Tyco International Ltd. was supposed to be the next Cendant. Or the next Sunbeam, perhaps, or Waste Management. Go ahead, pick your favorite corporate behemoth recently brought to its knees for aggressive accounting practices. Because that’s what was supposed to happen to Tyco after allegations surfaced last fall that the acquisition-hungry conglomerate had set up “cookie- jar” reserves to pump up future profits, and had encouraged several targets to take big, premerger write- offs.
“Everyone was expecting us to be next,” acknowledges CFO Mark H. Swartz. But as short- sellers swarmed and the stock swooned, falling more than 50 percent, Swartz and chairman and CEO L. Dennis Kozlowski insisted that Tyco had done nothing wrong. They held meetings with investors and analysts, offered pointed rebuttals of rumors deemed “unfounded and malicious,” and practically invited the Securities and Exchange Commission to investigate.
Which the SEC did, eventually clearing Tyco in July. So sure was Kozlowski of that outcome that he nominated Swartz for a 2000 CFO Excellence Award in the Mergers & Acquisitions Management category at a time when the investigation was still pending. “We were very, very confident of our accounting,” declares Kozlowski.
“Despite all that people were saying and what was happening to the stock price, we knew what the truth was,” adds Swartz during an interview with CFO, his first since the SEC backed off. Yet the 40-year-old finance chief was not named the M&A category- winner for dodging the armor-piercing bullet of regulators. Rather, the award reflects a recent flurry of deal making that no other company can match. Tyco’s tightly structured acquisition approach has been an unqualified success, one having no need of smoke-and-mirrors accounting.
Over the past three years, the Bermuda-based company has finalized more than 350 acquisitions, with a total purchase price of about $28 billion. Each–from the 250 or so worth less than $5 million to the largest, the $11 billion deal for AMP Inc.– has fit neatly within one of Tyco’s four business segments: telecommunications and electronic components, health-care and specialty products, fire and security services, and flow controls. Analysts expect revenues for fiscal 2000, ending September 30, to approach $30 billion, up from $9.8 billion in 1997, with earnings rising to $2.15 a share, a 330 percent increase. Hovering near 60, Tyco’s stock is more than 10 percent higher than it was before the accounting clamor, and nearly triple its value three years ago.
Tyco, says Wendy Caplan, an analyst at ING Barings, “is a well-oiled machine” when it comes to M&A. And Swartz, she adds, is the one who supplies the grease.
Living with Deals
Swartz arrived at Tyco in 1991 with a discipline for doing deals. He’d been a due diligence consultant at Deloitte & Touche for several years, and was hired by Kozlowski to assemble an M&A team. After Swartz was named CFO in 1995, the management team spelled out a stringent acquisition strategy. Every deal had to be friendly and immediately accretive to earnings, and the target company had to strengthen an existing Tyco business.
Perhaps most innovative, Tyco began developing a pool of operating-unit employees who would take part in every stage of the deal-making process. Swartz’s theory: Those who have to “live with a deal” will do a better job at due diligence and integration than any outsider might. The effect of such an approach, Swartz says, is that Tyco managers identify more than 500 possible acquisition targets in any given year–and walk away from the vast majority of them.
In addition, Tyco will not do a hostile deal, for the simple reason that such a charged situation typically hampers due diligence and integration planning. Without the target’s buy-in, the information available for forecasting pro forma results may be limited, and the support from the acquired workforce for meeting postmerger objectives may be harder to attain. “The advantage of doing only friendly deals is that [Tyco] can get behind the numbers,” says Jack Kelly, a Goldman Sachs analyst, “and once they take control, they can move quickly.”
Not only has every Tyco acquisition been accretive, but the company refuses to factor any top-line growth into the financial models. “Anything that isn’t accretive on a cost-reduction basis gets shot down,” says Swartz. That doesn’t mean that Tyco doesn’t pursue revenue enhancements when it puts these complementary businesses together, but a sizable return is not dependent on such synergies. “They don’t talk about sales growth when they announce a deal,” notes Caplan of ING Barings. “That’s always gravy on top.”
As for Tyco’s in-house approach to M&A, Swartz told CFO in 1996 that some 60 employees had been drawn from the business units to work on different deals. “If you have good people, they should be able to take their knowledge of your business and look at another business, and come up with various assumptions,” he explained at that time. Such a philosophy holds today, though now several hundred employees have deal-making experience. “Since we’re buying businesses in areas where we’re already involved,” Swartz confirmed recently, “we rely on the people already in those businesses.”
As savvy as Tyco has become at doing smart deals that boost revenues, Swartz points to internal growth rates and mounting free cash flow as the key indicators that its acquisition efforts are paying off. In its third-quarter results, reported in July, the company announced 17 percent sales growth from existing businesses, up from 11 percent the year before, and free cash flow of $1.9 billion for the first nine months of fiscal 2000, which exceeds the amount for the entire previous year.
“Not only have we been able to bring in companies that have added to our size, but we have been able to grow them at a very fast rate,” says Swartz. “And it’s the organic growth that is the report card on the health of the business.”
Internal growth is strongest in the telecom and electronic components segment (about 25 percent), and Swartz credits the ability to find businesses that fit well. AMP, for instance, had a bloated bureaucracy and declining revenues and profits. Since completing the purchase in mid-1999, Tyco has not only taken out $1 billion in costs, but it has also applied the same focus on customer service and new-product introductions that was part of its existing electronic components unit. Sales are now growing 20 percent annually, and the business is making money.
One of Wall Street’s favorite Tyco deals was the 1997 acquisition of AT&T’s submarine systems, for $850 million. The business was marginally profitable, but since merging it with its own underwater fiber-optic telecommunications cable unit, Tyco has become the world’s largest and most integrated supplier. Boasting operating margins of 20 percent, Tyco sold 20 percent of the business to the public in July. Recently, those shares had a market capitalization of $21.5 billion.
“That’s their most spectacular deal,” says Goldman Sachs’s Kelly. “You pay $850 million, you join it with a unit on the books for about $200 million, and now it’s worth $21 billion.”
But Swartz believes the single most compelling sign of Tyco’s deal-making prowess is the increase in free cash flow (operating income less capital expenditures and dividends). That total was $231 million in fiscal 1997, and is expected to top $4 billion in 2001.
In the year since Tyco was hit with charges of accounting legerdemain, the company kept making acquisitions, though it completed fewer big ones. All were for cash, because using the depressed stock would have been costly to shareholders. But according to Swartz, relieved by the “clean bill of health” from the SEC, what this corporate crisis imperiled was not the company’s ability to do deals.
“What we were most anxious about was the people who work at Tyco,” he explains. “We didn’t know how long the review period would go on, but we did know that when it was done, we wanted to be sure the business was on the same track. That was the biggest management hurdle–making sure our employees didn’t miss a beat in the marketplace.”
Evidently, they succeeded: Tyco’s internal growth rate accelerated while the company was under the gun. Mark Swartz, clearly, is not a CFO to be sold short.