Description

Investment Thesis

We recommend buying Tyco when-issued stock at current levels (~$26.50):

1) 20% return to stand-alone fair value over 12 month investment horizon in a high-quality name that should received renewed investor focus as a pure-play fire & security company

• Valuing TYC-w at 8.5x EBITDA, 14.0x P/E off of FY 2014 estimates and giving credit for interim FCF generation results in a share price of ~$32, 20% upside from current levels
• Sell-side price targets are all based off of FY 2013 estimates and therefore represent current fair value estimates, not one-year price targets
• Target valuation multiple based on Ingersoll-Rand and Schneider Electric as best comps
• We are not giving TYC management credit for the significant margin expansion opportunities they outlined at the recent investor day.  This is not baked into our numbers.

2) Potential for Schneider Electric to come back to bid for standalone TYC-w

• As widely documented in the financial press, Schneider Electric attempted to buy Tyco in April of 2011
• Clearly it was the businesses of TYC-w RemainCo that Schneider was interested in, so much so that it entertained the idea of acquiring all of Tyco
• We think that Schneider will look to acquire TYC-w again now that it is a focused fire and security company and a more digestible, albeit still large, acquisition
• Schneider has a $43bn USD enterprise value vs. TYC-w at $13.5b
• We think TYC-w could conservatively sell for 10.5x EBITDA, which would value the shares at $40 (50% upside)
• In addition to Schneider, the list of strategic buyers that could be interested in TYC-w includes UTX, HON, Siemens and possibly GE

Simply put, at current levels you can buy a great business for 8x forward EBITDA, 13.5x forward P/E (20% cheap to fair value over a year) with a free call option on a Schneider takeout at a potential 50% premium.  Downside case of ~10% presents highly skewed risk / reward.

Background

Tyco International (TYC) is again separating into three entities: ADT (being spun-off), Flow Control (being merged with Pentair via a Reverse Morris Trust) and Tyco (RemainCo).  The spin-off will be effective September 28; TYC-w and ADT-w began trading on the when-issued market last Monday, September 17, 2012.

While most investor attention seems to be focused on ADT, we believe TYC RemainCo represents a more attractive risk-reward.

Business Description

• TYC-w is the market leader in the global fire and security industries
• Geographic mix: North America (48%), EMEA (27%),Asia(20%), LatAM (5%)
• We find TYC-w’s new segment disclosure uninformative and have assembled the following business description from old filings and presentations

• TYC’s Fire business (~$3.5bn in revenue, excluding Life & Safety products)
• Sells fire alarm and fire detection systems, automatic fire sprinkler systems and special hazard suppression systems
• ~50% is electronic fire alarm monitors, 35% sprinklers, 15% suppression
• ~$2.2bn is North America(SimplexGrinnell)
• TYC’s fire business is the market leader in a highly fragmented industry
• TYC estimates this is a $32bn+ market where TYC has ~11% share
• Operates under the brand names SimplexGrinnell, Wormald, Mather & Platt, Total Walther, Dong Bang, Zettler and Tyco
• Customers are commercial enterprises (office buildings, hotels, retailers), institutions (government, schools, hospitals) and industrial companies (oil & gas, manufacturing)
• A high degree (~45%) of Fire revenue is driven by service of existing install base
• This includes ~25% of total Fire revenue that is contractually recurring (30% for TYC-w overall)
• The new order / installation part of the business is driven by non-residential construction end markets which have yet to recover from the recession
• Significantly, this business was the highest ROIC business in all of Tyco pre-separation (i.e. higher than the ADT business everyone raves about

• TYC’s Security business (~$5bn in revenue)
• Sells electronic security systems to the commercial, educational, governmental and industrial markets (and to residential customers outside North America)
• Estimated ~35% of TYC’s security business revenue is contractually recurring
• This business is more of an equipment-sale business than the residential ADT business which is focused on the ongoing service revenue
• North America Commercial Security (an estimated $2bn business)
• Systems installations (~50%), Recurring revenue (~38%), Other (~12%)
• Largest end markets are retail (~30%) & commercial / industrial (~30%)
• Sensormatic is an estimated $400mm of this total
• Provides EAS security solutions to retailers (the alarm gates as you exit a store plus the EAS security tags)
• EMEA Security Business (~$1.7bn business in 2010)
• Includes a residential business (ADT EMEA)
• Operating margins were in the mid-single digits for many years; have moved towards 10% since 2010
• Historically one of the biggest problems was undisciplined account acquisition, whereby Tyco purchased a lot of low-quality accounts from dealers who collected a sales fee and moved on; those accounts subsequently churned much more rapidly than expected
• Much of the margin improvement witnessed in TYC-w’s new “RoW Installation & Service” segment has been driven by the restructuring in ADT EMEA and the rolling off of these bad accounts
• Geographic split: ~$600mm UK, ~$850mm continental Europe, ~$250m Mid-East & Africa
• Rest of World Security (Asia and LatAm, combined a ~$1.2bn business in 2010)
• Solid growth and margins
• Low teens revenue growth; ~11% operating margins

• TYC’s Other Product business (~$2bn revenue)
• Fire Protection. $1.1bn revenue.  Fire extinguishers, sprinklers, fire detection.  Reported revenue is for products sold outside of TYC’s installation segment
• Life Safety. $400mm revenue.  Oxygen tanks for firefighters and air purification masks (military, industrial applications)
• Security.  $400 revenue.  Access control, video security systems; intrusion alert.  For products sold outside of TYC's installation segment

• We think these are great businesses because:
• High percentage of service sales driven by existing install base
• High percentage of contractually recurring revenue
• Market leader in highly fragmented industry
• Products and services that are legally required under building codes (fire) and/or a necessity (security and safety products)

Key Risks

• Exposure to late-cycle non-residential construction markets that are showing no signs of recovering soon
• Exposure to government spending, which is clearly under pressure.  Government and Institutional customers are a combined 25% of total TYC-w revenue; estimate government is half of this
• Tax rate.  Currently 20% as TYC-w is Swiss-domiciled.  Could come under fire if corporate tax reform addressed next term; could also limit price a strategic buyer could pay if there will be a step-up in rate

Valuation & Risk / Reward

• Base case: TYC-w does $1.8bn of EBITDA in FY Sept 2014 and trades for 8.5x Fwd. EBITDA by the end of 2013, resulting in a one-year price target of $32 / share (20% upside)
• This values TYC’s 49% stake in Atkore (the old Electrical & Metal Products business) at ~$340mm, half of what CD&R valued it at in 2010 transaction
• This also gives TYC credit for free cash flow generation  of ~$500mm after dividends and after one-time restructuring costs
• Best comps Ingersoll-Rand, Schneider Electric currently trade for 8.5x fwd EBITDA
• P/E-based valuation of 14x results in a $31 share price
• Upside case: Schneider acquires TYC-w for 10.5x EBITDA, resulting in a $40 per share deal price (50% upside)
• Downside case: $1.55bn of EBITDA and 7.5x Fwd EBITDA multiple, resulting in a $23.60 share price (~10% downside)
• This assumes disappointing performance relative to guidance but not a double-dip recession

Capital Structure, Free Cash Flow, Use of Balance Sheet

• Capital Structure
• Share Price: $26.50
• Diluted Shares: 469mm
• Market Cap: $12.4bn
• Net Debt: $1.1bn
• TEV: $13.5bn
• We estimate TYC-w will do $11.5bn in revenue, $1.8bn in EBITDA and $2.20 in EPS in FY Sept 2014
• Assumes ~5% revenue growth p.a. over next two years and modest margin expansion
• The biggest driver of margin expansion is the step-down in corporate overhead, where management is guiding to a reduced burden of $225mm p.a.
• TYC-w should generate over $900mm of free cash flow in FY 2013 and over $1bn in FY 2014
• At less than 1x net debt / EBITDA currently, TYC-w is clearly underleveraged
• Management indicated its intention to do tuck-in acquisitions and consolidate its highly fragmented end markets
• Very little was said at the investor day regarding share repurchase
• We do not factor in any optionality for more aggressive balance sheet deployment in our price target

Catalyst