Staying Buff at Tyco
from
Summer 2001
by John R. Engen
As revenue
growth slows in a faltering economy, all kinds of companies are
suddenly deciding that the best way to shore up earnings and stock
prices is to slash thousands of employees from the payroll. Motorola
has hacked 26,000 jobs, General Motors, 10,200; Procter & Gamble,
9,600; Morgan Stanley Dean Witter, 1,500...
One outfit that has managed to shelter its workforce from much of this nastiness is Tyco International, a manufacturing conglomerate that has been restructuring for most of the past decade in a largely successful effort to propel performance by staying trim. In 2000, when most companies were reporting flat earnings, Tyco charged ahead. Earnings rose 358.7% over the previous year, to $4.5 billion, on sales of $29 billion, a 29% increase. Not that this old economy powerhouse hasn’t had its share of layoffs. It has, but they’ve been part of an ongoing, self-induced belt tightening rather than a reaction to tough economic times.
While not exactly enjoying the carnage around them, Tyco’s strong board of directors can’t help but feel a little smug at the successful culture it has helped to create. “This is not a company that wakes up every five years and says, ‘Gee, we have to cut costs,’ ” says Frank Walsh, chairman of the Sandy Hill Foundation, a Morristown, New Jersey charitable group, and Tyco’s lead director. “It’s a company that’s lean and mean by design. Costs are the enemy here, and everyone’s compensation is improved by cutting excess down the line.”
This somewhat extraordinary focus on containing costs is driven by Tyco’s strong-willed chairman and CEO, Dennis Kozlowski, 54, whom shareholder activist Robert A.G. Monks, chairman of Lens Investment Management and a Tyco director from 1985 to 1994, calls “the best CEO in America.” Since taking the reins in 1992, when Tyco was a mid-sized player with a market capitalization of $2 billion, Kozlowski has made more than 200 acquisitions, building a company now valued at $105 billion. Analysts call it a “mini-GE.”
His strategy, reinforced by his involved board, is to reward members of his decentralized management team with hefty bonuses if their units meet or surpass board-approved performance goals, even if the company as a whole falters. Only Kozlowski and a handful of other top managers have compensation packages pegged to the entire company’s performance. Last year Tyco’s chief earned $25.8 million in total compensation and realized another $100 million by exercising options.
The result has been leaner operations, fatter profits, and elated shareholders. In that respect, the comparisons with GE take on a different hue because over a nine-year period, Kozlowski has done more for his investors than Jack Welch has for his (see chart).
Tyco’s strong stock performance has in turn provided the company with the currency it needs to continue financing acquisitions, even in down markets. The latest examples: a $9.2 billion purchase in March of commercial lender CIT Group, which has $55 billion in assets—a board-initiated deal that will give Tyco long-coveted in-house financing capability—as well as an agreement in late May to expand its medical products business by paying $3.1 billion for C.R. Bard, a maker of catheters and other urology devices with assets of $1.1 billion.
Though directors embrace the boss’s cost-cutting strategy, most admit to some discomfort in signing off on deals that require large plant closures and layoffs, such as the 10,000 job cuts that followed Tyco’s 1999 acquisition of AMP, an electrical connection maker based in Harrisburg, Pennsylvania. “It definitely bothers me,” says Wendy Lane, a director since last year and chairman of Lane Holdings, a private equity firm in Boston. Lane says she uses her Tyco board experience to talk with her two teenage children about “the morality of economics and raw capitalism.” Recently, the father of her teenage daughter’s boyfriend faced a layoff. “She asked, What do you think of that?” Lane recalls. “And I said, I’m working with a company that often buys businesses, and people get laid off. It’s painful in the short term, but over the longer term the business becomes more competitive because of it and they create more jobs.”
Tyco has five major business groups—electronics, telecommunications, fire and safety products, flow controls (such as valves and meters), and health care and specialty products. A mere 40 people work in the company’s modest two-story operating headquarters in Exeter, New Hampshire, despite a global workforce of 220,000. Like Jack Welch, Kozlowski says his company’s core philosophy is to be No. 1 or No. 2 in all of its business lines, “and to be the low-cost producer.” To do that, he adds, “requires a constant focus on productivity and cost reductions.”
As Frank Walsh notes, “No company has ever cut its way to greatness.” But a lean company, he says, can compete better on price, thus allowing it to capture more revenues.
If that were easy to achieve, more companies would do it. At Tyco, the restructuring mentality is rooted in Kozlowski’s predisposition for number crunching—an accountant by training, he began his Tyco career in 1976 as an assistant controller—and is backed by a carefully chosen board that Monks hails as a standard for other boards to emulate. “Tyco has the best governance in corporate America,” he says.
Directors are elected annually, and only four of the 13 board members—Kozlowski, Vice President Joshua Berman, CFO Mark Swartz, and newcomer Al Gamper, CEO of CIT—are insiders. The outsiders have the experience the company’s priorities demand: Four have finance or merger and acquisition backgrounds, four others bring manufacturing operations experience, while one is a former Tyco CEO. Four have been on the board at least nine years.
Kozlowski prefers seasoned executives with Wall Street smarts, folks he describes as “people with big-company experience who have been putting their own money on the table for a long time.” Kozlowski says this produces a board that “has a very practical viewpoint on how to make and lose money.”
They must also devote some of their time to ensuring that Kozlowski, a fiercely energetic leader known for working 18-hour days, doesn’t overextend himself. “He’s their horse,” Monks says, “and one of the primary responsibilities of the board is to take care of him the way you would a horse that’s won the first two legs of the Triple Crown and is getting ready for the third race.”
That’s not to say the board tries to coddle him. Directors describe meetings that turn heated; they aren’t afraid to tell Kozlowski when they think he is wrong. For example, in 1997 he was pushing the board to approve a $5.6 billion reverse merger with ADT, a Bermuda-based fire and security alarm company. Since it is expensive for a U.S. corporation to acquire an offshore company, the deal required Tyco to sell itself to ADT, resulting in a huge capital gains hit for Tyco shareholders. While Kozlowski argued that the long-term tax advantages of being based in Bermuda would far outweigh the deal’s short-term tax consequences, directors weren’t so sure. For two weeks the board debated the deal over the phone before coming together to vote.
Walsh, who was part of the deliberations, recalls being pulled into a four-hour conference call while his vacationing family waited impatiently at an airport. The directors, he says, “needed some convincing that what they were doing was really best for shareholders.” Adds Kozlowski: “It was one of the most spirited board-level debates I’ve ever seen.” Ultimately, the CEO won the day: The board voted unanimously in favor of the deal. And they looked smart afterward: The $140 million in predicted three-year savings from the merger swelled to $1.2 billion over that time. “It was the gutsiest deal we’ve done, and the most successful,” Kozlowski says.
Such diligence exacts a price. Being a member of the Tyco board requires more time and flexibility than most directorships. The board holds regularly scheduled quarterly meetings and gathers for an additional eight or nine meetings a year. But to maintain the company’s offshore tax advantages, the board cannot meet in the U.S.; as a result, directors usually gather at the company’s headquarters in Bermuda. “We need directors I can call on a Friday night and say, “I really need a meeting in Bermuda on Monday,” Kozlowski explains. While it might sound glamorous to venture mid-ocean for a meeting, like most everything else surrounding Tyco the board get togethers are short on frills. A typical meeting day, according to director Peter Slusser, president of Slusser Associates, a boutique investment banking firm in New York City: “You get on a company plane in Teterboro [New Jersey] at 7 a.m., fly down to Bermuda, have a three- or four-hour meeting, maybe lunch, and then you get back on the plane and go back to Teterboro.” At home, the board members talk with each other and Kozlowski in what directors refer to as “phone huddles” at least once a week, sometimes more. Much of that communication is funneled through Walsh who, as lead director, acts as a conduit between the CEO and individual board members.
Most of the board’s work centers on deal making—approving acquisitions and ensuring management has reasonable plans for whipping them into fighting trim. All deals, most of which are initiated by Tyco managers, are expected to generate returns of at least 15% in the first year, with that percentage rising to the lower 20s in the second year and the upper 20s in the third year. In making their arguments to the board, operating managers must figure out how to reach those return targets solely on the basis of pricing and cost cuts. When one of the five operating managers brings an acquisition idea to the board, the proposed purchase usually complements an existing operation in some way, providing the opportunity to carve out costs and attain acceptable returns.
Sometimes that’s done by combining sales forces. Often, outdated plants and those that duplicate existing Tyco facilities are shuttered. Almost always, headquarters operations are closed. “We cut the people who don’t add value—those that don’t design, manufacture, service, or sell the product,” explains Brad McGee, Tyco’s chief strategy officer. “Once you eliminate the overhead, it gives a much stronger base from which to work.” In the long run, most of the units Tyco restructures wind up employing more people than before they were purchased. “This isn’t a ‘Chainsaw Al,’ slash-and-burn operation,” Slusser says.
For example, when Tyco paid $11.3 billion to buy AMP, managers promised to cleave $650 million from costs during the first three years. Within months, Tyco laid off 10,000 of AMP’s 47,000 workers. It also consolidated the headquarters function (AMP had spent $80 million on succession planning alone), replaced the CEO with a sales manager, spun out some pricing authority to sales managers, and reduced research-and-development cycles significantly. Final cost savings: $1 billion. “It was a complete change in how that business was driven,” McGee explains. “And if you look at AMP today, it has 80,000 employees because the business is stronger.”
Managers who embark on such restructurings are well aware of the potential rewards awaiting them if they do the job right. Some have become millionaires several times over because they’ve hit their profitability and cash-flow targets. “Seeing people rewarded for the things they can control is a principle that everyone on the board buys into,” Walsh says. But those managers also face considerable risk if their plans go awry: Charges for most deals come straight out of the individual unit’s profit-and-loss statement, affecting the incentive payments the manager and employees make for that year. Tyco doesn’t normally capitalize restructuring charges. “They’re giving up some incentive earnings this year, because they believe it will generate a bigger payout in the future,” Slusser says.
Eighteen months ago, for instance, the fire and safety business manager concluded that about 20% of the distribution force was generating 60% of sales, while another 20% accounted for 1%. The laggards were promptly pared from the roster. “We cleaned it up in one quarter, and our margins came down for a while,” Kozlowski recalls. “But now margins are higher than before. We’re not giving anyone a free ride on accounting.”
Managers also are aware that the directors who approve their deals will be watching closely: Most of Tyco’s big deals are scrutinized by the board a year or two later in “postmortems” aimed at gauging whether the promised returns and savings actually occurred. The penalty for missing targets? “Increased scrutiny of deals proposed by that manager in the future,” says McGee. Potential revenue enhancements, while not advertised to investors, also are monitored by the board via a “side sheet” that directors keep to themselves.
The CIT deal was a bit of a departure for Tyco, but it is illustrative of the board’s power to steer the company in new directions. For years managers have lamented the sales opportunities lost because they lacked in-house financing and leasing capability. Directors had talked informally about acquiring a financing arm for nearly as long. Last year Walsh suggested that Kozlowski contact an old friend of his, CIT’s Albert Gamper.
The timing was good. One of CIT’s major Japanese shareholders, Dai-Ichi Kangyo Bank, which owned 27% of CIT, wanted to sell, and Gamper, with the stock under pressure, was considering his options. Becoming part of a manufacturing conglomerate, as opposed to being acquired by a bigger lender, offered the chance to retain some autonomy. For Tyco, adding a finance subsidiary would generate income-producing assets for the balance sheet: Tyco expects the deal to add 10 cents to 12 cents per share in earnings the first year.
The board debated the deal for weeks before concluding that the ability to increase sales justified breaking with its traditional cost-cutting model for acquisitions. “Admittedly, this is a different business for us, and it doesn’t have the same cost-cutting aspect,” Lane says. “But we’re still compensating people to do well in the same way we always have.”
Eventually CIT, too, will take on a different look—tightening its belt in some places, acquiring additional expertise in others, perhaps spinning off some operations—because that’s the way things work at Tyco. “A lot of times companies get concerned about the pressures of restructuring, as opposed to looking at the money that can be made on the upside,” says Lane, a former partner at Donaldson, Lufkin & Jenrette. “Because this company has been so successful in the past, and because people have been so handsomely compensated for success, they’re focused more on the carrot of restructuring than the stick.”
Adds Brad McGee, who will help with CIT’s integration: “The board,
through the compensation system and its oversight, encourages everyone
in this organization to constantly rethink and look for ways to take
costs out of their business. As an operating manager myself, I wouldn’t
want it any other way.”
