Saturday, January 26, 2013

Caterpillar's Latest Stumble in China

Recently Caterpillar announced having to write off $580 million investment in ERA Mining, a Chinese mining equipment company Caterpillar acquired less than a year ago. Reason given for the charge to earnings was the discovery of "deliberate, multi year co-ordinated misconduct" at the Chinese entity--in other words, somebody cooked the books.

This would not be the first time the Peoria multinational has stumbled in China.

Around 17 years ago, Caterpillar proclaimed amidst great fanfare that they have a formed a JV with Shanghai Diesel to make Diesel engines for the China market and for export.

At the time, the Chinese regulations did not allow for foreign entities to own majority controlling interests in ventures in a pillar industry. But Caterpillar insisted and persisted in their negotiations until they came away with controlling interest in a 55/45 JV.

Then Caterpillar informed their US based suppliers that to continue their business relationships with CAT, they would need to supply from China as well.

One of CAT's major supplier, a Wisconsin company, proceeded to retain me to help them find a manufacturing base and a Chinese partner that would become a qualified supplier to the Shanghai JV.

The entire process from identifying potential partners to signing MOU to drafting the letter of intent to completion of the feasibility study and sitting down to serious negotiations took a little over one year.

For a variety of reasons my client found China's way of doing business, especially getting around the then notorious triangular debt dilemma* daunting and was wavering about making the final commitment.

By then the CAT/Shanghai JV was coming apart which in effect took my client off the hook. The need to supply CAT from China became moot and they decided to backed away from investing in China.

While we were visiting China conducting various due diligence work, we invariably stopped in Shanghai to pay our respects to CAT and thus I had an up-close view of how the CAT JV was failing.

As the majority owner, CAT provided most the senior management team. At the time, CAT in the U.S. was on strike and thus CAT had plenty of idle executives to send to Shanghai.

As we toured the new JV plant under construction, we noted the presence of many American executives, each one with a young bi-lingual Chinese assistant in tow. The senior Chinese official accompanying us on the plant tour, confided to me that it was going to be very difficult for the JV to break even with such a costly top heavy structure.

Our host also told me privately that the CAT management insisted on hiring only bi-lingual graduates and engineers, which meant many skilled and competent professionals could not be employed because of their lack of English fluency. Conversely, he said that English proficiency did not equate to proficiency in their technical discipline.

Within a year of our last visit of the JV, CAT renegotiated and reversed the equity split giving the majority control back to their Chinese partner. That reversion was too late to save the venture and CAT eventually shuttered the JV and wrote off the entire investment.

The Shanghai JV failed because CAT insisted on the American way and made no attempt to localize their practice. The latest failure was apparently due to careless or insufficient due diligence before making the acquisition. One of the principals of ERA Mining was an American living in China and one time president of the American Chamber of Commerce.

Did the patina of American ownership cause CAT to take too much for granted? 
* In the mid 1990's China underwent a severe credit crunch and cash flow was reduced to a trickle. Companies delayed paying their bills, sometimes with IOUs and other times with all sorts of in-kind payments. The sales force frequently were charged with collection as well as getting sale orders. It was not an environment for the queasy.