Chinese CAT

The financial and reputational costs of diversification can be too high.

Half of the global demand for construction equipment now comes from China, so it might not be that surprising that Caterpillar, the world’s largest manufacturer of construction and mining equipment, with a market capitalisation of $63bn, should want to play there too. The most recent attempt to raise its profile in this challenging market was the acquisition of Zhengzhou Siwei, which sells mine safety equipment, by paying $700m in June, for Siwei’s parent company, ERA Mining Machinery Limited. Sadly, this seems to have come unstuck very quickly, with Caterpillar announcing a write down of some $580m on ERA, blaming “coordinated accounting misconduct designed to overstate profits” before the deal.

I have written quite recently about the high risk of diversification driven acquisitions; when CEO’s are cornered they seem to me to grasp at much riskier deals than they would normally consider (CLICK HERE for more on that) but perhaps I am being too critical and maybe we need to see it as little more than a market entry tax: with diversification comes both reputational and financial costs that most just can’t avoid; but are they really worth paying? The further you step out of your comfort zone, and China isn’t a very comfortable place to trade for anyone except the Chinese, the more you just have to accept you are going to make some pretty big mistakes, in the hope that you will gradually climb the “doing business in China” learning curve.

The problem for a company like Caterpillar is that in China you need to be pretty well connected with politicians, in their many guises, and you have a lot of low cost competition to contend with that seems to be operating on different rules. As Caterpillar have now found out, they even seem to account for things differently! If you take an imperial attitude to your trading strategy and hope to reproduce what you do elsewhere, because it is self evidently the right way to do business, then you are likely to fail. Maybe customers just don’t want to pay high prices for superior kit, as they have their eyes on other benefits: it seems to me to be a market where “good enough” is ok.

The management of a global US powerhouse like Caterpillar seem to see it as their duty to dominate the bits of the globe it hasn’t yet colonised. They seem to think that if they can’t “win” in China they won’t be global leaders anymore and that seems to be more important to them than making sensible and low risk investments. So what if it loses its global crown? Is the Chinese contribution to global market share really worth it? Some fights may not be worth fighting. There appears to be an argument that says if you don’t engage in a fight for market share in China local firms will prosper and eventually compete with you outside of China. With 23 factories in China Caterpillar’s market share is today about 3%, little changed since 2007, and it is arguable still too removed from end clients, and still too foreign, to make much headway.

If I were steering Caterpillar’s strategic development I’d severally limit my Chinese ambitions and protect and service my other more mature and less risky markets, so that I could be confident of delivering investors a steady stream of dividends for years to come, rather than occasional shocks, from yet another attempt at penetrating this inscrutable market, at least for now: things may be different in a decade or so, when this market is more addressable. Is it ego, or good business judgement, driving all this? Surely, a market capitalisation of $63bn should be big enough for anyone?

Mark

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