Deere & Company (NYSE:DE)
Q2 2016 Earnings Conference Call
May 20, 2016 10:00 A.M. ET
Tony Huegel - Director, Investor Relations
Joshua Jepsen - Manager, Investor Communications
Rajesh Kalathur - SVP and CFO
Andrew Casey - Wells Fargo
Jamie Cook - Credit Suisse
Adam Uhlman - Cleveland Research Company
Jerry Revich - Goldman Sachs
Ross Gilardi - Bank of America/Merrill Lynch
Ann Duignan - JP Morgan
Mircea Dobre - Robert W. Baird
Kwame Webb - Morningstar
David Raso - Evercore ISI Group
Michael Shlisky - Seaport Global Securities
Robert Wertheimer - Barclays Capital
Steven Fisher - UBS
Joel Tiss - BMO Capital Markets
Stephen Volkmann - Jefferies
Brendan Shea - RBC Capital Markets
Good morning and welcome to Deere & Company Second Quarter Earnings Conference Call. Your lines have been placed on listen-only until the question-and-answer session of today's conference. I would now like to turn the call over to Mr. Tony Huegel, Director of Investor Relations. Thank you, you may begin.
Thank you, Dexter. Also on the call today are Raj Kalathur, our Chief Financial Officer and Josh Jepsen, our Manager Investor Communications. Today, we'll take a closer look at Deere's second quarter earnings, then spend some time talking about our markets and our current outlook for fiscal 2016. After that, we'll respond to your questions. Please note that slides are available to complement the call this morning. They can be accessed on our website at www.johndeere.com.
First a reminder, this call is being broadcast live on the Internet and recorded for future transmission and use by Deere & Company. Any other use, recording, or transmission of any portion of this copyrighted broadcast without the express written consent of Deere is strictly prohibited. Participants in the call, including the Q&A session, agree that their likeness and remarks in all media may be stored and used as part of the earnings call.
This call includes forward-looking comments concerning the company's plans and projections for the future that are subject to important risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially is contained in the company's most recent Form 8-K and periodic reports filed with the Securities and Exchange Commission.
This call also may include financial measures that are not in conformance with accounting principles generally accepted in the United States of America 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/earnings under Other Financial Information. Josh?
Thank you, Tony. John Deere’s performance for the second quarter and first six months reflected the continuing impact of the downturn in the global farm economy as well as weakness in markets for construction equipment. Nevertheless all our businesses remained profitable. They benefitted from the sound execution of our operating plans, the strength of our broad product portfolio, and our success establishing a more flexible cost structure. You may have also noticed that we’ve made changes in our outlook for sales and profits for the full year.
Now let’s take a closer look at our second quarter results beginning on slide 3. Net sales and revenues were down 4% to $7.875 billion. Net income attributable to Deere & Company was $495 million. EPS was $1.56 in the quarter.
On slide four, total worldwide equipment operations net sales were down 4% to $7.1 billion. That’s better than our previous net sales guidance of down about 8%. The higher sales in the quarter were largely due to timing differences of shipments between quarters mainly attributable to agriculture and turf equipment in North America and Brazil. Price realization in the quarter was positive by one point. Currency translation was negative by two points.
Turning to our review of our individual businesses, let’s start with agriculture and turf on slide 5. Net sales were flat in the quarter-over-quarter comparison. Foreign currency exchange had a negative impact on sales with the biggest impact coming from the Brazilian Real. Partially offsetting this was positive price realization. Operating profit was $614 million down from $639 million last year. The decrease in operating profit was primarily driven by unfavorable foreign currency exchange, lower shipment volumes, and a less favorable product mix. These factors were partially offset by price realization, lower production cost, and lower selling, administrative, and general expenses.
Before we review the industry sales outlook let's look at the fundamentals affecting the Ag business. Slide 6 outlines U.S. farm cash receipts. Given the record crop harvests of the last three years and the resulting lower commodity prices, our estimates for 2015 cash receipts remains down about 10% from 2014 peak levels. Our 2016 forecast contemplates total cash receipts to be about $375 billion down only slightly from 2015.
On slide 7, grain stocks to use ratios remained at somewhat sensitive levels even after the abundant harvest of the past three years. Global grain and oil seed demand continues to be strong while supplies are now fully adequate. Even so, unfavorable growing conditions in any key region of the world as well as unknown impacts from any geopolitical tensions could result in prices quickly moving higher.
Our economic outlook for the EU 28 is on slide 8. Modest economic growth is continuing, however, the region is experiencing continued geopolitical risks such as the upcoming Brexit referendum. Farm income remains below the long-term average and weakness persists in the dairy sector. As a result we’re expecting lower industry farm machinery demand in the EU region.
On slide 9 you will see the economic fundamentals outlined for China and India. Due to the economic slowdown in China, we continue to anticipate lower industry sales. Although the government continues to be supportive of the agriculture sector recent policy changes related to corn floor prices, reduction of corn stock piles, and a less stringent position on grains self sufficiency are causing short-term uncertainty for both domestic and global markets.
Turning to India, the economy is growing, outpacing other emerging markets and foreign investment is returning. The government continues providing assistance to the Ag sector with programs such as minimum support prices for commodities, irrigation, and crop insurance. Lastly, the upcoming monsoon is expected to provide above average moisture after two years of below normal seasons. These factors are resulting in improved industry demand in India.
Shifting to Brazil, slide 10 illustrates the crop value of agricultural production a good proxy for the health of the Agri business there. Ag production is expected to decrease about 2% in 2016 in U.S. dollar terms due to lower global commodity prices. The situation is more positive in local currency as Brazilian farmer profitability remains at good levels as crops are sold in dollars. Although Ag fundamentals remain positive, farmer confidence is low due to economic and political concerns as well as growing inflation, all of which are leading to lower equipment sales.
The political landscape is shifting with the recent impeachment vote of the Brazilian President and the new administration taking shape. This includes the appointment of an agriculture minister with strong ties to farming and Agri business. Though it’s too soon to draw conclusions, the agricultural sector seems encouraged by these changes.
Staying in Brazil, slide 11 illustrates the finance rates for Ag equipment. Brazil recently announced details of eligible rates for government-sponsored finance programs. They apply to the upcoming budget year which runs from July 2016 through June 2017. Rates for Moderfrota will increase from 7.5% to 8.5% for small and mid-size farmers and from 9% to 10.5% for large farmers. While the rates are being increased, it’s important to note they remain below the level of inflation in Brazil. This announcement is a positive sign. It removes an element of uncertainty for farmers and conveys confidence the government will continue to support agriculture in spite of the economic and political challenges in Brazil.
Our 2016 Ag & Turf industry outlooks are summarized on slide 12. Low commodity prices, stagnant farm incomes, and elevated used equipment levels in the U.S. and Canada are continuing to pressure demand for farm equipment. The decline is most pronounced in the sale of high horsepower models. Our forecast for industry sales in the U.S. and Canada remains down 15% to 20%, with large Ag equipment sales down 25% to 30%.
The EU 28 industry outlook remains flat to down 5% in 2016, due to low crop prices and farm incomes as well as continued pressure on the dairy sector. In South America, industry sales of tractors and combines are now projected to be down 15% to 20% in 2016, a result of the downturn in Brazil and other commodity-driven economies in the region. Shifting to Asia, sales are expected to be flat to down slightly primarily due to weakness in China.
Turning to another product category, industry retail sales of turf and utility equipment in the U.S. and Canada are projected to be flat to up 5% in 2016. Putting this altogether on slide 13, fiscal year 2016 Deere sales of worldwide Ag & Turf equipment are now forecast to be down about 8%. This includes about two points of negative currency translation. The improvement in our forecast is driven almost entirely by foreign currency exchange. Ag & Turf division operating margin is forecast to be about 7% in 2016, unchanged from the previous forecast. The implied decremental margin for the year is about 28%.
Now let’s focus on construction and forestry on slide 14. Net sales were down 16% in the quarter as a result of lower shipment volumes and higher sales incentive costs. Operating profit was $74 million in the quarter, down from a $189 million last year. The decrease was driven by lower shipment volumes, higher sales incentive costs, and an unfavorable product mix. These were partially offset by lower production costs and lower selling, administrative, and general expenses. The higher sales incentive costs are reflective of the highly competitive environment in North America. The division’s decremental margins was about 43%.
Moving to slide 15, looking at the economic indicators of the bottom part of the slide, growth in construction spending less energy and GDP are both positive, and how these starts are expected to be just below 1.2 million units this year. In spite of these encouraging signs, the industry continued operating at a slow pace. Contributing factors are rental utilization rates continue to decline. Weak conditions persist in the energy sector. Used equipment is readily available and continues to be redeployed from energy producing regions to other parts of the country.
The mix of housing starts in the U.S. is skewed to multifamily homes requiring less earth moving equipment and economic growth outside the U.S. is sluggish. As a result Deere’s construction and forestry sales are now forecast to be down about 13% in 2016. The change from our previous forecast is largely driven by lower sales in the United States and Canada and the impact of higher sales incentive costs. The forecast for global forestry markets remains down 5% to 10% from the strong levels we experienced in recent years primarily as a result of lower sales in the U.S. and Canada. C&F's full year operating margin is now projected to be about 6%, the implied decremental margin for the year is about 32%.
Let's move now to our financial services operations. Slide 16 shows the annualized provision for credit losses as a percent of the average owned portfolio. At the end of April, it was 17 basis points, reflecting the continued excellent quality of our portfolios. The forecast for 2016 now contemplates a loss provision of about 23 basis points. The change from our previous guidance is related to our C&F retail note and agriculture revolving credit portfolios. Despite the increase, this would still put Deere’s losses below the 10 year average of 26 basis points and well below the 15 year average of 39 basis points.
Moving to slide 17, Worldwide Financial Services net income attributable to Deere & Company was $103 million in the second quarter versus $170 million last year. The lower results were primarily due to higher losses on lease residual values, less favorable financing spreads, and a higher provision for credit losses. 2016 net income attributable to Deere & Company is now forecast to be about $480 million. The outlook reflects the same factors cited for the quarter namely less favorable financing spreads, higher losses on lease residual values, and an increased provision for credit losses. Also remember that 2015 results benefitted from a gain on the sale of crop insurance business of about $30 million.
Before we move on to receivables and inventory let's discuss the losses on residual values noted in the earnings release. The losses in the quarter were primarily related to impairments on both construction and agricultural equipment operating leases with construction accounting for more than half of the amount. While short-term leases of 12 months or less make up only 15% to 20% of the operating lease portfolio, they account for over 60% of the impairment charges in the quarter.
Recent experience has seen both a higher rate of matured lease inventory being returned to John Deere Financial in addition to higher loss rates upon the remarketing of these lease returns. We’ve taken a number of actions to mitigate risk on our operating lease portfolio, a few examples include lowering residual values for future leases most heavily impacting short-term leases, significantly restricting our short-term lease offerings, and increasing risk sharing with dealers.
Slide 18 outlines receivables and inventories. For the company as a whole receivables and inventories ended the quarter down $381 million. For the quarter timing of shipments impacted the Ag and turf division. We expect to end 2016 with total receivables and inventory down about $400 million with reductions from both divisions. The change in the forecast for Ag and turf is largely driven by foreign currency exchange. Field inventory to sales ratios for new large Ag equipment are expected to end the year in line with 2015 year-end levels, which is consistent with our previous forecast.
Our 2016 guidance for cost of sales as a percent of net sales shown on slide 19, is about 79% unchanged from the last quarter. When modeling 2016 keep these unfavorable impacts in mind, unfavorable product mix, tier 4 product cost, and overhead spend. On the favorable side we expect price realization of about one point, favorable raw material costs, lower pension and OPEB expense, and lower incentive compensation expense.
Now let’s look at a few housekeeping items. With respect to R&D expense on slide 20, R&D was up 1% in the second quarter. Our 2016 forecast calls for R&D to be down about 1% with approximately one point of negative currency translation. Moving now to slide 21, SA&G expense for the equipment operations was down 5% in the second quarter with currency translation, pension and OPEB and incentive compensation accounting for nearly all the change.
Turning to slide 22, our 2016 forecast contemplates SA&G expense being down about 4%. The same factor cited for the quarter account for about seven points of the full year change. Turning to slide 23; pension and OPEB expense was down $50 million for the quarter and is forecast to be down about $200 million for the full year, unchanged from the previous forecast. On slide 24, the equipment operations tax rate was 31% in the quarter, primarily due to discrete items. For 2016, the full year effective tax rate is now forecast to be in the range of 31% to 33%.
Slide 25 shows our equipment operations history of strong cash flow. The forecast for cash flow from the equipment operations is about $2.1 billion in 2016. The company’s third quarter financial outlook is on slide 26. Net sales for the quarter are forecast to be down about 12% compared with 2015. This includes about two points of price realization and unfavorable currency translation of about one point. Turning to slide 27 in the full year outlook, our forecast now calls for net sales to be down about 9%. Price realization is expected to be positive by about one point. The reduction in price realization guidance is mostly in response to competitive pressures in the C&F division. Currency translation is negative by about two points. Finally, our full year 2016 net income forecast is now about $1.2 billion.
In summary, there's little question that Deere will face challenging conditions for the rest of the year. Even so, it is noteworthy the company is continuing to perform at a much higher level than we've done in previous downturns. This is due in large part to our success in developing a more durable business model and a broader range of revenue sources. What's more, the company’s financial condition remains strong. In fact we believe Deere is well-positioned to capitalize on attractive growth opportunities that will deliver value to our customers and investors in the future. Meanwhile on the cost side, we're continuing to look for ways to streamline our operations and make them even more efficient and profitable. I’ll now turn the call over to Tony.
Thank you, Josh. Now we're ready to begin the Q&A portion of the call. The operator will instruct you on the polling procedure. In consideration of others and our hope to allow more of you to participate in the call, please limit yourself to one question and that includes no multiple-part questions. If you have additional questions we ask that you rejoin the queue. Dexter?
Okay. So we will now begin the question-and-answer session. [Operator Instructions]. And our first question comes from the line of Andy Casey of Wells Fargo. You may now ask your question.
Thanks, good morning. Question on the guidance, I'm trying to understand the components of the $100 million net income guidance reduction, the tax rate down kind of more than offsets the $45 million down in credit. Can you kind of run through the other factors driving net income guidance decrease because it doesn’t really look like the operating profit post corporate really changed that much?
Sure. And yes, there's a lot of moving pieces and I know you all love when I point out rounding. But truly again this quarter there is rounding. I’ll point out a few of those specifically. As you think about Ag & Turf in the rounding there, we talk about a 7% operating margin, understand that is rounding up. So you’re actually let's say you are closer to a 6.5 and you are 7. And similarly construction is also rounding up. So as we point out, the 6% it’s really closer to 5.5%. And I would point out as well, the 1.2 billion in income is also a rounded number and, in this case it is actually rounding down a little bit. So to your point if you look at some of those moving pieces, when you think about construction, when you think about some of the positive as well as is financial services coming down, you don’t necessarily see a full $100 million. And I would point out as you look at the change in our internal forecast for net income it wouldn’t be a full $100 million reduction either. It is just a way of rounding looks it does go to the full $100 million.
So again you are right in the sense that obviously you are seeing some negatives from financial services. That income is obviously lower. The other larger item that did reduce in the quarter is around construction and forestry and as you think about that sales change, a good portion of that relates to pricing and with competitive pressures that we have seen our price realization has come down. Actually I will tell you it is slightly negative in our forecast today. And remember as we reduced pricing, that drops right to the bottom line and so that does have a greater impact on the profitability of that particular division. Those are the major moving pieces.
Okay, so it’s not really related to other expense because that was considerably higher?
Yes, that’s exactly right. Okay, thank you. Next caller?
Thank you very much. Our next question comes from the line of Jamie Cook of Credit Suisse. You may now ask your question.
Hi, good morning. I guess just a couple of questions, Tony I think you guys covered the finance sub in your prepared remarks but could you just give a little more color you said you changed some of your assumptions on residual values on risk sharing agreements with dealers, so can you give color exactly on what you did there and your confidence level that this isn't the first step I guess more to come? Thanks.
Sure, yeah, and certainly I can't get too specific on the details of what we have done again just from a competitive perspective. We try to be cautious around that. But I think maybe to put some of this in context, remember the two key drivers when you think about operating leases and the gains or losses on the return of matured lease inventory there is really two factors that we tend to focus on; what's the rate of return? So how much of that equipment actually comes back to John Deere Financial. And in this case as we talked about we’re seeing on short-term leases a much higher return rate than the average portfolio. So more of that equipment is coming back to John Deere Financial for disposition.
And then the second factor is now what of those that come back how much can you sell that for versus what the residual value is. And again on the shorter-term leases we’re seeing a higher level of loss generally on the disposition of that equipment. So those are that -- a lot of the work we’ve done is around how do we shore up and reduce the risk around those short-term leases. And so obviously as Josh talked about in the opening comments, it's around residual values, changing those, again bringing in more risk, sharing with the dealers. In fact I would tell you on some of the used equipment short-term leases, those 12 months leases dealers today effectively are guaranteeing the residual value in terms of if we are going to write a 12 month lease on used Ag equipment.
So, those are some of the changes that we would have made but again it’s with the focus on how do we reduce some of that risk primarily around the short-term portion of the business. So we’ll see as we move forward. Again we are doing a lot of work around how do we reduce the return rate going forward doing some advanced marketing with our dealers and customers to again see more of that matured lease inventory stay with either of the customer or the dealer, not get put back on John Deere Financial, as well as exploring a part of that, how can we dispose of that equipment more profitably. So we’ll see as we move forward but those would be the two areas I would point out.
As much as I’d love to say we've captured it all and there's really no risk going forward, the change in the return rate as well as the loss rates are going to be the two factors we're looking at internally. And that I would point out has a risk of getting worse. It also has the opportunity to get better if some of these activities do actually work out and we're able to reduce those two factors. So again, hopefully, a little bit more color that helps provide some idea of what we're doing there. Thank you. Next caller?
Okay. Thank you. I’ll get back in queue.
Thank you very much. Our next question comes from the line of Adam Uhlman of Cleveland Research Company. You may now ask your question.
Hi, guys. Good morning. On raw material costs, I guess you had mentioned that you expect that to be favorable for the year but we've seen steel prices move higher quite a bit recently. And so I'm wondering at what point in the year, in your model, does this start to become unfavorable, is that going to start in the fourth quarter as we expect that in the first quarter of next year, maybe talk through that?
That’s a good point and I would point out certainly we would describe steel prices today as very volatile. As you pointed out we've seen steel prices increase pretty dramatically here in the last several months, started really with some spikes in pricing in China. I'd note that actually in the Chinese market the pricing’s come down pretty dramatically again. So there are a lot of people who would argue that the high level they’re at today is likely to come off of that pricing. Again, not that we're saying it’s likely to come back down well below the $400 range either on some of the steel pricing. Candidly the steel mills at that level are largely unprofitable. So we would expect it to settle back a bit.
Now for Deere, to get specific to your question, we would point out our risk is mostly in our fourth quarter, the way our contracts are set up. We don’t have a lot of risk through third quarter, but going into fourth quarter, and then of course what that means for fiscal 2017 depending on where the steel prices settle in, could have some impact next year as well. So again it’s a little premature, given the volatility to talk much about what 2017 might look like but for us the risk is fourth quarter. And I’d point out it’s a relatively low steel purchasing quarter for us. So minimal impact on 2016, more risk in 2017. Okay. Thank you. Next caller?
Thank you. Our next question comes from the line of Jerry Revich of Goldman Sachs. You may now ask your question.
Hi, good morning everyone. Tony, can you talk about the pace of operating lease growth for used equipment in Ag for you from here? I think last year was one of the bigger levers that you folks used to bring down used equipment inventories in the channel and I'm wondering if this year you're expecting a similar contribution? Have your plans there changed at all post the adjustment this quarter? Thanks.
Yeah, again, I think the easiest way to answer that is it will depend on what our customer preferences are as we -– as our dealers seek to move that equipment, and I’ll point out again as I have in the past, when you think about leasing versus retail notes, our preference candidly would always be a retail note versus an operating lease. But if our customer’s preference is to have an operating lease then we’ll certainly consider that.
Now as I mentioned earlier, from a short-term perspective and specifically I'm talking about 12-month leases, we've done a number of -– made a number of changes that make those short-term leases candidly much less attractive. And in terms of some of the residual value changes that we would point out, it’s really setting those residual values at a level that’s more appropriate for the type of experience we're seeing today on the disposition of the matured lease inventory. So going forward certainly if a customer has a preference towards a longer-term lease when they’re looking to buy used equipment, we would continue to look to offer that lease option from a financing perspective. I think there's a little bit of misunderstanding or information in the marketplace around the level of leasing too. I’ve heard numbers as high as 50% is going into operating lease today. We would tell you year-to-date if you look at operating leases versus retail note its closer to a quarter of the volume is operating lease. Now again to be fair that is higher than what it would have been historically, but it is nowhere near that half type of range that some are talking about.
Thanks Tony, and that half is not from us, we appreciate it.
Thank you, next caller.
Thank you. Our next question comes from the line of Ross Gilardi of Bank of America/Merrill Lynch. You may now ask your question.
Thanks Tony, so what are the factors that actually got you to flat year-on-year revenue in Ag and yet you’re implying an 11% revenue decline in the second half of 2016. So what's going on there?
Sure, last quarter our sales came in a little lighter for the first quarter than what we had forecast and we talked about there that was largely a shift of production from first quarter into second quarter. So we anticipated second quarter being a little higher and I would tell you the opposite happened this quarter. We actually also saw in addition to the first quarter shipments moving into second pulling forward a little bit of the production from third quarter which is why again when you think about our agricultural Ag and turf division we really didn’t see a change. When you back out FX didn’t see a change in the sales impact. It is really just shifting between quarters and that’s largely what drove those higher sales in the second quarter.
Yes, thank you. Next caller.
Thank you. Our next question comes from the line of Ann Duignan of JP Morgan. You may now ask your question.
Hi, good morning.
Hi, I am struggling a little bit to understand your strategy on the agricultural side. If I look at industry data, there are about 15,000 used Deere over 100 horsepower tractors for sale and yet inventories of new equipment are now at 37% of trailing 12 month sales, almost double a year ago. So can you talk to us a little bit about what is your strategy on the used equipment side, how do you help dealers get rid of that used equipment? Thank you.
Actually, I’ll loop back around to used, but I want to address the new inventory because I think that is maybe as relevant as anything that you pointed out there. In the sense that I think you are looking at the AEM data that’s in the appendix. I would point out that 100 horsepower and above, so that’s a wider range than what we would consider large equipment. We would start at 220 horsepower as large Ag equipment and very specifically that 100 horsepower, 100 to 200 horsepower range is mostly for us to be our 6000 series tractors. I would point out that those 6000 series tractors come from Germany and as a result they aren't a build to retail order type of product as our large equipment large tractors would be in the U.S. and Canada. So you do get some shifts timing wise from that perspective.
I'd also point out similar to the previous question, we did have some higher level of shipments in the third quarter even on the larger equipment so there is some timing difference there as well. Maybe most importantly as we think about year-end, again think about the quarter-end as a timing issue in terms of inventory in the field of new equipment. When you look forward, what's in our forecast today assuming our retail sales forecast is accurate and our shipment forecast is accurate, we will end the year with that 100 horsepower and above inventory to sales ratio very much in line with where we ended 2015. Even inclusive of those 6000 series tractors.
Certainly from a large Ag perspective we’re expecting even a bit more of a decrease in that particular product. You know, again we work in a lot of ways on used equipment with our dealers. Certainly we leverage what we use as pool fund that provide availability to that dealer and again much of that is with the focus on the level of new equipment that they are willing to sell given the level of used. As you know, every new piece of equipment comes of the used trade. And so we do try to balance that and talk through that with our dealers. So -- but again, I think what you're seeing today in those inventories is largely some seasonality type of differences. So -- okay? Hopefully that gave you some additional color and we’ll go ahead and move on to the next caller. Thanks, Ann.
Thank you. Our next question comes from the line of Mircea Dobre of Robert Baird. You may now ask your question.
Good morning, everyone. Tony, if I may I’d like to ask you a question on farm balance sheets. That’s slide 40 of your presentation. And obviously based on that chart, things are looking pretty good. But if we're looking at farm balance sheets, land accounts for better than 80% of farm assets. We're starting to see some deterioration in cash ramps; we're starting to see some erosion in farmland values. So I guess my question is how do you think about the risk to farm balance sheets going forward? And most importantly can equipment demand eventually stabilize if land values continue to erode?
Yes, certainly you are seeing -– and you're seeing it really in that chart as well to your point, while relative to history those debt-to-equity ratios are still at pretty attractive levels and we would argue that farmers in general their balance sheets are pretty strong. They came into this downturn having come through a strong environment with balance sheets in good order. But you're seeing those creep up and some of that or a good portion of that is assets coming down and specifically land values. So you are seeing some of that and its coming down slowly.
We don’t anticipate any kind of precipitous decline in land values, we're certainly not seeing signals of that. It’s coming down but at moderate – modest-to-moderate pace. As a result financing ratios are creeping up a bit. But again, we don’t sense any major financial upheaval in the farm sector at this point. Again, I would point out, also at these levels, while farmer profitability is significantly lower, broadly speaking, farmers are still profitable at these corn prices. And again, not that they aren’t being pinched but are still being profitable.
So if corn prices stay at this level, I would point out as cash rent comes down that helps the profitability of most farmers as well. So there's a little bit of double-edged sword on those land values and in terms of the impact it has on farmers.
Thank you. Appreciate the question and we’ll move on to the next caller.
Thank you very much. Our next question comes from the line of Kwame Webb of Morningstar. You may now ask your question.
Good morning. Thanks for taking my question today. I just want to get a little bit of expanded commentary on South America. So as I think about the two big things going on there particularly in Brazil, not only was there uncertainty around the rates but also it seemed like there was a little bit of a bottleneck in terms of turnaround time on those applications. So if you’d kind of give some thoughts on that and then any early thoughts on your exposure to the Argentina market, as that seems to be opening up? Thanks so much.
Thank you and I appreciate the question, yes. Certainly as you think about Brazil I think I would still claim obviously is our outlook for South America did decline a bit on tractors and in combines. Things are still -– the market’s still pretty tough there. But to your point there are -– have been a couple of signs recently of potential positives. Certainly the fact that FINAME financing rates have been announced while they’re higher than what we've been at, they’re still at very attractive levels for farmer customers’ that point out below – continue to be below inflation.
So that is very helpful from that perspective. And actually in the short-term we point out could result in a little bit of a pull ahead. So farmers have until, I believe, its June 9th, to make their applications under the current rates before the rates move up those -– a couple of points. So again in the short-term we would expect to see some nice activity.
But again as Josh pointed out in the opening comments, a lot of that uncertainty around what will happen, will we even have a FINAME program, what's going to happen with down payment requirements, all those sorts of things that at least for the time being largely been alleviated. But we’ll see as we move forward because there is still some uncertainty. I think again we’re getting the sense that the agricultural community is viewing these changes positively but it is early and I would say the same thing in Argentina. Again some very positive changes for farmer customers, their ability to export their product, those sorts of things but it is still early. So we could potentially I suppose later in the year, you could see some benefit but I would argue most of that we would view as a 2017 opportunity versus the 2016 opportunity.
Thanks for the color.
You bet, thank you, next caller.
Thank you. Our next question comes from the line of David Raso of Evercore ISI. You may now ask your question.
Hi, thank you. Really just a simple question if you look at the second half implied EPS that you adjusted for what second half usually is at the full year, we are sort of walking away from the call with the idea of the second half of the years implying annualized earnings power roughly around $3. To walk us away from that assumption can you help us a bit maybe with is production in the second half going to be well below retail, maybe help quantify what the pull forward was from 3Q and a 2Q so I can smooth it out and put it back into the second half, I am just trying to understand is that what we should be walking away with given where you’re implying second half EPS?
Yeah, I mean when you think about net income in the back half you certainly as our guidance implies, our first half was stronger than the back half is forecasted to be. We have had some shifts in production. I mean broadly I can't necessarily say that that's been the case, but things like large tractors and there is obviously some relevance there. Year-over-year if you look at 2015, in the first half about 45% of our shipments occurred in the first half and 55% in the back half. 2016 that actually flips and again that was just the really more reflective of if that factory looked at the best way to line up the production for the year, that’s what made the most sense for 2016.
So we are seeing a little bit of shift in some of those products as we move forward. Certainly as you look at construction, things aren't getting easier there and our forecast as we talked about last year does not look for the back half of the year to improve. And seasonally you’ll see some sales increases but you are not going to see in our forecast anyway any anticipated lift in the overall market. So you don’t get that benefit year-over-year those sorts of things. So again I think you are right in the sense that the back half is a bit lighter than the first half in our forecast.
David, this is Raj I would not annualize the second half rather look at the full year. Quarter-to-quarter we have changes that can impact the full year and this time Tony said there was some pull ahead from the third quarter what would have been in the third quarter to the second quarter.
That is why I am asking if you can help quantify it, I mean is the 300 million and that’s roughly with a reasonable incremental margin, it was $0.16. I mean help us because if you don’t help us it is what it is, it’s the second half is usually 46% to 49% of the full year, that second half run rates implying like a $3.05 earnings power. But again if you help us with the pull forward say its $0.16 then it's more like implying a $3.35 annualized run rate. We’re just trying to help understand is this how we should view the earnings power as the back half is telling us, or is production also well below retail in the second half. We’re just trying to help frame it because otherwise it is what it is. It is implying $3.05 kind of annualized run rate?
So David all I would say is taken the second half and annualizing it will not give you the right answer going forward. So you may want -– so we cannot really quantify it any more than that.
Unfortunately I think that’s about all the further we’re going to be able to go with that one. So we can take that offline later. Just go on to the next caller. Thanks David.
Thank you. Our next question comes from the line of Mike Shlisky of Seaport Global. You may now ask your question.
Good morning guys, I want to touch on your share buybacks. I haven't seen all that much thus far in 2016. I guess is it kind of safe to say that 2016 buybacks will be behind what we have seen in 2015, 2014 and could you update us possibly are these sort of cash out there that are a bit higher in your hierarchy that you're kind of holding on to cash flow now, are there any good deals out there, any new markets, etcetera.
Mike, this is Raj. As you know cash use priorities remain the same. They’ve not changed at all. So our single A is the highest priority and then we look at strategic options. And with respect to strategic growth options you’ve seen us keep organic R&D spend at a pretty healthy rate and you’ve also seen us announce some inorganic acquisitions. And you’ve seen us talk about Precision Planting, Monosem, and more recently Heidi [ph]. So in this type of an industry environment where we have a very strong financial position, some of these inorganic options become more actionable for us. And if they are in the long-term interest of our shareholders for profitable growth in the long-term, we will act on some of those. And then dividends are our next priority and then finally share repurchases and we've always said share repurchases are a residual use of cash. And as you just mentioned we have higher –- if there are higher priority uses, we apply it those. Now I won’t say this with respect to share repurchases, we have also said we will do those only if it fits in the long-term interest of long-term shareholders. We still think it’s very good value for long-term shareholders, but we want to first allocate cash for other higher priorities.
Okay. Thank you. Next caller.
Thank you. Our next question comes from the line of Robert Wertheimer of Barclays. You may now ask your question.
Hi, thanks, good morning. Thanks for the question. The loss of the -– the charges or losses on leases, were that just on stuff that was turned in or did you change the depreciation assumption as well?
Yes, so there’s both losses and impairments that we took on some of the items that were either an inventory or as well as some of the future leases. So we did look at some of the impairments. We basically looked out a year at lease maturities and took what we felt was the most applicable experience that we're seeing. Again as I mentioned earlier on the return rates that we're experiencing as well as the loss rates and apply those to that future lease maturity. I’d point out to the extent that short –- as we looked out a year to the extent that those short-term leases have been our largest challenge, we would have captured obviously the lions share of those short-term leases in that analysis that we took. And then as we evaluate and make changes going forward, the intent is to reduce that risk significantly on future short-term leases to the extent we do book any 12-month leases as we move forward.
Rob, this is Raj. Let me just take a broader perspective on this. You know operating leases are only about 14% of our total portfolio. And then the impairments and losses have been concentrated in less than 20% of this 14%, okay? So this is primarily the less than 12 month and less leases. And you heard us talk about clearly taking significant steps to address this issue, lowered our residual values, we have significantly restricted the 12 month or less leases. But for those maturing in the next few quarters, now we've assumed recent loss rates and return rates and also forecasted that. We also, you heard from Tony, we’re also actively working on limiting our loss rates and return rates for what’s going to mature in the next few quarters. Now the other 86% of the GDF portfolio, we are forecasting we have about 23 basis points of loss provisions. So still a very good financial portfolio, especially given where the industry is or where all in the competitive environment is.
Okay. Thank you. Next caller.
Thank you. Our next question comes from the line of Steven Fisher of UBS Securities. You may now ask your question.
Great, thanks. Good morning. On pricing in construction including the selling incentives I know you said is now expected to be down slightly for the year, really just trying to understand the trend in the second half versus what you are seeing in the fiscal second quarter, is that currency is maybe not as much of a competitive threat from some players as it was in the first half and I think some folks are expecting that to really help the pricing dynamic going forward. So as to what extent are you expecting pricing to get increasingly challenging in the second half versus just what you saw in the second quarter and are you stepping up restructuring to kind of mitigate that?
Yes, I think in relation to the pricing what we’re looking at is really reflective of what we have seen in the marketplace to date from a competitive perspective. Certainly you would hope as we’ve hoped all year that some of that competitive pressure would ease up a bit and others would be as focused on some positive price realization as we are. I would point out that isn't all about FX benefit in terms of the competitive pressures that we’re seeing. Meaning it is not just people who are leveraging yen benefits specifically. And so I’ll probably leave it at that but remember as the impact in the second quarter on price was greater than what you would see as a run rate going forward in the third and fourth quarter, simply because of the accrual that you have to make when you perceive higher levels of discount in the future because you now have to increase your accrual on all of the field inventory that’s already been shipped in prior quarters. So again at quarter end what you see, the way the accounting works the quarter in which you see that higher level of incentives going forward does tend to take a more significant hit. And so that was the impact for construction in the second quarter.
And with that we’ll move on to the next caller.
Thank you very much. Our next question comes from the line of Joel Tiss of BMO Capital Markets. You may now ask your question.
Hi, how is it going. I am just going to glue two random ones together here. Can you just remind us what the mix in your C&F or the construction business is that you are still selling to rental? And I wonder also on the mix shift in Ag, is that partially deliberate because you guys are moving -- trying to move a little more into smaller Ag or is that just the market forces pushing things around?
Certainly from a construction perspective historically we would have said 15% to 20% of our sales go into rental. It would be on the lower -- actually below that range today and in terms of what's going to IRC. We have talked a lot about from a small large mix especially on the utility tractors. Our desire -- our compact utility tractors, our desire to improve market share there. But to be fair some of that’s also market. The market is certainly not as weak on the small equipment as it would be on the large as we talked about in our guidance. So it is a bit of both, our desire to increase market share as well as the market shifting in that direction. Next caller.
Thank you. Our next question comes from the line of Steven Volkmann of Jeffries. You may now ask your question.
Hi, good morning. I only have one last kind of a philosophical question and I guess as I go through your appendix and look at what you guys are assuming for the backdrop here for the next year or so it is hard to make a case that there is much of a recovery likely going out over the next year or two and I am not really asking you to bless that forecast. So, I guess I am just trying to figure out kind of where are you in the cost control process and if next year were to be another down year would you be able to hold these decrementals around 30% or would they get worse and at what point do you kind of think about doing some real footprint reduction restructuring rather than just kind of headcount stuff? Thanks.
Yes, I mean I think and obviously it is pretty early to bless any forecast for 2017. But I would point out to your comment, I mean obviously the current forecast is pretty high. Corn crop to be planted, I am sure of a significant weather event that would impact production and I would argue that’s a comment from really any of the key growing regions if you see a significant weather impact. We will continue to believe you would see a pretty responsive change in pricing and the environment could shift pretty quickly. But at this point that’s primarily about weather and we’re not going to make a call on weather at this point in the process.
So let’s go with the assumption that you’re seeing a flattish kind of environment. Let's go with I think your question was more about down. If you’re talking about large Ag seeing another significant downturn, as we have talked about last year I mean it will be challenging for us given the levels we’re at with our production capacity today it will be very difficult for us to maintain this level of decremental margin. Especially to the comment earlier of I think Adam asked about with steel pricing, as you start to get headwinds on some of the material cost, that adds pressure as well but even if all of those costs are those sort of external cost if you will remain flat, another significant downturn in large Ag would make it very difficult for us to maintain these low decremental margins.
Now I want to shift, it does not mean that we aren't continuing to look for ways that we can reduce cost. We talked before, we haven't done lot on R&D. If we continue to see a further weakening or even continue at these levels we would take a much harder look at those projects. Certainly from a SA&G perspective as well I would say clearly we’re looking -- continuing to look at ways that we can streamline our processes and streamline our operations in order to reduce those costs. But the ability to do that at a level that would offset another significant step down in large Ag would not be likely.
Steve, this is Raj let me add to what Tony said, and if you look at the longer-term demand for grains it is still in very good shape. So it’s continuing to increase globally which is a positive signal for the long term for us. And as we look at the future, we have said if there is a change in our overall pieces in terms of long-term demand that would make us take some drastic changes in terms of our strategy. But we haven't seen that otherwise it is basically localized to weather. And we have said weather can impact that you have seen the prices come back -- core prices and especially soybean prices come back up sharply with just some of the weather scenarios in Argentina and Brazil.
Now with respect to your question on decrementals it clearly is going to depend on which part of the Ag or C&F segment goes down or goes up. So with a small Ag there is -- it is what you know more and more left with small Ag. If that goes down then our decrementals can be managed at the current levels or around the current levels. If it is going to be more on the large Ag it is going to be harder for us to manage but it is still going to be much better than in previous downturns, okay. And we do have continuing efforts in terms of structural cost reduction whether they be on a material cost side, overhead side, or SA&G side. So you will see us continuously work on those to offset any of these if the scenario of your -- should happen.
Thank you so much.
Okay, we’ll have time for just one more caller please.
Thank you. Our last question comes from the line of Seth Weber of RBC Capital Markets. You may now ask your question.
Hi, good morning, thanks for fitting in my question. This is Brendan Shea on for Seth. Just touching back on your sales composition, how much have recent acquisitions contributed to your current revenue and then how much do you have acquisitions baked into your estimates?
As you think about acquisitions keep in mind in our forecast as a general rule we would not incorporate sales of an acquisition into our forecast until the point in which we actually close on those. So that would include, in this case Hagie and Monosem. So it would be a pretty small percentage. So, I would say it wouldn’t be in rounding. You really wouldn’t see it in the current forecast.
Alright, with that we will close the call. Again I appreciate all of your questions and participation and as always we will be around throughout the day to answer any follow-up questions. Thank you.
And that concludes today's conference, thank you all for participating. You may now disconnect.
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