Asia’s top mergers and acquisitions bankers gathered two years ago at the swanky Island Shangri La in Hong Kong to celebrate the top deals of 2012. As the transactions were being toasted, one was unraveling.
Advisers on Caterpillar Inc’s $677 million purchase of ERA Mining Machinery Ltd picked up an award for cross-border deal of the year. The purchase was billed as a coup for Caterpillar, the world’s top maker of tractors and excavators. ERA was the holding company for Zhengzhou Siwei Mechanical & Electrical Equipment Manufacturing Co Ltd, one of China’s biggest makers of hydraulic coal-mine roof supports. Siwei would help Caterpillar gain traction in the world’s largest coal industry.
“Siwei was going to be our Chinese business card,” said a person with direct knowledge of Caterpillar’s strategy.
The night of the awards on Nov. 16 three Caterpillar lawyers were wrapping up an eight-hour grilling of Wang Fu, Siwei’s chairman. Major accounting problems had been unearthed at Siwei headquarters in the gritty Chinese city of Zhengzhou. Two months later, on Jan. 18, 2013, Caterpillar said it had discovered “deliberate, multi-year, coordinated accounting misconduct” at Siwei.
Wang was sacked. Caterpillar took a non-cash goodwill impairment charge of $580 million - 86 percent of the value of the deal. The company says it was caught unaware by the problems at Siwei and only discovered them in November 2012, five months after the deal closed.
A Reuters review of hundreds of pages of public documents, as well as interviews with former employees, board members, bankers and advisers, reveals a more complex story. Accounting problems were rampant at Siwei before Caterpillar bought it. Yet at multiple junctures, Caterpillar chose to ignore existing or potential problems and push ahead with the deal.
A year and a half after directors of the Peoria, Illinois-based company signed off on the deal, it has become a case study in how a foreign company with decades of experience in China can still flounder in that market. It also shows how willing some multinationals are to accept risks they might otherwise avoid to establish themselves in the world’s second-largest economy.
The deal has triggered legal action against Caterpillar. In May, Caterpillar announced it had settled a dispute with Siwei’s controlling shareholder, owned by an heir to the Crown Worldwide logistics company fortune and the former head of the American Chamber of Commerce in Beijing. Four shareholder suits filed in the United States in Caterpillar’s home state of Illinois are continuing.
Meanwhile, Siwei has foundered. Former employees told Reuters that as of September, the company had no new orders in 2013, and it had fired or furloughed about half of its workforce.
Siwei’s former CEO, Wang, says his books were a mess but he committed no wrongdoing.
“We were a legend in the industry,” Wang, 52, told Reuters, in his first media interview since the announcement of the write-off. Wang is now pursuing a second act: He has launched a new company with a nearly identical name in the same business. He has yet to build a factory, but says he can take Siwei’s old customers when he does.
Becoming a Chinese Manufacturer
When it bought Siwei, Caterpillar had been doing business in China for more than 30 years. It had amassed 20,000 China employees, dozens of manufacturing, research, logistics and parts centers and a broad dealer network. It had nine new facilities under construction, and had just completed the $8.8 billion purchase of Bucyrus, a mining and earth-moving company with significant China operations.
When former Chinese president Hu Jintao dined with a group of American businessmen in 2011, Caterpillar Chief Executive Doug Oberhelman was included.
But the company was slow to ramp up production of construction machinery in China and lost out on market share as a result, says Anthony Farmer, a former executive at Caterpillar. It didn’t want to make the same mistake in coal mining equipment.
China’s coal industry is the largest in the world, but it also insular. Local companies, particularly state-owned enterprises, prefer locally made products, said Farmer, now at construction and mining consultancy Millton Group.
Siwei was attractive. It once was state-owned, but no longer. That, and the fact that it was listed in Hong Kong - under the name of ERA - made it much easier for a foreign company to buy.
Moreover, the roof supports it made - spatula-like hydraulic arms that keep underground coal mines from collapsing - were lucrative, since 80 percent of China’s mines are underground.
Siwei retained close ties to the government. In 2012 alone, it was visited twice by the Communist Party leader of Zhengzhou.
Adding to the appeal, Siwei also had three high-profile investors with American ties.
Li Rubo, an American-trained mining engineer and an early Siwei investor, had arranged mining deals in Russia and Mongolia - sensitive undertakings that would have required political connections.
Emory Williams, an American business associate of Li, was a major shareholder and chairman of Siwei’s parent. He had invested in a Beijing concrete business back in the mid-1990s. The son of a former senior Sears executive, Williams had also served as chairman of the American Chamber of Commerce in Beijing. And along with Li, he had founded another Chinese mining company recently sold to another American mining equipment maker.
The third investor was Jimmy Thompson. He was Li Rubo’s son-in-law - and the son of billionaire Jim Thompson, who founded Crown Worldwide, the transport, relocation and storage giant.
Li and Williams were part of the reason Caterpillar felt comfortable with the acquisition, several people with direct knowledge of the situation said.
“They provided loans, they helped finance the company,” one of those people said.
Beyond that, their influence was limited. “The show was run out of Zhengzhou on a day-to-day basis. Unfortunately, they [Li and Williams] were further away from the business than I had expected,” that person said. “Our reliance on them was the blind leading the blind.”
Li, Thompson and Williams declined to comment for this story.
Steve Wunning, the Peoria-based president of Caterpillar’s mining equipment division, Resource Industries, and then-Chief Financial Officer, Ed Rapp, pitched the idea of buying Siwei to the company’s board of directors in October 2011. It was codenamed “Project Sequoia.” The board expressed support for the strategy, according to court documents filed in the United States.
The first sign of trouble surfaced quickly. On Nov. 7, 2011, the board received a two-page memo explaining that Siwei would need an immediate $50 million loan for working capital. Excerpts of the memo were contained in the court documents.
The memo explained that Siwei’s customers weren’t paying what they owed. It also noted Siwei hadn’t made overtime payments to its workers and didn’t hold operating permits required by Chinese regulations. Fixing these and other issues, the memo said, would cost CAT as much as $30 million.
The board was unfazed. That same day, the directors voted for the acquisition, authorizing the purchase of Siwei for up to $964 million. It would be the biggest foreign machinery acquisition in Hong Kong or China since the country opened up for business in 1978. The board also authorised the loan for working capital.
Four months later, in March 2012, the board received another memo signaling trouble at Siwei, court documents showed. The company had missed its 2011 financial targets, and its parent company, ERA, was going to report a $2 million loss rather than a $16 million profit. Wunning also told the board that Siwei’s average receivables had grown to an extraordinary 371 days, according to filings in connection to the court case.
Corporate filings show the amount owed to Siwei by customers had risen 58 percent per year since 2008, overtaking total sales in 2011. Some 90 percent of those debts were overdue when Caterpillar launched its bid.
Mining equipment companies typically finance at least part of their customers’ purchases. However, once accounts are more than 90 days old, they are almost always disqualified from being counted as collateral for loans. At six months, they are widely recognized as needing to be turned over to a collection agency, or they are written off or reserved in full, according to one of the four shareholder suits filed in the United States. The complaint says the receivables issue rendered Siwei’s revenues and assets “highly suspicious and most likely wholly illusory.”
Unsold goods were also a problem for Siwei. At the end of 2010, the average number of days Siwei’s products sat in storage was 414, double what it was during China’s economic slowdown in 2009.
No ‘Red Flags’
Caterpillar spokesman Jim Dugan said the company would not comment directly on matters of “pending litigation.”
But he said Siwei’s accounting problems were unrelated to the profit warning and other issues the company found during its due diligence of the acquisition.
“The Siwei accounting issues that led to the goodwill impairment charge involved Siwei’s falsification of its books,” Dugan said in an email. “Therefore, Siwei’s profit warning and failure to meet its 2011 targets, the $50 million working capital loan to Siwei, and other issues that came up in the course of Caterpillar’s diligence were not ‘red flags’ as to the accounting fraud.”
The news release announcing Caterpillar’s tender offer went out on June 6, 2012.
Documents produced for one of the Illinois court cases show that Caterpillar’s board of directors did not ask for the results of the due diligence investigation, which ran from about September 2011 until June 2012. The board also did not look into whether Siwei’s financial problems had been resolved. And it did not adjust the offer price, the documents indicate.
Siwei had been focused almost entirely on gaining market share. Getting customers to actually pay their bills came to seem like an afterthought, former executives told Reuters.
“They would take orders without down payments, so they had to finance the whole thing,” said a person with direct involvement with Siwei. The point “was to try to get market share.” This person added: “These were all things we felt we could fix once we were on board.”
Caterpillar was so bullish on China, it may have been willing to overlook some of Siwei’s problems, former insiders say.
“There was also a lot of euphoria. We were really going to dominate. Not only in mining but also in China,” the person said, and old China hands Williams, Li and Thompson would help. “Obviously it was too much, and we got burned.”
Legand in the Industry
At first, Wang Fu was equally exuberant about the deal. Siwei’s former CEO is a native of the northeastern Chinese province of Liaoning with nearly 30 years experience in the machinery industry. His first job out of college in 1984 was with the state-owned company from which Siwei would eventually be spun out in 2003.
In Siwei’s first year of operation after the spinoff, sales were less than 20 million yuan. Growth came quickly amid China’s insatiable hunger for coal. By 2011, revenue approached 2 billion yuan ($500 million).
On June 8, 2012, two days after the acquisition was completed, Caterpillar executives addressed Siwei’s first post-merger board meeting in Zhengzhou. They pledged to preserve Siwei’s culture and way of doing business.
Wang says he was inspired. Siwei would retain independence, but be able to draw upon the experience and expertise of its new Fortune 500 parent.
The excitement faded quickly. Accounts of what went wrong, why and how, now diverge completely in Peoria and Zhengzhou.
In the interview, Wang said he knew Siwei’s accounting methodology was bad, and its finance team too inexperienced to make improvements. He said as CEO, his primary concern had been chasing market share. “Better to have market share than to solve every single problem and lose the market.” But his finance team, he said, couldn’t keep up as the firm grew and orders poured in.
Wang said he was proactive about the accounting problems. He raised it two or three times at Siwei board meetings, he said, hoping Caterpillar’s more experienced finance team could help. He said the board gave him half a year to resolve the issue.
Caterpillar denies that. Spokesman Dugan said Wang never brought the issue up and said Siwei’s accounting problems - including the existence of a second set of books - were only discovered in November 2012, after Caterpillar found inventory discrepancies.
Wang says there was no second set of accounting books.
The Game is Up
Wang said he mobilized employees in finance, sales, manufacturing and technology to dig into the accounting issues following the acquisition. At the time, Wang said, nobody knew exactly how bad things were.
By October 2012, Wang found that costs were sometimes allocated to incorrect projects. Other times, the company had simply not capitalized costs, or had accounted for them improperly on Siwei’s balance sheet. Siwei had also double-booked some sales, which led to inventory discrepancies.
At the same time, however, by Wang’s estimates, the company’s income had been underreported by about 170 million yuan because it had under-valued equipment made in-house.
Caterpillar spokesman Dugan said this account was not accurate, but did not respond to specific questions about whether Caterpillar had written off too much. Requests to interview Caterpillar Chairman and CEO Oberhelman were declined.
In the months to follow, Wang’s relationship with Caterpillar soured. Every decision, it seemed to Wang, had to go through Caterpillar’s lawyers, and Wang said he rarely interacted with senior Caterpillar executives.
At the end of Wang’s marathon grilling by Caterpillar attorneys on Nov. 16, the day of the awards ceremony in Hong Kong, the attorneys concluded there had been mismanagement but no fraud, Wang said.
Two months later, Wang says he was told to drop by Caterpillar’s China headquarters in Beijing at the tail end of a business trip. Company lawyers fired him, he says, and refused to answer his questions.
The written notice said: “Your misconduct and serious dereliction of duty have caused severe damage to the company. You have also seriously violated company rules.”
Since Caterpillar bought Siwei, it has had no new orders for hydraulic roof supports, two former employees with knowledge of customer accounts said.
The number of working employees fell to about 1,900 in September from about 4,300 at the start of the year, one former office employee said. Four other former employees corroborated the scope of the cuts.
Wang feels Caterpillar never had a “comprehensive understanding” of Siwei’s financial situation and believes he was the scapegoat.
“It looks like it is precisely to justify and cover up a dereliction of duty by their so-called elite teams that an easily discovered management issue is labeled as deliberate, intentional fraud,” he said.
Caterpillar stands by its allegation of fraud. And it is trying to open a new era at the company it acquired.
On Nov. 8 it announced the company name had been changed to Caterpillar (Zhengzhou) Ltd. The Siwei brand, it said, would be phased out. (Reuters)