Caterpillar Learns The Perils Of Investing In Chinese Companies

Friday after the close, Caterpillar Inc. (NYSE:CAT) announced that as a result of accounting misconduct at the Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. (“Siwei”) subsidiary of its recently-acquired ERA Mining Machinery (“ERA”) business in China, the company will be taking a $580mn non-cash goodwill impairment charge ($0.87/share) in 4Q12. Coming after slower-than-expected demand in China in 2012 and CAT’s significant investments in China over the past several years,  some investors may question the company’s approach to China in light of the newly-discovered accounting issues at Siwei. However, given CAT’s often articulated view of China as an important longer-term growth driver for the company, many expect to see no significant changes to the company’s China strategy.

Many analysts think that although the 4Q12 charge should have little to no impact on CAT’s long-term financial performance, the disclosure of accounting improprieties at Siwei does raise some questions about the viability of Chinese M&A. That said, CAT’s strategy in China in recent years has largely been an organically driven growth strategy, so it appears unlikely that the accounting driven write-down at Siwei should be construed as reflective of any broader concerns around CAT’s China portfolio.

The size of the charge equates to 73% of the purchase price, but  less than 1% of CAT’s market cap (but nearly 10% of adjusted 2012E EPS). However, the news does not help perception of CAT’s China growth strategy, which is important to the long-term investment case.

Accounting related issue – ongoing investigation

Caterpillar has determined that several Siwei senior managers engaged in deliberate misconduct beginning several years prior to the acquisition. According to CAT’s 8-K, the managers have been dismissed and replaced with a new leadership team, with the manufacturing operations rolled into Caterpillar’s China operations division. CAT’s extensive review identified improper revenue recognition practices and cost allocation that resulted in overstated profit. Caterpillar is reviewing litigation closely and other options to recoup losses and is conducting an ongoing investigation.

The Timeline

Caterpillar Inc. (NYSE:CAT) completed its tender offer of ERA, previously listed on the Hong Kong Stock Exchange, in Nov-2011 for ~$700 mln. Siwei’s profile fit into Caterpillar Inc. (NYSE:CAT)’s broader strategy of ‘winning in China’. In addition to producing roof supports, Siwei served as a beachhead into China’s coveted coal mining market, with a respected domestic brand, established relationships, and facility space fit for growth.

CAT first became aware of the accounting issues in Nov-2012 when they identified a discrepancy between the inventories reported in Siwei’s accounts vs. its actual physical inventory. It became evident that several Siwei Senior Managers engaged
in deliberate accounting misconduct beginning several years prior to its acquisition. The Managers responsible have been removed and replaced with CAT leadership.

CAT announced on Friday that following an internal investigation, the company discovered what it described as “deliberate, multi-year, coordinated accounting misconduct” at Siwei, a wholly-owned subsidiary of ERA, which CAT acquired via the completion of a tender offer on June 6, 2012.

CAT noted that several senior managers at Siwei who were responsible for the misconduct have been removed, a new leadership team has been put in place, and CAT continues to expect to use Siwei roof support products and manufacturing capabilities to help Chinese mining customers drive greater efficiency and safety.

While the review is ongoing, CAT does not expect these matters to have any impact on their 2013 sales or earnings outlook, which will be updated on the company’s 4Q12 conference call Monday next week. Currently, as a percentage of total CAT
revenues, sales to China (including engines, construction, and mining equipment engines) are in the single digit range.

CAT also announces departure of VP of Mining division

Earlier, in seemingly unrelated news, Caterpillar announced that Luis de Leon, VP of the Mining Products division is leaving the company to “pursue other opportunities.” The company has not named a replacement. Mr. de Leon joined the company in June 2011 upon completion of the Bucyrus acquisition, where he was COO for four years.

Disclosure: No position