This summer, as investors toss and turn at night, their worst dreams will be about complex balance sheets with large amounts of goodwill and numerous special purpose entities. Indeed, the witch hunt for the next Enron was already in full flight when investors began to express concern about Tyco International, the Bermuda-registered conglomerate whose interests range from electronics to medical supplies, from fire and security systems to undersea cabling, factoring and loans. Perturbed by the prospect that various off-balance sheet activities, goodwill writedowns and options tax deductions could be disguising the true value of the company, private investors and fund managers alike began to sell Tyco in droves. And the numerous hedge fund managers who had taken short positions in the company rubbed their hands with glee.
It was not, at least initially, a question regarding Tyco’s balance sheet that set off the share price decline, but rather an unfounded rumor late on Friday, January 11. The story went that Tyco was going to make a bid for Honeywell (subject of General Electric’s failed takeover last year). The rumor caused Tyco’s share price to plummet around 8.5 percent in the last half hour of trading, and although a company spokesperson denied there was any truth in it immediately after the close, Tyco was in the spotlight – it came under very close scrutiny in the days and weeks that followed.
Caught off balance
Since the Enron debacle, investors have been running scared of companies whose off-balance sheet activity is less than transparent. To be fair, much off-balance sheet activity is perfectly legitimate, and can be a useful tool for companies seeking to broaden their financing horizons. Robert Brookby, executive vice president at Wachovia Bank in North Carolina, affirms, ‘Off-balance sheet activity can be a plus for a company when it lowers the cost of capital and expands its sources of financing.’ This may make a company more attractive to creditors, who see a stronger looking balance sheet with less debt, and may therefore be willing to offer more credit, and at better rates of interest, or lighter loan covenants.
Off-balance sheet vehicles may also reduce taxes, for example by reducing the equity-to-debt ratio, one of the Internal Revenue Service’s accumulated earnings test benchmarks. Indeed Aram Kostoglian of accounting firm BDO Seidman maintains, ‘Ratings agencies and banks penalize companies not using these techniques.’
In any case, rating agencies such as Standard & Poor’s claim they take full stock of off-balance sheet financing and its various implications when rating a company’s debt. On January 30, S&P said it was satisfied with Tyco’s answers to questions about its accounting practices and confirmed the single A rating on the company’s senior unsecured debt. However, five days later the company debt was downgraded to BBB.
Tyco maintains that its guidance has been conservative, and suggests it goes out of its way to provide investors with information. But the company has not always been so candid about its spending. Over the last three years, some $8 bn was spent on acquiring around 700 companies in transactions that never appeared on the balance sheet. Investors were only informed of this on January 22, in response to an article in the Wall Street Journal. Incidentally, this was the same day the company announced it was to split into four separately traded units – ‘In order to unlock billions in shareholder value,’ according to CEO Dennis Kozlowski.
After that shock announcement, the company decided to start weekly conference calls to respond to questions from investors and analysts about how the breakup would take place, and how plans were progressing. Some skeptics saw this as an attempt by the company to cover their backs without dealing with the really crucial questions. Those who tried to contact the company to ask specific questions were referred to the weekly event, although the really tough questions still weren’t being answered. For example, why has the company got 16 subsidiaries based in Luxembourg? Could it be that the high level of confidentiality guaranteed by that country’s company law allows Tyco to further inflate its reported profits away from prying eyes?
A very special purpose
In the case of Enron, much of the company’s debt was shuffled off the company’s balance sheet into various special purpose entities (SPEs), many of which had been set up by Andrew Fastow, the company’s CFO until his firing last year. He has been accused of enriching himself through these vehicles at the expense of Enron shareholders. In addition, the company itself admitted acting improperly by financing these SPEs with its own shares, which led to a $1.2 bn reduction in shareholder equity in Enron’s October 2001 quarterly statement.
JP Morgan’s Mahonia set-up seems to have existed exclusively for the purpose of year-end transactions with Enron, which again involved the shifting of debt from Enron’s balance sheet. The activities served at least two purposes. First, Enron’s apparent level of debt appeared on the balance sheet to be far less than it actually was, and secondly, the company’s interest payments to the special purpose entities were tax deductible.
Such off-balance sheet activity should be explained in the footnotes of a company’s financial reports. The problem is, the more off-balance sheet activity, the more complex the footnotes become, and some of them don’t really explain much.
‘The more you read the notes to Tyco’s consolidated financial statements,’ says one analyst from Bear Stearns, ‘the more you may be intrigued by the amount of financial activity that takes place between Tyco, its operating subsidiaries and its limited urpose subsidiaries on September 30, the last day of Tyco’s fiscal year.’
Given the complexity of the maneuvers, it’s not surprising there should be some different opinions about Tyco’s reported cash flow. Harriet Baldwin of Deutsche Bank Alex Brown remarks, ‘Until investors who want out at any price are out, and in the absence of positive news flow, fear, not fundamentals, will drive Tyco’s share price.’ Baldwin rates Tyco a buy and insists that the company’s reported cash flow ‘looks real’.
The analyst at Bear Stearns does not agree, insisting, ‘If certain one-time items are stripped out of Tyco’s cash flow projections, the free cash flow is far lower than what it appears to be on the consolidated statement.’
‘It’s a simple rule of thumb,’ says a Credit Suisse First Boston fund manager. ‘The more footnotes there are, the less you should trust the company. It’s really that simple. Why else should companies complicate their balance sheets, if they aren’t actually trying to hide something? Tyco’s 10K is accompanied by some 50 pages of footnotes, much of which leads one to believe that most of the company’s financial transactions are with its own subsidiaries.’
Goodwill games
‘The Enron debacle has taught people to be very, very scared of pro-forma accounting and massive goodwill,’ says Nicola Tota, a client manager at Rolo Banca Private Banking. In January, Alex Berenson at the New York Times questioned the amount of goodwill Tyco assumes. It was yet another blow to the company’s tumbling share price.
‘By minimizing, or marking down, the value of the tangible assets and maximizing, or marking up, goodwill, Tyco can inflate its earnings,’ notes James Chanos, president of Kynikos Associates, a hedge fund that had a short position in Tyco at the time of this comment. This is because goodwill is treated differently from real assets which, under generally accepted accounting principles, lose value over time. ‘In addition,’ adds Chanos, ‘if Tyco sells the products it has devalued… it can make an even larger profit.’
With respect to the mid-2001 acquisition of CIT, now known as Tyco Financial, David Bleustein of UBS PaineWebber, says, ‘Tyco management believed the value of the assets on CIT’s books was overstated relative to their fair market value by $175 mn. Given management’s opinion, Tyco is required to write down the value of the assets to fair market value.’ But in a double-edged defense of the company’s accounting practices, Bleustein notes that Tyco wrote up the value of the liabilities being acquired. ‘As a result of these adjustments alone, we believe Tyco Financial will earn roughly $450 mn more over time than CIT would have earned as an independent company.’
Tyco’s four-way split
Way back in October 1999 David Tice of the Prudent Bear Fund, a hedge fund, suggested Tyco’s aggressive pooling of interest accounting methods, first adopted in 1995, made the company’s financial results look much better than they actually were. But an informal SEC investigation which resulted from Tice’s comments did not lead to any enforcement action, although the SEC did request some minor accounting adjustments. Although Tyco’s share price suffered a heavy drop after Tice’s comments, it had recovered all the lost ground and then some by the time the SEC inquiry was complete in July 2000. Investors were willing, it seemed, to ignore the company’s detractors just as long as Tyco continued to deliver its outstanding growth figures.
Tice, however, continued to take issue with Tyco’s accounting methods and in mid-January 2002 (when he had a short position and owned some puts in the company) affirmed that ‘aggressive accounting practices have continued to artificially inflate Tyco’s growth rate.’
When Tyco published its report for the first fiscal quarter of 2002, both revenues and earnings had beaten Wall Street estimates, although the company lowered guidance for the second quarter. Hedge fund managers, especially, were quick to slate the company. ‘The recession is over and now they’re telling you that they’ve got problems? Stay away!’ warned Seth Tobia, of hedge fund Circle. Added Tice, ‘When a company that is good at these machinations (ie, producing impressive growth figures) falls short, people wonder how bad it really is.’
Then the share price really did plummet as worried investors ran for cover. Rumors of accounting woes abounded, fueled by the fact that since June 2001 the company had stopped disclosing some key items on its balance sheet, including prepaid expenses, deferred revenue and deferred income tax which were unceremoniously lumped together with ‘other assets’ or ‘other liabilities’.
That was the moment the breakup bombshell was launched. The company was to split into four separately traded units: security and electronics; healthcare; fire protection and flow control; and financial services. Tyco plastics would be sold separately, and after the initial announcement, the complete sale of Tyco Financial (with a price tag of some $12 bn) was also mooted. The company said that the original plan would enable it to eliminate at least $11 bn of its $23 bn debt, and announced its intention to repurchase most of the bonds issued by Tyco International. According to the message at the time from Kozlowski, Tyco’s CEO, ‘As independent public companies, each of these businesses will offer investors a pure play opportunity with excellent growth prospects and greatly increased simplicity, clarity and transparency. As such, we believe that each will be valued substantially higher than the implied valuations it has received in recent years as part of Tyco.’
Too little too late
The share price bounced as numerous analysts enthused over the plan, but it didn’t last. Where had this plan come from so suddenly? Some skeptics saw it as a desperate move to draw attention away from the problems that had come under the spotlight with the company’s profit warning.
Muses Herb Greenberg of TheStreet.com, ‘Maybe the breakup of Tyco wasn’t planned at the time the earnings were released, and was concocted in the wake of questions about its accounting and other issues.’ Greenberg seems to have a point. The company’s 2001 annual report makes absolutely no mention of such a possibility. Indeed it suggests that Tyco had managed to weather the recession better than many competitors, precisely because strong growth in the company’s non-cyclical businesses had offset shrinking revenues and profits at, for example, the Tycom undersea cabling division.
Tyco’s woes continued through the spring with a $1.9 bn loss in its fiscal second quarter. With the weekly conference calls suspended at the end of April because of declining attendance, the company executed a stupendous flip-flop: forget the four-way breakup. Instead, CIT Group would be spun off in an IPO to pay down debt. Investors had greeted the initial breakup plan with skepticism, and now they treated the spin-off idea with downright disdain. The stock was driven down another 34 percent to a low not seen since 1997. That’s $84 bn in market value wiped out since the beginning of 2002. Ouch. And the jury is still out as to whether Tyco is worth more or less than the sum of its many, many parts.
