Scrutinizing the Tyco Split

 | Sep 19, 2012 | 12:30 PM EDT  | Comments
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Stock quotes in this article:

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pnr

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cov

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tel

Tyco (TYC) has formally announced shareholder approval to spin off its security and flow control units at the end of September. The flow control unit will be merging with Pentair (PNR). Meanwhile -- despite private equity and take-over murmurings -- the ADT security unit intends to remain an independent, publicly traded company.

Shares of the conglomerate are at their highest levels since the early 2000s, and are up 25% since a year ago. A week and a half before the anticipated Sept. 28 distribution -- the second such split in five years  -- the company sports market capitalization of $26 billion. In June 2007, Tyco completed a much-anticipated move and spun off Covidien (COV) and Tyco Electronics, now known as TE Connectivity (TEL). Since Covidien's 2009 lows, the company has kept pace with the broad market, but TE Connectivity is up nearly 300%.

Many analysts have said Tyco shares, at about 14x forward earnings, are trading near fair value. These cautious views of pre-split shares stem from questions about one-time separation expenses, tax information and the overall lack of specifics regarding potential growth catalysts. A post-split selloff would modestly depress prices, making room for a value play. But this makes Tyco's progeny interesting over the next two to six months -- not over the next two weeks.

The soon-to-be-leaner Tyco is projecting annualized earning growth of 15%. Meanwhile, the new CEO, George Oliver, has indicated that he hopes to squeeze margins while growing revenue at an annual rate of around 4% or 5%. The company has released presentation slides with information regarding the fire-and-safety business and, according to these, the segment generated pro forma revenue of $10.3 billion in 2011. That compares with $17.4 billion for the total conglomerate.

ADT, the second component of the spinoff, is one of the most recognizable security brands that Tyco owns and generated about $3 billion in 2011 pro forma revenue. Tyco will retain the use of this brand outside of North America, but ADT will be more occupied with residential sales than the mother company will be. In fact, ADT is something of an odd duck in that its peers will be telecommunication and cable companies.

As J.P. Morgan analyst Stephen Tusa notes, "Residential security itself is not a growth industry." Security systems are installed in new homes, and the housing market is still struggling with depressed prices. That said, ADT will be the largest company in the $12.5 billion North American security business, and the company itself has 6.5 million subscribers.

Tusa's comment notwithstanding, there is still potential for growth in the so-called "home automation space," which is currently only installed in 1% of American homes. Tyco Security and Fire President Naren Gursahaney wants to pitch a different way of thinking about security services -- that security systems protect against a negative experience. As he explains, "You're buying it because you feel you need to have the security system. . . . As we extend into home automation space, then it's more an issue of 'I want to have this.'" In the sense Gursahaney envisions it, the automation of lights and other electronics around the house is an untested market, so we will have to wait and see.

The flow-control unit, which will merge with Pentair and trade under its ticker PNR, will continue its focus on producing valves and various controls critical for energy systems. For investors, one of the most interesting aspects of the split is that plenty of shareholder value is generated in this aspect of the spinoff, which values Tyco's flow control business at around $5 billion. That pans out at 9.5x earnings before interest, taxes, depreciation and amortization -- a higher multiple than its peers.

Though management has provided some glimpses into the new companies, we would await the results of the distribution in order to see if a more attractive entry point becomes available. That said, all three are sure to nimbly maximize growth in a way that the conglomerate was unable to do.

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