Valuing 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 eoncomic 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 guessing 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 in money 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.

15 thoughts on “Valuing the Tyco Spinoffs

  • July 9, 2007 at 7:20 am
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    I’m not sure the Tyco spin-offs will create the same level of opportunity as most spin-offs. What really helps drive mispricing is when the new company is not part of the S&P 500 leading to index fund managers blindly selling holdings which are not in the indes. In this case all three TYCO companies are remaining in the S&P and two weaker companies Sanmina and PMC-Sierra are being given the boot. Sanmina dropped a little but PMC-Sierra did not.

  • July 9, 2007 at 11:21 am
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    How exactly do you use Google cache to search for old Web pages. I am doing some research on ADP and would like to get access to an audio file that was available on their site from 3/22/07 through 4/5/07.

  • July 9, 2007 at 10:46 pm
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    Doug,
    Good point regarding Tyco and its spinoffs staying on the S&P 500. I usually mention the index status of each of the companies after a spinoff, but I forgot to mention that in this article.

    Vern,
    Click on the link to Google in my post. It will show you the query I used. Build a similar query for the ADP site and then click on the “Cache” links on the Google results page. However, I don’t think the Google cache will still have pages as far back as March and April. It’s worth a try however. Maybe I’ll write a post next week with more detailed instructions on how to do this.

    Vitaliy,
    Thanks for the positive feedback. It means a lot to me that a pro investor (CFA) like yourself thinks I did a good job valuing these companies.

  • July 10, 2007 at 11:46 am
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    Thanks. I didn’t do as much work as you did on these three, but I came to the same conclusions in my recent portfolio review, where none of the three got added to my portfolio.

  • March 26, 2008 at 1:07 pm
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    This is an incredible blog, with highly effective information. I do recommend this for anyone to read.

  • April 12, 2008 at 5:05 pm
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    Although it is April 12, 2008, I recently received a T5 statement of investment income for tax purposes (I am a Canadian) which indicates foreign income derived from the spin-off of Covidien and Tyco Electronics. I wanted to confirm the spin-off date and found your site.

    I had 200 shares of Tyco International, received 50 shares each of spin-off companies and was left with 100 shares of the original stock.

    I am at a loss to understand why, if I lost 100 shares of TYC, I am deemed to have been “paid” the value of each of the 50 shares of Tel and COV as at the spin-off date.

    Perhaps you can explain. And, how do I indicate the loss of the 100 shares of TYC?

    Your comments, if you are familiar with this tax oddity, would be appreciated.

    As an aside, I am adept at editing and proofreading and found this error in your article:

    I’m guess companies and individuals stick with the reliable brands that they know when installing security and fire alarm systems.

    The second word should have been “guessing”.

    I did not read the entire article, but this error caught my eye, so to speak.

  • April 14, 2008 at 10:14 pm
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    Beverly, thank you for the edit. I just corrected the article as per your suggestion. I always appreciate receiving edits since I don’t have a proofreader and am often writing these posts at night when I’m tired. I’m sure there are many other typos hiding out on my blog. Feel free to alert me if you find any others.

    As for your question, I am unfamiliar with Canadian tax law. I was under the impression that the Tyco spinoff was a tax free event in the United States. It might be different in Canada. I didn’t invest in Tyco, so I’m not sure how this one turned out. I hope you are able to turn up an answer to your question. I suggest you work through the SEC EDGAR filings for Tyco to find the spin-off date and tax treatment of this event.

  • May 8, 2008 at 12:08 pm
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    Just wondering if anyone found out if the TYCO spinoff is addressed anywhere by CRA. I found a list of foreign spin offs that are eligible for tax-free treatment for Cdn shareholders but it doesn’t appear that TYCO did the paperwork with CRA. See:

    http://www.cra-arc.gc.ca/tax/business/topics/spinoffs-e.html

  • December 16, 2008 at 11:19 pm
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    has anyone found out about the Canadian tax treatment of Tyco spin off???

  • August 20, 2009 at 11:09 pm
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    I’m also wondering if anyone found out the Canadian tax treatment for the Tyco spin off? Can Canadian shareholders of Tyco make the election of Section 86.1? Please advise. Thanks

  • February 8, 2010 at 9:55 pm
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    I’m a Canadian Tyco shareholder. I’m proceeding to Canadian tax court to try to fight the unfair tax I have to pay on the investment income I supposedly received from the Tyco company spin-off. Is anyone in the same situation? I’m planning to meet with a tax lawyer to discuss the matter. Is anyone interested in joining me to rectify the unjust treatment from CRA?

  • February 18, 2010 at 9:17 am
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    I’m also a Canadian Tyco shareholder and heading to Tax Court to fight this. My view is that I certainly did not derive any income from the exchange of shares that Tyco did. In fact, by doing a reverse-split as part of the transaction, every shareholder ended up being in a wose-off situation.

  • May 11, 2010 at 5:35 pm
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    i’m like alot of you tyco shareholders.
    i’m canadian and i’m currently fighting in court with revenue canada over this issue.

    if anyone has any info regarding tyco spinoffs and any canadian court decisions regarding this matter.
    please post it on this site

    thxs g

  • November 29, 2010 at 1:17 pm
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    I’m also heading to the tax court for the same issue. Has anyone actually gone to the tax court and if so, what was the result?

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