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Deere & Company (NYSE:DE)

F3Q10 Earnings Call

August 18, 2010 9:00 a.m. ET

Executives

Marie Zieglar – Vice President Investor Relations

Susan Karlix – Manager, Investor Communications

James Field – Chief Financial Officer

Analysts

Ann Duignan – JP Morgan

Stephen Volkmann – Jefferies & Co.

Jerry Revich – Goldman Sachs

David Raso - ISI

Henry Kirn – UBS

Meredith Taylor – Barclays Capital

Eli Lustgarten – Longbow Securities

Seth Weber – RBC Capital Markets

Joel Tiss – Buckingham Research

Operator

Good morning and welcome to the Deere third quarter earnings conference call. [Operator instructions.] I would now like to turn the call over to Miss Marie Zieglar, vice president, investor relations. Please go ahead.

Marie Zieglar

Good morning. Also on the call today are Jim Field, our chief financial officer as well as Susan Karlix and Justin Marovec from the Deere investor relations staff. This morning we’ll take a closer look at Deere’s third quarter earnings and then spend some time talking about our markets and how we see the last quarter of our fiscal year shaping up. After that, we’ll respond to your questions.

Please note that slides are available to complement the call this morning and can be accessed on our website at www.johndeere.com. First, as usual, a reminder. This call is being broadcast live on the Internet and recorded for future transmission and use by Deere and Thompson Reuters. 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 projections, plans, and objectives for the future that are subject to important risks and uncertainties. Actual results might differ materially from those projected in these forward-looking statements. 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.

The company, except as required by law, undertakes no obligation to update or revise its forward-looking information. The call and accompanying materials are not an offer to sell or a solicitation of offers to buy any of the company’s securities.

This call may also include financial measures that are not in conformance with accounting principles generally accepted in the United States of America, otherwise known as GAAP. Additional information concerning these measures, including reconciliations to comparable GAAP measures, is posted on our website at www.johndeere.com\financial reports under “other financial information.”

Call participants should consider the other information on risks and uncertainties and non-GAAP measures in addition to the information presented on today’s call.

And now, for a closer look at our third quarter, here’s Susan.

Susan Karlix

Thank you Marie. John Deere’s strong performance continued in the third quarter of 2010. Income was up 47%, on a sales increase of 18%. Earnings were the highest for any third quarter in the company’s history, and sales were the second highest.

The gain was led by ag and turf, which had another blockbuster quarter. Construction and forestry had its highest profits in seven quarters, and our credit operations had another solid performance.

The company is being helped by somewhat improved business conditions, but tailwinds are only part of the story. After all, construction markets are still weak by historical standards, and some ag markets, such as Europe and the CIS, remain under pressure.

What our results clearly show is the disciplined execution of our business plan, and our focus on serving customers with advanced products and services. This has allowed us to fully capitalize on the current market conditions.

Now let’s look at the quarter in more detail, starting with slide 3. Net sales and revenues were up 16% to $6.8 billion in the quarter. Net income attributable to Deere & Company was $617 million, and as just mentioned, up 47% compared with the third quarter last year, and our highest ever income for a third quarter.

Turning to slide 4, total worldwide equipment operations net sales were up 18% to $6.2 billion. Currency translation on net sales was flat versus our May forecast for currency to be up about 2 points in the third quarter. Price realization in the quarter was positive by 2 points.

On slide 5, worldwide production tonnage was up 31% in the quarter. The slide illustrates that with one exception, tonnage in each SBU and region, was up in line with the forecast provided a quarter ago. The exception was outside the U.S. and Canada, where tonnage came in lower than anticipated due to continued weakness in Western Europe. For the full year, worldwide production tonnage is now forecast to be up about 14%.

Let’s turn to the company outlook on slide 6. Fourth quarter sales are expected to be up approximately 32% compared with the fourth quarter of 2009. Currency translation on net sales is expected to be negative by about 1 point. Net income attributable to Deere & Company is forecast to be approximately $375 million in the fourth quarter.

For the full year, net equipment sales are forecast to be up about 12% compared with fiscal year 2009. This includes about 2 points of positive currency translation and approximately 2 points of positive price realization.

Turning to a review of our individual businesses, let’s start with agriculture and turf on slide 7. Production tonnage was up 24% in the quarter, on a 12% increase in sales. Operating profits, however, jumped by nearly $345 million, or 72%, to $824 million.

The increase was primarily due to higher shipment and production volumes and improved price realization, partially offset by higher post-retirement benefit costs. As you can see, margins were impressive. The division had an operating margin of approximately 16% in the quarter, and an incremental margin of about 61%.

Before we review the sales outlook, let’s look at some of the fundamentals affecting the ag business, starting on slide 8. On the heels of the recent commodity price increases, the outlook for most crop prices is up considerably for the 2010-11 crop year.

Corn prices are being helped by increasing global demand, and have moved in sympathy with the core grain crops in many areas of the world. We project that 2009-10 stock in the U.S. and Canada will end 250 million bushels below a year ago, and fall another 150 million bushels in the coming year.

Soybean exports have remained strong. Growing global consumption is expected to keep soybean prices at extremely favorable levels for the 10-11 crop. Global wheat stocks have tightened, with lower winter wheat planting as well as yield losses in Western Europe and to an even greater extent in the CIS. 2010-11 cotton prices remain well above the 08-09 levels, driven by the recovery in global demand and a reduction in the global cotton supply.

Turning to slide 9, 2010 U.S. farm cash receipts are now forecast to be up about 6% from 2009, to about $317 billion. That’s about $4 billion higher than our last forecast, and is driven by increased crop receipts. 2011 farm cash receipts are forecast to be slightly above the 2010 level.

Deere’s outlook for the EU27 is shown on slide 10. The recent upward movement in grain prices might seem at odds with our rather subdued 2010 industry sales outlook for Western Europe. No doubt, some customers are locking in crop sales at attractive prices, which should provide support for 2011.

That said, industry sales of new goods have been weak this year, particularly in combines. While European farmer sentiment is slowly improving, the dairy and livestock sector is still reeling from the losses of prior years. Drought has hurt yields for customers in many areas, and used equipment inventories remain at high levels.

Slide 11 illustrates the extreme heat and drought conditions in Russia and Eastern Europe. These conditions have sparked wildfires and the picture on the right depicts some of the smoke from those fires, visible from our Domodedovo facility outside Moscow.

Last week, the USDA estimated that 2010-11 FSU12 wheat production would be down about 23%. Some industry observers believe the losses could go even higher. Although Russia is reporting success controlling the fires, the consequence of the severe drought, and its impact on global grain markets, won’t be fully known for some time.

Farm net income in Brazil and Argentina is on slide 12. We continue to see good farm income from soybeans and sugarcane, the two crops that drive the bulk of equipment purchases in Brazil. Other positive factors include strong global demand for Brazilian commodities, a 5% to 10% decrease in input costs, and strong government-sponsored low rate finance programs that run through at least the end of calendar year 2010. These all contribute to positive producer attitudes, which translate into higher spending on farm equipment.

We have increased our forecast for 2010 farm net income in Argentina. With milk and beef prices high, we continue to see increased demand for tractors, combines, sprayers, and forage equipment. Although too early to predict, we are closely monitoring the development of a La Nina weather pattern that could result in lower production and yields in 2011.

Slide 13 highlights the latest additions to our tractor lineup in India. In June we introduced the 5036C and 5041C tractor models. These tractors were designed and developed in India with features tailored to the India market. These 25 and 41 horse power tractors join the recently introduced 5038D, expanding our presence in the targeted 31-40 horse power market. This horse power segment makes up almost 50% of the tractor industry in India.

Our 2010 industry outlooks are on slide 14. Sales of agricultural equipment in the U.S. and Canada are forecast to be up 5% to 10%. We continue to see strength in our order books, and have early order programs in place for our seasonal equipment. Although very early, the combine early order program is progressing well, and as planned.

In absolute numbers, orders are well ahead of last year. In the sprayer, planter, and tillage equipment programs we are seeing strong results, very similar to last year. Demand for large tractors has been strong as well. The 8R series tractor introduced last year has been very well received, and we have continued to [add schedules] throughout the year.

We are just now introducing the Interim Tier 4 compliant 8R to our dealers, and are encouraged by the initial orders of over 1,000 units. Well over half are retail sold, with customer names on the order. Effective availability for 8R series tractors is February 2011. Effective availability for our 4-wheel drive tractors is November 2010.

Earlier, we touched on the conditions in Western Europe. While fundamentals are promising as we enter 2011, current market conditions are weak, and we are therefore lowering our industry forecast. We now expect ag sales to be down 15% to 20% in the year. Sales in Central Europe and the CIS are expected to remain under pressure, and based on the factors we covered earlier, we are increasing our industry forecast for South America to up 25% to 30%.

Turning to another product category, we expect retail sales of turf and utility equipment in the U.S. and Canada to be up 10% to 15% in 2010 from the very low levels of a year ago. We have seen an uptick in the commercial mowing, riding lawn equipment, and golf markets. However, with general economic conditions still uncertain, our optimism for this segment remains tempered with caution.

Putting this all together, on slide 15, Deere sales for worldwide ag and turf are now projected to be up about 8% in the year. Currency translation on net sales is projected to be positive, about 2 points. For the year, the A&T division’s operating margin is forecast to be around 13%. The division continues to benefit from strong sales of large ag equipment in the United States and Canada, with relatively weak sales in the turf and utility segment.

In May’s call, we said favorable mix added 1 point of margin to ag and turf second quarter results. Now, with our new forecast, for the full year this favorable mix is expected to add about 2 points to the division’s margin in relation to its typical year.

Let’s focus now on construction and forestry on slide 16. Deere’s net sales were up 59% in the quarter, while production tonnage nearly doubled, being up 96%. The division reported operating profit of $66 million.

On slide 17, although we are forecasting the U.S. construction industry to be down about 2% for the full year, we believe the market has reached its bottom. The business is experiencing a slow improvement. We are encouraged by the activity we have seen with independent rental companies and in the highway construction segment.

Also encouraging, Deere dealers continue to see an improvement in rental utilization and used equipment turns. Still, we remain cautious. Uncertainty over the economic recovery persists, and we have lowered our outlook for 2011 housing starts.

Meanwhile, global forestry markets are up significantly from the very low levels of last year, and our factories have responded quickly to the increased demand. We are now forecasting construction forestry sales to dealers to be up about 35% in 2010, from the very levels of 2009. The division’s full year operating margin is forecast to be in the low single digits.

Let’s move now to our credit operations. Slide 18 shows the worldwide credit operations provision for credit losses as a percent of the total average owned portfolio. Year to date, on an annualized basis, the provision is 49 basis points. Write-offs in the construction and forestry portfolios continue to improve. Recovery rates are improving steadily. We are seeing fewer repossessions and increased pricing on the repossessions that are occurring, up 9% to 10% since last fall. The full year provision for John Deere credit is forecast to run around 55 basis points, an improvement over our prior forecast of about 71 basis points.

On slide 19, past dues for the worldwide credit operations are lower than last year, with construction and forestry being the main driver of improvement. Annualized write-offs reflect a significant improvement in C&F losses.

Moving to slide 20, worldwide credit operations net income attributable to Deere & Company was $95 million in the quarter, versus $99 million for last year. The biggest factors were an improvement in financing [spreads] and a lower provision for credit losses. These were partially offset by lower tax credits related to wind energy projects. Looking ahead, we are now projecting worldwide credit operations net income attributable to Deere & Company of about $325 million in 2010.

Now let’s turn our focus back to the equipment operations, and take a look at receivables and inventories on slide 21. For the company as a whole, receivables and inventories were up roughly $450 million in the third quarter versus third quarter 2009. Keep in mind we ended fiscal 2009 with receivables and inventories at rock bottom levels. In fact, they were $1.3 billion lower than at the end of fiscal 2008.

For fiscal year 2010, we are now forecasting receivables and inventories to be up about $950 million. This reflects higher production volumes in the fourth quarter versus the very low volumes in the fourth quarter last year. These higher production volumes are intended in part to facilitate the transition to Interim Tier 4. It also reflects higher demand in our construction and forestry divisions and some ag and turf markets.

Now let’s discuss the latest on retail sales. Slide 22 presents the product category detail in the U.S. and Canada for the month of July, expressed in units. Utility tractor industry sales were up 3%. Deere sales were up double digits. Row crop industry tractor sales were down 10%. Deere was down in line with the industry. Four wheel drive industry sales were down 2%. Deere was down double digits. Combine industry sales were down 7%, and Deere was down slightly less than the industry. Looking at Deere dealer inventories in the bottom chart, for row crop tractors Deere ended July with inventories at 18% of trailing 12-month sales. Combine inventories were at 19% of sales.

Turning to slide 23, in Western Europe sales of John Deere tractors were up double digits, and combines were down double digits in July. Deere’s retail sales of selected turf and utility equipment in the U.S. and Canada were up a single digit in the month. Construction and forestry sales in the U.S. and Canada, on both a [first in the dirt] and settlement basis were up double digits for the month.

Slide 24 shows raw material and logistics costs up about $10 million in the quarter. We now forecast material cost decreases of approximately $150 million for the year. By division, the ag and turf savings are forecast at about $175 million. For construction and forestry, we continue to forecast a material cost increase of about $25 million. This is due to the currency impact on partner products and higher steel prices.

While this forecast is an improvement over last quarter, remember that prices for many commodities have been moving up recently, and our cost increases typically lag the commodity markets by three to six months.

Now let’s look at a few housekeeping items. Looking at R&D expense on slide 25, R&D was up about 5% in the third quarter, with currency translation accounting for negative approximately 2 points. Year to date, R&D expense is up about 6%. For the full year, R&D expense is expected to be up about 10%. We expect R&D spending to increase in the fourth quarter, as we approach significant product launches with Interim Tier 4 engines and remain at high levels over the next three years as we approach the final Tier 4 emissions standards.

Moving now to slide 26. Pension and OPEB expense in the third quarter was up about $100 million. The 2010 forecast calls for an increase of about $350 million in pension and OPEB expense, unchanged from our previous forecast.

We have had a slight change in the split between cost of sales and SA&G. Of the $350 million, about $275 million will hit cost of sales, with about $75 million now in SA&G. Approximately $275 million of the additional expense is attributable to the ag and turf division, while the increase for C&F is about $75 million.

On slide 27, SA&G expense for the equipment operations was up about 17% in the quarter. Variable incentive compensation accounted for about 8 points, and currency translation added about 3 points. For fiscal 2010, we project SA&G to be up about 9 points, unchanged from our previous forecast. Variable incentive compensation is expected to account for about 5 points of the change, as the company’s performance has continued to improve. Pension and OPEB accounts for about 2 points, and currency translation about 1 point.

Moving to the income tax rate, on slide 28, the third quarter effective tax rate for the equipment operations was about 34%. The full year 2010 effective tax rate is expected to be about 40%. That includes the tax expense of about $130 million related to U.S. health care legislation recognized in the second quarter. Excluding the charge, the forecasted effective tax rate for 2010 would be about 34%.

Before touching on cash flow, the combined effect of translation and transaction, or [unintelligible], increased operating profit by about $60 million in the third quarter, primarily in ag and turf. On slide 29 you see the strong cash flow from our equipment operations, even in years of tough market conditions like last year. This reflects in large part our success managing assets and controlling working capital levels.

We anticipate cash flow from equipment operations of about $2.4 billion for the year, a $1 billion increase over 2009. Such strong cash flow is further testament to our successful execution of the [FCA] model. As you can see on slide 30, in accordance with our stated use of cash priorities, we resumed share repurchase in the quarter, buying back some 1.7 million shares. As we generate good cash flow, share repurchases will continue to be an avenue we consider when assessing our use of cash.

Turning to slide 31, capital expenditures are expected to be about $850 million for the year, primarily driven by the Interim Tier 4 emissions rules. Depreciation and amortization is projected to be about $550 million. Our forecast currently includes about $700 million of pension and OPEB contributions in the year.

In closing, John Deere enters the last quarter of 2010 on a strong pace. Our performance reflects somewhat more positive economic conditions and strong demand for large farm machinery, particularly in the United States. At the same time, John Deere remains focused on serving a growing global customer base, steadily increasing capacity, adding productive new models of equipment, and successfully extending our competitive positions throughout the world.

As a result, we believe the company is exceptionally well positioned to benefit from a growing economy and to help meet the world’s increasing need for food, feed, fuel, shelter, and infrastructure, well into the future.

Marie?

Marie Zieglar

Thank you Susan. We are now ready to begin the Q&A portion of this call. The operator will instruct us on the polling procedure. As a reminder, and in consideration of others, please limit yourself to two questions, and as always you are welcome to get back into the queue. Operator?

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Ann Duignan.

Ann Duignan – JP Morgan

My first question is on the near term, your fourth quarter outlook, particularly on the ag and turf side. You noted that margins would be about 13%. That would imply much lower margin in Q4 than I had been forecasting, and much lower than Q3. Marie, I think you guys addressed it in the call, but I just wanted to make sure. Are you anticipating a significant hit on gross margin because of the buildup pre-Tier 4 Interim engines? Is that what maybe I was missing in my forecast?

Marie Zieglar

Not directly. In fact, instead of just addressing ag and turf, let me look at it for the full company, in relation to our full guidance, and just give you some of the numbers that are implicit in our guidance.

With the increased profitability for the company, incentive compensation is rising, and in the fourth quarter, over last year, it will be about a $90 million expense. Again, very low levels of activity in the fourth quarter last year.

Materials, which has been either a neutral or a tailwind for us in the first three quarters of this year, will be an expense and our projection is $75 million. R&D, we have a pretty significant jump. That’s why Susan called out the fact that year to date we’re up 6%. For the forecast we’re up 10%. That’s about $55 million in the fourth quarter.

That is a lot of money and that is very much impacted by IT4 as we’re getting ready to enter into this very significant launch phase and remember, we’ve got final Tier 4 following on the heels in just, like, 3 years.

Another factor is overhead absorption, and we estimate that at about $50 million. And I shouldn’t say overhead absorption, it’s overhead expense. We have a very significant spend in R&D. Likewise, we have a very significant spend in capital expenditures ahead of us in the fourth quarter, and that is disruptive to the factory efficiency as you bring new machine tooling in, as you train operators, and so we’ve provisioned for that in our outlook.

And then the only other thing of note would be SA&G is a little higher as well.

Ann Duignan

Okay, that’s very helpful. I just wasn’t sure where – what I was missing there. And then longer term, I know you won’t talk specifically about your outlook for 2011. I know better than to ask directly. But could you talk a little bit about the overall global impact? With a negative impact in Russia because of the drought, what that might do to the protein sector in Europe and their input costs, versus the positive impact it may have for U.S. farmers and South American farmers, how are you looking at putting all of these pieces together as you look into 2011 and the health of global agriculture as we step forward?

Marie Zieglar

There’s no question that the recent run in commodity prices driven by the events in the CIS and even into Eastern Europe certainly has supported the prospect for crop farmer incomes. You correctly note that the livestock sector is a little more concerned, obviously, with what’s happened, especially just having come out of two years of very very difficult financial situations. It is not as likely, therefore, you will have much crop – much herd expansion globally in the face of these rising feed costs. But overall, for the farm sector it would appear to be very positive as you look into 2011. Some of the other factors, though, that we are considering as we ourselves look into the future, obviously, with the events of the last couple of weeks regarding the global economy, which seems to vary day by day, people are perhaps a little less certain than they were. And that does raise a note of caution, especially a lot of talk about the U.S. economy which would effect, certainly, our construction equipment business and our turf and utility and frankly even the small ag sector, because a lot of that is economically sensitive, because it goes into homeowners and large property owners, etc.

The other thing that you’d want to think about is rising commodity costs affecting our materials as we go into 2011. I mentioned in the first question that I was answering of yours that we had had a tailwind or neutral in the first three quarters of the year. That’s worth about $250 million. If raw material costs just stay where they are today, obviously that’s something that would not be repeated.

And the other thing I would just note is that we are going to be in the midst of this IT4 transition. We are very encouraged by the early results on it. We’ve got some good orders, as Susan mentioned, on the 8000s, but it’s very early, so you’re really looking at a very small base. So we’ll see how that plays out as we look ahead. Jim do you want to add anything?

James Field

No, I think that pretty much covers it.

Ann Duignan

How about pension? That’s the one thing you didn’t touch on for going into 2011.

Marie Zieglar

Pension looks, today – and of course all things are never equal – we probably, because interest rates are looking a little lower than they were 31 October of 2009, you probably have a little bit of a headwind there as well, maybe $75 million. But obviously we’re a long way from 31 October, when we’ll actually be setting the rates.

Operator

Our next question comes from Stephen Volkmann.

Stephen Volkmann – Jefferies & Co.

I’m wondering, Marie you gave some forecast for cash received in the U.S. and net income in Latin America. Can you just frame for us how you think European farmers are going to be looking in 2011?

Marie Zieglar

It’s early, but people are pretty encouraged by the improvement in commodity prices. You’re hearing some stories of customers having locked in some good crop prices and selling their crops for good amounts of money. So we’re encouraged. We still have used equipment to deal with, which is unknown exactly how that will impact the market as you move into 2011. We’re starting to see a little bit of that equipment move. Again, that’s very encouraging. But there’s a lot yet to be done.

Stephen Volkmann

Sounds like you’re saying farm income probably up in 2011 in Europe? I don’t want to put words in your mouth, but –

Marie Zieglar

That will play off against what happens ultimately with livestock prices and what happens to their feed costs, and livestock is about – half the farmers in Europe have livestock, so it’s significant to our customers.

Stephen Volkmann

And just a follow up on the construction business. Obviously we’ve seen a nice recovery there in top line and in margins. How much of that is dealer restocking and do you think that – where are we in that game and how much longer can that go?

Marie Zieglar

There’s actually not very much dealer restocking taking place. Mostly what’s happening – last year when the dealer sold maybe three units, he or she would replace one. Now it’s more one for one replacement, so very little channel sale. Jim?

James Field

I think construction, if we look at history, it has a very long runway in front of it, because we are still at very depressed levels relative to mid-cycle volumes. So I think we have a situation where we’re running roughly 60% of mid-cycle volume. So we think there’s plenty of runway there.

Operator

Our next question comes from Jerry Revich.

Jerry Revich – Goldman Sachs

Marie, can you say more about the drivers of your increased inventory and receivables guidance for ag and turf? What proportion of the increase is related to Interim Tier 4 and which regions are driving the rest of the increase?

Marie Zieglar

First of all, we’re seeing strength in our construction and forestry business, so that is certainly a part of it. The other factor is just as we’re getting closer to the first of January we’re starting to land on some of our plans, so we know a little bit more precisely how some of the transitions are going to occur. And also very candidly, demand is looking pretty good. It’s very early, you’re looking at small numbers, so I want to be very careful, put this in the appropriate context, but the demand for the product’s early order program seem to be going fairly well. Again, early. So that’s encouraged us. If you look at our tonnage increases for the full year, and the fact that our third quarter tonnage basically came in as projected, that tells you all of that increase is really happening in the fourth quarter, so it will take time for that production to actually translate into a retail sell, because you’ve got to work it through the factory and through the receivable. So we actually feel pretty good. Actually, Jim took a look at our receivables and inventories by historic standards and they look really quite good. Do you want to talk to that?

James Field

It’s a big increase when you look at it, or perhaps could be viewed as a big increase, when you look at it on a year over year basis. But if you look back on a historical context, really this is receivables returning to levels that we last saw in ’08 and inventory actually that ends at levels that are below the ’08 level. So I think that hopefully provides some useful context when looking at that increase.

Jerry Revich

Absolutely. Thanks for that. And Jim, good to see you buying back stock for the first time in a while this quarter. Can you update us on your framework for stock buyback? Are you going to be looking at it as a portion of your excess free cash flow, or just update us on your broader framework. That would be great.

James Field

I appreciate that. Unfortunately I think we can’t say a whole lot beyond the notion that we’ve had a very consistently articulated use of cash policy and share repurchase is one of the things we will look at from time to time based on our cash position and we did so in the third quarter. I can’t provide much more than that at this time.

Operator

Our next question comes from David Raso.

David Raso - ISI

My question relates to that last comment about the production in the fourth quarter and it will take some time to translate into retail sales. And just trying to think about the margin in the ag division. Two questions related to that then are, at what time in the order book can I no longer get a pre-Interim Tier 4 tractor, out of Waterloo? Are we already into the market knowing when we officially are out of production slots for pre-Interim Tier 4?

Marie Zieglar

Remember, we have a rolling product launch, so all that’s been announced so far would be the 8Rs and if you would walk into your John Deere dealer today, to order an 8R tractor, you would be ordering an Interim Tier 4 tractor.

David Raso

My question, though, is the broader Waterloo product line.

Marie Zieglar

We have not made any further statements other than the 8R.

David Raso

Should it be terribly different than the 8R?

Marie Zieglar

We haven’t launched – so it’s going to be a little while you could assume because we haven’t said anything about some of the other products out of Waterloo.

David Raso

Okay. I’m just trying to think through the profitability of ag and turf in the fourth quarter and what’s that implying about ’11, because even if I do add back some of those year over year impacts from short term incentive comp up, materials, overhead absorption, and so forth, but also take the sales guidance for the year, it just seems like the implied incremental margins in the fourth quarter are interesting low. I’m just trying to think about the puts and takes. I guess broader picture, then, for the whole company, the construction margins for the fourth quarter, again, look around mid-single digits. To get you to the lower single digit for the year. How are you thinking about the profitability of that division? You took down the ’11 housing starts, though you’re still implying some pretty healthy growth in housing starts, ’11 versus ’10. Bigger picture, how are you thinking about the construction division profitability off this recent mid-single digit level?

Marie Zieglar

In the fourth quarter specifically?

David Raso

Well, you already kind of did the fourth quarter, where you’re implying high six percent.

Marie Zieglar

David, I’m sorry I don’t have any comments on 2011 if that’s where you’re going.

David Raso

Well, broader picture, how should I be thinking about the 5% to 6% we’ve been seeing third quarter, fourth quarter? How are you viewing that in the context of the profitability of the division broadly?

Marie Zieglar

Well, considering that they’re at under 60% of what a typical volume would be, we think they are working very hard and have demonstrated very good expense control and efficiency. As they move up into what I will call the sweet spot, which would be in the 80% range and above, their opportunities will grow for profitability.

James Field

I think too when you look at that and you had some large percentage increases in sales, but if you look at the absolute dollar numbers and the incremental margin that that would be expected to throw off, and then you overlay what’s going on with pension and OPEB, I think you get a long way to understanding the performance that that division has demonstrated and I think the other thing we would say, long term, the construction division has demonstrated over a long term what they can do and we would have every expectation that over time they would return to where they’ve been at other points in the cycle.

David Raso

In a nutshell, that run you had from 2004 to 2007 in that division with solid double digit margins, I’m just trying to think through how quickly do you feel, if we can get the revenue growth in ’11, is this structurally a double digit margin business in pretty short order? Or is how you’re thinking about mix for ’11 and a lot of other things? Is that a little too aggressive a ramp in how you’re seeing the recent run rate?

Marie Zieglar

First of all, I can’t comment on 2011, but I would very adamantly, very vehemently, state that we see no reason at all why this business does not return to margins that it delivered in that period of time, and if you’ll recall their peak margin in that business was 14% and they actually are aspiring to a 14.5% margin. Like the ag business, in the near term IT4 will affect them as well. They also have a staggered product launch that will be rolling out over the next couple of years, and so you’ll have some impacts from that. But this business is on very solid footing.

Operator

Our next question comes from Henry Kirn.

Henry Kirn – UBS

Could you chat a little bit about the impact of the pre-buy that your dealers may be reporting to you, at least on the equipment where you do, where you will have Tier 4 out early next year?

Marie Zieglar

You know, as you look at what’s happening there’s the very good level of cash receipts that we have in the marketplace, and it’s accentuated further, frankly, by the recent run in commodity prices. You’ve got improved farm net income as expenses like fertilizer and various things have come in. You’ve got historically low interest rates, very good value proposition in the market. We feel that the underlying economic fundamentals are in good support of the level of activity that we’ve seen. As we are moving closer to our launch date, there’s no question that there is some pull-ahead, but we believe the factors that I just mentioned do, really are, the primary decision drivers. The other thing that you can – again it’s very small numbers, but it could provide some comfort, if you will – is the fact that the early order positions are looking good on some of our products, and especially, perhaps more profoundly, that the IT4 8R has a good order bank. Again, very early in the year and very early in the launch. But it’s actually been very encouraging.

Henry Kirn

And on the construction equipment side, philosophically would you be willing to build some inventories at some point in front of expected rebound in demand from the rental guys and other contractors?

Marie Zieglar

Our philosophy is to produce to retail demand, and construction actually is a slightly different set of circumstances. As you’re aware, in construction in some areas you are required to use the latest technology, so you need to be at – if IT4 engines are available you need to be using that. Additionally, the bulk of the construction product line really is below 175 horse power, so that’s not going to be affected until 2012. And the other thing is, very frankly, we’re at extremely low levels of activity, and you don’t see contractors, a lot of contractors, with the financial confidence to go out and buy equipment that they may or may not use. The only indications where you may have a little bit of pre-buy ahead is in motor graders and some governmental segments, but that’s pretty small.

Operator

Our next question comes from Meredith Taylor.

Meredith Taylor – Barclays Capital

I’m going to go back to the ag and turf margin topic. I appreciate the fact that you’ve laid out a lot of the headwinds that you’re looking at fourth quarter versus third quarter. Something that I’m hoping you can talk a little bit more about though is the role that mix and productivity played in the third quarter for this business, and what your expectations are as we look ahead to the fourth quarter? I know you did note some overhead headwinds associated with Interim Tier 4, but if you could just talk about those two items in particular, third quarter versus fourth quarter, that would be helpful.

Marie Zieglar

Absolutely. In the third quarter we did not make comments specifically year over year on mix. Susan’s comments about the 2 points overall for the year really relates to a typical year, so we’re not looking at something that – because remember we had a very good mix of large ag in 2009 as well. So wouldn’t really be year over year a factor. If you looked at the third quarter and said just generally how does the back compare to a “typical year” then yes it would be about 2 points. If you look at absorption, last year in the third quarter we dropped receivables and inventory to I think it’s like $1.7 billion, and this year it was $300 million to $400 million, so there is a favorable absorption impact in our third quarter results, and that is, for the ag and turf division it’s about $90 million in their operating margin.

Meredith Taylor

And then as we roll forward to fourth quarter, how should we think about mix there, and then continued benefits from lean operational initiatives, etc.?

Marie Zieglar

I don’t have comment per se on mix. I know some of the smaller stuff is coming up in the quarter, but I don’t know what the actual impact is.

James Field

And actually in terms of the efficiency of the operation, as Marie said we have a lot of transition going on, and we do have some manufacturing inefficiencies built into the forecast for the fourth quarter reflecting the very significant amount of change that’s going to be occurring over this period of time, and some pretty significant capital [inaudible].

Meredith Taylor

Okay. And just a quick follow up on [unintelligible]. As I’ve looked at the [unintelligible] data over the last couple of months on the combine side of the market, I’ve noticed some volatility in terms of your wholesale numbers. Could you talk a little bit about what might be driving this?

Marie Zieglar

Yes, on the combine side, we converted to SAP on the first of May, and so we knew that we would not have shipments into the marketplace as we were making that transition. And so what you’re really seeing is we’re in a transitional period. Those transition issues are behind us but you’re seeing the result of having just now restarting the shipping. So it was planned.

Operator

Our next question comes from Eli Lustgarten.

Eli Lustgarten – Longbow Securities

It’s funny, we’re all having trouble with the fourth quarter, and maybe we put it into context that we haven’t gotten the first three quarters anywhere close anyway. You listed $270 million worth of impact, but a large part of those things that you gave us, materials, R&D, and that, were known to be bigger in the fourth quarter. Anyway, we’ve known that, so are any of them much bigger than we had expected? Because you still can’t get the margins, almost cutting in half, unless you put in either a huge impact from the transition products, and the launches, what have you, putting into the guidance at this point. That’s the trouble we’re all having at this point. Something is going on. Did you put more in the quarter in these costs than we expected? Because we knew they were all going up in the fourth quarter. R&D was going to be higher in the fourth quarter. We knew that from your guidance before, as were material costs. Something has to be driving the margin almost in half, which is what you’re forecasting from the third quarter, and the only think I can think of – you know you have more ag and turf – the only think I can think of is you’ve got a lot of inefficiency in from the new product launches [unintelligible].

Marie Zieglar

That’s kind of what we’re trying to pick up with that $50 million overhead, if you will. The incentive comp, probably, is higher than what maybe you were expecting because of course we’ve upped our guidance for income in total, so that might also be at work here. There’s also a little bit of inventory build. That of course, that doesn’t convert immediately into sales and so you don’t get the marketing margin on that. There may be a little bit of that as you guys are thinking about your modeling. Jim do you have anything to add?

James Field

No. You know, I think the incentive comp is certainly increased over what we had initially had laid out in the fourth quarter as the income forecast has proved most of that has gotten caught up.

Marie Zieglar

You know, the other thing that I haven’t mentioned is taxes and taxes in the quarter that might – are about $50 million. It’s very hard to calculate these tax rates between the fourth quarter of last year and the fourth quarter of this year. So I’ll just tell you point blank that’s approximately the net impact. It’s higher taxes, about 50. If that helps.

Eli Lustgarten

Can we ask one other question on – looking at 2011 production capability and pricing, we – you have – pricing has been announced and the new product has been relatively strong. So we’re looking into next year pricing going up to what you have announced and the [unintelligible] that we’re going to see more. How much more production capability will you have for a lot of these models? Because for the most part we’re told that you sold out for this year in most of the big product lines. How much more production capacity will you have next year, and is this pre-buy that we’re talking about actually going to be a rolling pre-buy in this market because Interim Tier 4 gets phased in over a couple of years and the prices clearly are going up materially as the product goes on.

Marie Zieglar

It is true that we have a rolling launch. Again, we’re not sure how much pre-buy there is occurring, because the economic factors seem to support the level of activity that we are experiencing and you’ve got good orders falling into 2011. But you are correct that it will be a series of rolling launches, both on the ag and construction side. If that helps – Waterloo had not put in all of the capacity that had been approved in 2008. They put in – I don’t know if you’ll recall but it was about a 40% increase and they had about 25 points of the 40 in and I expect that the remaining 15 will be available, I don’t know if by the end of this year but sometime in the not too distant future. So that will provide some additional assistance. Harvester had a 30% capacity increase that was in place really by – really would have been fully available to us this year. And so that’s there and ready to be used as required. And then there have been capacity adds in other facilities as well.

Eli Lustgarten

So we’re talking about at Waterloo probably another 10% to 15% incremental production available next year that we didn’t have this year?

Marie Zieglar

Well, 40 points. Yeah that’s – maybe 10. Mmm hmm.

Operator

Our next question comes from Seth Weber.

Seth Weber – RBC Capital Markets

Sorry if I missed this, but could you on the production tonnage adjustment – so your third quarter outside North America was below forecast, but then you raised your forecast for the full year. Can you just talk about where that’s coming from?

Marie Zieglar

Europe would have been the primary driver for the decline in the third quarter, reflecting a little softer conditions. The market in Brazil is very strong, and in South America I guess I should say, and so you would have some opportunity there.

Seth Weber

Okay, so you’re thinking the fourth quarter, Latin America would have been stronger than you would have thought last quarter.

Marie Zieglar

Yes, and I’m not sure how Europe plays out in this. You’re not talking huge numbers.

James Field

I think the change is 23% to 24%, so it’s really in the margin in terms of the full year, so – and the other piece, of course, that’s been very strong, and we mentioned it a little bit, is the global forestry markets, and so there would be some production being added there as well.

Seth Weber

And then just, I think Susan mentioned that your visibility into Brazil or Latin America financing right now is kind of through December – but the programs through December. Could you handicap or help us – are you hearing anything about that getting extended, or can you just tell us what your current thinking might be as far as next year?

Marie Zieglar

We believe that we will not know what the outcome of that will be until after the election. In our planning we’re assuming that interest rates could rise from the current 5.5%, but that they would be unlikely to go all the way up to a market rate, which – the rate before these current low rate programs that come into play was 9.5%, and so perhaps you got closer to 9.5% but maybe not all the way there. So we – I don’t have an exact number to give you, but I can tell you that in our own financial planning, as we’re looking into 2011, we’re going to assume that those – that the 5.5% does end at the end of December and that the rate goes up a bit. Now the impact, though, for us, will be delayed – actually for the industry – because the customer can make a contract by the end of the year, having entered into a contract at the 5.5% and we can deliver, I think it’s – I’m not sure if it’s 60 or 90 days. So for us, really effectively our first and second quarters, or at least a good chunk of the second quarter, would be still effectively benefitting from that 5.5%.

Operator

Our final question will come from Joel Tiss.

Joel Tiss – Buckingham Research

I just wondered if you could, in terms of the fourth quarter incremental margins, other people have asked about that, but could you just talk a little bit about the flow of production versus the inventory draw down and just so we can get a sense of what else may be going on there?

Marie Zieglar

I’m not sure I know how to answer that question, Joel.

Joel Tiss

So is there less overhead absorption baked into your numbers because you’re going to underproduce retail to clean out the old 2009-2010 inventories?

Marie Zieglar

No. Really the additional overhead that we are talking about really is just additional expense from rearranging production lines, the disruption that you have when you may have additional overtime because you have to bring people in to reset lines, because you’re adding a new piece of tooling, or making some factory rearrangements. So it’s really more related to that. Jim, can you help?

James Field

I would agree. If you look at the absolute levels of absorption, they’ll be higher than a year ago. Where we’re losing it is more on the spend side of the overhead equation.

Joel Tiss

And is that higher level of expenses going to flatten out as we go into 2011?

Marie Zieglar

Again, we don’t have a forecast for 2011. We will have a staggered series of launches and I don’t know how all of that will play out. We ourselves do not have our budget process done for 2011, so we’ll see how that ultimately plays out.

Maybe I could just end with the note that although there are a lot of things going on in the fourth quarter, in terms of our guidance, I still want to point out that $375 million, which is our guidance, is – would imply our second highest fourth quarter ever, and that’s despite the start of these launches and some additional expenses, and the fact that you have weak markets in Europe and the former CIS and construction and forestry, although recovering, still below 60% of typical. So we are very very proud of the results that we are delivering and we hope to deliver.

And with that, thank you all for participating in today’s call, and we will be available the rest of the day to answer your questions. Thank you.

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