Suspicious Minds: Caterpillar’s Chinese Disaster Has Us Wondering, What Else?
Geez, you wonder in an idle moment, is Cosgrove, our Midwest sales rep, padding his expense reports? He seems to take a lot of cabs. His meals on the road are pricey. And what the hell is “sundries,” a category he uses to account for odd amounts?
Your suspicions are probably overwrought, based on weak information – and then he puts in for a national client dinner that Jeffries, your East Coast man, also claimed as an expense. All of a sudden, those earlier, ticky-tack items seem worth looking into.
It isn’t too much of a stretch to say that Caterpillar (CAT) has similarly invited harsher scrutiny since announcing January 18, a Friday before a long weekend, that it was taking a $580 million write-off thanks to some smelly accounting at a Chinese company it purchased just last June. Caterpillar called what it found “deliberate, multi-year, coordinated accounting misconduct,” and Caterpillar CEO Doug Oberhelman, sounding a little wounded by the alleged subterfuge, called it “offensive and completely unacceptable.”
When the market opened after the weekend, investors briefly punished Caterpillar and then moved on, as seen in a stock chart.
The offending acquisition was ERA Mining Machinery Limited, a Hong Kong-listed company Caterpillar paid about $700 million for. According to Cat, during a physical inventory count last November, it found some discrepancies between recorded inventory and actual inventory at a subsidiary of ERA, Siwei. Shocking. But as Reuters reported less than a week after the write-off was announced, Cat had missed – or chose to disregard -- some red flags, like the fact that some of ERA’s directors had lent the company money and that receivables at an ERA unit exceeded annual revenues in 2011.
“Corporate filings show that the amount of money Siwei was owed by its customers had grown 58 percent a year since 2008, overtaking total sales in 2011, and that some 90 percent of those debts were overdue when Caterpillar launched its bid.”
“John Hempton, a prominent hedge fund manager with Sydney-based Bronte Capital, said 20 minutes research into ERA was enough to convince him to short Caterpillar's shares after he heard it was buying the Chinese company.”
“Hempton found what he considered a problem with ERA's receivables -- it often took 180 days to collect payment, twice the industry average. "This was something that should have been spotted in only a few minutes," he said.”
So, Like Cosgrove, out fictional salesman, Cat’s acquisition misadventure invites us to wonder, what else is the company up to that we should worry about? Research firm GMI Ratings is in the business of worrying about things most of us consider inconsequential, and then GMI totes up all its little worries – it must be stressful work – and assigns risk rankings to companies. In November, when Cat was discovering the inventory discrepancy, GMI was including Cat on its “Black Swan Risk List,” 40 companies GMI deemed most likely to experience a price drop of 50% or more in the next six months.
Now, GMI isn’t – nor is YCharts – suggesting Cat shares are about to plunge due to some shady, or fast-steeping behavior. But over some years, GMI has decided that certain corporate behaviors – taken together – add measurably to risk.
GMI, which issues risk ratings for more than 18,000 companies, currently rates Caterpillar “Very Aggressive” in terms of Accounting & Governance Risk (which it shortens to AGR). It issued its most recent AGR score for Caterpillar last December and gave the company a 6% grade -- as in, worse than 94% of companies. Some of what GMI doesn’t like seems stickler-ish. GMI knocks Caterpillar for having the same person, Oberhelman, serve as chairman and chief executive. While GMI has found that companies that separate those jobs have generally higher returns, having one person in both roles is common.
GMI found fault with Cat’s board of directors in a blog post last August:
"The board of Caterpillar Inc. is not only large, with 16 current members, but also well paid. Non-employee directors earned between $266,089 and $313,218 in total compensation for service on the company’s board last year. Of 16 board members just one is female, seven have served for at least a decade, and there are certain relationships on the board that skirt the SEC rules for independence, but signal camaraderie among board members. For instance, two directors serve together on the board of Abbott Laboratories and two more serve together on the board of The Boeing Company. In fact, Caterpillar’s board is a virtual who’s who of blue-chip directors."
GMI is also critical of Cat’s pension accounting, saying it assumes a higher return rate on pension investments than 80% of its industry peers. As of December 2011, Cat was assuming an 8.5% rate of return on plan assets. Lydall (LDL) lowered its expected long-term rate of return on plan assets to 7.75% for 2012, from a prior 8%. Joy Global (JOY) said, “Due to mid-year curtailment measurements, the 2012 weighted average expected return on plan assets ranged from 6.75% – 7.00% for the U.S. Pension Plans.” GMI notes that Cats pension plans are underfunded, by $6.3 billion as of December 2011, up from $3.8 billion at the end of 2009, a natural consequence of crummy market returns by also one that could require making big contributions to the plans to catch up.
GMI also scolds Cat on accumulation of goodwill. Intangible assets were $4.4 billion at the end of 2011, up from $465 million in 2009. That’s what happens when companies make acquisitions – unless they’re paying liquidation value for hard assets – but GMI’s concern here is that sometimes acquisitions don’t work out and companies have to write off goodwill. In 2011, Cat paid $8.8 billion for mining company Bucyrus, and that included $4.6 billion in goodwill.
The GMI litany goes on. Cat’s debt-to-equity ratio is high compared to that of some peers.
Enough. Cat has a fabulous market position around the world. Digging up raw materials to feed the world’s growing economy requires machines that Cat makes expertly. It recently had more than $5 billion of cash sitting around. It pays a rising dividend that of late consumes less than 20% of earnings. And if you believe the global economy is going to resume more rapid growth, Cat stock looks cheap, with a PE ratio of less than 12. GMI’s criteria don’t mean anything bad is about to happen at Cat. But, given the knuckleheaded Chinese acquisition, we’d be remiss not to wonder what else might go wrong at the big equipment maker.
Emily Lambert, a contributing editor at YCharts, is a former staff writer at Forbes. She can be reached at email@example.com.
Filed under: Company Analysis