Deere & Company - Earnings Call - Q1 2012
February 15, 2012
Transcript
Speaker 8
Good morning and welcome to Deere & Company's first quarter earnings conference call. Your lines have been placed on listen-only until the question and answer session of today's conference. I will now turn the call over to Mr. Tony Hegel, Director of Investor Relations. Thank you, sir. You may begin.
Speaker 10
Thank you. Also on the call today are Jim Field, our Chief Financial Officer, Marie Ziegler, Vice President and Treasurer, and Susan Karlich, our Manager of Investor Communications. Today, we'll take a closer look at Deere & Company's first quarter earnings, then spend some time talking about our markets and the outlook for the remainder of 2012. After that, we'll respond to your questions. Please note that the slides are available to complement the call this morning. They can be accessed on our website at www.johndeere.com. First, a reminder: this call is being broadcast live on the internet and recorded for future transmission and use by Deere & Company and Thomson Reuters. Any other use, recording, or transmission of any portion of this copyrighted broadcast without the express written consent of Deere & Company 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 projections, plans, and objectives 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 U.S., or GAAP. Additionally, information concerning these measures, including reconciliations to comparable GAAP measures, is included in the release and posted on our website at www.johndeere.com/financialreports under Other Financial Information. Now, here's Susan.
Speaker 4
Thank you, Tony. With this morning's first quarter earnings announcement, John Deere has started 2012 on a strong note. Income and sales both reached new records for the first quarter of the year. It was our seventh straight quarterly record. The improvement was broad-based. Ag and turf had another strong quarter, and our other divisions, construction and forestry, and financial services, contributed as well. Healthy demand for farm machinery continued to play a big role in our results. Our performance also reflected success executing our ambitious marketing and operating plans. Such execution is especially important right now, as we are adding new products and global capacity at unprecedented rates. Finally, our full-year earnings forecast has been adjusted upwards and now stands at about $3.275 billion. All in all, it was a solid start to what is expected to be another strong year.
You may have noticed the slide deck looks a little different this quarter. We have moved slides we felt were only number updates to the appendix to allow more time for your questions. Now, let's look at the first quarter in detail, starting with slide three. Net sales and revenues were up 11% to $6.8 billion in the quarter. Net income attributable to Deere & Company was $533 million. As we noted earlier, this was the company's seventh consecutive quarterly earnings record. Total worldwide equipment operations net sales were $6.1 billion, up 11% quarter over quarter, shown on slide four. Price realization in the quarter was positive by four points, while currency translation was a negative one point. The company outlook is on slide five. Second quarter net sales are forecasted to be up about 15% compared with the second quarter of 2011.
This includes about four points of positive price realization and about three points of negative currency translation. For the full year, net sales are expected to be up about 15% versus 2011. This includes about three points of negative currency translation, which is a negative swing in currency translation of four points from our previous forecast. Effectively, forecast volumes have increased by four points, all of which have been offset by exchange. In addition, we're expecting positive price realization of about four points. Remember, our price realization excludes any pricing related to Interim Tier 4, which is included in volumes. The full-year impact on operating profit from currency translation is negative, about $80 million. Net income attributable to Deere & Company is now projected at $3.275 billion in 2012. Turning to our review of our individual businesses, let's start with ag and turf on slide six.
Sales were up 8% in the quarter. Production tonnage was up 5%. Operating profit was $574 million, resulting in an impressive 12% operating margin, the second highest margin for the ag and turf division in any first quarter. Price realization and higher shipment volumes benefited results, but were partially offset by increased production costs related to new products and to the emission requirements and higher raw material costs. Taking a look at ag and turf's incremental margin, it came in at 5%. As we discussed on the call in November, first quarter incremental margins would be a challenge due to the timing of expenses and a very tough comparison to the first quarter of 2011. Importantly, pricing offset material costs in the quarter, including Interim Tier 4 product costs.
As the press release states, the improved operating profit for ag and turf was partially offset by increased production costs related to new products and engine emission requirements. Those costs in the quarter were roughly $100 million. The additional expense was associated with a significant number of startups, which resulted in higher capital spend, factory costs, and overhead expenses. Included were costs of installing new equipment, training new workers, and starting pre-production processes. Coupled with strong demand in the quarter, we experienced some inefficiencies in our factories. All that said, we met customer demand and delivered a 12% operating margin, signifying very strong execution. The forecast calls for double-digit incremental margins the remainder of the year. Before we review the industry sales outlook, let's look at some of the fundamentals affecting the ag business. Slide seven outlines the U.S. commodity price estimates that underlie our financial forecast.
As you can see, U.S. crop prices are forecast to remain strong in the 2011-2012 crop year, driven by strong global demand and tight supplies. The assumption for more normal, higher yields next year accounts for the drop in crop prices in 2012-2013. Slide eight highlights cash receipts. In 2011, U.S. farm cash receipts were at record levels, 16% higher than the previous record in 2008. The 2012 cash receipts number is down slightly from 2011's record level, but are still extremely strong. In our modeling, current year and prior year cash receipts are the primary driver of equipment purchases. This bodes well for the ag business and is translating into increased demand, as illustrated by our strong outlook. Our base case on acres planted and yields for the 2012-2013 crop year is shown on slide nine.
Driven by strong global demand and low carryover stocks, our base case calls for an increase in total planted acres this crop year. The increase in corn acres reflects a shift from cotton. Assuming moisture levels recover in the wheat belt, acreage will increase slightly. As a result of the extreme drought in West Texas, we expect cotton acres planted to decrease in the 2012-2013 crop year. Keep in mind that forecasts involving acreage and yield are very preliminary at this point and will be ultimately determined by weather and springtime prices. Our economic outlook for the EU27 is on slide ten. We see the European ag sector strengthening, with 2012 farm income expected to remain at very attractive levels, supported by commodity prices. Equipment demand continues strong, with a favorable outlook for large farm markets in Northern Europe offsetting weakness in the South.
On slide 11, you'll see the economic fundamentals outlined for a few additional targeted growth markets. Slide 12 tells the weather-related story for Argentina and southern Brazil, which serves as the basis for our outlook change in the region and the slide change from the farm net income slide you are used to seeing. Drought conditions in central Argentina and southern Brazil have lowered production and yields, while heavy rain in central Brazil has slowed the soybean harvest and the planting of the second-season cotton crop. Our 2012 ag and turf industry outlooks are summarized on slide 13. With strong farm fundamentals in the U.S. and Canada, demand continues to increase, especially for high-horsepower equipment. We have increased our forecast for the region to up about 10%. The EU27 industry outlook has been increased and is now projected to be flat to up 5% from the attractive levels of 2011.
The improvement is due to favorable conditions in the grain, livestock, and dairy sectors, which are outweighing general economic concerns in southern Europe. Our 2012 industry outlook in the CIS countries is for considerably higher growth after last year's notable rise. Moving to Asia, we expect sales to increase moderately. The tweaking in our forecast is the result of the tractor industry in India. After two years of strong double-digit growth, the 2012 forecast for tractors is flat this year. Higher interest rates and moderating commodity prices are also dampening growth. We view this as only a pause in India, as government support for agriculture and farm mechanization are both on the rise. Industry sales of tractors and combines in South America are now expected to be flat to down 5% in relation to the strong levels of 2011 due to drought in parts of the region.
Remember, industry outlook for South America does not include cotton and sugarcane harvesting equipment, both categories in which Deere has a strong market presence. The ag sector in Brazil continues to receive governmental support stimulating investments in ag equipment. Turning to another product category, we expect industry retail sales of turf and utility equipment in the U.S. and Canada to be up slightly in 2012. Putting this all together on slide 14, the fiscal year 2012 forecast is for Deere sales of worldwide ag and turf equipment to be up about 15%. Currency translation is negative by about three points, which is a four-point negative change from our forecast in November. Effectively, forecast volumes have increased by four points. Operating margin for the division is forecast at about 15%, which would be a record, and that's despite the headwinds we discussed earlier. This certainly illustrates solid execution on our part.
To update you on our early order programs, the combine early order program ended in the middle of January, with about 95% of the production slots covered. Concerning used combine levels, you may recall, we made good progress in reducing the number of used units at year-end. We made still more progress in the first quarter. January ended with used combines well below year-earlier levels, with values rising. In response, we added additional combine production to the schedule. This clearly demonstrates our confidence that we have effectively managed through this situation. The cotton early order program is full. Remaining early order programs for air seeding, sprayers, planters, drills, tillage, windrowers, and self-propelled forage harvesters have gone exceptionally well. Aggregate orders for these programs are up about 30% over last year.
The order book for large tractors is also strong, with effective availability of August 2012 for the 8R model and June 2012 for the four-wheel drive 9R. All this supports our outlook for very good market conditions. Let's focus now on construction and forestry on slide 15. Deere's net sales were up 22% in the quarter, while production tonnage was up 26%. Division operating profit rose 41% to $124 million, helped by higher shipment volumes and improved price realization, partially offset by increased raw material costs. C&F recorded a 9% operating margin and a 14% incremental margin. On slide 16, let's look at the economic indicators on the bottom part of the slide. While stable or increased from last quarter, the underlying fundamentals certainly don't point to strong recovery. Overall, economic growth continues at a slow pace, though there are promising signs that things are picking up.
C&F continued to benefit from replacement demand for very aged fleets and improved sales to independent rental companies, as they record higher utilization levels and rental rates. We also see strength in the energy and material handling sectors, the latter pertaining mostly to skid steers and loaders. Also, encouraging, Deere dealers continue to see an improvement in rental utilization and used equipment markets. Net sales in construction and forestry are now forecast to be up about 18% in fiscal 2012, with negative currency translation of about one point. Global forestry markets are expected to be flat to up 5% in 2012 from the strong levels of a year ago. We are seeing growth in all our markets except Europe, where the market remains healthy but restrained by economic concerns. The full-year operating margin for the C&F division is projected to be about 8%.
Let's move now to our financial services operations. Slide 17 shows the financial services provision for credit losses as a percent of the total average owned portfolio. Year to date, on an annualized basis, the provision is at an incredibly low two basis points. This reflects lower write-offs, primarily in the ag and construction and forestry portfolios, as well as recoveries of prior year write-offs and fewer repossessions. Our 2012 financial forecast contemplates the provision for credit losses increasing toward a more normal level to about 24 basis points as a percentage of the average owned portfolio. For your reference, the 10-year average is about 34 basis points. Moving to slide 18, worldwide financial services net income attributable to Deere & Company was $119 million in the quarter versus $118 million in 2011.
Net income benefited from growth in the credit portfolio, revenue from wind energy credits, and a lower provision for credit losses. These items were largely offset by higher crop insurance claims and increased selling, administrative, and general expenses. The wind energy credits relate to the wind energy business we sold in 2010. Looking ahead, we are now projecting worldwide financial services net income attributable to Deere & Company of about $460 million in 2012. The decrease from 2011, when income was $471 million, is mainly attributable to two things. First, the provision for credit losses rising toward more normal levels, about 24 basis points for the year. Last year's loss provision was only 4 basis points, well below average levels. Second, the forecast also includes higher selling, administrative, and general expenses in support of the equipment operation's global growth.
For example, financial services has recently added or soon will be adding locations in China, Russia, Chile, India, and Thailand. Growth in the portfolio will partially offset these two items. Now, on slide 19, let's look at receivables and inventories. For the company as a whole, receivables and inventories ended the first quarter up about $1.6 billion compared to the first quarter of 2011, equal to 30% of trailing 12-month sales. The same percentage of trailing 12-month sales was achieved in the first quarter of 2011. Historically, for the first quarter, we run between 28% and 30%. The higher first-quarter inventory levels are necessary to meet the strong demand ahead of us this year. For the full year, receivables and inventories are expected to be about $150 million higher versus 2011. Let's turn now to raw materials and logistics on slide 20.
First-quarter material costs were up about $130 million in comparison with the first quarter of 2011. Our 2012 full-year forecast now assumes an increase of around $400 to $500 million versus 2011, as we are seeing lower steel prices run through our costs. About 80% of the increase is for ag and turf and about 20% for C&F. As we have shared in the past, increases or decreases in Deere's raw material costs tend to lag by three to six months, depending on the commodity or type of contract. Our forecast calls for about two-thirds of the increase in raw material costs to occur in the first half of the year. Finally, as we introduce new products and features to our growing customer base, the product cost of compliance with engine emission regulations in North America and Europe will be roughly $500 million higher than 2011.
However, the forecast four points of price realization will offset the combination of increased material costs and Interim Tier 4 product costs. Looking at R&D expense on slide 21, R&D was up 16% in the first quarter compared to the same period last year. Our 2012 forecast calls for R&D expense to be up about 12%. Currency translation is negative by about two points. As stated in previous quarters, R&D spending is expected to remain at high levels for the next few years as we continue product launches with Interim Tier 4 engines and soon thereafter meet final Tier 4 emission standards. Also included is ongoing new product development expense for our growing global customer base. Moving to slide 22, SANG expense for the equipment operations was up 7% in the first quarter. Growth accounted for almost all of the increase.
Our fiscal year 2012 forecast calls for SANG expense to be up about 10%, with growth accounting for about four points and currency translation a negative two points. Turning to slide 23, we detail our use of cash priorities. Deere's worldwide financial services operation provides a strategic advantage in funding customer purchases, but only so long as we can access the credit markets on a cost-effective basis. One of the key elements to this end is maintaining a single A rating, which is our top priority. Rating agencies expect 12 months of debt maturities to be covered by cash and/or untapped credit facilities. This also implies appropriately funding our pension and OPEP benefits, which we have done proactively and prudently over the years. Our second use of cash priority is funding value-creating investments in our operations.
As an example, mentioned in the press release, over the last year, we announced plans for seven new factories, as well as expansions at existing factories. A third priority is to provide for the common stock dividend. Over time, we want to consistently deliver a series of moderately increased dividends while targeting a 25% to 35% payout ratio on average. We are mindful of the importance of maintaining the dividend and thus not growing it beyond a point that it can be comfortably sustained by cash flow. Deere repurchases are a method of deploying excess cash once the previous requirements have been met, so long as such repurchase is viewed as value enhancing. On slide 24, you see our equipment operations' history of strong cash flow. Following years of impressive cash flow performance, we are forecasting cash flow from equipment operations to reach about $3.5 billion in 2012.
In closing, the company started out 2012 on a strongly positive note and is looking for further improvement in the quarters ahead. Our recent performance and our positive outlook for the year give strong momentum to the company's plans for achieving increased growth and profitability in the future. What's more, our substantial investment in new products and additional capacity puts Deere on a sound footing to respond to any further improvement that may occur in key markets now in the early stages of recovery. These investments, as you see summarized on slide 25, include the seven new factories referenced in the press release in emerging markets crucial to our growth, as well as significant expansions and modernizations now underway in the United States.
The added capacity will help the company capitalize on the world's increasing need for food, shelter, and infrastructure, and for the productive equipment needed to help produce it. These powerful trends, in our view, have staying power, and they represent nothing less than an exceptional opportunity for John Deere and its investors in the quarters and years to come. Tony.
Speaker 10
Thank you, Susan. Now we're ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. As a reminder and consideration of others, please limit yourself to one question and one related follow-up. If you have additional questions, we ask that you rejoin the queue. Operator?
Speaker 8
Thank you. At this time, if you would like to ask a question, please press star one on your touch-tone phone. To withdraw your request, you may press star two. Once again, if you have a question, please press star one. Our first question comes from Andrew Oban, and please state your company name.
Speaker 7
Bank of America Merrill Lynch.
Speaker 5
Good morning.
Speaker 7
Good morning. Just a question on your outlook. You know, you guys guided first to a down Q1 versus last year. It also seems that production was a little bit lower in the Q1 than we were thinking, so more of it is being pushed back in the second half. You also guided to lower costs. Yet, as I look at the increase, it sort of barely covers the beat and lower costs that you guided to. Why would incremental production in your outlook not result in more earnings?
Speaker 5
Andrew, this is Jim. I think one of the key pieces in that whole equation is this $80 million or in round numbers, about $100 million of headwinds that we're facing on the currency side from a translation perspective. I think if you look at the increase in physical volume that we've added after you strip out the FX and you put normalized incremental margin assumptions on that and consider the other headwinds we've talked about and then consider also this, in round numbers, $100 million of translation headwind, it seems to be a pretty reasonable outcome where we ended up.
Speaker 7
A follow-up question on construction and forestry. If we go back in the prior cycles, construction and forestry was a much bigger % of your revenue and profit as well. Given sort of the ongoing mix change in the company, do you think in several years construction and forestry can go back to its historic % of revenue and profit that would be similar to what we saw in the middle of the past decade, or has the mix changed sufficiently that we should just think about the company being different?
Speaker 5
This is Jim again, Andrew. Absolutely, it can, and the expectation is that it would. As you've rightfully pointed out, when you look at the last construction cycle, construction recorded the highest operating margin of any of our divisions, and they would be shooting for operating margins that are very consistent with that going forward.
Speaker 7
Thank you very much.
Speaker 5
Thank you.
Speaker 3
Thank you.
Speaker 8
Thank you. Our next question comes from Andy Kaplowitz, and please state your company name.
Speaker 2
Good morning, guys. It's Barclays Capital.
Speaker 5
Good morning.
Speaker 2
Maybe I could follow up on Andrew's question about construction in one sense, and that is, I mean, you had almost 9% margins in the quarter in what usually is a seasonally weak one-Q, and you didn't change the guidance for the year. I guess I'm just trying to figure out why that is, and you know the incremental margins were also quite good versus you know what we thought. Any help you can give us as to, you know, maybe there's a little upside in your guidance now for the year?
Speaker 3
This is Marie Ziegler. As you think about construction, they will have a phase-in of the Interim Tier 4 engine compliance machines over the course of the year, and you will see the costs of product transitions and the product costs reflected in their costs as we move through 2012, and that's the difference.
Speaker 2
Okay, Marie, that's helpful. Just shifting back to ag, you mentioned inefficiencies in the factory in the first quarter, and you know production was a lot less than you’re guided. I'm just wondering how that improves over time. You know, why did first quarter production, why did it look weaker than you guys had expected it to be?
Speaker 10
Right. Keep in mind that the inefficiencies in the quarter that we talked about with Interim Tier 4, again, going back to Interim Tier 4 transitions, certainly you know our combines were transitioning as well as large tractors, our 9000 Series tractors were transitioning during that first quarter. That's part of what's driving some of those inefficiencies.
Speaker 2
Tony, we'll give you the floor.
Speaker 3
The tonnage change is merely just shifts in a variety of products, a little bit less in the first quarter and a little bit more as you move through the year, and that's pretty typical for us. The tonnage numbers, as many of you are aware of, are not terribly precise.
Speaker 2
Marie, it's really just timing, you're saying?
Speaker 3
Yeah, absolutely, because we took our full tonnage up for the year.
Speaker 2
Okay, that's fine. Thank you, guys.
Speaker 3
Okay, thank you.
Speaker 8
Thank you. Our next question comes from Jamie Lyn Cook, and please state your company name.
Speaker 9
Good morning, Credit Suisse.
Speaker 5
Hi, Jamie.
Speaker 9
Hi, good morning. Two questions. One, just back to the Tier 4, I just want to make sure I understood you correctly, and it relates to Andy's question in construction. Is Tier 4 now $500 million, but you said you'll cover all of it? Relative to before, you said $475 million, and you'd cover a good portion. I'm just trying to make sure I understand that relative to the comments you made about Andy's margin impact on the C&F business. My other question is you talked about just on the combine issue, it sounds like you're taking production up. Is that all happening in the fourth quarter, and how should we think about combine production relative to retail in 2012 now?
Speaker 10
Sure. On the first question, Interim Tier 4 costs, as we look, you're right, we did bump that up a little bit to about $500 for the year. As you look at the four points of price realization, what we've said is that will more than cover the Interim Tier 4 as well as the material price increases that we're anticipating for the year.
Speaker 9
Is that better than what you said last quarter? I think I didn't think last quarter you were covering it all, so that's the disconnect I'm trying to, unless I misinterpreted it.
Speaker 3
It's a little bit of a change, but not much.
Speaker 9
Is it better?
Speaker 3
It's a little better, yes.
Speaker 9
Okay. With Andy's comments and why it's going to hurt, if you're more than covering it, why is it going to hurt your C&F margins?
Speaker 3
We aren't in production yet on a lot of the construction equipment that has a phase-in over the course of the year, Jamie. You're not seeing some of the Tier 4 product costs yet in the first quarter at the same level that you will in subsequent quarters just simply because we're launching products over the course of the year.
Speaker 9
Okay. Just the last on the combines, if you're taking the production up in the fourth quarter and where we're going to produce relative to retail in 2012?
Speaker 3
Jamie, we don't have specific fourth quarter public guidance, but it is true that we added combines, and I think you could say that some of those combines certainly would have been added in the latter half of the year.
Speaker 9
Production issues.
Speaker 10
This is Jim. I think relative to the combine issue, which was yesterday's headline, the important thing is that we've reached closure on this issue. We've got the channel where we think it needs to be in terms of used goods, and it also shows the type of actions that we will take as a company to make sure that this is a long-term sustainable business. I think that's the important thing as you look at the combines situation.
Speaker 9
Okay, thank you. I'll get back in queue.
Speaker 10
Thank you. Thanks, Jamie.
Speaker 8
Thank you. Our next question comes from Henry Kern, and please state your company name.
Speaker 0
Hey, good morning, guys. It's UBS.
Speaker 5
Hey, Henry.
Speaker 3
Good morning.
Speaker 0
I'm wondering if you could chat a little bit about where you think we are versus normalized demand in South America and Europe.
Speaker 10
Certainly in Europe, from a normal or mid-cycle, while we're continuing to look at kind of a flat 5%, we would still be below mid-cycle levels within the company in Europe.
Speaker 3
In South America, as we look to South America, we see a very exciting opportunity as that market continues to grow and as Deere individually continues to broaden its market coverage with product and with distribution.
Speaker 10
I think as you look at Europe, an important point there is, as was said by Tony, we are below mid-cycle. We have seen some strength in that market. As a matter of fact, if you look at tractors, the order book's up 12%, combines 25%, self-propelled forage harvesters 17%. That's all happening in a market where there's still, in our view, a significant amount of headroom vis-à-vis mid-cycle.
Speaker 0
Can you update your thoughts on the steps you're taking to improve the market share in both those regions?
Speaker 3
He's asking about market share. We could not hear you, Henry, but I believe your question was, what steps have we taken to improve market share in both those regions?
Speaker 0
Yeah, that's right. Update the thoughts on the steps you're taking to do that.
Speaker 3
When you were in Lisbon in the summer, you saw over 100 new products that had been introduced in Europe to broaden the market coverage. In that market, we're continuing to add and strengthen our dealer capabilities. We've added parts capabilities throughout really what Europe and far into the CIS. Really, the same is true in Brazil and South America, where we continue to add, again, additional dealer locations, and we've had a very significant broadening of the product line, and that's already been reflected if you look at market shares.
Speaker 10
Right. Marie mentioned the distribution network, and in addition to the products, certainly we've talked a lot about continuing to strengthen our distribution network. In Brazil, we would say our distribution actually is very strong, and I think you've seen that reflected in the market share gains as we brought that new product. We've seen those market share gains, and that's reflective of both sides of that equation. We'll continue to work on those same concepts in Europe as we move forward.
Speaker 0
Thanks a lot.
Speaker 10
Thanks, Henry. I think we need to move to the next caller, please.
Speaker 8
Thank you. Our next question comes from Rob Wertheimer, and please state your company name.
Speaker 0
It's Vertical Research Partners. Good morning, everybody. Just wanted to circle back to inventory. You talked about inventory and receivables, but if you look at inventory on a standalone, it looks to me like your turns were the worst in 10 or 15 years, either forward-looking or on sales or backward-looking. I just wanted to make sure you're not having any production hiccups with Interim Tier 4 or anything else that would explain that, or maybe I've got the arithmetic wrong.
Speaker 3
There's absolutely no production hiccups with Interim Tier 4. It has gone very smoothly. That said, year over year, Rob, we have a very different look in the first where we ended the first quarter in terms of our production. It is somewhat difficult to make a comparison because last year you were in very high production in the first two months of the quarter. This year, relatively low levels of production because of the significant turnover that we had in our production on combines and on large tractors.
Speaker 10
A great example of that, Rob, is if you looked at the harvester works last year, the schedule was very heavy in the first quarter, which would have drawn down a lot of that inventory. This year, we're facing a schedule that's accelerating as you went into the quarter, which means you're building the inventories. Obviously, when you look at the endpoint, you get a different equation. I would definitely underscore what Marie is saying. As a matter of fact, we're not having any production difficulties. As a matter of fact, we're very, very proud of what we've been able to accomplish with this major number of new products coming off the line and the efficiency levels of which we completed a winner.
Speaker 0
Okay. Yeah, I mean, you guys have been great on inventory for a long, long time. It just seemed like an outlier even relative to the sales ramp. I hear you. Just one quick follow-up, if I may. Do you have the—I know you don't disclose this quarterly or anything, but the construction mix and geography, it looks like the volumes are back, at least on a quarterly basis, above peak. I know you've gained share, and I know you're expanding geographically. I just don't quite know how to think about which of those is, yeah, is predominating.
Speaker 3
We are not even back to mid-cycle volumes in that division.
Speaker 0
In the U.S. Okay.
Speaker 3
The forestry business, which is 20% to 25% of the business, as we had said, has been stronger and is taking a little bit of a pause. The construction business, which the bulk of it is still in the U.S., that's been very weak. It's been recovering from an extremely low level, but they are nowhere near mid-cycle.
Speaker 0
Okay. It's just the one Q number, but I get it. Okay. Thank you.
Speaker 3
Okay. Thanks, James.
Speaker 8
Thank you. Our next question comes from Andy Casey, and please state your company name.
Speaker 2
Wells Fargo Securities. Good morning, everyone. Question on the cadence of the outlook for the remaining three quarters in ag and turf incremental margin. You're looking for roughly 21% with the numbers that you gave. Is that more back half loaded than what we normally see in Q2?
Speaker 10
No, I think you'll see, I mean, again, our seasonal shipping in ag and turf is returning to a much more traditional pattern this year versus what we would have seen last year.
Speaker 2
Okay. On construction and forestry, I think in the last call, some of the muted margin expectations were talked about as being caused by production ramp-up. I'm wondering if you're seeing an impact from the production capacity expansion in international markets this year or if that's more a 2013 event.
Speaker 10
Yeah, you know, most of that's going to be a 2013 event when we look outside of the U.S. and Canada. Of course, we have talked about the factory in India is producing, but it's on relatively low levels at this point. We'll ramp up as we go through the year. Again, most of that is a 2013 event.
Speaker 2
From a production standpoint, obviously, we're incurring costs related to that geographic expansion, which are, in fact, being reflected in the 12 numbers. I would say vis-à-vis steady state has suppressed them somewhat.
Speaker 0
Okay, thank you very much.
Speaker 10
Thank you. Next caller.
Speaker 8
Thank you. Our next question is from Steven Volkman, and please state your company name.
Speaker 6
All right. Good morning. It's Jefferies & Company.
Speaker 10
Morning.
Speaker 6
I guess you just answered this, but I was thinking also about all the news that are coming online and some of the costs that are going to be ramping up before you get revenues and so forth. I guess I'm wondering, is the margin headwind from that bigger in 2013 than it is in 2012? Does it sort of ramp down in 2014? Am I thinking about that the right way, sort of medium-term?
Speaker 10
Of course, we aren't going to get into giving a whole lot of guidance as it relates to 2013. Clearly, we have some of the Interim Tier 4 engine costs behind us as you look out at 2013, but on the other hand, we'll have still the development cost going forward. You know our expectation, of course, would be as you bring these factories online, you're going to start generating revenues to cover some of these expenses. Of course, there are some expenses that are initial startup expenses that do go away. The aggregate picture of how that all fits together, to be perfectly honest with you, we don't have a good view of that today.
Speaker 6
Okay. Fair enough.
Speaker 10
That we're willing to share.
Speaker 6
Fair enough. I'll ask it again in a couple of quarters, maybe. How about that.
Speaker 10
Somehow, that would be my expectation.
Speaker 6
Maybe just a little bit of a follow-up in Europe. I'm kind of struck by, thank you, Jim, for the color on the order book in Europe. You know, clearly we've seen some strong retail numbers over there recently for the past few months, and your order book looks pretty good. Sort of the flat forecast there. I guess I'm wondering, are you hearing something from the marketing folks that just makes you nervous about the second half, perhaps, or is it more just we're not sure what's happening and we want to be conservative?
Speaker 10
First of all, the outlook is flat to up 5%, which is an increase from the prior outlook. With that, keep in mind, what Jim was talking to was our order book. As we mentioned earlier in the call, of course, with the new products and our drive there in Europe for market share, I think that's just reflecting some of those expectations in terms of our performance versus the overall market.
Speaker 6
You're not calling for a deceleration over there?
Speaker 10
No, not at all. As a matter of fact, if you look around the world, I mean, basically, we've got all the markets accelerating on South America. Europe is the same way.
Speaker 6
Great, thanks so much.
Speaker 10
Okay, thank you.
Speaker 8
Thank you. Our next question comes from Robert McCarthy, and please state your company name.
Speaker 0
Hi. Good morning. It's Robert W. Baird. I wanted to ask about your forecasting for the U.S. and Canada ag market in the context of the discussion about crop receipts, etc., and a reversion to more normal yields. Of course, we have an ongoing precipitation issue, particularly in the upper Midwest, but also in the southern plains. You referred to, you know, West Texas cotton. What explicit, how do you factor that into your forecast? Do you just accept that you can't be a weather forecaster and so by default at this point in the year, you're going to assume normal yields, or have you baked something specific into your forecast that could accommodate, you know, some pressure on yields because of, you know, the low moisture condition that we're looking at?
Speaker 3
Rob, at this point, the only weather impact that we have put into the forecast is the shift down in some cotton acreage and a little bit of increase in corn as a result because of the drought situation that we have talked about in Texas. At this time of the year, our practice has been to go with a trend yield because there's a lot of variables yet in the weather that can affect that. You're really looking at what we would consider to be trend yield.
Speaker 0
Okay. I just want to make sure that I understood. Just a point of clarification, you know, the answer may be obvious, but as I look at your slide 13 that details your ag and turf industry outlook by region, you know, the first five of the six bullet points are the core agricultural business. Would it be fair to say that in your plan, you expect to outperform these industry growth numbers in each of those five regions?
Speaker 3
Absolutely.
Speaker 0
Okay, thank you.
Speaker 10
Thank you.
Speaker 3
Thank you.
Speaker 8
Thank you. Our next question comes from Jerry Rebich, and please state your company name.
Speaker 0
Good morning. It's Goldman Sachs.
Speaker 10
Hi, Jerry.
Speaker 6
Good morning.
Speaker 0
Can you say more about the factors that drove 16% lower production than you expected outside the U.S. and Canada this quarter? I'm looking at slide 27. Thanks.
Speaker 3
Slide 27. Change the tonnage.
Speaker 10
The first thing, of course, it's at 16% on a seasonally weak quarter for our European operations. The other issue is we had some production shift that's reflected in the overall tonnage that we moved into the second quarter that's affecting some of that as well. Beyond that, Marie.
Speaker 3
There would be a little bit of impact probably from combines out of South America. I think that's well documented. If you look at the full-year forecast for outside the U.S. and Canada, it's actually up a little bit.
Speaker 0
Jim, did you mention some of that is because of a production shift in Europe? Can you say more about that point into the second quarter?
Speaker 10
It was just as we got into the schedule for the European operations, there were some units that were moved from late in the quarter to the following month. It's just really minor timing changes within the production.
Speaker 0
Okay. Your sales guidance and C&F implies a slower production increase in coming quarters than typical seasonality. Is that just room for upside or any specific drivers that you're looking at?
Speaker 3
Again, that reflects IT for conversions. Remember, you have to shut the line down, then you convert, and then you restart. You've got some ramp-up through there.
Speaker 10
Keep in mind, as compared to last year, in the first and second quarter, we had some increased production as we were moving to the SAP conversion that was right at the end of our second quarter. It is really as much a 2011 shift in production as 2012.
Speaker 0
Thank you.
Speaker 10
Thank you.
Speaker 8
Thank you. Our next question comes from Joel Tiss, and please state your company name.
Speaker 0
Hi, Buckingham Research. How are you doing?
Speaker 5
Hello.
Speaker 0
Hello. I just wondered if you can give us a sense of what's happening to the farmers' break-even costs on corn and on beans. I'm just trying to gauge how much of an impact a potential drop in crop prices in 2013 might have on volumes.
Speaker 10
Sure. Actually, one thing I would cite is if you look at there was a University of Illinois study that was done last fall that kind of looked at expected crop price or input costs and so on. It was they looked at a 1,200-acre farm. The metric they used is in terms of not so much break-even, but making decent money. At $50,000 net farm income, corn, the pricing they had on corn was about $3.70, and soybeans would be about $8.50. That's very consistent with what we would get from Inform Economics, who is our outside consultant. They would say corn in the $3.50 to $3.70 range, farmers still make good money, and soybeans in the $7.50 to $8 range.
Speaker 5
is lots of headroom vis-à-vis where prices are today.
Speaker 0
Right. Okay, good. Is there any number you can share with us on the earnings impact from the lower provision for credit losses in the quarter?
Speaker 5
Is that material?
Speaker 10
Yeah, it was in the $4 million range.
Speaker 5
Okay. All right. Thank you very much.
Speaker 10
Okay, thank you.
Speaker 8
Thank you. Our next question comes from Ashish Gupta, and please state your company name.
Speaker 2
Credit Ag Global Securities. Good morning. If we just step back for a second and focus on the long term, you have seven new factories and increasing production capacity at existing facilities. Can you just kind of give us an idea of what you're most excited about in terms of incremental contributions over the multiple-year period?
Speaker 10
We're excited about several different aspects of it. You know, what we've said is near term, one of our largest growth opportunities would be kind of Europe from an SBA perspective. You know, South America, we believe, has plenty of headroom. We're seeing really pretty good activity starting to be restored in the CIS regions today. The CIS is all about large ag for us, just in many respects, very, very similar to the upper Midwest and generates margins that are very, very consistent with the types of margins that we see in the large ag space in North America. You know, we've, of course, announced these factories in Asia. These are large unit volume markets. I think you're looking at something north of 500,000 industry volume in India this year, but of course, a much, much lower ticket per unit.
You know, there's six geographies we're focused on around the world, and each of them holds some very interesting and promising opportunities for us.
Speaker 2
Great. Just to follow up on the balance sheet quickly, I'm just trying to think about how much incremental cash you guys will have this year to buy back stock. Can you kind of review your balance sheet management and your debt maturity schedule versus your liquidity for 2012?
Speaker 3
Our cash flow that we expect to generate from operations is about $3.5 billion. We've talked about the fact that we do have some large debt maturities that's in one of the schedules in the appendix. Our cash management, we will be positioning ourselves with some amount of cash to make sure that we have a fairly smooth transition as we have to repay those. We've got a very large maturity in the second and then another one in the third quarter. Quite candidly, we have been doing some pre-funding. You see that reflected in our cash balances. I mean, we expect to manage very comfortably through it. I have already demonstrated by virtue of the amount of cash that we have on that we will have a smooth transition.
Speaker 2
Okay, thank you.
Speaker 10
We need to move on to the next caller, please. Thank you.
Speaker 8
Thank you. Our next question is from Seth Weber, and please state your company name.
Speaker 6
Hey, good morning. It's RBC.
Speaker 5
Hey, Seth.
Speaker 6
Sorry if I missed this, but the $100 million of additional costs that you absorbed in the quarter for startup and overhead, can we talk about how that's going to trend through the year? Do you expect that to trend down quarterly as we go through the year, or is that kind of a steady state for the next couple of quarters?
Speaker 10
Right now, the way we see it is that that would be a heavier headwind in the first half of the year than in the second half of the year. Yes, it does trend down in the second half of the year.
Speaker 6
Okay, great. Thank you. Just to follow up on Latin America, you guys have done a really nice job taking share there. Have you noticed any kind of competitive response with respect to pricing as pricing got more aggressive across the industry, or can you comment on any of that?
Speaker 10
It's not our practice really to get into talking too much about what's going on with the competition, but I would tell you that we had positive price realization in South America last year. We're forecasting positive price realization in South America this year, and we had it in the first quarter. Obviously, there's a lot of competitive dynamics around the globe. For us, it's about getting market share and getting it in a sustainable way. If it's through price, it's not sustainable. I think the fact that we've gotten this price realization is good evidence that we're doing it the John Deere way and the right way and the sustainable way.
Speaker 5
Okay. Thanks, Seth. We'll move on to the next caller, please.
Speaker 8
Thank you. Our next question is from David Raso, and please state your company name.
Speaker 2
Really just one quick question. The cost you said in the first quarter for ag and turf, if I add those back, it implies an incremental margin of 33% and an operating margin that's 14.3%. A 33% incremental would be the strongest incremental in a couple of years. I'm just trying to get a feel for how you look at the underlying profitability of ag and turf. If you look at the full-year guidance, you're roughly implying still the same idea of about a 15% ag and turf margin, maybe a tad higher. I'm just trying to get to the underlying business when these costs recede. Should I, I'm just trying to get my arms around Exos costs. You had a core incremental margin of 33% for the quarter. It just doesn't seem that logical given the tough comp against the combine production a year ago.
Speaker 10
I think for starters, it's certainly, you know, as we talked about with combines, were lower in the quarter, but we did have some strength last year. You know, our large tractors, the 8000 series tractor was lower than normal as we went through conversion in January of last year. There are other products that have very strong margins as well that we're seeing some strength in this year. I think, you know, if you think about this from a macro perspective, David, I think you are thinking about it more right than wrong. You know, what we've got here is a situation where we're investing a lot around the globe for the future growth of this company. We have these headwinds caused by regulatory requirements. Despite all of that, we're putting up first-quarter operating margins on an absolute basis.
Forget about the incrementals that are about as good as we've ever had. I think we're accomplishing what we wanted to accomplish, which was invest in the growth, invest in what we need to do to bring out a superb Interim Tier 4 engine product and maintain very healthy levels of margins. We've done that. Thank you, David.
Speaker 2
Okay.
Speaker 10
Okay. Thank you. Next caller. I think we have time for one more call.
Speaker 8
Thank you. Our final question comes from Anne Dyknan, and please state your company name.
Speaker 1
Hi, good morning. JPMorgan Chase & Co.
Speaker 10
Hi, Anne.
Speaker 5
Hi, Anne.
Speaker 1
Yeah, one of the questions we get a lot from investors is just Deere's mix going forward. You know, as you invest in the rest of the world and the North America, high horsepower, and combine market maybe matures, you know, the mix going forward may be a negative. Could you just talk about what your expectations are for the mix of product, maybe the mix of margin? I know you won't get into margin in any great detail, but you know, any color you could give us in terms of what your expectations are from a mixed perspective as you expand globally?
Speaker 10
Right. I think I'd start, first of all, as part of that global expansion, we also, and in our aspirations, we talk about an aspiration of growing our operating margins from roughly 10% at mid-cycle to 12%. I think that's reflective of our expectation that, mix aside, that we'll continue to improve our operating margins as we move forward. Again, as you look at mix, I think you can also look at, yes, we have growth in some regions where you might be more heavily weighted towards smaller ag, but we also have some good growth opportunities in places like Russia and the CIS, which will have certainly a significant large ag mix, not to mention South America and our growth opportunities there.
Speaker 1
Just as a follow-up, you know, on your outlook for Asia, Asia is a very large region. Within it, we have China, and we also have Australia and New Zealand. Can you talk about the fundamentals in both of those regions, you know, one versus the other?
Speaker 10
In terms of Australia versus in Asia?
Speaker 1
Australia/New Zealand versus China. You know, when you give guidance, you just give Asia, which incorporates both.
Speaker 10
Right. Our Asia guidance is primarily being driven by India and China.
Speaker 1
Okay.
Speaker 10
We talked about in the opening comments that, you know, India in the tractor industry this coming year, we're looking at about a relatively flat tractor industry after two very strong growth years and still at very, very high levels. Certainly, China continues to see some nice growth. In both cases, government is very supportive of the growth of agriculture. With that, we thank you for your call.
Speaker 3
Thank you for joining us today as we talked about an excellent first quarter, excellent prospects for the remainder of the year. Certainly, we've had the opportunity to talk about some of the things we're doing to position ourselves to take advantage of the very exciting tailwinds we have globally. Susan, Tony, I, and Christian will be available for your questions as we move through the day. Thank you.
Speaker 8
Thank you. This does conclude today's conference call. We do thank you for your participation, and you may end.