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Can Caterpillar Engineer a Turnaround in China?

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Hurt by acquisition-linked accounting woes, the company nonetheless still sees plenty of growth potential in China.

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To say that the past year was a troubled one for Caterpillar's (NYSE:CAT) China operations might be an understatement. Thanks to a lull in construction, sales of hydraulic excavators, an important product category for the company, fell 30% year-over-year in 2012, while rivals like China's Sany Heavy (PINK:SNYYF) and Japan's Komatsu (PINK:KMTUY)have gained market share by outcompeting Caterpillar on price.

Worst of all, in January, Caterpillar had to make an embarrassing goodwill impairment charge of $580 million because of account misconducts at ERA Mining (HKG:8043), a Chinese firm the industrial giant had paid $700 million to acquire in June. A key Caterpillar executive left the firm due to this accounting scandal.

Caterpillar's China operations today account for a disappointing 3% of the company's global revenues, which is barely higher than the 2.5% share in 2007.

A series of bad decisions cost Caterpillar dearly. The failed acquisition of ERA Mining contributed, of course. Also, the company failed to move fast during stimulus-fueled Chinese construction boom of 2009 and 2010 and found itself constrained by production capacity. Then, the company increased capacity just when the Chinese real estate market started to slow in 2011, which resulted in a supply glut.

Caterpillar has also been hurt by its high prices. "Caterpillar tried very hard to maintain its traditional virtues of trying to maintain premium products and premium customers," David Phillips, head of consultancy Off-Highway Research, told the Financial Times. "I don't think that is a mistake, but it has certainly held them back a little bit."

To ensure that the company employs the right strategy for China, Businessweek pointed out that it is important for Caterpillar to place key executives in the region, so they can have a better understanding of how things work at the ground level. The CEO of Schneider Electric (PINK:SBGSF), for example, is based in Hong Kong even though the company is still headquartered in France.

Having high-level executives in China would enable Caterpillar to develop the kind of guan xi – a term used to described the close relations developed between individuals and companies that smoothen business relations in China – needed to succeed in China.

Caterpillar has also realized that it is important to groom local leaders as they would be able to better navigate the often byzantine Chinese regulatory environment.

"Out of all our facilities in China, two-thirds are led by local Chinese leaders," Edward J. Rapp, Caterpillar's group president, said, adding that his firm aims to groom local leaders in all of its Chinese facilities by 2015.

Despite his firm's mistakes, Caterpillar CEO Douglas Oberhelman is confident that the company will find its footing in China. He said that China's economic slowdown will actually be beneficial to Caterpillar.

"The reason we haven't made greater inroads [in China] is because the level of growth has been so fast that no company can keep up. In the past few years with the slowdown we have done a lot better, our market share is up," he told CNBC. "As the economy goes from double digit growth to 7, 8, or 9 percent, we are very happy to see that because it helps with consolidation and the construction industry here is starting to look a lot like others around the world."

Oberhelman also see plenty of growth opportunities in the mainland because of continued urbanization, which will see a need for greater investment in homes, commercial buildings, and related infrastructure. About half of China's 1.3 billion population reside in cities currently, compared with 80% in the UK and 82% in the US.

China's per-capita energy consumption is still far lower than that of developed countries, which presents an opening for greater sales of Caterpillar's power equipment and mining machinery. An average person in China consumes some 3.5MWh of electricity each year, compared to 12.5MWh in the US.

Currently, Caterpillar has 31 existing manufacturing, R&D, and logistics facilities in China, with four new ones under construction. In 2012, the company's global revenues totaled $65.88 billion, a 10% increase from 2011.

Twitter: @sterlingwong
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No positions in stocks mentioned.
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