James B. Stewart, of Smartmoney.com, in a recent article entitled “Breaking Up is Hard to do” outlines what has become a consensus view that de-merging companies into spin-off components is a value-subtracting exercise. Recent data suggests that investors greet such de-mergers with less than complete enthusiasm. I tend to view such spin-offs positively; such action represents an unwinding of a holding company or a conglomerate discount into leaner, meaner components that can control their own destiny rather than fund the nefarious or dubious needs of other parts of the organization.
As Stewart points out:
“That said, there are good reasons the market casts a skeptical eye on these deals. Mergers at least hold out the possibility of operating efficiencies. So-called horizontal mergers may reduce competition and result in higher margins and profits. This is why the Guidant deal is being viewed so warmly, since it's likely to consolidate the growing market for heart defibrillators. "Vertical" mergers promise — though rarely deliver — in-house customers and suppliers. But the very nature of a breakup offers neither reduced competition nor vertical advantages. Generally they're touted for the inverse advantages of bigness. Cost-saving efficiencies like a single management, headquarters, legal, accounting and personnel staffs, are arguably more than offset by the advantages of a management that isn't stretched too thin and a company that is more nimble and opportunistic.”
I view the Tyco International (TYC) de-merger quite favorably. The break-up of the business into its component parts should reveal some otherwise buried levels of profitability.
For example, Tyco Healthcare sports operating margins of close to 27%. Almost as high as JNJ’s 29% but well above Baxter (BAX) at 16.3% or Abbott (ABT) at 17% or CR Bard’s (BCR) 24.5%. Using an average 16.5 times EBIT for enterprise value for the comparable (but less profitable) group would value Tyco Healthcare at about $42 billion. Apportioning debt according to segment sales would leave Tyco Healthcare with about $2 billion in debt. This values the equity of Tyco Healthcare at roughly $20 per share.
The Electronics segment of Tyco sports operating margins of about 15%. Let’s compare that to Motorola (MOT) at 9.6%, American Power Conversion (APCC) at 11.5% and Amphenol (APH) at 19.1%. Using a group average 14 times EBIT for enterprise value would correlate to Tyco Electronics being valued at about $26 billion. Again apportioning debt according to segment sales leaves Tyco Electronics with $2.5 billion in debt. This values the equity of Tyco Electronics at roughly $12 per share.
The fire and security, Sensormatic business of Tyco has about 10% operating margins. Compare this to Parker Hannifin’s (PH) 8.1% operating margin or Cooper Industries’ (CBE)12% operating margins. Checkpoint Systems, one of the competitors to the Sensormatic business has had recent operating losses, so provides little relevant comparison. Using a EV/EBIT multiple of only 10 times, well below the group average, provides a valuation for Tyco Fire and Security of about $6.50 per share.
As you can see, even attributing zero value to the smallest component, the Engineered Products division, still nets a valuation of the sum of the parts of $38.50 per share compared to the current market valuation of $26.00.
What follows is Oscar Shafer’s views of Tyco as espoused in this week’s Barron’s. There is a serious disconnect between the market price and valuation of Tyco.
Schafer: My next pick is Tyco International. The stock is about $29. The company has 2.1 billion shares and $40 billion of sales. It will earn close to $1.90 in the fiscal year ending Sept. 30. Investors are missing two things. First is the enormous cash-generating power of the company, which results in free cash flow of 15 to 25 cents more than reported earnings per share. Second is the value of the company's $10 billion health-care business, which earns close to a dollar a share and would be valued near $20 as a stand-alone company. You're paying only 10 times earnings for the remaining businesses.
When Tyco stock was at $36 last January, there was little incentive to split up the company. But, at 29, there is a serious disconnect between the price and intrinsic value. In November, CEO Ed Breen said that if "the valuation disconnect persists," he was prepared to take additional action besides repurchasing shares. When asked, he said "the full range of options" was being considered. One would be a spinoff or IPO or sale of the health-care division.
Meanwhile, Tyco has reduced net debt from $9.3 billion at the end of September to $6.3 billion now. With $4.5 billion of free cash flow, the company can simultaneously reduce debt, buy back stock and make acquisitions. [Subsequent to the Roundtable, Tyco announced it would split into three separate publicly traded companies specializing in its various business lines. Oscar, who applauded the split, said in a follow-up conversation, "This split aligns three shareholder constituencies in a tax-efficient manner, and allows each company more flexibility to pursue strategies unique to that business."]
I, my family, and my clients are all shareholders of Tyco.