Tax Inversion Proposal Shouldn't Scuttle Johnson Controls-Tyco Merger

On April 4, the U.S. Department of Treasury proposed a new framework designed to block tax inversion deals. This brings into question the merger between

The two key proposals from the government center on serial inverters and earnings stripping. We think neither applies to the JCI-Tyco deal. The rule says that stock issued in the past three years by Tyco to make U.S. acquisitions will not be counted by the government for staying below the 60% ownership inversion threshold. This proposal is designed to prevent a company such as Pfizer from owning less than 60% of a combined Pfizer-Allergan since Allergan made numerous large deals after inverting. (On April 6, Pfizer and Allergan terminated their planned merger.) However, our review of Tyco's press releases and 10-K filings show no indication of stock issuance to make acquisitions during the past three years; the only large deals were for a few hundred million dollars and paid all in cash.

Earnings stripping would involve the combined JCI-Tyco lending money to its American subsidiary in order to receive U.S. income tax deductions on the interest. The U.S. government will no longer allow these loans to be considered debt for tax purposes. In January, the companies announced annual tax savings of $150 million and the combined firm having Tyco's current tax rate of 16% instead of JCI's 19%. We continue to believe that tax inversion was not the main reason for the merger, unlike the Pfizer deal. We think combining JCI's HVAC products with Tyco's fire and security offerings for a smart-buildings world makes a lot of sense.

The S-4 filing states that either JCI or Tyco will pay a termination fee of $375 million if the deal does not occur as a result of one firm receiving a better offer. The filing also says that a $500 million fee will apply if one firm breaks off the deal because of a change in the law while the other firm still believes the merger is in its best interests.

Complementary From Product Perspective as Well as Geographically JCI and Tyco announced their merger Jan. 25. The deal is unusual in that JCI is not paying any cash to merge with Tyco but is increasing its share count and taking on Tyco's debt, which we estimate at $6.2 billion when the merger closes by Sept. 30, the end of fiscal 2016. Tyco shareholders will receive 0.9550 share in the new company per Tyco share owned and Tyco will take on about $4 billion in bank debt to fund a $3.9 billion cash payment to JCI shareholders. The deal does not affect JCI's automotive spin-off, which is likely to be in October, but Tyco shareholders will now participate in the spin-off.

JCI shareholders have the choice of receiving one share in the new company per one JCI share currently owned or receiving cash equal to $34.88 per share. However, their choice is subject to proration so that $3.9 billion in cash will be paid out to JCI shareholders. The deal is set up so JCI shareholders will own about 56% of the new company. The new company will be held under Tyco International plc, which will be renamed Johnson Controls plc. The new company will trade in New York under the JCI ticker but will have legal domicile in Ireland, while its North American headquarters will be in Milwaukee, where JCI is currently based.

We think the deal makes a lot of sense from a strategic point of view. JCI can combine its commercial building HVAC and systems expertise and add on Tyco's fire and security offerings, making the company a bigger one-stop shop and controlling more of the buildings systems in an "Internet of Things" age. We see the deal as very complementary from a product perspective as well as geographically since Tyco is strong in Europe, unlike JCI's buildings group, while JCI's buildings group is better in Asia than Tyco.

Management expects cost synergies of at least $650 million and revenue of about $32 billion after the automotive spin-off. About $500 million of that will come in selling, general, and administrative expense and cost of sales in the three years after the deal closes via eliminating redundancies and integrating the two firms' branch networks. The combined company is expected to have Tyco's tax rate, which was 16% before special items in fiscal 2015, compared with JCI's rate of about 19%. The difference between the two tax rates is not dramatic, in our opinion; the $150 million in annual tax savings estimated by management does not seem like the main reason to do this inversion deal, nor do we expect regulatory problems from the U.S. government. In addition to a very complementary product lineup that management expects to have unspecified revenue synergies, we suspect that JCI wanted to make itself bigger to avoid possibly being acquired by a large diversified industrial firm after the auto spin-off.

Although the deal is taxable to JCI shareholders but tax-free to Tyco shareholders, the deal makes sense in context of CEO Alex Molinaroli's vision to turn JCI into a leading multi-industrial company. The deal's structure allows JCI to likely maintain an investment-grade balance sheet and a strong and growing dividend as part of a balanced capital-allocation policy. Management estimates the revenue mix will be about 56% Americas, 24% Asia, and 21% Europe, Middle East, and Africa after the auto spin-off.