Deere's Management Discusses F2Q13 Results - Earnings Call Transcript

Seeking Alpha

Deere (DE)

F2Q13 Results Earnings Call

May 15, 2013 10:00 a.m. ET

Executives

Tony Huegel - Director of Investor Relations

Susan Karlix - Manager of Investor Communications

Raj Kalathur - Chief Financial Officer

Marie Ziegler - Deputy Financial Officer

Analysts

Jamie Cook - Credit Suisse

Andy Kaplowitz - Barclays

Ann Duignan - JPMorgan

Ashish Gupta - CLSA

Rob Wertheimer - Vertical Research Partners

David Raso - ISI Group

Jerry Revich - Goldman Sachs

Mircea Dobre - Robert W. Baird

Andrew Casey - Wells Fargo Securities

Larry DeMaria - William Blair

Seth Weber - RBC Capital Markets

Ross Gilardi - Bank of America

Presentation

Operator

Good morning, and welcome to Deere’s second quarter earnings conference call. Your lines have been placed on listen-only until the question-and-answer session of today’s conference. I would now like to turn the call over to Mr. Tony Huegel, Director of Investor Relations. Thank you. You may begin.

Tony Huegel

Thank you. Also on the call today are Raj Kalathur, our Chief Financial Officer, Marie Ziegler, Deputy Financial Officer, and Susan Karlix, our Manager of Investor Communications.

Today, we will take a closer look at Deere’s second quarter earnings, then spend some time talking about our markets and the current outlook for the second half of 2013. After that, we will respond to your questions. Please note that slides are available to complement the call this morning. They can be accessed on our website at www.johndeere.com.

First, a reminder. This call is being broadcast live on the internet and recorded for future transmission and use by Deere and Thomson Reuters. Any other use, recording, or transmission of any portion of this copyrighted broadcast without the express written consent of Deere, is strictly prohibited. Participants in the call, including the Q&A session, agree that their likeness and remarks in all media may be stored and used as part of the earnings call.

This call includes forward-looking comments concerning the company’s plans and projections for the future that are subject to important risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially is contained in the company’s most recent Form 8-K and periodic reports filed with the Securities and Exchange Commission.

This call also may include financial measures that are not in conformance with accounting principles generally accepted in the United States of America, or GAAP. Additional information concerning these measures, including reconciliations to comparable GAAP measures, is included in the release and posted on our website at www.johndeere.com/financialreports under Other Financial Information.

Susan?

Susan Karlix

Thank you, Tony. John Deere’s second quarter was a good one. Income and sales both reached new all-time quarterly highs. It also was our 12th consecutive quarter over quarter record.

Ag and turf led the way last quarter, with higher sales and profit, and there was improvement in financial services as well. John Deere is continuing to benefit from positive conditions in the global farm economy, which, as our CEO, Sam Allen, said, is showing impressive strength.

In conjunction with new products and further investments, this has led to more demand for our products and higher results. It was, in summary, a record-breaking quarter, one that put Deere on track for another strong year.

Now let’s take a look at the second quarter in detail, beginning on slide three. Net sales and revenues were up 9% in the quarter to $10.9 billion. Net income attributable to Deere and Company was $1.1 billion, including a charge related to taxes of approximately $56 million, a $0.14 impact to EPS.

As noted, these are the best-ever quarterly results recorded by the company. On slide four, total worldwide equipment operations and net sales were $10.3 billion, up 9% quarter over quarter, including an unfavorable impact from currency translations of about 2 points. Price realization in the quarter was positive by 3 points.

Turning to a review of our individual businesses, let’s start with agriculture and turf on slide five. Sales were up 12% in the quarter on continuing strength in the global ag economy. Operating profit was $1.6 billion, up 13%.

Before we review the industry sales outlook, let’s look at some of the fundamentals affecting the ag business. Slide six outlines U.S. farm cash receipts. Driven by strong crop prices, 2012 forecast cash receipts were at a record $402 billion. Cash receipts for 2013 are expected to remain historically strong and be the second highest on record.

For the year ahead, crop yields are forecasted to be higher than in 2012 and much closer to normal, but prices will be somewhat lower. This reflects recovery from last year’s drought conditions. Livestock receipts are forecasted to be higher.

As a result of these factors, our forecast calls for 2013 cash receipts of about $388 billion. As a reminder, in our modeling current and prior year cash receipts are the primary driver of equipment purchases in the U.S. market. With cash receipts remaining at near record levels in 2013, this bodes well for future farm prospects.

Our economic outlook for the EU 27 is on slide seven. We continue to see offsetting trends for the EU. On the one hand, ag fundamentals remain positive and production is expected to increase slightly. Still strong commodity prices are driving higher farm income. These prices are leveling off at historic highs and pork and milk prices are favorable.

Conversely, farm machinery demand is expected to be lower in 2013 as the financial crisis continues to weigh on farmer sentiment and cold, wet weather in the U.K. threatens the 2013 harvest, following on the heels of the poor harvest of 2012.

On slide eight, you’ll see the economic fundamentals outlined for a few of our other, targeted growth markets. Slide nine illustrates the value of agricultural production, a good proxy for the health of agribusiness in Brazil. With expectations for a strong soybean crop, due to an increase in acres planted, higher yields, and sustained high crop prices, the 2013 value of ag production in Brazil is expected to increase about 5% over the 2012 level.

The history of available financing rates on FINAME-eligible ag products is detailed on slide 10. Current government programs in Brazil are supporting higher amounts of equipment sales. Not only is the 2012-2013 subsidy amount allocated to agriculture higher, but available interest rates are also extremely low. The FINAME financing rate is at 3% until June 30, then 3.5% through the end of December.

Our 2013 ag and turf industry outlooks are summarized on slide 11. We have raised industry sales forecast in the U.S. and Canada every quarter this fiscal year, and are now projecting industry sales to be up about 5% in relation to the healthy level of 2012. We continue to see strength in demand, especially for high horsepower tractors and combines.

The EU 27 industry outlook is down about 5%, no change from our prior forecast. South America is another region for which we have consistently, each quarter, raised the industry outlook. With strong commodity prices, forecasts call for an increase in planted acres and record crop production.

This combination of positive farm fundamentals, plus the supportive financing programs in Brazil discussed earlier, has led us to increase our forecast for the region once again. We now expect industry sales of tractors and combines in South America to be up 15-20% in 2013.

Our 2013 industry outlook in the CIS countries remains at down slightly due to import duties that are reducing demand for Western manufactured combines. In Asia, we are tweaking our outlook downward to be little changed from 2012.

Turning to another product category, we now expect industry retail sales of turf and utility equipment in the U.S. and Canada to be flat to down slightly in 2013, reflecting the cool, wet spring in North America and cautious consumer sentiment. This, too, is a slight reduction from last quarter. Historically, riding lawn equipment sales that are lost in the important selling months of March and April aren’t recovered as the season goes on.

Putting this all together on slide 12, fiscal year 2013 Deere sales of worldwide ag and turf equipment are now forecast to be up about 7%, including about 1 point of negative currency translation. At constant currency, the sales forecast is up about 8%, 2 points higher than our February outlook.

2013 operating margin for the ag and turf division is forecast at about 15%. It is important to remember when modeling ag for the remainder of the year that production was back-end loaded in 2012. This results in some very tough comparisons as we head into the second half of 2013, especially for combines.

Sales comparisons in the back half of the year are not reflective of a slowing market, but of tough comparisons to sales levels a year ago. In 2013, U.S. and Canada combine shipments are returning to a more normal pattern, about 40% in the first half, 60% in the second.

This compares to a 25/75 split in 2012. So, while full year 2013 combine shipments are up year over year, shipments will be lower in the second half compared with the strong levels we saw last year.

Let’s focus now on construction and forestry on slide 13. Net sales were down 6% in the quarter and operating profit was down 42%. The division’s results were affected by lower shipment volumes and higher production costs, including those associated with interim tier four.

Increased SA&G expenses in support of global growth also hurt the quarterly’s results. Looking at the economic indicators on the bottom part of the slide, you’ll note that global insight has slightly improved its outlook for GDP and nonresidential spending since last quarter. Other indicators, however, are flat to down.

Overall economic growth continues at a sluggish pace, awaiting resolution of the fiscal, economic, and trade issues that are undermining business confidence and restraining growth. And, cool, wet weather conditions in the United States and Canada have delayed spring construction projects, which have further slowed demand for equipment. We are also experiencing lower sales to independent rental companies compared with the pre-interim tier four transition purchasing experienced in 2012.

Global forestry markets are expected to be about flat in 2013, as weakness in Europe is being offset by improvement in the United States. Fiscal 2013 net sales in construction forestry are now forecast to be down about 5%. Our previous outlook was up about 3%.

The sales decline is reflected in lower inventory and receivable numbers, which we will discuss shortly, and it has had an impact on mix as we reduce shipments of high margin equipment. C&F full year operating margin is now projected to be about 5%.

Let’s move now to our financial services operation. Slide 15 shows the financial services provision for credit losses as a percentage of the total average owned portfolio at the end of the quarter was 2 basis points. This reflects the excellent quality of our portfolios and recoveries from prior years writeoff.

Our 2013 financial forecast now contemplates a loss provision of about 7 basis points as a percentage of the average owned portfolio. That is a reduction of 9 basis points from what was being forecast last quarter. The 10-year average is about 27 basis points.

Moving to slide 16, worldwide financial services net income attributable to Deere & Company was $125 million in the second quarter, versus $109 million last year. For the full year, net income attributable to Deere and Company is now forecast to be about $550 million.

Slide 17 outlines receivables and inventory. For the company as a whole, receivables and inventories ended the quarter up about $420 million, or equal to approximately 33% of prior 12-month sales compared with almost 36% a year ago. The year over year forecasted increase is in ag and is mainly reflective of higher sales volumes.

C&F is expected to be down about $150 million, driven by slowing demand and a reduction in Canadian consigned inventories. We expect to end 2013 with receivables and inventory up about $175 million. That is a decrease of $325 million from our February forecast.

Our guidance for cost of sales as a percentage of net sales, shown on slide 18, remains at approximately 74% for the full year. Cost of sales ran about 73.3% in the first half, which implies the second half of the year will be about 75%. Factors affecting cost of sales include price realization, production or manufacturing costs, raw material costs, engine emission product costs, absorption, and effects of foreign exchange.

When modeling the full year, keep in mind price realization. We are forecasting about 3 points in 2013. Favorable year over year raw material costs, the impact on cost of sales of new employees. In keeping with our growth plans, Deere hired an additional 5,000 people in 2012, with over 3,000 of them joining us in the last three-quarters of the year.

These additions are critical to support our growth, both domestically and internationally, and will impact cost of sales, R&D, and SA&G in 2013, interim tier 4 product cost absorption due to the lower build in inventory compared to 2012 and an unfavorable mix in product in C&F, as we talked about earlier, as well as some strengthening in small ag compared to 2012.

Looking at R&D expense on slide 19, R&D was up about 7% in the second quarter, compared with the same period last year. This is consistent with our earlier guidance that the increase R&D spending for 2013 would occur in the first half of the year. Our 2013 forecast continues to call for R&D expense to be up about 3% for the full year.

Moving now to slide 20, SA&G expense for the equipment operations was up about 9% in the second quarter. Very much like R&D, the quarter over quarter increases for SA&G were heavily weighted to the first half of the year.

SA&G expense is forecasted to be up about 7% in 2013, no change from our previous guidance. On slide 21, pension and OPEB expense was up about $60 million in the quarter, compared with last year. Second quarter 2012 benefited from lower post-retirement healthcare costs.

Turning to slide 22, the equipment operations tax rate was about 38% in the second quarter, with the rate affected by discrete items, the most significant explained on the slide. The charge of about $56 million impacted EPS by approximately $0.14, and the tax rate by about 3%. For full year 2013, the effective tax rate is forecast to be in the range of 34% to 36%, representing no change from our previous forecast.

On slide 23, you see our equipment operations history of strong cash flow. We continue to forecast cash flow from equipment operations to be about $3.4 billion in 2013.

On slide 24, we outline our 2013 outlook for the third quarter and full year. Our net sales forecast for the third quarter is up about 3% compared with 2012. This includes about 2 points of price realization. The full year forecast now calls for net sales to be up about 5%, with about 1 point of unfavorable exchange. At constant currency, up about 6%, which represents no change from our last forecast. Price realization is expected to be positive by about 3 points. Finally, our full year 2013 net income forecast remains unchanged at about $3.3 billion.

In closing, 2013 is shaping up as another good year. The ag economy in particular remains in sound shape, and Deere is very well-positioned to benefit from that fact. It is true the near term outlook remains guarded due to uncertainties over global financial issues as well as the cold spring weather in North America. But the longer term picture remains extremely bright, and the source of much confidence about the future.

Indeed, Deere’s plans for helping make the world’s growing need for food, shelter, and infrastructure are well on track and moving ahead. In our view, trends of this nature have power and persistence, and we firmly believe they hold great promise for our customers and investors in the years ahead. Tony?

Tony Huegel

Thank you, Susan. Now we’re ready to begin the Q&A portion of the call. The operator will instruct you on the call procedure, but as a reminder, in consideration of others, please limit yourself to one question and one related follow up. If you have additional questions, we ask that you rejoin the queue. Operator?

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Jamie Cook.

Jamie Cook - Credit Suisse

Just some additional color on the lower guide within construction and forestry. Again, I feel like it’s the same question as last quarter. If I look at your U.S. economic indicators, they really haven’t changed that much, and in some instances have gone up, yet you’re lowering your forecast. So can you talk about sort of what’s Deere-specific versus the market? Are you losing market share? And how much of it was weather-related? And just the second question, can you just give a little more color on the mix issues that you cited that are impacting the margins?

Tony Huegel

Really, what’s driving most of it, as you look at the industry overall, as Susan talked about in the opening comments, we’re really just seeing a lag. To your point, the underlying fundamentals continue to be relatively strong, but as you look at some of the general economy, you look at GDP last quarter for example, was slower than expected. Some of the overhang that we’re experiencing from the fiscal policies is weighing, again, on construction. And to your point, whether being cold and wet has delayed some construction projects in the spring, and we think that’s also had some impact. But it’s really not a market share story, per se.

Jamie Cook - Credit Suisse

I guess you’re just not hearing about this as much from some of your peers, so that’s what’s more surprising. And I know I’m only allowed one question, but you had some dealer inventory issues in the latest quarter, which were small. Are they largely resolved now?

Tony Huegel

I think as you look at dealer inventory, and we’ve talked about guiding lower, our guidance for the end of the year is lower for receivables and inventory and down year over year, which again is reflective of sales.

So I would tell you that both last quarter and this quarter most of that inventory reduction is really just reflective of the change and being in line with the change in the overall sales that we’re forecasting, not so much that we have excess inventory that we’re trying to take out, but as the sales forecast comes down so does the necessary inventory.

And I’d also point out, as the demand reduces, you also have some shorter lead times. So dealers don’t need to carry as much inventory, which is part of the reduction that they’re seeing in terms of what they need to have on their lots in terms of meeting the existing demand.

Jamie Cook - Credit Suisse

And then sorry, the last one on the margins, on C&F. Now we’re guiding to 5%. How much of that is mix, or of the 3% pricing, what are you getting in C&F, if any? If you could just give color on that.

Tony Huegel

In terms of pricing, and we’re talking about the 3% on the enterprise, all I can say is that construction and forestry is certainly contributing to that. But as you know we don’t give guidance on individual divisions. But certainly they are contributing. As you look at mix, that’s certainly a part of it, but keep in mind, now with our current outlook, we’re well below mid-cycle in our forecast for construction, and that certainly weighs on margin. And as Susan mentioned, the reduction that we’ve experienced in our outlook is on some of the higher margin product as well. So that’s certainly weighing on margins as well.

Raj Kalathur

Your comment about you’re not hearing this from others, with regard to construction and forestry, now, do compare the commensurate quarter, most recent quarter, for comparable competitors. In terms of our operating return on sales, we are either comparable or better than most. This came up last quarter as well, and I think we were actually in the same position. Our operating return on sales is comparable or better than most of the competitors in the industry, and if you look at the North America, we’re not different from the competitors on the sales as well.

Operator

Our next question comes from Andy Kaplowitz.

Andy Kaplowitz - Barclays

Can you talk about your ag and turf inventory? You actually lowered your forecast for the end of the year despite raising your overall sales guide. Should we read into your inventory change that it’s reflective of your confidence level going into 2014? Because last year you obviously had a big inventory build going into the end of the year. Or is this just a tweak?

Tony Huegel

I would argue it’s just a tweak. As you look at the change for the ag and turf division, it was like $100 million change, which is very minimal. Most of that is really related to final tier 4. Again, as we solidify plans around that transition, you’re going to see some tweaking there, and that’s how I would describe it. Nothing more.

Andy Kaplowitz - Barclays

And it’s fair to say, though, that in the second half of the year that’s when you really decide what the ’14 outlook looks like, and you could change inventory again based on that, correct?

Tony Huegel

Certainly, yeah. As we move into this next quarter, we’ll start to have a better feel of what 2014 is looking like as we begin some of our early order programs. We’ll start to see our tractor order books in some cases will begin to extend into the next year, and so we’ll have some visibility at that point.

Andy Kaplowitz - Barclays

So let me ask you about ag incrementals. I know everybody’s going to ask you about this, but you were pretty clear about saying that mix is going to work against you in the second half. We know that you’ve said that before. But at the same time, you did have an execution issue in Q3 of last year and you have said, over and over again, that SG&A and R&D would be front-end loaded. So why can’t margins be up pretty significantly year over year in Q3, both incremental and year over year? What’s stopping that from happening?

Tony Huegel

Certainly from an incremental perspective, keep in mind that the biggest change incrementally will be on absorption, as you look at production in the first half versus the second half. Last year, and even year over year, you had a heavier build schedule in the back half of the year versus what we did this year. So that’s a big part of the difference.

Raj Kalathur

And in terms of ag and turf incrementals, you’ll also notice, if you think about Q2, there was an increase in the pension and OPEB expense, FX, and R&D. So that contributed. If you add those back, our incrementals would look like you would expect. Now, some of that is also going to carry into the second half.

Operator

Our next question comes from Annual Duignan.

Ann Duignan - JP Morgan

Can we talk about your cash position? You get on the call, you say how wonderful things are, how great the cycle is, and how the fundamentals are wonderful in agriculture, and yet we continue to sit on excess cash. Why are we not being more aggressive buying back shares at this point? Is it the fear that the ag cycle is well above mid-cycle and that things could deteriorate from here? What’s the root cause of the hesitancy at this point?

Marie Ziegler

Absolutely not, in terms of where we are in the ag cycle. I would admit that our balance sheet is a bit defensive right now. We continue to be concerned about the functioning of the market overall. Bear in mind that our capital corporation, which is over $30 billion in receivables, or in assets that must be funded, is a big user of cash. And the rating agencies are very, very riveted on liquidity. So we are ensuring that we remain very liquid in order to support the financial services business.

Raj Kalathur

Our cash use priorities have not changed. So again, with respect to dividends and share repurchases, if you take a long term view, you should not see a change on how we act on it. But what Marie explained, short term, we have some costs, costs in the environment that we are living in, and we are taking appropriate precautions.

Marie Ziegler

And I do note that we did increase our dividend $0.05 a share, which is about an 11% increase per quarter. So we are increasing our return.

Ann Duignan - JP Morgan

That’s a fair point. My follow up question is more on the fundamentals. You know, we’re sitting here kind of at the crossroads of the ’13 to ’14 crop. We either get the corn planted and we get lower prices potentially. Farmers have not hedged as much this year, at least those that I’ve spoken to, which could leave them in a risky position. Or we don’t get the corn planted, and we switch into beans and we’re short a crop again. Can you guys talk a little bit about each of those scenarios and what you think each one might do to the fundamentals in terms of equipment demand? I’m just curious how you take those outcomes and put them into a forecast.

Tony Huegel

At this point, that’s really a challenge in terms of what might happen. Certainly most of the planting in the corn belt, on corn, already would have taken place in a more normal year, by May 5 or so. But certainly if you get good weather, to your point, that can change in terms of what gets planted in a hurry.

We look at our forecast and just as you know it’s about cash receipts being the primary driver. So as you look at what may happen, but not just what production level, or what the price level is, or how much corn or soybeans is produced, it’s going to drive that demand. Certainly for 2013 we’re continuing to see a very strong cash receipts level. I think it’s the second highest on record. So slightly below the 2012 cash receipts, but at very very high levels.

And so that data point would certainly bode well for the future, but also, as you know, as we look at next year, it will be impacted both by the 2013 and 2014 cash receipts. But at this point, it would be highly speculative to try to estimate what 2014 would be.

Marie Ziegler

If you look at the global fundamentals you continue to see rising demand for food and some increase in consumption of meat. You see, in the U.S., very strong farmer balance sheets. Despite what’s been happening with land prices, you haven’t seen a big ramp up in debt loads for farmers. And in fact, the debt-to-cap ratio has actually declined this year. So we’re in a very strong position. And we continue to feel very positive about the outlook and prospects for the global business.

Ann Duignan - JP Morgan

Marie, the cynic in me wants to say, and that would bring me back to my first question. So I’ll leave it there and get back in line and take it offline.

Operator

Our next question comes from Ashish Gupta.

Ashish Gupta - CLSA

Can you give us some more color on the order book?

Tony Huegel

Sure, the order book does remain pretty strong. We talked about combines last time. There’s really no change there in terms of as it relates to the early order program, effectively for the U.S. for all practical purposes sold out. Large tractors continue to progress very well. You look at 8R tractors, for example, availability is further out than a year ago, even on some higher capacity.

So as you look at the track tractor, you’re looking at late September availability. And for the wheeled tractor, you’re into October for availability. And on the 9000, you’re looking at October for the track large tractor, and then August for the wheeled tractor. So again, it remains very, very strong in terms of the order book.

Ashish Gupta - CLSA

One clarification on the tax item. Is it correct to assume that the unchanged tax rate would be inclusive of the item for the full year?

Tony Huegel

Absolutely. In fact, the question we had last quarter even with the lower tax rate in the first quarter, you’ll note that we kept our annual forecast the same. And it’s reflective of what you saw in the second quarter.

Operator

Our next question comes from Rob Wertheimer.

Rob Wertheimer - Vertical Research Partners

Two quick questions. I guess you kind of answered it with the comments on the order board. Does that mean, then, that your cautious comments on the weather and the planting are really applicable to the last quarter of the year? Because Q3 is kind of dialed in. And then as a corollary to that, there’s been some changes in production capacity you mentioned. Can you talk a little bit about production capacity? Typically Q3 has been lower than Q2, and I think that’s on shutdowns in June. Has that changed at all in terms of what you can produce Q3 versus Q2?

Tony Huegel

Certainly as you look year over year. Combines is the largest difference when you compare year over year. We were very back end loaded on combines last year. The first half, second half of shipments was 25% in the first half versus 75% in the back half. A more normal year would be 35-65, and this year we would actually be a little bit more front-end from normal, so about 40-60.

Again, when you’re looking year over year, you’re seeing the back half definitely impacted by that in terms of orders. But again, as you look at the overall year, very strong orders in that regard. It’s more about the timing of our production, much of it driven by interim tier 4. Now as we look forward to final tier 4 you have some disruptions here and there.

Marie Ziegler

As you look ahead, you’ll see, because of the compressed production transition times that we will have with final tier 4, you’re going to see some noise in early next year and late this year as we adjust.

Maybe I could go back to the first part of your question. Given the thought that corn plantings and bean plantings are very significantly delayed from typical averages, we felt it was prudent to put that note of caution in the press release. Certainly they have plenty of time to make it up, and they can if we get some breaks in the weather, which we’ve had in the last couple of days. We have not seen any cancellations at this stage, and you are absolutely correct that very strong order books do portend well.

Rob Wertheimer - Vertical Research Partners

So the caution, therefore, in the press release, is more Deere caution that what you’re hearing from farmers and dealers in terms of getting nervous in?

Marie Ziegler

Correct. Everyone says that given the opportunity to plant, there’s still plenty of time to plant before you hit significant yield erosion.

Operator

Our next question comes from David Raso.

David Raso - ISI Group

The second half of the year growth for ag and turf, can you just help us with blatantly just clarifying the order book or the backlog? What is the backlog for ag right now year over year?

Marie Ziegler

It would be better.

Tony Huegel

Yeah, as you look at the tracker, certainly the order book on 8s and 9s are further out. So you have a stronger order book. But again, some of that is timing of production year over year and that’s really what you’re seeing. And again, overall, on ag, as you go into the back half of the year, we’re lower first half than second half, and that’s why you start to see some of the drag on margins and higher cost of sales as you go into back half of the year.

Marie Ziegler

Year over year, our guidance does imply a modest increase in our sales in the second half.

David Raso - ISI Group

That’s what I’m just trying to square up. Obviously revenues for you globally are notably bigger on big tractors and combines. A global comment. Your order book for large tractors is longer than a year ago, and you’re doing it on higher capacity capabilities at the factory. So tractors, if you get rid of combines, the tractor looks like it should be up a lot more than the 1% total ag and turf revenue for the rest of the year. So combines are obviously down a lot to get the whole division to only up 1.

Tony Huegel

Keep in mind that as you look at total annual production versus the timing, you’ve got final tier 4 coming in, so you’re going to have some disruption there within the factories doing limited production builds, those sorts of things, that do have an impact on individual quarters of availability. As you look also, our inventory build year over year is not as large as it was last year. So that’s also going to have some impact as you look into the back half of the year. So again, those are really what’s primarily driving that difference, is timing of production as you look sequentially from the first half to the second half.

Raj Kalathur

You know, what Tony talked about in terms of harvesters, 25-75 last year first half, second half versus 40-60 from harvester [works]. Waterloo, if you take some of the key tractors in Waterloo, that’s also 45-55 last year, to about 50-50. So there is some shift in tractors as well. It’s not just a combine phenomenon.

David Raso - ISI Group

So let’s take the revenue guidance, then, as well-explained. That’s why it’s up only 1. Why, then, in the second half of the year, with a bit of an adverse mix of combines down that much, would the incremental margins be better in the second half than the first? Because that is what’s being implied. You’re implying 25-30% incrementals for ag and turf in the second half, and they were only 22% in the first half.

Marie Ziegler

Our guidance for cost of sales would suggest that our cost of sales would be lower in the second half of 2013 than it was in the second half of 2012.

David Raso - ISI Group

I’m asking why though.

Marie Ziegler

You don’t have the disruption, if you will, of last year in terms of the combine costs. The incremental raw materials are going the right direction this year. And while we have some significant costs ahead on final tier 4, you are anniversarying some costs on interim tier 4.

David Raso - ISI Group

That’s helpful. So the price cost may be a bit helpful at a minimum, in general, if costs are part of the story.

Operator

Our next question comes from Jerry Revich.

Jerry Revich - Goldman Sachs

Tony, can you just talk about the learning curve that you’ve seen at your facilities over the course of interim tier 4 implementations? And just talk about how that has impacted any change in the plan for tier 4 final. Do you think you can do it maybe more efficiently than you were thinking about it two to three quarters ago? Can you just help us understand that dynamic?

Tony Huegel

To your point, as we went through interim tier 4 there was a significant number of transitions in a more narrow window than we normally would have. But keep in mind that as you think of final tier 4, there’s learning to be had there. As you look at final tier 4, however, that window’s going to be even more narrow. And in some cases, we had some product that skipped interim tier 4 and will go directly to final tier 4. So you have a larger number of models that need to transition. And again, relative to interim tier 4, a more narrow window. So it is not without risk or challenge, and certainly that comes with additional cost too, as we try to manage that short window.

Marie Ziegler

I would further add, the learnings that we have from [IT4] very much help position us to accomplish, but will be this large number of introductions in this compressed timeframe ahead.

Tony Huegel

Right. For example, as you look at the number of engines, the different tiers of engines, you think of tractors that are built in Waterloo, for example, when we went to interim tier 4 you added another model of engine that you had to had, because you’re still building tier 3 for certain markets, tier 2 for certain markets, and now you’ve added interim tier 4. As you go to final tier 4, while it’s a different technology, in most cases you’re not still building interim tier 4. So the number of different engines that you’re introducing doesn’t change while you’re transitioning over. So you get some of those learnings and some of those benefits.

Jerry Revich - Goldman Sachs

And can you just talk about what you’re seeing in your European business? I know you’ve had a pretty big new implement cycle recently. Your retail sales have been pretty good in April. Can you just talk about from a Deere standpoint what does your outlook for Europe look like this year in contrast to the industry outlook that you provided? And then perhaps give us an update on how you’re thinking about potential to localize combine assembly and what it would take to get localization standards in Russia to help the VAT issue there.

Tony Huegel

Sure. And as you know, as it relates to Europe, we don’t provide guidance by geography there, but certainly as you pointed out, not only with the new products, but also working on our dealer distribution and strengthening that further, and as it relates to market share, those are going well.

But it’s a difficult market, to be honest, in the sense of, as Susan pointed out in the introduction, while you have great underlying fundamentals, you have the overarching concerns with the fiscal issues there that are putting pressure on sales. And so our forecast for the industry is certainly down year over year. So again, it’s a tough market from that perspective.

But certainly in northern Europe, with the exception of the U.K., still seeing those markets hang in pretty well, especially as you look at Germany and France. Those markets remain pretty strong. The U.K., because of weather issues, is not doing quite as well.

As it relates to Russia, I assume is what you meant with localizing combine, it’s really too early. We’ll have to wait and see what happens with that tariff in June or July, whether that gets extended or not and reevaluated at that point.

Operator

Our next question comes from Mircea Dobre.

Mircea Dobre - Robert W. Baird

My first question is, I’m trying to get a better sense for performance in the second quarter. When I look at your guidance for the second quarter, you call for 4% revenue growth yet you did about 9% in the quarter. And I’m wondering, given that you generally have pretty good visibility three months out, especially in ag, where you do a lot of preselling, why was there such a surprise to the upside?

Marie Ziegler

Good levels of activity in ag, in large ag especially. Large ag has continued to be very strong, and that’s reflected in our guidance. I don’t have anything more exciting than that.

Mircea Dobre - Robert W. Baird

Nonetheless, it does bring some question with regard to your visibility here. Because there’s quite a bit of departure from your initial guidance.

Marie Ziegler

Well, I’d like to say that we are the world’s experts at forecasting. I think if you’ve followed us, as you continue to follow us, there is some variability quarter to quarter in terms of how shipments go, what’s on the water, what’s not, and how currency moves. And so we are not as precise as I guess we would like to be. So I think we would view this as more a normal noise.

Tony Huegel

And to Marie’s point, as you think about the export markets and so on, in terms of when we recognize sales, that certainly can shift. And as we see more sales outside the U.S. and exports to those markets, it does create some variability. So a lot of times, it can be as simple as timing of when those products arrive in port.

Mircea Dobre - Robert W. Baird

My follow up here is I’m trying to understand your farm cash receipts forecast. So you’re talking about the late planting season and the risk that that adds to crop. And looking this quarter versus the prior quarter, your yield estimates are a little bit lower. Planted acres are a little bit lower. So the size of the crop is a little bit lower. Yet your farm commodity price projections are also a little bit lower. You’d think that if we have a smaller crop, all else being held constant, we’d have at least stable, if not higher overall prices. So how are you thinking about that?

Tony Huegel

Well, you’re looking at just a few of the pieces that go into that forecast. There are a number of pieces. One in particular I would note is carryover stocks, and there was an adjustment by the USDA during the quarter of the carryover stock levels coming out of 2012. So there are a large number of variables that go into that forecast. But keep in mind much of that is still based on assumptions of, generally speaking, [trend yields]. So to your point, it was brought down a little bit based on the late planting, but by and large, we’re still assuming trend or close to trend yields and normal weather.

Marie Ziegler

The other thing that you might want to think about as you look at those estimates is also impacted by the South American crop development, what’s happening down there. Harvest has gone pretty well, good yields there. And by patterns in terms of seed and residual use, even in the U.S. And you’ve seen some adjustments there due to high corn prices.

Operator

Our next question comes from Andy Casey.

Andrew Casey - Wells Fargo Securities

Understanding that the 2013 U.S. large farm equipment demand continues to be very strong, I’m wondering how anticipatory the company may be in reaction to the forecast that was just discussed, the 8% decline expected.

Marie Ziegler

Sorry, what 8% decline?

Andrew Casey - Wells Fargo Securities

The 8% U.S. crop cash flow that’s included, basically on page 34. Year over year.

Marie Ziegler

The second highest ever.

Andrew Casey - Wells Fargo Securities

I understand, Marie. So as you just indicated, it’s still strong, but historically, inflections have kind of suggested some future directional changes for the large equipment demand. So if your forecast proves accurate and the historical relationship holds, could you help us understand what actions we should look for if your medium-term cycle outlook starts to deteriorate sometime during the back half of the year?

Tony Huegel

One of the things we’ve talked about, and we’ve said this both when the forecast was slightly up and when it was slightly down, and so really what we have said is you’re looking at the very high levels of cash receipts. It’s not a one-for-one relationship of up and down, driving sales up and down. Really what we would consider is this is more flattish at very, very high, very supportive levels. And you’re going to see some minor inflections literally going both ways. And again, we said this first quarter, when the forecast was actually slightly up. We were saying the same thing. The important point is that these are at very high, very supportive levels for continued strength in large ag sales.

Operator

Our next question comes from Seth Weber.

Seth Weber - RBC Capital Markets

On the construction and forestry margin, can you help us understand, I know you’ve had some startup costs there over the last couple of quarters. How big of a headwind is that, and how much longer do you think that will continue, and just maybe give us a status update on that capacity increase.

Tony Huegel

Certainly, we have new facilities, we talked about China, Brazil, where really at this point we’re not seeing - in Brazil’s case, we’re not seeing any sales from that particular facility that are being generated while we have the higher costs, both in terms of people on the ground, building out dealer networks, those sorts of things. And you’d have the same thing in China.

Really, you’re not going to see any significant sales from those markets until well into 2014, and they’ll begin to produce 2014, but they won’t be fully ramped up probably until 2015 for all practical purposes.

You may be aware that in Brazil we are importing product to that market, as we do have some dealers in place. But keep in mind, both with the tariffs that have come in as well as the FINAME rates that we talked about being very supportive for ag, are not so supportive for imported construction products, as you compete in the market with some local manufacturers. So that then is a challenge from a margin perspective.

But long term, we still believe that’s the right direction as we build out that dealer network so that they’re prepared and in place when those factories do begin to produce. So there’s certainly some challenges there, but don’t underestimate, also, the fact that as we bring our sales forecast down, it’s challenging both from the perspective of we’re lower as a percentage of midpoint in those factories. That certainly hurts margin. And that reduction in a lot of cases was on very high margin construction equipment, which also pulled margins down. So that’s really what’s driving that margin decrease.

Seth Weber - RBC Capital Markets

So you don’t think the startup costs actually become a bigger headwind the next couple quarters before the production really hits?

Tony Huegel

I wouldn’t say that. Certainly, as you get closer, you’re adding more people, and those costs do increase. But all I’m saying is don’t underestimate just the impact, also, of lower sales on higher margin business.

Seth Weber - RBC Capital Markets

Is it possible to give an idea how much currency affected the ag margin in the quarter?

Tony Huegel

Yeah, it was about $40 million in the quarter.

Seth Weber - RBC Capital Markets

On operating income?

Tony Huegel

Yes, absolutely.

Operator

Our next question comes from Larry DeMaria.

Larry DeMaria - William Blair

I’m curious as to your thoughts on China becoming a more material net importer of corn. The USDA has China importing some this year, and there [grumble] that we may be near a tipping point, which would obviously be able to scoop up some of the large surplus that we may have this year. So do you guys see that as a big benefit for the U.S. farmer over time? Or not material?

Marie Ziegler

I think we’re very cautious on what the potential there is. Depending on whose viewpoint you’re looking at, it could be very significant for the U.S. farmer, but there’s certainly some who are quite cautious about what that opportunity at the end of the day really will be.

Tony Huegel

The other thing that I would note is right now USDA is projecting about 7 million tons, up from about 3 million from the 2012-2013. So that’s certainly a sizable increase. The other thing that I would note is the new leadership. Previously there was a very strong pursuit of self-sufficiency. That has tended to moderate some. So to your point, I think some have been maybe a little more optimistic about what that could mean for imports, but to Marie’s point, it’s very very difficult to forecast Chinese foreign imports.

Larry DeMaria - William Blair

Okay, so no material sea change from what you see today. And then just second question, you guys called out the subsidies in Brazil and the fundamentals in Brazil. Can you just help us understand how you guys think about which is more important going forward? And if subsidies reverse and the interest rates go up going into next year, would that imply a relatively significant drop off if the fundamentals stay pretty strong? Or could we grow through this? How are you thinking about subsidies versus fundamentals in Brazil over time?

Tony Huegel

You know, it’s hard to split the two and know which is really driving more. What we would say is clearly they’re both beneficial. We are hopeful that when they announce the upcoming year’s budget in either late May, early June, that they’ll make an announcement of what the interest rate will be going into 2014. The government has made statements publicly about being very supportive of agriculture, so there’s some optimism that those rates will stay low. Whether they’ll stay as low as they are this year is hard to guess. But at this point, it’s hard to guess what may happen there.

Larry DeMaria - William Blair

Do you think we might know in the next couple months?

Tony Huegel

Certainly we’re hopeful that we would know what the rate will be as we go in, but there’s not any real history that they always announce it. But there’s some speculation that they will.

Operator

Our final question comes from Ross Gilardi.

Ross Gilardi - Bank of America

Just on that last question, you guys obviously talked a lot about the headwinds in the fourth quarter in ag, but could you see a surge in year-end buying in Brazil in advance of the rates going up in December?

Tony Huegel

Again, it depends on what those rates are doing. And keep in mind, our calendar year end is the beginning of our fiscal year. So that would, even if that were to happen in that November - December timeframe, that really does benefit our 2014. The other thing I would point out is keep in mind it’s a little bit different than what you tend to think of in U.S. policies in that the sales needs to be in place and the approval for the financing by the end of the year. But you have, in most cases, a couple of months to actually take delivery of the equipment. So even with a December 31 cutoff, that can benefit a couple of months calendar into 2014, and really well into our fiscal 2014.

Thank you very much, and with that we’re going to have to cut off. We thank you for your participation in the call. And as always, we will be available the rest of the day to answer any additional questions you may have.



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