Deere & Co (DE) Q2 2022 Earnings Call Transcript

Good morning, and welcome to Deere & Company's Second Quarter Earnings Conference Call. Your lines have been placed in listen-only mode until the question and answer session at today’s conference. I would now like to turn the call over to Mr. Brent Norwood, Director of Investor Relations. Thank you. You may begin.

Hello. Also on the call today are Ryan Campbell, Chief Financial Officer; Josh Jepsen, Deputy Financial Officer; Kanlaya Barr, Director of Corporate Economics; and Rachel Bach, Manager of Investor Communications. Today, we'll take a closer look at Deere's second quarter earnings, then spend some time talking about our markets and our current outlook for the fiscal year 2022. After that, we'll respond to your questions. Please note that slides are available to complement the call this morning. They can be accessed on our website at johndeere.com/earnings. First, a reminder. This call is being broadcast live on the Internet and recorded for future transmission and use by Deere & Company. Any other use, recording or transmission of any portion of this copyrighted broadcast without the expressed 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, GAAP. Additional information concerning these measures, including reconciliations to comparable GAAP measures, is included in the release and posted on our website at johndeere.com/earnings under Quarterly Earnings and Events. I will now turn the call over to Rachel Bach.

Thanks, Brent, and good morning. John Deere completed the second quarter with strong execution despite ongoing supply challenges. Financial results for the quarter included a 19.9% margin for the equipment operations. Agricultural fundamentals remain robust, with our order books nearly full for the remainder of the year and growing demand for our model year '23 products. Additionally, the construction and forestry markets continued to experience strong demand and pricing, leading to solid performance in that division for the quarter. In the second quarter, net sales and revenues increased by 11% to $13.37 billion, while net sales for the equipment operations rose by 9% to $12.034 billion. Net income attributable to Deere & Company was $2.098 billion, or $6.81 per diluted share. Looking closer at our production and precision ag business, net sales of $5.117 billion were up 13% from the second quarter last year, primarily driven by price realization and higher shipment volumes. Price realization during the quarter was positive by approximately 11 points. Operating profit was $1.057 billion, resulting in an operating margin of 20% to 21% for the segment. The year-over-year increase in operating profit was mainly due to price realization and increased shipment volumes, which were partially offset by higher production costs and increased R&D spending. The increased production costs were largely attributed to elevated material and freight expenses. Ongoing supply challenges also led to production inefficiencies and higher overheads for the period. The increase in R&D spending reflects our commitment to developing and integrating technology solutions into our equipment to provide added value for our customers. Additionally, operating profit for the quarter faced a negative impact from a $46 million impairment related to the events in Russia and Ukraine. Regarding small ag and turf, net sales increased by 5%, reaching $3.57 billion in the second quarter as price realization more than covered the negative impact of currency translation. Price realization in the quarter was positive by just over 8 points, while currency translation contributed negatively by about 2 points. For the quarter, operating profit decreased year-over-year to $520 million, resulting in a 14.6% operating margin. The decline in profit was primarily due to higher production costs, particularly for materials, and an unfavorable sales mix, though these were partially offset by price realization. I am pleased to introduce Kanlaya Barr, Director of Corporate Economics, to provide more insights into the current global ag and turf industry and its fundamentals. Kanlaya?

Thanks, Rachel. Turning to Slide 6. I would first like to take a few moments to talk through some points that are influencing the global industry. Global stock for grains and oilseeds have declined over the past 3 seasons, and we expect to see significantly less production and export out of the Brexit region. On the demand side, there was an increase in imports into China as China's hog herd recovered. So both supply and demand factors are leading to higher crop prices as reflected in the recent industry release. Meanwhile, growers are experiencing input cost inflation and availability concerns, most notably with fertilizer. Row crop producers are contending with higher input costs, facing pressures in advance of the recent inflation and are marketing their crops at higher prices. As a result, growers continue to experience strong profitability and cash flow. While farmers expect another year of high input costs in 2023, global grains and oilseeds prices have risen enough to deliver healthy profit margins into the next season. With respect to small ag equipment, two consecutive years of industry-wide production constraints have resulted in further aging of the fleet. The higher-than-average fleet age, coupled with low channel inventory, is contributing to pent-up demand and is likely to remain beyond fiscal '22. With this backdrop of continued strong ag fundamentals, we expect U.S. and Canada industry sales of large ag equipment to be up approximately 20%. Order books for the remainder of the current fiscal year are mostly full, and we already see signs of strong demand for model year '23 equipment, with some order books opening in June. Small ag and turf industry demand continues to be forecasted to be about flat this year. We are seeing moderate increases from our turf segment, while consumer products are lower due to supply constraints and low inventory in the channel. Rising interest rates will likely impact home sales and home improvement spending in North America, although we expect them to remain elevated. Equipment inventories remain well below normal and are unlikely to begin recovering until 2023. Now moving on to Europe, the industry is forecasted to be up roughly 5% as higher commodity prices strengthen business conditions in the arable segment. We expect the industry will continue to face supply constraints, resulting in demand outpacing production for the year. At this time, our order book expands through the duration of fiscal '22 and even into early fiscal '23 for some product lines. In South America, we expect industry sales of tractors and combines to increase by approximately 10%. Despite the low crop yield due to weather, our customers are very profitable this year, benefiting from high commodity prices. Our order book reflects the strong sentiment and is nearly full for most product lines. Industry sales in Asia are forecasted to be down moderately as India, which is the world's largest tractor market by unit, moderates from the record volume achieved in 2021. I will now turn the call back to Rachel.

Thanks, Kanlaya. Moving on to our segment forecast beginning on Slide 7. Production and precision ag net sales continue to be forecasted up between 25% and 30% in fiscal year '22. The forecast assumes about 13 points of positive price realization for the full year, which will allow us to be price/cost positive for the fiscal year. Additionally, we expect roughly 1 point of currency headwind. For the segment's operating margin, our full year forecast remains between 21% and 22%, reflecting consistently solid financial performance across all geographic regions. Slide 8 shows our forecast for the small ag and turf segment. We expect net sales in fiscal year '22 to be up about 15%. This guidance includes over 8 points of positive price realization and 3 points of currency headwinds. The segment's operating margin is forecasted to be between 15.5% and 16.5%. Although price/cost remains positive for the year, supply challenges, as well as higher material and freight costs, are expected to continue to put pressure on margins. Turning to construction and forestry on Slide 9. For the quarter, net sales of $3.347 billion were up 9%, largely due to price realization and higher shipment volumes. Operating profit increased year-over-year to $814 million, resulting in a 24% operating margin. During the quarter, there was a one-time gain of $326 million from the Hitachi transaction. Results were also impacted by a $47 million impairment related to the events in Russia and Ukraine. Excluding those special items, operating margin would have been 16%. Higher production costs and an unfavorable product mix were detrimental to the quarter's results. The production costs were mainly a result of higher material and freight. Now let's take a look at our 2022 construction and forestry industry outlook on Slide 10. Industry sales of earthmoving equipment in North America are expected to be up approximately 10%, while the compact construction market is forecasted to be flat to up 5%. End markets for earthmoving and compact equipment are expected to remain strong as the U.S. housing market is forecasted to remain elevated. Oil and gas activities continue to ramp up and strong capital expenditure programs from independent rental companies drive reflating efforts. Compact construction equipment inventory levels are extremely low due to supply constraints affecting those product lines. In forestry, we now expect the industry to be flat to up 5%, and global road building markets are also expected to be flat to up 5%. The C and F segment outlook is on Slide 11. Deere's construction and forestry 2022 net sales continue to be forecasted up between 10% and 15%. Our net sales guidance for the year includes 9 points of positive price realization and 2 points of negative currency impact. The segment's operating margin outlook has been revised to a range of 15.5% to 16.5%. The update reflects the one-time gain from the Deere-Hitachi transaction and the impairment related to the events in Russia and Ukraine that occurred in the second quarter of 2022. The normal course of business continues to benefit from increases in price and volume. Shifting over to our financial services operations on Slide 12. Worldwide financial services net income attributable to Deere & Company in the second quarter was $208 million. This is a slight decrease compared to the second quarter last year, primarily due to the higher reserves for credit losses, partially offset by income earned on a higher average portfolio. For fiscal year '22, we maintained our net income outlook at $870 million as the segment is expected to continue to benefit from income earned on a higher average portfolio balance. Slide 13 outlines our guidance for net income, our effective tax rate, and operating cash flow. For fiscal year '22, we are raising our outlook for net income to be between $7 billion and $7.4 billion, reflecting the one-time items in the second quarter of this year. The full year forecast is inclusive of the impact of higher raw material prices and logistics costs. At this time, our forecasted price realization is expected to outpace both material and freight costs for the entire year. The first two quarters are expected to be our most difficult material and freight inflationary cost comparisons, while the third quarter comparison to last year should improve slightly. As we progress into the fourth quarter, we expect those material and freight comparisons to improve even further. We also expect shipments to be more back half-weighted than we've seen historically as we work through a backlog of partially built inventory waiting for supply parts and while seasonal factories continue to produce without the typical shutdown periods. Moving on to tax, our guidance incorporates an effective tax rate projected to be between 22% and 24%. Lastly, cash flow from the equipment operations is now expected to be in the range of $5.6 billion to $6 billion. The decrease in the forecast reflects the increases in working capital required through the year. At this time, I would like to turn the call over to Ryan Campbell, Chief Financial Officer, for comments. Ryan?

Before we transition to the Q&A portion, I would like to make a few remarks on our results and the opportunities ahead of us. Reflecting on the second quarter results, as we indicated in our prior earnings call and outlook, the supply chain-related constraints continued through the quarter and will not likely abate during this fiscal year. With respect to our forecast, excluding the special items in the second quarter, our operational guidance remains roughly unchanged. I want to commend our employees, dealers, and suppliers for their efforts to support customers and deliver products as quickly as possible in this dynamic environment. Given the strong fundamentals in agriculture, coupled with the underlying supply constraints, we do not see the industry being able to meet all the demand that exists in 2022. While difficult to quantify exactly the impact of this, we expect 2023 to be another strong year of industry demand. Strategically, each day that passes gives us more confidence in our smart industrial strategy and our recently announced leap ambitions. While we are hard at work managing our operations in this dynamic environment, we are also executing on our strategy. Our production systems teams continue to identify and execute against opportunities to drive both economic and sustainable value for our customers and their operations. This is even more critical in an environment where inputs are significantly increasing in costs and/or hard to come by.

Thanks, Ryan. Now before we open the line for Q&A, I would like to dive deeper into a few important topics for the quarter. Let's start with our full year revenue guidance. The top line forecast implies a second half shipment schedule that is higher than the first half. Brent, what factors led to this? And how does Deere plan to deliver on a back half-loaded year?

Yes. First, I'll spend a few minutes talking about some of the factors in the first half of the year. The first quarter was unusually low due to the work stoppage that we experienced. So we expected the delivery schedule would be seasonally different earlier in the year. We also had two large new product programs that we're ramping up to full production in the first half, the X9 combine and the 9R tractor. Our production plans always reflected higher volumes of these products later in the year. Typically, we see some of our seasonal factories taking shutdowns in the second half of the year. However, this year, we'll see some of our production and precision ag factories producing through much of the third and fourth quarter. Overall, we expect to have more production days in the second half of 2022 than the previous year, and we expect to grow production progressively from the second quarter through the fourth quarter, meaning we expect Q4 to be our highest revenue quarter for the year. Additionally, supply disruptions led to inefficiencies at factories resulting in unusually high inventory of partially completed machines. As soon as we get the parts, we will be able to complete and ship product, providing confidence in the second half shipment schedule. Our guidance does contemplate getting enough parts to fulfill the production schedule. As Ryan mentioned, we are collaborating with suppliers and our factories and are working hard to make sure we get there.

This is Josh. One thing to add is that we're noticing this reflected in the AEM retail data as well, where some categories are down year-to-date but showing variability in month-to-month retail figures. The decline in certain categories isn't indicative of a drop in demand, but rather the difficulties we're facing in getting products shipped, which is an issue affecting the entire industry due to the current supply environment.

Great. Thank you. Next, let's discuss how margins will progress throughout the year, especially in the context of price and material freight costs. Can you talk a little bit more about how we should think about margins in the second half versus the first half? Brent, how do you expect the rest of the year to unfold?

So we experienced the most difficult material and freight comparisons in the first half of 2022. Lagging contracts on steel mean we have seen progressively higher costs since the third quarter of 2021. Other costs are ramping as well. Commodities such as copper and aluminum, electronics, and even things like labor and energy are increasing. We'll begin to anniversary some of these cost increases in the third and fourth quarters. So we'll see easier comparisons relative to the previous year. Freight remains elevated, too. Recent COVID lockdowns in China have caused delays in shipping globally, compounding some of the previous logistics bottlenecks. With the supply chain backed up, we're utilizing significantly more air freight solutions, and we expect this to continue throughout the second half of 2022. In addition to material and freight, overhead has increased. This has come from the choppiness in the supply base and is particularly evident in the number of partially completed machines in our inventory that are missing parts required to be complete. So while the comparisons get easier, we probably won't see much moderation in material and freight costs this year. Fortunately, price realization should get progressively better, potentially making the fourth quarter the highest margin period for us, which is a bit atypical. We have managed our order books differently than we have in the past, enabling us to adapt to changes in inflation. So as noted earlier, we expect our price for the full year will more than offset increases in material and freight.

Thanks, Brent. Let's take a closer look at ag fundamentals. Kanlaya, can you share more insight?

Sure. Let's start with the global stocks for grain oilseeds, which we have seen decline over the last 3 seasons, and that's driven by both the supply and demand side. Now looking at the demand side, we experienced a large increase in Chinese imports, starting in the crop year 2021 as China's hog herd recovered from the African Swine Fever. Now on the supply side, the world is experiencing significant damage to crops in 2021 and 2022, in multiple locations in North America, South America, and parts of the CIS. Together, strong demand and declining supply have led to the higher prices we're experiencing over the past two years. Now expected lower production of crops from the Black Sea region adds to the challenges that agricultural security faces. The region accounts for almost one-third of global wheat exports as well as a notable source of corn exports. The USDA forecasts production and exports for wheat and corn to be almost 50% lower for the '22/'23 crop year from the Black Sea region. In fact, the potential export loss could impact two crop years. As a result, wheat ending stocks among key exporters could fall below 50 million tons, which is the lowest level in 15 years. Fertilizer prices, which have climbed in some markets, are experiencing scarcities of these critical inputs. Persistent fertilizer constraints and high prices will lead the supply chain to adjust, but this is likely going to take some time. If you put these factors together, while row crop producers are experiencing high input costs, many have purchased them in advance of recent inflation and were able to market their crops at a high price, which helps mitigate the higher input costs. Additionally, tight global supply will likely remain supportive of prices next year, which is helping to sustain some more profitability. Given this backdrop of elevated commodity prices, combined with two consecutive years of constrained machinery production, we have an older fleet age and low channel inventory. The fundamentals for agricultural machinery remain favorable.

Thanks, Kanlaya. And maybe just to punctuate all of that, we're seeing strong demand as we look into model year '23 orders and even begin to take orders in Q1 '23 for certain products in different geographies. So we're expecting continued demand to be a tailwind going into '23.

As a follow-up to that, our technology helps alleviate some of the pressure that Kanlaya talked about on the input costs by enabling the customer to use less while still achieving yields.

That's right. Traditionally, in ag, to boost yields, we've seen an approach that had to be do more with more. Both rising input costs and our customers are looking at how they can do more with less. They're looking to us and the strategy that we've been talking about over the last few years. Using less inputs but not losing out on yields, or in some cases, using less input and increasing yields. For example, we introduced a product called ExactRate last year, which applies liquid nitrogen at the time of planting. This helps our customers get more precise with fertilizer usage, which has been an input experiencing rapid inflation this year. Not only can this reduce the cost but also improves our customers' nitrogen efficiencies, unlocking significant environmental benefits as well as helping yield by applying nutrients when the seed needs them most. So not only do we see continued strong demand, but the demand for our precision ag solutions is growing as our customers look for opportunities to do more with less.

Thanks, Josh. And speaking of precision ag and technology, Deere announced a few acquisitions during the quarter. Ryan, can you share more?

Sure, Rachel. Consistent with the themes that we've previously discussed of digitization, automation, autonomy, life cycle, electrification, and sustainability, we've executed during the quarter to expand our access to talent, technology, and business opportunities in these areas. I'd like to highlight one investment, GUSS Automation, which is a pioneer in semi-autonomous spring for high-value crops. GUSS Automation brings in-depth knowledge of HPC customers and innovative solutions that deal with some of the most pressing issues facing that segment today. We look forward to working together on further collaboration with the Deere sales channel and in other areas that drive value for HPC customers. I highlight this investment as it is illustrative of the new smart industrial strategy focused on production systems. Our teams work to deeply understand customer production systems and how to deliver better outcomes, both from an economic and sustainability perspective. Then we work to deliver differentiated solutions. Sometimes we'll design to deliver that solution organically. Other times, we'll invest, partner or acquire unique capabilities to accelerate that delivery. Overall, you'll see us continue to aggressively expand our capabilities to deliver differentiated customer value, and we will dive deeper into this at our Tech Day on May 26.

Now we are ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. Operator Instructions

Our first question comes from Jamie Cook from Credit Suisse. Your line is open.

Could you explain why the second quarter was viewed as a miss by the street and how it compared to your expectations? Additionally, can you quantify the inventory you have that is waiting for parts? I'm trying to understand how significant this issue is and if this was the reason for the entire reduction in cash flow.

Yes. Thanks for the question. With respect to the second quarter, there are a lot of different variables going on there. Certainly, inflation has been broader based than just steel. We're seeing it impact a lot of other commodities. And I think we see continued pressure on material costs that have kind of led to some of the margin performance in the second quarter. In addition to that, just with the delays in deliveries we're seeing in the supply chain, we're utilizing a lot of additional premium freight right now. So that's also having an impact on our results for the quarter. Really, the biggest challenge, though, as we noted, in the second quarter was the number of partially completed machines that you referenced, Jamie. In many cases, those partially completed machines will drive poor overhead absorption, but they also give us a lot of confidence in the second half production schedule because we do have confidence that we'll be able to complete and ship and ultimately retail those parts in the second half of the year. To give a little bit of an idea of the size of that, you can certainly look at the change in inventory that we had on the balance sheet sequentially in the second quarter from the first quarter. If you go back in history, typically, you don't see an increase in inventory in the second quarter, so that will give you a little bit of an idea of the magnitude that we saw of those partially completed machines.

Yes. Jamie, it's Josh. To add to what Brent said, those machines are currently waiting on parts. If we consider the second half of the year, we expect an increase of nearly 25% year-over-year. So, as Brent pointed out, getting those machines out will significantly boost our sales in that later part of the year.

Our next question comes from Kristen Owen from Oppenheimer. Your line is open.

Josh, you talked about some of this in some of the commentary that you made. But obviously, a lot of noise in the retail statistics and the industry sentiment indicators that we're seeing coming out. Just given the ongoing production challenge, how do you think investors should interpret some of those readings in the context of some of the demand commentary that you've made?

Yes. With respect to retail data, we're certainly not surprised to see it come in a little bit choppy this year as we're dealing with delays in deliveries in the supply base, but I presume that most of the industry is as well. Given the number of partially completed machines, I think we'll continue to see that data come in waves and be a little bit choppy as we get through the rest of the year. Certainly, with respect to market share in any given month, it's really a function of who can produce what that month. And so again, that'll be a little bit choppy. Certainly, particularly in the first quarter, we probably outperformed our own expectations there with respect to what we could deliver given the work stoppage. I'd say other than that, we feel like we've been holding our own in terms of retailing machines. We do have a couple of standouts, though, and bright spots. ADR’s, in particular, is a product line that we've had a lot of success outperforming the industry in terms of production. Mannheim tractors is as well. So if you look at the first half of the year, we picked up a little bit of market share on the ADRs and also in Europe for our high horsepower tractors, and certainly look to holding on to that lead as we produce through the back half of the year. Yes. Kristen, as it relates to the demand piece specifically, we have not seen that shift or change or cool as it pertains to large ag in particular. Anecdotally, for example, in Brazil, as we opened month-to-month, we filled a month of production in a day when we opened it. As we start to get ready for early order programs, we're anticipating strong activity as we're talking with dealers who are already working with customers. So we think that demand environment continues and provides a good tailwind for '23.

Kristen, it's Ryan. Maybe just to add, some of the customer sentiment surveys can be driven by just the overall volatility in the environment and the input pressures and concerns that customers may have with respect to that. Ultimately, demand comes from the actual economics, which we see continuing to be favorable.

Our next question comes from Stephen Volkmann from Jefferies. Your line is open.

So I kind of want to go back to this first half, second half thing, if we could. It feels like a lot of what you're planning on requires the supply chain to sort of improve going forward and get you those parts you need to get those parked vehicles shipped. So I'm curious, A, how did that play out in April? Because it feels like it actually may have deteriorated a little bit, but correct me if I’m wrong. And then secondarily, just how much visibility do you have on that in the second half to give you that confidence in that kind of ramp that we're seeing?

Yes. Thanks, Steve, for the question. I think with respect to the supply base, we have seen a supply base that got, I would say, progressively worse over the course of 2021. Since the fourth quarter of '21, we've characterized the supply base as just kind of persistent challenges. We wouldn't say that it's necessarily deteriorated over the course of 2022 or gotten better. It's just been persistently challenging throughout the first half of the year. We would expect to see that same environment continue over the second half. So our guidance does contemplate a similar level of choppiness in the supply base as we progress through the year. We don't necessarily see it moderating or getting better. Some of the root causes have changed quarter-to-quarter, but the end result has been the same. In the first quarter, we were primarily grappling with Omicron and a high degree of absenteeism. In the second quarter, we spent a lot of our time responding to recent global geopolitical events as well as lockdowns in China that are having an indirect impact on us through just the bottleneck of global logistics networks. When we think about the rest of the year, though, we expect those conditions to continue a bit. Our guidance certainly contemplates that, and we think the current conditions do support our second half production schedule. We do have confidence that we will get the parts we need to complete those machines currently in inventory, ultimately having those shipped in retail mostly in the third quarter, maybe a little bit in the fourth quarter there.

Our next question or comment comes from Tami Zakaria from JPMorgan. Your line is open.

I think you mentioned you're taking orders for 2023 in Europe, and order books are opening next month in North America. So what's the pricing you expect to realize for these products next year, given this year has been shaping up to be a really strong year in terms of pricing?

With respect to order books, maybe before I even get to fiscal year '23, it's just important to note fiscal year '22 is largely complete for most of our product lines. We will have our early order programs open up for crop care in early June, which is fairly typical for our planters and sprayers. We would expect combines to begin sometime in the fall period. Again, that's fairly standard for us. For our rolling order books, we'll see Waterloo open up here in the next couple of weeks, and Mannheim is already opened up for fiscal year '23, and we're about quarter full for the first year for the next fiscal year there. Importantly, we are putting pauses in all these order programs to maintain a little bit of flexibility in pricing as we have an eye towards how material and freight costs are fluctuating into next year. As it relates to our crop care order program, where we do have prices set, we are seeing pricing for crop care products in the high single digits for next year. So we expect pricing to be above trend line for those products going into next year.

Our next question or comment is from John Joyner from BMO. Your line is open.

So maybe asking Steve's question a slightly different way. When looking at the back half shipments, how do you envision the cadence of the ramp higher? Or maybe where are you running today versus the level that you expect to get to in the fourth quarter?

Yes. Thanks, John, for the question. Regarding our cadence, we expect to see a slightly different seasonal pattern than many investors have come to expect from Deere. Some of this had really been in our plans all along with the work stoppage in the first quarter and the new product programs we're launching, like the X9 combine and the 9R tractor. We'll see production progressively ramp each quarter, leading to the fourth quarter, which should likely be our highest quarter with respect to production. Part of what's boosting that, again, is just the completion of those semi-completed machines that are currently on Deere lots in our inventory. But keep in mind, too, when comparing '21 to the back half of '22, most of our UAW factories were shut down for the last couple of weeks of October. That's going to give us a significantly higher number of production days in the fourth quarter of '22 than what we saw in '21.

Our next question comes from Tim Thein from Citigroup. Your line is open.

I wanted to follow up on the comments about the spring end-of-period and the pricing communicated to dealers. Josh, historically, how reliable is this as a reference point, considering there are various products within the PPA? How well does this reflect the segment as a whole, especially when it comes to planters and sprayers compared to the larger agriculture sector?

Yes. Regarding our EOP programs and how that serves as a proxy for other large ag product lines, it's a really important first data point for us, first from just a demand perspective. Typically, what we see in the early order program for crop care does have some correlation to what we'll see for combines and tractors as well, just from an overall demand perspective. As it relates to price increases, again, I would say that the pricing we see for our crop care products, planters and sprayers, is generally fairly correlated to the pricing we'd see for large tractors and combines in the North America market. You'll see different prices as we look through other regions. As you think about a market like Brazil, we have the most dynamic pricing capabilities there due to the way that we manage our order fulfillment process. Due to higher inflation there and fluctuating FX, you may see pricing in Brazil differ and detach a little from what we do in our North American market. Other than that, I would say the read-through from our crop care products to other North American products is generally pretty good.

Tim, this is Josh. One other thing to add, too, is that we'll watch really closely to see what we're seeing with technology uptake in that early order program. Particularly when you look at planters and sprayers, given the increases in input costs and what we can deliver from a value point of view, we would say our value proposition on a lot of those things has become even better with higher input costs and being able to be more precise and accurate to deliver better outcomes for our customers. As we roll those out here, we'll be watching that closely too because we think there's a tremendous amount of opportunity with those features and tools.

Our next question comes from Jerry Revich from Goldman Sachs. Your line is open.

I'm wondering if you could just talk about for the construction and forestry business now that you've completed the excavator technology acquisition, what's the impact on the margin profile of the business? And can you update us on your smart industrial strategy for C and F specifically now that you have that entire product suite?

Yes. Thanks, Jerry. Regarding our construction and forestry division, this is really the first quarter that we are operating post the joint venture that we've historically held with Hitachi. Maybe just a quick update on how that's going so far. We still have a supply agreement with Hitachi, and they're still an incredibly important partner to us as we transition during this time. So far, that has been a really great partnership, and operations have run very smoothly out of our Kernersville factory in North Carolina. Things are going really well on that front. Certainly, longer term, we would see this as margin accretive to us. The way that we've accounted for that historically has put the excavator product line for us at a lower margin relative to other large earthmoving equipment. We see an opportunity to improve that certainly. In the short term, though, it may be hard to ferret out exactly what the impact on margins is given the noise of the gains on the remeasurement. But excluding that, we expect to see a little bit of margin enhancement this year. However, it's really the out years where I think that will deliver continued value for us.

Yes. On the technology side, Jerry, I think like in ag, this is where technology can play a huge role in driving profitability and sustainability for our customers, and importantly, safety as well. You think about labor challenges and skilled labor on the job site; a tool like smart grade effectively automates jobs that someone without a tremendous amount of experience can perform as well as an experienced operator, reducing rework at a time when contractors have more jobs than they can do. If I can reduce rework because I'm automating parts of the production system, that allows our customers to get more done. The smart industrial strategy and leveraging technology in construction, earthmoving, and road building is a big opportunity. We're at the very early stages of this, but there's a lot of potentials to create value for our customers. Bringing the excavator in-house is a key step to unlock more value there.

Our next question or comment comes from David Raso from Evercore ISI. Your line is open.

Can I first have clarification on something that was said earlier? I think, Josh, you mentioned the machines still waiting on parts. If you look at the back half of the year, the year-over-year growth represents close to 25%. Do you mean 25% year-over-year growth just from those machines shipping? Or do you mean that of the needed growth in the back half of the year, roughly a quarter of it, 25% of it is going to come from the machines that are waiting for parts?

Yes. The latter. Of the growth that we see in the back half of the year, roughly a quarter of it is effectively represented by those machines waiting on parts.

So that's the basis of my question. It appears that the sequential growth from the second quarter run rate for the remainder of the year is mainly in production and precision agriculture. To meet the needs for the second half of the year, you would need to achieve about a 23% increase quarter-to-quarter from what you average in the third and fourth quarters. It would be beneficial for us if we could break that down. It seems like the inventory aspect could account for around 10% to 11% of that sequential growth, based on your calculations. Can you clarify the two other key components you mentioned? Is pricing contributing additional dollars sequentially from the second quarter to the third quarter? Also, could you provide insights into the level of production days in the second half compared to what we had in the second quarter? Understanding that 23% growth comes from those three factors: partially built inventory, minimizing shutdowns, and achieving improved pricing.

Yes. David, thanks for the question. You're absolutely right. Price is certainly a component of it. You saw us raise our price realization forecast for production and precision ag from 10% to 13%. If you look year-to-date for production and precision ag, I think we've averaged close to 10% in the first half of the year. So the implication for the last two quarters is that we'll get a little bit more than that. And that's part of the explanation for the higher revenue year-over-year. With respect to the shutdown period, it really varies factory by factory. Some factories shut down for a couple of weeks and others shut down for more or less than that. So it depends on the factory we're talking about. But net-net, the minimization of factory shutdowns, plus the lack of a work stoppage we experienced in October of 2021, will contribute to higher production days year-over-year that help us support the build schedule currently in place. Thanks, David.

Our next question comes from Michael Feniger from Bank of America. Your line is open.

There's a lot of commentary right now in the market with consumers 'trading' down. Farmers are facing higher input costs, and there was reference to the sentiment indicators for farmers having weakened. I'm curious from your vantage point, have you seen any evidence of farmers trading down in just certain areas? I recognize that Deere's technology helps improve efficiencies for farmers. But is there any sticker shock being observed there? Are farmers trading down certain product categories to kind of compensate for the higher input costs?

Thanks for the question. With respect to price, so far what we've seen in 2022 is that it hasn't had much effect on demand. As we noted, we're seeing indications of interest for '23, even though some products may be above trend line price realization already for '23. Certainly, the material and freight inflation we're experiencing on our end is real. We price for the following year, accounting for this to maintain our price/cost ratios. Machinery costs still represent a relatively smaller portion of the farmers' P&L. The bulk of their variable cost structure really relates to seed, fertilizer, and chemicals. Those variable costs are increasing at a much more significant rate than machinery costs. In many cases, our machinery is reducing the usage and reliance on some of these inputs. The more inflation we see in chemicals and fertilizer costs, the more valuable our equipment becomes to farmers. One other point is that we've seen significant appreciation in used pricing as well, which has been helpful for customers purchasing new equipment. This has limited the trade differential for them, which has helped us price as high as we've been able to this year and should be beneficial looking forward to next year.

Mike, it's Ryan. Maybe just quickly, we see our take rates for our tech that allow our customers to manage their P&L better. They continue to be very strong, and we would expect them to get stronger. So if anything, we see customers trading up, not down.

Our next question comes from Steven Fisher from UBS. Your line is open.

Brent, you just made a comment about used values in general. I guess I'm curious what you saw with used values in the quarter. Was there any particular strengthening there? And if so, should that be an incremental benefit to the FinCo? Related to that, I saw that you raised the provision for credit losses. Was that just for Russia? Or can you talk about why that would be and how that might relate to a sort of farmer income and farmer confidence?

Yes, concerning used pricing, it has remained quite strong for the past 12 to 18 months, and there was no change in this trend in the second quarter. It has consistently outperformed pricing for new equipment. As for John Deere Financial, we have benefited from a higher average portfolio this year along with very favorable credit conditions. You will notice a slight increase in our provision for credit loss in the second quarter, which was partially influenced by the situation in Russia and Ukraine. This increase reflects a tough comparison to Q2 2021, when conditions were improving significantly and we had a negative provision in the second quarter. We are just seeing this normalize now. Our provision is still well below the 15-year average, and overall conditions for John Deere Financial remain very favorable. Regarding the lease book, we continue to observe declining return rates, particularly in large agriculture, where they are almost approaching zero. Recovery rates on returned equipment have been rising for the last 18 months, and the quality of the John Deere Financial portfolio is currently very good, which we expect to continue in the near term.

Our next question comes from Larry De Maria from William Blair. Your line is open.

You made a comment earlier in the call that the average age was increasing, which is obviously one reason we're getting trade-ins because farmers want to make their fleet younger. Can you talk a little bit more specifically on the average age? Where are we now? And how many years do you think it would take to get back towards some equilibrium kind of number where farmers are comfortable?

Regarding fleet age, we've seen it age out really since 2013; we have aged out every year since then. The further aging of the fleet over the last two years has really been due to the industry's inability to meet demand in 2021 and into 2022. Overall, it's aged out a little bit even in 2022, which means we haven't fully hit volumes to replace the equipment coming out of the fleet. Tractors is where we see the most aging in 2022. For combines, we produced just enough to bind the age of the fleet down a little bit. We're still well above average there but at least produced enough to begin the process of replacing the combine fleet. Thanks, Larry.

Our next question comes from Chad Dillard from Bernstein. Your line is open.

I was hoping you could talk a little bit more about your industry view on small ag. It looks like you kept volume growth flat, but we've seen in the AEM data sales down to the mid to high single digits, at least on a year-to-date basis. Can you just talk about what gives you confidence that we'll be able to see growth in the second half? And then as it pertains to Deere, how are you guys thinking about restocking relative to retail demand?

Regarding our small ag and turf business, we've seen retail data come in really choppy, and in some cases, down. A number of factors are impacting that. First and foremost, exceedingly low inventory levels are probably starting to have an impact on retail settlements right now, particularly in utility vehicles, riding lawn equipment, and compact utility tractors, which continue to be fairly scarce. That is impacting the number of retail settlements. We are seeing a little bit of an impact from just the late spring we have here. Typically, early spring drives a lot of sales for those types of equipment. Further compounding the issue, our small ag and turf business has probably been the most impacted by acute shortages, particularly related to engines, limiting volume not just for Deere but for the industry as a whole. As we get through the year, we continue to see that as a governing factor for where volumes can go for small ag and turf. Kanlaya, anything you'd add?

Yes. Just to give some ideas on where the market is right now: When you look at the protein prices, with pork and poultry all at record highs, as well as strong milk demand, this will help support and offset the rising feed cost. The margins in that market are still looking fairly steady.

It looks like we have one last caller.

Our final question comes from Seth Weber from Wells Fargo Securities. Your line is open.

I guess just going back on the supply chain. I assume semiconductors are problematic. Is there anything else you'd call out there? Related to the semiconductors, is the message that the mix is disproportionately being hurt on the precision and the tech side because of the semiconductor issue? Is that really weighing on mix and that should get better in the back half of the year? Is that the right way to think about it?

Yes. With respect to the supply chain, we are seeing issues be fairly broad-based. Our supply management team would describe it as whack-a-mole. Certainly, chips are an issue and will probably continue to be an issue as we work through the year. I would say so far, we've managed that and have been able to keep that from having a material impact on mix of any kind. As we look to the back half of the year, I would expect us not to single out any particular area of the supply base due to the broad-based nature of it. We're seeing challenges with castings, wire harnesses, hydraulics, pumps, and tires. It really depends on the day in terms of what's causing challenges for us. Fortunately, our supply management team has really done an excellent job of working through each of these as they come up. We've been able to solve them without any material work stoppages or any particular mix issues to call out.

Thank you. That concludes today's conference call. Thank you for your participation. You may disconnect at this time.