Good morning. Welcome to Deere's third 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.
Thank you. Hello. Also on the call today are Jim Field, Raj Kalathur, Marie Ziegler, Susan Karlix, and J.B. Penn, our Chief Economist. Today, we'll take a closer look at Deere's third quarter earnings, then spend some time talking about our markets, the outlook for the fourth quarter, and the current drought conditions. After that, we'll respond to your questions. Please note that slides are available to complement the call this morning. They can be accessed on our website at 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 johndeere.com/financialreports under Other Financial Information.
Please turn to Slide three, I'll turn the call over to our Chief Financial Officer, Jim Field.
Good morning. Thank you for joining us as we discuss what was a great quarter on most fronts. John Deere reported record sales and profit in the quarter. Operating margins in the Agriculture & Turf division were approximately 14%. We successfully launched new products while continuing the build-out of our global footprint. Our sales increase of 16% was short of our guidance by nine percentage points or about $700 million. This had a corresponding negative impact on the bottom line and was lower than first call estimates. The miss was in Agriculture & Turf. Half of the shortfall is due to softening market conditions outside the U.S. Of note, China, India, and the EU 27. Sales were negatively impacted as the granting of import licenses in Argentina continues at a slow pace.
Timing of and changes to finance programs, as well as the weaker BRL, affected sales in Brazil. Turf equipment sales in the U.S. were hurt by weather conditions. The other half of the shortfall is manufacturing execution. The good news is we expect to make up the bulk of the sales miss related to execution during the fourth quarter. In the third quarter, we had very aggressive production levels as we continued to ramp up our schedules, we experienced some hiccups. The all-new North American Combine line with significant product innovations and IT4 compliant engines was most challenged and accounts for the bulk of the shortfall. The issue is not quality. We were receiving positive customer reviews on the machines already in the field. We just had trouble ramping up production to meet the aggressive build schedules in the quarter.
We experienced production delays of up to 14 calendar days. We are seeing an unprecedented early harvest of up to four to five weeks in some areas. Consequently, some machines will be shipped too late for harvest, we have allowed dealers to cancel orders. This affects only about 3% of Harvester's 2012 production and is reflected in our updated guidance. We know less than stellar execution is not what you expect from John Deere. What happened? There are 40% more unique part numbers in the new Combines than previous models. New parts required new suppliers and new challenges for existing suppliers. We had a significant number of new employees requiring extensive training, many of whom were hired as production schedules were sharply ramping up.
We were running a factory at full speed, there was no downtime to get caught up once we fell behind. These issues are being addressed. The key is that these are not quality or customer satisfaction issues. They are execution issues, problems we at John Deere know how to fix. The sales shortfall is reflected in higher inventories in the third quarter and at year-end. Actions have been taken to manage the inventories, it will take longer than the end of the year to work them off. In summary, our quarter was historic, it could have been better. We did not execute to the usual John Deere standard. Mitigation and corrective actions have been implemented, now I will hand it over to Susan.
Thank you, Jim. Before getting to the numbers, the drought and its potential impact on some of our farm and livestock customers is on everyone's minds and has received a lot of contemporary press coverage. The drought had minimal impact on our third quarter results, and the same holds true for our full year forecast. However, as a result of dry weather, global grain supplies are expected to further tighten.
This supports higher commodity prices and should result in robust field activity in the 2013 crop year in markets throughout the world. J.B. Penn will discuss the drought and resulting outlook for the agricultural markets in detail shortly. Back to Slide 3. Let's take a look at the third quarter in detail. Net sales and revenues were up 15% to $9.6 billion in the quarter. Net income attributable to Deere & Company was $788 million. On Slide 4, total worldwide equipment operations net sales were $8.9 billion, up 16% quarter-over-quarter. At constant exchange, sales were up 21%. Price realization in the quarter was positive by five points. Turning to a review of our individual businesses, let's start with Agriculture & Turf on Slide 5. Sales were up 14% in the quarter. Operating profit was $1 billion. Margins improved to 14% from 13% a year ago.
Of note, used Combine levels at the end of July were well below year-ago levels. Our 2012 Agriculture & Turf industry outlooks are summarized on Slide 6. The outlook for industry sales in the U.S. and Canada remains at up more than 10%. Demand continues to be strong, especially for high horsepower equipment, a reflection of continued strong commodity prices in the global farm economy, forecasted record cash receipts in the United States, and minimal impact expected from the current drought conditions. We have revised the EU27 industry outlook to flat with the attractive levels of 2011. Farmer sentiment remains generally positive due to attractive grain, beef, and pork prices. Differences in the countries of Northern and Southern Europe continue. In the north, production levels are expected to increase while the south is hampered by drought.
Financing continues more readily available in the north, the overall macroeconomic factors are having a greater impact in Southern Europe. Our 2012 industry outlook in the CIS countries is up strongly, a tweak from our outlook a quarter ago. While the farm sector remains strong, above normal temperatures have lowered the yield projections in the CIS by about 20%. Some CIS countries, notably Ukraine, are facing financing constraints. In Asia, we now expect sales to be down moderately. In India, after several years of strong growth, the Tractor market is forecast to be down slightly, and the monsoon deficit is expected to lower grain output. The industry outlook for China has softened as government subsidies have been delayed in reaching farmer customers.
Industry sales of tractors and combines in South America are expected to be down 5%-10% in relation to the strong levels of 2011 due to the import licensing process in Argentina and drought earlier in the year in parts of the region. It is important to note that the second season of corn production surpassed the summer season. Planted acres and yield increases, combined with record commodity prices, bode well for strong crop activity in the region this planting season. 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 up about 5% in 2012, impacted by weather conditions in the U.S. Putting this all together on Slide seven, fiscal year 2012 Deere sales of worldwide Agriculture & Turf equipment are now forecast to be up about 13%.
This includes negative currency translation of about four points. At constant currency rates, net sales are expected to be up about 17% compared to 2011. Full-year operating margin for the division is forecast at about 15%. Before moving to C&F, let's touch on our early order programs. The combine early order program began 1 August. While early orders are running ahead of last year. The other seasonal programs for planters, sprayers, drills, air seeding, and tillage are running more than 15% higher than last year. Let's focus now on Construction & Forestry on Slide eight. Net sales were up 23% in the quarter. Operating profit was $113 million. For the quarter, C&F had a 7% operating margin. The largest factor underlying C&F margins is investments in growth.
As you know, the division has two new factories going up in Brazil and one in China, adding additional R&D costs and selling and administrative and general expense. In China, sales are not anticipated in the market until late 2013, and the production ramp-up will be at a measured pace to ensure we deliver the highest quality products to the market. Production and shipments in Brazil are not expected to begin until calendar year 2014. While we are currently importing goods into the country to support the development of our dealer group prior to the factories coming online, margins are challenged due to the cost to import and the ineligibility for FINAME financing on the imported goods. Consequently, we expect growth expenses and costs with little to no revenue from the new factories to run through 2013 and well into 2014.
Despite recent market weakness, China holds long-term potential for the construction industry, and Brazil is one of the world's fastest-growing markets for construction equipment. On Slide nine, let's look at the economic indicators on the bottom part of the slide. Although there are some promising signs that things are picking up, overall economic growth continues at a slow pace. C&F continues to benefit from improved sales to independent rental companies as they record higher utilization levels and rental rates. We also see strength in the energy and material handling sectors. Also encouraging, Deere dealers continue to see an improvement in their rental and used equipment markets. Net sales in Construction & Forestry are now forecast to be up about 17% in fiscal 2012, with negative currency translation of about one point.
The three-point change in our outlook reflects the timing of some shipments to Canada, causing sales to be pushed into 2013, a slower start to dealer sales in Brazil, and market softening in Russia. Global forestry markets are expected to be flat in 2012 from the strong levels of a year ago. Weakness in Europe is being offset by improvement in other international markets. C&F's full-year operating margin is projected to be about 7%. Let's move now to our financial services operations. Slide 10 shows the financial services provision for credit losses as a percent of the total average owned portfolio. Year-to-date, on an annualized basis, the provision is essentially zero, reflecting the excellent quality of our portfolios, as well as some allowance reductions in construction and forestry.
Our 2012 financial forecast contemplates a loss provision of about four basis points as a percent of the average owned portfolio, down from about 23 basis points last quarter. Moving to Slide 11, worldwide financial services net income attributable to Deere & Company was $110 million in the quarter versus $126 million in 2011. Net income was impacted by increased selling, administrative, and general expenses, narrower financing spreads, and higher reserves for crop insurance claims, partially offset by growth in the portfolio and a lower provision for credit losses. Looking ahead, we are now projecting worldwide financial services net income attributable to Deere & Company of about $450 million in 2012. The decrease in income from last year is attributable to increased selling, administrative, and general expenses in support of the equipment operations global growth and narrower financing spreads.
Included is an after-tax provision of about $25 million for higher reserves for crop insurance claims based on the current conditions of the U.S. drought event. Slide 12 outlines the receivable and inventory numbers that Jim discussed earlier. Now let's turn to raw material and logistics on Slide 13. Third quarter material costs were up about $70 million over last year. Virtually all of the $400 million increase forecast for the year has been incurred year-to-date. As we have shared in the past, changes in Deere's raw material costs tend to lag the market by three to six months, depending on the type of commodity or contract. About 80% of the increase is for ag and turf and about 20% for C&F.
As we introduce new products and features to our growing customer base, the product cost of compliance with engine emission regulations in North America and Europe will be roughly $475 million higher than 2011. This is a $25 million reduction from the forecast provided in May. Note, however, that the combined increase in material and Interim Tier 4 product costs will be more than offset by what we are forecasting to be about four points of price realization. Looking at R&D expense on Slide 14, R&D was up 18% in the third quarter compared to the same period last year. Spending was up about 21%, offset by about three points of currency translation impact. Our 2012 forecast calls for R&D expense to be up about 15%. Spending is projected to be up about 17%, offset by about two points of currency translation impact. Moving now to Slide 15.
SG&A expense for the equipment operations was up about 8% in the third quarter. Expense was up about 12%, offset by about four points of currency translation impact. Our fiscal year 2012 forecast calls for SG&A expense to be up about 9%, with growth accounting for about four points. Expense is forecast to be up about 12%, offset by about three points of currency translation impact. I do want to point out currency movements, both translation and transaction or trade flows, reduced operating profit, excluding R&D and SG&A, by about $150 million in the quarter. Over the course of a year, our trade flows are relatively well-balanced. But that may or may not be the case in any reporting period. Where there tend to be an annual imbalance, we may hedge our exposure using currency forward contracts or currency risk-sharing agreements.
On slide 16, pension OPEB expense was down about $20 million in the third quarter. Our fiscal year 2012 forecast calls for pension OPEB expense to be down about $110 million. About $85 million of the decrease has occurred year-to-date. On slide 17, you see our equipment operations history of strong cash flow. We are forecasting cash flow from equipment operations to be about $2.9 billion in 2012, about flat with 2011's record amount. The reduction from our prior guidance is mainly due to the increase in inventories forecast for the year. On slide 18, we outline our 2012 outlook for the fourth quarter and the full year. The fourth quarter forecast calls for net sales to be up about 13% compared to the fourth quarter of 2011. Price realization is expected to be positive by about three points, with currency translation being approximately negative four points.
The net sales forecast for the full year is up about 13% compared to 2011, translated at constant exchange, up about 16%. Price realization of about four points will contribute to results. Our full-year 2012 net income forecast is now about $3.1 billion, a company record. Now to discuss this year's record drought, I will turn the call over to Dr. J.B. Penn, former USDA Under Secretary of Agriculture and John Deere's Chief Economist. J.B.?
Good morning. Please turn to slide 19. Just a couple of months ago, we had a much different business outlook than we have today. At that time, we were looking for some softening of food demand against expected large harvest, resulting in increasing stocks and softer commodity prices. In fact, there was much media discussion about the end of the cycle for agriculture. Today, the business outlook is vastly different. A severe disruption in annual production is occurring owing to the most severe drought in at least half a century in the U.S., drought in the Black Sea region, and a diminished monsoon in India, along with newly emerging concerns about crop conditions elsewhere. In the foreseeable future, the global agricultural plant will be hard-pressed to keep pace with demand and replenish stocks to more comfortable levels.
Crop analysts are still grappling with the full extent of the shortfall and the implications for 2012, 2013, and beyond. However, early assessments point to a continued solid ag sector performance for 2012 and very bright prospects worldwide for 2013. Turning to slide 20, we are fortunate to have fresh information from last Friday's USDA crop report to inform our review. USDA reported revised estimates for acres expected to be harvested this year, per acre yields and total output, and forecast a season average price for the crops. For corn, the report showed a reduction in harvested acres to 87.4 million, another reduction in yield to 123.4 bushels, 10.8 billion bushels production, and the midpoint of the forecast season average price was $8.20.
Although this was the largest crop planted since 1973, production is now forecast to be 13% below last year, and the yield of 123.4 bushels per acre is down almost 24 bushels per acre from last year. For soybeans, the situation was not as severe, but it was down as well. Harvested acres at 74.6. The yield was reduced to 36.1 bushels per acre. Production, 2.7 billion bushels, and the midpoint of the season average price was forecast at $16. For soybeans, production is forecast down 12% from last year. For wheat, the situation is much different. The situation was improved, especially the price outlook. USDA shows now a harvested area of 48.4 million acres, a 46.5 bushel per acre yield, 2.3 billion bushels production, and the midpoint of the price forecast is $8.30.
At this point, clearly, we have more rationing of the old crop corn and soy supplies among competing uses yet to be done, and we will have substantial adjustments in the utilization of new crop supplies. Thus, grain and oil feed prices are expected to remain strong for the remainder of this year and well into 2013. Moving now to slide 21, we should note that the crop season still is far from over, and more USDA assessments are yet to be issued. We will have crop reports of importance in September, October, and November. It is very difficult to estimate the effect of the U.S. drought on corn and soybean yields. The crop was planted much earlier than usual. Conditions vary widely across the country and even in individual fields, and genetics today are far superior to those of previous droughts. There are no good analog years.
Thus, it will be sometime before final crop size and the full implications become known. Friday's USDA report provides enough solid information to enable developing the broad outlines of the likely performance of the agricultural economy this year and next. On slide 22, while the 2012 drought situation is unusual in many respects, a key one is that farmers entered the year in perhaps the strongest financial condition ever. This owes to the several consecutive years of strong farm income and a continually strengthening balance sheet. The financial health of the farm sector is as strong as it has been in modern times. Another aspect this year is that crop and revenue insurance opportunities are much improved, and coverage is far more widespread than in any previous calamity.
While the livestock sector is very severely impacted in parts of the country, the Congress is expected to provide some kind of disaster package to help ameliorate the distress. Farmers now have available much better crop genetics, machinery, technology, and management practices than ever before. Turning to slide 23, futures markets indicate strong prices across 2012 and 2013. Higher prices, of course, will benefit farmers in 2012 who have a crop to sell. Much of the crop that will be harvested remains to be sold, and insurance will greatly ameliorate the drought losses. This together suggests that gross receipts from crops will be strong for 2012, and the markets are clearly signaling the need for much more output in the coming season in both the southern and northern hemispheres. Moving to slide 24, this chart affirms the impacts of higher prices and offsetting reduced output volumes.
Cash receipts last year, 2011, were an all-time record. Despite the reduced output due to drought, receipts are expected to be even larger for 2012. Looking ahead to 2013, strong prices with a normal crop could propel revenues even higher to yet another record. Aggregate gross receipts are the best predictors of large agricultural product sales. On slide 25, this chart reaffirms the strong condition of the farm sector going into the drought. Net cash farm income set new records in six of the past 10 years. 2011 was the all-time record high income year. 2012, as now forecast by USDA, will be perhaps the second best. We will have a new forecast at the end of the month. The futures prices are signaling that with good crops, next year could be just as strong.
Looking at slide 26, it shows that while cash flow to the sector has been strong, the sector balance sheet also has been strengthened appreciably. The financial ratios are strong. Farmers have managed debt exceptionally well in recent years, while asset values have grown steadily. Overall, looking at both cash flow and the balance sheet, the farm sector entered the drought this year far stronger than in any previous drought. Turning to slide 27. Another distinguishing feature of this drought is the widespread use of crop and revenue insurance. Farmers are now able to guarantee revenue as well as yield, and coverage is extensive for the major crops in the drought-affected areas. We know that about 85% of the corn and soybean acreage was enrolled in an insurance program in 2011, and industry analysts suggest that as much or more is enrolled in 2012.
The level of coverage generally is adjusted to reflect current price conditions, which at harvest time will reflect the run up in prices of the past few weeks. As a point of reference, insurance indemnities paid in 2011 were about $11 billion, and early estimates reported by the University of Illinois and others suggest indemnities could be well above last year's amount. Livestock farmers have little access to insurance, of course. Pastures across wide areas have been very severely damaged, and higher feed costs have significantly eroded margins. Herds are being reduced in response, pushing prices lower. Congress is expected to provide disaster assistance to livestock farmers whose pastures have been severely damaged by drought and who face much higher feed costs.
The House of Representatives, before adjourning for the summer recess, passed a $383 million drought assistance package. The Congress is expected to act upon return to enact either a standalone drought package or a new farm bill that contains livestock farmer assistance. Both insurance indemnities and disaster assistance augment the receipts from strong prices, leading to the strong cash receipts expected and forecast for the sector. Now, slide 28. There are no good examples of how farmers may react to this year's adversities. A review of history shows that previous large-scale adverse weather event years have been followed by strong sales in the following year, as the graph shows. This was the case for the drought of 1988 and the floods experienced in 1993. It's true that the fleet in North America this time is newer than in previous times.
Again, gross cash receipts are the strongest predictor of large ag equipment sales. Moving to slide 29, while the 2012 agricultural economic and equipment sales picture is coming into much clearer view, what are the implications for 2013? Clearly, the adverse growing conditions in the U.S. have been combined with those in other parts of the world and are serving to push prices worldwide to near record levels. The effect, of course, will be to encourage expanded agricultural activity worldwide in the coming season. This will be seen most immediately in the southern hemisphere crop plantings, especially in Brazil and Argentina, where strong prices are expected to boost areas sown, especially for major crops of corn and soybeans. It should be noted that farmer sentiment in that region today, at the beginning of the season, is very positive.
We should also not overlook the fact that the drought has not extended to Canada, which expects a bountiful harvest this fall to be marketed at very strong prices. Canada, too, will be very responsive to strong prices in 2013. Turning to slide 30. This slide, portraying production and consumption of all grains worldwide, illustrates the challenge faced by the global agricultural plant in the past dozen years in trying to keep pace with the steadily rising demand. This rising demand reflects the ascendancy of the emerging market and developing market economies. For 2012-13, forecast production again falls a bit short of the consumption requirements, boosting prices and encouraging additional output in the following year. As can be seen on slide 31, the precarious global stocks-to-use ratios are evident.
This is the amount of grain carried over at the end of each year relative to the amount needed for an entire year's consumption. Grain stocks are low worldwide and historically low in the U.S. for corn and soybeans. Large harvests will be required for the next couple of seasons to not only meet the consumption requirements but to also rebuild stocks to more comfortable levels. In closing, on slide 32, I would just note that the current situation is unprecedented. Some time will be required to fully understand all the far-flung ramifications on the farm sector in the U.S. and on farmers worldwide, and to fully appreciate the implications for the farm equipment business.
Early assessments, however, suggest that the U.S. farm sector is much better prepared to absorb the impact than in previous history, and that farmers worldwide are poised to respond to much stronger commodity prices with expanded agricultural activity next year. Thus, we continue to see aggregate sector performance for 2012 to be very strong and for that performance to continue across 2013 at least.
Thank you for joining us today, J.B. Now we're ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. As a reminder, in consideration of others, especially with our more limited Q&A time today, 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 star one on your touch-tone phone. To remove yourself from the queue, you may press star two. As a reminder, please limit yourself to one question and one follow-up. Our first question comes from Jerry Revich, and please state your company name.
Hi. Good morning. It's Goldman Sachs.
Morning, Jerry.
Can you update us on what was the impact of the transition to Interim Tier 4 products on your factory costs this year, given the adjustment you made this quarter? Please step us through how the Interim Tier 4 product transition plan for 2013 compared to the range of products that you transitioned this year. Thank you.
In terms of 2013, I'll go backwards, Jerry. 2013, there will be very modest transitions. I think there's just a couple of products throughout the product line. We will again, of course, in 2014, start complying with the Final Tier 4. In terms of the cost, maybe the best way to characterize the cost would be what our previous forecast was and a total cost, which was $300. Help me, Tony. Do you have that number handy? $320?
It's $325.
$325 million is the production impact from all of the transitions, not just in the quarter, but really the forecast for the full year.
Okay. Thanks, Marie. Then can you talk about how you're thinking about your production schedule over the next three to nine months? You mentioned inventories in some areas are higher than you'd like. Just wondering if you could step us through how we should be thinking about the schedule from here. You mentioned that early order combine program's off to a good start, but I think you had restricted the number of slots you allowed a year ago. Can you just step us through the production schedule broadly?
I can comment certainly on the remaining three months in the year. I can't comment on 2013. Jerry, basically, you can see that we not only adjusted or because of the third quarter results, we're a little lighter on sales this quarter, but we did make some adjustments for the full quarter as well. Really that is reflected in the slowing of the international markets and the desire to get those inventories back in line. It'll take a little bit of time because, of course, some of those products are spring season products and won't move until we get into next year.
I was going to say, add too, Jerry, this is Tony. As you look at combine, you mentioned that specifically. This year, as you know, our shipping pattern was vastly different than what would be kind of a normal or average, where we had about 75% of the shipments in the back half of the year. That, again, was related to the Interim Tier 4 transition during 2012. As a reminder, the weighted average of the three to four years prior to that would have been about 35/65, and would expect to probably go back to a more normal shipping pattern next year.
Thank you.
Maybe just one final point. In terms of the manufacturing execution, we expect to make most of that up in the fourth quarter, and that's, again, ultimately reflected in the forecast. Thank you, Jerry.
Thank you.
Thank you. Our next question comes from Ashish Gupta, and please state your company name.
CLSA, thank you. Good morning. Just kind of wondering if you could give us a little more color on sort of where lead times are right now and where your order book is relative to a year ago.
Well, again, the early order programs, ex-Combines, because Combines, it's very early for that. They're running about 15% above year-ago levels. Combines are off to a very solid start, but we're only a couple of weeks into a program that runs for several months. It's premature to quote statistics.
On the Tractors, again, this is Tony. Again, 8R Tractors and the 9R Tractors are running very similar to what we would have had a year ago.
Just on the incremental margins. I know the manufacturing issues are being worked through, but I guess the guidance for operating margins would imply incrementals would be up in the fourth quarter sequentially.
I think we'll let our guidance speak for itself on that. Thank you, Ashish.
Thanks.
Thank you. Our next question comes from Ann Duignan. Please state your company name.
Hi, good morning. JPMorgan.
Hi, Ann.
Good morning.
Hi. Nice to hear you, J.B.
Hi.
I guess my question's probably targeted to you also. I appreciate on slide 19 that your fourth bullet refers to potentially very positive year for agriculture and farmers for 2013. Could you talk about some of the risks also, J.B., maybe in terms of availability of seed or the extension of the drought into next year and the fleet is newer versus prior cycles. Could you just talk about some of the downside risks that could potentially be a headwind heading into next year?
Yes, Ann, it's good to hear you. I think you mentioned probably what I would think is the greatest risk, that is continuation of adverse weather in various parts of the world. If we continue to have a prolonged drought, then of course that's going to reduce output and keep prices high and affect farmers' bottom lines, of course. Beyond that, I don't think there are any other big risks lurking like seed shortages or fertilizer shortages or things of that nature. I don't see that. There may be some in various parts of the world, but they're very localized if they exist. I think weather is probably the biggest risk in the agriculture business that we can see at this moment. Yeah. I should note that South America is gearing up now, as you know, for the planting season. There's a lot of enthusiasm there.
They're looking to expand area and of course, to take advantage of these very high corn and soy prices now.
Okay. A nice follow-up question is on your crop insurance business. Can you give us a little bit more color? We know that you reinsure that business. You took a $25 million charge. Is that what you anticipated the full year loss might be? Should we anticipate higher SG&A costs in financial services just on the potential huge volume of claims that, given the crop the way it was, can you just talk a little bit more about that business?
Ann, this is Jim. The provision that we've talked about in the press release is our current best estimate of what we will be dealing with in terms of insurance. As you note, there's a significant amount of reinsurance that backs the policies that we write, and we're just left with some of the residual risk. To put it in perspective, we took kind of the aggregate industry-wide losses that we were looking at, and we said, "What happens if that doubles?" Even if that doubles, you'd be talking about something that would be less than a $50 million impact to the financial services operation. Clearly, de minimis in the grand scheme of a $3.1 billion net income. Thank you very much.
Thank you.
Next question.
Thank you. Our next question comes from Andrew Casey. Please state your company name.
Wells Fargo Securities. Good morning, everyone.
Good morning.
I guess turning to Construction & Forestry, could you elaborate on the magnitude and drivers for that Canadian shipment delay you talked about? Because in that segment, you're looking for your guidance for a pretty sharp moderation in Q4 growth from Q3 on a year-over-year basis. Is that decrease really driven by the Canadian thing, or is it equally split between the three different factors that you talked about?
Yeah. The Canadian piece would certainly be a big part of that change. As a reminder, in Canada, we do have confined inventory there, and so we don't recognize the sale until the retail sale to the customer. That's part of that shipping delay issue is getting it into the country in time to recognize the retail sale.
Okay. Thanks, Tony. Just to follow up on that, is this part of the inventory increase the outlook for the year?
This is Marie. It'd be a very small part of it. The bigger story, quite candidly, is Ag, which you can see from the guidance.
Sure. Okay. Thank you.
Thank you.
Thank you.
Thank you. Our next question comes from Stephen Volkmann, and please state your company name.
Hi. Good morning. It's Jefferies.
Steve.
J.B. Outecho. Thanks for joining us, a couple of quick questions, I think, for you. You talk about the farm income, or actually, I guess the cash receipts forecast on slide 24 here, and I guess it seems to me like the big difference this year is going to be a lot more of that is going to be made up of government payments and insurance payments. Do you have just a kind of a guesstimate of how that's going to change year-to-year?
It's pretty clear that crop insurance indemnities paid to farmers will be larger this year than last year. There are no good estimates yet because the data are still being accumulated, but it'll be significantly more than last year, I think everyone expects. Government payments from the commodity programs will probably not be as much this year as last year because prices are higher. Except for the direct payments, which are made regardless of prices, those will stay the same. I think we're mostly looking at gross receipts being made up of sales in the marketplace, plus crop insurance, plus the little bit of government payments. It's a little bit mixed from last year, but not terribly different except for crop insurance indemnity.
Maybe, it's Marie, I'm going to just chime in here because I think the relevant question is, do they spend these payments from crop insurance or government any differently? The survey data and past history suggests that is treated as regular revenue, and I think that's a significant fact.
The other thing I would add is this is Jim. To put it in perspective, we're talking about aggregate receipts that are in the range of $400 billion. On the crop insurance, I think we told you about $11 billion last year. If you assume that goes up by 50%, you're talking still just over a point of the total amount of the payment stream. It's got a lot of headline value, but if you step back and look at it in the aggregate, it's not a very big chunk of the overall total.
Thank you. Great. I think I still got a quick follow-up, and if it's okay, Thank you, Marie, for asking my follow-up.
You got half the team responding to your question, though. That was it.
You can answer this one real quick. I think the answer is just no. Based on all the stuff you've given us here, which is fairly bullish, I think, for 2013, are you willing to say that you think 2013 can be a year of growth for your ag businesses globally?
I would tell you that you know, of course, we are not going to provide you with an outlook for 2013 other than to say that certainly we are trying to paint a picture of very strong positive fundamentals. While saying, as always, there's a little bit of caution, things look very encouraging for most sectors of agriculture. Thanks, Steve.
Thank you. Okay.
Thank you. Our next question comes from David Raso, please state your company name.
ISI Group. I was just wondering if you can really just help clarify the changes in guidance. If you look at the revenue change, the guidance, it's roughly $575 million-$600 million, the EBIT went down $350 million-$375 million or so. It's a pretty hefty decremental margin there of over 60%. It'd be helpful, can you bucket the pieces driving that? For example, when people are trying to think through that Combines issue, how much of the $350 million-$375 million EBIT would you allocate to that? How much to the Canadian issue of construction? We're just trying to get a feel for how much do you feel All right. It was a tough quarter on execution for Combines, a couple issues we mentioned to get a feel of how you're looking at the run rate.
If maybe you can bucket what's driving that big decremental margin, because the revenue really, the guidance at least, didn't go down that much, but your EBIT, your implied EBIT went down a pretty healthy amount.
Well, I tried to address somewhat this in my comment that when you look at the sales for the quarter, 50% was related to these issues that we caught up on largely in the fourth quarter, and 50% was related to weakening markets. The bottom line impact would be relatively similar.
Okay. Basically.
Maybe one of the things, David, that you probably wouldn't have had, we certainly wouldn't have had in our previous forecast, was the impact of exchange.
Yes. That would be the other big piece of it.
Susan commented that it's a positive benefit in SG&A and R&D expense. Ex that, it's about $150 million in the quarter, and certainly that's a pre-tax number and that had an impact. For those of you who may not be familiar, we have, over the course of the year, very well-balanced trade flows. But they don't perfectly match on any given day. You can get some noise because of that. The other thing is that, where we aren't perfectly balanced, we do have hedging programs. But as a practical matter, you don't necessarily, or are unable, in some cases, to perfectly hedge 100% of that exposure. You're aware, certainly, of what's happened with the dollar relative to other currencies.
Just maybe to help people with the math, the shortfall this quarter was $725 million of revenues, roughly.
David, I think in the interest of time, if you want to talk more tactically, we'd be happy to take that offline.
Well, I guess it's the same question about the inventory and receivable increase. How would you bucket that a little more succinctly, if you could? How much was just simply higher inventory receivables than you had planned on, versus how much of a purposeful look at confidence in 2013? Just trying to understand the moving pieces of that. At least on a reported basis, you're saying it's going up $725 million higher than the previous guidance for receivables and inventory.
Thanks. I would say basically last time our guidance had been up about $600 million for receivables and inventories, that really reflects the underlying market conditions. The balance of the increase really reflects some market slowdown and some timing of production, primarily.
Okay. Thank you very much.
Thank you.
Thank you.
Thank you. Our next question comes from Eli Lustgarten. Please state your company name.
Longbow Securities. Good morning, everyone.
Good morning.
Morning.
Can we just follow through what Raso was talking about? You told us that you had a big impact from inefficiencies. Can you quantify that? Because you're claiming you're going to make that up, it can't be 50/50 impact and make it up in the fourth quarter and still be down $350 million, $300 million plus in the guidance for EBIT. Can you separate out the impact of those?
I think what we said, what we're going to catch up on is most of the sales shipments.
It's the sales shipments you're going to-
Pardon me?
It's the sales shipments you're counting up, not the production inefficiencies in the quarter?
Well, no. Obviously, we're going to be much more efficient. To the extent that we generated inefficiencies related to not hitting these, those are going to be with us for the balance of the year.
I just wonder whether you can quantify.
Eli, maybe just to short circuit this. It's very difficult to calculate an exact number, we would tell you that we're in the range pre-tax of somewhere in the range of $50 million-$75 million. That will.
That's been incrementally reflected.
That's been incrementally reflected due to the disruptions, if you will, and the delay.
That's what will be made up in the fourth quarter, that magnitude?
No, that's money that's a sunk cost from some of the transitional activity issues. The production will get made up by some of that operating efficiency to cut to the chase.
As a follow-up, can we talk a little bit about the insurance income that we claim it will be protected, but there's a real debate as to when it will be paid, and it looks like it's going to talk out later than earlier because particularly when you have an October fiscal year. Either it may be recognized, the recognition may not be through 13 to 12. Does that have any implications of how you have to run your business not only third quarter, but the first part of next year? Can you give us some color on the recognition income? While it may be matched and the farmer spends it may be spent later rather than earlier.
First of all, farmers come into this with their very strong balance sheet and in very solid financial position. If they are waiting for some revenue, obviously, some of our products are seasonal products, and they're on waivers.
Second of all, you have a component of it that not all the buyers are cash buyers. If they have a solid balance sheet and they have a solid-looking projection with insurance receipts that they haven't received, but they're going to be there, they also have the ability to finance these machines.
I should also, for our John Deere crop insurance customers, point out that we are very adequately staffed in terms of adjusters. The timing of when they receive the payments depends on when the farmer contacts us and then when the insurance adjuster is able to make the assessment. We have adequate staff to cover this event.
Eli, maybe to your point, in terms of those that have the revenue protection, there's initial payments that are made, and then as the prices come out from RMA later, there may be an additional payment made at that time.
It's a dual payment system. They'll get some money up front anyway. You're saying?
Correct. Yes.
All right. Thank you.
Thank you.
Thank you. Our next question comes from Vance Edelson, and please state your company name.
Thanks. It's Morgan Stanley. Keeping in mind that weather is perhaps the biggest risk on a global basis and just thinking about the future, the U.S. drought impact has been fairly minimal, but Southern Europe has been more hampered by drought, and South America to some extent as well. Could you provide a little more detail on how the specific dynamics in North America that make it more resilient may simply not exist in other regions? In terms of insurance coverage, ability to lock in future prices, farmer balance sheet strength, the technology. Is this really all quite unique to North America or to the U.S.?
I think perhaps as you think about Europe, the most important thing is to remember the overlay of the economic backdrop there and the situation in Southern Europe, I think is perhaps most relevant with what's happening economically. I think that in this particular case, the drought is an unfortunate add-in, but really not the major factor driving the results there. J.B., do you have anything else to add?
No, I think you mentioned the reasons that North America may be unique. It should rebound from this drought very quickly. Again, assuming that weather is normal next year.
Okay. As a closely related follow-up, within the U.S., could you expand a little on the differences of larger farmers versus smaller ones in terms of their ability to deal with the drought? Are the smaller farmers becoming more sophisticated year after year?
Well, first of all, I think we should make the delineation between crop farmers and livestock farmers. I do want to point out that livestock farmers in certain parts of the country are very severely affected by this drought. As I said, they don't have insurance available to the same extent that crop farmers do. They are seeing their pastures completely destroyed. Their hay crops are nonexistent. They are having a very severe adjustment process. The crop farmers, on the other hand, it varies by region of the country as to how severely they've been affected. Of course, most have access to crop insurance, so that's going to make a big difference. I think as you suggest, the large farmers generally have better risk management programs both for natural disaster and for price and income fluctuation.
I think they're probably better geared to manage this adversity than some of the smaller farmers would be. By and large the high prices affect everybody who's got product to sell, and it affects them in a very positive way.
Sure. Okay. That's very helpful. Thanks.
Thank you.
Thank you. Our next question comes from Jamie Cook. Please state your company name.
Hi, good morning, Credit Suisse. Two questions, one of which I don't think you'll answer. I'll try. I guess, Jim, just longer term, you guys have given a picture without giving specific guidance about 2013. Sort of consistent with what you said at the Analyst Day, you feel okay about demand for farm equipment for 2013. I guess my question is more on the incremental margin line. Without giving specific guidance about incremental margins, can you sort of talk about potentially the positives and the negatives that we should be thinking through as we're thinking about incremental margins? You mentioned U.S. should be fine, but you mentioned some Deere-specific issues. Maybe we don't have as much Tier 4 headwind. We have inventory issues that run into 2013. You talked about Brazil and China on the C&F side.
I was just sort of wondering if you could give more color there. My second question, if you could just elaborate on some of the supplier issues that you mentioned during the earnings call, where they are and what your comfort level is that the supplier issues don't continue into 2013. Thanks.
Jamie, this is Jim. Let me talk about the supplier question. I think in that regard, we've more or less said what we're going to say on that. We have isolated issues from time to time. Beyond that, we're not going to say much more right now. On the 2013, I think on that, to give much more color, we're going to have to wait until the next call. We're in the process, quite frankly, right now of pulling together our first cut of the budget for 2013, I think we would be wise to wait until we have that run through the process before we start talking about 2013. Thank you very much.
Thanks.
Hey, operator, we have time for one more call.
Thank you. Our final question comes from Henry Kern, please state your company name.
Hey, good morning. It's UBS.
Hi, Henry.
You mentioned financing challenges in Southern Europe and CIS. Can you give some view on how significant the headwinds were to demand? Are you willing to step up in financial services presence to keep credit available in the key markets?
You are correct that we do have credit operations in several of these countries. The answer is yes, we're able to help out and offset some. In some markets, there is just not a lot of credit available. You're well aware of some of the banking system issues, and that's also affecting some of the, I'll say, the speed with some of these things are processed. It is a factor, quite candidly. Certainly not the largest factor, but something that we wanted to cite. It's not a huge factor at this moment.
As a follow-up on the canceled Combine orders, do you expect the customers who are canceling orders to buy from someone else or use their old Combines and then come back and buy from you in the future?
Yeah, Henry, I think it's important to note that most of those cancellations were not retail orders. The bulk of those were dealer purchase for stock.
Okay. That makes sense.
They didn't reflect reduction in retail. With that, we expect that those very few customers who have delayed or who have not purchased because we are not going to get the Combine to them on a timely basis will be definitely in the market for the most productive, best John Deere harvesting equipment that we have ever had available. With that, Tony? Okay. Before we close the call, I just want to circle back on some items that we covered earlier. First of all, this was a great quarter on many fronts. The best ever third quarter for sales and profits. We clearly have work ahead of us, though, as we resolve the manufacturing issues from the third quarter and focus on managing our inventory levels lower. We're up to the task. 2013 looks to be a very positive year for agriculture and many farmers.
There's no question of the urgent need to rebuild global stocks with our highly productive equipment. John Deere is well-positioned to play a key role. With that, we thank you for your participation in the call, and as always, we'll be available the rest of the day to answer any additional questions you have. Operator?
Thank you. This does conclude today's conference call. We do thank you for your participation.