By one measure, Dennis Kozlowski helped clean up Tyco International. The indicted ex-CEO gave laser-sharp focus to his successor, making it easy for new CEO Edward Breen to identify his top remediation task: restore investor confidence by exorcising Kozlowski’s inner circle.
Breen, formerly president of Motorola, wasted little time. Immediately following his July 2002 appointment, he ousted about 50 executives who worked for Kozlowski — as well as the entire board that had hired Breen himself. Breen then assembled his own clean team, installing nine independent directors (Breen, the chairman, is the tenth), bringing aboard former United Technologies CFO David FitzPatrick as Tyco’s new finance chief, and hiring Eric Pillmore, former CFO of Multilink Technology Corp., as chief governance officer.
Breen displayed good governance know-how, say experts, by having Pillmore answer to the board’s nominating and governance committee, rather than another C-level executive. Tyco management maintains that the reporting structure, which they believe is unique, bolsters the board’s oversight power.
Breen’s mighty, swift sword encouraged interested observers. As brand expert and Lippincott Mercer senior partner James Bell tells it, Tyco is a capital markets brand, not a consumer brand, so cleanup efforts had to start with distancing the new Tyco from the old, corrupt Tyco.
Indeed, the Tyco tarnish was heavy. In January 2002, an in-house probe revealed major breakdowns in financial controls, including transparency problems in the plastics division and suspect operating income, related to dealer accounts, at the ADT unit.
Eventually Kozlowski and former CFO Mark Swartz resigned after being indicted on personal tax evasion charges — but not before the duo allegedly pilfered $600 million from the company. Federal charges chronicled lavish living by Kozlowski and his lieutenants at the expense of shareholders. The main offenses: abuse of executive loan programs, self-dealing transactions, unapproved bonuses, unauthorized pay, and fraudulent stock sales.
In short order, Breen expanded the ongoing internal audit into a full-scale, independent investigation that kept 25 lawyers and 100 accountants busy for five months. The forensic team uncovered breakdowns in the control processes associated with executive compensation, and problems with reported revenues, profits, cash flows, use of reserves, and non-recurring charges, among other financial shortcomings.
So far, several repair measures have been implemented, says a Tyco spokesman Gary Holmes, including splitting up the plastics group into two reporting segments, changing the definition of free cash flow to include cash paid for the acquisition of new dealer accounts, detailing free cash flow by reporting segment, and providing details of how “organic growth” is calculated.
Planning for the Long Term
Recall that growth at Tyco under Kozlowski and Swartz was anything but organic. It was a “smash and grab mentality,” says research analyst Brian Langenberg, a principal at Langenberg & Co in Chicago. “The focus was to make short-term gross margins, and they did,” but Kozlowski and Swartz never wanted to spent time on integrating companies to extract efficiencies, says Langenberg. “They weren’t hitting their numbers the right way.”
On the other hand, says Langenberg, Breen and FitzPatrick hail from companies with long-term perspectives and are more patient about growth. Lippincott Mercer’s Bell, agrees, noting that he likes the way Breen has laid out a blueprint for change “and is sticking to his outline.” But Bell doesn’t expect Tyco to heal overnight: “Breen is running a real business, not a speculative one, and the cleanup will take time.”
It’s been a little over a year since Breen took the reins, and several operational and financial reporting hurdles remain to be cleared. “Breen’s on track, but he’s been left with no systems in place to track what’s going on,” opines Langenberg. “There’s no operating plan or strategic forecasting methodology.”
Perhaps more startling, confirms Langenberg, is that Tyco lacks a central purchasing department — despite spending $14 billion annually on goods and services. Furthermore, Tyco lacks a companywide IT system, operates redundant manufacturing plants, is still in the process of closing two of its four headquarters, suffers from a rising customer attrition rate in its fire and security units — and continues to be the subject of an investigation by the Securities and Exchange Commission.
If that laundry list isn’t enough, Tyco’s 2,150 operating units seemed rife with accounting and financial reporting problems, and spooked suppliers are calling for cash, not credit.
Considering the hand that Breen has been dealt, analysts who watch Tyco believe that the new CEO is doing a fairly good job, if perhaps too eager to announce good news.
Breen was criticized by analysts earlier this year for jumping the gun when he announced that Tyco’s restatements for prior quarters were a thing of the past — only to see the company restate two more times. So far the company has made $1.4 billion worth of adjustments since Breen’s arrival. Langenberg, whose personal holdings include Tyco, thinks that the company may restate its results for one more quarter, but he doesn’t expect the adjustments to be significant.
Company officials have assured investors that the restatements won’t trigger debt covenants. However, Carol Levenson, head of research at Gimme Credit, notes that she’s uncomfortable with controversial accounting methods that “keep popping up,” such as changing the definition of cash flow.
Indeed, research analyst Albert Meyer, general partner of 2ndOpinionResearch.com, was the first to point out that Tyco overstated free cash flow in the third quarter by $152 million. Meyer emphasizes that Tyco “has cleaned up” and that he doesn’t expect any more scandals. Nevertheless, he sees room for improvement in the clarity of Tyco’s financial disclosures.
More importantly, claims Meyer, Tyco management fumbled during the company’s most recent earnings call by admitting that the debt reduction payoff was “not readily apparent on our financial statements.” Says Meyer, “If they knew it wasn’t apparent, why not clarify it in the financial statements?”
The breakup of Tyco is another issue. Until the SEC finishes its investigation, Breen can count on a reprieve from analysts who are calling for the spin-off of the company’s flagship fire and security unit, ADT. Langenberg says the spin-off doesn’t make sense and claims that the idea is being advocated by investment banks hungry for fees. He reckons the value of ADT as a part of Tyco “will be reflected over time as operational and revenue synergies develop.”
While Tyco’s management remains focused on strengthening operating performance, they do admit that some divestitures will probably occur during the next few quarters. According to Tyco’s Holmes, the divestitures will represent less than 10 percent of the company’s assets, but would enable Tyco “to prune our portfolio of non-core assets.”
Despite Tyco’s woes, Meyer reckons that the company is correctly valued (as of the second quarter this year). Meanwhile, Tyco’s portfolio is strong, says Langenberg, who notes that many of the companies rank either first or second in their industry. By his lights, Tyco’s stock prospects are “more bull than bear.”