Tyco International told investors yesterday that they could not trust its previously reported sales and profits. It did not mention its cash flow, but perhaps it should have.
On Sept. 24, only six days before the end of its fiscal fourth quarter, Tyco told investors that its cash flow for the quarter would fall short of its previous estimates. The company said it expected to have $800 million to $900 million in “free cash flow,” not $1 billion, as it had previously forecast.
One month later, Edward D. Breen, who in late July succeeded L. Dennis Kozlowski as Tyco's chairman and chief executive, said proudly that Tyco had easily surpassed its September forecast.
“I am extremely pleased with our fourth-quarter free cash flow and revenues, both of which exceeded the revenues we discussed on our Sept. 24 conference call,” Mr. Breen said. “Free cash flow for the quarter came in at $1.3 billion, significantly above our previous estimate.”
Mr. Breen attributed the improvement in cash flow to a decrease in the company's inventory levels and more aggressive collecting of overdue bills. But he did not disclose that on Sept. 30, the last day of the quarter, Tyco had sold $350 million in receivables — unpaid bills from customers — to CIT, a finance company that Tyco owned until early July.
The money from the sale increased the cash on Tyco's balance sheet to $6.2 billion. Investors and analysts look closely at the cash on Tyco's balance sheet. Most analysts say that cash flows are more difficult to manipulate than reported profits, which Tyco acknowledged yesterday that it inflated by at least $380 million between 1999 and 2001. (In addition, Tyco has more than $9 billion in bonds and bank loans coming due in 2003. In a filing with the Securities and Exchange Commission yesterday, the company said that if it could not refinance those loans, it might face a serious liquidity crisis.)
Tyco uses a very unusual definition of free cash flow. Beginning with the quarter ended in June, the company began to factor out the cash it took in from selling receivables — or spent to buy them back — from its definition of free cash flow. The change came at the same time that Tyco's sales of receivables dropped off, draining cash from the balance sheet. During the quarter ended in June, Tyco's reported free cash flow would have dropped by $86 million, or 13 percent, if Tyco had not adopted the new definition.
Tyco's definition of cash flow is “brand new to me,” said J. Edward Ketz, an associate professor of accounting at Pennsylvania State University. But accounting rules give companies flexibility to define cash flow as they choose, he added.
Because of the definition change, Tyco's sale of receivables did not affect the $1.3 billion in cash flow that it reported to investors. But under a more typical definition of free cash flow, the $350 million sale accounted for about one-fourth of all the cash Tyco brought in during the quarter. Without the sale, Tyco would have generated about $1 billion in cash in the quarter, under a standard definition of free cash flow. With the sale, it generated $1.35 billion. A spokesman for Tyco said that the receivables sale was an arms-length transaction with CIT and that the fact that it took place on the last day of Tyco's fiscal year was a coincidence. The deal was simply a refinancing of an earlier one that had expired, the spokesman said. CIT also said the transaction had been at arms length.
But short sellers, who profit when a company's stock falls, said the timing and terms of the transaction showed that with investors nervous about Tyco's liquidity, the company badly wanted to move the receivables off its books and buttress its cash position.
“My belief is that, under both old and new management, Tyco is engaging in aggressive end-of-quarter balance-sheet management,” said Lawrence Kam, an analyst at Sonic Capital, a Boston hedge fund that has sold Tyco shares short. “They have a funding gap, a liquidity crisis, and no one is particularly willing to hold their obligations, even relatively safe ones like factored receivables.”