Caterpillar Digs Into Trouble in China

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Two years ago in the US, over a dinner of filet mignon and sweet potato gratin, Caterpillar chief executive Doug Oberhelman looked on as China's President Hu Jintao praised the "mutually beneficial economic co-operation" between the US and China.

With a violin serenade and a hearty welcome from Chicago mayor Richard Daley, the dinner feted Mr Hu and highlighted the industrial ties between the world's two largest economies. Caterpillar, one of the first US companies to set up shop in China after it reopened to western businesses in the late 1970s, was a co-sponsor.

(Read More: Caterpillar Earnings Hit by China Fraud, Cautious for 2013)

At the time the US machinery company's prospects in China could not have looked better. Sales of crawler excavators, a key segment, had surged 70 per cent from the previous year as the Chinese machinery market boomed. "We're going to play offense [in China], and we are going to win," Mr Oberhelman told investors.

More recently, however, Caterpillar has come badly unstuck. It has been bleeding market share as homegrown companies – many deploying suspiciously similar technology – have grabbed sales. Caterpillar's chief Chinese rival, Sany Heavy, surpassed it in market share for excavators for the first time in 2011. Last year, a drop-off in construction pushed all-important excavator sales down more than 30 percent from the previous year, according to Barclays data.

As if that were not bad enough, Caterpillar has been forced to make a costly and embarrassing goodwill impairment charge of $580 million after uncovering alleged accounting misconduct at a Chinese mining equipment company it acquired six months before.

(Read More: Caterpillar Writes Off Most of China Deal After Fraud)

It is an abrupt reversal of fortune for a company that once seemed like a textbook case of how to do things right in China. The US machinery company saw the country's potential so early that, in 1978, it opened its first Beijing office in the same year that Washington and Beijing established diplomatic ties after decades of estrangement.

In the 1980s, Caterpillar curried favor by cautiously sharing technology and know how with a dozen Chinese state-owned enterprises. As China began to urbanize in the 1990s, it was one of the first to set up a factory through a joint venture with an ambitious local group in Xuzhou. Instead of operating through dealerships, Caterpillar sold its equipment directly to its customers, even sending western executives out to remote mine sites to sign major contracts – a popular approach, according to a former customer.

However, in spite of decades of careful investment, China still accounts for only 3 per cent of Caterpillar's worldwide sales. Sales in Asia Pacific even dropped two percent in the final quarter of last year, dragged down by poor sales in China.

The US machinery company has misjudged China's capricious market for heavy machinery time and time again. In 2010, when the Chinese market was booming, Caterpillar was constrained by production capacity. Last year, as unsold machines started filling up Caterpillar's lots, the company exported more than 2,300 excavators out of China to help draw down stocks.

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Caterpillar also abandoned the direct sales model several years ago and switched to a dealership model similar to what it uses in the West, which one customer describes as a "major mistake" because it hurt sales.

"Caterpillar tried very hard to maintain its traditional virtues of trying to maintain premium products and premium customers," says David Phillips, head of consultancy Off-Highway Research. "I don't think that is a mistake, but it has certainly held them back a little bit." He adds that they have not been "dragged into price wars" as much as other companies.

Yet it is the dispute with ERA that has been Caterpillar's biggest sore point in China. In January the US group ended up taking a $580 million writedown on the value of the business, alleging multiyear accounting misconduct and kicking out key executives whose relationships may be central to winning and maintaining this line of business in China.

Caterpillar, which has not released details of the misconduct, insists it remains dedicated to building this and other businesses in China. But observers and people familiar with the deal say it may have been too heavy handed in its treatment of the ERA deal and that this could taint its whole approach to China.

The trouble with ERA began far before the deal was signed. When ERA Mining issued the first of two profit warnings in March 2012, Caterpillar was already locked into its $800 million deal to buy the mining machinery group. The US machinery company flew ERA executives to Peoria to explain the profit warning, but decided to push forward with the deal and negotiated for itself some wriggle room in terms of price.

As the slowing growth in China took its toll in early 2012 – particularly on the construction and basic industries sectors at the heart of the investment-led economy – Caterpillar was able to put pressure on the main shareholders of ERA to take more of their payments in loan notes whose value could be reduced if the performance of the Chinese company suffered, according to several people familiar with the deal.

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Nobody close to the deal doubts that Caterpillar's due diligence was thorough and lengthy – there were operational people and two sets of accountants going over the business and its books. They had tens of people all over its main site in Zhengzhou for several months while they were awaiting Chinese regulatory approval for the deal, according to one person familiar with the process.

The $580 million writedown – which was double the asset value of the company at the time it was purchased – caught those involved in the deal by surprise. "When you lay the accounting systems of someone like Caterpillar over a small, growing Chinese company there are always going to be discrepancies – but $580 million worth?," says a person close to the deal.

The dispute over account misconduct also risks fraying ties with one of ERA's key shareholders, Li Rubo (John Lee), who has extensive ties in the mining community.

"The naive thing Cat has done is throw the main relationship guy under the bus," says another person familiar with the deal. "John Lee is the one who knows the industry, knows the people and is effectively the lead salesman. What does that do for their prospects in China?"