CHICAGO (Aug. 24, 2016) — Few would dispute that Caterpillar Inc. paid too much for Bucyrus International, the mining equipment manufacturer it acquired in 2011 for $7.4 billion at the height of the commodity price boom.
The price for Cat's biggest acquisition ever was 32 percent more than Bucyrus' stock market value. At the time, Caterpillar CEO Doug Oberhelman could justify such a generous premium by pointing to strong demand from mining companies digging as fast as they could to supply coal, copper and other resources to China and other red-hot emerging markets.
But the cycle soon turned, as commodity markets are wont to do. Developing economies cooled down, depressing commodity prices and demand for mining gear.
Since 2012, Cat's annual mining sales have dropped by two-thirds to $7.6 billion. The Peoria-based company's “resource industries” business unit lost $88 million last year, compared with a $4.3 billion profit in 2012. All Cat's businesses have struggled, but mining accounted for the vast majority of a 29 percent drop in companywide sales over the past three years.
Cat's recent actions and statements reflect a somber outlook for the business it acquired at such a rich price. Plants are closing and jobs disappearing in the resource industries unit. Last week, Cat announced a review of “strategic alternatives” for a business line that makes equipment for underground mines — an indication that business will likely be sold or shut down if a buyer can't be found.
After reporting another 29-percent drop in resource industry sales for the second quarter, Cat squelched any hope for a quick rebound by warning that it sees “no clear signs of recovery” in demand for mining equipment. Monthly sales of mining equipment by Cat dealers plunged 42 percent in July, Cat reported last week.
For the most part, expectations have adjusted to the glum future facing Cat's mining business. So why does its balance sheet still look like 2011?
Cat carries as an asset some $3.6 billion in goodwill related to Bucyrus. Goodwill is an accounting construct reflecting the difference between the value of an acquired company's assets and the total acquisition price. In the Bucyrus deal, goodwill was enlarged by the big buyout premium. That premium, in turn, reflected an optimism that has long since dissipated.
‘Day of reckoning'
A company is supposed to write down goodwill when it becomes clear that the future prospects of an acquired business no longer justify the current valuation. That sure seems to be the case for Cat's Bucyrus acquisition. People have been questioning the Bucyrus goodwill for a while. They include regulators at the Securities and Exchange Commission (SEC), which launched an investigation two years ago. Cat has called its accounting for Bucyrus “appropriate.”
In its second-quarter SEC report, Cat said it reassessed goodwill in 2016 and 2015 and determined that the fair value of its mining business exceeds its carrying value, “based on our estimates for long-term growth, profits and cash flows.”
There are no strict guidelines on when a company should write down goodwill, leaving management with plenty of leeway to conclude that current carrying values are realistic. Caterpillar, for example, could justify its stance by pointing to the cyclical nature of commodity prices, which inevitably rise after falling.
“If there is going to be a day of reckoning, they can put it off until they can no longer say with a straight face that commodity prices will come back up,” said professor Erik Gordon of the University of Michigan's Ross School of Business.
And when commodity prices finally rise again, demand for mining equipment almost certainly will follow. On a conference call with analysts last month, Mike DeWalt, vice president of finance services for Caterpillar, pointed to an uptick aftermarket sales as a good sign, adding, “so it'd be nice if it would improve a lot quicker and hopefully somewhere down the road, it will.”
Hope is fine. But it's no basis to believe demand will return any time soon to the levels that inspired Mr. Oberhelman to pay so much for Bucyrus. Caterpillar's balance sheet — which investors rely on as an accurate representation of the company's value — should reflect realistic expectations for the timing and extent of an eventual recovery in mining equipment sales.
There are many reasons why Cat might resist writing down Bucyrus goodwill. Lopping off a significant amount of goodwill weakens a company's financial profile, which might hurt Cat's credit rating and drive up borrowing costs. On the other hand, maybe Cat is waiting for the SEC to finish its investigation, so it can take a single write-off in line with the agency's conclusions.
And then there's denial. Prominent executives pulling in eight-figure pay packages based on their supposedly unparalleled strategic acumen don't like to admit they wasted gobs of shareholders' money by overpaying for an acquisition.
But that's what Mr. Oberhelman did.
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Joe Cahill wrote this analysis for Crain's Chicago Business magazine, a sister publication of Tire Business.