Good morning, and welcome to Deere & Company'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. You may begin.
Thank you. Also on the call today are Rajesh Kalathur, our Chief Financial Officer, Dr. J.B. Penn, our Chief Economist, and Josh Jepsen, our Manager, Investor Communications. Today, we'll take a closer look at Deere's third quarter earnings, then spend some time talking about our market and our outlook for the remainder of the fiscal year. 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. As 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?
Thanks, Tony. John Deere today reported solid financial results for the third quarter and did so in spite of the continuing impact of the global farm recession and difficult conditions in the construction equipment sector. All of Deere's businesses remained profitable for the quarter, and earnings per share was slightly higher than last year. Operating profit for our ag and turf division and for the equipment businesses overall was above last year's levels, even though sales were down nearly $1 billion. Our results were helped by the sound execution of our operating plans, the impact of a broad product portfolio, and our success keeping a tight rein on costs and assets. Now let's take a closer look at the third quarter in detail, beginning on slide three. Net sales and revenues were down 11% to about $6.7 billion.
Net income attributable to Deere & Company was $489 million. EPS was $1.55 in the quarter. On slide four, we see that worldwide equipment operations net sales were down 14% to just under $5.9 billion. Price realization in the quarter was positive by two points. Currency translation was negative by two points. Turning to a review of our individual businesses, let's start with Agriculture and Turf on slide five. Net sales for the division were down 11% in the quarter-over-quarter comparison, with a decrease primarily due to lower shipment volumes in the U.S. and Canada. Also affecting sales was the negative impact of foreign currency exchange. Operating profit was $571 million. Ag and Turf operating margins were 12.1% in the quarter. The gain on the sale of a partial interest in SiteOne Landscape Supply contributed nearly two points of operating margin in the quarter.
Even excluding the SiteOne impact, operating margins were above the levels of last year's third quarter. Before we review the industry sales outlook, we're pleased to welcome Deere's Chief Economist, Dr. J.B. Penn. He will spend a few minutes sharing his thoughts on the state of the global Ag economy. J.B.?
Thanks, Josh. I would begin with a bit of context that might be useful as we ponder the outlook. Slide number six shows the strong tailwinds that now drive the global agricultural economy. Major changes in agriculture and food markets began occurring sometime around the turn of the century, that ushered in a dozen or so unparalleled years characterized by strong demand growth, record high prices and farm incomes, food price spikes, expanded investment and innovation, and increased trade. A convergence of forces was responsible. Global population growth, widespread global economic growth, especially in emerging market and developing countries, rapid urbanization, and biofuels. In 2000, the UN was projecting that the population would grow from 6.1 billion in that year to 9.3 billion by 2050. Today, that projection for 2050 is 9.7 billion. That's another 2.4 billion from today's 7.3 billion people.
Although having slowed somewhat, the global expansion continues, especially across much of the developing world, bringing millions more into the middle class and enabling ongoing improvements in diet. On urbanization, we passed the 50% mark of population sometime around 2010, that is now expected to approach 70% by 2050, with implications for food production and trade. Slide number seven reflects global Ag as a whole, showing the production and consumption of all global grains. Perhaps the most noteworthy point of the slide, and one often overlooked with all the focus on supply, acreage, and yield, that is the persistent consumption growth. Consumption remains very strong, still rising steadily year after year, and it has risen without fail every year since 1994, 1995, even including the Great Recession of 2009.
Fueled by earlier high prices, and after four consecutive great growing seasons worldwide, commodity supplies now are fully adequate to meet all needs. Prices, of course, have moved off the previously high levels and farmer margins have narrowed. Slide eight provides more details, showing global stock holdings and the supply to use ratio. While carryover stocks have reached levels of 15 years ago in physical quantities, it is important to remember that we are now consuming one third more grains, so the supply use ratio is the key indicator. While it has moved above the average of recent years, it remains in a sensitive area and especially so when viewed with Chinese grain stocks excluded. Notably, the Chinese are thought to hold about 45% of the global stocks, and the supply use ratio actually has ticked down the last couple of years when the Chinese stocks are excluded.
Slide nine illustrates that even with abundant supplies, the production consumption balance still could shift rather quickly. Any significant production disruption will tilt the supply use ratio downward and prices will immediately move higher. The recent price movements in response to reports of relatively minor weather events certainly highlight the continued sensitivity. You'll note from the slide that both corn and soy futures were trading in a rather narrow range in the first four months of this year. We saw some reports of adverse weather in Brazil and Argentina in April. Prices quickly reflected the uncertainty that brought. Corn moved almost $0.90 a bushel higher. Soy moved $3.25 a bushel higher. That's an increase of 25% for corn, 36% for soy. By late June, the South American weather conditions abated, followed by the early July USDA WASDE report, indicating larger acreages of both corn and soy.
The weather premium quickly disappeared from the corn price, and it was reduced for soy. Just for reference, the U.S. drought in 2012 reduced corn yields 22% below trend, pushing ending stocks to barely 800 million bushels and prices to new record highs. This year, a corn yield reduction of only 4% would have been sufficient to reduce ending stocks to one billion bushels and push prices to $5 per bushel or higher. A further illustration of the sensitive supply utilization balance. There was some expectation that farmers would reduce acreage in response to the softer prices as we came into the northern hemisphere planting season. On slide 10, we note that despite the softer prices, farmers worldwide did not reduce acreage.
In the U.S., farmer supply response this year was influenced by market prices, of course, which provided a pared but still positive margin. They were also influenced by farm program subsidies, revenue insurance, and production cost declines. For example, of the subsidy, the agricultural program ARC-CO forecast of 2015 payments for Illinois is $0.37 per bushel on corn base acres and $0.98 per bushel on soybean base acres. As a result of this combination, U.S. farmers this year expanded planted area for all major crops except wheat, illustrating continued profitability despite softer prices. We also expected a similar reduction in other parts of the world, but we noted there that farmer supply response was influenced largely by currency values and also some policy shifts, notably in Argentina.
In this crop year, major exporters expanded grain and oil seed area all around the world. Grains and oil seeds were up 3.7% in South America. As an example, Brazilian farmers saw corn prices in reais of BRL 5.24 per bushel in September 2015, compared to BRL 3.43 per bushel the year before, indicating that it was still very profitable to continue to expand. Slide number 11 speaks to the financial condition of the U.S. farm sector. Overall, the farm sector balance sheet remains strong. Farmer debt has been well managed. The financial indicators are still solid. It was not until 2000 that farm sector equity reached $1 trillion. It took only 10 more years to add a second trillion dollars, and five years later, we've added another half trillion dollars.
A major part of that balance sheet, of course, is farmland. USDA forecasts land prices to decline in 2016. Croplands have declined 1%. This is the first time since 2009, and only the second time in almost three decades. Slide 12 summarizes the situation across the global ag sector. As I noted, supplies are fully adequate. The risk premia have been erased from the grain markets. We saw very little reduction coming into the year in response to the lower prices, and that was because of the aberrational forces at play, the subsidies, the risk measures, and also currency values, which boosted commodity prices. We're in the fourth consecutive favorable weather year. Adding all of those things together, barring adverse weather events, little near-term improvement in ag market conditions is anticipated.
We would note that the long-term drivers, population growth, incomes growth, and urbanization are still intact. Slide 13 pertains to the U.S. ag sector. We note that farming is still profitable despite softer prices, as evidenced by the continued expansion of planted acres this year. Financial conditions across the sector remain solid. There is some individual farmer stress, to be sure, but no widespread stress is yet evident. Finally, slide number 14 lists some key factors that are worth watching in the coming months. In the short term, of course, weather is key. We know that demand is strong. We now know that supply depends upon the weather. Weather is the major market disruptor, and it's still one season at a time.
Attention now will turn from North America to the Southern Hemisphere as the planting growing season gets underway there in late September and October. We'll continue to watch that until next spring in the Northern Hemisphere, when we'll start focusing on planting and growing conditions here. Over the longer term, I would just note that any of these geopolitical hotspots that could erupt and become a drag on global GDP would be a negative. Lots of other things to watch include relative currency values, the political situation in several countries, central bank behavior all over the world. I would just conclude by noting that after a dozen years of unprecedented prosperity, planting, commodity price, food price, and trading patterns are now stabilizing. A new commodity price trading range with favorable weather is emerging, and weather remains the major commodity market disruptor.
The outlook is still one year at a time, depending upon the weather. I will now turn the call back to Josh.
Thanks, J.B. Our 2016 Ag and Turf industry outlooks are summarized on slide 15. You'll note there are no changes from our previous forecast. Low commodity prices, weakening farm incomes, and elevated used equipment levels in the U.S. and Canada are continuing to pressure demand for farm equipment, especially high horsepower models. We expect industry sales in the U.S. and Canada to be down about 15%-20% for 2016, with sales of large ag equipment down 25%-30%. The EU 28 industry outlook remains flat to down 5% due to lower crop prices and farm incomes, as well as persistent pressure on the dairy sector. In South America, industry sales of tractors and combines are expected to be down 15%-20% in 2016. This is a reflection of the downturn in Brazil and other commodity-driven markets in the region.
Shifting to Asia, the industry sales outlook continues to be flat to down slightly. This is due in part to weakness in China, partially offset by improving conditions in India, where the monsoon rains have been higher than normal. Turning to another product category, industry retail sales of turf and utility equipment in the U.S. and Canada are projected to be flat to up 5% in 2016. Again, no change from our prior forecast. Putting this all together on slide 16, FY 2016 Deere sales of worldwide Ag and Turf equipment are forecast to be down about 8%, including about two points of negative currency translation. This is unchanged from the previous forecast. Our forecast for the Ag and Turf division's operating margin is now about 7.7% for the year, with an implied decremental margin of about 15%. Now let's focus on Construction & Forestry on slide 17.
Net sales were down 24% in the quarter, and operating profit was down 58%, due mainly to lower shipment volumes and an unfavorable product mix. The division's decremental margin was 20%. Moving to slide 18. The economic indicators noted at the bottom of the slide, although down somewhat from the previous quarter, remain positive. Notwithstanding these positive signals, the market demand for construction equipment continues to soften. Among the factors contributing to the weakness, conditions in the oil and gas sector continue to be slow, with the impact most pronounced in the energy-producing regions of the U.S. and Canada. Contractors are less apt to replenish or grow their machine fleets when faced with uncertain markets. Rental utilization rates continue to decline, leading to a reduction in fleet sizes and higher levels of used equipment.
Housing starts in the U.S. for single-family homes, which require more earth-moving equipment, remain well below the long-term average. As a result, Deere's Construction & Forestry sales are now forecast to be down about 18% in 2016. Currency translation is forecast to be negative by about one point. The global forestry market forecast remains down 5%-10%, primarily as a result of lower sales in the U.S. and Canada. C&F's full year operating margin is now projected to be about 4.1%. The implied decremental margin for the year is about 31%. Let's move now to our financial services. Slide 19 shows the annualized provision for credit losses as a percent of the averaged owned portfolio, which was 24 basis points at the end of July. This reflects the continued excellent quality of our portfolios.
The financial forecast for 2016 contemplates a loss provision of about 23 basis points, unchanged from the previous forecast. The provision remains below the 10-year average of 26 basis points, and well below the 15-year average of 39 basis points. Moving to Slide 20. Worldwide financial services net income attributable to Deere & Company was $126 million in the third quarter versus $153 million last year. Lower results for the quarter were primarily due to less favorable financing spreads, a higher provision for credit losses, and higher losses on lease residual values. The division's forecast, net income attributable to Deere & Company remains at $480 million for the year. Slide 21 outlines receivables and inventories. For the company as a whole, receivables and inventories ended the quarter down $764 million.
We expect to end the year with total receivables and inventories down about $500 million, with reductions coming from both divisions. Field inventory to sales ratios for new large ag equipment are expected to end the year in line with 2015 year-end levels, which is consistent with our previous forecast. C&F inventory and receivable to sales ratios are forecast to end the year roughly in line with last year's levels as well. Our 2016 guidance for cost of sales as a percent of net sales, shown on Slide 22, is about 78.7%. When modeling 2016, keep these unfavorable factors in mind: an unfavorable product mix and engine emission costs. On the favorable side, we expect price realization of about one point, favorable raw material costs, lower pension and OPEB expense, and lower incentive compensation expense. Now let's look at a few housekeeping items.
With respect to R&D on Slide 23, R&D was down 2% in the third quarter. Our forecast calls for R&D to be down about 1% for the full year, including about one point of negative currency translation. This is consistent with our previous forecast. Moving now to Slide 24. SA&G expense for the equipment operations was down 10% in the third quarter. Most of the decline was attributable to incentive compensation, commissions to dealers, pension and OPEB, and currency translation. Turning to Slide 25. Our 2016 forecast contemplates SA&G expense being down about 5%, with incentive compensation, currency translation, and pension and OPEB accounting for about six points of the full-year change. On Slide 26, pension and OPEB expense was down $53 million in the quarter and is now forecast to be down about $210 million in 2016.
On Slide 27, the equipment operations tax rate was 31% in the quarter and is now forecast to be in the range of 29%-31% for the full year. Slide 28 shows our equipment operations history of strong cash flow. Cash flow from the equipment operations is forecast to be about $2.1 billion in 2016. The company's fourth quarter financial outlook is on Slide 29. Net sales for the quarter are forecast to be down about 8% compared with 2015. This includes about one point of price realization and favorable currency translation of about one point. Turning to Slide 30 and the full year outlook. The forecast now calls for net sales to be down about 10%. Price realization is expected to be positive by about one point, with negative currency translation of about two points.
Our forecast now calls for net income attributable to Deere & Company to be about $1.35 billion for the full year. In closing, Deere continues to perform well in the face of challenging market conditions, this is particularly true in relation to previous farm recessions. Our performance in the third quarter and for the year to date underscores our success developing a more durable business model and a wider range of revenue sources. At the same time, we're continuing to look for ways to make our operations more profitable and efficient by seeking out further structural cost reductions. All in all, we remain confident in the company's present direction and believe Deere is on the right track to deliver significant value to its customers and investors in the years ahead. I'll now turn the call back over to Tony.
Thanks, Josh. 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 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. Operator?
Thank you. If you would like to ask a question, please press star followed by the number one. Please record your name when prompted. You may cancel your request by pressing star two. Our first question is from Timothy Thein from Citigroup Global Markets. Your line is open.
Thank you. Tony, some pretty big moves during the quarter that you alluded to in both corn and soybeans, I guess grains in general. I'm curious what you're hearing just in terms of overall sentiment from your dealers in North America and how that's kind of influenced farmer decisions and especially how that kind of carried through in terms of the spring early order program, how that finished relative to last year. Thank you.
Thanks, Timothy. As you might imagine, we talked last quarter and even the early part of the third quarter where sentiment was a bit more positive as those commodity prices were up. As we mentioned there that can change in a hurry, and it certainly with the commodity prices coming down, I think it's fair to say that the overall mood would be less positive than it was a couple of months ago even. Related to the spring seasonal equipment, we just finished the first phase. Remember, these are multi-phase early order programs. I want to stress this is still quite early. We did see on some of those key products like planters and sprayers, as well as spring tillage equipment. We are seeing those early order programs down year-over-year.
As you think about the magnitude of that decrease, considerably less of a reduction versus where we were a year ago. In fact, if you look at just planter EOP in particular, which is often considered a good indicator for large ag in this current environment, orders are down in the single digit range. Just to give you an idea. Again, I would stress that it is quite early. Next call.
Our next question is from Andy Casey from Wells Fargo Securities. Your line is open.
Thanks. Good morning, everybody.
Hello.
Ag and Turf margin question. You mentioned the margin increased even without the SiteOne gain. First, was that gain consistent with the $76 million identified in the 10-Q? Then exing the gain out really it's the first positive year-to-year since the first quarter of 2014, but the implied Q4 guidance suggests a fairly deep year-to-year decline. I'm just wondering what drove the improvement in Q3 and what's changing in Q4 to drive a continuation of the margin declines?
Certainly, the third quarter was a very strong quarter for Ag and Turf. On lower sales the operating margins were higher. Obviously, price realization continues to be very strong. You pointed out the SiteOne gain, that was about $75 million. I think Josh indicated it's just under 2 points of margin there. Really a lot of it was cost management. We had lower production costs things like obviously incentive comp, material costs continued to be a tailwind for us. Obviously had a little higher Tier 4 emissions cost. SA&G was also lower. Those were some of the positives. Obviously, volume and FX continued to be drags on the profitability as well. As you look out into fourth quarter, I think a couple of things to keep in mind. One is mix shifts.
As you think about the production, a couple of our key factories in particular, you think about Waterloo with large tractors as well as Harvester Works, will see considerably lower production in the fourth quarter of 2016 versus 2015. Just to put some context around that, Harvester Works for combines would be about a 60% reduction in output hours and Waterloo is about a 20% reduction in output hours. A couple of very profitable products for us that the production will be down pretty considerably. The other thing I think that's worth noting is material costs. That's been a nice tailwind for us through the first three quarters of the year. That actually becomes more flattish. It's slightly negative but really more flattish in the fourth quarter. You lose the tailwind in the quarter would be the other item I'd point out.
Those are probably the biggest differences as you move into the fourth quarter. All right.
Thanks.
Let's go ahead and go to the yep, thanks, Andy. Next caller.
Our next question is from Jamie Cook from Credit Suisse Securities. Your line is open.
Hi, good morning. I guess, Tony, the question I usually ask, can you just talk about the progress you've made in the U.S. or North America on the used equipment issue where we are relative to last year and relative to your expectations, and what that implies for do we think we have to take incremental inventory out on the used side in 2017? Thanks.
Thanks. Jamie. I want to kind of parse that out again as we always do. When you think about large ag used inventory, we continue to be down about 23% from the peak of kind of summer of 2014. That's consistent with where we were at the end of last quarter. Keep in mind, seasonality does create a challenge in terms of even keeping things flat. I would say that is kind of as expected, at least in line with what we would expect. We would hope to see and certainly expect to see progress continue to resume in fourth quarter with that number continuing to move back down. To your point, we still have a significant amount of work to do yet this year, but even into 2017. That kind of talks to the inventory balance a bit.
I think when you look at the balance sheet of dealers and the pricing and the valuation of that equipment, generally what we're hearing is that dealers are feeling a little better about the income or the equipment that they do have and the value that it's at on their balance sheet. We've seen some pricing stabilization on used equipment. Again, I think things are stabilizing, but I want to be clear, we have a lot of work on the actual level of used inventory at our dealers that will continue into 2017.
Okay, thank you. I'll get back in queue.
Thank you. Next caller.
Next question is from Eli Lustgarten from Longbow Research. Your line is open.
Good morning, everyone.
Hi, Eli.
Very nice quarter.
Thank you.
One thing I'd say economists will look at, by the way, is that the big movements in commodity prices, particularly in corn, were related to 252,000 money manager long contracts that unwound in 11 days to a -100. It was really money managers that drove it more than the free market. That's public data, by the way. My question really is looking at production levels as we go into the fourth quarter and actually into next year. You've indicated your inventory level will be sort of that same place as 2015, but we're talking about a U.S. market that's down 20%-25% and almost 30% in big tractors and probably may have some more to fall next year.
It just suggests that there's either plant shutdowns coming now or in early 2017, and that will probably have some weight on the $0.35 that you sort of projecting for the fourth quarter. Can you give us some color on how production levels, you started a little bit on how far down the fourth quarter will be, but the inventories aren't going to go away.
Yeah. Eli, I'm going to jump in here because, A, I think you're mistaken in what we said. Okay? We're not saying that the field inventory levels are the same. We're saying are going to be in line as a % of sales.
Okay.
They'll be in line. That's implying large ag is down pretty considerably when you look at field inventories. Again, the reason we're clarifying that is, as we talked earlier in the year, when you're looking at total ag inventories and receivables, you have small ag in there as well, and we've seen some increases there. If you look at just large ag, we have taken pretty considerable reductions in the year to keep those inventory and receivable levels in line with the sales when we get to the end of October. I think that's probably the most important statement. In regard to 2017 shutdowns and production schedule, we'll talk more about that next quarter when we have the 2017 outlook. Anyway, appreciate the question, and we'll move on to the next caller. Thank you.
Thank you. Our next question is from Jerry Revich from Goldman Sachs. Your line is open.
Good morning, everyone. Tony, can you please talk about your allocation of pool funds between used transactions versus new this year, or the dealers' use of pool funds, I should say, and how we should think about as we enter 2017, where that balance of allocation of use of pool funds shakes out between new and used? Just put it into context versus history for us, if you don't mind.
Sure. Yeah. I think there can often be confusion around pool funds. When we refer to pool funds, at least in the U.S. and Canada, those funds are only for used equipment. They earn them on the sale of new equipment, but it's really the funds that are available for them to provide incentives for the sale of used. We often talk about one way they can use those is for helping to subsidize the floor planning that they have of used equipment as well as actual retail. We do tend to manage that. There was a period of time where we were starting to see a shift towards more use of wholesale financing and floor planning, but that has shifted back to a very attractive use on actual retail in Canada and pretty much in line with what we would expect.
That's been a positive trend that we saw really early in the year, and it's continued through the year on pool funds. Another question around there that I'll throw in as a bonus is, if you look at pool funds in aggregate, we would say certainly as we look at that relative to used inventory, we would be comfortable in aggregate. As we said before, there are clearly some dealers who we would look at and say their pool funds are too light relative to the used equipment that they have, and that's when we have those individual conversations with those specific dealers. In aggregate, still at healthy levels.
Appreciate the bonus. Thanks.
All right. Thank you. Yep. Next caller.
Our next question is from Lawrence De Maria from William Blair. Your line is open.
Thanks. Good morning, guys.
Larry.
Hey, I want to ask specifically about the FinCo and some of the headwinds that are potentially going forward around residual values. I think if we look at the book, they're set around 64%. It's up significantly from a decade ago, around 40%-42%. I guess I'm kind of wondering what kind of risk you guys see from that declining given the weaker market prices we've seen over the last couple of years and what kind of headwinds to think about from that over the next maybe year or two, I guess.
If you think about the operating leases just kind of in general, I think, hopefully the read-through, as you looked at the quarters, things seem to have stabilized at least in the short term, in terms of the losses that were recognized, no additional impairments, those sorts of things. Obviously, the forecasted income for financial services stayed the same, all positive signs. To your point, I would say in the near term, short to midterm, there's still certainly risk. As we look at future maturities, we continue to work hard to reduce the return rates on those maturities, as well as finding more effective ways to dispose of those when they get returned so that the loss rates are not as significant.
As long as we stay at these lower levels, as long as used equipment prices continue to be at more depressed levels, I think that continues to bear watching and certainly has risks. While we take some comfort in the short term with the stabilization we saw in the quarter, it's going to be a while before we're willing to say we're out of the woods there. To your point, stay tuned and certainly we would be deciding some additional risk.
Right. To that point, Tony, if I could just follow up, when would we expect some of the biggest returns to occur given the peak a few years ago and the duration of some of the leases on there? Would that kind of the returns sort of peak in 2017 or 2018? Are we going through that kind of bell curve now?
You're hitting some of that now. We'll hit some pretty strong maturities in the fourth quarter of this year. Certainly as you move into spring next year is I think another kind of wave of maturity. Think about timing of when you tend to see a fairly healthy level of retail activity. That's when you're gonna see some of those peaks. Let's go ahead and move. I appreciate the question.
Thank you.
I think we can move on to the next caller. Thank you.
Thank you. Our next question is from David Raso from International Strategy and Investment Group. Your line is open.
Hi, good morning. Really just a kind of big picture question about all that you know about your new and used inventory in the channel and how production is this year versus retail. Just for a generic framework, if hypothetically retail was flat next year for ag globally, and maybe the same question for construction, how would Deere's production be in that environment? Up, down, in line with that retail environment? Just trying to think through all the underproduction versus inventory drawdown needs. Just wrap it all into that one question.
Yeah, I think in both cases, I would say in line with which would imply higher year-over-year sales.
Can you repeat that? If flat retail-
In line with retail.
Yes.
Which would imply higher sales.
So just-
Because we're underproducing this year.
That's what I'm trying. Just to be clear, your production would be higher than retail?
Correct. Yes.
When it comes to the mix of that-
No, no, no. Our production would be in line with retail, but it was less than retail in 2016.
Okay, let's not confuse it with the comp. Just straight out, if retail is flat.
Yes
Deere's production year-over-year is flat or up?
Higher. Our production is higher because we will produce in line with retail. Our year-over-year production will be higher.
Okay. A follow on that, the mix within that, if retail's flat but Deere is up because you underproduced last year, this year, I mean, next year you want to underproduce. Is that particularly a Harvester Works Waterloo comment, or how should we think about that on the mix of up and flat retail?
Certainly our greatest underproduction would've been on large ag in the year, to your point. Mix would be favorable year-over-year.
Does that comment hold for Construction & Forestry as well?
That I don't have the details on as well, so I have a hard time answering that offhand. But yeah. All right.
Very helpful. Thank you.
Yeah, thanks. Next caller?
Our next question is from Joe O'Dea from Vertical Research Partners. Your line is open.
Hi, good morning.
Joe.
On the construction front, could you just talk about kind of where your demand levels stand relative to what you see in the end market activity? If you see anything on the horizon where, as some of the challenges from oil and gas or some of the dealer destock, if you see some potential near-term relief from that such that your demand could improve.
I think in the short term and what you're seeing reflected in our outlook on construction is our dealers do continue to destock so as the market continues to decline, as we would expect them to and hope that they would, they're bringing their inventory down in line with that. Some of that actually is related to the lead times we're able to have right now in our factories. With the lower production, they can get replenishment equipment pretty quickly. As a result of that, they're able to do more of that destocking and make sure that they're putting their inventories in a good kind of low level type of environment. I turn it around a little bit to the extent you start to see positive turns in that market.
Our dealers are likely to, in our estimation, would respond maybe a bit more aggressively as dealers would need to do a little bit more stocking up. It does have some negative now, but more positive when the market does eventually rebound.
Great.
Okay?
Thanks very much.
Thank you. Next caller.
Our next question is from Ann Duignan from J.P. Morgan Securities. Your line is open.
Yeah. Hi, good morning. Good morning, JP. Hope all is well there.
Good morning.
My one question, I hate to waste my question on this, but it's one that I'm racking my brain over. Did you actually record a mark-to-market gain on your nine and a half million remaining shares at SiteOne in the quarter?
No, we did not.
Okay. That's my question then. Thank you.
All right. Thank you, Ann.
Our next question is from Seth Weber from RBC Capital Markets. Your line is open.
Hey, good morning.
Good morning.
I wanted to ask about Brazil. I know you didn't update your outlook for South America for this year, but some of the data points that we've been getting, some of the shipment data out of Brazil for the last couple of months has been a little bit better. Do you think that that's a market that could be up next year?
Certainly. If you asked me today which market was likely, if I had to pick one, which one had the best likelihood of being up, I think I'd have to say Brazil or South America in general. One of the things to keep in mind is, and we talked about this throughout the year, is a lot of the downturn there has been related to the uncertainty around the government and the overall economy. Farmers have been pretty profitable. As a result of that, with the new government, at least to date, there appears to be a more positive sentiment. The inflation is coming down, as an example. The overall economy seems to be showing some level of improvement. In the short term, we're seeing that in the order books as well.
The question there is, remember, there is a conversion to Tier 3, what we consider Tier 3, on January 1 in Brazil on large ag equipment. Dealers know and customers know that will come with a price increase. Undoubtedly, some of the, at least short term, order book activity we're seeing is strength around that, buying equipment ahead of the Tier 3 conversion. The real question remains, will we continue to see that demand surge as we go into calendar 2017 or not? Again, I think there's some fairly favorable signs that would indicate that that could possibly be the case.
Have you been building inventory for the emissions change?
Our order books would reflect demand related to that, but we have not built inventory ahead to have on our dealer lots to lead kind of further into 2017.
Okay. Thanks very much, guys.
Next caller.
Our next question is from Robert Ortmeier from Barclays Capital. Your line is open.
Hi, good morning. Did you see any sequential materials cost reduction that was meaningful to margin? I mean, the margins were very strong in ag and turf on revenues that was down sequentially, materially. Seasonally, obviously. I'm just curious about if you can bridge whether materials is a big part of that or whether it's something else.
Actually, if you look, obviously, we don't give the actual number any longer, but the benefit in the quarter for ag would have been slightly less than second quarter for material.
That's on a year-over-year basis. Yeah, okay. Fair enough.
Yep. Again, it's starting to come down a little bit, which you would expect as we're looking at some slight increase going into the fourth quarter. It was a contribution, but it was holding other costs and finding ways to operate, again, as efficiently as we can at these low levels. They just did a great job working through some of those costs.
Great. Thank you.
Thank you. Next caller.
Our next question is from Michael Shlisky from Seaport Global Securities. Your line is open.
Good morning, guys. Just checking out your slides towards the back. You did update your outlook for the 2015 cash receipts. I do see that. I don't see in there a 2017 outlook, although at this time last year, in 2015, you gave us a 2015 outlook. Just wondering if that's just a reflection of the uncertainty out there, or could you give us maybe a base case scenario or directional view for next year's receipts for both crops and livestock? Thanks.
Yeah. You noted correctly. That's actually a change we did make this year. Historically, we would have provided the first look at a cash receipts forecast out into the future year. Candidly, in our view at this point, it's just so premature and preliminary that we decided that we would make that change this year. I'll note, the USDA won't provide their first 2017 cash receipts outlook until February of 2017. Historically, we were almost six months ahead of the USDA. As a result, we've decided that we will wait. We do expect in November that we'll have, again, it'll still be very preliminary, but we will have our first 2017 cash receipts outlook. I would tell you, if you looked at our number At this point, year-over-year. Again, I can't emphasize enough, it's very premature.
Okay, fair enough. Thank you.
Thank you. Next call.
Our next question is from Mircea Dobre from Robert W. Baird. Your line is open.
Good morning. This is Mircea Dobre with Baird. A quick question back to Ag and Turf. Tony, can you give us any color at this point, how much Turf and maybe the smaller equipment contributes to operating income? I'm also wondering how you're thinking about smaller equipment and inventory in the channel. Is there any risk of destocking here into next year? Thanks.
We don't provide any profitability breakdown by large and small. We do, on an annual basis, provide some sales breakdown, as you know. I think the second part of your question is worth noting. Especially when you think about small Ag, and I'd say the higher end of that small Ag business. What really is attributed to livestock, we have seen some softening in the retail environment around some of those product categories as the livestock margins have gotten squeezed a bit. You actually see that reflected a little bit in some of the inventory levels that we report in the appendix. The 100 horsepower and above, you'll see, and I forget what slide that is. Josh, if you want to look that up quick. If you look there, you'll see it's still in the mid 30% range.
47.
Slide 47. We'd be back down typically in the 20% range. What's driving that is 100 to 200 horsepower. The 6000 Series tractors are a bit elevated. It's possible, last quarter we talked about this and said that our expectation is we would have those in line year-over-year. With some of the weakness in livestock, it's possible that that number will be a bit elevated. It should come down, but it may not hit quite the same level that we were at as we ended 2016. Again, that product is coming from Germany, so there's longer lead times. Not building to retail order, we're building to forecast. That retail sales forecast has slipped a bit in the quarter. Obviously it wasn't dramatic enough for us to change the overall retail sales outlook, but it did soften some.
Tony, isn't there a bit of an issue with under 40 horsepower as well?
From an inventory perspective, I don't believe that is the case. You're seeing ours come up, but remember, our inventory levels are coming up, but our sales are too. It's really coming up more in line with the sales at this point.
All right, thanks.
All right, thank you. Next caller.
Our next question is from Steven Fisher from UBS Securities. Your line is open.
Thanks. Good morning. It looks like your leasing exposure went up in the quarter to about $5.6 billion. It's up around $100 million. Can you just talk about how your efforts to effectively discourage some of that leasing activity is being received, and when might you expect to see that lease exposure actually start to come down?
I think you are right in the sense that the overall lease activity has continued to increase. I think what's also worth noting is the short-term leases and the activity there is down significantly. A lot of the actions that we were taking at the end of second quarter and into third quarter were focused on reducing those short-term leases, and that has been effective. We're pleased with that. Certainly, I think, again, we've said this before, our preference would always be a retail note over an operating lease. To the extent our customers continue to prefer an operating lease, our obligation there is to make sure we're structuring those in a way that John Deere Financial can continue to be profitable. That's what we're focused on. Last quarter, we did raise residual values.
Can't say across the board, but pretty much across the board, not just on short-term leases. I'm sorry, we reduced residual values pretty much across the board last quarter to try to correct some of those challenges that we had been facing, so.
Can you quantify what the percentage of short-term leases is now? How much it kind of declined in the third quarter versus-
I don't have that number offhand. It was a significantly lower number in the quarter, so.
Okay, thank you.
Okay, thank you. Next caller.
Our last question is from Joel Tiss from BMO Capital Markets. Your line is open.
Just snuck in there. I'll make it quick too. In financial services, it seems like the debt is rising roughly about $2 billion while the portfolio is shrinking. I just wonder if you could explain what's going on there.
Joel, I'm not sure you're tracking. Our debt-to-equity ratio, we try to maintain at 7.5 to 1. That's been close to that. We've still maintained it around 7.5 to 1. Our portfolio overall has been slightly lower. Even if you take a constant FX, it's about flat. The portfolio has not grown. Yeah, I know, the debt is up $2 billion since the end of the year. All right, I'll ask you later.
Okay. Yeah, that sounds good. I think we did have one more come into the queue, so we can go ahead and take that.
Our next question is from Ann Duignan from J.P. Morgan Securities. Your line is open.
Thank you for squeezing me in. My question is more on the European end markets. We saw German registrations down 21% last month, which I don't know if we've ever seen a drop like that in one month, and I recognize it's registrations, not retail sales. Can you just talk about the environment in Europe, in France, Germany, U.K., and also how you're feeling about dealer inventories in the region?
Certainly, as you track things like there's the CEMA Business Barometer and so on, we started seeing even a quarter or so ago, that starting to track more negative. A year ago at this time, that was actually moving a more positive direction, and we had some relatively positive hope for Europe as we went into 2016. I think in the short term, certainly, you have a lot of factors like Brexit and so on that are causing some uncertainty. There were some challenges, as you look at some of the eastern part of the EU28 with subsidies and timing of when subsidies were released again. When you look at France, you're starting to see some indication that the crop there is certainly not what many had hoped. So you're seeing some weakness there.
I think that certainly you're seeing the sentiment get a bit weaker here in the latter part of the year. J.B. or Raj, I don't know if you have anything to add.
No.
Okay. All right. Yeah, beyond that, I'm not sure there's much more. I'd say, and to your point, it's one month, it's registrations. I wouldn't read too much into a single month.
Dealer inventories?
Dealer inventories, I think we're reasonably comfortable with. That's one where, again, we would cite used equipment, not an issue at this point, but one we certainly have our eyes on, and I'd say cautionary. Actually, one of the bigger challenges there had been Great Britain, U.K., and with some of the FX, and it was because the FX had held up pretty well. With Brexit now and the FX changing, that's actually in the short term, created some benefit for their used equipment to move because most of that, of course, comes to the mainland and gets distributed in the eastern part of Europe. That's been a positive, again, very short term impact of Brexit. Okay?
Okay. Thank you.
Thank you. Before we close, Raj has a couple of comments he'd like to make.
Yep. There have been some questions around our third quarter margins and fourth quarter margins and around 2017, what to expect. I just wanted to make a few comments along those lines. We mentioned in the past that each of our units plan for the mid-cycle trough and peak scenarios, in addition to the following year's forecast. You will have noted our incremental margin performance in the last three years show how well we've executed in this downturn. As a result of our disciplined process, our margins have improved about 300 basis points at mid-cycle volumes now compared to mid-cycle volumes in 2010. We have been working on reducing our SA&G overhead expenses and also structurally reducing our material costs.
We have diverted more of our R&D resources to focus on cost reductions in the last two years, and we have increased focus on efficiency improvement and structural cost reduction activities broadly and in general. With such structural cost reduction activities, we expect to improve our pre-tax income by at least $500 million by the end of 2018 if large ag downturn persists at current levels. I should also say our internal goals and targets are even larger. Having said this, we should also note that we are balancing structural cost reductions with investments for the future, and we remain committed to maintaining manufacturing capacity to support an eventual turnaround. Thank you.
All right. Thank you, Raj. With that will conclude our call. We appreciate the questions. We, of course, will be around throughout the rest of the day to answer any follow-ups. Thank you.
That concludes today's conference. Thanks for participating. You may now disconnect.