Why I Passed On the Tyco Spinoffs

On June 29th, Tyco International (TYC) spun off Covidien (COV) and Tyco Electronics (TEL). Many investors, including several prominent value investors, had been waiting for this spinoff opportunity for quite some time. But as you can imagine, if everyone was waiting for this opportunity, the likelihood of the market mispricing these stocks was slim to none. Nevertheless, the best way to determine whether this spinoff provides an investment opportunity is to estimate the intrinsic value of each of the new companies.

I turned to the presentations given at the June 19th Tyco Investor Meeting. I find the slide presentation given at these meetings to be particularly helpful when trying to understand what is going to happen after a spinoff. Sadly, I can’t seem to find links to these presentations anymore on the Tyco website. However, using one of my handy investor hacks, I located this link to the Tyco Investor Meeting presentations and webcasts. (Hack: I used the cache links in Google to help find what was on the Tyco corporate website a few weeks earlier. This trick comes in handy on occasion.)

Let’s start by looking at Tyco Electronics. My gut sense tells me that Tyco Electronics likely has the smallest economic moat of the three companies. Tyco Electronics is in the industrial electronic components industry. My experience with the electronics industry leads me to think there is heavy price competition and intense creative destruction due to innovation. However, according to Tyco Electronics they derive approximately 70% of their sales from products that are number one in the industry. These products include connectors, cable assemblies, heat shrink tubing, touchscreens, and undersea telecom systems. Their operating margins are above 15%. However, revenue growth has only been about 5-7%. ROIC has been about 8% over the past three years. Given lack of direct knowledge regarding Tyco Electronics products I am not prepared to declare that Tyco Electronics has a wide economic moat.

Regardless, it might still be worth looking at the intrinsic value of Tyco Electronics. Tyco Electronics reported free cash flows [FCF] of between $1.068 billion in 2004 and $1.122 billion in 2006. The capital expenditures component of FCF has been fairly consistently between 4 and 5% of revenues (about $600 million). The company reported a goal of achieving organic growth of 5 to 7%. Free cash flows have been fairly close to net income. Therefore, I’m estimating the growth rate of FCF to be about 6%. Given that we are well into 2007, I’m estimating 2007 free cash flow of $1.189 billion.

I then projected future FCF out ten years and then discounted the present value of those free cash flows using a 10% cost of capital. I also estimated the terminal value after 10 years using a sustainable growth rate of 5% (approximately equal to the long term nominal GDP growth rate). This gave an enterprise value of about $25.58 billion. The new company will have approximately $3 billion in net debt so my intrinsic value estimate is $22.58 billion or $45 per share (based on 500 million shares outstanding). TEL closed last Friday (July 6, 2007) at $39.82. That’s only an 11% margin of safety.

Next we have Covidien. Covidien is primarily a medical device manufacturer. Medical device manufacturers often have patents on the devices that they develop that protect them from intense competition. This likely provides Covidien with an economic moat. One drag on this competitive position are the weak commodity business lines in medical supplies and retail sales. The company estimates that sales from these businesses could experience negitive growth in 2007.

Based on the companies guidance of 4% to 6% revenue growth, I’m going to assume that free cash flows are going to grow at about 6%. FCF was $903 million in 2006. Using a similar method of valuation as the one I did for Tyco Electronics, I came up with an enterprise value of $20.59 billion. The Covidien will have $4.45 billion in debt after the spinoff and about $800 million in cash. Therefore, my estimated intrinsic value for Covidien is $16.94 billion. Using the diluted number of shares outstanding of 499 million, I estimate the intrinsic value of one share of COV to be about $34 per share. COV last traded at $42.31 on July 6, 2007. There is no margin of safety on this one unless I got something really wrong in my valuation.

Finally, we need to look at the parent company, Tyco International, after the spinoffs. I must admit that out of the three companies, I was biased towards Tyco International. I think the parent company will be left with the widest moat business of the three companies. The security and fire alarm systems have strong brands and likely have high switching costs. I believe the ADT and SimplexGrinnel are pretty strong brands. I see ADT sign up all over my neighborhood and back in college when I worked as a security guard for a summer I became familiar with looking a Simplex panels at all hours of the night. I’m guess companies and individuals stick with the reliable brands that they know when installing security and fire alarm systems. I could probably go on an on about the competitive position of Tyco International, but I really should just move on to the valuation of this company.

Tyco International produced $1.05 billion in free cash flow in 2006 according to the investor presentation. I’m estimating that FCF will grow at about 8% over the next ten years. Then I assumed a 5% terminal growth rate after that. I also used a discount rate of 10% and I started discounting back estimated cash flows in 2008, since we are already half way through 2007. I estimated the enterprise value of Tyco to be $26.67 billion. Debt after the spinoff will be $4 billion and cash with be approximately $3 billion, giving a negative net cash of about $1 billion. Therefore, I estimated the intrinsic value of Tyco International to be $25.67 billion. There are approximately 507 million shares now after the recent 1:4 stock split. This gives you an intrinsic value per share of TYC of $50.60. I was hoping that I’d get TYC at a discount but alas it is trading at $53.17.

I am curious as to what others have estimated the intrinsic value of each of these shares to be. Please share your estimates in the comments section below.

I was really excited for the Tyco spinoffs, but I maintained my discipline and decided to pass on this opportunity. Time will tell whether I was too conservative with my estimates. Regardless, I would rather pass up opportunities that turn out well than invest money in potentially overvalued stocks that could cause me to lose capital. Of the three companies, my least favorite company, Tyco Electronics, currently provides the best value. However, I don’t think it provides a sufficient margin of safety.

Disclosure: I do not currently hold shares in any of the stocks mentioned in this article.

Comments

[boris123]

Why does Seeking Alpha always rename postings "Why I did this" or "Why I like this"? I much preferred your original title "Valuing the Tyco Spinoffs". Far more descriptive.

[velunder]

The free cash flow number you are using for Covidien reflects $376 million of negative working cash flow (see below excerpt from the Covidien Information Statement). You might want to adjust your valuation upwards to reflect this. I am not a stockholder in any of the three, but I think Covidien looks interesting.

Fiscal 2006 Cash Flow Activity
The net cash provided by operating activities of $1,335 million was primarily attributable to net
income for fiscal 2006, as adjusted for deferred income taxes, depreciation and amortization, the loss
from discontinued operations, purchased research and development and non-cash compensation
expense. This source of cash was partially offset by a $376 million decrease in accrued and other
liabilities, driven by payments of $324 million for two patent infringement matters, a decrease in
income taxes payable of $263 million and an increase in inventories of $212 million.

[maz]

I agree that the Covidien valuation misses the mark. Also with spin-offs there is a lot of extra expenses & capex that tend to be short term (one to two years) in nature. Using the pro forma statements will usually result in a lower base FCF and it takes time to go thru and estimate "normalized" figures.

COV - $54 in a range of $45 to $61
TEL - $42 in a range of $35 to $48
TYC - $49 in a range of $42 to $57