Good morning, 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 Tony Huegel, Director of Investor Relations. Thank you. You may begin.
Thank you. Also on the call today are Rajesh Kalathur, our Chief Financial Officer, Marie Ziegler, Deputy Financial Officer, and Susan Karlix, Manager of Investor Communications. Today, we'll 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'll respond to your questions. Please note that slides are available to complement the call, 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?
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 puts 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 & 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 net sales were $10.3 billion, up 9% quarter-over-quarter, including an unfavorable impact from currency translation of about two points. Price realization in the quarter was positive by three 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 forecast 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 forecast 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 in 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. Beef 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 30th, then 3.5% through the end of December. Our 2013 ag and turf industry outlooks are summarized on Slide 11. We have raised the 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 one point of negative currency translation. At constant currency, the sales forecast is up about 8%, two 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. I'll repeat that. 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. 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 32%. The division's results were affected by lower shipment volumes and higher production costs, including those associated with Interim Tier 4. Increased SA&G expenses in support of global growth also hurt the quarter'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 non-residential 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. Cool, wet weather conditions in the U.S. 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 4 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 U.S. 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's full-year operating margin is now projected to be about 5%. Let's move now to our financial services operations. 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 two basis points.
This reflects the excellent quality of our portfolios and recoveries from prior years' write-offs. Our 2013 financial forecast now contemplates a loss provision of about seven basis points as a percentage of the average owned portfolio. That is a reduction of nine 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 & 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 projected to be down about $150 million, driven by slowing demand and a reduction in Canadian combine 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 percent 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 three 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 SG&A in 2013. Interim Tier 4 product costs. Absorption due to the lower build in inventory compared to 2012. And an unfavorable mix of 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 in 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. SG&A expense for the equipment operations was up about 9% in the second quarter. Very much like R&D, the quarter-over-quarter increases for SG&A were heavily weighted to the first half of the year. SG&A expense is forecast 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%-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 two points of price realization.
The full-year forecast now calls for net sales to be up about 5%, with about one 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 three 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. The longer-term picture remains extremely bright and a source of much confidence about the future.
Indeed, Deere's plans for helping meet 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?
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?
Thank you. At this time, if you would like to ask a question, please press *1 on your touch-tone phone. To withdraw your request, you may press *2. Once again, if you have a question, please press *1 at this time. Our first question comes from Jamie Cook, and please state your company name.
Hi, good morning. Credit Suisse. Just some additional color on the lower guide within Construction & 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. Can you talk about what's Deere specific versus the market? Are you losing market share? How much of it was weather-related? I guess just the second question, can you just give a little more color on the mix issues that you cited that are impacting the margins? Thanks.
Sure. 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. 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. To your point, weather being cold and wet has delayed some construction projects in the spring, and we think that's also had some impact. It's really not a market share story per se.
I guess you're just not hearing about this as much from some of your peers. That's what's more surprising. I know I'm only allowed one question, you had some dealer inventory issues in the last quarter, which were small. Are they largely resolved now?
Well, I think if you look at dealer inventory, 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. 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. I'd also point out, as the demand reduces, you also have some shorter lead times.
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.
Just, 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. Thanks. I'll get back in queue.
Sure. Yeah. In terms of pricing, we're talking about the 3% on the enterprise, all I can say is that Construction & Forestry is certainly contributing to that. As you know, we don't give the guidance on individual divisions. Certainly, again, they are contributing. As you look at mix, that's certainly a part of it. Keep in mind, now with our current outlook, we're well below mid-cycle in our forecast for construction, and that certainly weighs on margins. As Susan mentioned, the reduction that we've experienced in our outlook is on some of the higher margin product as well. That's certainly weighing on margins as well.
Okay, thanks.
Jamie, this is Raj.
Hi.
On your comment about you're not hearing this from others with regards to construction and forestry. If you compare the commensurate quarter, most recent quarter for our comparable competitors in terms of our operating return on sales, we are either comparable or better than most. Okay. 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. If you look at North America, we're not different from the competitors on the sales as well.
Okay. Operator?
Thank you. Our next question comes from Andy Kaplowitz. Please state your company name.
Good morning, guys. It's Barclays.
Morning.
Good morning.
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?
I would argue it's just a tweak. As you look at the change for the ag and turf division, it adjusted, 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 here and there, and that's how I would describe it. Nothing more.
Tony, it's fair to say, though, that in the second half of the year, that's when you really decide what the 2014 outlook looks like, and you could change inventory again based on that, correct?
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, we'll begin to extend into the next year, we'll have some visibility at that point.
Okay, let me ask you about ag incrementals. I know everybody's going to ask you about this, you were pretty clear about saying that mix is going to work against you in the second half. We know that you said that before. At the same time, you did have an execution issue in 3Q of last year, and you have said over and over again that SG&A and R&D would be front-end loaded. Why can't margins be up pretty significantly year-over-year in 3Q, both incremental and year-over-year? What's stopping that from happening?
Yeah. Certainly from an incremental perspective, keep in mind that we'll see the biggest change incrementally will be on absorption. If you look at production in the first half versus the second half. Last year again, keep in mind, even year-over-year, you had a heavier build schedule in the back half of the year versus what we did this year. That's a big part of the difference.
Andy, in terms of ag and turf incrementals, this is Raj. You'll also notice if you think about quarter two, there was an increase in the pension and OPEB expense, FX, and R&D. Okay? That contributed. If you add those back, our incrementals would look like you would expect. Some of that is also going to carry into the second half.
Okay, guys. I'll get back in queue. Thank you.
Thank you. Operator?
Thank you. Our next question comes from Ann Duignan, and please state your company name.
Hi. Good morning. It's JP Morgan.
Morning.
Morning. Can we talk about your cash position? You get on the call, you say how wonderful things are, how great the cycle is, how the fundamentals are wonderful globally in agriculture, 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?
Well, absolutely not in terms of where we are in the ag cycle. Ann, our cash position is, I would admit that our balance sheet is a bit defensive right now. We continue to be concerned about the functioning of the markets 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. We are ensuring that we remain very liquid in order to support the financial services business.
Ann, this is Raj. Our cash use priorities have not changed. Okay? With respect to dividends or share repurchases, if you take a long-term view, you should not see a change in how we act on it. What Marie explained is short-term, we have some caution. Cautionary environment that we are living in, and we are taking the proper precaution.
Okay. I appreciate the color.
I do note that we did increase our dividend $0.05 a share, which is about 11% an increase per quarter. We are increasing our return.
That's a fair point, Marie. Yeah. My follow-up question is more on the fundamentals. We're sitting here kind of at the crossroads of the 2013, 2014 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. 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 that 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.
Yeah. At this point, that's really a challenge in terms of what might happen, both with planting. Certainly, most of the planting in the corn belt on corn already would have taken place in a more normal year by May 5th or so. Certainly if you get good weather, to your point, that can change in terms of what gets planted in a hurry. When we look at our forecasts, and just as you know, it's about cash receipts as being the primary driver. As you look at what may happen, it's not just what production level or what the price level is, but how much corn or soybeans is produced that's going to drive that demand. Certainly for 2013, we're continuing to see very strong cash receipts level. I think it's second highest on record. Slightly below the 2012 cash receipts, but at very high levels.
That data point would certainly bode well for the future. Also, as you know, as we look at next year, it'll 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.
You look at the global fundamentals, Ann, 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. You have actually, despite what's been happening with land prices, you haven't seen a big ramp-up in debt loads for farmers. In fact, the equity or the debt-to-cap ratio has actually declined this year. We're in a very strong position. We continue to feel very positive about the outlook and prospects for the global business.
Yeah. Marie, the cynic in me wants to say, that would bring me back to my first question. I'll leave it there and get back in line and take it offline.
Thank you.
All right, Ann.
Thank you. Our next question comes from Ashish Gupta, please state your company name.
Hi, good morning. It's CLSA. First question is, can you give us some more color on the order book?
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. As you look at the track tractor, you're looking at late September availability, for the wheel tractor, you're into October for availability. On the 9R, you're looking at October for a large track tractor then August for the wheel tractor. Again, it remained very strong in terms of the order book.
Okay, great. Just 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?
Absolutely. The question we had last quarter, even with a lower tax rate in the first quarter, you'll note that we kept our annual forecast the same, and it was reflective of what you saw in the second quarter.
Great. Thanks very much.
Thank you. Operator?
Thank you. Our next question comes from Rob Wertheimer. Please state your company name.
It's Vertical Research, good morning, everybody.
Good morning.
Two quick questions on you. I guess you kind of answered it, Tony, with the comments on the order board. Does that mean then that your cautious comments on the weather and the wet and the planting are really applicable to the last quarter of the year? Because 3Q is kind of dialed in. As a corollary to that, there's been some changes in production capacity that you mentioned. Can you talk a little bit about production capacity? Typically, 3Q has been lower than 2Q, and I think that's on shutdowns in June. Has that changed at all in terms of what you can produce 3Q versus 2Q?
Certainly as you look year-over-year, with combines is the largest difference. When you compare year-over-year, we were very back-end loaded. We talked about on combines last year, the first half, second half split 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. Again, if 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. As we look toward the Final Tier 4, you have some disruptions here and there.
Yeah. 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 fact that corn planting 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. We get some breaks in the weather, which we've had over the last couple of days. We have not seen any cancellations at this stage. You are absolutely correct that very strong order books do portend well.
Great. Just a quick follow-up. I think you just answered, Marie, but the caution therefore in the press release is more Deere caution than what you're hearing from farmers and turf dealers in terms of getting nervous about putting orders in.
Correct. Everyone says that given the opportunity to plant, there is still plenty of time to plant before you hit significant yield erosion.
Excellent. Thank you.
Thank you. Operator?
Thank you. Our next question comes from David Raso. Please state your company name.
ISI. 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?
It would be better.
Yeah. As you look at the tractor, certainly the order book on eights and nines are further out. You have a stronger order book. Again, some of that is timing of production year-over-year and that's really what you're seeing. Again, overall on Ag, as you go into the back half of the year, we're lower year-over-year. You're seeing that on margins with the not on year-over-year, but first half versus 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 that back half of the year.
Yeah. Year-over-year, our guidance does imply a modest increase in our sales in the second half.
Well, that's what I'm just trying to square up. Obviously, revenues for you globally are, I'd say 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. Tractors can keep a lot more than the 1% total Ag and Turf revenue for the rest of the year. Combines are obviously down a lot to get the whole division to only up one.
Yeah. Well, as I-
Please respond to that, just so I have that right.
Yeah. Let's make sure, Raj will clarify some things here too, but keep in mind that as you look at total annual production versus the timing, you've got, as Raj mentioned earlier, or I think it was Marie maybe, that you have Final Tier 4 coming in. You're going to have some disruptions there within the factories doing limited production builds, those sorts of things that do have an impact on individual quarters of availability. If you look also, our inventory build year-over-year is not as large as it was last year. That's also going to have some impact as you look into the back half of the year. 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.
Let's take out of-
This is Raj.
Okay.
Hey, David. In addition to what Tony talked about in terms of harvesters, 25/75 last year, first half to second half, versus 40 to 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, okay?
Yeah.
There is some shift in tractors as well. It's not just a combine phenomenon. Okay?
Okay. That's helpful. 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 also a bit of an adverse mix with combines down that much, why 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 there were only 22% in the first half.
Well, 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.
I guess I'm asking why, though.
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. While we have some significant costs ahead on Final Tier 4, you are anniversarying some costs on Interim Tier 4.
That's helpful. The price cost may be a bit helpful at a minimum in general, if costs are part of the story. That's helpful. I appreciate it. Thank you.
Thank you, David. Operator?
Thank you. Our next question comes from Jerry Revich, please state your company name.
Good morning. It's Goldman Sachs.
Jerry.
Good morning.
Tony, can you just talk about the learning curve that you've seen at your facilities over the course of Interim Tier 4 implementations, just talk about how that has impacted any change in the plan for Final Tier 4? Do you think you could do it maybe more efficiently than you were thinking about it two to three quarters ago? Can you just help us understand that dynamic?
Sure. Certainly, to your point, as we went through Interim Tier 4, there was a significant number of transitions in a more narrow window than what we normally would have. Keep in mind, as you look at 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. You have a larger number of models that need to transition, and again, in a relatively, relative to Interim Tier 4, a more narrow window. It is not without risk or challenge, and certainly that comes with additional cost, too, as we try to manage that short window.
I would further add, the learnings that we have from IT4 very much help position us to accomplish what will be this large number of introductions in the compressed timeframe ahead.
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. As you go from when we went to Interim Tier 4, you added another model of engine that you had to have 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. The number of different engines that you're introducing doesn't change while you're transitioning over. You get some of those learnings and some of those benefits.
Okay. 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? 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.
Sure. As you know, as it relates to Europe, we don't provide guidance by geography there. Certainly, as you pointed out, not only with the new product but also working on our dealer distribution and strengthening that further 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 ahead of the introduction is, while you have great underlying fundamentals, you have the overarching concerns with the fiscal issues there that is putting pressure on sales. Our forecast for the industry is certainly down year-over-year. Again, it's a tough market from that perspective. 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 reevaluate at that point.
Thank you.
Thank you. Next caller.
Thank you. Our next question comes from Mig Dobre, and please state your company name.
Robert W. Baird, good morning.
Good morning.
Good morning.
I guess 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 called for 4% revenue growth, yet you did about 9% in the quarter. I'm wondering, given that you generally have pretty good visibility three months out, especially in ag, where you do a lot of pre-selling, why was there such a surprise to the upside?
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.
Well-
I don't have anything more exciting than that.
Nonetheless, though, it does bring some question with regards to your visibility here, because there is quite a bit of departure from your initial guidance.
Well, Mig, I'd like to say that we are the world's experts at forecasting, and 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. We are not as precise as I guess we would like to be. I think we would view this as more normal noise.
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. As we see more sales outside the U.S. and exports to those markets, it does create some variability. A lot of times it can be as simple as timing of when those products arrive in port.
Okay. My follow-up here is, I'm trying to understand your farm cash receipts forecast. You're talking about the late planting season and the risk that that adds to crop. Looking this quarter versus the prior quarter, your yield estimates are a little bit lower. Planted acres are a little bit lower. 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. How are you thinking about that?
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. There are a large number of variables that go into that forecast. Keep in mind, much of that is still based on assumptions of generally speaking trend yields. To your point, it was brought down a little bit based on the late planting. By and large, we're still assuming trend or close to trend yields and normal weather.
Mig, the other things that you might want to think about as you look at those estimates is we're also impacted by the South American crop development, what's happening down there. Harvest is gone pretty well, good yields there. By patterns in terms of feed and residual use, even in the U.S., and you've seen some adjustments there due to high corn prices.
Okay.
Okay. Very helpful. Thank you.
Great. Thank you. Next caller.
Thank you. Our next question comes from Eli Lustgarten, and please state your company name. Eli, your line is open. Please check your mute feature or lift your handset. We'll move on to the next question, Andrew Casey, and please state your company name.
Good morning, Wells Fargo Securities.
Good morning, Andy.
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. As you indicated.
I'm sorry, Andy, what's 8% decline?
Oh, the 8% U.S. crop cash flow that's included basically on page 34, year-over-year.
The second highest ever.
No, I understand, Marie. As you just indicated, it's still strong.
Yep.
Historically, inflections have kind of suggested some future directional changes for the large equipment demand. 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 this year?
Yeah. Andy, one of the things we've talked about. We said this both when the forecast was slightly up and when it was slightly down. Really what we have said is, if you're looking at these 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 this is more flattish at very, very high, very supportive levels. You're going to see some minor inflections literally going both ways. Again, we said this first quarter when the forecast was actually slightly up. We were saying the same thing, that the important point is that these are at very high, very supportive levels for continued strength in large ag sales.
Okay. I'll come back to you offline. Thank you.
Okay. Thank you. Next caller.
Thank you. Our next question comes from Seth Weber. Please state your company name.
Hey, good morning. It's RBC.
Good morning.
Morning.
Most of the questions have been asked, but on the Construction & 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? Just maybe give us a status update on that capacity increase.
Yeah. Certainly, as we've talked about for actually some time, we have new facilities. We talked about China, Brazil, where really at this point, 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. 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. I mean, they'll begin to produce 2014, but they won't be fully ramped up probably till 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.
Keep in mind, both with the tariffs that have come in, as well as the FINAME rates that we talk about being very supportive for ag, are not so supportive for imported construction products as you compete in the market with some local manufacturers. That's been challenged from a margin perspective. 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. 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 % of midpoint in those factories. That certainly hurts margin. That reduction, in a lot of cases, was on very high-margin construction equipment, which also pulled margins down.
That's really what's driving that margin decrease.
You don't think that the startup costs actually become a bigger headwind for the next couple of quarters before the production really hits, it's basically?
I wouldn't say that.
Okay.
Certainly, as you get closer, you're adding more people.
Right
Those costs do increase. All I'm saying is don't underestimate just the impact also of lower sales on higher margin business.
Sure.
Okay.
Understood. Okay. Just a quick follow-up, is it possible to give an idea how much currency affected the ag margin in the quarter?
Yeah, it was about $40 million in the quarter.
$40 million? On operating income? Okay. Thank you.
In operating profit.
Yep, absolutely. Okay. Thank you. Next caller.
Thank you. Our next question comes from Larry DeMaria. Please state your company name.
Thanks, William Blair. Good morning.
Good day.
I'm interested your thoughts on China becoming a more material net importer of corn. The USDA has China importing some this year, and there's a growing belief that we may be nearing a tipping point, which would obviously be able to scoop up some of the large surplus that we may have here this year. Do you guys see that as a big benefit for the U.S. farmer over time, or not material?
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.
Yeah. The other thing that I would note, right now, USDA is projecting about 7 million tons, up from about 3 million from the 2012-2013. 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. To your point, I think some have been maybe a little more optimistic about what that could mean for imports. To Marie's point, it's very difficult to forecast Chinese corn imports.
Okay. No material sea change from what you see today. Can I just say a second question? You guys called out, obviously, 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? If subsidies go back, reverse obviously, 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?
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. 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. At this point, it's hard to guess what may happen there.
You think we might know in the next couple of months?
Certainly, we'd be hopeful that we would know what the rate will be as we go in. There's not any real history that they always announce it, but there's some speculation that they will.
Okay. Thank you.
We need to move on to the next call, please. We have time for one more call.
Thank you. Our final question comes from Ross Gilardi, please state your company name.
Hi, Bank of America. Thank you. 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?
It depends on what those rates are doing. Keep in mind, our calendar year end is the beginning of our fiscal year. 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 sale needs to be in place and the approval for the financing by the end of the year. You have, in most cases, a couple of months to actually take delivery of the equipment. Even with a December 31 cutoff, that can benefit a couple of months calendar into 2014 and really well into our fiscal 2014. Okay.
Okay. Thank you.
Thank you very much. With that, we're going to have to cut off, and we thank you for your participation in the call. As always, we'll be available the rest of the day to answer any additional questions you may have. Operator?
Thank you. This does conclude today's conference. We do thank you for your participation, and you may now disconnect your lines.