Caterpillar Inc. (CAT) announced the resolution of its outstanding issues with Mining Machinery Limited regarding Caterpillar’s acquisition of ERA, including its wholly-owned subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. (or Siwei). This brings Caterpillar’s embarrassing chapter to a close, which had so far overshadowed the company’s benefits from the acquisition.
Caterpillar still owed $164.5 million for the acquisition of ERA. As part of the agreement between Caterpillar and former directors of ERA and two other interested parties, Caterpillar’s total obligations have been slashed by $135 million to $29.5 million. In exchange, Caterpillar has agreed to end any litigation targeting ERA’s former directors or auditors related to the alleged accounting misconduct.
In a bid to strengthen its presence in the Chinese mining industry, Caterpillar had announced its intention to acquire ERA in Nov 2011. ERA primarily engaged in the design, manufacture and supporting underground coal mining equipment in China through its wholly owned subsidiary, Siwei.
Siwei possesses a manufacturing base of 600,000 square meters in Zhengzhou, Henan province, where it manufactures and sells roof support equipment to underground mining customers in China. In June 2012, Caterpillar closed the deal after receiving a go-ahead from the Ministry of Commerce of the People’s Republic of China (MOFCOM).
However, in Jan 2013, Caterpillar announced that it unearthed accounting misconduct at ERA as well as its subsidiary Siwei The issue first came to the fore when discrepancies were identified between the inventory recorded in Sewer’s accounting records and the actual physical inventory.
An investigation revealed that inappropriate accounting practices had been carried out for a number of years prior to Caterpillar’s acquisition of Siwei. This included improper cost allocation that resulted in overstated profit and also improper revenue recognition practices involving early and, at times unsupported, revenue recognition. As a result Caterpillar has removed the erring senior managers and a new leadership team has been put in place. In this regard, Caterpillar had incurred a goodwill impairment charge of approximately $580 million (87 cents per share) in its fourth quarter 2012 results.
The settlement will eliminate the management distraction caused by the issue and will help Caterpillar realize the targeted benefits from this acquisition. Caterpillar believes that the Siwei acquisition is well aligned with its strategy to expand its role as a leading equipment and solutions provider for the Chinese coal mining industry. Caterpillar continues to systematically strengthen its business in China and remains committed to providing the lowest owning and operating costs in the industry.
Signs of a slowdown in China have triggered concerns lately as it will have a negative effect on infrastructure and construction spending. In its first quarter 2013 results, Caterpillar noted gain of market share in China despite a slowdown in economic growth. Sales of its construction and mining machines were up in the first quarter of 2013 year-over-year even as inventories declined.
Furthermore, the company faces risks from a global economic slowdown and the expansion of big Chinese companies in the international arena. We maintain our Underperform recommendation on Caterpillar given its trimmed outlook for 2013, weak demand for its mining equipment, recent loss of sales momentum, declining backlog and negative impact of the European debt crisis.
Caterpillar currently retains a Zacks Rank #4 (Sell).Other stocks in the industrial products sector with a favorable Zacks Rank are H&E Equipment Services Inc. (HEES), Alamo Group, Inc. (ALG) and CNH Global NV (CNH), all carrying Zacks Rank #2 (Buy).
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