THIS CHAPTER ZOOMS OUT FROM the focused discussion on working capital and liquidity and looks at these aspects in the context of the enterprise’s financial strength. We review the key areas of the firm’s financials, highlight some of the important ratios, and finally look at a case study that shows a practical instance of Treasury restructuring in the context of a crisis in liquidity and financial strength.
The balance sheet and sources of capital and liquidity, and thus the current and expected financial strength of an organisation, form a core part of the Treasurer’s responsibilities. Here we review the universe of a firm’s financial statements (see Figure 12.1) and their utility for different users.
The balance sheet, profit and loss statement, and cash flow statement form the core of the firm’s financial statements. The balance sheet contains the Liabilities, or the sources of funds, and the value of assets, the utilisation of these funds. The profit and loss or income statements show the income and expenditure elements by category, while the cash flow statements highlight the firm’s inflows and outflows. Coupled with estimates and forecasts of how the business and relevant expenses are expected to perform, the financials of the enterprise are projected to determine its future financial strength. Financial ratios are also determined to provide objective assessment parameters to determine the relative and absolute performance of a firm. Since different firms have different kinds of numbers, the ratios provide a benchmark for assessment. We discuss ratios in detail later in the chapter.
Apart from being a barometer of the strength and performance of the company’s management and board, financials serve as indicators to potential and current investors (directly or through research, rating, and advisory firms) of the relative attractiveness of different securities or liabilities of a company. Regulators, stock exchanges, governments, and industry use the data to assess the performance of the firm individually and in the context of the industry and the country’s economy.
From an accounting standpoint, the reporting and filing of returns that the companies and subsidiaries perform in each location or jurisdiction where they are present provides an interesting challenge and pits the accounting financials against the value that the business actually believes it has generated. These are subjects of long discussions and are well covered by many esteemed authors.
We now focus our attention on some of the ratios that also serve as yardsticks to measure the company’s strength across different aspects of its business, management, and operations.
Some of the key ratios and determinants of financial strength are discussed here (see Figure 12.2).
Taken from the profit and loss (P&L) or income statement of the company, these give a quick overview of the profitability of the firm at different levels.
Gross margin is the first level of profitability. It depicts the direct impact of the revenue generated and the expense incurred to generate the revenue (i.e., the gross profit).
Operating margin is the second level of profitability. It shows the overall operating income as a percentage of sales. Note that operating income is derived after the deduction of selling, general and administrative expenses, and depreciation from the gross profit.
Net margin is the third level of profitability. It shows the net income as a percentage of sales. Note that net income is the operating income less interest expense and provisions for taxes.
Derived directly from the balance sheet, the balance sheet ratios indicate the performance levels and nature of capitalisation of the sources of funds and their utilisation. Given the relevance and importance of the balance sheet and its contribution to the firm’s strength, as well as the very wide scope and nature of different assets and liabilities, balance sheet ratios provide in-depth perspectives of a company’s financial management.
The structure of the firm’s capital can be conveyed in many ways. The degree of indebtedness is indicated by the debt/equity (D/E) family of ratios provides in addition the dependence and hence capacity of the firm to take on more debt; e.g., a company with a lower D/E ratio will have more ability to take on debt than a similar company with a higher D/E ratio, all other things being equal.
The simple debt/equity ratio is one of the most prominent and commonly used indicators.
The general level of indebtedness can also be expressed in terms of the total capital, which includes the debt, equity, and minority interest.
The overall total assets to liabilities ratio provides an indication of the degree of asset protection, since the total liabilities can be represented by the total assets less the equity of the firm.
The current and quick ratios provide a good picture of the firm’s liquidity in case of a general shortage of cash flows. They show, for different sets of assets, the extent to which the assets can be liquidated in case of a limitation in access to liabilities to fund those assets.
The current ratio is a reflection of the current cash payable (or that which will need to be paid in the very short term) to make the payments due with cash currently available (or that which will be available in the very short term). The ability to do this can be estimated by the ratio of current assets (assets already in cash or to be converted to cash during the current operating cycle) over the current liabilities (dues that the company will need to pay during the current operating cycle).
The quick ratio (also referred to as acid test) refers to assets that can be liquidated faster (quick assets), taking into consideration only the cash and very liquid assets, such as receivables and securities that can be sold or liquidated immediately. The quick ratio hence is a more stringent measure of immediate liquidity than the current ratio.
Working capital and its related ratios were discussed in detail in Chapter 11. The ratios provide a good estimate of the amount of working capital required for the firm to operate on a day-to-day basis. Along with the cash conversion cycle (a hybrid since it also uses elements from the balance sheet and the P&L statement), the working capital family provides an idea of the firm’s ability to fund itself through internal sources.
The cash flow statement on its own provides a basic snapshot of the simplest financial performance, with a focus on the firm’s ability to service liabilities (especially debt) through its cash flows and on the degree of flexibility and reliance on external capital sources for funding its operations.
The cash flow/capital exchange (capex) ratio is one of the key elements for industries or firms with large capital expenditure items.
The firm’s depreciation will provide a good indicator of future estimated cash outflows, given the certainty of this item in the cash flow projections.
Hybrid ratios are those derived across components of the company’s financials. There are different kinds of hybrid ratios; here we focus on three different families.
The return family provides an idea of the effectiveness of the utilisation of investors’ capital, or how the returns from the company’s financial performance fare compared to the funding that the operations use. The simplest return ratio is the return on equity, which depicts the net income of the company as a ratio of the equity of the firm.
One of the drawbacks of this ratio, and indeed of a few hybrid ratios that combine elements from P&L statements and the balance sheet, is that net income is a cumulative number across the financial year, but the equity number can be a snapshot number at a point of time (typically the year-end).
To overcome this problem, some firms use average equity, which is the average of the equity number over a period of time.
Throwing debt into the mix to obtain an estimate of the return on total capital, net income is augmented by two elements that are impacted by debt: the tax element and the interest expense. Hence the return on capital can be depicted by this formula:
The turnover ratios provide an overview of the utilisation of assets and the churn of liabilities. This includes ratios such as days sales outstanding, days payable outstanding, and days inventory outstanding, which determine the cash conversion cycle discussed in Chapter 11.
Debt servicing ratios enable a firm to service its debt through its cash flows.
The debt service coverage ratio (DSCR) is one of the more popular measures that provides the liquidity available to service a company’s debt including principal, interest, and lease rentals. The higher the DSCR is, the better the ability of the firm to service its debt and hence its ability to assume incremental debt.
The debt/cash flow ratio provides a longer term perspective on the ability of the firm to service its debt.
Valuation and market ratios have to do with finding the right value of a firm for the purposes of assessing the market or the firm’s overall value.
The most common ratio for most firms is the price/earnings (P/E) ratio. It provides the market price of the firm per share as a ratio of the firm’s annual EPS.
This is effectively the ratio of the firm’s market capitalisation to its annual earnings.
The P/E also reflects the firm’s capital structure and cost of capital. Investors are more willing to buy shares of a company with a higher P/E than to buy shares of a company with a lower P/E. Hence the equity of the firm with the higher P/E is more expensive.
The price family includes other ratios that use the price to determine value, such as:
The EV/EBITDA ratio is the ratio of the enterprise value (EV) of the firm to the EBITDA (earnings before interest, taxes, depreciation, and amortisation), which provides an alternative to the valuation of the firm.
The EV/EBITDA is agnostic to the capital structure of the firm and can be used to benchmark or compare companies across industries and to benchmark companies across a market.
We conclude this chapter with a look at a cutting-edge case study on the handling and resolution of a liquidity crisis and corresponding financial strength of a global corporation.
CASE STUDY: TYCO INTERNATIONAL: CORPORATE LIQUIDITY CRISIS AND TREASURY RESTRUCTURING
Note: This pre-release version may be used for teaching purposes but it has not yet received an official case number by the European Case Clearing House.
Copyright © 2010 INSEAD
Having spent the last two years playing a key role in Lucent Technology’s restructuring efforts, Martina Hund-Mejean had just started dreaming of a much-needed break when the phone rang. The caller at the other end of the line was David Fitzpatrick, Tyco’s new CFO, offering her an opportunity to join his team to steer the fast-sinking industrial conglomerate through its current corporate storm.
Until six months earlier, Tyco International, led by “rock star” CEO Dennis Kozlowski, had been the darling of Wall Street. However, with Kozlowski accused of corporate fraud and the company facing an epic liquidity crisis, the industrial conglomerate with $40 billion in global sales and a presence in 90 countries worldwide faced a real threat of having to declare bankruptcy.
Already highly regarded in the industry as a turn-around specialist following stints at General Motors and Lucent, Hund-Mejean was always up for a challenge. Quickly shelving thoughts of a break, she agreed to join Tyco’s new management team in fighting to save the company. At a Tyco press conference, Hund-Mejean announced, “I believe that Tyco, with its solid operating businesses and strong market positions, has the potential to be one of the most exciting companies of the future.”
Company History and the 2002 Liquidity Crisis
Over the past decade, Tyco had grown rapidly through acquisition, snapping up more than 200 firms and creating a highly complex conglomerate in the process. By 2002, Tyco had become one of the world’s largest and most diverse companies, producing a wide variety of products including burglar alarms, plastic hangers, duct tapes, automotive cabling, electronic connectors, surgical instruments, and many other necessities of daily life, justifying Tyco’s marketing tagline “A vital part of your world.” While most consumers were unfamiliar with the Tyco name, its brands, including ADT, Raychem and Keystone, were well known among businesses and consumers. Each day, companies under the Tyco umbrella manufactured approximately 8 million hypodermic needles, provided security (through its systems) to over 7.3 million customers worldwide and over 80% of the world’s top 100 retailers. Its claim of being “vital” was no exaggeration for heart disease patients; over 240 open-heart surgeries were performed using Tyco’s cardiac devices every day. In addition, Tyco Healthcare’s pharmaceutical group was the world’s largest producer of acetaminophen and opiate-based pain management pharmaceuticals.
As illustrated in
Figure 12.3, Tyco was structured into five business segments, each of which was bigger than most of their competitors’ entire companies. Tyco’s Fire and Safety division alone reported $10.6 billion in sales in 2002, while its Electronic and Healthcare divisions generated staggering revenues of $10.5 billion and $7.9 billion respectively. Engineered Products and Services recorded $4.7 billion in revenue, and even its smallest division, Plastics and Adhesives, clocked up sales of $1.9 billion. Although Tyco’s revenue was diversified across the globe, the majority (57%) of its $35.6 billion revenue from external customers was generated in the United States. Europe was its next largest source with $8.4 billion (24%), followed by Asia Pacific with $4.9 billion (14%), and the rest of the Americas generating $2 billion (6%).
Tyco’s acquisition strategy had been intended to produce a “recession-proof” conglomerate through industry and geographic diversification. Instead, the acquisition spree led to a build-up of debts and resulted in expensive goodwill write-downs. Furthermore, the strategy of aggressive growth through acquisitions attracted increasing criticism amid concerns that the company’s complex structure was both impossible for headquarters to manage effectively and in fact masking its true financial position. With analysts and investors unable to discern whether Tyco’s reported profits came from real growth or financial manipulations, and jittered by corporate scandals including Enron, Tyco’s stock had lost more than two-thirds of its value since the start of 2002.
By the time Hund-Mejean moved into her new Tyco office, the company was facing an overhang of $11.2 billion of debt maturing in 2003. More worryingly, she noted that $6.8 billion of it was due in the first quarter of 2003. With little time to settle in, Hund-Mejean rolled up her sleeves and plunged straight into resolving Tyco’s liquidity crunch. Despite having approximately $6 billion of cash and short-term investments on its balance sheet, its cash was locked up in myriad subsidiaries scattered across the globe and essentially inaccessible at the corporate level where it was critically needed. In the past, Tyco had effortlessly raised funds through conventional debt refinancing routes, but various ongoing investigations arising from the fraud crisis prevented the company from raising capital in a similar fashion. In a race against time, Hund-Mejean struggled to secure financing through alternative channels.
Fighting the Fire—The Immediate Response
On 30 December 2002, the Tyco team saw its first ray of light in months. A team of accounting experts and external auditors commissioned by Tyco declared that it found “no significant or systemic fraud” in the company’s financial statements. That verdict helped to nudge Tyco’s bankers to commit to a new $1.5 billion credit facility just weeks before the expiration of the existing one-year agreement.
Despite the drama at headquarters, Tyco’s fundamental business remained strong with its businesses generating positive net cash flows of $776.3 billion and its financial leverage (assets/equity) seemingly healthy at 2.7 at the end of 2002 (see
Figure 12.4). However, bond ratings agencies, concerned about how the Tyco management was managing its debt maturity commitments, had continuously downgraded its bond rating throughout the year. For example, S&P had rated Tyco’s bonds “A” in January 2002 but less than half a year later, by June 2002, its rating had plummeted to “BBB–”. Moody’s and Fitch went a step further and rated Tyco’s bonds “BB/Ba2,” which were considered non-investment grades.
Figure 12.5 shows Tyco’s credit rating and default spreads over the period.
Together with her team, Hund-Mejean weighed the pros and cons of issuing new convertible bonds. Unlike previous occasions, when Tyco was in a position to issue convertible bonds on highly favourable terms, placing a convertible debt now was going to be both unfavourable and costly to the company due to its poor credit rating. The advantages of issuing the convertible debt included being able to target credit-insensitive investors, quick execution in a liquid market and the ability to put in tax-advantaged structures. However, the disadvantages were daunting—it was more expensive than straight debt, and could cause potential equity volatility which would result in Credit Default Swap (CDS) widening on issuance, and increase the financing risk of puts, as well as giving additional rights to holders.
After intense debate, the team concluded that issuing the convertible bonds was Tyco’s best option under the circumstances. Following that decision, the team focused on negotiating the best possible terms with the bond underwriting banks as well as pulling out all the stops to market the bonds to potential investors. Following days and nights of tough negotiations with its six lead bond underwriters, Tyco announced on 8 January 2003 that a deal had been structured to privately place a $3 billion principal amount of 2.75% Series A Convertible Senior Debentures due in 2018, and a $1.5 billion principal amount of 3.125% Series B Convertible Senior Debentures due in 2023 through its wholly-owned subsidiary, Tyco International Group S.A. The Series A debentures were to be convertible at $22.7832 per share and the Series B debentures had a conversion price of $21.7476 per share. With the debentures fully and unconditionally guaranteed by Tyco, holders of the Series A debentures could require their repurchase at five and ten years after issuance, while holders of the Series B debentures could require their repurchase at twelve years after issuance.
Hund-Mejean shared the team’s rationale for the two issuances. Series A debentures were aimed at the market liquidity ‘sweet spot’ with a 5-year put and 3-year non-call which fitted nicely with hedge funds’ volatility time horizons. With credit default swaps available, she estimated that the conversion premium ranged from 28–32%. In contrast, the Series B were positioned for income-oriented funds and fundamental investors who would be attracted to the higher 3 1/8% to 3 5/8% interest rates despite a higher equity exposure with the 12-year put option.
With a targeted strategy focused on fundamental investors, Tyco arranged a conference call with the new CEO, CFO and Treasurer, as well as follow-up one-on-one calls with either its CEO or CFO. The message to the investors was concise and consistent: leading brands, solid fundamentals, new leadership with stringent controls, and strong cash generation. In order to maximise demand for the bonds, the management also showed a willingness to indicate a relatively wide range on coupons as well as the conversion premium. Preliminary feelers out in the market reported that investors seemed eager to purchase the debentures which Tyco was planning to offer. An industry source familiar with the deal observed:
“What is interesting here is that an investment-grade company is issuing bonds paying a cash coupon. In the roaring days of zero issuance in 2001, which took off with Tyco’s $3.5 billion deal for zeros in November 2000, investment-grade companies paid no interest at all. Even more interesting is that the bonds don’t have a co-co.”
A successful sale would signal a vote of confidence in the new management team by investors and, more importantly, ensure the survival of the company. Thus the team heaved a collective sigh of relief when investors snapped up bonds worth $4.5 billion—the second-largest offering in U.S. history—exceeding by $1.25 billion the $3.25 billion that they had initially considered offering. It was also the biggest convertible bond offering in history. The announcement of the deal boosted Tyco’s stock price to $17.26, up 6.2% on that day and almost 150% from a 52-week low of $6.98 on 25 July 2002 (as detailed in
Figure 12.6).
The $4.5 billion debt offering marked a successful first attempt by Tyco to enlist investors’ assistance in reducing the debts that had piled up during the company’s multi-year acquisition binge. The bond sale also sealed the $1.5 billion credit agreement that it had earlier struck with several banks to replace an expiring loan facility. The deal had been contingent on the successful completion of the 15- and 20-year bond offering. In fact, to the surprise of some industry observers, Tyco’s order books for the bonds were ten times oversubscribed which allowed them to pick their investors. Thus, six months after launching a public campaign to clean up its tarnished image, Tyco International Ltd. succeeded in closing a $6 billion bond and bank financing agreement that helped the conglomerate fend off creditors.
Strategic Reform for the Long Term—Migrating to a Centralised Treasury System
With the liquidity crisis behind her, albeit somewhat precariously, Hund-Mejean and her Treasury team were keen to ensure that Tyco would not face a repeat crisis in the future. Examining Tyco’s books closely, she noted with a sigh of relief that there would be no significant scheduled debt maturities until early 2005. She resolved to keep close track of future debt maturities in order to ensure that they would be better planned and distributed over financial periods. Hund-Mejean now turned her energy inward and focused on centralising Tyco’s Treasury division, which until then had been completely decentralised. She explained her rationale:
Through installing a global cash management structure and having Tyco International Group SA Luxembourg (TIGSA), the issuer of external debt, as the beneficial owner of a greater percentage of cash holdings, Treasury would have greater visibility and control over cash in the company. Restructuring to optimise liquidity would require Tyco’s companies to break away from legacy structures, even if it would meet with internal resistance. Given Tyco’s complexity and challenges, Hund-Mejean concluded the long-term benefits would outweigh the short-term pain of centralising the global Treasury function. In an internal meeting with Treasury staff, she outlined her objectives for the department:
- Ensure adequate liquidity
- Obtain visibility of cash balances
- Have cash available when and where we need it
- Control and protect important assets
- Improve investment performance
Having extinguished the fire of a liquidity crisis which had threatened to bankrupt the company, the first three points were straightforward and took little time to discuss. However, the last two points generated heated discussions within the Treasury team: How would the ‘important assets’ be controlled and protected and how could investment performance be improved? After an intense debate, the team reached a consensus that cash had evolved into a strategic asset which could be used as a hedge against market volatility and unforeseen corporate crises, and would allow Tyco to stay nimble when new business opportunities arose in the future. Furthermore, while the Treasurer’s team sought to achieve the maximum investment yield from cash holdings, risk management would also be a key priority. The recent crisis had shown the importance of synchronising the credit and liquidity components with the needs and risk-tolerance of the company.
After discussing with Corporate Tax, Hund-Mejean unveiled the new corporate cash management structure. In the new structure the Treasury was divided into three distinct layers: Parent (Bermuda), Intermediate Holding Company (Europe), and the Operating Company (subsidiaries around the world). The purpose of the European holding companies was to own most of the international subsidiaries in a tax-efficient manner. Europe’s strategic location from a time zone perspective allowed overlapping working hours with Asia and the Americas. Also, certain European countries provided tax incentives for managing international Treasury activities from there. Hund-Mejean wanted to leverage that structure for Treasury operations by concentrating cash from across all the global subsidiaries in various currencies at the intermediate level in Europe. (Tyco’s global cash management structure is shown in
Figure 12.7.)
The Treasury team also instituted a process for centralising cash, which was rolled out across its regions. With the goal of migrating banking services to key relationship banks, the team conducted a country-by-country analysis of their bank networks. Following this detailed exercise, which unearthed the fact that Tyco had almost 200 bank relationships for its 2,000 legal entities across the globe, the team selected a ‘lead bank’ per country, which enabled Tyco to negotiate global relationship pricing and services. In order to maintain control over the banking relationships, new standardised forms had to be filled in and proper approvals obtained prior to any establishing of new bank accounts and authorised signers. The Treasury system was also programmed to implement automated sweeps and zero balance account (ZBA) structures for in-country pools, subject to tax/legal and foreign exchange restrictions. Finally, thanks to the electronic pooling of bank account balances, Global Treasury achieved global financial visibility and the ability to monitor consolidated cash balances on a daily basis. The Global Treasury mandate was clear: centralise the subsidiary cash, obtain visibility of cash balances, and have cash available when and where it was needed.
Tyco Asia Treasury—A Centralised Treasury System Amidst a Complex Regulatory Environment
Over in Asia Pacific, the Treasury team led by Director of Asia Pacific Treasury, Gourang Shah, worked tirelessly to establish and install Tyco’s new Treasury structure and processes. With $6 billion of sales in the region, a presence in 18 countries, and 225 active legal entities, the only thing in common appeared to be that they were all under the Tyco umbrella. Shah conducted a quick “as is” analysis of the existing state of Asia-Pacific Treasury. Within a couple of days the status was painfully clear—there was poor visibility and control on cash balances that spread across all the subsidiaries. To remotely manage bank accounts from Regional Treasury in Singapore, electronic banking was a necessity, but to his surprise, Shah found that in many Asia Pacific countries e-banking was a foreign concept.
Shah faced additional internal and external challenges as Tyco’s organisation in Asia-Pacific was particularly complex. The regulatory environments in the 18 countries where Tyco had a presence varied greatly. While Australia, Hong Kong, Japan, New Zealand and Singapore had unrestricted markets, many others, including the large markets in China, India, Malaysia, South Korea and Taiwan, had restrictive regulatory environments. Aware that negotiating with the regulatory bodies in each of these countries would be time consuming and complex—China alone had three different government bodies overseeing capital and monetary flows—Shah faced tremendous pressure to meet the timeline set by the Global Treasury team.
Internal issues also cropped up as the Asia Pacific Treasury team hunkered down for the long and arduous task ahead. They discovered that each business unit had its own ERP system—in fact there were several instances where different ERP systems were found within individual business groups! As Shah’s team continued to dig deeper, they uncovered further startling information: There were more than 150 banking relationships and 1,600 Tyco bank accounts in Asia, which resulted in widely varying pricing across its entities. Inconsistent banking services also led to sub-optimal cash utilisation and minimal cash control and visibility. Accustomed to operating independently and free from “headquarters interference,” Tyco’s senior managers balked at having to implement the new systems and processes. In order to convince the Asia Pacific management team as well as local financial controllers of the benefits of implementing the strategic Treasury solution, Shah personally journeyed to over 60 locations to gain their buy-in.
After gaining support from all key stakeholders, the team put together an implementation plan to generate the biggest impact in the shortest time frame while causing minimal disruption to Tyco’s operations. The plan called for a phased approach based on the market size of each of its countries and its regulatory complexity. The Phase I countries were the unrestricted markets and large markets: Australia, China, Hong Kong, Japan, New Zealand, Korea and Singapore. The Phase II countries—Malaysia, Thailand and New Zealand—followed thereafter, and the final phase of the implementation consisted of India, Taiwan and the remaining Asia-Pacific countries.
Exhausted after months of travelling to all corners of the region and countless meetings, Shah still had not found solutions to overcome the regulatory challenges in China, Malaysia and Korea, the major roadblocks to the successful completion of Tyco’s Asia-Pacific Treasury restructuring. With controls in place to restrict the movement of funds out of the countries, Shah faced the prospect of significant amounts of trapped cash in Asia-Pacific’s emerging markets and concluded that he must personally negotiate with the government and regulatory bodies of the countries for special exemptions to be granted to Tyco. Shah started with the low-hanging fruit—Malaysia. Following the 1997 Asian crisis, Malaysia had instituted capital controls in 1998, imposing conditions on the operations and cross-border transfer of funds under capital account, i.e., loan or equity. The cross-border transfer as inter-company loans from surplus cash in Malaysia required prior approval for any amount (previously it had been freely allowed). Fortunately, Bank Negara Malaysia, the central bank responsible for monetary controls, had the authority to approve special exemptions. Keen to retain Tyco operations in Malaysia, one of the bigger multinational companies in the country, Bank Negara Malaysia officials met with Shah and granted special exemptions to Tyco’s Treasury operations in Malaysia.
Korea was next on Shah’s list. He approached the Bank of Korea (BOK) to apply for exemptions to Tyco’s operations there. Despite language and cultural difficulties, Shah succeeded in achieving his objective of moving funds out of South Korea on a regular basis. With this experience in negotiating with central banks under his belt, he boarded a flight to Beijing, China. Expecting to negotiate with its central bank, The People’s Bank of China, Shah found himself bounced back and forth between three government authorities: the Ministry of Commerce, the State Administration of Foreign Exchange, and the People Bank of China. Each maintained that they had no authority to grant exemptions and referred Shah to the “right official who could help”. After months of fruitless discussions with various officials and failing to obtain meaningful concessions, Shah decided that the best strategy for China was to engage in “leading and lagging”—leading the intercompany payables out of China and lagging the intercompany receivables into China.
Tyco’s Treasury Scorecard After Two Years
In January 2005, after yet another hectic day filled with meetings, Hund-Mejean reflected on her past two years at Tyco International. Tyco had quickly found its footing again after the issuance of the two convertible debts. She noted with a certain satisfaction that the liquidity structure and debt maturity profile of the company had also improved considerably since 2002. Tyco’s debt maturity profile had been planned so that there was no more than $2 billion debt maturing in any one fiscal year. The Treasury team had also put in place measures to ensure that maturing debt could easily be managed with cash from Tyco’s operational FCF. (Selected financial data from 2002 to 2006 are shown in
Figure 12.8.)
Tyco’s stock had risen steadily and had in fact outperformed the S&P Composite Average and Dow Jones Industrial Average since mid-2003. While she was proud of the way the convertible debt issuance had been pulled together in such a short time, Hund-Mejean wondered what the implicit cost of the convertible bonds might be to Tyco and made a mental note to ask an analyst on her team to make a quantitative estimate using the bond spread yields data gathered (as shown in
Figure 12.9).
Over in Asia, Shah also reflected on a journey which had taken him to over 60 locations to align the stakeholders and enable the realisation of Tyco’s Treasury management strategy. He pulled out his list of challenges compiled back in 2003 and was pleased to note that most of them had been successfully resolved. In the same folder, Shah also came across his “As is” status report from back when he first landed in Singapore. With a sense of satisfaction, he took out his pen and drew in the “After” status of the Asia-Pacific Treasury department (as illustrated in
Figure 12.10). In addition to establishing a Regional Treasury Centre in Singapore, the Asia Pacific team now had just ten primary banks and had reduced bank accounts by 40%. All its entities were entitled to uniform pricing, irrespective of size, which also ensured consistent service by the central management of bank relations. Subsidiary borrowings from external sources were replaced with internal funding and Treasury was able to maintain and control 85% of cash in the region.
Conclusion—Evolution Through Splitting
Beginning in the spring of 2005, the Tyco management team, including Hund-Mejean, began exploring whether the company should sell a unit, embark on new acquisitions or even split itself up. CEO Breen explained that these new plans had emerged in large part as Tyco had successfully reduced its once-crushing debt and “was not the No. 1 focus anymore.”
The team argued that action was necessary to unlock Tyco’s value by enabling individual units—especially its jewel-in-the-crown Healthcare division—to operate more nimbly in their respective industries.
On 13 January 2007, after almost two years of wrestling with Tyco’s various strategic options, the company announced that its Board of Directors had approved a plan to separate the company’s current portfolio of diverse businesses into three separate, publicly traded companies—Tyco Healthcare, one of the world’s leading diversified healthcare companies; Tyco Electronics, the world’s largest passive electronic components manufacturer; and the combination of Tyco Fire & Security and Engineered Products & Services (TFS/TEPS), a global business with leading positions in residential and commercial security, fire protection and industrial products and services.
Single-digit growth rates in some of its core businesses in 2006, including Tyco Electronics, had finally convinced the management team that the only way to address the growth problem was to carve Tyco up. The team believed that Tyco had reached a “crossroads” after recovering its financial health and reputation. By allowing its divisions to operate unencumbered by its corporate structure, they would be able to maximise shareholder value. In an interview with Fortune magazine in March 2006, Breen reiterated that the company could only evolve through a split: “It’s the best way to create long-term shareholder value at the company. I really stress long term, because I’m not looking for some overnight pop here.” In the press conference announcing the split, Breen elaborated on the strategic rationale behind Tyco’s separation
Watching the news conference from their offices, Hund-Mejean and Shah had mixed feelings as they noted the irony of coming full circle with Tyco: first to successfully keep it from breaking apart, only to subsequently help it break up successfully. While confident that Tyco’s centralised Treasury structure and award-winning Treasury system would benefit its newly separated companies, they mentally sketched out how each new company would need its own centralised Treasury structures to ensure proper capital planning and cash/risk management strong enough to withstand potential macroeconomic or internal liquidity crunches.
Tyco Case Appendix I: Tyco International Balance Sheet
Tyco Case Appendix II: Tyco International Income Statement
Tyco Case Appendix III: Tyco International Statement of Cash Flow
Tyco Case Appendix IV: Tyco Share Performance and Volume January 1999–December 2002
Tyco Case Appendix V: Corporate Scandal of 2002
In June 2002, CEO Dennis Kozlowski and CFO Mark Swartz were asked to resign from the company largely because they had taken bonuses without proper approvals from the board and were accused of using corporate resources for their personal gain. It was in the period when Enron and MCI Worldcom had declared bankruptcy and investor faith was at an all-time low. Tyco was being talked about in the same vein as both Enron and MCI Worldcom and seen as a potential candidate for bankruptcy.
Criminal charges were subsequently brought against Kozlowski and Swartz of enterprise corruption for allegedly stealing more than $170 million from Tyco and obtaining $430 million by fraud from the sale of company shares. However, they claimed during their trial in March 2004 that the board of directors was aware of the deals and had authorised them as compensation. On 17 June 2005, Kozlowski and Swartz were convicted on all but one of the more than 30 counts against them. The verdicts carried potential terms of up to 25 years in state prison. Kozlowski was sentenced to no less than eight years and four months and no more than 25 years in prison.
Tyco Case Appendix VI: CIT Group Acquisition and Divestiture
In June 2001, under CEO Dennis Kozlowski, Tyco had acquired CIT Group, then the national’s largest independent commercial finance company. Despite being unfamiliar with the industry, Kozlowski was confident that he could rev up CIT’s growth, declaring “I think CIT will be one of the best deals we’ve ever done.”
Less than a year later, CIT looked like the worst deal Tyco had ever done. Its plunging stock price, exacerbated by Tyco’s corporate scandal, forced a downgrade of CIT’s credit rating, and CIT was forced out of the commercial paper market, which was its bread-and-butter business. As a result, CIT and Tyco had little choice but to swap their $13 billion in commercial paper for pricier bank loans, which further heightened fears of a liquidity squeeze. It became increasingly clear to all Tyco stakeholders that Tyco would need to cut CIT loose, either through a sale or outright handover to shareholders. Barry Bannister, an analyst at Legg Mason Inc., stated, “Nearly everyone accepts that they will take a multibillion-dollar loss on a sale.”
On July 8, 2002, Tyco completed the divestment of its Tyco Capital business through an initial public offering, via the sale of 100% of the common shares in CIT Group Inc.
Tyco Case Appendix VII: Timeline of the Tyco International Scandal
Key dates and events that led to the conviction of former Tyco CEO L. Dennis Kozlowski and CFO Mark Swartz are presented next.
March 13, 2001: Tyco announces $9.2 billion cash and stock deal to purchase the CIT Group, a commercial finance company. Tyco director Frank Walsh helps arrange the deal.
December 5, 2001: Tyco shares close at a high of $59.76 on the New York Stock Exchange.
January 14, 2002: Businessweek magazine lists Tyco CEO L. Dennis Kozlowski as one of the top 25 corporate managers of 2001.
January 22, 2002: Kozlowski announces plans to split Tyco into four independent, publicly traded companies. The announcement starts a slide in the price of Tyco shares.
January 29, 2002: Tyco shares drop sharply, one day after the company files a proxy report with the Securities and Exchange Commission disclosing that Walsh received a $10 million fee on the CIT Group deal and that another $10 million went to a charity where he was a director.
January 30, 2002: The New York Times reports that Kozlowski and CFO Mark Swartz sold more than $100 million of their Tyco stock the previous fiscal year despite public statements that they rarely sold their stock. Kozlowski and Swartz say they will buy 1 million shares with their own money.
June 3, 2002: Kozlowski resigns unexpectedly as the New York Times reports he is the subject of a sales tax evasion investigation by Manhattan District Attorney Robert Morgenthau’s office.
June 4, 2002: Morgenthau announces a criminal indictment accusing Kozlowski of conspiring to evade more than $1 million in state and city sales tax on fine art purchases.
September 12, 2002: Morgenthau announces a criminal indictment accusing Kozlowski and Swartz of enterprise corruption for allegedly stealing more than $170 million from Tyco and obtaining $430 million by fraud in the sale of company shares. Former Tyco corporate counsel Mark Belnick is charged separately with falsifying records to conceal more than $14 million in company loans.
December 17, 2002: Former Tyco board member Frank Walsh pleads guilty to an alleged scheme to hide the $20 million in fees for the CIT Group deal.
October 7, 2003: The first trial of Kozlowski and Swartz begins with opening statements in which prosecutors characterise them as crime bosses who looted Tyco. Defence lawyers call them honest executives who deserved and disclosed all corporate payments and perks.
October 28, 2003: The jury is shown a video of a birthday party Kozlowski threw for his wife at a resort in Sardinia. Tyco paid roughly half the $2 million cost of the event, which featured entertainers clad in togas and an appearance by singer Jimmy Buffett.
November 25, 2003: Prosecutors show the jury a video of the $6,000 shower curtain and other lavish furnishings that decorated Kozlowski’s Tyco-owned apartment in Manhattan.
April 2, 2004: A mistrial is declared after a juror says she received a letter pressuring her to convict Kozlowski and Swartz. Some observers said the juror, Ruth Jordan, had previously appeared to make an “OK” sign to defence lawyers. She subsequently denied making any gesture toward the defence team.
July 15, 2004: In a separate trial, former Tyco corporate counsel Mark Belnick is acquitted of charges that he received millions in loans from the company and failed to disclose the payments.
January 26, 2005: The second trial of Kozlowski and Swartz begins with opening statements in which prosecutors switch tactics to focus on money the two allegedly stole from Tyco. They do not mention Kozlowski’s $6,000 shower curtain or the Sardinia birthday party for his wife.
April 27, 2005: Kozlowski, who did not testify at his first trial, takes the stand and testifies that the millions of dollars in Tyco payments and perks he received had been properly authorised and disclosed.
June 17, 2005: A Manhattan jury finds Kozlowski and Swartz guilty of stealing more than $150 million from Tyco. They each could face 25 years in prison.
Source: USATODAY research
We looked at some of the key components of financial strength and their role and utility across the financial universe. Key ratios, determinants of strength, were reviewed, and a practical exposure to the use of financial statements in the case of a corporation was discussed. In the next chapter, we look at external sources of capital, one of the core performance areas for a global Treasurer.
