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Caterpillar (CAT) CEO Douglas Oberhelman believes that the worst is behind Caterpillar concerning its China strategy. Even though Caterpillar has been selling in China since 1978, the company has poorly timed its strategy. During this time, the company has only been able to build a 7 percent market share, behind Chinese company Sany Heavy Equipment (OTC:SNYYF) and Japanese competitor Komatsu (OTCQB:KMTUY). China sales for Caterpillar account for only 3 percent of global sales, an increase of only .5 percent since 2007.

Poor Timing

CEO Douglas Oberhelman said in 2010 that Caterpillar would play offense in the growing Chinese market. This statement came at the end of an aggressive investment push by China in infrastructure and real estate. In 2009 and 2010, China introduced a 4 trillion yuan stimulus program to help the country get through the global financial crisis. By 2011, the country began to throttle back over worries that the property market was overheating. Property prices started to drop and the demand for commodities cooled. When CEO Oberhelman went on offense, he should have been playing defense.

When the Chinese construction market was booming in 2009 and 2010, Caterpillar was hampered by production capacity. Once Caterpillar was able to expand capacity, the Chinese market had cooled and the company was left with unsold inventory on company lots. Caterpillar actually had to export 2,300 excavators out of China!

Caterpillar also sought to maintain its premium status and maintain pricing power in the Chinese market. Its competitors, however, engaged in aggressive price discounting. Caterpillar discovered that brand loyalty in China is ephemeral and price matters more.

$580 Million Acquisition Charge

The company's problems in China were further amplified due to the acquisition of ERA Holdings. ERA Holdings was a defunct video-distribution company that did a reverse merger with Siwei, which manufactured roof supports for mines. In November 2011, Caterpillar agreed to pay up to $886 million for the renamed ERA Mining Machinery. Before the deal even closed, ERA issued 2 profit warnings starting in March 2012.

Further adding to the warning signs were a slew of unpaid bills at Siwei. The company was running low on cash and posted a net loss of $2 million in 2011. Caterpillar thought it could make things better after the acquisition closed. Unfortunately for Caterpillar, things got worse after the acquisition closed. Caterpillar discovered that the physical inventory didn't match the stated inventory on the books. It happens all the time in China, but to have a global icon like Caterpillar miss such a blatant fraud was embarrassing.

Where the story got even stranger is that the main force behind ERA Mining is Emory Williams, an American expat based in Beijing. The ERA acquisition has become a PR nightmare for Caterpillar in China with the Chinese newspapers stating that it's a case of "Americans cheating Americans."

CEO Douglas Oberhelman Responds

In Peoria, Caterpillar CEO Douglas Oberhelman issued his mea culpa. "I recognize the decision to acquire Siwei happened on my watch, and the buck stops at my desk," said Oberhelman. Oberhelman further responded to the company's efforts in China with:

"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."

What Caterpillar Needs To Do

In order to succeed in China, Caterpillar needs to put more senior managers from Peoria on the ground in China. And I'm not talking about visiting, but living and working in China. Peoria is over 6,600 miles from Beijing and it's one thing to visit and read reports on China, but living and working there will give senior managers a better understanding of what it takes to succeed in China. If CEO Oberhelman really wants to play offense going forward, I recommend that he live and work in China.

Second, Caterpillar needs to go back to its original direct sales model. The company is now selling machines via dealers, the same as in the West. This strategy isn't working as well with customers as they favored when Caterpillar would come directly to the customer. Going back to the direct sales model would go a long way with boosting customer relationships.

What Caterpillar Has Done Right

Caterpillar is focused on China and wants to get it right. Even though Caterpillar was forced to take a $580 million writedown on ERA Mining Machinery, Siwei provides inroads to new customers. The writedown is relatively small considering that Caterpillar did $65.88 billion in sales last year.

Second, Caterpillar has made substantial investments into China. The company has 31 existing manufacturing, R&D, logistics facilities in China. There are 4 new facilities under construction.

Outlook For China

Lately there has been positive data out of China, the most important of which is that inflation isn't that bad. Food prices didn't increase as much as many had feared. As long as this trend continues, Beijing will continue to pump money into the economy and refrain from tightening.

Last week we heard from Alcoa (AA) and Ford (F) that said demand out of China was strong. There's strong demand for new cars, trucks and aluminum. That's a very bullish sign for Caterpillar if China's economy is strengthening as the company is better positioned now.

Overall in China, there is a migration from rural areas to cities. This will boost demand for the nation's construction and power sectors. In China only 50% of its population lives in cities compared to 82% in the U.S. Furthermore, China's energy consumption is still low on a per-capita basis. People in China consume around 3.5 MWh of electricity compared to 12.5 MWh in the U.S.

Outlook For The Stock

I'm bullish on the stock long-term, but right now the stock is weak. How the stock performs for the rest of the year will depend on how the global economy fares. But in analyzing the stock, it is very attractive. The company trades with a forward P/E of 9.22 and the PEG ratio is lower than 1 at 0.75. Operating margins are a solid 13.21%. Caterpillar pays an annual dividend of $2.08 per share for a yield of 2.50%. The payout ratio is only 29%, so the company can easily increase the dividend, pay down debt, or buy back stock if the stock continues to weaken this year.

Source: Caterpillar Needs To Better Execute Its China Game Plan