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January 23, 2013 3:47 am
When Caterpillar spent $886m last year to buy a small mining equipment company virtually unknown outside China, it was hoping to jump-start its sales in one of the world’s most promising markets.
Instead it has become the latest example of the missteps that have plagued foreign multinationals in China, some of which have been in the country for decades.
Caterpillar announced last week that it had uncovered “deliberate, multiyear, co-ordinated accounting misconduct” at the Chinese company, ERA Mining, it bought less than a year ago. Caterpillar said the discovery forced it to take a charge of about $580m – knocking out almost a tenth of the company’s 2012 earnings.
China’s annual Rmb400bn ($64bn) machinery market – the world’s largest in volume terms – has become a key battleground for global dominance among equipment makers, and Caterpillar’s travails illustrate just how punishing that market can be.
The loss is a huge setback for Caterpillar, which has been operating in China for nearly two decades. Through aggressive investment it has captured a market share of about 6 per cent in the country’s machinery sector, according to consultancy Off-Highway Research.
Meanwhile, China’s homegrown machinery companies such as Sany Heavy and Zoomlion are starting to threaten Caterpillar; not just in China where they dominate but also around the world as they push into fast-growing developing markets.
The loss has also led to questions about Caterpillar’s due diligence in its purchase of ERA, which was lossmaking at the time of the acquisition and had debt of more than $200m, according to filings.
The Chinese mining equipment company, which makes roof supports used in coal mines, was listed in Hong Kong in 2010 through a reverse takeover with a failing home video company – the same manoeuvre used by Sino-Forest, a Toronto-listed company that filed for bankruptcy protection last year after an accounting scandal.
ERA was unusual among Chinese listed companies because it was effectively controlled by an American living in Beijing, Emory Williams, and by the family of his Chinese business partner, Li Rubo. Mr Williams controlled 16 per cent of the shares and Mr Li’s son-in-law controlled 31 per cent at the time that ERA was purchased by Caterpillar, according to public filings. Mr Williams has been living in Beijing for several decades and headed the American Chamber of Commerce in 2005 and 2006. He did not respond to interview requests.
Before the reverse takeover, ERA was known as Zhengzhou Siwei and the company was China’s third-largest supplier of mining roof supports with a market share of 9 per cent in 2008, according to data from the Coal Mining Machinery Association. The company appeared to be expanding rapidly: in 2007, pre-tax profit was HK$14.4m ($1.9m); two years later, pre-tax profit had risen more than tenfold to HK$157m, according to filings.
At the construction machinery’s growth peak in 2010, annual sales expansion in some sectors was as high as 50 or 60 per cent, says Shi Yang of Off-Highway Research. “Everyone thinks they can make a profit from this growth,” he says, “but not everyone knows how to do so.”
Analysts say the end of 2011 marked the beginning of a steep slide in China’s machinery market, as slowing construction activity resulted in fewer machinery sales and lower coal prices led to lacklustre mining equipment demand.
There were troubling signs from ERA: in March 2012, the company issued a profit warning. A month later it reported a full-year loss of HK$10.3m because of increased financing costs and higher steel costs. Caterpillar, which was advised by Citi, pressed ahead. ERA was advised by Blackstone and Platinum Securities.
By June 2012, the deal – at a one-third premium to the previous day’s market close – was concluded. But China’s machinery market had already shifted dramatically. Caterpillar described China sales as “very disappointing” in an October earnings call.
At ERA, further troubles came in November, when Caterpillar noticed discrepancies in a routine inventory count. Those discrepancies sparked an investigation that revealed “improper cost allocation” and “improper revenue recognition practices”.
“The actions of the individuals involved were clearly wrong and purposely designed to overstate the profitability of the company before our acquisition,” Caterpillar said in a statement. The company did not specify who at ERA was responsible for the misconduct, but said it had removed several senior managers. In a separate announcement on the same day, Caterpillar said Luis de Leon, head of mining products, was leaving Caterpillar.
Additional reporting by Neil Munshi in Chicago and Paul Davies in Hong Kong
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