Deere & Co Q4 FY2022 Earnings Call

Good morning, and welcome to Deere & Company's Fourth Quarter Earnings Conference Call. Your lines have been placed on a listen-only mode until the question-and-answer session of 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 John May, Chairman and Chief Executive Officer; Josh Jepsen, Chief Financial Officer; and Rachel Bach, Manager of Investor Communications. Today, we'll take a closer look at Deere's fourth quarter earnings, then spend some time talking about our markets and our current outlook for fiscal year 2023. 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 express written consent of Deere is strictly prohibited. Participants in the call, including the Q&A session, agree that their likeness and remarks in all media may be stored and used as part of the earnings call. This call includes forward-looking comments concerning the company's plans and projections for the future that are subject to important risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially is contained in the company's most recent Form 8-K and periodic reports filed with the Securities and Exchange Commission. This call also may include financial measures that are not in conformance with accounting principles generally accepted in the United States of America, 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 & Events. I will now turn the call over to Rachel Bach.

Good morning. John Deere finished the year with a strong fourth quarter, thanks to a 40% increase in net sales. Financial results for the quarter included an 18.5% margin for the equipment operations. Across our businesses, performance was driven by continued strong demand, higher production rates, and progress on reducing our inventory of partially completed machines. Looking ahead, ag fundamentals remain positive, continuing to drive healthy demand as evidenced by our order books full into the third quarter of fiscal year 2023. The construction and forestry markets also continued to benefit from solid demand contributing to the division's notable performance in the quarter. Similarly, order books are extended into the second half of '23, providing visibility and confidence in the new fiscal year. Slide 3 shows the results for fiscal year 2022. Net sales and revenues were up 19% to $52.6 billion, while net sales for the equipment operations were up 21% to $47.9 billion. Net income attributable to Deere & Company was $7.1 billion or $23.28 per diluted share. Next, fourth quarter results are on Slide 4. Net sales and revenues were up 37% to $15.5 billion, while net sales for the equipment operations were up 40% to $14.4 billion. Net income attributable to Deere & Company was $2.2 billion or $7.44 per diluted share. Let's take a closer look at fourth quarter results by segment, beginning with our production and precision ag business on Slide 5. Net sales of $7.434 billion were up markedly at 59% compared to the fourth quarter last year. This was primarily due to higher production rates both year-over-year and sequentially. Additionally, we made progress on clearing partially completed machines from inventory. Both contributed to higher shipment volumes for the quarter. Price realization in the quarter was positive by about 19 points, whereas currency translation was negative by about 3 points. Operating profit was $1.74 billion, resulting in a 23.4% operating margin for the segment. The year-over-year increase in operating profit was primarily due to higher shipment volumes and price realization, partially offset by higher production costs and higher SA&G and R&D spend. Operating profit for the quarter was negatively impacted by higher reserves on the remaining assets in Russia, affecting the quarter's margin by about 1 point. The production costs were mostly elevated material and freight. Overhead spend was also higher for the period as factories continued to experience some production inefficiencies due to supply challenges and clearing of partially completed machines in inventory. Despite these headwinds, our factories were able to maintain higher rates of production and reduce the number of partially completed machines in inventory, allowing us to deliver more equipment to our dealers and customers. Moving to small ag and turf on Slide 6. Net sales were up 26%, totaling $3.544 billion in the fourth quarter due to higher shipment volumes and price realization, which more than offset negative currency translation. Price realization in the quarter was positive by nearly 13 points, while currency translation was negative by over 6 points. For the quarter, operating profit was higher year-over-year at $506 million, resulting in a 14.3% operating margin. The increased profit was primarily due to price realization and improved shipment volumes and mix. These were partially offset by higher production costs, higher R&D and SA&G expenses, and unfavorable currency impacts. Please turn to Slide 7 for the fiscal year 2023 ag and turf industry outlook. We expect large ag equipment industry sales in the U.S. and Canada to be up 5% to 10%, reflecting resilient demand that continues to be higher than the industry's ability to supply, bolstered by the need to replace aging fleets. Our order books now extend into the third quarter and the dealers remain on allocation for '23. For small ag and turf, industry demand is estimated to be flat to down 5%. The dairy and livestock segment remain steady. However, demand for products more correlated to the general economy, such as compact utility tractors and turf equipment, is softening. Shifting to Europe. The industry is forecast to be flat to up 5%. Farm fundamentals in the region are generally stable since small grain prices continue to outpace input inflation. Meanwhile, supply constraints in 2022 are extending the equipment replacement into 2023. In South America, we expect industry sales of tractors and combines to be flat to up 5%, moderated by supply chain constraints. The region remains one of the stronger end markets, especially in Brazil, where they are forecasting record production and strong profitability for the year. Industry sales in Asia are projected to be down moderately as India, the world's largest tractor market by unit, stabilizes after record highs in 2021. Turning now to our segment forecast on Slide 8. We anticipate production and precision ag net sales to be up between 15% and 20% in fiscal year '23. The forecast assumes approximately 11 points of positive price realization and 1 point of negative currency translation. For the segment's operating margin, our full year forecast is between 22% and 23%. Slide 9 shows our forecast for the small ag and turf segment. We expect fiscal year '23 net sales to be flat to up 5%. This guidance includes about 7 points of positive price realization, partially offset by 2 points of unfavorable currency impact. After accounting for the effects of price and FX, the guide implies a slight volume decrease due to softening in certain product segments. The segment's operating margin is projected to be between 14.5% and 15.5%. Turning to construction and forestry on Slide 10, price realization and higher shipment volumes both contributed to a 20% increase in net sales for the quarter to $3.373 billion. Price realization in the quarter was positive by nearly 13 points. This was partially offset by almost 5 points of negative currency translation. Operating profit increased to $414 million, resulting in a 12% operating margin. Favorable price realization and higher shipment volumes more than offset higher production costs during the quarter. Segment quarterly results were also negatively impacted by 1.5 points of margin due to higher reserves on the remaining assets in Russia. Now I'll cover our 2023 construction and forestry industry outlook on Slide 11. Industry sales of both earthmoving and compact construction equipment in North America are expected to be flat to up 5%. End markets overall are expected to remain steady as oil and gas, U.S. infrastructure spend, and CapEx programs from independent rental companies offset moderation in the residential sector. Global forestry markets are expected to be flat as stronger European demand continues to be limited by the industry's ability to produce and demand in North America begins to subdue. Global roadbuilding markets are also expected to be flat. Demand remains strongest in the Americas, while Europe is softening and Asia remains sluggish. Our C&F segment outlook is on Slide 12. 2023 net sales are forecasted to be up around 10%. Our net sales guidance for the year includes about 8 points of positive price realization and just over 1 point of negative currency translation. The segment's operating margin is projected to be 15.5% to 16.5%. Note, fiscal year '22 operating margin would have been 14.5%, excluding special items, such as the one-time gain from the remeasurement of the Deere-Hitachi assets. Let's transition to our financial services operation on Slide 13. Worldwide financial services net income attributable to Deere & Company was slightly higher in the fourth quarter year-over-year, mainly due to income earned on a higher average portfolio, partially offset by less favorable financing spreads. The provision for credit loss increased, reflecting economic uncertainty in Russia. Financial services received an intercompany benefit from the equipment operations, which guarantees investments in certain international markets, including Russia. For fiscal year 2023, the net income forecast is $900 million. Results are expected to be slightly higher year-over-year primarily due to income earned on a higher average portfolio. The portfolio has continued to grow in line with growth in the equipment operations. Overall, Financial Services is expected to continue to deliver steady results. Credit loss provisions, lease return rates, and past dues all remain in good shape, reflecting sound balance sheets for our customers. Slide 14 outlines our guidance for net income, our effective tax rate, and operating cash flow. For fiscal year '23, our full year net income forecast is a range of $8 billion to $8.5 billion. We expect favorable price realization and higher volumes to more than offset increased spend. Next, our guidance incorporates an effective tax rate between 23% and 25%. And lastly, cash flow from equipment operations is projected to be between $9 billion and $9.5 billion. Before we transition to Q&A, John, I'd like to thank you for joining us today. Do you have anything you'd like to add?

Yes. Thanks, Rachel. First, I want to recognize all of our dedicated employees, dealers, and suppliers. Fiscal year 2022 was another unprecedented year in several ways. We started the year in a work stoppage at some of our largest U.S. factories, but we resolved that with a groundbreaking industry-leading new contract, then supply and logistics hurdles created disruption and constrained our production worldwide. At times, deliveries were delayed as demand simply outstripped what the industry could supply. Our operations folks worked tirelessly to get equipment shipped to our dealers and customers. The team overcame disruptions from part shortages and delays, to the clearing of partially completed machines to meet our customers' needs. In the last half of the year, and particularly here in the fourth quarter, we executed our plans, saw a substantial lift in production, and outpaced the industry production and retail sales. This resulted in our highest revenue and margin quarter for the year. It proves what we've known all along, that we've got the best factory teams in the industry, and I'm extremely proud of their efforts and resilience. As I look ahead to fiscal year 2023 and beyond, I truly believe our best years are still ahead of us. In the near term, order books across our businesses are full into the third quarter. And it's important to note that not only do the order books continue to fill when we open them, but the velocity of orders has remained strong. We opened North American combined EOP back in August. Like our crop care EOP, it was on allocations, but it filled in 2 months. That's noteworthy because we normally have the EOP open for five to six months. And since our order books are still on allocation for retail sales, we have yet to begin replenishing dealer inventory. And as we continue to make progress on our Smart Industrial strategy and Leap Ambitions, I'm even more confident in our ability to unlock immense value for our customers. When you integrate the industry's best equipment with cutting-edge technology and a world-class dealer channel, it's powerful and exciting. We already have solutions in fields and on work sites, and we are bringing more solutions to the market that will make our customers a lot more productive, a lot more profitable, and help them do the jobs they do in a much more environmentally sustainable way.

Great. Thanks, John. Now we know there are some common topics of interest, so let's dig into those before opening the line for Q&A. First, I'd like to take some time to look more closely at the macro environment and some of the fundamentals for each of our segments. Let's start with production and precision ag. We're forecasting the industry to be up 5% to 10%. Brent, there's a lot going on there in terms of what is driving that growth. Can you unpack a little for us?

Sure. There's a few things going on I'd like to point out, Rachel. Stocks-to-use ratios for key grains still remain very, very low, while exports from the Black Sea region are expected to be down about 40%. So it's going to take a couple of growing seasons to ease the tight supply, and this should help support commodity prices in the interim. While crop prices may have come down a little bit since the summer, they remain at levels where our customers still have healthy profits despite some of the higher input costs they're facing. Finally, the industry has not been able to meet demand due to supply chain constraints, and demand continues to outpace supply. And we see that in how quickly our order books fill up and historically low dealer inventory of both new and used equipment. It's also evident in the fleet age, which is well above average.

All right. So fundamentals remain solid, but weather, geopolitical tensions, and broader economic conditions may be weighing on our customers' minds.

Yes, that's absolutely true, Rachel, and we recognize that. But our order books really serve as the best indicator though. Not only are they extending into the third quarter of 2023, but the velocity in which they fill remains really encouraging for us. Recall that our order books are still on an allocation basis; when those orders ship, they generally retail right away, and almost all of those machines have a customer's name on them when they go down the production line. Remember that our dealer inventories still need to be replenished. Four-wheel drive inventory to sales ratios are at 10%, while 220-plus horsepower tractors are at 12%. And those numbers might even be a little bit overstated because our dealers are working through all of those fourth quarter shipments right now, and they're still delivering them to customers. Also of note, our guidance does assume that we build to retail demand. So any dealer inventory replenishment will likely be pushed to 2024. Additionally, I would like to point out that the 2023 North America large ag volumes will be 20% to 25% lower than the five-year average volume from the 2010 to 2014 replacement cycle. This is clear if you look at the AEM data; our revenues are higher because we've increased our value per machine for our customers through precision ag solutions. But volumes are still rather modest when compared to the entire replacement period of that five years of 2010 to 2014.

Yes, Brent, I have a few things to add here. This last year, I've been out meeting with dealers on a regular basis. And I often hear them telling me that they're not able to quote every customer who wants to place an order because we're still constrained by the supply base and on an allocation basis. So clearly, there's more demand for our equipment. And this replacement cycle will have an extended duration. I am confident we will produce more large ag equipment in 2023 than we did in 2022, and not just more equipment but more value per machine. Our production system approach has us laser-focused on the customer and unlocking more value for them. This will increase the value per machine even more.

All right. Let's move on now to small ag and turf. This division has the most diverse end markets of any of our segments. Josh, can you elaborate more on how we're viewing those different markets?

Sure. There are definitely different macro drivers when you break down the segment a bit further. If we begin with small ag, the supply of meat and dairy products has remained tight, which has helped prices remain elevated. And as a result, livestock and dairy margins remain above historical averages. Additionally, dealer inventory to sales ratios for midsized tractors are below normal levels as demand has continued to outstrip supply. So this part of SAT has remained stable and resilient. A good proof point here is that the order book for our midsized tractors built in Mannheim, Germany is about 70% full, taking us well into the third quarter of fiscal '23. On the other hand, turf and utility equipment as well as compact utility tractors are more closely correlated to the general economy and somewhat specifically to housing. So we've seen some softening there. Channel inventory remains low, especially for turf, buffering our shipments to some extent. But we're monitoring inventory closely so that we can react if demand pulls back and forth. We don't intend to let inventory climb to pre-pandemic levels here.

All right. That's helpful. Thanks, Josh. Let's shift now to C&F. The last few years of demand were largely driven by housing. So how is that segment housing starts? Brent, can you talk through that?

You bet, Rachel. So on one hand, we have seen some softening in housing while non-res building projects have continued to decline a little bit. On the other hand, oil and gas CapEx has been very steady with rig counts projected to be up next year. And U.S. infrastructure is beginning to show some promise going into 2023, which is especially important for Wirtgen. In addition to that, both the dealer-owned rental channel and the independent players have significant refleeting programs going into 2023. So all in all, we're seeing a shift in the composition of demand drivers for that business, less housing, but more than offset by rental infrastructure and oil and gas.

Brent, I'd like to add that C&F dealer inventory, as with other parts of our business, is historically low and needs to be replenished. But we're currently focusing on retail demand, and our order books are close to 70% full.

All good insight into the various industries and market dynamics and it's all factored into our net sales guidance for the full year. To recap, common themes across our businesses, our order books are strong, but still on allocation. We're focused on meeting pent-up retail demand, and we still need to replenish channel inventory possibly late 2023, but more likely into 2024. Brent, can you talk about what all this means for our '23 production schedule?

Sure. So this past year, we did not have our normal seasonality. We had the work stoppage at the beginning of the first quarter, and we had experienced the worst of the supply chain issues as we tried to ramp up more during the second quarter. So we played catch up later in the year, resulting in a significantly more back half-weighted 2022. In fact, we ended up producing more in each successive quarter throughout the year with the fourth quarter being the high point. We achieved our highest daily production rates in the fourth quarter, and we plan to keep those higher daily rates going into the first quarter of 2023. Now while line rates remain at those higher levels, there will be some key differences in sequential revenue though. First, there are about 15% less production days in the first quarter due to the holiday season. So expect revenue for small ag and turf and C&F to drop by about 15% sequentially in the first quarter of 2023 when compared to the fourth quarter of 2022. Our PPA factories will have another 5% to 10% fewer production days due to some model year changeovers, maintenance, training, and supplier recovery. So in total, production and precision ag production time will decrease by 20% to 25% in the first quarter compared to the fourth quarter of 2022. Now also keep in mind that PPA benefited from clearing about $400 million of partially completed machines from inventory in the fourth quarter. So that benefit won't repeat in the first quarter. So we likely won't get back to a similar level of 4Q revenue until the second quarter of 2023.

Yes, this is John. Brent, I want to reiterate something you said; while sequentially, the first quarter compared to the fourth quarter will be lower, however, year-over-year production will be higher in the first quarter. We aren't starting the year out behind, so we'll have more production in the first half of 2023 than we did in the first half of 2022.

That's helpful. Let's switch gears now to the supply chain. We've taken steps to try to mitigate risk, but the supply base remains fragile. We do see pockets improving, but at a slow pace and certainly not to pre-pandemic levels that we would consider to be a healthier supply chain. So our guide does not assume significant improvement or deterioration in 2023. Josh, can you elaborate on our production costs included in the forecast?

As it relates to production costs in '23, there are a few puts and takes. Certain raw materials like hot-rolled coil steel are easing, as you can see in some of the different indices. Also, we expect the need for premium freight to subside next year. On the other hand, labor and energy costs will increase. That's not only impacting us directly but also our suppliers, so we continue to see increased cost for purchase components as well. Additionally, as you mentioned, we're seeing pockets of improvement in the supply chain, but it remains fragile. So we're not assuming that our operations return to normal levels of productivity and efficiency in our forecast. With the different ups and downs, our guide assumes a net increase in production costs in 2023, but we fully expect this to be offset by price realization and anticipate the full year being price production cost positive.

Thank you for that. And before we open the line for other questions, Josh, can you talk briefly about the use of cash priorities and capital allocation in 2023?

Sure. Simply put, they remain unchanged. We're happy with our liquidity position to maintain our single A credit rating and fund our business. Our guide considers an increase in R&D and CapEx as we continue to progress on strategic projects building upon the tech stack and unlocking more value for our customers. Next, the dividend. We increased it 8% in fiscal year '22. And it's worth noting that over the last two years, we've increased it nearly 50%. Finally, share repurchase. We purchased over $1 billion of shares in the fourth quarter for a total of $3.6 billion for fiscal year '22, and we have an opportunity to continue that trajectory heading into fiscal '23. So all in all, we're in a great position to grow our business, execute on our Leap Ambitions, and continue to return cash to shareholders.

Thanks, Josh. Brent, let's see what other questions our investors have.

Now we are ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. In consideration of others and our hope to allow more of you to participate in the call, please limit yourself to one question. If you have additional questions, we ask that you re-join the queue.

Our first question comes from Tim Thein of Citigroup.

Could you elaborate on your earlier comments regarding the full year expectations for pricing to exceed production costs? There are many factors to consider year-over-year due to how the comparisons will unfold. Do you anticipate that the margin benefit will be more weighted toward the second half of the year as the spread grows, or will trends in costs affect that? Any additional insights you can provide on a quarterly basis would be helpful.

Tim, this is Brent. Thanks for the question. As we look out to next year, we probably see a little bit of a different quarterly cadence than what you experienced in 2022. If I do a look back on this last year, we saw our most challenging price/cost quarters in the first half of the year. In fact, that compare got better as we got through each of the quarters with the fourth quarter being the most positive from a price relative to production cost perspective. As we look out to 2023, I think you'll see a very different cadence there. We intend to be price/cost positive on a much more even basis throughout all of the quarters. You'll probably see the strongest price performance for us really earlier in the year just as the compares are most favorable. And then in the back half of the year, as some of those price compares get a little harder, production cost compares maybe get a little bit easier in the back half of the year. So I would expect for next year just more even cadence throughout the course of the year as we compare price to overall production cost.

Tim, one other thing. I mentioned this earlier in the prepared comments, but we have not forecast a return to normal productivity and efficiency in our factories. So as it relates to the overhead inefficiencies we saw in '22. To the extent we see more stability in supply chain, the ability to operate more in line with our plans through the year, there could be some benefit there. But at this point, we haven't pulled that into the forecast. We need to see that stability first.

Our next question comes from Seth Weber of Wells Fargo Securities.

Josh, I think you mentioned the $400 million of inventory that you cleared in the fourth quarter. Can you just frame for us what's still to come? I mean, is first quarter like an equivalent amount? And do you expect that to be largely done by, call it, the first half? Or just how should we be thinking about the inventory that's kind of sitting around waiting for parts or materials?

We have made a lot of progress on the partially completed machines. We've had in inventory since the second quarter. That's really where we saw that figure peak. We took down about 1/3 of that over the course of the first quarter, and then we took another $400 million down in the fourth quarter. I would say the level of partially completed inventory within the system right now is running at a much more normalized level. I mean, there's always some level of partially completed machines kind of within our working capital system. So it's much more normalized right now. The benefit that you saw in the fourth quarter is not going to repeat in the first quarter really at any other time, I think, in 2023, assuming we don't build more inventory of partially completed machines. So I would say, by and large, the tailwind from that has largely been completed in the fourth quarter.

Yes, Seth, this is Josh. Maybe importantly, too, our intent in our factories is to not have partially completed machines and build and have to take things offline and bring them back because of the inefficiencies and disruptions that drives. So the intent is to run much more linearly with our plans and not create as much of this rework that has to happen because it does drive a lot of disruption in the factory.

Our next question comes from Jamie Cook of Credit Suisse.

It was a good quarter, and happy Thanksgiving. I have a question regarding the order book, which you mentioned is full through the third quarter. Is there any variation by geography within large ag? Also, when do you expect to reopen the order book for visibility throughout the full year? My second question, regarding production in large ag, given your comments about production in the first half, how should we interpret the second half of the year? Does your sales forecast suggest that fourth quarter sales might see a slight decrease based on my rough calculations? I'm trying to understand the production timeline better.

Jamie, thanks for the question. I'll start on the order book. As we noted, we're running about kind of 70% full for next year. It varies a little bit by product line, things like combines were effectively sold out for the entire year. In North America, the tractor order book is, I think, 2/3 full. If I move to Europe, that's 70% full for Mannheim, 65% pool for combines. So pretty similar, I think, across those two geographies. Brazil is the one that we manage a little bit differently than the other two. We run that at about a three-month window just so that we have a little more flexibility with respect to pricing. That market tends to be a little dynamic with both FX and inflation can change quarter-to-quarter. So we're holding that order book in a little bit tighter than North America and Europe. And we've been executing that strategy for two years. We've been really successful there. I think managing price a little more dynamically in that region. I think going forward, you expect us for the remaining order book that's left in North America and Europe to manage it on a rolling six-month window, in front of us. So as we get to the first quarter, we should have pretty good visibility on the rest of the year with just a few slots left available. As it relates to sort of the production cadence in the year, as we noted, the first quarter will have just less production days, but we'll continue at those higher line rates. That will put quite a bit of production in the second quarter to give us a much better start to the first half of the year in '23 than we had in '22, as John noted earlier, probably just maybe a little less than 50% of the production will happen in the first half. So I think when you look first half, second half, you're not going to see as big a differential in the splits when you compare it back to 2022.

Our next question comes from Stephen Volkmann of Jefferies.

My question is on how we should think about increasing interest rates, both with respect to kind of the impact on your finance company, but also what you're seeing relative to kind of how customers are reacting to higher financing rates as well?

Hey, Steve, good morning. Well, I'll start with the question on the customer first, and we can talk about John Deere Financial. I think the impact to the customer maybe varies a little bit depending on what customer segment we're talking about. Historically, the customer segment most sensitive to interest rates is the customer segment for more of our consumer-facing products. So I think compact utility tractors and turf products tend to be a little more reliant on low interest rate financing. I think what you'll see as we progress through 2023. You may see a little more discount or incentive spend from the equipment operations on things like rate buy-downs, but that's where we see the most sensitivity historically. When we look at large ag, interest costs overall are a relatively small portion of their P&L. That's not to say there's no sensitivity there, but it tends to be a little less sensitive than maybe other customer segments that we have. And I think the good news for 2023 is that customer balance sheets are really in incredible shape right now. Over the course of 2022, we actually saw lower penetration rates at John Deere Financial because customers were using more cash to finance that acquisition. So that just speaks to not necessarily their sensitivity to interest rates, but more on just a strong balance sheet position that they're in going into 2023. From a John Deere Financial perspective, we run a match funded book there. So as our cost of borrowing goes up, that will take form in higher costs to our customers. We tend to manage that book in a way so that you don't see a lot of spread degradation because we manage those interest rates pretty closely and that match funded book. So I wouldn't say you'll see a big impact on profitability there. You'll see higher interest income and higher interest expenses going into 2023.

Our next question comes from Stanley Elliott of Stifel.

Can you talk a little bit about the road construction business in North America? Obviously, we've got a lot of money coming IIJA. Do you think that the roadbuilding business gets front loaded on that? Should it be continuous over this period of time when you think about kind of like a five-year plus sort of horizon?

Yes, we are definitely seeing higher levels of demand in North America for Wirtgen. So if we kind of go across the different geographies, Wirtgen operating in right now, by far and away, the strongest are in North America, followed by South America. Europe is starting to ease a little bit. And to your point, I mean, we're really just now starting to see the benefit from infrastructure going into '23. So I think that probably grows for Wirtgen over the course of the year and continues to strengthen that market. Importantly, North America right now is really strong mix for Wirtgen. I think about our manufacturing footprint, which is primarily German based. So the FX rate is actually really favorable for a strong North American market.

Yes. Maybe to add to that, Brent, we just completed the bauma show, and we had really, really strong bauma order activity; it was actually higher versus 2019. So the demand is strong, and customers are buying new equipment and new technologies in order to serve their customers.

Maybe just one other thing to add to that. As we ended 2022, we had the strongest margin performance for Wirtgen that we've seen since we've owned that business. So we continue to be pleased with the progress of the acquisition and the synergies that we've integrated in over time.

Our next question comes from Tami Zakaria of JPMorgan.

Given there were some one-off items this year, taking those out, can you just confirm what kind of core incremental margins you're expecting in each of your segments in 2023?

Yes. Absolutely. Good morning, Tami. We can talk through that. We did have a few special items in the year on the construction side, the one-time gain on the Deere-Hitachi deal as well as some Russia impairment. When we look at incrementals for next year, a couple of things to keep in mind. One, it's really still a very dynamic operating environment that we're in. We are still seeing some production costs running higher, right? Labor, energy. A lot of our purchase components are all going to be higher. Some of that is getting offset by decreases in raw materials and freight. But all in all, we could see mid production costs increased by mid-single digits next year. We're also going to see a little more higher SA&G and R&D in the year as well. Now we're getting the price to offset that and enough to put us back in line with historical incrementals at Deere. So I think even once you adjust for some of those one-time items, you'll see incremental margins sort of commensurate with what we've done traditionally or maybe even just a tad higher.

Yes, Tami, it's Josh. One thing to add is that I believe it's important to note that we're likely performing a bit above our historical incremental levels when excluding some of the one-time items. We're also making significant investments to execute on our future direction. As we focus on the Leap Ambitions and the transformation of our business model, these efforts will create more value for our customers, reduce cyclicality, and build a more resilient business. Therefore, included in our strategy are investments in key projects to achieve these goals.

Our next question comes from Matt Elkott of Cowen.

Brent, and I think, John, you mentioned that a little less than 50% of production will come in the first half. Given the fact that you guys have more of a tailwind for pricing in the first half and more of a tailwind from subsiding costs in the second half, does ultimately the earnings cadence basically just follow the production cadence for the year?

Matt, with respect to the earnings cadence, I think that's probably a fair assessment that you'll see. You'll see earnings cadence sort of follow that production ramp that you just outlined there and sort of the puts and takes between higher price in the first half of the year, lower production costs in the back half of the year. So I think those sort of net out a little bit. And really, you can just, I think, factor in some of those traditional incrementals as you apply them to the varying production rates throughout the course of the year.

Yes, Matt, it's Josh. Maybe one thing to point out. It's been a while since we've had a year that followed a typical trend for seasonality. And I think this year, '23 probably returns a bit more to that, where you see higher levels of both sales and margin in 2Q, 3Q, which is much more traditional to what we've done in the past.

To build on what Brent and Josh mentioned, we are very focused on starting strong in 2023 and delivering our machines to customers. The key takeaway is that we will not have as much of our business loaded towards the end of 2023 as we did in 2022. We are committed to maintaining the excellent production progress we achieved in the fourth quarter, and we believe we can sustain that execution into the first and second quarters of 2023.

Our next question comes from Jerry Revich of Goldman Sachs.

I'm wondering if you could just talk about Precision Ag. Can you just update us on Blue River? We're talking to folks that are seeing pricing in the mid- to high single-digit dollars per acre range for the subscription. I'm wondering if you could comment if that's representative of the pricing points. And I believe you folks planned on full rate production year two of commercial availability. I'm wondering, is that still the plan for 2024 at this point?

Just a couple of high-level comments on Precision, and we can dive into Autonomy and See & Spray after that. But overall, we're seeing kind of higher take rates for a lot of our existing technologies that have been in the market for the last couple of years, I would say anywhere from 5% to 10% higher take rates in 2023. So we're super encouraged by that. Technologies like ExactEmerge and ExactApply continue to do well, continue to penetrate the market further. Also notably, some of the newer technologies that we've had, like ExactRate or the CH950, have also made really good inroads as we start filling out the order book for next year. I think for ExactRate, we're almost double the take rate, almost 20% going into next year. Now, as you noted, we're also very focused on some of these next-gen technologies like See & Spray, like Autonomy. And those two technologies carry with them more recurring revenue opportunity than we've had in the past. So we've been super encouraged by putting this out with customers. We've done it on a limited basis. But these are paying customers, and they are adapting to the new business model, and that's part of the learnings that we've had over the course of the summer. And then in the fall, we were running autonomous paid acres over the fall. The vast majority of our customers have really accepted the model, and we're really encouraged by that. We're going to get a little bit smarter and tighten that up as we go into 2023, which will be the second year of a limited production release there.

Yes, Brent, just to add to that, I think an important comment that underscores why this is happening and why we're seeing these strong take rates is the current environment underscores the need for precision. Challenges of our customers are definitely more acute than they've ever been, and the need for our customers to do more with less is greater than it's been in the past, especially when you consider all the rising input costs, not just labor scarcity, but lack of skilled labor. So precision ag is the best solution to help them solve these very, very difficult problems. We're more confident today in our opportunity to create value for our customers through our identified $150 billion of IAM, and we're going to continue to prioritize our investments towards the technologies and solutions that unlock that value. And Josh indicated earlier on. This year, we're spending more than we ever have in the past to create those new products, new solutions, and that's going to have a big benefit in future years.

Great point, John. Maybe one thing I'd add there is we've also made a change to our dealer pay for performance. So we're including precision ag execution in that pay for performance. And that's a really important step as we think about continuing to drive the outcomes that we wanted to deliver, and really a shift from adoption to utilization to make sure we're delivering on that and we're showing and demonstrating the incremental addressable unlock that we can create, which we think is differentiated for Deere.

The next question comes from Nicole DeBlase of Deutsche Bank.

Just maybe asking a quick one on pricing. With the price guidance that you guys have embedded, is that all price carryover? Or are you embedding another annual increase as per like a return to normal in 2023? And how has the customer response been to pricing?

Regarding pricing, there is a mix of factors at play. We see some carryover from 2022, especially since we had higher prices in the latter half of that year. Therefore, comparisons will likely appear higher in the first half of 2023. Additionally, we implemented further list price increases for the 2023 order book, so it will be a combination of both elements. As for demand elasticity, we have not observed any decline in demand so far. We have had to set limits on our order books due to ongoing demand surpassing supply. As mentioned earlier, the pace of orders has remained consistent throughout the fourth quarter.

Our next question comes from Mircea Dobre of Baird.

I want to return to the topic of precision agriculture. I'm curious about how your approach to commercializing the Autonomy product suite has evolved and what progress you have made in making this a mainstream product. Are we looking at a timeframe of 2024 or 2025? Additionally, for customers purchasing 8R tractors now, do they have the option to include this feature as a standard product?

Great question about Autonomy. Currently, our autonomy technology is being introduced in a limited manner, so it isn’t available to all customers yet. In 2023, we will continue to have a restricted commercial rollout of Autonomy. Our perspective on precision is evolving due to two key factors. First, this technology fits well with a per-acre monetization model, which differs from our traditional point-of-sale approach for most of our products and services. We’re looking to implement this with customers, and we’re observing that their usage of our solutions varies across the customer base. Many customers appreciate the variable cost feature, as we see them using autonomy in a hybrid manner—they operate their tractor themselves at times and switch to autonomy mode overnight to complete tasks while they rest. This model allows them to pay only for the product usage they engage in. Secondly, it’s important to note that our rollout of autonomy will prioritize retrofitting or field kits before moving to factory-installed technologies, unlike what has typically been done in the past. This shift will change how we approach next-generation technologies, offering opportunities for recurring revenue and a stronger focus on field kit or retrofit solutions at the beginning of these technology introductions.

Yes, Brent, just to add to that, a couple of things I think are important. First of all, our experience with customers this fall really reinforced our view on the very real challenges our customers are facing with respect to labor, labor availability, and the value of hitting that agronomic window. So with limited skilled labor, the downside effect to it is not hitting the agronomic window and then having an impact on yield. So having the machine running when it needs to run was very critical to our customers. Also, as you mentioned, the customer acceptance of the per-acre model was really, really good. And one evidence of that is every single customer that used this product in this fall has signed up to use it in the spring. So really, really important. Last thing I want to leave you with is when you think of autonomy, I want you to start thinking about autonomy and automation. And this is just one major productivity unlock in an entire production system. And if you remember, as part of our Leap Ambitions, we're committing to have a total autonomy and automation solution for corn and soy in the U.S. We want to unlock all of this value for our customers. And what we've been doing here for the last couple of years is proving out that this is technically possible, and I am really excited about it.

Our next question comes from Larry De Maria of William Blair.

Good morning, Josh. Continuing on that subject, you're clearly focusing on price and value for each machine, but it's becoming more challenging for midsized farmers, which requires greater scale in the industry. I'm curious if we are approaching the limits of what growers can manage and accept in terms of pricing. Do you believe they need to transition into 2024, or are we potentially moving towards a broader per acre model that extends beyond just your Autonomy sooner?

Thank you for the question, Josh. The opportunity ahead of us involves retrofitting existing equipment to upgrade and enhance productivity and technology without the need for entirely new machines. This represents a unique solution compared to what we've offered before and also provides relative value depending on farm size, especially if costs are based on per use or per acre. We believe this is a key factor in delivering value to our customers and enables the technology to cover more acres as we progress through the field.

Our next question comes from John Joyner of BMO Capital Markets.

It feels like we're celebrating the positive results here. I want to quickly address Mig and Larry's question. When considering the per-acre model, does it ultimately create a take it or leave it situation for producers? If they want autonomy and the See & Spray feature, do they have to subscribe, or is it possible to opt-out?

Yes, John, thank you for your question. The opportunities provided by retrofitting offer some flexibility in how it can be utilized. It's crucial for customers to have the option to engage with these technologies, as we've noticed with both See & Spray and Autonomy. Customers weigh various trade-offs, including timing, field conditions, and labor availability. Creating options is essential and enables a broader, more effective application of these technologies across larger acreage and farm sizes.

Yes, it's also important to talk about what our goal here is with each one of these technologies. Our goal is to develop technologies that are targeted at the greatest problems that our customers have with the outcome being by using John Deere technology, you as the customer will be more profitable because it will minimize your inputs, you're going to be more productive because of the case of Autonomy, when we might take somebody out of the cab or other technologies. And you're going to do the jobs you do in a more environmentally sustainable way. That's really good for our business. It's good for our business long term regardless of where we are in any given cycle. Customers are going to buy these technologies to improve their profitability.

Our next question comes from David Raso of Evercore ISI.

I was curious about the comment you made about the inability to raise your dealer inventory through '23. Obviously, that's very encouraging for your build schedule for '24. Can you give us a sense of what percent below normal? Do you see your dealer inventory exiting '23?

Yes, thanks for the question, David. Regarding dealer inventory, I'll address both new and used. I understand your question is focused on new. For high horsepower equipment, four-wheel drive inventory to sales is at 10%. High-horsepower two-wheel-drive tractors are at 12%. Historically, these ratios would be between 25% and 30%. Combines are particularly low, though that's somewhat seasonal, as they tend to be low post-harvest at the end of the year. This illustrates the magnitude of the inventory increase we need to see in the channel as we move into 2024. And with that, we'll wrap up the call. We appreciate everyone's time and hope you all have a great Thanksgiving.

Thank you. This does conclude today's conference. You may disconnect at this time. Thank you, and have a good day.