Deere & Company Management Presents at ISI Industrial Conference (Transcript)

| About: Deere & (DE)

Deere & Company (NYSE:DE)

ISI Industrial Conference Call

March 5, 2013 10:55 AM ET

Executives

Rajesh Kalathur – SVP and CFO

Tony Huegel – IR

Analysts

Connor Zeere – ISI

Alex Blanton – Clear Harbor Asset Management

Connor Zeere – ISI

I’d like to get started here. So here we have Deere & Co. This is Connor F. Zeere from ISI. Deere & Co, we have Rajesh Kalathur, Senior Vice President and CFO; Tony Huegel to my left in Investor Relations; and Susan Karlix, Investor Communications. So Raj will speak for a couple minutes and we’ll have Q&A, so if you have any questions please ask them. Thank you.

Rajesh Kalathur

Thank you. I’m really proud here to represent the company. It’s been around for 175 years and doing very well in 175 years. One of the things you may know about John Deere is the quality and reliability of the products to be produced. It’s been second to none in our industry.

Beginning in 2001 through 2010 we embarked on a mission to have a business that is as great as our products as well. So a couple of areas we focused on that we had not focused on prior to 2001, one was operating return on assets and second is shareholder value added. So we started that journey in 2001. Beginning in 2004 until today with the exception of – actually until today we have had positive SVA, shareholder value added, every year.

So in 2010 we looked at the tailwinds that are supporting both agriculture globally, this has more to do with the population and improvements in diet around the world, and the second is move towards more infrastructure development around the world because of the fact that more people are moving into urban areas from rural areas around the world. So those two drivers meant that we could afford to look at higher rates of growth.

So beginning 2010 – historically we have done about 6% to 7% compounded annual growth rate on our top line. 2010 to 2018 we said we are going to shoot for 9.2% compounded annually, and we’re going to do that by also increasing our operating return on sales at mid cycle from about 10% in the past to 12% and also improve our asset turns from 2.2 to about 2.5.

So if you think about prior to 2010 we were delivering – at mid-cycle volumes we were delivering operating return on sales of 10% and turns of about two, so we were doing about 20% operating return on assets. Now we are saying that we’re going to go back to 2.5% and 12% it’s almost 30%. So while at the same time we are now increasing the top line of the compound annual growth we have 9.2%. That’s the journey we’ve embarked on since 2010. We will tell you that since 2010 we have done well in that journey. The last 13 quarters we have had higher quarterly net income over the previous year’s same quarter. 11 quarterly net incomes have been record. Okay so we’ve actually performed well since we started on this new strategy.

You will also notice that in terms of top line growth at mid-cycle we think we are on target to our creating aspiration. In terms of our operating return on sales growth we’ll tell you is slightly below where we want to be and are projected at 12% operating return sales at mid- cycle.

On the asset, and again the asset grow of 2.5% is by 2018. I will tell you that has actually – we were among the best in terms of asset turns in S&P industrials. You know we have taken on a task to actually become better than what we had before while our average dollar of inventory is moving a longer distance and we have more capacity built in more locations that are not fully utilized yet. So that’s going to be even more challenging for us to achieve.

Okay. So we’re making good progress on the 9.2%. We’re making decent progress but less that where we would like to see on a 12% operating return on sales; on the 2.5% we have more work ahead of us.

With that I’ll also provide you a glimpse of where we see growth coming from in the future. In Ag, North America is the most important market for us today. South America, which has the characteristics of North American in terms of soybean, corn, cotton and larger farmers who appreciate technology in their products, it’s possibly the second most important market for us.

And our combined market shares are mid 30% in Brazil. Our tractor market share five years back was about 7%. We’ve grown that to 21% more recently when it’s grown consistently. So that’s a very important market that has additional room for growth. There’s another 17 million hectors available land that can come into agriculture, not from you know the forest areas but way south of there, an Argentina has another 15 -14 million that they can bring into agriculture that’s in pasture land and so on right now. So very promising area for us, North America then South America.

After that we would say CIS which basically includes Russia, Kazakhstan and Ukraine. Those three are very good opportunities for us in terms of Ag. And next up we have a sizeable opportunity for us is in growing our share in EU27, the Western European markets. And then we would say Asia and Africa and longer term Sub-Saharan Africa. So we have a long pipeline of opportunities in the Agree market in front of us for at least the next couple of decades.

The concession at growth aside – you know most of our sales today comes from North America. There is a small portion that comes from Forestry side from Europe. But most of our growth ambition and concession beyond North America is going to be in Brazil followed by some extent China. And a little lesser in Russia and in India. But the finely focus for us is Brazil. We think we can leverage our Ag in infrastructure and our capabilities in the local markets to compete very well in the Brazilian market, the Construction equipment. I think so. With that we’ll open it up for any questions you may have.

So rather than parading you with going through a presentation we thought we will actually open it up to any questions you may have.

Question-and-Answer Session

Connor Zeere – ISI

Early in the year be it argued North America the farmers are spending the crop insurance payments they’re starting to receive and that their receipts last year were pretty strong. This year we’re looking at potentially higher yields, lower crop prices. You have some of the early order programs already pretty well spoken for.

But what’s the feedback from your sales reps, how you’re thinking about managing inventory through the rest of the year? Production schedules transitioning from last year’s crop being sold at say $7 and the thought is this new crop is targeted for December futures as down at $5.50. And there’s always a trade-off between better yields, lower price. It’s about the total receipts. But just what’s the feedback you’re getting from the field on how this year is turning the field differently as this year’s crop and last year crop fades away?

Rajesh Kalathur

So we’re pretty optimistic about this year’s crop based on the information they’re getting from the farmers. And as you said, David, it’s about cash receipts, and as you know, a lot of the large farmers think about – they sold ahead a portion of their crop for 2013 and October, November and December when the prices were much higher than they are now for December Futures.

Now you also probably know that a lot of them are going to take crop insurance and now a lot more of them are moving towards revenue crop insurance. And in revenue crop insurance you have an option of taking either the spring price or the fall price – you think about corn. The spring price for corn, this is based on – that’s the February, December futures number, average of February, that’s almost $5.67. So you get a portion of it already sold at much higher prices, you almost have a floor at $5.67, and for any excess capacity they haven’t been able to sell, many of the farmers now have storage capacity that they can actually sit for a while before they sell out.

Now corn is just one portion of the story. You have soybean obviously, which both those are at pretty good price levels, and we’ll tell you even at $5.25 or $5.50 and so on, it’s still a very good price. Now last year it kind of made $5.25 look not so good, otherwise $5.25 was always a very good price for the corn farmer. Now input costs are going up, but in spite of that, we think that the cash flows to the farmer, even at those levels, are very good. Now nobody knows what the prices are going to be as you go through the season and start harvesting a crop is when you really know what the prices are likely to be.

Last year at this point, so end of quarter one, our price prediction was also $5.30. So you see where that actually ended up. We all come up with a prediction but there’s only so much we can do on the prediction side given weather and other things impacting it, but the demand side on a worldwide basis is pretty strong for both these commodities. And the demand in the U.S. is likely to come up in 2013 we are – if the prices are a little softer, it’s likely to come back up even more in 2014. So overall cash receipts should moderate.

Connor Zeere – ISI

And the engine omission changeover, any early read on how their customers are thinking about buying ahead of it, waiting? You’re making more of an engine change than most other companies. But in aggregate, your customer base is pretty loyal customer base, they’re not going to switch brands around the engine technology necessarily. But they could make a decision to pull forward, want an EGR, avoid the SCR, avoid a price increase. Is there anything from the field that’s telling you the back half of 2013 might be a little stronger than you think because they’re going to pre-buy 2014 or maybe the opposite? Any feedback on that?

Rajesh Kalathur

On the iT4 side, especially on the large equipment, ag equipment North America, you did not see a substantial buy ahead iT4. Now in – for proof final iT4 we’re not expecting a substantial pull ahead or any significant pull ahead, and primarily driven by – additional production would be additional features and so on that come with the new machines that the customers actually like.

And but the increase and importance of information customers are appreciating the information, and what they are getting from that is more precisely planting it in a certain period of time, okay, or harvesting it within a narrower period of time so they can actually save on drying costs and so on. So the features are driving depressions more than the emissions cost itself, and to the extent we are able to build the value in these products, which we are – which we think we will be able to more than offset the cost increase from emissions and emission slated parts. The customer should actually – we should not see a significant pull ahead.

Now if you look at smaller ag equipment this is very true – what I said just now is true for large ag equipment. When you get the small ag equipment we are likely to see some pull ahead. When you talk about construction equipment, which is more 2015, you’re likely to see and we did see going to iT4 some pull ahead construction equipment in November and December 2011. We are likely to see that, not at the end of this calendar year, but next calendar year.

Alex Blanton – Clear Harbor Asset Management

It’s Alex Blanton, Clear Harbor Asset Management. Most of the slides in your handout have to do with farm, but you do have a Construction Equipment business as you mentioned, and that has expanded geographically recently from North America I think to Brazil. Is that correct?

Rajesh Kalathur

Correct. So primarily next place, primary additional investments are in Brazil, about a $50 million investment in China.

Alex Blanton – Clear Harbor Asset Management

Okay. So the question is this, do you intend to continue that expansion of construction equipment to other parts of the

world. That’s a new strategy on the part of the company. And second part of that is, housing is still relatively weak although recovering. Your equipment has traditionally been housing and light infrastructure related. So how much opportunity is there in the North American market for further improvement there? It seems to me there would be a lot.

Rajesh Kalathur

Yeah. So we would say we are – so today our primary business is in North America. Probably about 15% or 20% of our business is Forestry equipment. And out of that 15% to 20%, 60% of the Forestry is outside North America, that’s what’s driving it.

Alex Blanton – Clear Harbor Asset Management

So how much outside North America?

Tony Huegel

60, 60.

Rajesh Kalathur

Six zero. Yeah so about 80% to 85% of our Construction Forestry business is Construction equipment. A substantial portion of that is in North America today. Our expansion plans for Construction equipment our primary focus is in Brazil jointly with our joint venture partner Hitachi. They’re investing about $180 million in two facilities. One that will manufacture excavators and the second that will manufacture backhoe loaders.

So that’s the primary investment for in Construction equipment beyond North America. The next piece of investment we have is in China. And in China our intent is more to learn to compete with the competitors that are going to come from China longer term, not necessarily to be participate in a Chinese construction equipment market in a significant way. So we participate there, we learn to design products at a value spec, we get compete more capably in the Brazil and Argentinas and in the North Americas longer term than some of those value spec products come from these markets.

Okay so we will compete in China but our reason for investment in China has a second dimension which is probably even more important which is going to compete in the value specs space. So those are the two significant ones for us in terms of investments in Construction equipment, I would say North America. Okay?

Alex Blanton – Clear Harbor Asset Management

When you say value piece you’re talking a lower price point?

Rajesh Kalathur

Yeah. These are, you know if you take a normal loader these are about 40% lower price point than a similar loader in the North American market.

Alex Blanton – Clear Harbor Asset Management

So you’re in China to learn how to compete with the Chinese when they come into Brazil and North America?

Rajesh Kalathur

So partly we want to be able to design those value spec products in China, compete but it’s more of a defensive strategy, more than just an offensive strategy.

Alex Blanton – Clear Harbor Asset Management

Got it. Thank you.

Unidentified Analyst

Can you discuss the replacement cycle for ag equipment? You’ve had a good number of, a run of a good number of years. How long does this equipment stay in the field before the farmer decides he wants a new one? How do you generate additional demand from your current customer base?

Rajesh Kalathur

It’s a very good question that we ask ourselves and we go look for data on it. Now this question precipitates on a combine site first. Combines is one that a farmer can choose to postpone the purchase of, and one of the things we have seen is we looked at the data in the U.S. for combines to see how new the overall fleet is. Five years back combine fleet 15% of the – actually 12% of the combine fleet five years back was five years or younger.

So last year we did the same thing and it’s actually 15% of the combine fleet is five years or younger. So two more percent of the fleets become new but the fleet is still not very new completely, only 15% of the fleet is new. So what drives the purchase, the question is the business reasons for the farmer of wanting to buy a new combine for additional productivity, for the improved reliability he or she might get and wanting to use the warranty period of one year in a more effective way. So those are business drivers as to why they buy a combine more often than they did in the past.

The information that they’re getting right now from these combines and from the sensors we have in all technology we’ve added, sort like nora system almost picking up yields and picking up different types of margin levels or even – they are actually showing – as they get more data, they’re understanding that yeah, Monsanto might say that you can extend the planting period to more weeks, but they are seeing even within that period now there’s a shorter time period if you plant, you can get a much higher yield.

Yields can go up 5% to 15%. So the value of the additional yield by going to newer equipment that can you know, you can have higher productivities. So you can plant in a narrower time window. That value is higher than the incremental cost they’ll have to pay for the combine itself. So what we feel is likely to happen is if the farmers can boost their divisions purely on business reasons and costs not cash flow constraints they will choose to operate where they have more recently and they have more room to do that. But if they are cash constrained that is when we think they will start postponing the purchases of some of their equipment. Because you can always have the fact, you know your combine work for another year. You can always get another year out of a combine or a large tractor.

Unidentified Analyst

Well do you think they cash constraint at this point in time?

Rajesh Kalathur

So right now the farmer buying seeds on the best levels ever. They’re more robust levels than ever and we don’t see that changing very fast given the improvements we have of broader demand for these commodities on a worldwide basis. We’ll see consistent growth in the broader demand for these commodities on a worldwide basis driven by the diet improvements in Asia and Sub-Saharan Africa, that’s one. So that’s what’s driving it.

Tony Huegel

If you look at Slide 48 of the presentation, you’ll see where cash receipts are better than recent years. And they’ve been at or above record levels for the last several of years.

Unidentified Analyst

And one last question. Book rate to your shipping rate, how is that trending?

Rajesh Kalathur

Book rate?

Unidentified Analyst

Yeah. In other words incoming orders versus what you’re shipping. How’s that trending?

Rajesh Kalathur

So it’s very healthy. I’m going to put it that way. Okay. It’s very healthy. We’ve had a higher capacity and it’s healthy. It’s still pretty healthy.

Unidentified Analyst

Yes, could you just tell us when you look at those two elements, productivity improvement and fuel efficiency, what are those numbers versus equipment maybe five years ago? And are those improvements getting greater because there’s more of a focus on it? Or is it trending along a pretty consistent curve?

Rajesh Kalathur

The improvements again in North America there’s a greater emphasis on productivity improvement on these machines. In Europe there is a higher, slightly higher emphasis on fuel economy and fluid economy. I mean, they’re both practice in both the markets. So and again, we can actually provide you the productivity increases in these machines.

They vary by the type of machine, the type of model. One of the examples we have cited in that I don’t know if it’s in this is most recent largest combine, the latest version has a productivity improvement of almost 30%. It can do 350 acres in a day. So that’s a 30% increase. So now not all of them provide that type of an increase, so they would be between 0% and 30%. Anything else you would add?

Unidentified Analyst

How are you thinking about bonus depreciation when you start – I know it’s a little early but your year end is October, not December so not that far away. The bonus depreciation I know it would end on a calendar year, not your fiscal, but when you think about how bonus depreciation, it’s probably been utilized more by your customers, the ag market in North America than any other lease mobile equipment market if not any captured market given a success of the farmer. How – if I told you that was going away December 31, how would that change your view of the cycle for 2014, 2015?

Rajesh Kalathur

I think it was section 179 is significant benefit to a number of our customers. So if it were going away for next year, we would see people act on it, but we think it’s going to make a difference not as much of a difference on the new equipment, we think it will make a difference on a used equipment market. I mean, it’s applicable to the used equipment as well.

Unidentified Analyst

The section 179 is the bonus depreciation but still...

Rajesh Kalathur

Yes. Section 179...

Unidentified Analyst

Same question...

Rajesh Kalathur

I mean, if you have capital purchases of say $1.9 million you can actually deduct $500,000 of that year one plus on the remainder you get a 50% bonus deprecation. So it’s a substantial benefit postponing some of that. So it’s a huge cash flow benefit to the farmers that they will act on, and we think it’s going to help move the used equipment a lot more than on the new equipment.

Unidentified Analyst

Fair to say you have folks in Washington lobbying to make sure that doesn’t go away? I mean, it is – if section 179 did go down and stay back down to $25,000 or $50,000 and bonus depreciation went away, that’s probably one of the major risks that obviously none of us here can determine what’s going to happen. I mean, I would have told you going into the fiscal cliff that had a decent chance to go away and that was a nice situation that it was extended.

Tony Huegel

What I would say to that point though is, you’re right. Going into the end of the year this year we were – there was expectations that, that was likely going away. And it didn’t. And we certainly weren’t seeing the impact in our order book as we looked at 2013. So that order book didn’t fill out all of a sudden once the fiscal cliff you know was moved forward and, or resolved, or kind of resolved. And all of a sudden bonus appreciation was back. So you know in terms of bonus appreciations certainly beneficial but we would say actually marginally.

If you’re purely making a tax play by the time you know that you need that additional tax deduction it’s too late to get the new equipment from John Deere with the very robust market. On the used equipment side which is to Raj’s point, certainly you get to the end of the year and may not be able to get a new piece of equipment. But I can get a used piece of equipment either from my local dealer or another John Deere dealer. And so it – but indirectly that’s very supportive to new equipment because you’re able to continue to move used equipment through the process.

Unidentified Analyst

So basically the way you figure your forecast you’ll have this in the bonus appreciation as still in place? The Section 179 is still that elevated deduction? Or it just is what it is? It’s an unknown that’s a bit hard to...

Rajesh Kalathur

It’s an unknown.

Unidentified Analyst

Yeah. It is what it is. And you should know the answer but it’s a bit of a risk out there I guess.

Rajesh Kalathur

And like Tony said I think it’s got an indirect benefit on our new equipment but more purpose in the used. It helps alleviate most of our used count. So it is helpful but not that significant where it changes our forecast drastically one way or the other.

Unidentified Analyst

On the point of the used equipment I was recently in a meeting with a large farm equipment dealer in Canada. And they were commenting on this idea that people are buying combines and keeping them one year. He said those are our large corporate type customers.

They buy the combine and keep it one year and next year they buy a new one because they want the highest productivity they can get. And then that combine goes through the dealer organization and gets fixed up and sold as a used equipment to a smaller size farmer who might keep it three or four years and then he brings it back and it goes to a used smaller farmer. But the dealer keeps acting as that middle man and getting a fee and replacement parts all the way through the cycle. Is that the way you see it happening from your point of view?

Rajesh Kalathur

Well so you know an average rotation period of three years for large customers, not one. We have seen that tendency with one year with some large customers but that’s not the average, okay? The average would be three years.

Unidentified Analyst

Three years.

Rajesh Kalathur

So if you look at farmers with farm cash receipts of over $2.5 million they typically think to want to buy new equipment. And a portion of them want to go take that every year. And again in those cases they want the predictability of warranty. You know one year warranty. So they want the predictability of that one year warranty and you know they want – what the dealer does if he knows this is a farmer that’s going to rotate his equipment in the three years the dealer has time now to find out another farmer that’s going to be the buyer of that combine now. So he’s got three years to do that.

Unidentified Analyst

Okay

Rajesh Kalathur

So in a lot of cases the dealers would know who the next buyer of that combine would be because they also know the customers well. They know this customer is, you know he’s got so much, so many acres of land, how many of his own, how many of others this land rented. He knows the type of utilization that a pretty good combine will get. And who is a likely buyer of that combine with X number of hours in three years.

Unidentified Analyst

Okay.

Rajesh Kalathur

So they set that up. Now you have an event like the Section 179 and bonus depreciation and you get more people buying say new equipment than his calculations, he has to start over on some of these additional purchases.

Unidentified Analyst

Okay.

Rajesh Kalathur

Or where you have some of the technologies that we’ve put attract a lot more customers from competition. There the dealers are not prepared for where he’s going to sell the used equipment especially if it’s a competitor make. Usually for John Deere customers that have traditionally been buying Deere, they have a pretty decent plan. It’s what we’ve seen. And again this a net total. We’ve seen it case after case after case but we don’t have a very robust data to say that’s exactly what happened.

Unidentified Analyst

Do you support the consolidation of dealers? Are you actively looking to get larger dealers with more capability to do the kind of thing you’re talking about?

Rajesh Kalathur

So what we have seen as – there is a limit to the size as well, okay? So beyond a certain scale the scale is not as beneficial. But we have clearly seen within that limit larger dealers get higher market shares which is for us. Larger dealers have higher returns for themselves, for their business, and they also have much higher customer satisfaction. So that model has proven to be very appropriate for us and that’s the reason you will see us looking for larger dealers, going towards that larger dealer model, in new geographies, and also in geographies like Europe.

Unidentified Analyst

Okay. When you look at your North American construction sales, what percentage goes into the rental channel? And what are you hearing from some of the major customers at this point?

Rajesh Kalathur

I think about 15% to 20% goes into the rental channel and we resell to the independent rental companies. We also have our dealers have rent-to-own fleets. So we have good data with the independent rental companies and we get a significant share among the independent rental companies. What they’re saying, it’s early on, with the housing starts going up and with general economic mode being slightly better.

Things are looking up a bit earlier in the year for us. That’s end of October, early November, but between then and now, given the fiscal uncertainties, and given the utilization rates are now at a high level, but they’re staying at that high level, they’ve not gone up beyond. So we’ll say, on our rental loan equipment, 65% and up of utilization is high utilization. And they’ve reached, we have seen about 70% there, now we’re at about 69%/70%.

One of the things we have seen is people are now waiting for things to burst at the seams before they will add more equipment and we’ve also noticed that the markets that are good are the Material Handling and Energy sectors.

The Residential and Commercial Construction still hasn’t come in, as you would think, given the increase in the housing start numbers. What we think is happening, what we have learned is happening is, if you have a subdivision it’s more of the vertical additions, like more homes in existing subdivisions. Where you start seeing more of where equipment is when they start horizontal, which is more of new developments, in talking to some of the home builders, looks like that’s going to happen in the future. So second half, we think there’s going to be more of the horizontal construction stuff.

Tony Huegel

And I did just want to clarify that. 15% to 20% is to the independent rental companies... that wouldn’t include the portion that goes

Rajesh Kalathur

Rental companies, yeah.

Unidentified Analyst

And that wouldn’t include the portion that goes into our dealer rent-to-own fleet.

Connor Zeere – ISI

Thank you very much for joining. There will not be another session in here until after lunch. Thank you.

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