Tyco Makes A Conservative Debut

By Stephen D. Simpson, CFA | November 16, 2012 AAA

If Tyco's (NYSE:TYC) first post-split quarter is any indication, this is going to be a conservatively-managed company focused on smart growth and steady operating improvements. Although a global recovery in commercial markets would be a big help, improving cost efficiency and takeout chatter is likely to buoy the stock in the near term.

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Closing the Year as Expected
Although Tyco's fiscal fourth quarter report was pretty messy from a GAAP standpoint (due in part to the split from ADT (NYSE:ADT) and the flow control business (since merging with Pentair (NYSE:PNR)), it was basically in line with expectations.

Revenue fell about 3% as reported, with organic revenue up about 1%. The North American Installation and Service segment saw revenue fall 1% on an organic basis (as services were flat and installation revenue declined), and the ROW segment saw a similar 1% net organic revenue decline (with 4% service growth and a 7% decline in installation). Product revenue rose 9% organically, with double-digit growth in life and security.

Considered differently, overall installation revenue fell 4%, while service was up 2% and products rose 9%.

Tyco also did fine on margins at a corporate level. Gross margin improved a point and a half. Operating income was down 4% as reported (and the operating margin shrank 20 basis points), but segment-level profits rose 1% and segment-level margin expanded 50 basis points; all segments would have reported operating margin expansion on an adjusted/ex-items basis.

Slow, Steady and Smart will Win this Race
Tyco's management offered few surprises in terms of their execution or near-term plans. The company continues to look for incremental acquisition opportunities in the M&A arena, and with more than 60% of the non-residential installation/services business spread among hundreds of small companies it shouldn't be hard to find deals.

At the same time, management is being smart about its own operations. Installation revenue was a little soft because the company is getting increasingly selective with its projects - passing on those that don't offer long-term service relationship opportunities. While turning down business always carries some risk, I don't think they're going to cede share to the likes of Honeywell (NYSE:HON), United Technologies (NYSE:UTX), Stanley Black & Decker (NYSE:SWK) or Siemens (NYSE:SI) in doing so, as these large rivals all have the same needs/desire for recurrent service revenue.

Tyco is also focusing on the "blocking and tackling" that fundamentals-oriented investors love to see. Centralizing operations, integrating disparate businesses and just overall streamlining should be enough to add a few points of operating margin over the next few years.

Is It When or If?
Prior to Tyco's final split, there was ample speculation that the company was going to get a bid from a buyer looking for a commercial fire and security business. While that didn't happen, I still wouldn't rule out the possibility of a deal.

Tyco is the number one player in non-residential installation and services (holding low-teens share in each), and well ahead of those aforementioned names, such as United Tech and Siemens. It is likewise the co-number one player in products, with Honeywell holding a similar 9% or 10% share.

Any large company with a presence in these markets could be a logical bidder (except Ingersoll-Rand (NYSE:IR), which is much too small), with Siemens and Schneider making a lot of sense. Johnson Controls (NYSE:JCI) could also be an interested party, and I wouldn't rule out 3M (NYSE:MMM) either - the service-heavy nature of the business is not typical for 3M, but it would add scale to its existing safety/fire/security products business and represent a good cash flow opportunity.

The Bottom Line
Despite speculation about an eventual takeout, and a belief on the Street that Tyco is a good non-residential growth play, Tyco shares may still be a bargain. Admittedly, my high single-digit free cash flow growth forecast is aggressive, but I do believe in the margin/free cash flow conversion improvement story. Investors certainly need to mind those margins, but this could be an attractive stock to consider today for patient investors.

At the time of writing, Stephen D. Simpson owned shares of 3M since 2007.

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