Caterpillar Punked By Chinese Fraud, To Write Off Half Of Q4 Earnings

Fraudulent Chinese corporations are nothing new - we have been warning about them since late 2010, spurring the creation of a cottage industry focused exclusively on unmasking such public reverse merger companies (and generating trading profits along the way). One company, however, which apparently was completely unaware of the now pervasive and proven for the past two years Chinese corporate fraud, is US industrial titan Caterpillar. This was made clear when, after hours on Friday night naturally, the company revealed that it had been misled by "deliberate, multi-year, coordinated accounting misconduct" at a subsidiary of a Chinese company it acquired last summer, leading it to write off most of the value of the deal. In the process it would also take a $580 million, or $0.87 cent charge to earnings, which would wipe out more than half its expected earnings of $1.70 for the fourth quarter of 2012. One wonders, however, is there more to this story than just a case of a gentle, naive board duped by fraudulent, evil, cunning "Chinamen" which may have watched one too many episodes of Autonomy does Hewlett Packard?

Reuters has more details on the Fraud:

Caterpillar closed the purchase of ERA Mining Machinery Ltd and its subsidiary Siwei, China's fourth-largest maker of hydraulic roof supports, last June, paying HK$5.06 billion, or $653.4 million. ERA had been publicly traded in Hong Kong, doing business through Siwei, which is known for making equipment to support roofs in mines.


A member of the Caterpillar board during the course of the Siwei deal told Reuters the board was distracted at the time by a larger transaction and paid relatively little attention to the Siwei acquisition.


"It came as a complete surprise to us," the former board member said of the fraud, speaking on condition of anonymity because of the sensitivity of the situation. "It was presented to us as a pretty straightforward transaction. It's a shame. It should have been investigated further."


The source said the driving force behind the deal was Ed Rapp, the former Caterpillar chief financial officer who now serves as a group president with responsibility for China, among other operations. The source said it was Rapp who presented the deal to the board and pushed for its completion.


A Caterpillar spokesman declined to comment on Rapp's role in the deal. Rapp could not be immediately located for comment.


In a statement, Caterpillar said an ongoing investigation launched after the deal closed "determined several Siwei senior managers engaged in deliberate misconduct beginning several years prior to Caterpillar's acquisition of Siwei."


According to a question-and-answer dialog Caterpillar included in its statement, the company found discrepancies in November between the inventory in Siwei's books and its actual physical inventory, triggering the probe.


The company also said it had replaced several senior managers at Siwei, adding that their conduct was "offensive and completely unacceptable."

So the board was "distracted"? Perhaps, the board was perfectly "tracted" and instead what the board did was pay close attention to what Hewlett-Packard did with Autonomy, where the allegations of fraud are still an open-ended case of he said, she said, and immediately saw an opportunity to use a tiny bolt on acquisition in a country which is the source of its entire marginal growth, as a scapegoat on which to pin everything that was going wrong in China, and maybe the world.

Recall from the Q2 CAT earnings release warning profusely about what is going on in China:

In China, we are lowering production levels and have started to export machines to other regions of the world.  However, the construction industry in China is still weak and our dealers are reducing their inventories of new machines, further reducing our shipments.  While our inventory of new machines in China increased, the combination of our finished inventory and dealer machine inventory was about flat with the end of the first quarter of 2012.  We are working to lower finished inventory, but given the weak construction equipment industry in China it will be a gradual reduction throughout 2012.  We are being appropriately cautious—we intend to lower inventory, but are considering our supply chain and are acting in an orderly manner.  In addition, we are trying to balance our actions—the industry in China has been weak over the past year, but can move quickly when it turns around.


As we began 2012, our expectations for sales in China were higher, and we built substantial new machine inventory in the first quarter to support what is usually a seasonally strong quarter.  First-quarter sales were lower than expected, and we ended the first quarter with higher inventory in China.  We developed and are executing a plan for an orderly reduction of China inventory that includes lower production, merchandising programs to improve sales and the export of machines from China to other parts of the world.


We remain very positive on long-term industry growth in China and our strategy to grow our business there.  Our plans for the remainder of 2012 reflect an orderly ramp down of production that considers our entire supply chain in China.  Given the current low rate of sales and the production ramp down, it will likely take the rest of 2012 to reduce inventory to appropriate levels.

Subsequently, in Q3 CAT did all it could to telegraph that things in China may finally be improving, so no need to change anything about how business is conducted there:

From an economic standpoint, we are expecting slightly better world growth in 2013 with modest improvement in the United States, China and most of the developing world, but continuing difficulty in Europe.


"We are taking a pragmatic view of 2013—we're not expecting rapid growth, and we're not predicting a global recession.  At this point, we expect 2013 sales will be similar overall to 2012, but with a slightly weaker first half and a slightly better second half.  While machine deliveries to end users have continued to hold up, our sales will probably remain relatively weak early in 2013 as dealers are likely to continue reducing inventories.  When expected dealer inventory reductions level off, and easing actions by central banks and governments around the world begin to improve economic growth, we expect our business will begin to improve.  While there's reason for optimism, and we're not expecting a global recession in 2013, we are prepared and stand ready to take action no matter what happens to the global economy," Oberhelman added.

Betting one's business model on the "easing actions by central bankers" - brilliant. But let's leave that for another day (yet one does wonder: was one of the "actions" the board was "prepared to take" in case of global recession, the release of news of massive fraud at a small Chinese subsidiary, thereby being excused for missing earnings by half?)

Reuters said as much:

The Siwei deal came as part of Caterpillar's larger ambitions in China. In early 2012, it added Jon Huntsman, the former U.S. ambassador to China, to its board of directors.


The company, which already has 23 manufacturing facilities in China and four more under construction, said the Siwei episode would not change its strategy in the country.

Of course it won't change the strategy: in fact, CAT will welcome the acquisition of futher such EPS-charge off enabling microcaps. After all, all it takes for the company to pull a get out of jail card by missing EPS by half in any given quarter, is for it to blame lax accounting and someone else's fraud for the problem.

Because who is to say what is really going on? Naturally, nobody will trust the Chinese side of the story now. As for CAT: well, let's say operating earnings were so horrible that not even all the GAAP accounting magic in the world could make the company beat earnings estimates. So what does the company do? It takes a "charge" which allows it to mask a whopping one-eighth of its entire full year EPS miss courtesy of a perfectly convenient scapegoat. As for what is really going on behind the scenes - it could be due to Chinese business imploding, or global economic conditions getting so bad the firm just can't find a way to offset the losses, or anything else. Alas, we will never know as the official spian has been released.

But in the meantime, business in China continues as usual of course, now that CAT has reset losses with enough of a buffer to last it one more quarter. And if Chinese growth, and by growth we mean the construction of empty cities and hollow malls, does not pick up, well then - some other "manager" will be thrown under the bus for pushing a "distracted" board to purchase yet another Chinese microcap, whose books everyone is shocked, shocked, to learn were cooked end to end.

We look forward to even more high flying companies whose stock price has been pulled artificially higher due to the relentless ramp in ES by prop desk of primary dealers, to come up with comparable excuses for why earnings will miss. Because if it is not some softward glitch's fault, it is some manager, or some auditor, or some accountant, or some M&A advisor, or some regulator.

Whose fault it never, ever is, is the ever declining global cash flow in a world in which the stock market and the economy have now hopelessly and laughably disconnected.