How Ed Breen Saved Tyco
Tyco couldn’t sell new debt in the capital markets the way a reputable company could. Tyco, even with Breen stage- managing the damage control, wasn’t a reputable company.
by Steven Flax
The board of directors of Tyco International hired Ed Breen from Motorola to rescue their scandal-tarnished company. On September 12, 2002, less than three months after the board hired him as CEO, with annual compensation of $1.5 million plus a signing bonus of $3.5 million and options to buy 8.7 million shares, he began to do exactly that.
At a board meeting conducted via conference call, a director, Lord Michael Ashcroft, who sold ADT to Tyco in 1997, offered a resolution: Every member who served during the era of Dennis Kozlowski, whose corruption and extravagant spending buried Tyco under an avalanche of exposés and investigations, would not stand for reelection at the next annual meeting.
To say that consternation reigned would be an understatement. This was, perhaps, an unprecedented corporate decapitation, and, according to sources close to the company, several board members didn’t conduct themselves with a stoic sense of honor. While half said they might be willing to fall on their swords, the other half’s attitude was: You go first. The gist of the rants: We can’t believe we hired you, and now you’re getting rid of all of us.
For three hours, the directors wrangled with their CEO. Finally, Ashcroft called for a vote. The 10 members on the conference call deciding their own fate voted 5–5. That put Breen in the role of tiebreaker. He put the speakerphone on hold for a few minutes and collected his thoughts.
Surely he had to pause when confronted with the ramifications of casting the deciding “yea” vote. But he was mainly giving the impression of deliberation. Breen was convinced he had to get rid of the old board members who repeatedly acquiesced to Kozlowski and his former managers, approving over-the-top pay, bonuses and loans — including some that reeked of self-dealing.
“There was a crisis of confidence that could sink a ship,” Breen says. “You couldn’t [redeem and rehab Tyco] by waving your hands and making speeches. You had to change the company.” He took the phone off hold and cast the deciding vote to dismiss the board. Tyco’s ship was indeed sinking, and there was no dock to tow it to for repairs. All that had changed was the name of the CEO at the helm. Breen’s plan for Tyco had three phases: save it, fix it and grow it.
Now, five years after Breen put that plan into effect, it’s time to recognize it for what it has become: one of the great turnarounds in modern corporate history.
Step 1
Save It:
Purge Culture, Fix Balance Sheet
Breen doesn’t immediately come across as a charismatic leader. His looks are more ruddy than chiseled, his manner more subdued than electric.
He does, however, possess two qualities best suited for a company facing collapse: decisiveness and focus. “From the first, he projected cheerful, unpretentious confidence,” says Linda Robinson, the well-known crisis manager whose firm, Robinson Lerer & Montgomery, was retained by Tyco. “No aloofness, no swagger.”
“Ed would make an outstanding general,” adds Jack Krol, the former DuPont CEO who, like Jimmy Carter, was selected for Hyman Rickover’s vaunted Navy nuclear-submarine program. “He’s decisive.” The model, he says, would be less bombastic George Patton, more tactical Omar Bradley.
Kozlowski’s team had twice approached Krol about joining Tyco’s board, but Krol had resisted. “I was concerned that the company would be filing for bankruptcy soon,” he says. “And I worried about what new bomb would be going off — what sort of accounting irregularities would suddenly come to light.” Breen similarly craved the integrity and credibility Krol would help bring, and ushered him into his office within a week of arriving.
“Before I left for the meeting, my wife told me that if I took the job I couldn’t come home,” Krol recalls. Krol toted along a list of eight things he would do in the first 90 days. Breen took out a list of six, all of which dovetailed. “He turned me in an hour,” says Krol, who worked with Spencer Stuart to help recruit the rest of the new board and is now Tyco’s lead director. “When I came home, my wife said, ‘I hope you said no.’ But what could I do? I was outsold.”
The board situation resolved, Breen moved to replace top management. By the time he was done, of the roughly 100 people working at company headquarters in the Kozlowski-built Versailles-in-the-sky on 57th Street in Manhattan, the only people who kept their jobs were a receptionist and two assistants. “I knew there was no way I could be completely fair about [the firings],” Breen says. “But during the first six months, every day I came into work I heard scandalous things from everybody about everybody. I was never going to figure out who knew what when. I knew I’d never know who to trust.”
Not long after cleaning out headquarters spiritually, Breen moved it physically to a standard-issue suburban office park in Princeton, New Jersey, where his nicely appointed office now overlooked some shrubs. Then he tackled a still more vexing issue: cleaning up the balance sheet.
When Breen’s appointment as CEO was announced after the market close on July 25, 2002, rumors flew that Tyco would file for bankruptcy as Enron, WorldCom and Adelphia had before it. Tyco’s stock, which had lost 86 percent of its value during the preceding seven months, opened at $9.95 that day and was beaten down still further to $6.98 at one point. “There was a total lack of confidence,” Breen says.
He learned that the bankruptcy rumors were half-true: Though no filings were prepared, creditors would soon be poised to push Tyco into Chapter 11. Tyco was carrying roughly $30 billion in debt, $12 billion of which the company had to repay in Breen’s first year. Although it had around $2 billion in cash, it couldn’t be used for debt repayment. “We needed that to run the company,” he says. “Like gas in the car.”
But Tyco couldn’t sell new debt in the capital markets the way a reputable company could. Tyco — even with Breen stage-managing the damage control — wasn’t a reputable company. “Our debt was a crisis, because we had to raise money when we were in the middle of a scandal,” he says. Even though Tyco had a number of divisions with strong brands and dominant market share, those assets wouldn’t be good for long if they were starved for capital because of the company’s debt burden.
To make matters worse, in fiscal 2002 (ending September 30 of that year), Tyco lost $9 billion. Although previous management boasted that Tyco generated around $4 billion a year of free cash flow, it produced a measly $894 million in fiscal 2002. Of the roughly $12 billion owed in 2003, $2.5 billion was needed to repay bank and bond debt as early as February.
Destroyed reputations are tough to rebuild quickly, but that’s what Breen had to do to borrow money to repay the soon-to-be-due debt. Tyco was in a race to rehabilitate its image before it defaulted.
Breen’s swift personnel moves were seen as steps in the right direction. He appointed a new senior vice president of corporate governance who reported directly to the new board. He set up an internal audit staff that grew to 110 people, with the audit chief reporting to the new board’s audit committee chairman, Jerome York, a former CFO of Chrysler and IBM. He also brought on Boies, Schiller & Flexner, the law firm of attorney David Boies, to conduct what turned into an intense four-month investigation of the company’s accounting and other practices.
When Boies’s investigation began, nobody knew how long it would take or whether it would find more instances of venality and fraud. What Tyco’s leaders did understand was that the SEC wouldn’t allow it to file its year-end financial results, let alone a registration statement for a debt offering, until the company answered a number of questions from the agency. As a practical matter, those questions and regulatory reservations couldn’t be laid to rest until Boies filed his report. The clock was ticking.
Meanwhile, Breen made cost-cutting moves and publicized his priorities. In his presentations, he emphasized that Tyco would focus first on cash flow and second on earnings, and would not concentrate on growth for a while — a stark contrast to Kozlowski’s regime.
Then Breen acted to turn priorities into realities. For example, Tyco had spent $5 billion to develop an enormous undersea cable business called Tycom. It planned to spend another $1.5 billion in 2003. “I immediately stopped that and put it up for sale,” Breen says. “Spending this money to build an undersea cable business that was worth nothing made no sense.” Tyco lost billions on the venture, but cut its losses and sold it in 2005 for some $300 million to Videsh Sanchar Nigam, an Indian company controlled by the Tata Group.
Initiatives such as this cut costs and moved the company forward constructively, but still didn’t cover its debt repayments. Fortuitously, on the day before New Year’s Eve 2002, Boies, with the assistance of three accounting firms working overtime, issued its report. It didn’t exonerate Tyco, finding accounting practices pertaining to earnings growth that it termed “aggressive.” The company had to restate its results for 2002, but the investigation didn’t find any “significant or systemic fraud.”
Tyco exhaled a heady breath of collective relief. In short order, it answered the SEC’s questions, filed its registration statement and, before the end of January, sold $4.5 billion in convertible bonds. “We paid the debt we had to pay literally the next month,” Breen says.
Since then, Tyco has rehabbed its capital structure, reduced debt to $10.2 billion and boosted free cash flow, from $894 million in 2002 to $3.7 billion last year. It also bought back 11 percent of its shares outstanding while the price was (relatively) low, spending around $8 billion to repurchase more than 220 million shares.
“The credibility that Breen established in the early days facilitated restoring the stability of the company,” says Jack Kelly, who followed Tyco for years as a managing director of industrials research at Goldman Sachs. Tyco would survive.
Step 2
Fix It:
Deprogram ADT’s Sales
ADT was, by a wide margin, Tyco’s largest division — last year, it logged revenues of $7.2 billion — with a sales model that could have dragged the entire company down. ADT had a dominant 11 percent share of the fragmented $65 billion global electronic-security market — built up mostly by buying new accounts from outside dealers. And these middlemen were well-paid. In 2002, ADT spent $1.5 billion getting two-thirds of its new accounts from dealers or others outside ADT, and planned to boost that customer-acquisition number to $2.4 billion in 2003. This sales approach meant that, on average, ADT paid a little over $1,000 per new account.
For all its size, revenues and opportunity, ADT had a parasitic relationship with Tyco — in 2002, Tyco subsidized its acquisitions to the tune of $220 million. It was emblematic of Kozlowski’s era: growth as a crutch, with a complete lack of oversight. The division didn’t have to focus on new products or new services.
It didn’t have to earn its growth the hard way: by doing it internally. “It was just another acquisition spree, like Kozlowski’s,” says Goldman’s Kelly. “Breen forced them to refocus.”
Tyco, page 2
Breen ordered ADT to develop and increase its own sales team and stop relying so much on dealers. “We let our sales force atrophy,” says Breen, who for years was one of the sample case–carrying Willy Lomans who schmoozed cable operators for General Instrument, the Chicago-based electronics manufacturer.
Worse, a number of the customers ADT paid so much to acquire dropped the service as soon as their initial contract term expired, if not before. The dealers hadn’t determined if the customers they sold to Tyco would be reliable long-term subscribers; they just wanted to pump up their commissions. So customer-attrition rates rose. In 2003, ADT lost a worrisome 16 percent of its recurring revenue this way.
Growing your own sales force takes time, however. According to Nigel Coe, an analyst at Deutsche Bank, growth at ADT fell to 1.3 percent over 2005 and 2006. “Organic growth [at ADT] severely and consistently underperformed the market,” Coe says. But as Breen told the investment community, growth wasn’t Tyco’s short-term imperative. “I figured that if I made 10 decisions, seven were going to be OK,” he says. “The three I got wrong we’d be able to fix.” The slowdown in growth exacerbated another problem. One of the most reliable and profitable components of ADT’s revenue stream is its recurring-services business. ADT is, in a sense, a subscriber business, like a cable-TV operator or traditional magazine publisher. Customers sign up, then keep paying year after year for security-monitoring services. Around half of ADT’s worldwide sales are reliable and recurring.
When a company allows growth to slow, and the new-customer count goes down, it loses chances to accrue — and allows a decrease in — such reliable recurring revenues. That brought down ADT’s monthly average revenue per user, a key benchmark. But Breen was determined that ADT would get its own customers. What he demanded of ADT’s management, was, essentially, eat what you kill — and make customers a source of steady cash flow for the long term.
Since the inception of the new sales model, Breen has encouraged ADT’s sales force, now 4,000 in North America alone, to organize itself into residential and commercial teams. These specialists are better able to help develop and sell services that appeal in the long term to their markets, which boosts recurring revenues. Fewer customers who defect means spending less to replace defectors; more of the new customers are additives rather than replacements. The cycle starts to become constructive instead of pernicious. “Breen’s internal-growth emphasis is a higher-value proposition for shareholders,” Kelly says. “When you grow internally, you’re controlling your own destiny.”
There was a long period before this change in the sales model began to develop a noticeable momentum. But by last year, the shift had started to pay off. In the third quarter of 2007, growth at ADT reached 4 percent. Now two-thirds of its new accounts are recruited by its own salespeople, and subscriber acquisition costs have fallen 25 percent, to around $750. Average monthly revenue per user has grown from $37 to $44, and customer attrition has fallen to around 12 percent. North American operating income was 16.6 percent in 2006. Also noteworthy: In 2006, ADT contributed almost $1 billion in operating income to Tyco.
In other areas, ADT isn’t performing as well. Its performance in Europe is a particular problem: Operating income in that part of the world is a measly 6.3 percent, 10 percentage points poorer than in North America. Overall, ADT has substantially regained momentum, and practices in place in North America are being introduced around the world. Much like drip irrigation, this improvement will take time to take effect — especially in Europe, where contracts run for five years, not three as in the U.S. Nevertheless, ADT has the market-dominating resources to maximize all advantages.
Step 3
Grow It:
Deconstruct the Company
Given the circumstances that led Tyco to recruit Breen, corporate structure was a major issue. It couldn’t keep going as it had been. However, determining the optimal structure wasn’t an urgent survival issue. So Breen put off considering it. You don’t wash the windows, after all, when the house is on fire.
Under Kozlowski, Tyco was drastically different from the industrial companies where Breen learned to be a CEO. It wasn’t just a conglomerate — it was an organizational Tower of Babel. Between 1997 and 2001, Tyco spent some $70 billion acquiring more than 1,000 companies.
“Executives would come in on Monday and ask, ‘Who are we going to acquire today?’ ” Breen says. “They were M&A people. [To them, Tyco] was, in effect, a big private-equity firm.”
Although Tyco had promising companies in its sprawling portfolio, it was messy. “Nothing was integrated properly,” Breen says. “They didn’t have any discipline in place. There were a lot of good companies, but no real foundation.”
Once Tyco was no longer on life support, Breen planned to make it more coherent — specifically in the service of growing organically, rather than by acquisition. Tyco had GE’s scale and complexity without GE-caliber housekeeping and organization. It had interests in four main business categories: health care and medical devices; electronic connectors and components; fire-protection and security products and services; and flow-control equipment (such as valves). It had $40 billion in revenues, around 250,000 employees, was made up of 2,180 legal entities and was in 4,000 locations. The company had 35,000 employees in China alone. “We had five world-leading large platforms, but there was no synergy between them,” Breen says. He believed that the platforms grew differently, were affected by different factors, used different approaches to gain market share, had different capital requirements and appealed to different sorts of investors. “At some point, you have to sit back, take your personal emotion out of it and ask yourself: ‘Would a different structure be better for the long term?’”
Breen’s vision was to separate the health- care business (now named Covidien) and the electronic-components business (now named Tyco Electronics) and spin each one off to shareholders. When he discussed the deconstruction project with the board in the summer of 2005, Breen insisted that all three companies would have their own independent board of directors, capable management, adequate capital, strong cash flow and balance sheets sound enough to give their debt investment-grade rating. He wanted to make sure that no one would grouse that the spun-off companies were foster children equipped too poorly to compete. As with other aspects of running Tyco, the separation presented significant challenges. When a company is as hastily cobbled together and poorly integrated as Tyco was, separating it into parts isn’t as smooth as cutting a birthday cake. It’s more like untangling spaghetti. Because of its scandal-ridden past, Tyco faced unresolved ERISA and shareholder class-action lawsuits and about $2.1 billion of tax liabilities owed for 1997 through 2000, as well as other legal hassles. All such negative legacies had to be allocated as equitably as resources were.
But Breen and the board were convinced that the three companies would be better off if on different paths, with more freedom to pursue their self-interest and more focus on their particular businesses, than if they were kept in harnesses. The separation occurred this past June 29.
The old Tyco, an embattled outpost of many quickly erected tents and temporary dwellings, had ceased to exist — or, at least, as it was conceived and conglomerated by Kozlowski. The new Tyco International gives Breen a much smaller sandbox in which to play. It was a company with revenues of $41 billion in fiscal 2006. The new Tyco has annual revenues of $18.6 billion. Operating income has diminished from $4.1 billion in 2006 to $1.5 billion. Shareholders’ equity has decreased from $35.4 billion in 2006 to $15.5 billion. But the combined performance of the three companies indicates that the spin-off led to a combined $58.4 billion market cap.
Plus, one gets the impression that Breen is more comfortable with the new, leaner Tyco. Because of the various programs to reduce waste and increase efficiency, the new ship is trimmed to respond more quickly to the helm. “A lot of people kind of grooved on crises,” Breen says. “But now we’re operating with a different mindset: how to grow the business organically by becoming more efficient and using our resources better. What a lot of people don’t realize yet is that this is a normal company now.”
The Bad Old Days
To appreciate the enormity of the task Ed Breen faced in restructuring Tyco, it helps to recall the outsized career of his infamous predecessor, Dennis Kozlowski — and the frenzy of dealmaking that produced the unwieldy conglomerate Breen inherited. Kozlowski joined Tyco — then a small New Hampshire–based manufacturing and technology company only recently listed on the NYSE — in 1975 as a $28,000-a-year accountant. By 1992, he had climbed all the way to the corner office, and Tyco had grown into a conglomerate with $3.1 billion in sales. Kozlowski soon began making acquisitions on a grand scale (obtaining 200 companies one year, nearly one for each working day), earning himself the nickname “Deal- a-Day Dennis.” From 1997 through 2001, Tyco’s revenues rose by an astonishing 48.7 percent per year, and just before Kozlowski’s fall, reached $34 billion. BusinessWeek named him “The Most Aggressive CEO,” and he seemed destined to join the ranks of such legendary conglomerate builders as Harold Geneen and Jack Welch.
But while few executives in the history of capitalism rose so high, fewer have fallen so far. Kozlowski’s problems began in 2002, when a New York State grand jury indicted him for tax evasion — for, of all things, buying millions of dollars’ worth of master paintings and having them shipped to Tyco’s New Hampshire address to avoid paying sales tax. Prosecutors dug further. Allegations emerged that Tyco paid $30 million for his apartment (including $6,000 for a shower curtain) and $1 million for his wife’s fortieth-birthday party (in the guise of a shareholder meeting). Tyco’s market capitalization dropped more than $90 billion as the scandal spread — more even than Enron’s at its peak.
Kozlowski was ultimately convicted, along with his chief financial officer, Mark Swartz, for misappropriating some $600 million in company and shareholder funds. In 2005, he was sentenced to eight and one-third to 25 years in prison, making him eligible for parole in 2014. These days, he’s known as Prisoner 05A4820 at the Mid-State Correctional Facility in Marcy, New York.
Tyco, page 3
Breen’s Best Bet
Could Ed Breen’s Tyco turnaround have been predicted? Clues lie in his tenure running General Instrument from 1997 to 2000 — specifically, in his drive to sell digital set-top boxes for cable television.
Without a transition to digital — and the capacity for hundreds of channels as well as the video on demand that came with it — the cable industry faced slaughter at the hands of satellite television. Conversion, though, would require an enormous amount of capital to update equipment for General Instrument. Digital boxes were more expensive to make, and cable operators would have to pay for millions of them — at up to $600 a pop. A catch-22 emerged: General Instrument wouldn’t make the investment without massive preorders, and cable operators wouldn’t preorder without cheaper boxes that had proven track records.
Breen’s tactic was to turn his customers into technology investors. First, he went to Denver to discuss the conversion with John Malone, the head of TCI, the country’s biggest cable operator at the time. This took guts: Not long before, General Instrument had failed to deliver set-top boxes to TCI on time, and many of the boxes were faulty. In the summer of 1996, TCI canceled its entire order with General Instrument. Nevertheless, Breen asked Malone to give him an order for nearly 5 million digital boxes. In return, he offered to sell Malone not only the boxes, but also warrants to buy stock in General Instrument. Malone took the deal.
With the green light from TCI, Breen offered similar deals to other big cable operators such as Cox, Comcast and Time Warner. During one sleepless 36-hour period, Breen sold around 15 million digital boxes valued at close to $4.5 billion. He gave up around 15 percent of the company to get the orders, but now General Instrument was surfing the conversion wave instead of being wiped out by it. Within three years, the price of digital cable boxes had come down to around $300.
Breen not only outflanked competitor Scientific Atlanta, but he also stole some opportunity from Microsoft, Sony and other companies planning to cash in on the cable industry’s digital conversion.
In the process, meanwhile, he made General Instrument an appealing acquisition. When he took over the company in 1997, it was worth about $2 billion. Motorola agreed to buy it in 2000 for $17 billion.