Earnings Call Transcript - DE Q3 2023

Operator, Operator

Good morning, and welcome to Deere & Company's Third Quarter Earnings Conference Call. I would now like to turn the call over to Mr. Brent Norwood, Director of Investor Relations. Thank you, sir. You may begin.

Brent Norwood, Director of Investor Relations

Hello. Also on the call today are Josh Jepsen, Chief Financial Officer; and Josh Rohleder, Manager of Investor Communications. Today, we'll take a closer look at Deere's third 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 statements concerning the company's plans and projections for the future that are subject to uncertainties, risks, changes and circumstances and other factors that are difficult to predict. Additional information concerning factors that could cause actual results to differ materially is contained in the company's most recent Form 8-K, Risk Factors in the annual Form 10-K as updated by 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 Josh Rohleder.

Joshua Rohleder, Manager of Investor Communications

Good morning, and thank you all for joining. John Deere finished the third quarter with another strong performance, resulting in 22.6% margin for equipment operations. Performance exceeded expectations as a result of sustained demand for both farm and construction equipment as well as sound operational execution across all business units. Ag fundamentals continue to remain healthy with a full order book and positive customer sentiment supporting a strong finish to fiscal year 2023. Meanwhile, construction and forestry remain sold out for the remainder of the fiscal year with robust shipments driven by strong retail demand and rental re-fleeting. Slide 3 begins with results for the third quarter. Net sales and revenues were up 12% to $15.801 billion while net sales for the equipment operations were up 10% to $14.284 billion. Net income attributable to Deere & Company was $2.978 billion, or $10.20 per diluted share. Third quarter net income results included a $243 million tax benefit and a $47 million of associated interest income stemming from a favorable tax ruling on Brazilian VAT tax subsidies. Turning now to Slide 4. Let's begin our segment review with the production and precision ag business. Net sales of $6.806 billion were up 12% compared to the third quarter last year, primarily due to price realization. Price realization for the quarter was positive by just under 12 points. Currency translation was also positive by approximately 1 point. Operating profit was $1.782 billion, resulting in a 26.2% operating margin for the quarter. The year-over-year increase was driven by favorable price realization, improved shipment volumes and favorable sales mix, which was partially offset by higher production costs, increased selling, administrative and general expenses and R&D spending, and unfavorable currency exchange. Shifting to small ag and turf on Slide 5. Net sales were up 3%, totaling $3.739 billion in the third quarter. The increase was a result of price realization, which was partially offset by lower shipment volumes. Price realization was positive by slightly over 9 points. Currency was also positive by slightly under 0.5 point. Operating profit improved year-over-year to $732 million, resulting in a 19.6% operating margin. The year-over-year increase was primarily due to price realization and was partially offset by higher production costs, lower shipment volumes and increased selling, administrative and general expenses and R&D spending. Slide 6 shows our industry outlook for ag and turf markets globally. In the U.S. and Canada, we expect industry sales of large ag equipment to be up approximately 10% during the fiscal year, reflecting a continuation of strong demand. Ag fundamentals remain solid with farm net income expected to be near historical highs even if down from last year's record levels. Drier weather conditions over the summer put some downward pressure on yields, tightening ending grain stock estimates and further supporting commodity prices. Solid order visibility provides a high level of confidence as we move into the fourth quarter. Within small ag and turf, we estimate industry sales in the U.S. and Canada to be down between 5% and 10% and as strength from mid-sized equipment continues to be offset by weaker consumer-oriented products, which have been pulled down in part by high interest rates. Mid-sized tractors in the 100- to 180-horsepower range are sold out for the remainder of the year while production cuts in the sub-40-horsepower compact tractor range have helped to bring inventory levels down from April highs. Hay and forage continues to see significant year-over-year increases as production shortages in 2022 fully abate. Turning to Europe. The industry is forecasted to be flat to up 5% for fiscal year 2023. Our visibility for the rest of 2023 remains excellent as order books are largely presold at this point in the year. In South America, we expect industry sales of tractors and combines to be flat to down 5% following a record year of equipment in 2022. Positive sentiment around record grain production in 2023 was somewhat offset by political uncertainty and a delayed government-sponsored financing plan. The market remains stable and order books now provide visibility through the remainder of 2023. Industry sales in Asia are forecasted to be down moderately as volumes in India remain subdued when compared to record levels in 2021. Moving now to segment forecast on Slide 7. For production and precision ag, net sales continue to be forecasted up around 20% for the fiscal year. The forecast assumes roughly 15 points of positive price realization for the full year and minimal currency impact. Segment operating margin for the year remains between 25% and 26%, reflecting strong execution globally. Slide 8 gives our forecast for the small ag and turf segment. Net sales are expected to remain up around 5% in fiscal year 2023. Guidance includes about 9 points of positive price realization and approximately 1 point of currency headwind. The segment's projected operating margin is now between 17% and 18%, reflecting stronger-than-expected operational efficiency, notably in Europe. Now switching to construction and forestry on Slide 9. Net sales for the quarter were $3.739 billion, up 14%, primarily due to price realization and higher shipment volumes. Price realization was positive by nearly 10 points and currency translation was also positive by approximately 0.5 point. Operating profit increased year-over-year to $716 million, resulting in a 19.1% operating margin due to price realization and improved shipment volumes. These were partially offset by increased selling, administrative and general expenses and R&D expenses, higher production costs and unfavorable currency impact. Slide 10 shows our 2023 industry outlook for construction and forestry. Industry sales of earthmoving and compact construction equipment in North America are both projected to remain flat to up 5%. Demand for earthmoving and compact construction equipment remains robust, driven primarily by the early stages of infrastructure spending and rental re-fleeting. The industry also benefited from some stabilization in housing as well as reshoring efforts in the manufacturing sector, which are helping to offset weaknesses in office and commercial real estate. In forestry, we estimate the global industry will be flat to down 5% with growth in Europe offset by softening markets in the U.S. and Canada. Global roadbuilding markets are forecasted to be flat to up 5%. Strong performance in North America and emerging markets in South America and India are supporting strong fundamentals across Europe. Continuing on with the construction and forestry segment outlook on Slide 11. Deere's construction and forestry 2023 net sales are now forecasted up between 15% and 20% with the results likely to converge towards the middle of that range. Our net sales guidance for the year contains about 11 points of positive price realization. Operating margin is now expected to be between 18.5% to 19.5%. Next, we'll transition to our financial services operations on Slide 12. Worldwide financial services net income attributable to Deere & Company in the third quarter was $216 million. The 3% year-over-year increase was due to the income earned on a higher average portfolio, partially offset by less favorable financing spreads. For fiscal year 2023, our outlook remains at $630 million, reflecting less favorable financing spreads; the second quarter correction of the accounting treatment for financing incentives; a higher provision for credit losses; increased selling, administrative and general expenses; and lower gains on operating lease dispositions. These were partially offset by benefits from a higher average portfolio balance. Finally, Slide 13 outlines our guidance for net income, effective tax rate and operating cash flow. For fiscal year 2023, we are raising our outlook for net income by $0.5 billion, to be between $9.75 billion and $10 billion, reflecting another quarter of strong results and continued optimism for the remainder of the year. Next, our guidance incorporates an updated effective tax rate between 21% and 23%, which reflects the impact of a favorable tax ruling in Brazil as mentioned earlier. Lastly, cash flow from equipment operations is now projected to be in the range of $10.5 billion to $11 billion. This concludes our formal remarks. We will now turn to a few specific topics relevant to the quarter before opening the line for Q&A. Let's begin with Deere's performance this quarter, Brent. We had another really strong quarter with operational results coming in just ahead of our own expectations. Net sales for equipment operations were up 10% year-over-year while operating margins came in at 22.6% for the quarter. Can you break down what went well for us this quarter?

Brent Norwood, Director of Investor Relations

Thanks, Josh. First, our factories ran really well in the third quarter. We saw continued progress from our supply base, enabling our operations to hit production schedules almost exactly as planned. This precise execution from our factories is evident in our top line quarterly cadence, which will show a return to normal seasonality in 2023 when compared to 2022. And a return to normal seasonality is incredibly important to us because it means that we are delivering on our customer commitments to get them machines in season. Importantly, this is a real testament to our factory teams. And the real story, as you alluded to, is around margins, right? All three divisions saw lower-than-expected production cost inflation as our operational teams continued to deliver on cost reduction activities, having eliminated many of the inflationary and disruption-driven costs over the last couple of years. This was especially notable for construction and forestry, which delivered record year-to-date margin performance. In addition to exceptional near-term execution, construction and forestry is also benefiting from executing on our business strategy, as shown by our successful integration of Wirtgen, the dissolution of our Deere-Hitachi joint venture and the strategic portfolio actions that have helped us focus the business. As it relates to the quarter, these results underpin our commitment to operational excellence. With supply chains continuing to improve, we have been able to reduce delinquencies and improve resiliency in our supply base. In premium freight alone, we've been able to reduce costs by nearly 50% this year when compared to last year. From a production standpoint, we've seen material cost inflation come down meaningfully throughout the year. We expect this trend to continue throughout the rest of the year. And when you successfully execute on all of these different initiatives simultaneously, you get factories that fundamentally run better. Across the board, we're seeing smoother operations, leaner in-process inventories and better ability to meet our delivery commitments, which ultimately lead to a better customer experience.

Joshua Rohleder, Manager of Investor Communications

That's great. Thanks, Brent. With operations running much more smoothly, maybe we can flip to the other side of the equation. There's been a large amount of focus on industry fundamentals, both from a construction and an ag perspective. I'd like to start with construction equipment. We've seen record amounts of government funding announced in the past few years. Alongside the IIJA and CHIPS Act, the IRA has already announced more than $130 billion worth of clean energy projects. How are construction fundamentals faring today?

Brent Norwood, Director of Investor Relations

Yes, that's great context, Josh. Earthmoving industry fundamentals remain quite strong, driven by construction job growth across most sectors, and in particular, large infrastructure project spending. Coupled with continued rental industry re-fleeting, demand is expected to remain steady throughout the remainder of the year. And while we see nice tailwinds from mega project spending tied to government funds, most of these projects will primarily benefit 2024 and potentially even 2025, supporting an elongated cycle for construction equipment sales. In the near term, the residential housing market, while down from the highs in 2021, has stabilized despite elevated interest rates. For non-residential demand, reshoring trends are driving manufacturing projects while sectors linked to office space and apartment building construction remain quite sluggish. Ultimately, this demand backdrop translates to a strong 6-month rolling order book extending into the second quarter of 2024. And finally, while we have had some success increasing inventory from historic lows, inventory-to-sales ratios still remain well below target levels.

Joshua Rohleder, Manager of Investor Communications

Okay. That's perfect. So near-term construction fundamentals remain resilient and the business appears to be very well positioned on the construction side heading into 2024. Focusing now on ag fundamentals. Farmers are expected to have another strong year relative to historicals. WASDE just released its latest forecast last week, showing crop yields down and stocks tightening. How should we be thinking about farmer fundamentals, Brent?

Brent Norwood, Director of Investor Relations

Grain prices have definitely seen a large amount of volatility this year. But equipment demand has remained strong, particularly for large ag. While down year-over-year, crop prices are forecasted to be the third highest in over a decade. And in North America, farmers are projected to have another year of healthy net income. Additionally, farm inputs have trended back down to pre-COVID levels, providing a benefit to next year's farm margins. And finally, as grain production remains subject to ever-volatile weather patterns and adverse geopolitical events, expect stocks to remain tighter for a bit longer. So in summary, ag fundamentals are still supportive in the North American market. Farmers will continue to see relatively healthy economics, supported by downward-trending input costs and continued constraint on grain supplies globally.

Joshua Rohleder, Manager of Investor Communications

Thanks, Brent. That's great color on the U.S. and Canada. If we look outside North America, how will we see these fundamentals impacting Brazil?

Brent Norwood, Director of Investor Relations

Yes, Brazil has been a real dynamic market this year. Earlier in the year, we saw some of the political uncertainty and the delayed government-sponsored financing plans weigh on sentiment. While profitability has been very good, some farmers generated lower-than-expected income due to lower grain prices, combined with a strengthening Brazilian currency relative to the U.S. dollar. As such, we saw the industry forecast come in a bit. And as a result, we trimmed our equipment production some in the back half of 2023. At this point, the order book extends through the fiscal year, and our presold position is robust, eclipsing 90% for combines.

Josh Jepsen, Chief Financial Officer

And Brent, this is Josh Jepsen. Just to add to that, Brazil still experienced record production this year. We're seeing continued acreage expansion and a supportive government-sponsored financing program is now in place. So long-term, Brazil remains a key market for us that we'll continue to invest in for the future as we accelerate precision technologies in the region.

Joshua Rohleder, Manager of Investor Communications

Thanks, Josh. Now switching back to the North American market. With order books full through the end of the year, how are new field inventory levels shaping up as we exit 2023 and begin planning for 2024?

Brent Norwood, Director of Investor Relations

That's a great question, Josh. Starting from the top, all of our North America large ag production is sold out for this year. We expect ending year-over-year changes in new field inventory to be modest. In-season inventory increases have largely corresponded to our quarterly production schedules, which will come down in the fourth quarter. Combine inventory, for example, saw its highest level in the second quarter and is currently down from its peak. We will see that figure step down further in connection with seasonal retail activity ahead of harvest. And while high-horsepower tractor inventory remains sequentially flattish in the third quarter, we'll see that drop off at the end of the fourth quarter, which is typically the highest retail quarter for tractors. Keep in mind that combines and high-horsepower tractors are 95%-plus retail sold to customers already.

Joshua Rohleder, Manager of Investor Communications

Perfect. So we will expect to see inventories wind down further throughout the fourth quarter. Now what about used inventories? We've seen those rise pretty significantly year-over-year from their historic lows last year.

Brent Norwood, Director of Investor Relations

We have. But the key phrase here is historic lows last year. When you are starting with a historically small existing inventory base, like we had in 2022, even modest changes in units will reflect large percentage increases. That said, our dealers have been watching used inventories very closely and have been managing them proactively. Large ag equipment has roughly 4 to 5 owners over its useful life in North America. So for every combine or tractor we sell, a dealer will typically facilitate 3 to 4 additional transactions as used equipment works its way down the trade ladder. Now when you put it in the context of my previous comments around new inventory, it would make sense that we saw inventory levels rise during the middle part of the calendar year. However, if we look at used combines, for example, we saw a 10% decrease in used inventory since May. Also, August tends to be an important month for used inventory. So we'll watch closely how that trends. Importantly, used gear inventory for both combines and tractors remains about 20% lower than the 7-year average on a unit basis.

Josh Jepsen, Chief Financial Officer

And this is Josh, maybe one thing, too, to highlight. Just I think the important takeaway here is that by year-end, we expect both new and used inventory levels to be below historic levels on a unit basis, so really position us well as we exit 2023 into 2024.

Joshua Rohleder, Manager of Investor Communications

Perfect. But how are we doing from an EOP perspective in North America?

Brent Norwood, Director of Investor Relations

At this point, we have launched and, in some cases, completed our early order programs for certain product lines. I want to emphasize that it is still early in the process. While we do not have a comprehensive view yet, the early order programs are providing us with some preliminary data. We initiated our sprayer early order program in May, which concluded on July 31. We have sold out all of our model year '24 production slots, achieving unit sales increases in the double digits compared to model year '23 sprayers. The year-over-year growth for 2024 is attributed to improved supply conditions that significantly restricted sprayer production in 2023. Phase 2 of the plant program began in mid-July and has just under two weeks remaining. Orders are relatively stable compared to the same period last year but are down 5% compared to the end of last year's program. However, we will not have a final assessment of this year's early order program until the end of August. Importantly, we are observing a favorable shift towards our larger planters and increased adoption of technology. Our combine early order program just started at the beginning of this month and is off to a promising beginning, but it is too early to draw conclusions for 2024 since the program will run until the end of November. Additionally, our tractor order book opened this week for Q2 2024, and we currently do not have any data points to share. However, I should mention that the order book is fully booked through the calendar year 2024.

Joshua Rohleder, Manager of Investor Communications

Thanks for the color on North America, Brent. Clearly, too early to tell here, but it sounds like preliminary data is supportive. To round out our discussion, can we focus on Europe and discuss how things are shaping up there for next year?

Brent Norwood, Director of Investor Relations

Yes, absolutely. And actually, Josh, I just want to amend my prior statement. Tractors are sold out through calendar year '23, not to '24. In Europe, however, order books are stretching into the second quarter of 2024, providing decent visibility. But with some early order programs having just kicked off, it remains too early to form a view on 2024 outlook. Expect markets in Europe to remain dynamic with outlooks varying a bit between Western Europe versus Central and Eastern markets. Western markets are seeing arable cash margins stabilize at supportive levels while declining input costs will help buttress financials going into next year. Meanwhile, dairy margins may see some pressure in 2024. On the other hand, markets with close proximity to Ukraine will contend with lower commodity prices as reduced port access means grains are flowing over neighboring borders, pressuring local prices. All-in, expect Europe to remain a dynamic market going into 2024. And we'll have a more informed view as we get closer to the start of our fiscal year.

Josh Jepsen, Chief Financial Officer

And one point I'd add to highlight in Europe is our dealer network. We continue to see higher levels of sales flowing through dealers of scale. This has driven better market share, higher rates of precision ag adoption and overall stronger businesses for our dealers and Deere.

Joshua Rohleder, Manager of Investor Communications

Perfect. That's great insight. I now have one last question for you, Josh. Given the high level of cash flow this year, we've had an opportunity to execute on all elements of our capital allocation priorities. Can you walk through some of the decisions we've made this year with respect to funding further investments in our business, both organic and inorganic, while at the same time returning higher levels of capital back to investors?

Josh Jepsen, Chief Financial Officer

Yes, great question, Josh. This is, first and foremost, a direct reflection of the strong performance this year, which is projected to yield between $10.5 billion and $11 billion in operating cash flow for the equipment operations. We're very proud of what we've been able to accomplish this year and are encouraged by our ability to both invest aggressively in the business while at the same time returning a significant amount of earnings to our shareholders. During the year, we've increased R&D by 15%. We pulled ahead some CapEx projects into 2023 and have still managed to simultaneously deliver over $5.5 billion to shareholders year-to-date through dividends and share repurchases. It further reinforces our excitement for the future and the opportunities we see ahead as we execute on the strategy, unlocking value for customers.

Joshua Rohleder, Manager of Investor Communications

Thanks, Josh. And before we open up the line for questions, do you have any final thoughts you'd like to share?

Josh Jepsen, Chief Financial Officer

Yes, thanks. As previously noted, the team is executing at a high level in 2023, which is evident in our results. We're actively working to reduce some of the inflationary and disruption costs experienced over the past couple of years, and we expect to see that benefit continue. Over the last decade, we've been on a journey to deliver more value per unit. This is clearly visible today through our higher revenues on lower new units, making us less dependent on new unit sales to drive increased levels of performance. As we continue to execute our strategy, this trend should accelerate even faster over the coming years. By utilizing our production systems approach and leveraging the tech stack, we can help our customers do their jobs more profitably and sustainably. That is our purpose. And we are more excited about it each day.

Joshua Rohleder, Manager of Investor Communications

Thanks, Josh. Now let's open up the line for questions from our investors.

Operator, Operator

Our first question is from Jerry Revich with Goldman Sachs.

Jerry Revich, Analyst

Josh, I'm wondering if we could just continue the discussion you just touched on in terms of higher value per unit. So in the past, you folks have been able to outgrow ASPs by 3% to 4% per year beyond price. Do you have a finer point that you can share on what that might look like in '24 and if you could just touch on precision ag take rates and how they're tracking as part of that conversation as well if you don't mind?

Josh Jepsen, Chief Financial Officer

Yes. Thanks, Jerry, appreciate the question. I think we're seeing that continued trend of 3, 4 points on top of the inflationary price as it relates to technology and the appetite we're seeing to continue to drive technology into the machines. As we look forward and start to drive the business model shift, that may change a little bit as we see and build a little more recurring revenue. But I think all-in, we're continuing to see the benefits on the unit economics through what we're doing in technology and the value that we can create for customers.

Brent Norwood, Director of Investor Relations

Yes, Jerry, as it relates to take rates on technology, obviously, we just finished up our sprayer early order program and are near complete on planters. Those are two product lines that have a high degree of technology embedded in those solutions. And for some of those mainstay technology innovations, like ExactEmerge and ExactApply, we continue to see those take rates increase mid-single digits year-over-year. I mean, both of those are really approaching high levels. I think ExactEmerge is around 60% for 2024, ExactApply is a little over 70%. So great progress on those. Other products, like Combine Advisor, have almost just become standard. I think we're at almost 100% take rate there. And the same is true for our premium and automation activation suite for our tractors, which is almost near 100% take rates. So these things are really driving that higher average selling price that Josh talked about. And as we begin to launch some of those next-generation technologies. I think we've got opportunity to supplement the higher average selling prices with some recurring revenues as we get into 2025, 2026 and beyond.

Josh Jepsen, Chief Financial Officer

Yes, Jerry, maybe one last thing I'd add, too, that bodes well in terms of the direction we're headed is we're seeing growth in engaged acres and we're seeing growth in highly engaged acres. So the interaction we're seeing, the value that we can create with our digital tools and having that all in one place in the John Deere Operations Center for our customers is continuing to drive value. And we're seeing that continue to aid in our business.

Operator, Operator

Our next question is from Jamie Cook with Crédit Suisse.

Jamie Cook, Analyst

Congrats on a great quarter. My first question is about the improving supply chain, which likely positions us well for 2024. As you consider this improvement along with the early order program, could you discuss your inventory strategy for next year at both Deere and the dealer level? Will you consider overproducing to align with normal inventory levels? That's my first question. My second question is for Josh regarding the company's margin performance. Can you elaborate on your efforts to minimize margin volatility? Given the anticipated downturn, how resilient are your orders, and how is this affecting your internal initiatives?

Brent Norwood, Director of Investor Relations

Thank you for the question, Jamie. I'll begin by discussing the supply chain and its implications for our inventory next year, with Josh providing insights on margin progress. Our factories performed exceptionally well in the third quarter, and we have a strong cost agenda planned for next year. We're pleased with our progress in reducing production cost inflation, especially comparing third quarter results. The inflation numbers in Q3 were about half of what we initially expected, reflecting the effective efforts of our factory and supply management teams. We're making significant progress in lowering delinquencies back to nearly pre-COVID levels and reducing freight costs. While we're still facing some pressure in purchasing components and see increased labor and energy costs, trends are moving positively. We have a solid plan for next year focused on further cost reductions in our supply base, enhancing resiliency, and designing out costs for upcoming programs, all of which will assist us in managing inventory. As we mentioned, large ag inventory is currently below historic and target levels, and we expect to end the year somewhat low as we navigate anticipated fourth quarter retail sales. Our strategy at the beginning of any fiscal year is to align production with retail sales, while also allowing for flexibility to adjust inventory as we progress through the selling season. Once we have a clearer picture for next year after finalizing our early order programs and assessing our tractor order book, we'll make informed decisions on the appropriate inventory levels, with input from our dealers. For now, our approach is to produce in alignment with retail demand, but given our favorable inventory exit position, we'll keep options open for next year.

Josh Jepsen, Chief Financial Officer

Yes, Jamie, if you think about reducing volatility, I think there's some near-term things that we're working on. Brent mentioned what we're doing as it relates to cost management, continuing to take some of the cost that we've seen through inflation and disruption out of the system. That's an important one. Continuing to drive technology into our machines, driving, as I just mentioned, more value per unit from an economics point perspective will be beneficial. There's a lot of work, great work going on in terms of lifecycle solutions and how we take care of our customers through the life of our products, from first owner down to the fourth and fifth owner. And that activity will help dampen some cyclicality as well. And I think the last one is, maybe a little bit longer term, is we are building the infrastructure to drive solutions as a service for our business in terms of how we shift business model on some of our new technologies. And that's going to help us to deliver more value to customers and importantly to more customers and more acres more quickly. So that's a focus area. Some of those, we're early in the journey. Others, we feel really good about what we're executing on. And I think importantly, structurally, we feel like we're performing from a profitability perspective at a different level. And our expectation is you look at where we're performing today, with volumes as they shift and move up or down, we would move up or down that line based on where we're performing. So we think this is a meaningful structural shift in profitability and one that we're going to keep working on.

Operator, Operator

Our next question is from Tim Thein with Citigroup.

Timothy Thein, Analyst

Could you provide some insights on Brazil, specifically regarding the production cuts you've mentioned and your targets for the second half of the year? Given the volatility of the market, how do you foresee ending the year in terms of inventory in Brazil and the dealer inventories as we approach 2024?

Brent Norwood, Director of Investor Relations

As it relates to Brazil, it's been a very dynamic year with many ups and downs. Currently, our order book is full for the rest of 2023, and managing the year has been interesting. We've recorded high production levels for corn, soybeans, and nearly record levels for cotton and sugar, resulting in strong profitability for our customers, though down from 22%. However, we've seen a bit less activity than expected from our customers due to lower levels of forward selling and challenges in marketing the large crop from 2023. There has also been some political uncertainty and delays in the government-sponsored financing program. This led to a revision in our industry guidance from flat to a decrease of 5%, reflecting lower production anticipated in the fourth quarter. This situation exemplifies our proactive approach to managing a dynamic market in near real-time. Brazil has traditionally been flexible in its operations, and we have adjusted our order book, pricing strategy, and production management accordingly. Our aim with the modest production cuts in the fourth quarter is to align our inventory with targets by the end of the year, allowing us to begin the next year with an intent to produce in line with retail sales for 2024. On a positive note, in terms of combines, we're over 90% retail sold, giving us a clear view of where our inventory will be at year-end, which positions us well for the following year. Long term, despite some current market dynamics, Brazil remains one of our key growth markets, and we will continue to invest there for the future while managing short-term production challenges.

Operator, Operator

Our next question is from Steven Fisher with UBS.

Steven Fisher, Analyst

So the year-over-year step-down in pricing in production and precision ag from Q2 was a bit bigger than the kind of headwind you had from tougher comparison in the year before. I guess, were you expecting such a big step-down in pricing? I mean, you didn't change your pricing forecast, so maybe it's really not any surprise. But I'm curious if the environment and what you're seeing in the order activity is still supportive of a 2% to 3% pricing, including incentives? And how is the need for incentives kind of shaping up here?

Brent Norwood, Director of Investor Relations

Steve, as it relates to pricing, I would say that the second quarter came in almost right on the forecast for production and precision ag and construction and forestry. Small ag and turf probably fared just a shade better as they're retaining a little more price than we had in the forecast. But all of this is largely in line with our expectations. Particularly as we lap some of the mid-year price increases that we took in 2022, we would expect from a percentage basis to see that price realization come in. For production and precision ag, I think we were 12% in the third quarter. That should be high single digits in the fourth quarter as expected. And importantly though, we're seeing production cost inflation ratchet down at a similar pace. So when you look at the absolute delta between price and cost, for production and precision ag, for example, I think we were about $1.4 billion positive in the first half. Second half should be something not dissimilar to that. So we are maintaining that price/cost discipline throughout the entire year. Now as it pertains to next year, no change in some of the early pricing that we've put out there, which has been in the sort of 2% to 4% range. And we are certainly managing our incentive spend as well embedded in that. So we would expect overall realization to be within that range, inclusive of whatever discounts begin to get layered back into the market for 2024.

Operator, Operator

Our next question is from Kristen Owen with Oppenheimer.

Kristen Owen, Analyst

Wanted to ask about the construction margins. You lifted the target once again and really narrowing the gap with your ag businesses that what is arguably a different point in the cycle. Just given some of the comments of normalization in pricing across the portfolio and what you talked about in the prepared remarks for 2024, how we should think about the sustainability of that improved margin performance in the construction segment?

Brent Norwood, Director of Investor Relations

Kristen, regarding the construction and forestry margins, I would like to refer back to some of the comments we made during our opening remarks about the structural changes we've implemented in construction and forestry over the last four to five years. These changes have transformed that business into a more stable and robust operation, which has helped close the gap with large agriculture in recent years. The most significant move we made was integrating a roadbuilding business, which we see as a high growth, lower volatility market and is an appealing sector to be part of. We acquired the leading asset in that business through Wirtgen. We're still in the early stages of executing our excavator strategy, with the first crucial step being the dissolution of the Deere-Hitachi joint venture, which we successfully negotiated last year. We are now moving toward offering a complete line of Deere-designed excavators, signifying the next phase of our strategy and how we plan to enhance margin performance in the future. While we haven't emphasized it much publicly, we have been actively managing our portfolio over the past couple of years, concentrating on products where we are most differentiated and in markets where we have a competitive advantage. We believe all these aspects are structural and will continue to support us in the future.

Josh Jepsen, Chief Financial Officer

Yes, Kristen, I would add that as we look ahead and consider the next phase for C&F, we believe there is another opportunity, particularly in technology. We are focused on integrating technology to assist our customers in performing their tasks more effectively, efficiently, and sustainably. We’re observing this with our initial set of automation tools, such as grade control. There are increasing opportunities to apply technology in construction, especially in roadbuilding, which will generate significant value for our customers. We believe this will set us apart in the market, and as we create value for our customers, we anticipate receiving appropriate compensation as well. We are optimistic about the future and see ongoing opportunities.

Operator, Operator

Our next question is from Rob Wertheimer with Melius Research.

Robert Wertheimer, Analyst

And actually, I wanted to follow up on what Josh was just talking about, where construction pricing, what you've achieved to date, is that largely market-related? Or do you feel like you've had enough technology flow in to sort of support a rising price overall? And maybe as a part of that question, I suppose, definitionally, if you have a tech widget, you target for that balance in volume, I think. But I assume there's just an overall price hit as long as your products deliver more value to customers. So maybe just talk about where you are in technology and...

Brent Norwood, Director of Investor Relations

Yes. Rob, I'll start with a comment on pricing and then we can discuss technology more broadly. Regarding the pricing we've achieved, it's evident in the construction equipment markets. We strive to lead in pricing and maintain discipline as an industry player. We're still in the early stages of obtaining higher average selling prices due to increased technology and innovation in our equipment. We're beginning to see progress in specific product lines. However, for our entire portfolio, it's still early, indicating more potential for growth as we start integrating technology. Wirtgen will likely benefit the most from a higher average selling price as we introduce more technology in the coming years.

Josh Jepsen, Chief Financial Officer

Rob, if we consider the timeline of our journey in large agriculture back in 2013 and 2014, I would say we're likely at a similar stage now, perhaps not quite a decade in, but still behind that mark. We're in the early phases of integrating more technology. The excavator is a prime example, as we are just beginning to design that fully integrated machine. From what we're observing and hearing from customers testing it, there is significant potential for advanced technologies and improved usability. We're really excited about what the future holds and believe we are still in the early stages.

Operator, Operator

Our next question is from Steve Volkmann with Jefferies.

Stephen Volkmann, Analyst

I wanted to go back. I think a couple of you have used the words robust cost agenda for next year a couple of times. And I'm just wondering if there's any way for us to think about sizing that. Is this like sort of a big deal, where we could see these sort of production costs in your waterfall chart could actually be positive next year? Or is this kind of continuous improvement a better way to think about that?

Brent Norwood, Director of Investor Relations

Steve, it's a great question. We've seen over the last couple of years, billions of dollars of cost inflation flow into our operations. Some of that is coming from systemic inflation. A portion of that though is coming from just, I would call it, COVID disruption cost, inefficiency cost, also associated with our deferred ratification of our UAW contract in '22. All of those things caused overheads to run higher than they normally do. So we're bringing a lot of those back in 2023. I think there's more room to run certainly in 2024. I would not probably characterize it as just a normal continuous improvement program here at Deere because we do have line of sight to specific costs that we want to take out. Particularly, as some commodity prices have come down, it's really easy to capture that in our raw material spend. And we did see a tailwind in raw materials in the third quarter. But for a lot of our purchase components that have those raw materials embedded in their purchase price, there's an opportunity to go back and actively renegotiate. So we're very proactive there on executing the strategy. And we do have a formalized process in place to take further action in 2024.

Josh Jepsen, Chief Financial Officer

Yes. Steve, I would like to add that over the past three years, which have been quite atypical due to the pandemic and supply chain issues, we have been focused on identifying and eliminating the costs associated with those disruptions that arose despite strong demand. We will certainly continue this work to return to a standard cadence of cost reduction and operational efficiency. We believe there is still significant potential for improvement in this area.

Operator, Operator

Now our next question is from David Raso with Evercore.

David Raso, Analyst

The earlier comment regarding construction mentioned that the six-month rolling order book extends into the second quarter of 2024. Can you provide details about that order book? Are your orders increasing year-over-year? Does this suggest growth in construction and forestry through the second quarter? Additionally, any insights on pricing within that order book would be appreciated. I also have a quick question about large ag. For the fourth quarter, it appears we are returning to normal seasonal trends, but the fourth quarter shows a significantly weak sequential margin. In the case of large ag, it seems that profits are declining almost as much as the expected decline in revenues. I want to ensure I understand this correctly—are there unique costs, such as those related to Brazil or a negative mix, that explain why profits are falling nearly in line with the revenue decrease sequentially?

Brent Norwood, Director of Investor Relations

Yes. David, I'll begin by addressing the latter part of your question regarding the agriculture segment, and then I'll allow Josh to elaborate on construction and forestry. In the fourth quarter, we can expect revenues to remain flat or possibly decrease slightly in agriculture. The primary factor driving this change is a return to normal seasonality, which includes typical factory shutdowns, particularly at Harvester Works. Historically, we have conducted factory shutdowns in September and/or October. Therefore, you will notice the effects of these shutdowns, which we haven't implemented in the past couple of years due to delays in delivering machines to customers that began in late 2021 and continued through 2022. This is the major impact expected in the fourth quarter. Additionally, I want to mention that in the fourth quarter, and this applies to all three divisions, we anticipate an increase in R&D spending. This is a typical trend for our fourth quarter, and it will hold true this year as well. Lastly, we will also see a reduced mix from Brazil in the fourth quarter. All three of these factors combined will slightly reduce margins in the fourth quarter compared to the third quarter results.

Josh Jepsen, Chief Financial Officer

Yes. As it relates to C&F and if you look at the order book, I mean, I would say, comparing year-over-year is a little bit difficult because we were constrained last year, so probably not a good way to compare just total order activity. But what I would say is on the order book that we have, we're looking at similar production rates, 2023 to 2024, so not a significant change there and realistically, obviously, less disruption expected as well in '24 than we saw in '23.

Operator, Operator

Our next question is from Tami Zakaria with JPMorgan.

Tami Zakaria, Analyst

So I wanted to step away from the quarterly trend and ask you about your new battery plant. I think you do speak to a new battery manufacturing location. Can you tell us a bit more on that, when it will be operating at run rate, what volume you expect that run rate, what products you expect it to feed into, any impacts on margins or potential cost savings? So any thoughts on this initiative?

Josh Jepsen, Chief Financial Officer

Thank you for the question, Tami. This initiative is a follow-up to our acquisition of Kreisel Electric, which we made over a year ago. It's an important step in enhancing our manufacturing capacity for batteries and charging, as we announced earlier this week in North Carolina. Overall, this is a strategic investment aimed at expanding our production capabilities and positioning ourselves as a leader in the off-highway segment. As this sector evolves, we are focusing on developing strong charging technologies alongside a battery portfolio that supports long-term electrification in our products. We anticipate that the new facility will take about a year to become operational. Currently, we are producing batteries in Europe on a smaller scale, but we see significant potential with our technology to advance charging solutions soon. We have a solid plan for integrating Kreisel batteries into our products, starting with those under 125 horsepower, and we will continue to expand that product lineup, including hybrid technologies in the future.

Operator, Operator

Our next question, from Chad Dillard with Bernstein.

Charles Albert Dillard, Analyst

So I want to spend some time on the average age of the fleet. Can you just talk about where we will be ending the year versus normal? And I recall you talking about how there are, I guess, 5 different owners within the fleet. I think where is the bulge in age in terms of the fleet? And then just the last question is if the higher average age structural? Why or why not?

Brent Norwood, Director of Investor Relations

Regarding the average age of the fleet, the replacement cycle has had a delayed start. Demand began to increase at the start of 2021, but several factors have hindered production for the entire industry. There were labor shortages, supply chain issues, and significant inflation impacting production. Over the past three years, demand has surpassed supply, which has slowed the industry's progress in reducing the age of the fleet. Specifically, for four-wheel drives and 220-plus horsepower tractors, the fleet has aged each year since 2013. While we've started to stabilize that trend somewhat, there hasn't been a significant reduction in age, and we're still likely a couple of years older than historical averages. In contrast, combines have seen some progress in the past year, and we expect to make additional strides in 2024, although we will still be slightly above historical averages. It's going to take more time for tractors, especially for four-wheel drives, as indicated by AEM data. This segment has been one of the most constrained, similar to sprayers, which means the age of the fleet will take longer to reduce. The bulk of the age issue lies with machines from 2010 to 2014, which still comprise a large portion of the installed base and are aging more quickly than the industry can replace them.

Josh Jepsen, Chief Financial Officer

Yes, one thing I'd like to add is that we continue to see demand for technology throughout the trade ladder in our equipment. Just a couple of weeks ago, I spoke with a dealer principal who mentioned this exact point. It's not only the first owners seeking the latest technology, but also the second, third, fourth, and fifth owners. When considering the age of the fleet and the state of the trade ladder, this is a significant factor because there is a strong desire to upgrade technology regardless of where the customer is in that chain. This is an important aspect that highlights both the age of the equipment and the ongoing demand.

Operator, Operator

So our last question now is from Seth Weber with Wells Fargo Securities.

Seth Weber, Analyst

I wanted to ask about the small agriculture business. The margin was much better than we anticipated. I believe you mentioned something about Europe. Are these structural changes something we should consider as permanent moving forward? Additionally, regarding the small agriculture inventory coming down from its peak, do you think we have overcome the challenges there and that the situation will improve, or will it just be less problematic going forward?

Brent Norwood, Director of Investor Relations

Thank you for the question, Seth. Regarding the small agriculture and turf segment, it's definitely a more stable business today compared to previous cycles. I'll discuss some margin factors shortly, but let me first address your inquiry about inventory. In the small ag and turf sector, there's been considerable attention on the lower segment, particularly the under 40-horsepower compact utility tractors. The industry seems to be leveling off or even experiencing a slight decline recently, suggesting that we might be entering the early stages of reducing those high inventory levels for compact utility tractors. However, most of this business is centered around mid-sized tractors used in dairy, livestock, hay, forage operations, or high-value crops, and I believe we are nearing our target inventory levels in that regard. Therefore, we don't see an excess of inventory in those categories. Additionally, we'll encounter seasonal factors affecting margins for the remainder of the year, including a factory shutdown in Monheim, our sole production site for the 6 Series tractors, which constitute a significant portion of small ag and turf revenue and margin. Looking ahead, from a margin standpoint, especially with those mid-sized tractors, we will be implementing higher levels of technology from production and precision agriculture. In past years, there wasn't much technological advancement in small ag and turf, but that is changing. Our customers, especially those in high-value crop production, are seeking solutions like autonomy and electrification. This shift presents an opportunity to strengthen the margin profile we have achieved this year and carry it into future years.

Josh Jepsen, Chief Financial Officer

Yes, Seth, one last thing I would add is just the deep geographic diversity of small ag and turf. So it's much broader in terms of global coverage. And we're seeing performance really strong across the globe. And to Brent's point on driving technology, we're seeing technology be driven into utility tractors in India, leveraging telematics and bringing connectivity to the farm there. So there's a lot of activity that we see that is going to both create customer value and also drive a different business in small ag and turf than you've seen in the past.

Brent Norwood, Director of Investor Relations

That concludes today's call. We appreciate everyone's time, and thank you for joining us today.

Operator, Operator

This conference has concluded. Again, thank you for your participation. You may please disconnect at this time.