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Deere & (NYSE:DE)

Q2 2011 Earnings Call

May 18, 2011 10:00 am ET

Executives

Marie Ziegler - Vice President and Treasurer

Susan Karlix - Investor Relations

Tony Huegel -

James Field - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Ann Duignan - JP Morgan Chase & Co

Jerry Revich - Goldman Sachs Group Inc.

Stephen Volkmann - Jefferies & Company, Inc.

Seth Weber - RBC Capital Markets, LLC

Henry Kirn - UBS Investment Bank

Andrew Casey - Wells Fargo Securities, LLC

Robert Wertheimer - Morgan Stanley

David Raso - ISI Group Inc.

Charles Rentschler - Boenning and Scattergood, Inc.

Koki Shiraishi - Daiwa Securities Capital Markets Co. Ltd.

Joel Tiss - Buckingham Research Group, Inc.

Jamie Cook - Crédit Suisse AG

Mark Koznarek - Cleveland Research Company

Operator

Good morning, and welcome to Deere's second quarter earnings conference call. [Operator Instructions] I would now like to turn the call over to Mr. Tony Huegel, Director of Investor Relations. Thank you. You may begin.

Tony Huegel

Good morning. Also on the call today are Jim Field, our Chief Financial Officer; Marie Ziegler, Vice President and Treasurer; and Susan Karlix, our Manager of Investor Communications. As some of you may be aware, Justin Merrimac has moved on to other responsibilities within the company. And over the next several months, Josh Garrison will be transitioning to the IR staff to replace Justin as Manager of Investor Relations.

Today, we'll take a closer look at Deere's second quarter earnings. Then spend some time talking about our markets and how we see the record half -- the second half of 2011 shaping up. After that we will respond to your questions.

Please note that slides are available to complement the call this morning. They can be accessed on our website at www.johndeere.com. First, a reminder, this call is being broadcast live on the Internet and recorded for future transmission and use by Deere and Thomson 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. Additional information concerning factors that could cause actual results to differ materially is contained in the company's most recent Form 8-K and periodic reports filed with the Securities and Exchange Commission.

This call also may include financial measures that are not in conformance with accounting principles generally accepted in the United States of America, or GAAP. Additional information concerning these measures, including reconciliations to comparable GAAP measures, is included in the release and posted on our website at www.johndeere.com/financialreports under Other Financial Information.

Now for a closer look at the quarter, here's Susan.

Susan Karlix

Thank you, Tony. Today, John Deere announced earnings for the second quarter of 2011, and what a quarter it was. Income jumped 65% on a 25% increase in sales and revenue. Sales and earnings both reached their highest point for any single quarter in the company's history. As we've been pointing out for some time, our performance reflects the skillful execution of our business plans plus strong demand for our innovative lines of equipment. In addition, the company's ongoing action to expand its global presence are showing good results, and helping drive new customers worldwide to the John Deere brand.

We're also starting to see positive movement in some key markets that are in the early stages of recovery, namely, construction equipment in the United States and farm machinery in Europe and the CIS. We're looking forward to further improvement in these areas in the future.

Finally, our full year earnings forecast has been raised and now stands at approximately $2.65 billion. All in all, it was an impressive quarter, unprecedented in many respects and the company seems well on its way to an equally impressive year.

Now let's look at the quarter in more detail, starting with Slide 3. Net sales and revenues were up 25% to $8.9 billion in the quarter. Net income attributable to Deere & Company was $904 million. As you just heard, both were the highest for any quarter in the company's history.

Slide 4 is a reminder as you compare the 2 quarters. It details the tax charge impact in the second quarter of 2010.

On Slide 5, total worldwide equipment operations net sales were $8.3 billion, up 27% year-over-year and the first time quarterly sales have exceeded $8 billion. Price realization in the quarter was positive by 4 points, while currency translation was up 3 points.

Production tonnage is shown on Slide 6. In line with equipment net sales, worldwide production tonnage was also up 27% in the quarter. The table at the bottom of the slide illustrates 2011 tonnage by quarter. This emphasizes the considerably higher year-over-year change in the first half of the year, compared with our expectation for the second half. Second half incremental margins will be impacted by this same pattern. Much of the difference in tonnage results from our Interim Tier 4 product transition plan. Also Ag & Turf dealers placed orders earlier this year in anticipation of the implementation of SAP in late April and early May. Projected worldwide production tonnage is up about 11% in the quarter and up about 19% for the full year.

Let's turn to the company outlook on Slide 7. Third quarter sales are expected to increase by approximately 20% versus the same quarter of 2010, with positive currency translation on net sales of about 6 points. For the full year, projected equipment net sales will be up 21% to 23% compared with fiscal year 2010. This includes about 3 points of positive currency translation and 3 points of positive price realization.

Net income attributable to Deere & Company is now forecast to be approximately $2.65 billion in fiscal 2011 versus last quarter's guidance of about $2.5 billion.

Turning to our review of our individual businesses, let's start with Ag & Turf on Slide 8. Both sales and production tonnage were up 24% in the quarter. Operating profit was $1.2 billion. The profit improvement was primarily due to higher shipment and production volumes and improved price realization, partially offset by increased raw material costs and higher selling, administrative and general expenses. In line with our strong operating performance incentive compensation expenses are higher, which is driving a good part of the SA&G increase. Operating margin was strong in the quarter, about 17%, while the incremental margin was approximately 15%.

Before we review the sales outlook, let's look at some of the fundamentals affecting the Ag business. Slide 9 outlines our U.S. commodity price estimates. Corn stock used ratios are at one of the lowest levels on record, due to growing global consumption coupled with a disappointing yield in 2010. As a result, we raised our corn price estimates for the 2011/2012 crop year by $0.60 to the low end of the USDA price forecasts. Wheat prices and exports are expected to remain strong as the world recovers from the 2010 supply shock. Soybean prices are expected to remain high through the 2011/'12 crop year as stocks are low and Chinese demand is growing. In the latest USDA supply and demand report, China is projected to import 58 million metric tons of soybeans in '11/'12. This amounts to about 22% of worldwide production. Global levels of high-quality cotton are extremely low. Asian demand and exports to other countries will allow cotton prices to remain strong.

2010 U.S. farm cash receipts is shown on Slide 10. They remain at a healthy level, and are little changed since our last forecast. Farm cash receipts are now forecast to reach $371.4 billion in 2011, $41 billion more than the all-time high of $330.5 billion recorded in 2008. This quarter, we are introducing our 2012 farm cash receipts forecast. At over $365 billion, we anticipate 2012 receipts will remain very close to the record-setting 2011 level. Historically, farm cash receipts for both the current and prior years are a key driver for current year ag equipment sales.

Slide 11 highlights forecast acres planted and yields for the 2011/2012 crop year. It is still too early to know the ultimate outcome as acres and yield will be determined by weather in the short run.

Here's the outlook for the EU 27 is shown on Slide 12. Farm income and the future expectations of farmers in the EU 27 are improving. Grain, beef and milk prices remain at good levels, while pork prices are improving. 2011 margins for the arable farmer are expected to approach those experienced in 2007/2008. Used equipment levels are low and we are seeing a higher tendency for farmers to invest in ag machinery.

Farm net income in Brazil and Argentina is on Slide 13, led by increases in sugarcane and soybeans, the 2 crops that drive the bulk of equipment purchases in Brazil. Farm net income is now expected to be about $26 billion in 2011. The outlook for 2012 remains positive, with farm net income expected to be about $22 billion, 44% above 2010 level. Contributing to strength in the region are strong global demand for Brazilian commodities as well as high sugar and cotton prices and lower production costs. Farm income in Argentina is forecasted about $7.6 billion in 2011 and about $6.4 billion in 2012, due to high commodity prices.

Our 2011 Ag & Turf industry outlooks are on Slide 14. Fundamentals in the U.S. and Canadian farm sectors remain robust and we have raised our industry forecast, which now calls for an increase of 5% to 10%. Based on factors cited earlier, the EU 27 is now projected up about 15% for the year. In the CIS, farm income is expected to increase in 2011 on the heels of significantly higher grain prices than the 2009/2010 crop year. Also milk and beef prices are expected to remain at high levels.

Russia has taken several actions to support the ag sector. For example, subsidies are in place for such things as grain, railway, transportation costs, fertilizer, seed and livestock. There is increased support for the ag modernization program and loans and the subsidies are being directed to last year's drought regions. All these factors, coupled with an easing in financing availability, have led to an increase in our industry guidance. We now expect notably stronger gains in the CIS countries this year from the depressed levels of last year.

Moving to Asia. Sales are forecast to grow strongly again this year.

Industry sales in South America are expected to be down 5% to 10% in 2011 in relation to last year's strong level. Underlying economic fundamentals for the region remain positive. However, recently enacted trade policies in Argentina and weakness in the small tractor market in Brazil are contributing to the more subdued outlook.

Sales of lower horsepower tractors have benefited from Brazilian government programs that targeted smaller farms over the last few years. These programs may have reached the saturation point. Tractor sales under these programs accounted for about 35% of 2009 industry sales, about 22% in 2010 and are running around 17% year-to-date, 2011.

For the last couple of quarters, we had talked about the 50 new products that have been introduced to the Brazilian market over the last year. Deere's lineup of tractors changed dramatically in 2010 and 2011, as we broadened our lineup with features and price points to appeal to broader segments of the market. We expect the strong start seen in the first half of the year to continue as we benefit from these products. Other positives are the ongoing investment in our dealer network, and our presence in cotton and sugarcane equipment.

Turning to another product category. After rising almost 15% in 2010, we expect retail sales of turf and utility equipment in the United States and Canada to be about flat in 2011. Our new line of utility vehicles continues to be extremely well accepted in the marketplace.

Putting these all together on Slide 15, Deere's sales for worldwide Ag & Turf are projected to be up about 20%. Currency translation is positive, about 4 points. Operating margin for the division is forecast at about 14%. As we discussed last quarter, small ag equipment sales are expected to recover from their fairly low levels of the past few years. The Ag & Turf division's operating margin will receive about one point of benefit from the mix of large ag equipment sales in comparison with the normal year. Remember last year, the mix advantage was greater, about 2 points more than a typical year.

Before moving on to Construction & Forestry, I'd like to point out that Deere made 2 additional announcements this morning. The first relates to the large square baler outlined on Slide 16. Deere and the Kuhn Group have established a strategic operation to provide a Deere-branded baler manufactured by Kuhn for Europe and the CIS countries in 2012. This is one of the first steps to increasing our product offering in the EU 27, which is a key priority in our company strategy. The large square baler fills a portfolio gap for the livestock, commercial and contractor customer segments and leverages the strength of our John Deere dealer network. With the acquisition of the intellectual property license from Kuhn, Deere will manufacture a large square baler adapted to customer requirements for distribution outside Europe and the CIS by 2014.

On Slide 17, the second announcement concerned a new operation in Harbin, China. With an initial outlay of about $80 million, we are building a factory to manufacture mid and large-sized tractors, sprayers, planters and harvesting equipment. Ground-breaking is expected to take place in the third quarter of calendar year 2011, with production beginning in late 2012. This is our seventh manufacturing location in China including 2 joint ventures, all of which primarily serves the rapidly growing Chinese market.

Let's focus now on construction and forestry on Slide 18. Deere's net sales were up 46% in the quarter, while production tonnage was up 51%. The division's operating profit of $105 million was helped by higher shipment and production volumes and improved price realization. These were partially offset by higher selling, administrative and general expenses and increased raw material costs. The increase in SA&G expense included higher incentive compensation expenses in line with our improved operating performance.

On Slide 19, fundamentally, growth is slower coming out of this recession than in previous ones. Unusually bad weather, which hurt the construction industry, lower defense spending, surging oil prices and continuing efforts to cut government spending at the state and federal levels have caused deterioration in economic indicators since our last forecast. Following last year's 41% increase, net sales in Construction & Forestry are forecast to be up about 35% in fiscal 2011. This would bring construction sales for the year to about what we would consider typical trough level. C&F is benefiting from improved sales to independent rental companies, also encouraging Deere dealers continue to see an improvement in rental utilization and used equipment markets. Meanwhile, Global Forestry markets are expected to build on last year's big gains. The industry was up 50% last year. Our current forecast calls for a further increase in 2011 up 35% to 40% led by strong pulp and paper prices. The full year operating margin for Deere's C&F division is projected to be in the neighborhood of about 8%.

Let's move now to our Financial Services operation. Slide 20 shows the worldwide Financial Services annualized provision for credit losses at 10 basis points as a percent of the total average owned portfolio at the end of April. The 2011 full year forecast is now about 23 basis points. That is down about 15 basis points from our last forecast and almost 25 points lower than 2010. This reflects much lower write-offs primarily in the Construction & Forestry portfolio. We're also seeing fewer repossessions and much stronger used equipment values. On the repossessions that are taking place, we are experiencing better pricing and improved recovery rates.

Moving to Slide 21. Worldwide Financial Services net income attributable to Deere & Company was $105 million in the quarter versus of $87 million last year. A higher income was primarily due to growth in the portfolio and a lower provision for credit losses. Looking ahead, we are projecting worldwide Financial Services net income attributable to Deere & Company of about $435 million in 2011.

Now on Slide 22, let's turn our focus back to the equipment operations and look at receivables and inventories. For the company as a whole, receivables and inventories were up roughly $1.8 billion compared with the second quarter of 2010. This mainly reflects parts and complete goods in support of global growth, particularly in the BRIC countries. On a full year basis, receivables and inventories are expected to increase about $100 million due to improved global prospects and some Interim Tier 4, Stage 3b transition late in the year.

Now let's discuss the latest on retail sales. Slide 23 presents the product category detail in the U.S. and Canada for the month of April, expressed in units. Utility tractor industry sales were down 5%, Deere was down in line with the industry. The row-crop tractor industry sales were up 1%, Deere was down a low single-digit. Four-wheel drive industry sales were up 4%, Deere was down a single digit. Combine industry sales were up 19%, Deere was up more than the industry. Looking at Deere dealer inventories for row-crop tractors, Deere ended April with inventories of 17% of trailing 12-month sales. Combine inventories were at 10% of sales.

Turning to Slide 24. In the EU 27, sales of John Deere tractors and combines were up double digits in April. Deere's retail sales of the selected turf and utility equipment in the U.S. and Canada were down double digits in the month. Last year's early and warm spring makes April sales difficult to measure against. This is especially true, considering that turf and utility sales in April of this year were impacted by severe weather and tornadoes, especially in the Southeastern U.S, which is a key sales region. Construction & Forestry sales in the U.S. and Canada, on both the First-in-the-Dirt and Settlement basis were up double digits for the month.

Let's turn now to raw material and logistics on Slide 25. Second quarter material costs were up about $175 million in comparison with the second quarter of 2010. The increase was mostly Ag & Turf. For the fiscal year, our forecast assumes a negative margin impact from raw materials of about 2 points, with the percentage breakdown about 85% Ag and 15% Construction & Forestry. With 3 points of price realization forecast for the year, we will fully cover these costs increases.

Looking at R&D expense on Slide 26. R&D was up about 12% in the second quarter. For fiscal 2011, R&D expense is forecast to be up about 17%. As stated in previous quarters, R&D spending is expected to remain at high levels for the next few years as we approach significant product launches with Interim Tier 4 engines, and soon thereafter, meet Final Tier 4 emission standards. Also included in the R&D expense is ongoing new product development expense for our growing global customer base.

Moving now to Slide 27. SA&G expense for the equipment operations was up 19% in the second quarter. Incentive compensation accounted for about 8 points of the increase, in line with our improved financial performance. Currency translation was about 2 points of the increase and growth accounted for about 1 point.

For the full year, SA&G is expected to be up about 14%. Incentive compensation will account for about 3 points of the change with currency translation accounting for about 2 points and growth about 1 point.

Moving to the income tax rate on Slide 28. The second quarter effective tax rate for the equipment operations was about 32%. For 2011, our effective tax rate is forecast to be in the range of 33% to 35%. The renewal of the R&D tax credit through this year affected both rates.

On Slide 29, you see our history of strong cash flow from Deere's equipment operations. We anticipate cash flow from equipment operations of about $3.1 billion in fiscal 2011.

As Slide 30 illustrates, for 2011, capital expenditures are expected to be about $1.1 billion, primarily driven by investments related to Interim Tier 4. The increase is also related to new product development, as well as our expanded presence in global growth markets. Depreciation and amortization for 2011 is expected to be about $600 million, with pension/OPEB contribution of about $115 million.

Finally, turning to Slide 31, you see a summary of the amounts returned to investors through share repurchase over the last 7 years. During the second quarter, we repurchased 3.2 million shares or about $300 million. Since 2004, we have repurchased about 127 million shares at a cost of $6.5 billion. That works out to an average purchase price of $51.57.

In closing, John Deere has reached the halfway mark of 2011 on a strong pace and fully expects to have a record year. What's more, our record of strong financial performance is driving aggressive levels in investments, which puts the company on a solid footing for the future. Indeed, John Deere is exceptionally well positioned to address the world's growing need for agricultural commodities, shelter and infrastructure. We believe these developments will have a positive impact on demand for productive farm and construction equipment for years, if not, generations to come, and that they hold tremendously exciting promise for the company and its investors. Tony?

Tony Huegel

Thank you, Susan. Now we're ready to begin the Q&A portion of the call. [Operator Instructions] Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jamie Cook.

Jamie Cook - Crédit Suisse AG

Crédit Suisse. A couple of questions. One, you mentioned in the beginning that the C&F business, and when you think about farm, Europe and CIS are still relatively at trough levels. Can you talk about how you're viewing the U.S. and Brazil relative to peak within the farm business? And then last, unless I missed it, you talked about the Japan income -- you talked about the Japan hit for the year. Can you just talk about how we should see that impacting the quarters? If one -- was there any in this quarter? And how we'll think about Q3 and Q4?

Tony Huegel

Sure. First of all, in terms of -- you were talk -- you asked first, I believe, about ag for South America.

Jamie Cook - Crédit Suisse AG

And U.S.

Tony Huegel

In the U.S., certainly, from a large ag perspective, it's a very strong market. And within the smaller ag equipment, you would have some room yet to improve. I mean it's come back this year. And you'll see that -- we've talked about that in our margins. Last year, there were a couple of points of margin benefit on large ag. And this year, as small ag has also come back, we're closer to one point of margin benefit, so the negative one year-over-year. Certainly in South America, that's an interesting market because we're seeing weakness in the smaller ag sector in Brazil. Large ag is performing pretty well, and in cotton and especially sugar are at very strong levels there as well. So certainly pretty strong but good opportunities for us in both markets.

Jamie Cook - Crédit Suisse AG

But just to be clear, you gave a cash receipt forecast for 2012. So it sounds like you would expect the strength in the U.S. and tractor sales to continue into 2012? You're not seeing any signs of weakness or -- at all within the U.S. farm equipment market?

Tony Huegel

Well of course, as you know, we wouldn't give a forecast for 2012 at this point. There's a lot yet to happen between now and then in terms of crops and so on. But certainly if you look at our forecast, and we said for years that the cash receipts are a good indicator of future equipment sales, that's our #1 indicator in terms of our internal modeling both in the current year as well as one year out. So certainly, that would bode well for sales in the U.S., and similarly in Brazil and Argentina. Sales are net income for farmers and those markets are very strong.

Jamie Cook - Crédit Suisse AG

Okay. And the second question's just with Japan, sorry.

Tony Huegel

Yes. With Japan, certainly there would be a little bit in the second quarter. But that's going to mostly impact our third and fourth quarters. And again, keep in mind that just effectively as we look -- as we have our outlook, sales that effectively lost sales with the related margin on both.

Operator

Our next question comes from the Jerry Revich.

Jerry Revich - Goldman Sachs Group Inc.

It's Goldman Sachs. Tony, can you say more about the impact of the tragedy in Japan on your business? Your excavator margins, they're significantly lower than the profit drag? You're estimating what other product lines are impacted? Or can you just help us with the high profit drag relative to the sales drag you're thinking about there?

Tony Huegel

Sure. And really, that -- I mean you're right, most of our impact is in our Hitachi-related product with our Hitachi relationship. And keep in mind on that product that we only recognize the marketing or distribution margin on that. We, as part of that relationship, do not have the manufacturing margins on our books. So that's why you'll see a little bit, maybe lighter margin impact than what you might otherwise see.

Jerry Revich - Goldman Sachs Group Inc.

So the $80 million profit drag -- or $70 million profit drag on only a $300 million of sales drag implies much greater operational difficulties than what the distribution arrangement implies? So that's the bridge I'm trying to gap, Tony.

Tony Huegel

Well, those margins would actually be lighter than what you would normally see.

Jerry Revich - Goldman Sachs Group Inc.

Yes, so the operating profit hit. I would have expected if it had been lower than the $70 million to your point because the margins on those sales are lower?

Marie Ziegler

We're not following you. This is Marie, Jerry. We've got $300 million of sales impact. Again, as you are aware, Hitachi did lose several months of production in one of its northern factories. That would be the primary source for these large mining machines and excavators, and those factories are expected to be up and running, I believe it is, yes this week. So we think our supply base and Hitachi, in particular, to be commended for the work that they have put into recovering from this tragedy.

Jerry Revich - Goldman Sachs Group Inc.

My question is the $70 million profit drag implies north of 20% margins on those Hitachi excavators. And for Tony's comment, that is a lower-margin business for you and it's not a drag on your production facility, so that's the part I'm...

James Field

Let me try to clarify, Jerry. You're right. I advised the 23% operating margin. What we have in there is we have Hitachi-branded mining machines and then we have the mid-sized and large excavators. A portion of that business has margins that are greater than 23%. And a portion of that has margins that are less than 23%. And this is the blended average of those margins. And yes, you're right, some of this is pure distribution margin, which would be less -- significantly less than the 23%. And some of it, we get -- we enjoy a little bit more margin. So I don't think you should read anything more than -- that's the weighted average margin of the equipment that's been disrupted.

Jerry Revich - Goldman Sachs Group Inc.

That's a very helpful color. And on the ag equipment business, can you help us with the bridge for the Ag & Turf EBIT performance this quarter versus last year? And perhaps touch on what was the impact of Interim Tier 4 product rollout costs? I guess, considering how strong pricing was this quarter versus raw mats and SA&G? I guess I was looking for higher operating leverage in that. I'm wondering if you could just step us through the pieces there?

Marie Ziegler

Again, we talked about the fact that we had very good operating margins at 17% for the second quarter. The factors that did weigh some on the incremental margin were things that we had discussed in advance, like raw material costs, higher SA&G, higher R&D in the quarter. There's a little bit of absorption impact as we had talked about for the full year as ag has a very significant number of product introductions and capital expenditure ahead of it and some behind. And that added -- had some impact in the second quarter as well. It's disrupted to the factories as their bringing some of this capital in.

Jerry Revich - Goldman Sachs Group Inc.

And what order of magnitude can you...

Marie Ziegler

No new information.

Jerry Revich - Goldman Sachs Group Inc.

Okay. Can you quantify that last point, Marie, rough order of magnitude in the quarter?

Marie Ziegler

We've talked about for the full year, full company, about $100 million. I don't have a breakdown by quarter, but there would be some impact in this quarter.

Operator

Our next question comes from Charlie Rentschler. [Boenning & Scattergood, Inc.]

Charles Rentschler - Boenning and Scattergood, Inc.

First question is can you talk about what explains the $1.6 billion increase in inventory year-to-date since October? It's about one month's production, I figured, in the first 6 months?

Marie Ziegler

Actually, Charlie, we ended October with our inventories in round numbers somewhere between $1 billion higher. That reflected the very high levels of production we had in the fourth quarter relative to a year ago, and the fact that the production would be somewhat heavier this year versus the typical seasonal patterns than it would traditionally be. That said, we still expect to end the year with our inventories in very round numbers, so it's essentially flat for the full company with last year. And this reflects very good business conditions in many parts of the world and the prospects of better conditions in places like Europe and the CIS.

Charles Rentschler - Boenning and Scattergood, Inc.

Okay, and my second question has to do with the CIS. You mentioned if you're seeing strong -- stronger gains over there. Could you kind of benchmark that against the peak of 3, 4 years ago? And what are you seeing now? Do you think that this might accelerate over the next couple, 3 years?

Tony Huegel

This is Tony. Keep in mind while we're certainly looking at what we refer to it as notable improvements year-over-year, we're also off of very low levels. If you look at where we were in 2008, our sales in the CIS last year were less than half of those levels. So again, it's certainly low -- it's coming off of low levels but we're seeing some strong improvement there.

Operator

Our next question comes from Ann Duignan.

Ann Duignan - JP Morgan Chase & Co

JPMorgan. Can you talk a little bit about North America ag equipment. We know the farmers will continue to trade the equipment into 2012 so long as, as you pointed out, cash receipts remain strong. But also they need the value of their used equipment to remain strong. Can you comment on the used equipment industry in North America, both used equipment values as well as the inventories of used equipment? And maybe any difference or similarities between combines and tractors?

Tony Huegel

Absolutely. And when you look at used equipment values, they're actually holding very strong. They are either flat to improved year-over-year, including combines. Combine used equipment values are actually slightly higher year-over-year in the U.S. so that certainly bodes well. When you look at inventory level, tractors or used equipment are at a very good levels. Combines, of course, are at relatively high levels year-over-year, but some of that is driven by the timing of our sales. As you look at a typical seasonal pattern of our sales with our -- again driven by our Interim Tier 4 transition, we've shipped quite a bit more combines, new combine in the first half of the year compared to what we normally would. And as you know, with a new combine comes, in almost all cases, a trade in, and used, so certainly, we're at higher levels. But also, we also track those within a band and they would still be -- our levels would still be in a reasonable band based on new equipment sales. So we feel comfortable with the levels that they’re at. But you're right, they are at high levels.

Ann Duignan - JP Morgan Chase & Co

So would you agree that if cash receipts come in somewhere around where you're forecasting and used equipment values stay around where they're currently at, but there's no reason to think that the North American ag equipment sector will fall off a cliff next year?

Tony Huegel

As we look at what our dealer's response is and our dealers seem to be comfortable that they will be able to move those combines and they've been very aggressive at doing that both within the U.S. as well as with some export markets.

James Field

Certainly, Ann. This is Jim, certainly that would be consistent with history. As we've said, we modeled the business and sales, based on cash receipts, as being the largest driver. And so if you don't have -- if the used is still flowing through the channel and you have good cash receipts, history would suggest that you're going to have good retail activity.

Ann Duignan - JP Morgan Chase & Co

Yes. I agree with that. And just to follow up a different topic. I'm just curious, you spent about $600 million buying back shares in the quarter. Can you tell us what the share count was, the diluted share count at the end of the quarter? Just for modeling.

Marie Ziegler

We were about 420 million shares.

Ann Duignan - JP Morgan Chase & Co

And that was at quarter end?

Marie Ziegler

That's at quarter end.

Operator

Our next question comes from Henry Kirn.

Henry Kirn - UBS Investment Bank

It's UBS. If the North American ag demand conditions warrant, would you be able to ramp production above what's implied in guidance? Or are you bumping against where you could go for production at this point?

Tony Huegel

As you look at our order book -- I assume you're referring to in the U.S. with the large ag equipment?

Henry Kirn - UBS Investment Bank

That's exactly right.

Tony Huegel

Yes. If you look at our order book today on 8R tractors, our effective availability is really out into about the November time frame. And on the 9000 Series, we're out into October. Keep in mind, we have a significant number of Interim Tier 4 transitions on those large ag products in the year. And so as we've talked about in the past, we do have some capacity limitations this year with those transitions.

Henry Kirn - UBS Investment Bank

And could you talk about on the supply chain side, their ability to ramp and how much that might be holding you back? Sort of where are you seeing bottlenecks and where things...

Tony Huegel

We do not have at any -- I mean of course, on any given day, there are issues that we would be working through. But there are no supplier issues that are currently hampering our ability to produce products. Again, with the exception of Japan.

James Field

Let me just elaborate on that. I mean, first, I think kudos ought to go to our excellent supply management professionals around the world and our supply base. And as Tony said, at any point in time, there may be a particular issue somewhere that we're dealing with, besides Japan, we've managed through this pretty flawlessly. So and we have a lot of confidence in our supply management team and our suppliers around the world.

Operator

Our next question comes from David Raso.

David Raso - ISI Group Inc.

ISI. Can you give us a little more quantification how you're thinking about the incremental in the next couple of quarters? I'm just trying to think through the price versus cost in the back half of the year. It looks like you're implying it's a positive. And if anything, if this is positive enough to offset those incremental costs you've cited for some of the new products? And the sales growth you're implying is higher than your SG&A growth this second half. I'm just trying to think through why the incremental margins look like you're almost implying will be lower than your operating margins. But if you maybe just flush out first to come from the bogey, how are you thinking about your incrementals the next 2 quarters?

Marie Ziegler

As Susan had indicated, David, as we look in the back half of the year, especially in Ag, we do see that incremental margins, we expect, will be softer than what you've seen in the first and second quarters. Some of the factors for that, again, are alongside of the significant number of IT4 transitions that lie ahead of us. We won't tap the same pattern of year-over-year sales and tonnage, times and gains. We don't have some of the opportunities for incremental margin opportunities that you would have. We've talked about raw materials, we had very, very good sales, or excuse me, price realization in the quarter. We have improved our guidance for the year to 3 points. But it was -- our guidance was our actual price realization was 4 points in the quarter, so it will abate a little. We certainly expect that we will cover our product with raw material costs up in the second half of the year. But you won't have maybe the same kind of margin opportunity. And then finally, we do have higher product costs related to IT4 componentry. We've talked about that before. That's the catalytic converters and things like that, that are on these IT4-compliant engines. And for the full year, full company, that's about $170 million. We'll see more of that costs in the second half than we did in the first half as we ramp up production models.

Tony Huegel

This is Tony. The other thing I would add to that is keep in mind that we bring our inventory levels down in the second half of the year. We benefited from absorption in the first half. And that will flip and move the other direction here in the second half and will be a drag on margins as well.

David Raso - ISI Group Inc.

Between the 2 segments, do you see one more than the other? I mean obviously ag, more new product rollout, I would argue. So is that where you expect to see more sequential degradation than incremental?

Tony Huegel

Well, keep in mind with C&F as well, right now they're in the midst of an SAP transition. And so they took some shutdown ahead of that, a couple of weeks. And of course we'll also have some pretty slow ramp-up. So effectively, they are at about 3 weeks of lower production and then if you look specifically at the third quarter for that particular division. So that will certainly have an impact on margins. As Marie cited some of the Interim Tier 4 costs, that certainly is more directed at the ag product line than C&F.

David Raso - ISI Group Inc.

And then just for clarification, and Jim, if you want to tackle this, so we're implying incrementals below operating margins for the second half of the year?

Marie Ziegler

I would just say that our forecast, we've been very candid in terms of what our incremental, or I mean our absolute margin guidance is for the 2 divisions. And I think we'll let the numbers speak for themselves.

Operator

The next question will come from Robert Wertheimer.

Robert Wertheimer - Morgan Stanley

It's Morgan Stanley. Real quick follow-up on South America, just to confirm that the reduction of the market growth outlook does not involve any large equipment in your view. I think you said the word saturation for small equipment, not so much on just the financing with the actual market. So I wonder if you could comment on where you think large equipment is there?

Tony Huegel

Yes. If you look at South America, there's really 2 factors that Susan cited again. And you're correct, it's on the small ag side, there's -- we referred to it as MDA program. That's really targeted at small tractors and small farms. And that's been, in the past, a pretty high percent of the overall tractor sales and has sequentially reduced year-over-year. And we would expect a similar pattern again this year, as well as when you look at overall South America, Argentina, with some of the recent trade policies, would certainly have a dampening effect. But on large ag and especially, part of what's not included in that outlook will be cotton and sugar. And so -- and there is certainly strong markets there, so.

Robert Wertheimer - Morgan Stanley

You didn’t take the large ag part down? Okay. And the second question would be on just a little one on tax rate guidance, you're sort of below where you've been for the year. Does the unchanged tax rate guidance imply a higher mix in the U.S. towards the second half of the year? And a Tier 4 aside, that would be a positive margin shift, I would think?

James Field

Yes. This is Jim. I don't know that -- I wouldn't necessarily jump to that conclusion. We've got a lot of discrete items that impact particular quarters depending on the timing of certain events. And so there is an element of lumpiness to the tax rate in the quarterly periods that sometimes defies a little bit of logical reasoning.

Robert Wertheimer - Morgan Stanley

Okay. That's helpful.

James Field

I would not jump to the conclusion that, that is an income mix necessarily.

Operator

Our next question will come from Seth Weber.

Seth Weber - RBC Capital Markets, LLC

It's RBC. I guess just first a clarification, did you raise your IT4 costs from 160 to 170 then? Is that what I heard?

Marie Ziegler

Yes, we did.

Tony Huegel

Yes. That's correct.

Seth Weber - RBC Capital Markets, LLC

Okay. And then there's -- on the Construction & Forestry business, you mentioned that with the 35% growth this year, you're basically kind of getting back to trough levels. But looking at your, I guess Slide 19, you're talking about another 3% decline next year in non-res [non-residential] construction. So I mean what -- I guess what I'm trying to understand is how much of this is just restocking or replacement? And what will we need to see growth in that business next -- going forward?

Tony Huegel

Right. This is Tony, Seth. And first of all, just to clarify that the trough levels are for the Construction side of that division only. And certainly, some of what we're seeing, obviously there is some restocking but also, as we've indicated previously, you tend to see some overshooting of the fundamentals, both on the high side and end on the low side. And we believe that part of the story as well is that some of this is really a correction of the retail environment back up to what the underlying fundamentals would support. But to your point, not at strong levels, I mean we're at -- and as we've indicated, we’re certainly still -- while, year-over-year percentages are high, still at basically trough levels.

Seth Weber - RBC Capital Markets, LLC

Okay. And if I could just ask a follow-up. Can you give us some color on where you're at for Europe capacity on the Ag business? I mean it sounds like you're starting to get a little bit more comfortable with the dynamics in that market relative to North America? Do you still have excess capacity in Europe if you needed to expand that there?

Tony Huegel

Certainly, that market is coming back as we've indicated. We've bumped up our outlook again there, but would not have capacity issues in Europe.

Operator

Our next question will come from Andy Casey.

Andrew Casey - Wells Fargo Securities, LLC

Wells Fargo Securities. On the cash flow outlook, I kind of get it, but can you walk us through the approximate $200 million reduction? Looks like $100 million is related to the adjusted receivable and inventory. Where's the other $100 million coming from?

Marie Ziegler

Actually, the bulk of it really is receivable and inventory because we changed our guidance from down $250 million to up $100 million. So there's probably some exchange running through there with rates. But...

Tony Huegel

Timing and payables.

Marie Ziegler

So there's a bunch of knick knacks. But that's really the biggest factor.

Andrew Casey - Wells Fargo Securities, LLC

Okay. When you look at that receivable and inventory reduction, could you help us what portion is going to happen in Q3? Because you have the C&F shutdown, you've got some other stuff going on in Q4?

Marie Ziegler

I don't -- Andy, I don't have a split between how it will go in the third quarter and the fourth quarter. Typically, I wouldn't have a comment there.

Andrew Casey - Wells Fargo Securities, LLC

Okay. And then lastly, back on the Brazilian market, there has been some competitor comment about aggressive pricing directed primarily at you guys. And some of that may be related to your segmentation of the market. What are you seeing with respect to industry pricing?

Tony Huegel

From our perspective, what I can tell you is for Deere in Brazil, we have had positive price realization both in the second quarter, year-to-date, and in what we anticipate for the fiscal year. Certainly, we've done very well on that market with our market share. Really, we would cite 2 factors for why that's happening. We talked a lot in recent months about the new products we have in that market. So this is probably closer -- we would argue this is as it's expected. As well as we've invested quite a bit into our dealer network there. And so we have a very strong distribution network and good products with a great fit for that market, and I think you're seeing the results of that.

Operator

Our next question will come from Joel Tiss.

Joel Tiss - Buckingham Research Group, Inc.

Buckingham Research. Just on this Brazilian -- a little bit of a disconnect between the farmer profitability increasing and sales flat to down for the year. Can you just give us a sense about -- I'm not asking for 2012 forecast, but do you think we're setting up some pent-up demand for 2012? Like is this more of a transitional issue? Or do you think there's something a little more structural beyond just the financing?

Marie Ziegler

The government subsidies, Joel, is that small and were extremely attractive. And as that market segment has -- so they really weren’t dependent, if you will, on farm income. So there's a very much a disconnect in terms of what would happen with that small tractor segment versus the farm income. The prospects for farm income, as we've said, are good in Brazil that supports a broad array of implements, tractors, cotton equipment, sprayers, sugarcane harvesting equipment. So the prospects remain very good for the market.

Joel Tiss - Buckingham Research Group, Inc.

Okay. And then just to try to cheat a little bit, I'm going to glue 2 questions together but they're both easy. The percentage of construction equipment that goes into rental? And also just philosophically, why keep more than $3 billion worth of debt on equipment operations when you have more than that in cash?

Marie Ziegler

The rental, excuse me, is about 15% of our Construction business. And over time, structurally that probably could grow as given what has happened with the liquidity crisis you may see some contractors choosing to rent a little longer than they would typically. So that's item one. In terms of the debt level, the reason for keeping cash is in part for liquidity. We're going to -- prior to the liquidity crisis, we had talked about having about $1 billion of cash on our balance sheet for liquidity. As we continue to grow our business overseas, and quite candidly because of liquidity concerns, we're targeting into something more in the range of $2.5 billion to $3.5 billion in cash. And so you should expect that going forward. That said, don't forget, we have been buying back shares, so you're seeing us return cash that way. And additionally, we've had 8 dividend increases since 2004. So we're continuing to reward our shareholders directly with the return of cash in the form of dividends share repurchases, as well as continuing to make the necessary investments to grow our business platform.

Operator

Our next question comes from Mark Koznarek.

Mark Koznarek - Cleveland Research Company

It's Cleveland Research. A question on the effective capacity impact of the Tier 4 launches in large ag equipment. All things held equal moving into 2012, those large ag Tier 4 problems will be behind us, the launch problems. So what kind of effective capacity increase are we looking at next year, everything else held equal?

Tony Huegel

Yes. We would say for large ag, specifically in Waterloo, our capacity year-over-year for 2012 would go up in the 10% to 15% range and that's not coming just from the Interim Tier 4 impact. We've also talked about adding capacity there through 2012. And so we'll get some benefit of that capacity increase throughout the year. So those 2 combined would add about 10% to 15%, 2012 over 2011.

Mark Koznarek - Cleveland Research Company

And that's Waterloo and East Moline?

Tony Huegel

That's Waterloo large tractors.

Mark Koznarek - Cleveland Research Company

And East Moline basically would be similar?

Tony Huegel

Well, they would have an Interim Tier 4 advantage. But we're not adding additional capacity there like we are in Waterloo. So I think it's less than...

Mark Koznarek - Cleveland Research Company

Is it somewhat less. And then sort of the flip side of that, you're now 7000s and smaller stuff has to transition next year. Are we going to expect to see sort of a hit to effective capacity because of that transition similar to the numbers you just stated here for large ag?

Tony Huegel

Certainly, you'll have some capacity impact next year as those products transition, so.

Koki Shiraishi - Daiwa Securities Capital Markets Co. Ltd.

Yes. So overall, it could wash. But at least large ag could have some effective increases.

Tony Huegel

Exactly.

Operator

Our final question is from Stephen Volkmann.

Stephen Volkmann - Jefferies & Company, Inc.

It's Jefferies. So I think most of them have been answered. But I'll ask corollary to Mark’s, which is on the cost side, I guess, as we look into 2012, it would seem that there are a number of things that have kind of hit us here in 2011 that should go away in 2012. And I'm wondering if we should be thinking about incremental margins actually kind of go and back up again, as we get into 2012? Or do you see enough on the costs front that it's too early to kind of commit to that?

James Field

Steve, we're not going to get in to talking too much about 2012 margins. But there are a couple of issues that we have dealt with this year that we certainly wouldn't anticipate next year. R&D going up 17% again. I think we've said that, that we are going to stay at healthy levels but not -- we're not certainly anticipating those sorts of double-digit increases. And so I think it's fair to say, without commenting too much on 2012 that as you look through the analysis, there are some items here that we wouldn't expect to repeat.

Stephen Volkmann - Jefferies & Company, Inc.

Just a quick follow-up if I could. You guys have talked a little bit lately about trying to better balance your shorter-term performance, which has been great, on the back of SVA with some longer-term growth opportunities. And I'm just wondering if there is a sort of a strategic shift that we should be thinking about? And if there's some bigger projects out there that we should be starting to think about you guys pursuing that kind of balance you better with longer-term growth?

James Field

Well, I would start the answer to that question that as what we've said in prior is we remain fundamentally committed to SVA and the SVA model. And we're going to focus on that, but at the same time, focus on our 2 global growth platforms, which is agricultural and construction equipment. And I think the announcements that you saw this morning is good evidence of our commitment to delivering growth for the future, but at the same time delivering some very, very solid operating results. And so I think that's the kind of performance you should expect from us going forward. We're going to be focused on both aspects of the business, solid performance and solid growth. So with that, we should sign off. Thank you very much.

Tony Huegel

Thank you all for your interest. And as always, we'll be available throughout today for any follow-up questions. Thank you.

Operator

Thank you. This does conclude today's conference call. We thank you for your participation. You may now disconnect your lines.

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