M&A

Didn’t dig enough?

Caterpillar’s Chinese acquisition mired in scandal

“We’re going to play offense [in China] and we’re going to win,” Doug Oberhelman, chief executive of Caterpillar, vowed to investors in 2010.

So Caterpillar started looking for acquisition targets, and it soon found what it liked: Zhengzhou Siwei Mechanical and Electrical Engineering, a mining equipment producer that was delivering a dizzying 21% yearly growth in revenue since 2008. So last year Caterpillar paid $886 million for Siwei, at a one-third premium to its previous day’s market close in Hong Kong (the company was listed under the name ERA Mining Machinery, the result of a “backdoor listing” of Siwei).

But in its haste one thing Caterpillar may not have done enough of: digging around in the accounts. Last Friday the US machinery maker made the shocking announcement that it has taken a $580 million write-down on the Chinese investment, erasing almost two-thirds of that deal’s value.

So what happened? According to Caterpillar, the Chinese company had overstated its profit for years by claiming non-existent sales on inventory that couldn’t be traced. In a statement, Caterpillar said it had found “deliberate, multi-year, coordinated accounting misconduct” at Siwei, adding that senior management at Siwei had been fired and replaced with a new team that was under direct control of Caterpillar’s China division.

But even before Caterpillar launched the bid, there were troubling signs from Siwei: the company’s account receivables – the amount that is owed by customers – had been growing at 58% a year since 2008, and actually overtook total sales in 2011. While it is normal for heavy equipment companies to have high receivables, Siwei’s was suspiciously large.

More worryingly, some 90% of those debts were overdue when Caterpillar launched its bid. Yet the US machinery maker pressed ahead. And by June 2012, the deal was concluded.

“None of those factors alone offered evidence of misdeeds… But there was enough to suggest Siwei’s growth was probably unsustainable, and undeserving of such a generous price. Caterpillar may have fallen foul of fraud, but it also looks like a victim of exuberance,” is the verdict of Reuters’ Breaking Views.

Indeed, many industry insiders had expressed doubts about the valuation before the acquisition. And many now question whether Caterpillar performed enough due diligence on Siwei, reports National Business Daily.

The Financial Times concurs that the “loss has led to questions about Caterpillar’s purchase.”

More worrying for Caterpillar, even before the latest accounting woes, the company was already struggling to compete in China. In 2007, when China sales accounted for 2.5% of Caterpillar’s $41.5 billion in global revenue, the company announced a goal to triple its Chinese sales by 2010. But despite investing in 23 factories in China, Caterpillar early last year said the country accounted for only 3% of the company’s sales, which were $60.1 billion in 2011. By comparison Japanese rival Komatsu gets about 8% of its sales from China.

To be fair, China’s heavy equipment industry is notoriously competitive. Domestic firms Zoomlion and Sany have a near monopoly on China’s concrete-machine market, accounting for more than 80% of sales last year. And between those two the competition is so intense that last year Sany’s Vice Chairman Liang Linhe took to weibo to express his concern. “Concrete machinery competition has gone crazy,” he wrote.

But Caterpillar is hardly the first Western investor to be mired in accounting scandals in China. In 2011, Longtop Financial Technologies, a China-based software company, was delisted from the New York Stock Exchange after US regulators charged that it failed to file accurate financial reports. Longtop has denied wrongdoing.

Hedge-fund titan John Paulson, too, had to take a $750 million loss on a big position in Sino-Forest, which ultimately filed for bankruptcy. Last year one of Paulson’s investors even sued the hedge fund, alleging it failed to conduct sufficient due diligence into Sino-Forest before and after purchasing shares.

But for the US Securities and Exchange Commission (SEC), which is still in a stand-off with the China Securities Regulatory Commission (CSRC) about access to audit records, this latest incident will no doubt only bolster its case.


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