
• As a separate, stand-alone entity, management will be able to focus on maximizing the value of the franchise through sales efforts (more emphasis on internally driven ADT sales, quality dealer accounts, and resale efforts).
• Restructuring actions (reducing the high cost footprint, improving working capital management).
• Due to legacy issues and a slow ramp in sales efforts, operating margins and organic growth rates are well-below normalized levels and have disappointed Wall Street.  As margins expand and revenue growth rates increase, the market will attribute a higher multiple for the business than it does currently.

 

 

Engineered Products

 

We expect EBITDA margins of 15% and revenue growth of 4% to 2010 to result in $.44/share in earnings. At 13x earnings and cash build Engineered Products should be worth $6.50/share on 2010 numbers. Our estimates are based on disclosed financial results and target EBIT margins given by management.

 

 

Variant View

 

The market has begun to price in the upcoming spin-off by using a sum of the parts valuation. However, people are missing the magnitude of how poorly each division has been integrated from the acquisition binge of late 90’s and early century. There is a large amount of potential for operating margin expansion once each management team is incentived and focused on these issues. The market will begin to give the companies credit for these improvements in profitability once the businesses are separate and management has begun to outline and quantify all the opportunities in front of them.

 

 

Risks

 

Fire and Security:

• Downturn in end markets.
• Organic growth does not materialize.  Despite all his efforts, Ed Breen has not proven that he can grow the business yet.
• Problems combining back-office functions.

 

Electronics:

• Downturn in end markets.
• Raw material costs, especially copper, could continue to adversely affect margins. 
• Problems relocating manufacturing facilities.
• Secular decline in margins as products become commoditized.  This appears to have happened to other products in the portfolio.

 

Healthcare:

• Regulatory issues that we can not foresee hurt the companies reputation and financial results.
• Management is not able to execute on operational efficiency projects.
• Temporary problems in Respiratory, Imaging, and Retail continue to worsen and prove more permanent in nature and organic sales growth is flat.

 

All Divisions:

• Outstanding shareholder litigation.
• Poor capital allocation

Catalyst

• Spin off in the first half of 2007.
• Guidance from each management team as to the opportunities for improvement in profitability in their respective businesses. This could happen at the road show in April/May but management could sandbag before their options are struck concurrent with the spin-off. Upbeat guidance should be given with in the next 12 months.
• Increased leverage in the capital structure to either buyback stock or make accretive acquisitions.