Ed Breen has scrubbed the scandal out of Tyco. Now, can he make it another GE?
(FORTUNE Magazine) – If the rumors playing out on CNBC were right, Ed Breen had just made one of the worst career moves in the annals of American business. It was a steamy Thursday in July 2002, and Breen had returned to his office at Motorola's campus near Chicago for the last time. Minutes before, Breen had told his stunned boss, CEO Chris Galvin, that he was leaving his cozy job as president and heir apparent of Motorola to tame Tyco International--a notorious corporate rogue that, in the public's mind, would rank with Enron and WorldCom for murky accounting, corrupt leadership, and guile at conning investors.
Even Breen's wife, Lynn, warned him that he'd be absolutely crazy to take the job. "I wondered if we'd stay together," he jokes. Now, as Breen prepared to pack up, the Internet was aflurry with news reports that Tyco would file for bankruptcy within days, and CNBC was reporting the company's denial. Wall Street, however, clearly believed the chatter. Breen watched the TYC quote keep shrinking as it rolled across the screen, tanking to $7 a share. It had dropped 87% in just the previous six months. That's when Tyco's former chief executive L. Dennis Kozlowski had announced a plan to break up the company into five parts. Investors thought it was a panic move, motivated by a possible cash shortage. Soon after, more bad news broke: Kozlowski had paid a $20 million consulting fee to a fellow board member, launching an investigation that would expose scandal throughout the top layer of management. "It was a wild day," says Breen.
But the bankruptcy scare that freaked out investors didn't bother Tyco's new chairman and CEO. Burly and mustachioed, the 48-year-old former high school wrestler is said by friends to be a congenital optimist--someone who believes good things will happen simply because he wills them. "I'd studied Tyco's finances," insists Breen. "I knew the bankruptcy reports weren't true." Investors, he thought, were mistaking a crisis of confidence for a real meltdown. "Tyco had all the attributes of what could be a great company," he says. "It baffled me. Its basic businesses were so good that it should have been generating significant cash flow, but it wasn't." Where others saw disaster, he spotted the opportunity of a lifetime. If he could steer the ship past two looming shoals, he'd find clear sailing.
The first hurdle was straightforward enough: survival. Tyco had $11.3 billion in debt coming due in 2003, $2.5 billion of it in February--and the company had no seeming ability to make the payments. The second would take more time to navigate and was equally perilous: getting everyone else to see what he could see. In roughly two years at the helm, Breen has managed both feats. It is no small accomplishment. Of the biggest names wracked by scandal since 2000, Enron, WorldCom, Adelphia, HealthSouth, Qwest, and Tyco, the first three went bankrupt, and HealthSouth and Qwest are struggling. The lone success story is Tyco.
The echoes of Tyco's dark past still aren't silenced. Kozlowski and his CFO, Mark Swartz, go on trial for allegedly looting Tyco of $600 million next January, following a mistrial in 2004. The company also faces shareholder suits that, by one estimate, could cost up to $4 billion. Nevertheless, it looks as if Tyco's comeback is the real thing. "Breen has rebuilt Tyco's management and governance from scratch, like a startup," says David Boies, the attorney hired by the old board to investigate corruption in the Kozlowski regime.
The strongest endorsement has come from investors. Since Breen's first day on the job, Tyco's share price has jumped nearly 300%, to $31, adding $45 billion in market capitalization. "They've cleaned up their big problems," says Joel Levington, a fixed-income analyst with S&P, who was influential in raising Tyco's bond rating. "Now the question is what to do with all the money they're making. That's a big improvement from trying to escape a liquidity crisis." Leon Cooperman, whose Omega fund has long been a major Tyco shareholder, agrees that the company has been saved. "Breen has unequivocally brought the company back," he says.
How Breen revived one of the most notorious casualties of the Era of Greed could be a case study in corporate housecleaning. Start at the top and throw out nearly everyone in a position of oversight--that is, the executives and managers who should have caught the problems ... and didn't. It may seem simple; it's anything but.
It was Breen's first day at Tyco, and the new CEO had several important visitors. At ten on Monday morning, seven major shareholders, representing 15% of Tyco's ownership, showed up unannounced at the company's 57th Street headquarters in Manhattan. The institutional investors, including Bill Miller of Legg Mason, made a simple demand: that Breen replace the majority of the board of directors right away. Their argument was that the company's directors had let the corruption happen under their noses. Details of what looked like looting by Kozlowski and his lieutenants, including abuses of everything from exit packages to relocation loans to bonuses, were flooding into the open. A compliant board had encouraged a culture of entitlement, the big shareholders said, by approving over-the-top pay deals for executives. Two of Tyco's nine outside directors had lucrative financial arrangements with the company to boot. Even if, as the directors claimed, Kozlowski had concealed many of the lavish perks and payments, it was clear that they'd exercised virtually no oversight of management.
Breen decided to go further than that--and replace the entire board. "To reassure investors, we had to go overboard on corporate governance," he says. But the process required hard-nosed salesmanship. In a dramatic five-hour meeting held by speakerphone on Sept. 12, 2002, Breen asked the directors to vote that none of the veterans of the Kozlowski era could stand for reelection at the next annual meeting in early 2003. Breen's position caused an uproar. "Directors were saying, 'This will make it look like we're guilty.' They were worried about liability," recalls current lead director Jack Krol, a former chairman of DuPont. "They also thought continuity was important. Ed wanted the opposite of continuity." With the vote deadlocked at 5-5, Breen cast the deciding vote to replace the entire board. "It was a tough all-day meeting," says Krol. "But Ed won. He was very determined."
Nonetheless, a stubborn group of directors refused to resign immediately, or even to step down at the annual meeting scheduled for the following March. They had a strong legal position. "If the board changed without the support of the existing directors, it tripped covenants on Tyco's loans that could have caused bankruptcy," explains Boies. So Breen worked out a compromise, allowing two former directors to stay on for one year as advisors to the board--providing they resigned voluntarily.
The argument worked. Over the next few months Breen replaced the old, weak board with a strong cast of current and former CEOs who bring diverse skills. They include Krol, a restructuring specialist who revived DuPont; George Buckley of Brunswick Corp., a hands-on operating guy and a former chief technology officer who headed two divisions at rival Emerson Electric; and Brendan O'Neill of Imperial Chemical--a Brit who formerly ran brewing giant Guinness and boasts a wealth of global experience. Breen is the only insider on the board. "We set up a matrix so that we'd get a combination of financial experts, executives who had gone through restructurings, and people who knew the nuts and bolts of running industrial companies," says Krol. (One potential cloud: Two of the directors--Sandra Wijnberg, CFO of Marsh & McLennan, and Brian Duperreault, who's chairman of ACE--come from the beleaguered insurance industry. Both companies are now under investigation by New York State attorney general Eliot Spitzer for allegedly rigging insurance bids. Breen says only that he has no plans to change any members of the board.)
Nor did Breen stop there. The new CEO instituted an internal audit staff, consisting of 110 people; the audit chief reports not to Breen, but to the director who heads the board's audit committee, Jerry York. As CFO of Chrysler in the early 1990s and IBM in the mid-1990s, York helped engineer two of the biggest turnarounds of the last two decades. In 2003 he held an amazing 19 meetings of the board's audit committee. Tyco's ombudsman also reports to York; employees can call an 800 number to report anything they perceive as wrongdoing, from sexual harassment to price-fixing. This year Tyco has conducted almost 1,300 investigations--a quarter of which have resulted in disciplinary action or a change in procedures.
Both top and middle management needed a scrubbing as well. Tyco's operating principle had been all about frenzied dealmaking, not management and integration.From 1997 to 2001, Tyco spent about $70 billion purchasing over 1,000 companies--but failed to fit the pieces together. That culture simply had to change: The new CEO fired no fewer than 290 of Tyco's 300 highest-ranking managers in the first few months. "I didn't know what people knew or what they should have known," says Breen, "so I decided to start with a clean slate." One of the first to go was Mark Swartz, who was still CFO when Breen arrived. Swartz, who had yet to be indicted, had an agreement calling for $110 million in severance. "Ed wanted to get him out, and pay him less," says Boies. By threatening litigation, Breen shaved Swartz's exit package by more than 90%, to $11 million.
The new boss likewise refused to pay bonuses to Tyco managers--which looked more like those given at an investment bank than any industrial company in America--until he understood the numbers on which they were based. That caused a huge flap, but it signaled that the new boss was dead serious about reform. Division heads were regularly pocketing $8 million a year, and over 100 Tyco employees received bonus checks for $1 million or more in 2001. "The only thing that united this company was compensation," says Laurie Siegel, whom Breen plucked from Honeywell to head the human resources department. "Before I found the restroom, people were calling to say, 'You better pay these bonuses or I'll sue!'" Since 2001, Breen has cut the bonus payments from $355 million a year to $183 million.
None of the governance changes--as sweeping as they may have been--dealt with the emergency cash crunch the company was facing. Tyco had that $2.5 billion in bank and bond debt coming due in early February--which would be followed in the months to come by billions more. And the money that investors thought was pouring into the company's coffers--Tyco's executives had boasted about some $4 billion a year in free cash flow--simply wasn't there.
Yes, Tyco was generating scads of cash from its many hundreds of businesses. The problem was, the old Tyco under Kozlowski wasn't counting two huge financial drains. First, the company was spending more than $1 billion a year building, and subsidizing losses on, a huge undersea cable network called Tycom. (Breen quickly halted spending and put Tycom up for sale.) Second, Tyco was squandering cash on its home-security business. For the most part, instead of selling alarm systems directly to customers, it was buying accounts from third-party dealers. Tyco's financial officers treated it as part of the acquisitions budget, rather than an operating cash flow item. When the company offered Wall Street its projections of free cash flow, somehow these payments--$1.3 billion a year--weren't factored in.
What's more, many of the customers were deadbeats: They stopped paying for their new home-security systems after a few months. Breen tackled the problem on two fronts: He revised Tyco's cash-flow projection to the real number, less than $800 million for 2002. He also sharply cut the payments to dealers and ramped up internal sales, focusing on better, long-term customers.
Still, the swift actions weren't nearly enough to cover the huge debt payments coming due. Kozlowski had left the company with not only a smeared reputation, but also the legacy of an overstretched empire. In the mid-1990s, Kozlowski had transformed a sleepy manufacturer of industrial valves into a sprawling conglomerate that makes thousands of items in five general areas: health care, electronics, security and fire systems, plastics, and engineered products. Kozlowski's strategy had its virtues, certainly. He bought solid companies in fragmented industries, establishing big, market-leading positions in countless everyday products. Tyco is now the world's largest producer of plastic garbage bags and hangers, and sprinkler systems. It dominates the market for the bread-and-butter electronic connectors that link wires to motors, for instance, and connect the circuitboards in dishwashers and cars. Its ADT division monitors alarms for six million households, six times as many as its nearest rival, Brink's. In medicine, Tyco stands on a par with Johnson & Johnson as a giant producer of sutures and staplers.
The problem was that the imperial CEO had vastly overpaid for most of these businesses. On average, Tyco spent an astounding 52% more for the large companies it acquired than their value before Tyco made its bid. Then, Kozlowski let the local managers mainly go their own way. Some division heads did a pretty good job integrating new acquisitions with the companies in their portfolios, while others shunned the grunt work completely. In the plastics division, for example, Tyco bought over one hundred industrial plants and left many of them swimming in unused capacity.
As it turns out, Kozlowski's managers could drive up profits--and earn giant bonuses--by acquiring more and more companies. Yet headquarters didn't charge the division heads any interest for the capital they were using to expand their fiefdoms. In the bubble of the late 1990s it didn't seem to matter: Tyco's shares kept soaring. But it was paying cash for many of its big deals, and the heavy borrowing was driving debt to dangerous levels--hitting $28 billion at the peak. Shockingly, Tyco's debt exceeded its shareholder equity.
Breen had only one hope for repaying the $11.3 billion due in 2003. To save Tyco he had to borrow bigtime, starting with a new bond offering in early 2003. But the SEC wouldn't let the company file its year-end financial statement until Tyco satisfied a number of the SEC's questions. And it couldn't float a bond offering without the 10-K. It was a race against the clock.
Tyco had to prove that its accounting wasn't hiding any time bombs, for example. But to really restore investor confidence, Breen knew, Tyco needed to go further than that. So he hired attorney Boies, who had already been retained by the company's former management to probe corruption in the executive suite, to investigate the company's books. With the help of three accounting firms, Boies issued a report on the day before New Year's Eve, 2002. It found that Tyco was guilty of aggressive accounting, mainly with respect to its acquisitions: The company restated a number of erroneous accounting entries that adjusted income for all four quarters of fiscal 2002--(two went up, two went down). But Boies had found no "systemic or significant fraud" and concluded that the business was basically healthy. Breen breathed a sigh of relief.
With that cloud out of the way, Tyco could file its 10-K. Two weeks later it raised $4.5 billion in bond and bank financing. That was the turning point in the company's fortunes. From there on, as Breen had predicted all along, the company's businesses were strong enough to generate heaps and heaps of cash. For fiscal 2003, Tyco's free cash flow--a number investors could finally trust--was $3.2 billion. By 2004, it had climbed to $4.7 billion--a major-league stat that puts Tyco in the ranks of GE and Emerson Electric. The company's total debt, meanwhile, has fallen from a ruinous $28 billion to $12 billion, and Tyco has regained the investment grade bond rating it lost in 2002.
Tyco wasn't the first company where Breen had turned a potential disaster into a golden opportunity. Seven years ago, as CEO of General Instrument, which made cable TV set-top boxes among other things, he faced a technological revolution that threatened to hammer his business. It was late 1997, and satellite television, boasting 300 digital channels, was threatening the primacy of cable TV, which was still stuck in the analog era. Cable operators knew that they could compete if they could only switch their customers to digital boxes, but such set-top controls were costly to make, with prices running as high as $600 apiece. Cable TV companies, which provide the boxes along with the service, were afraid to make the digital jump. Breen, however, found an ingenious way to make the boxes cheaply and dominate the market at the same time: He convinced every major cable company--TCI, Time Warner, Comcast, and others--to join forces and give GI an enormous order, which in turn would drop the per-unit price down to around $300. As an added carrot, if the cable providers signed up in 24 hours (before GI rivals like Microsoft and Sony could talk them out of it), Breen would grant them stock warrants in GI.
The ploy worked brilliantly. In a single day, the cable companies placed orders for $4.5 billion worth of boxes. GI's stock shot up, making the warrants extremely valuable. Two years later, in 2002, Breen sold General Instrument to Motorola for $17 billion, an unthinkable $15 billion more than GI's value before Breen took the CEO job in 1997. Breen pocketed $40 million--and secured a job as president of Motorola. "What Breen did was unprecedented," says Brian Roberts, CEO of Comcast. "It took a lot of creativity to take what looked like a natural and make it reality."
Breen, happily, seems to have no shortage of creativity when it comes to getting out of tough spots. But growing a mature and sprawling conglomerate is a different kind of problem--one that may stretch the CEO's talents to the limits. In short, Tyco's goal is to become another GE. The problem, in other words, is growth-- organic growth, something his predecessor never understood.
No surprise, Breen is confident he has the horses to do it. A case in point: Tyco Healthcare. The $8.5 billion division is highly profitable; it accounts for 22% of Tyco's sales and a remarkable 44% of profits. Now that acquisitions have stopped, however, the unit has been depending on organic growth--and that's been slow. Sales are rising by just 5% a year. Like the rest of Tyco, the medical group doesn't make products that are extremely high tech, such as drug-coated stents. It specializes in items like skin staplers, tracheotomy tubes, and operating room trays.
Breen thinks that he can boost organic sales growth to 8%. The missing ingredient, he says, has been R&D. He plans to raise research spending from 2% of sales today to 4%, or around $400 million, by 2007. He plans to fund this R&D expansion with money saved by streamlining the company's purchasing and by reductions in working capital. Since 2002, Tyco has cut its inventories, the biggest factor in working capital, from an average of 92 days to 80 days.
More rich turf for cost cutting has come in the area of purchasing. Each year Tyco buys $16 billion of everything from resin to plane tickets. Yet under Kozlowski, Tyco bought virtually nothing on a companywide basis. Breen has established 80 teams, composed of representatives from all five divisions, that pool Tyco's purchasing power in products as varied as phone services, resins, and office supplies. The company didn't have a CIO under Kozlowski. Hundreds of businesses bought tech equipment on their own. Now such PC purchases are centralized--a process that has shaved $11 million from the IT equipment budget. Tyco has saved another $40 million a year by shrinking the number of packaging suppliers from 300 to 25.
And the company has been saving bucks in a more controversial way as well: The new CEO has been under fire for keeping the company's official domicile in Bermuda--the CEO and other top executives are actually based near Princeton, N.J.--an advantage that saves $300 million a year in taxes, even as it deprives the U.S. Treasury. (Breen insists the offshore status is justified because Tyco was purchased in 1997 by Bermuda-based ADT, even though the former was much bigger.)
Tyco has come so far, so fast, against such high odds, that even Breen's believers are marveling at how it could be. At least one old Wall Street sage isn't surprised, however: "Tyco always had real businesses making real products," says big shareholder Cooperman. "The key was getting them in the hands of an unpretentious, capable, honest manager like Breen--the opposite of you-know-who."