Good morning. Welcome to Deere & Company's first quarter earnings conference call. Your lines have been placed in listen-only mode until the question and answer session of today's conference. I would like to turn the call over to Mr. Tony Huegel, Director of Investor Relations. Thank you. You may begin.
Hello. Also on the call today are Rajesh Kalathur, our Chief Financial Officer, and Josh Jepsen, our Manager of Investor Communications. Today, we'll take a closer look at Deere's first quarter earnings, then spend some time talking about our markets and our current outlook for fiscal 2017. 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 www.johndeere.com/earnings. First, a reminder, this call is being broadcast live on the internet and recorded for future transmission and use by Deere & Company. 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/earnings under Other Financial Information. Josh?
With the announcement of our first quarter earnings, John Deere has started the year on a positive note and done so in the continued face of soft market conditions. Though earnings were somewhat lower than last year, all of our businesses remain solidly profitable. Some of the factors helping our performance in the quarter included sound execution, a broad product portfolio, and the impact of a more flexible cost structure. At the same time, we are seeing encouraging signs that after several years of steep declines, our key agricultural markets may be stabilizing. Partly as a result, we've raised our full year forecast for sales and earnings. Now let's take a closer look at our first quarter results in detail, beginning on slide three. Net sales and revenues were up 2% to $5.6 billion. Net income attributable to Deere & Company was $194 million. EPS was $0.61 in the quarter.
Our equipment operations effective tax rate was 50% in the first quarter due to largely unfavorable discrete items. It is worth noting the effective tax rate of the equipment operations in the first quarter of 2016 was 20%. That reflected a benefit from the permanent extension of the R&D tax credit and other favorable adjustments. On Slide four, total worldwide equipment operations net sales were down 1% to $4.7 billion. Price realization in the quarter was positive by two points. Currency translation was positive by one point. Turning to a review of our individual businesses, starting with agriculture and turf on Slide five. Net sales were flat in the quarter-over-quarter comparison. Lower shipment volumes and higher warranty costs were offset by price realization and the favorable effect of currency translation. Operating profit was $213 million, up from $144 million last year.
Ag and turf operating margins were 5.9% in the quarter. The increase in operating profit was driven primarily by a gain on the sale of a partial interest in SiteOne Landscape Supply, Inc., and price realization. These were partially offset by voluntary separation expenses, higher warranty costs, and the unfavorable effects of foreign currency exchange. The gain on the sale of a partial interest in SiteOne Landscape Supply contributed nearly three points of operating margin in the quarter, while expenses related to the voluntary separation program lowered margins by nearly two points. Excluding these impacts, operating margins were about one point higher than in last year's first quarter. Before we review the industry sales outlook, let's look at fundamentals affecting the ag business. Slide six outlines U.S. farm cash receipts.
Given the large crop harvest and consequently the lower commodity prices we're seeing today, our 2016 forecast calls for cash receipts to be down about 5% from 2015 levels. Moving to 2017, we expect total cash receipts to be about $367 billion, roughly flat with 2016. It is worth noting that net farm cash income, a good measure of farm business health, is forecast to be up slightly in 2017. You can see this information in the appendix. On Slide seven, global grain and oil seed stocks-to-use ratios are forecast to remain at elevated but generally unchanged levels in 2016/2017, as abundant crops are mostly offset by strong demand around the world. Chinese grain and oil seed stocks continued to increase in 2016, with supply, domestic production, plus imports outpacing demand. Chinese stocks of grains and oilseeds now represent almost half of the world's stocks.
Remember, these Chinese stocks are unlikely to be exported. That means the world market, particularly oilseeds, remains sensitive to any production setbacks, major geopolitical disruptions, or trade disputes. World cotton stocks have now fallen for a second consecutive season to the lowest level in five seasons. This reflects lower plantings and stronger global demand. Our economic outlook for the EU 28 is on Slide eight. Economic growth in the region is improving at a moderate pace, though geopolitical risks such as Brexit and populist sentiment remain elevated, as does currency volatility. Farm income remains below the long-term average due to high global grain stocks and last year's poor harvest in the Northwest EU, particularly France. The dairy market is seeing early signs of recovery as prices are forecast to return to average levels after many years of declines. Sentiment and margins are expected to improve throughout 2017.
Shifting to Brazil on slide nine. The chart on the left displays the crop value of agricultural production, a good proxy for the health of agribusiness in Brazil. Ag production is expected to increase about 8% in 2017 in U.S. dollar terms due to record acreage expansion and yield expectations. In local currency, the value of production is forecast to be up about 3%. Profitability for Brazilian farmers remains at good levels as crops are sold in $. On the right side of the slide, you will see eligible rates for ag-related government-sponsored finance programs. Rates for Moderfrota remain at 8.5% for small and mid-size farmers and 10.5% for large farmers. Importantly, the overall budget for Moderfrota has been raised by nearly 50% from the initial BRL 5 billion to BRL 7.5 billion. This demonstrates the government's ongoing commitment to agriculture and is driving continued improvement in farmer confidence.
Our 2017 ag and turf industry outlooks are summarized on slide 10. Industry sales in the U.S. and Canada are forecast to be down 5%-10%, with the effects being felt in both large and small models of equipment. Particularly affected are products used in the livestock sector, such as mid-size tractors and hay and forage tools. Still, there are signs the large ag market is nearing bottom. For example, the magnitude of the industry decline expected in 2017 is considerably less than that experienced in 2016. Also, the used equipment environment is stabilizing. The EU 28 industry outlook is forecast to be down about 5% in 2017 due to low crop prices and farm incomes, as well as the geopolitical risks mentioned earlier. In South America, industry sales of tractors and combines are now projected to be up 15%-20% in 2017.
This is a reflection of improved confidence, slowing inflation, and lower benchmark interest rates in Brazil, as well as positive industry sentiment in Argentina. Shifting to Asia, sales are expected to be flat to up slightly, with growth in India being the main driver. Turning to another product category, industry retail sales of turf and utility equipment in the U.S. and Canada are projected to be roughly flat in 2017, with Deere sales outpacing the industry. Putting this all together on slide 11. Fiscal year 2017 Deere sales of worldwide Ag and Turf equipment are now forecast to be up about 3%. The forecast change is a result of sales improving in all regions of the world, most notably in South America. The Ag and Turf division's operating margin is forecast to be about 9% in 2017, roughly in line with 2016.
Now let's focus on Construction and Forestry on slide 12. Net sales were down 6% in the quarter as a result of lower shipment volumes and higher sales incentive costs. Operating profit was $34 million in the quarter, down from $70 million last year. Lower results were driven mainly by higher sales incentive costs in the voluntary separation program. C&F operating margins were 3.1% in the quarter. Expenses related to the voluntary separation program were incurred as expected in the quarter, creating a nearly one and a half point headwind to operating margins. Moving to slide 13. Looking at the economic indicators affecting the Construction and Forestry industries, there is a slight improvement in the fundamentals. GDP growth is positive. Job growth continues. Construction spending is up from 2016 levels, and housing starts are expected to exceed 1.2 million units this year.
Construction investment in oil and gas activity improved in the fourth quarter of calendar 2016 after seven quarters of decline, while residential and commercial institutional construction continued to increase moderately. Machinery rental utilization rates have made slight improvements after multiple quarters of deterioration. Forward-looking sentiment has improved with the prospect for higher infrastructure spending. On the other hand, used inventory for the industry remains above normal levels and rental rates are still soft. Also, economic growth outside the U.S., particularly in Latin America, is sluggish. All in all, our outlook on the construction industry is cautiously optimistic. Moving to the C&F outlook on slide 14. Deere's Construction & Forestry sales are now forecast to be up about 7% in 2017, largely driven by production moving closer to retail demand.
The forecast for global forestry markets is flat to down 5%, a result of lower sales in the U.S. and Canada. 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 provision for credit losses as a percent of the average owned portfolio. At the end of January, the annualized provision for credit losses was eight basis points, reflecting the continued excellent quality of our portfolios. The financial forecast for 2017, shown on the slide, contemplates a loss provision of 29 basis points, unchanged from the previous forecast. This would put losses just above the 10-year average of 26 basis points and below the 15-year average of 39 basis points. Moving to slide 16. Worldwide financial services net income attributable to Deere & Company was $114 million in the quarter versus $129 million last year.
The lower results were primarily due to less favorable financing spreads and expenses related to the voluntary separation program. 2017 net income attributable to Deere & Company is forecast to be about $480 million, unchanged from our previous forecast. Slide 17 outlines receivables and inventories. For the company as a whole, receivables and inventories ended the quarter down $461 million. We expect to end 2017 with total receivables and inventory down about $200 million, with reductions being made by both equipment divisions. With respect to North American large ag field inventories, Deere inventories as a percent of rolling 12 sales are roughly half of those of the rest of the industry. As an example, at the end of December, the inventory-to-sales ratio for Deere two-wheel drive tractors of 100 horsepower-plus was 37%, while the industry less Deere was 81%.
Slide 18 shows cost of sales as a percent of net sales. Cost of sales for the first quarter was 80.8%, which includes the impact of the voluntary separation program costs. Our 2017 cost of sales guidance is about 78% of net sales, unchanged from the last quarter. When modeling 2017, keep these unfavorable impacts in mind: an unfavorable product mix, emissions costs, voluntary separation expenses, and overhead spend. On the favorable side, we expect price realization of about one point. Now let's look at some additional details. With respect to R&D on slide 19, R&D was down 3% in the first quarter, including the cost associated with the voluntary separation program. Our 2017 forecast calls for R&D to be down about 2%. Moving to slide 20.
SA&G expense for the quarter for the equipment operations was up 12%, with the main drivers being the voluntary separation program expenses and commissions paid to dealers, which result from direct sales to customers. Our 2017 forecast contemplates SA&G expense being up by about 5%. More than half of the full-year change is expected to come from voluntary separation expenses and commissions to dealers. Turning to slide 21. The equipment operations tax rate was 50% in the first quarter, primarily due to discrete items, as noted earlier. For 2017, the full-year effective tax rate forecast remains in the range of 33%-35%. Slide 22 shows our equipment operations history of strong cash flow. Cash flow from the equipment operations is now forecast to be about $2.6 billion in 2017. The company's financial outlook is on slide 23.
Net sales for the second quarter are forecast to be up about 1% compared with 2016. This includes about two points of price realization. Our full-year outlook now calls for net sales to be up about 4%, which includes about one point of price realization. Finally, our full-year 2017 net income forecast is now about $1.5 billion. In closing, John Deere continues to perform far better than in agricultural downturns of the past, and our first quarter results provide further evidence of that fact. This is due in large part to our ongoing success developing a more durable business model and a wider range of revenue sources. In addition, our efforts to improve operating efficiency are gaining traction, and we remain confident we can deliver at least $500 million of structural cost reductions by the end of 2018.
All of this reinforces our belief that Deere is well positioned to deliver significant value to our customers and investors in the future.
Thank you, Josh. Now we're ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. In consideration of others and our hope to allow more of you to participate in the call, please limit yourself to one question. If you have additional questions, we ask that you rejoin the queue. Cindy?
Thank you. We will now begin the question-and-answer session. If you would like to ask a question, please press star followed by the number one and record your name at the prompt. To cancel your request, press star two. Once again, please press star one to ask a question. One moment please for our first question.
The first one is from Ross Gilardi. Your line is now open.
Sorry if I missed this at the beginning, I just wanted to understand. Is the guide increase on net income from 1.4 to 1.5, is that being driven largely by the SiteOne gain? Can you help us understand why a 300 basis point increase in the revenue guide doesn't drive a greater than $100 million net income guide?
Sure. Yeah, I think certainly, our original budget would not have assumed the SiteOne gain. That would be part of the change from original budget to our current guidance. Of course, I'd note also in the quarter, as Josh talked about, there was a tax impact that's about $25 million negative. If you think about some of the increased sales that came, mix was not as favorable. I think some would anticipate, especially in the ag division, for example, a higher incremental margin. Keep in mind, again, as Josh pointed out in the opening comments, the sales increases were really pretty widespread geographically. To the extent that there was additional sales coming from the U.S. and Canada market, it was mostly, or largely coming from small ag.
Compact utility tractors, which again, have attractive margins versus things like our large tractors and combines, not quite as significant of a margin. That's really what was driving some of that. Okay?
Okay, thanks.
Thank you. Next call.
Thank you. Next question's from Timothy Thein of Citigroup. Your line is open.
Hi, good morning. Tony, the question relates to financial services, and I guess I'll tie it in in part to Josh's comments about some stabilization that you've seen in the used market in North America. It doesn't appear that you booked an impairment this quarter. I'm just wondering, did that signal kind of an improvement that you've seen in terms of the rate of lease returns, as well as some of the values realized on some of the used sales?
Yeah, certainly, to your point, really no change in the guidance on financial services as it relates specifically to operating leases. I think I'd say largely, the quarter went as expected. I think many would view that as good news in that regard. I would point out, though, to be fair, first quarter is a relatively low quarter for lease returns. You'll see more just with the seasonal impact. You'll see a bit more in the second quarter. I think as you think about risk going forward, certainly as we've taken some additional depreciation and impairment in the past to anticipate this, as well as the fact that the used equipment market is appearing to stabilize is a good sign and gives us, I think some, I'll say cautious optimism as we go into second quarter with those operating lease returns. We'll see how that progresses.
Again, at least through the first three months, things moving pretty much as planned for financial services. Okay. Thank you. Next caller.
Thank you. Next question is from Ann Duignan of J.P. Morgan Securities. Your line is open.
Just follow up on the last question. Your other operating expense and financial services remains elevated, and last quarter, a large portion of that was the loss on sale of used equipment. Could you talk about whether you incurred a loss on sale of used equipment in the quarter and how much that was?
Yeah. Certainly you see that and was forecasted to see some loss on the sale of equipment. Again, it was largely according to forecast. As you look at that year-over-year, it was roughly in line with what we incurred last year. Really no elevated level of losses coming from those leases. Maybe just some of the other things that we're seeing, volumes actually showed year-over-year in the first quarter, a slight decrease. That's on operating leases, which are a pretty good sign. As well as when you think about return rates, we're seeing those return rates also stabilizing. I'll further note that if you think about going past second quarter, we largely get beyond that headwind that we've been experiencing with those 12-month leases.
We would have significantly fewer as we go through the second half of 2017, which again, assuming the performance on those longer than 12-month leases maintain or improve would actually bode pretty well for operating lease returns again, as we move further into the year. Hopefully that helps, and we'll move on to the next caller. Thank you.
Thank you. Next question is from Jerry Revich of Goldman Sachs. Your line is open.
Hi, good morning, everyone.
Hi, Jerry.
Tony, I'm wondering if you could talk about the stabilization in dealer inventories. It sounds like from the prepared remarks you're producing in line with retail demand this year. Can you just frame for us over the past couple of years how much dealer inventory has come out of the channel? Is there any opportunity for some modest restocking at Over the next couple of years, or are you folks planning on running leaner than you did call it three, four years ago in terms of dealer inventories?
I think if you think about new equipment, and what we've really talked about through 2016 and even in 2015, is as we ended the year, the target was to have inventories in line with our current retail sales environment. The real difference this year is we aren't seeing a significant decline in that retail environment year-over-year as we had both in 2015 and 2016. As a result of that, we're able to produce largely to retail demand. Now, obviously, there's going to be puts and takes by individual product. As you think about large ag in total for the U.S. and Canada, we're producing in line with retail, which does give us some year-over-year benefit, obviously, in our sales as we're able to do that. Really, the answer to your question would depend on what happens to the retail environment.
In a year where you start to see the retail environment improving, that's when we would consider starting to lift that inventory level in line with that. Again, we're in pretty good shape. I think your question was specifically around ag and turf, and I'd point out for C&F, we ended the year, and again, we talked about this last quarter. If anything, inventories at our dealers were actually maybe a little light versus where we would normally have them, and that's where you have some benefit. Potentially, if you start to see some recovery in that market, you'd certainly see some inventory coming back in for C&F. If we see that industry really starting to improve.
Thank you.
Thank you. Next caller.
Thank you. Next question is from Jamie Cook of Credit Suisse. Your line is open.
Hi, good morning. Tony, just want to dig into. You talked about C&F, and you talked about where the dealer inventories are, but you did raise your outlook for C&F, which is curious to me because I know that's a division that sort of has disappointed you guys in the past in terms of being a little optimistic and then the forecast doesn't follow through. Just sort of on the ground, what are you seeing to give you that confidence level that we should be raising guidance? Because I think you wanted to take a more conservative approach there. I don't know if you saw anything in the quarter or in January or February to give you confidence. Thanks.
Yeah. I appreciate that question. Yeah, certainly, 7% increase in Construction & Forestry for the year is what we're currently guiding. We did see the industry. Our industry outlook improved a little bit certainly from where we were at original budget. Really what we saw in the quarter was a very strong order book. That's what's driving that confidence in terms of where that outlook improved. Now, I'll go back to the previous comments. A lot of this is really the benefit we're seeing in those higher sales in large part is the fact that, again, inventories at our dealers ended the year at very low levels, and especially compared to the industry, our used equipment at our dealers are actually in very good shape as well.
That does give us the opportunity and, again, some additional optimism that we'll see those sales pull through for the fiscal year. Again, I used the term cautious optimism earlier related to operating leases. I think we'd say the same thing with Construction & Forestry. Certainly seeing some optimism, cautiously viewing that simply because of, to your point, some of the experiences we've had in recent years.
I know you said the order book improved, can you put any more color around that or numbers on that? I'm assuming you won't, I'll try.
Hey, Jamie, if you just take the first 12 weeks of orders for this quarter or even 13 weeks for the first quarter versus the same time last year, our orders are up over a third.
Wow.
This is for U.S. and Canada. Now again, we don't think that's going to be the case for the full year. That shows the sentiment out for the dealership, for the customers, and so on, okay?
Right. I'd remind you that some of that as there's optimism that comes in, and we've talked about this all along. Because of where our inventories are at, if our dealers start to sense that there is any kind of improvement in the market because of the significant destocking they did, there would need to be some additional stocking. Again, you're seeing that reflected, at least in the short term, in our order books.
Okay. That's helpful. Thank you.
Thank you. Next caller?
Thank you. Next caller is David Raso of Evercore. Your line is open.
I was curious. Organically, you raised Ag and Turf revenues by over basically $900 million, kind of a 5% swing. Your end market outlook hasn't changed notably, except for a little bit in South America. Can you help us better understand? Also, you didn't change your inventory outlook as well. Is there a change in your production versus retail? I didn't hear that in the earlier answer. Have you changed your view of production versus retail in Ag?
Specifically in Ag, actually, I'll look at the slide that we show. Really very little change for Ag when you think about the fiscal forecast, still forecasting inventory and receivables combined down $125. What I would say is, I think on the margin, we saw some slight improvement kind of across the board geographically, with the exception of South America, as you pointed out. Not enough, really, to shift the overall industry guidance. I think, again, on the margin, some slight improvement in the underlying industry that certainly from our sales perspective, we saw maybe a little bit more growth there in terms of market share anticipation in the year.
In general, within each range, some improvement with only South America, a true bump up in range.
Correct. Yep.
Okay.
Yep, exactly.
For David, this is Raj. Just to add some more color to what Tony said and what Josh said earlier. On the ag side, we are looking at retails actually growing around the world, right? This is in region 4, we said there are some compact utility tractors. You're also seeing some strength in some commodities, like cotton, for example, okay? Beyond that, you'll also look at region 3. We talked about Brazil. There's also more enthusiasm in Argentina and a little bit more in Mexico. If you go to region 1, a little bit more enthusiasm in China. All these things add up to what you said.
Okay. Thank you. Next caller?
Thank you.
Yeah.
Thank you. Next is from Joe O'Dea of Vertical Research Partners. Your line is open.
Hi. Good morning. In terms of the inventory, you talked about carrying about half as much as the rest of the industry. We still continue to see the 100-plus horsepower category for the industry come in pretty high. Are you able to give any kind of breakdown for your own inventory levels if we split that 100 plus into the large stuff and the small stuff? Combines are actually at what look like very healthy inventory levels for the industry. Do your large tractors mirror what we would see in combines? We can kind of bucket all of the higher inventory levels in the small category, but just to try to understand that important category of tractor where we don't get as much visibility.
Sure. I'm not going to be able to give you specific numbers. Keep in mind, large tractors do tend to run a little higher than combines. Some of that's just the significant seasonality of combines and the way we use the early order program versus tractors using a more sequential, traditional type of order book. Again, you do see generally a little higher level of orders. What I would say is similar to what we said in the past, really what is driving that elevated level would be what we would consider mid-size livestock-oriented machines that are in that kind of 100-200 horsepower. It's not what we would consider large ag in the 220+ kind of range. Those are in very good shape from a new inventory level perspective.
Again, keep in mind, as you move into lower horsepower ranges, you also have a bit of a shift in our stocking strategies. We've talked about on the very small stuff, we tend to run with higher levels of inventory as a percent of sales simply because those tend to be a bit more of an impulse buy. As you move into that mid-size, certain products within that mid-size range are going to mirror a little bit closer to what we have with small ag, and others are going to mirror more what we do, lean more towards what we do with large ag. You do get a little bit of mix there as well. That's really what is driving those levels.
We are moving some of those mid-size, livestock-oriented type of products, is where we're seeing most of the inventory reduction in the year that's forecast. Again, I think generally, you see a little bit higher stocking strategy on those versus the very large equipment. Hopefully that helps. Let's go ahead and move on to the next caller. Thanks.
It does. Thanks.
Thank you. Next question is from Steven Fisher of UBS. Your line is open.
Thanks. Good morning. From a timing perspective, if you're forecasting roughly flat revenues in the first half on equipment side, that would imply you have upwards of 8% revenue growth in the second half. You talked to Jamie about some of the visibility you have in the orders on the construction side. What's the visibility you have on the ag side in getting to that overall strong growth in the second half of the year?
Yeah, if you think about it, again, we've talked about this quite often. North America, we certainly have our best visibility. When you think about large ag, in particular in North America, we do, as I just mentioned, have early order programs on combines and other seasonal equipment. Certainly, that combine early order program, in most years is 90-plus % of our annual production. That ended during our first quarter. We have very good visibility on combines. I'll assume the next question on that will be how did it end? I'll go ahead and give you that now.
Sure.
We did on combines ended up a single digit year-over-year. Again, I think it's reflective. A couple questions ago, someone mentioned the combine inventory position, and that certainly is reflected in that strong sales. On large tractors, again, we run a more of a traditional kind of sequential order book. There, I would say, if you look at our 7R, 8R, and 9R tractors, it's kind of a mix, but generally in line year-over-year from an availability perspective. What we mean there is if a customer comes in today and orders a tractor, when would that next availability be? Some are a little further out year-over-year. Some are a little closer. 8Rs, for example, are actually a little behind from an availability perspective, three to four weeks.
Last year would have been end of May, early June, and this year, availability is early May. You look at things like 7R tractors, and they're a few weeks ahead, as are some of the 9R tractors. Again, in general, running very much in line. I would say our visibility is pretty good, and our order book is very comparable year-over-year in terms of what we're seeing today versus the forecast that we have in place. Again, I think we'll obviously have even better visibility next quarter, but on large ag, pretty good visibility for the.
Thank you.
Thank you. Next caller?
Next is from Lawrence B. Murray of William Blair. Your line is open.
Hi. Thanks. Good morning, Tony. Hey, guys.
Hi, Larry.
In North America, specifically, some of your competition has been having some issues with their distribution. I'm just curious how you would view your distribution vis-a-vis the competition in terms of stress levels. I'm assuming it's in better shape, obviously. Just kind of curious what kind of market share changes or programs you might be running to take advantage of the situation and your relative health. Then just on the last question you just answered, can you give a large tractor percentage like you did for combines? Thanks.
Again, we don't comment in terms of the order book specifically on tractors, because it's a different type of ordering program in terms of not using an early order program. As it relates to the dealers, our dealer distribution, especially in North America on the ag side and construction as well for that matter, is actually in very good shape. We've done a lot of work in recent years with that dealer network, seen a lot of consolidation. Generally, those dealers of tomorrow, in particular, their margins are very strong. They utilize parts and service to really cover a significant portion of their fixed costs, which help them as they go through leaner complete goods years, like we're seeing over the last several years. So that's really helped us maintain, again, a very strong dealer network.
It's one of the things we talked about as you go through a downturn, often it does provide a good market share opportunity for us as we tend to manage our inventories much better than the competition. We're in a better position that way. Our dealers tend to be much stronger. We've had additional investment in product, so really expanding that technology gap between our product and customers. When you do see that market returning, generally that's, again, some of our best market share opportunities, and we would expect the same to occur as we go into future years here.
Would that be factored into this year, Tony, or would that provide upside if you're able to take advantage in the downturn this year?
Well, yeah. Certainly, we would have that factored in. I think as you look at our sales versus the sum total of the guidance that we have for industry, I think certainly that's reflected in those numbers.
Okay. Thank you.
Yep. Next caller?
Next is from Michael Chwistek of Seaport Global Securities. Your line is open.
Good morning, guys. Just want to go back to your comments earlier on the livestock industry. It's only been a few quarters of some kind of weak trends here. Do you think we're kind of seeing the early innings of a multi-year downswing in the livestock world at this time, or is it just more of a temporary blip? I know you have some kind of new mid-size tractor refreshes this year. Is it possible that if we do see a downswing, Deere might gain some share with some of your newer products out there to kind of fit that 100 horsepower, 110 horsepower range?
Yeah. Well, certainly, when you bring out new product, you always hope that drives some market share gain. Livestock, again, I think you've certainly seen some tighter margins, especially through the fall months. You're going to get a varying range of what could happen as you move through the year. I think as many people are aware, we do use Informa Economics as an external consultant there. Generally, I think they would see the feeder cattle market seeing some improvement in margins as we go into 2017. Again, not forecasting the very strong margins that we saw a couple of years ago, but certainly seeing some improvement. Same thing, really, for the pork industry. Poultry has remained pretty positive, although as production has increased you see a little bit of erosion in some of those margins, but again, staying positive.
I think what I would point out is across the board on all of those commodities, there is a healthy level of export demand anticipated for U.S. producers, I think that's probably one of the bigger questions is, does that export market actually happen or not? If you want to point to risk, I think that would be the major one we would point to. Certainly, today in the forecast, we would anticipate margins to stabilize and maybe even slightly improve across the complex.
Thanks.
Okay. Thank you. Next caller?
Thank you. Next question is from Andrew Casey of Wells Fargo. Your line is open.
Thank you. Good morning, everybody.
Andy.
Can you kind of provide some additional color on Europe? Specifically, orders and whether industry inventory levels are elevated in any particular region?
Yeah. If you think about Europe from an inventory perspective, certainly not a major concern there. Used in pockets would be elevated. Places like the U.K. with exchange sliding a bit there actually has helped the used equipment market. That was the area we previously had been pointing to with some elevated used. You'll see pockets there. From a new side, actually pretty good shape from an inventory perspective. It's a market that's kind of languished a bit over the last several years in terms of slight up, slight down throughout the region and really kind of forecasting that as we move through the year. One of the positive signs, as Josh pointed out, is dairy now after a year and a half of really creating some headwind in that market appears, in current forecasts anyway, to maybe be seeing some recovery.
That likely isn't going to drive equipment until maybe later in the year, but really into 2018, assuming that recovery continues. Again, as usual, kind of pockety, but inventory largely is not really a concern from that perspective. Thank you.
Thanks.
Next caller?
Yes. Next question is from Adam Uhlman of Cleveland Research. Your line is open.
Hi, good morning.
Adam.
I wonder if we could go back to the Construction & Forestry outlook. I'm curious if a pickup in demand from the rental channel is what has been driving the improvement in the order book recently. Related to that, have you changed your pricing assumptions at all for C&F this year with the dealer inventories getting weak and it sounds like with the strong orders. Has that been a component of the forecast increase?
Yeah. Certainly rental, I think for us, with some of the new product, especially in the compact equipment, is certainly a positive year-over-year. We've talked about things like our skid steer loader that's new this year, that we talked about that really at original budget. That certainly is a part of the sales for Deere in that regard. Pricing, keep in mind, that's less a function of an inventory issue for us. The negative pricing that we saw last year was not driven by our dealers having excess inventory. It was simply the competitive environment where in order to get sales we were losing market share early in the year and had to ramp up discounting in order to protect some of that. I think it's a little early yet to anticipate any improvement from a competitive perspective.
Certainly, we're hopeful that that would happen, but that would not have been part of the change in our outlook from original budget. Okay. Thank you. Next caller?
Thank you. Next is from Brett Wong of Piper Jaffray & Company. Your line is open.
Hey, guys. Thanks for taking my questions.
Yes.
Have you started to see any increased lending in Brazil? On the government credit availability, do you see any risk to where funds are going to come from and any thoughts around kind of rates moving lower for Moderfrota there? Do you see any risk to demand in Brazil given the strength in the Brazilian Real impacting some farmer profitability? Thanks.
Yeah, I think broadly as our outlook would anticipate, we continue to see strength and strengthening markets in South America, including Brazil. Profitability, while FX may have some impact, certainly is still very positive there. From a Finame perspective, there's always risk. I think the risk is always greater when you think beyond June when you move into the next fiscal year in particular. To your point, there's actually opportunity there as well as the overall market rate has come down. I think there is some speculation that there could be some pressure to reduce the Moderfrota rate as we go forward. We'll see what happens there. From a funding perspective, I think the government continues to be very supportive of agriculture. We've seen that, as Josh mentioned. We've already seen them add 50% to the original budget for Moderfrota.
What we've been told is their commitment remains, and to the extent there's need for additional funding that it will be available. Again, I think history would tell us that that's something that they have supported in the past. Hopefully we'll continue to see that type of support as we go forward. Thank you. Next caller.
Thank you. Next is from Robert Wertheimer of Barclays Capital. Your line is open.
Thank you. Good morning. Tony, just to clarify on your comments on how far you're out on the sevens, eights, and nines. That assumes a flat underlying production rate, and you're a few weeks ahead, a few weeks behind. Is that how I should interpret that?
No, because that implies a production rate in line with what our forecast is.
What your forecast is. Okay. Yeah.
Yeah.
Okay.
That's a very good clarification. It does not necessarily imply that even if we're same availability, that you have flat sales year-over-year. They could be higher, they could be lower.
Exactly. Okay, perfect. Then on commissions paid to dealers, maybe I missed it, but I think that's a new disclosure. Is that a new business practice? What exactly does that mean? Is there something shifting in the market where dealers want you to coordinate with big farmers more directly? Or maybe it's on the used trade-in more directly, or what exactly does that imply, if anything?
Yeah. There are some markets where we do have a little higher level of direct sales to large and very large customers. Brazil would be a market that we would highlight in particular. We have talked about commissions to dealers in the past, it's usually in environments like this where you're seeing sales in Brazil really elevated. Again, in order to compensate our dealers as those sales go directly, there are commissions paid to those. Those instead of being booked as part of our net sales, actually accounting rules would require us to book those as SA&G in sales, again, sales commission. That's largely what's driving it. You see it a little bit in U.S. and Canada. Again, mostly what you're seeing in the quarter was driven by Brazil.
Got it. Thanks.
Yep. Thank you. Next caller.
Thank you. Next is from Mircea Dobre of Robert W. Baird & Co.. Your line is open.
Yes. Thank you. Good morning. Growth is very much back half weighted, per your guidance. I'm trying to see if you can give us a little bit of color as to how we should be thinking about margin progression sequentially or maybe operating income, however you want to frame it, first half versus second half. Also associated with this, have you made any changes to your raw material assumption for the year?
Yeah. Generally again, as you would expect if you move through the year, I'm looking at total equipment operations, second and third quarter tends to be our stronger margin quarters. Then you start to see that come off in the fourth quarter. First quarter being, as usual, the lowest margin quarter. Again, not a significant shift in that breakdown as you move through the year. Again, I'd point out some years, second and third quarter often compete for which one is the higher margin quarter. Again, that would be kind of the progression. On a raw material perspective, certainly commodity prices have risen a bit in the quarter from, it actually came down a bit and then back up. We're still forecasting, I'd say, in some cases slight headwind, but really mostly flattish.
When you consider the offset of the cost reduction programs that we have in place, those elevated commodity prices are being offset. Really not a significant change from original budget.
Okay. Thanks.
Next caller.
Thank you. Next is from Seth Weber of RBC Capital Markets. Your line is open.
Hey, good morning, everybody.
Hey, Seth.
Just wanted to go back to the pricing question, or the pricing discussion. The pricing was up 2% in the first quarter. You're guiding to 2% in the second quarter. Full year is only up 1%. Is that just some conservatism, or are you seeing something out there in the order book that's causing you to think second half pricing will be softer? Thank you.
Yeah. Keep in mind, first quarter is, again, a very light quarter, and rarely do you see the first quarter drive the full year. Some of that gets into comp year-over-year, if you think about the progression. As you think about pricing, we've talked about over the last several years, even when it's been 1%, it's been closer to 1.5%, and that wouldn't be unique this year versus some of the other years. Again, we'll see as we go through the year how that pricing works out. And as we talked about earlier, what happens with C&F could drive some of that as well. If the market's competitive environment lessens up a bit, I think that's where we would hope at some point we would see some better pricing.
Okay.
Next caller.
Thank you.
Thank you. Next is from Sebastian Bray of Berenberg Bank. Your line is open.
Yeah. Good morning, gentlemen. We all know that the farmer expectations for future income is really bullish, yeah, since November. The Midwestern farmers are very positive on the outlook. I think this might translate also to the dealers becoming a bit more positive. When you say that the pre-orders are shooting up, is that really orders from the end farmer for purchase and order these large equipment, or is it more restocking with the dealers? Do you see a difference in Q1 this year compared to last year?
Yeah. It's a good point and one to always keep in mind. What I would tell you is on the Combine Early Order Program, there is a mix there every year between retail and some dealer order for stock. The mix this year is very consistent with what we saw a year ago, and similarly on our large tractors, it would be a very similar mix. The short answer is no. It's not increased orders that should be implied to see just inventory increases. It's again, a similar mix between retail and stock. With a heavier on our large ag equipment, a much heavier mix towards retail versus stock. Okay? Thank you. Next caller.
Yeah, just a quick follow-up. It's true that last year the focus was more on destocking with your dealers, whereas this year the trend is more towards restocking.
Again, what we're not doing is under-producing to retail. Last year we would. Again, I would say inventory levels, other than the fact that we have the ability to produce to retail, is not really a story, if you will, in terms of our orders year-over-year. Okay, next caller?
Thank you.
Thank you. Next is from Nicole DeBlase of Deutsche Bank. Your line is open.
Thanks for squeezing me in, guys. Good morning. I want to ask about the Construction & Forestry margin guidance. I know you guys had 150 basis points headwind from sales incentives during the first quarter. I guess I'm curious, does that completely go away in 2Q and beyond? I'm just trying to think of the cadence of C&F margins throughout 2017.
Yeah. Certainly, as you get into the back half of the year, the comp gets much easier. Now, I guess I should point out in the second quarter, remember, because we increased our outlook for discounting, there was the accrual bumped up in the second quarter. That does create an easier comp in the second quarter. As you think about sequentially pricing in the end market, we would hope becomes more consistent as you move through the back half of the year. Really a little bit higher material cost, not so much from materials being purchased in the U.S. so much, but some higher emissions-related costs. And remember, we do purchase, we have some partner products that come from Japan. Some of those yen-based products on excavators, the exchange has created some higher cost year-over-year there.
Again, the negative price realization is really what's driving from a negative side, some of the lower margins in C&F.
Got it. Thanks.
Yeah, thank you. We'll take one last call.
Yeah, the last question is from Joel Tiss of BMO. Your line is open.
Hey. Most of them have been answered. I don't know if you talked about the warranty, why it was up so much, and I just wanted to add on that the cost-cutting, is that pretty much all just headcount reduction, or is there anything else in there? Thank you.
Okay. I'll start with warranty, and I'll let Raj handle the cost reduction. Really, if you think about that warranty that was identified for ag in the quarter, again, I would emphasize first quarter is a relatively low quarter, changes tend to be magnified a bit more than they would be certainly in things like our second and third quarter. But it was in part due to a change in our service parts warranty program. In the U.S. and Canada, our parts for ag and turf in the past would have been 90-day warranty. That has shifted to a full year for ag parts and six months on turf parts. Obviously, when you make those changes again, there's an accrual for all of the service parts that are already at a dealer in dealer inventory, and that accrual rate goes up for all of those.
That's reflected in the quarter that the change is made, and you're seeing that reflected this quarter.
Joel, your question on structural cost reduction, which buckets it's coming from. We have said in the past material costs, direct and indirect, would be about 40% of that, and people-related costs about 20%. There are a lot of other areas like R&D and lower depreciation that constitute the rest. I'll say people-related costs is definitely delivering as we anticipated. Is the material cost. If you recall on the material costs we set, the structural cost reduction we are aiming for is about 2.5%, but we allow for 1.5 points of material inflation and FX, and net of only one point is included in the structural cost reduction goal of over $500 million. That is also yielding results as we anticipated.
Just a quick, sorry. Why would you have to take a charge for raw material cost-related reductions?
It just simply as we did the calculation from a practical perspective, we assumed there would be some commodity inflation that would be more than offset by the cost reduction project. That's not uncommon for us historically as you see inflationary periods here and there. It was a way to make sure that we really were looking at this on a net basis, not a gross basis from a cost reduction perspective as it relates to material.
Okay. Thank you very much. Thank you.
Thank you.
Yep. Again, that will conclude our call. We appreciate your participation. As always, we'll be available throughout the day and into next week to take any follow-up calls. Thank you.
Thank you. That concludes today's conference. Thank you all for joining. You may now disconnect.