Form 10-Q
Table of Contents

 

LOGO

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 2, 2011

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-3671

 

      GENERAL DYNAMICS CORPORATION      
  (Exact name of registrant as specified in its charter)  

 

Delaware     13-1673581

State or other jurisdiction of

incorporation or organization

   

I.R.S. employer

identification no.

 

2941 Fairview Park Drive, Suite 100

Falls Church, Virginia

    22042-4513
Address of principal executive offices     Zip code
   

 

  (703) 876-3000  
 

Registrant’s telephone number,

including area code

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer  þ    Accelerated Filer  ¨    Non-Accelerated Filer  ¨    Smaller Reporting Company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ

356,112,755 shares of the registrant’s common stock, $1 par value per share, were outstanding on October 2, 2011.

 

 


Table of Contents

INDEX

 

     PAGE  

PART I - FINANCIAL INFORMATION

  

Item 1-

   Unaudited Consolidated Financial Statements   
   Consolidated Balance Sheet      3   
   Consolidated Statement of Earnings (Three Months)      4   
   Consolidated Statement of Earnings (Nine Months)      5   
   Consolidated Statement of Cash Flows      6   
   Notes to Unaudited Consolidated Financial Statements      7   

Item 2 -

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      27   

Item 3 -

   Quantitative and Qualitative Disclosures About Market Risk      44   

Item 4 -

   Controls and Procedures      44   

FORWARD-LOOKING STATEMENTS

     44   

PART II - OTHER INFORMATION

  

Item 1 -

   Legal Proceedings      45   

Item 1A -

   Risk Factors      45   

Item 2 -

   Unregistered Sales of Equity Securities and Use of Proceeds      45   

Item 6 -

   Exhibits      46   

SIGNATURES

     47   

 

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PART I – FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEET

 

(Dollars in millions)    December 31
2010
    (Unaudited)
October 2
2011
 

ASSETS

    

Current assets:

    

Cash and equivalents

   $ 2,613      $ 1,540   

Accounts receivable

     3,848        4,119   

Contracts in process

     4,873        5,137   

Inventories

     2,158        2,506   

Other current assets

     694        738   

Total current assets

     14,186        14,040   

Noncurrent assets:

    

Property, plant and equipment, net

     2,971        3,063   

Intangible assets, net

     1,992        2,044   

Goodwill

     12,649        13,454   

Other assets

     747        807   

Total noncurrent assets

     18,359        19,368   

Total assets

   $ 32,545      $ 33,408   

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Short-term debt and current portion of long-term debt

   $ 773      $ 222   

Accounts payable

     2,736        2,584   

Customer advances and deposits

     4,465        4,690   

Other current liabilities

     3,203        2,986   

Total current liabilities

     11,177        10,482   

Noncurrent liabilities:

    

Long-term debt

     2,430        3,907   

Other liabilities

     5,622        5,400   

Commitments and contingencies (See Note K)

                

Total noncurrent liabilities

     8,052        9,307   

Shareholders’ equity:

    

Common stock

     482        482   

Surplus

     1,729        1,853   

Retained earnings

     17,076        18,483   

Treasury stock

     (4,535     (5,758

Accumulated other comprehensive loss

     (1,436     (1,441

Total shareholders’ equity

     13,316        13,619   

Total liabilities and shareholders’ equity

   $ 32,545      $ 33,408   

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.

 

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CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

     Three Months Ended  
(Dollars in millions, except per share amounts)    October 3
2010
    October 2
2011
 

Revenues:

    

Products

   $ 5,290      $ 5,070   

Services

     2,721        2,783   
       8,011        7,853   

Operating costs and expenses:

    

Products

     4,217        3,991   

Services

     2,347        2,372   

General and administrative

     481        492   
       7,045        6,855   

Operating earnings

     966        998   

Interest, net

     (38     (38

Other, net

     —          (8

Earnings from continuing operations before income taxes

     928        952   

Provision for income taxes, net

     279        287   

Earnings from continuing operations

     649        665   

Discontinued operations, net of tax

     1        (13

Net earnings

   $ 650      $ 652   

Earnings per share

    

Basic:

    

Continuing operations

   $ 1.71      $ 1.84   

Discontinued operations

     —          (0.03

Net earnings

   $ 1.71      $ 1.81   

Diluted:

    

Continuing operations

   $ 1.70      $ 1.83   

Discontinued operations

     —          (0.03

Net earnings

   $ 1.70      $ 1.80   

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.

 

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CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

     Nine Months Ended  
(Dollars in millions, except per share amounts)    October 3
2010
    October 2
2011
 

Revenues:

    

Products

   $ 15,867      $ 15,186   

Services

     7,998        8,344   
       23,865        23,530   

Operating costs and expenses:

    

Products

     12,690        12,005   

Services

     6,861        7,143   

General and administrative

     1,445        1,506   
       20,996        20,654   

Operating earnings

     2,869        2,876   

Interest, net

     (124     (103

Other, net

     2        34   

Earnings from continuing operations before income taxes

     2,747        2,807   

Provision for income taxes, net

     848        858   

Earnings from continuing operations

     1,899        1,949   

Discontinued operations, net of tax

     (4     (26

Net earnings

   $ 1,895      $ 1,923   

Earnings per share

    

Basic:

    

Continuing operations

   $ 4.96      $ 5.31   

Discontinued operations

     (0.01     (0.07

Net earnings

   $ 4.95      $ 5.24   

Diluted:

    

Continuing operations

   $ 4.91      $ 5.26   

Discontinued operations

     (0.01     (0.07

Net earnings

   $ 4.90      $ 5.19   

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.

 

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CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 

     Nine Months Ended  
(Dollars in millions)    October 3
2010
    October 2
2011
 

Cash flows from operating activities:

    

Net earnings

   $ 1,895      $ 1,923   

Adjustments to reconcile net earnings to net cash provided by operating activities –

    

Depreciation of property, plant and equipment

     257        259   

Amortization of intangible assets

     167        176   

Stock-based compensation expense

     88        96   

Excess tax benefit from stock-based compensation

     (19     (22

Deferred income tax provision

     65        63   

Discontinued operations, net of tax

     4        26   

(Increase) decrease in assets, net of effects of business acquisitions –

    

Accounts receivable

     (178     (143

Contracts in process

     (478     (252

Inventories

     149        (346

Increase (decrease) in liabilities, net of effects of business acquisitions –

    

Accounts payable

     201        (171

Customer advances and deposits

     (331     (7

Other current and noncurrent liabilities

     (244     (261

Other, net

     (9     (129

Net cash provided by operating activities

     1,567        1,212   

Cash flows from investing activities:

    

Business acquisitions, net of cash acquired

     (233     (1,143

Purchases of held-to-maturity securities

     (452     (428

Maturities of held-to-maturity securities

     599        322   

Purchases of available-for-sale securities

     (199     (350

Maturities of available-for-sale securities

     120        227   

Capital expenditures

     (219     (273

Other, net

     123        188   

Net cash used by investing activities

     (261     (1,457

Cash flows from financing activities:

    

Proceeds from fixed-rate notes

     —          1,497   

Purchases of common stock

     (726     (1,449

Repayment of fixed-rate notes

     (700     (750

Dividends paid

     (471     (504

Net proceeds from commercial paper

     —          200   

Proceeds from option exercises

     159        186   

Other, net

     16        (6

Net cash used by financing activities

     (1,722     (826

Net cash used by discontinued operations

     (4     (2

Net decrease in cash and equivalents

     (420     (1,073

Cash and equivalents at beginning of period

     2,263        2,613   

Cash and equivalents at end of period

   $ 1,843      $ 1,540   

Supplemental cash flow information:

    

Cash payments for:

    

Income taxes

   $ 750      $ 804   

Interest

   $ 145      $ 112   

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share amounts or unless otherwise noted)

 

A. BASIS OF PREPARATION

Basis of Consolidation and Classification

The unaudited Consolidated Financial Statements included in this Form 10-Q include the accounts of General Dynamics Corporation and our wholly owned and majority-owned subsidiaries. We eliminate all inter-company balances and transactions in the Consolidated Financial Statements.

Consistent with defense industry practice, we classify assets and liabilities related to long-term production contracts as current, even though some of these amounts are not expected to be realized within one year. In addition, some prior-year amounts have been reclassified among financial statement accounts to conform to the current-year presentation.

Interim Financial Statements

The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). These rules and regulations permit some of the information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) to be condensed or omitted.

Our fiscal quarters are 13 weeks in length. Because our fiscal year ends on December 31, the number of days in our first and fourth quarters varies slightly from year to year. Operating results for the three- and nine-month periods ended October 2, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

In our opinion, the unaudited Consolidated Financial Statements contain all adjustments, that are of a normal recurring nature, necessary for a fair presentation of our results of operations and financial condition for the three- and nine-month periods ended October 3, 2010, and October 2, 2011.

We have evaluated material events and transactions that have occurred after the balance sheet date and concluded that no subsequent events have occurred that require adjustment to or disclosure in this Form 10-Q.

These unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010.

 

B. ACQUISITIONS, DIVESTITURES, INTANGIBLE ASSETS AND GOODWILL

We completed four acquisitions in the Information Systems and Technology group in the first nine months of 2011 for an aggregate of $1.1 billion in cash:

 

   

A provider of enterprise services and cloud computing to the U.S. Department of Defense (on July 18).

 

   

A provider of secure wireless networking equipment for the U.S. military and other government customers (on July 22).

 

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A company that provides information assurance and security software (on August 12).

 

   

Vangent Inc., a business that provides healthcare information technology services and business systems to federal agencies (on September 30).

In 2010, we acquired three businesses for an aggregate of $233 in cash:

Combat Systems

 

   

A business that demilitarizes, incinerates and disposes of munitions, explosives and explosive wastes in an environmentally safe and efficient manner (on May 12).

Information Systems and Technology

 

   

A provider of software for military mission planning and execution (on January 8).

 

   

A company that designs and manufactures sensor and optical surveillance systems for military and security applications (on June 22).

We funded these acquisitions using cash on hand. The operating results of these acquisitions have been included with our reported results since their respective closing dates. In the third quarter, we recognized in other income $10 of transaction-related costs associated primarily with the acquisition of Vangent, Inc. The purchase prices of these acquisitions have been allocated preliminarily to the estimated fair value of net tangible and intangible assets acquired, with any excess purchase price recorded as goodwill.

In the second quarter of 2011, we sold the detection systems portion of the weapons systems business in our Combat Systems group. The pretax gain of $38 on the sale was reported in other income in the Consolidated Statement of Earnings for the nine-month period ended October 2, 2011. The proceeds from the sale are included in other investing activities in the Consolidated Statement of Cash Flows.

Intangible assets consisted of the following:

 

     December 31 2010      October 2 2011  
      Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
 

Contract and program intangible assets*

   $ 2,421       $ (949   $ 1,472       $ 2,588       $ (1,088   $ 1,500   

Trade names and trademarks

     483         (58     425         495         (70     425   

Technology and software

     176         (94     82         216         (106     110   

Other intangible assets

     207         (194     13         207         (198     9   

Total intangible assets

   $ 3,287       $ (1,295   $ 1,992       $ 3,506       $ (1,462   $ 2,044   

 

  * Based on acquired backlog and probable follow-on work and related customer relationships.

 

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The amortization lives (in years) of our intangible assets on October 2, 2011, were as follows:

 

      Range of
Amortization
Life
     Weighted
Average
Amortization
Life
 

Contract and program intangible assets

     7-30         16   

Trade names and trademarks

     30         30   

Technology and software

     7-13         9   

Other intangible assets

     7-15         11   

Total intangible assets

              19   

We amortize intangible assets on a straight-line basis unless the pattern of usage of the benefits indicates an alternate method is more representative of the usage of the asset. Amortization expense was $55 and $167 for the three- and nine-month periods ended October 3, 2010, and $60 and $176 for the three- and nine-month periods ended October 2, 2011. We expect to record 2011 full-year amortization expense of $239 and annual amortization expense over the next five years as follows:

 

2012

   $     244   

2013

     203   

2014

     180   

2015

     175   

2016

     148   

The changes in the carrying amount of goodwill by reporting unit for the nine months ended October 2, 2011, were as follows:

 

      Aerospace      Combat
Systems
    Marine
Systems
     Information
Systems and
Technology
    Total
Goodwill
 

December 31, 2010

   $ 2,650       $ 2,828      $ 198       $ 6,973      $ 12,649   

Acquisitions

     —           —          —           840        840   

Other*

     50         (72     —           (13     (35

October 2, 2011

   $ 2,700       $ 2,756      $ 198       $ 7,800      $ 13,454   

 

  * Consists primarily of adjustments for foreign currency translation.

 

C. EARNINGS PER SHARE, DIVIDENDS AND COMPREHENSIVE INCOME

Earnings per Share

We compute basic earnings per share using net earnings for the period and the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporates the additional shares issuable upon the assumed exercise of stock options and the release of restricted shares. Basic and diluted weighted average shares outstanding were as follows (in thousands):

 

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     Three Months Ended      Nine Months Ended  
      October 3
2010
     October 2
2011
     October 3
2010
     October 2
2011
 

Basic weighted average shares outstanding

     379,088         359,710         382,738         366,783   

Dilutive effect of stock options and restricted stock

     3,452         3,175         3,947         3,438   

Diluted weighted average shares outstanding

     382,540         362,885         386,685         370,221   

Dividends

Dividends declared per share were $0.42 and $1.26 for the three- and nine-month periods ended October 3, 2010, respectively, and $0.47 and $1.41 for the three- and nine-month periods ended October 2, 2011, respectively. Cash dividends paid were $471 in 2010 and $504 in 2011.

Comprehensive Income

Comprehensive income consisted of the following:

 

     Three Months Ended     Nine Months Ended  
      October 3
2010
     October 2
2011
    October 3
2010
     October 2
2011
 

Net earnings

   $ 650       $ 652      $ 1,895       $ 1,923   

Foreign currency translation adjustments

     317         (408     157         (23

Other

     65         (73     61         18   

Comprehensive income

   $ 1,032       $ 171      $ 2,113       $ 1,918   

 

D. FAIR VALUE OF FINANCIAL INSTRUMENTS

Our financial instruments include cash and equivalents, marketable securities and other investments; accounts receivable and accounts payable; short- and long-term debt; and derivative financial instruments. We did not have any significant non-financial assets or liabilities measured at fair value on December 31, 2010, or October 2, 2011.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:

 

   

Level 1 – quoted prices in active markets for identical assets or liabilities;

 

   

Level 2 – inputs, other than quoted prices, observable by a marketplace participant either directly or indirectly and

 

   

Level 3 – unobservable inputs significant to the fair value measurement.

The carrying values of cash and equivalents, accounts receivable and payable, and short-term debt (commercial paper) on the Consolidated Balance Sheet approximate their fair value. The following

 

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tables present the fair values of our other financial assets and liabilities on December 31, 2010, and October 2, 2011, and the basis for determining their fair values:

 

Financial assets (liabilities) (a)    Carrying
Value
   

Fair

Value

    Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2) (b)
 
    

 

December 31, 2010

  

Marketable securities:

         

Available-for-sale

   $ 47      $ 47      $ 47       $ —     

Held-to-maturity

     165        165        —           165   

Other investments

     113        113        55         58   

Derivatives

     130        130        —           130   

Long-term debt, including current portion

     (3,203     (3,436     —           (3,436
    

 

October 2, 2011

  

Marketable securities:

         

Available-for-sale

   $ 67      $ 67      $ 67       $ —     

Held-to-maturity

     268        267        —           267   

Other investments

     118        118        61         57   

Derivatives

     47        47        —           47   

Long-term debt, including current portion

     (3,929     (4,207     —           (4,207

 

  (a) We had no Level 3 financial instruments on December 31, 2010, or October 2, 2011.

 

  (b) Determined under a market approach using valuation models that incorporate observable inputs such as interest rates, bond yields and quoted prices for similar assets and liabilities.

 

E. CONTRACTS IN PROCESS

Contracts in process represent recoverable costs and, where applicable, accrued profit related to long-term contracts that have been inventoried until the customer is billed, and consisted of the following:

 

      December 31
2010
    October 2
2011
 

Contract costs and estimated profits

   $ 15,675      $ 18,968   

Other contract costs

     909        936   
     16,584        19,904   

Advances and progress payments

     (11,711     (14,767

Total contracts in process

   $ 4,873      $ 5,137   

Contract costs consist primarily of labor, material, overhead and general and administrative (G&A) expenses. Contract costs also include estimated contract recoveries for matters such as contract changes, negotiated settlements and claims for unanticipated contract costs. We record revenue

 

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associated with these matters only when the amount of recovery can be estimated reliably and realization is probable. Assumed recoveries for these items were not material on December 31, 2010, or October 2, 2011.

Other contract costs represent amounts that are not currently allocable to government contracts, such as a portion of our estimated workers’ compensation obligations, other insurance-related assessments, pension and other post-retirement benefits and environmental expenses. These costs will become allocable to contracts generally after they are paid. We expect to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. If the backlog in the future does not support the continued deferral of these costs, the profitability of our remaining contracts could be adversely affected. However, our business base includes numerous contracts for which we are the sole source or are one of two suppliers on long-term U.S. defense programs. We expect to bill substantially all of our October 2, 2011, contracts-in-process balance during the next 12 months, with the exception of these other contract costs.

 

F. INVENTORIES

Our inventories represent primarily business-jet components and are stated at the lower of cost or net realizable value. Work-in-process represents largely labor, material and overhead costs associated with aircraft in the manufacturing process and is based primarily on the estimated average unit cost of the units in a production lot. Raw materials are valued primarily on the first-in, first-out method. Inventories consisted of the following:

 

      December 31
2010
     October 2
2011
 

Work in process

   $ 1,124       $ 1,424   

Raw materials

     965         993   

Finished goods

     69         89   

Total inventories

   $ 2,158       $ 2,506   

 

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G. DEBT

Debt consisted of the following:

 

      Interest Rate      December 31
2010
     October 2
2011
 

Fixed-rate notes due:

        

July 2011

     1.800%       $ 749       $ —     

May 2013

     4.250%         1,000         1,000   

February 2014

     5.250%         997         998   

January 2015

     1.375%         —           499   

August 2015

     5.375%         400         400   

July 2016

     2.250%         —           499   

July 2021

     3.875%         —           499   

Commercial paper, net of unamortized discount

     0.130%         —           200   

Other

     Various         57         34   

Total debt

        3,203         4,129   

Less current portion

              773         222   

Long-term debt

            $ 2,430       $ 3,907   

Fixed-rate Notes

On October 2, 2011, we had outstanding $3.9 billion aggregate principal amount of fixed-rate notes. The fixed-rate notes are fully and unconditionally guaranteed by several of our 100-percent-owned subsidiaries. See Note N for unaudited condensed consolidating financial statements. We have the option to redeem the notes prior to their maturity in whole or in part at 100 percent of the principal plus any accrued but unpaid interest and applicable make-whole amounts. On July 12, 2011, we issued $1.5 billion of fixed-rate notes in $500 increments due in January 2015, July 2016 and July 2021. We used the proceeds from these notes in part to repay $750 of fixed-rate notes on their scheduled maturity date in July of 2011.

Commercial Paper

On October 2, 2011, we had $200 in commercial paper outstanding at an average yield of approximately 0.13 percent with an average maturity of 12 days. We have $2 billion in bank credit facilities that provide backup liquidity to our commercial paper program. These credit facilities include a $1 billion multi-year facility expiring in July 2013 and a $1 billion multi-year facility expiring in July 2016. These facilities are required by rating agencies to support our commercial paper issuances. We may renew or replace, in whole or in part, these credit facilities prior to their expiration. Our commercial paper issuances and the bank credit facilities are guaranteed by several of our 100-percent-owned subsidiaries.

Our financing arrangements contain a number of customary covenants and restrictions. We were in compliance with all material covenants on October 2, 2011.

 

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H. OTHER LIABILITIES

A summary of significant other liabilities by balance sheet caption follows:

 

      December 31
2010
     October 2
2011
 

Salaries and wages

   $ 773       $         808   

Workers’ compensation

     537         538   

Deferred income taxes

     383         169   

Retirement benefits

     254         267   

Other (a)

     1,256         1,204   

Total other current liabilities

   $ 3,203       $ 2,986   

Retirement benefits

   $ 3,596       $ 3,373   

Customer deposits on commercial contracts

     1,039         817   

Deferred income taxes

     220         503   

Other (b)

     767         707   

Total other liabilities

   $ 5,622       $ 5,400   

 

  (a) Consists primarily of dividends payable, environmental remediation reserves, warranty reserves, liabilities of discontinued operations and insurance-related costs.

 

  (b) Consists primarily of liabilities for warranty reserves and workers’ compensation.

 

I. INCOME TAXES

Deferred Tax Assets/(Liabilities)

Our net deferred tax liability was included in the Consolidated Balance Sheet as follows:

 

      December 31
2010
    October 2
2011
 

Current deferred tax asset

   $ 30      $         187   

Current deferred tax liability

     (383     (169

Noncurrent deferred tax asset

     359        280   

Noncurrent deferred tax liability

     (220     (503

Net deferred tax liability

   $ (214   $ (205

Tax Uncertainties

We periodically assess our liabilities and contingencies for all periods open to examination by tax authorities based on the latest available information. Where we believe there is more than a 50 percent chance that our tax position will not be sustained, we record our best estimate of the resulting tax liability, including interest, in the Consolidated Financial Statements. We include any interest or penalties incurred in connection with income taxes as part of income tax expense for financial reporting purposes.

 

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General Dynamics has participated in the IRS’ Compliance Assurance Process, a real-time audit of our tax return, since 2010. We have recorded liabilities for tax uncertainties for all years that remain open to review. We do not expect the resolution of tax matters for these years to have a material impact on our results of operations, financial condition, cash flows or effective tax rate.

Based on all known facts and circumstances and current tax law, we believe the total amount of unrecognized tax benefits on October 2, 2011, is not material to our results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits on October 2, 2011, if recognized, would not have a material impact on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.

 

J. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

We are exposed to market risk, primarily from foreign currency exchange rates, interest rates, commodity prices and investments. We may use derivative financial instruments to hedge some of these risks as described below. We do not use derivatives for trading or speculative purposes.

Foreign Currency Risk

Our foreign currency exchange rate risk relates to receipts from customers, payments to suppliers and inter-company transactions denominated in foreign currencies. To the extent possible, we include terms in our contracts that are designed to protect us from this risk. We periodically enter into derivative financial instruments, principally foreign currency forward purchase and sale contracts with an average maturity of two years. These instruments are designed to minimize our risk by fixing, or limiting the adverse impact on, the amount of firmly committed and forecasted foreign currency-denominated payments, receipts and inter-company transactions related to our business and operational financing activities.

Interest Rate Risk

Our financial instruments subject to interest rate risk include fixed-rate long-term debt obligations and variable-rate commercial paper. However, the risk associated with these instruments is not material.

Commodity Price Risk

We are subject to risk of rising labor and commodity prices, primarily on long-term fixed-price contracts. To the extent possible, we include terms in our long-term contracts that are designed to protect us from this risk. Some of the protective terms included in our contracts are considered derivatives but are not accounted for separately because they are clearly and closely related to the host contract. We have not entered into any material commodity hedging contracts but may do so as circumstances warrant. We do not believe that changes in labor or commodity prices will have a material impact on our results of operations or cash flows.

Investment Risk

Our investment policy allows for purchases of fixed-income securities with an investment-grade rating and a maximum maturity of up to five years. On October 2, 2011, we held $1.9 billion in cash and

 

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equivalents and marketable securities. Our marketable securities have an average duration of ten months and an average credit rating of AA-. Historically, we have not experienced material gains or losses on these instruments due to changes in interest rates or market values.

Hedging Activities

We had $4.2 billion in notional forward foreign exchange contracts outstanding on December 31, 2010, and $3.9 billion on October 2, 2011. We recognize derivative financial instruments on the Consolidated Balance Sheet at fair value (see Note D). The fair value of these derivative contracts consisted of the following:

 

      December 31
2010
    October 2
2011
 

Other current assets:

    

Designated as cash flow hedges

   $ 128      $         66   

Not designated as cash flow hedges

     35        25   

Other current liabilities:

    

Designated as cash flow hedges

     (16     (18

Not designated as cash flow hedges

     (17     (26

Total

   $ 130      $ 47   

We had no material derivative financial instruments designated as fair value or net investment hedges on December 31, 2010, or October 2, 2011.

We record changes in the fair value of derivative financial instruments in operating costs and expenses in the Consolidated Statement of Earnings or in accumulated other comprehensive income (loss) (AOCI) within shareholders’ equity on the Consolidated Balance Sheet depending on whether the derivative is designated and qualifies for hedge accounting. Gains and losses related to derivatives that qualify as cash flow hedges are deferred in AOCI until the underlying transaction is reflected in earnings. We adjust derivative financial instruments not designated as cash flow hedges to market value each period and record the gain or loss in the Consolidated Statement of Earnings. The gains and losses on these instruments generally offset losses and gains on the assets, liabilities and other transactions being hedged. Gains and losses resulting from hedge ineffectiveness are recognized in the Consolidated Statement of Earnings for all derivative financial instruments, regardless of designation.

Net gains and losses recognized in earnings and AOCI, including gains and losses related to hedge ineffectiveness, were not material for the three- and nine-month periods ended October 3, 2010, and October 2, 2011. We do not expect the amount of gains and losses in AOCI that will be reclassified to earnings during the next 12 months to be material.

Foreign Currency Financial Statement Translation

We translate foreign-currency balance sheets from our international business units’ functional currency (generally the respective local currency) to U.S. dollars at the end-of-period exchange rates, and earnings statements at the average exchange rates for each period. The resulting foreign currency translation adjustments are a component of AOCI.

We do not hedge the fluctuation in reported revenues and earnings resulting from the translation

 

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of these international operations’ income statements into U.S. dollars. The impact of translating our international operations’ revenues and earnings into U.S. dollars was not material to our results of operations for the three- and nine-month periods ended October 3, 2010, or October 2, 2011. In addition, the effect of changes in foreign exchange rates on non-U.S. cash balances was not material in the first three or nine months of either 2010 or 2011.

 

K. COMMITMENTS AND CONTINGENCIES

Litigation

Termination of A-12 Program. The A-12 aircraft contract was a fixed-price incentive contract for the full-scale development and initial production of the carrier-based Advanced Tactical Aircraft with the U.S. Navy and a team composed of contractors General Dynamics and McDonnell Douglas (now a subsidiary of The Boeing Company). In January 1991, the U.S. Navy terminated the contract for default and demanded that the contractors repay $1.4 billion in unliquidated progress payments. Following the termination, the Navy agreed to defer the collection of that amount pending a negotiated settlement or other resolution. Both contractors had full responsibility to the Navy for performance under the contract, and both are jointly and severally liable for potential liabilities arising from the termination.

Over 20 years of litigation, the trial court (the U.S. Court of Federal Claims), appeals court (the Court of Appeals for the Federal Circuit), and the U.S. Supreme Court have issued various rulings, some in favor of the government and others in favor of the contractors.

On May 3, 2007, the trial court issued a decision upholding the government’s determination of default. This decision was affirmed by a three-judge panel of the appeals court on June 2, 2009, and on November 24, 2009, the court of appeals denied the contractors’ petitions for rehearing. On September 28, 2010, the U.S. Supreme Court granted the contractors’ petitions for review as to whether the government can maintain its default claim against the contractors while invoking the state-secrets privilege to deny the contractors a defense to that claim.

On May 23, 2011, the U.S. Supreme Court vacated the judgment of the court of appeals, stating that the contractors had a plausible superior knowledge defense that had been stripped from them as a consequence of the government’s assertion of the state-secrets privilege. In particular, the U.S. Supreme Court held that, in that circumstance, neither party can obtain judicial relief.

In addition, the U.S. Supreme Court remanded the case to the court of appeals for further proceedings on whether the government has an obligation to share its superior knowledge with respect to highly classified information, whether the government has such an obligation when the agreement specifies information that must be shared (as was the case with respect to the A-12 contract), and whether these questions can safely be litigated by the courts without endangering state secrets. On July 7, 2011, the appeals court remanded these issues to the trial court for further proceedings consistent with the U.S. Supreme Court’s opinion. These issues remain to be resolved on remand.

We believe that the lower courts will ultimately rule in the contractors’ favor on the remaining issues in the case. We expect this would leave all parties where they stood prior to the contracting officer’s declaration of default, meaning that no money would be due from one party to another. Additionally, even if the lower courts were to ultimately sustain the government’s default claim, we continue to believe that there are significant legal obstacles to the government’s ability to collect any amount from the contractors given that no court has ever awarded a money judgment to the government.

 

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For these reasons, we have not recorded an accrual for this matter. However, in connection with the U.S. Supreme’s Court decision in the second quarter of 2011, the anticipated timeline associated with this litigation was significantly extended. Therefore, we recognized in discontinued operations in the second quarter our revised estimate of the legal costs to conduct this ongoing litigation.

If, contrary to our expectations, the government prevails on its default claim and its recovery theories, the contractors could collectively be required to repay the government, on a joint and several basis, as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.6 billion on October 2, 2011. This would result in a liability to us of half of the total (based upon Boeing satisfying McDonnell Douglas’s obligations under the contract), or approximately $1.5 billion pretax. Our after-tax charge would be approximately $825, or $2.28 per share, to be recorded in discontinued operations. Our after-tax cash cost would be approximately $735. We believe we have sufficient resources to satisfy our obligation if required.

Other. Various claims and other legal proceedings incidental to the normal course of business are pending or threatened against us. These matters relate to such issues as government investigations and claims, the protection of the environment, asbestos-related claims and employee-related matters. The nature of litigation is such that we cannot predict the outcome of these matters. However, based on information currently available, we believe any potential liabilities in these proceedings, individually or in the aggregate, will not have a material impact on our results of operations, financial condition or cash flows.

Environmental

We are subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. We are directly or indirectly involved in environmental investigations or remediation at some of our current and former facilities, and at third-party sites that we do not own but where we have been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, we expect that a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable contract costs and, therefore, recoverable under U.S. government contracts.

As required, we provide financial assurance for certain sites undergoing or subject to investigation or remediation. We accrue environmental costs when it is probable that a liability has been incurred and the amount can be reasonably estimated. Where applicable, we seek insurance recovery for costs related to environmental liability. We do not record insurance recoveries before collection is considered probable. In the third quarter, we recognized a $13 loss, net of taxes, in discontinued operations from the settlement of an environmental matter associated with a former operation of the company. Based on all known facts and analyses, as well as current government policies relating to allowable contract costs, we do not believe that our liability at any individual site, or in the aggregate, arising from such environmental conditions, will be material to our results of operations, financial condition or cash flows. We also do not believe that the range of reasonably possible additional loss beyond what has been recorded would be material to our results of operations, financial condition or cash flows.

Other

SEC Request. On September 23, 2011, the SEC’s Division of Enforcement requested that we provide certain information, documents and records relating to accounting practices for revisions of

 

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estimates on contracts accounted for using the percentage-of-completion method. We are cooperating with the SEC Staff. This request is in early stages and we cannot predict its outcome.

Letters of Credit. In the ordinary course of business, we have entered into letters of credit and other similar arrangements with financial institutions and insurance carriers totaling approximately $1.5 billion on October 2, 2011. These include letters of credit for our international subsidiaries, which are backed by available local bank credit facilities aggregating approximately $1.1 billion. From time to time in the ordinary course of business, we guarantee the payment or performance obligations of our subsidiaries arising under certain contracts. We are aware of no event of default that would require us to satisfy these guarantees.

Government Contracts. As a government contractor, we are subject to U.S. government audits and investigations relating to our operations, including claims for fines, penalties, and compensatory and treble damages. Based on currently available information, we believe the outcome of such ongoing government disputes and investigations will not have a material impact on our results of operations, financial condition or cash flows.

Aircraft Trade-ins. In connection with orders for new aircraft in funded contract backlog, our Aerospace group has outstanding options with some customers to trade in aircraft as partial consideration in their new-aircraft transaction. These trade-in commitments are structured to establish the fair market value of the trade-in aircraft at a date generally 120 or fewer days preceding delivery of the new aircraft to the customer. At that time, the customer is required to either exercise the option or allow its expiration. Any excess of the pre-established trade-in price above the fair market value at the time the new aircraft is delivered is treated as a reduction of revenue in the new-aircraft sales transaction.

Product Warranties. We provide product warranties to our customers associated with certain product sales. We record estimated warranty costs in the period in which the related products are delivered. The warranty liability recorded at each balance sheet date is generally based on the number of months of warranty coverage remaining for products delivered and the average historical monthly warranty payments. Warranty obligations incurred in connection with long-term production contracts are accounted for within the contract estimates at completion (EACs). Our other warranty obligations, primarily for business-jet aircraft, are included in other current liabilities and other liabilities on the Consolidated Balance Sheet.

The changes in the carrying amount of warranty liabilities for the nine-month periods ended October 3, 2010, and October 2, 2011, were as follows:

 

Nine Months Ended    October 3
2010
    October 2
2011
 

Beginning balance

   $ 239      $ 260   

Warranty expense

     54        45   

Payments

     (38     (44

Adjustments*

     2        —     

Ending balance

   $ 257      $ 261   

 

  * Includes warranty liabilities assumed in connection with acquisitions and foreign exchange translation adjustments.

 

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L. RETIREMENT PLANS

We provide defined-benefit pension and other post-retirement benefits, as well as defined-contribution benefits, to eligible employees.

Net periodic cost associated with our defined-benefit pension and other post-retirement benefit plans for the three- and nine-month periods ended October 3, 2010, and October 2, 2011, consisted of the following:

 

     Pension Benefits    

Other

Post-retirement Benefits

 
Three Months Ended    October 3
2010
    October 2
2011
    October 3
2010
    October 2
2011
 

Service cost

   $ 54      $ 64      $ 3      $ 3   

Interest cost

     127        129        15        16   

Expected return on plan assets

     (150     (150     (8     (8

Recognized net actuarial loss (gain)

     17        40        (1     1   

Amortization of prior service credit

     (11     (11     —          1   

Net periodic cost

   $ 37      $ 72      $ 9      $ 13   
     Pension Benefits    

Other

Post-retirement Benefits

 
Nine Months Ended    October 3
2010
    October 2
2011
    October 3
2010
    October 2
2011
 

Service cost

   $ 162      $ 191      $ 8      $ 10   

Interest cost

     381        388        45        46   

Expected return on plan assets

     (450     (450     (24     (24

Recognized net actuarial loss (gain)

     50        120        (3     3   

Amortization of prior service credit

     (33     (33     —          4   

Net periodic cost

   $ 110      $ 216      $ 26      $ 39   

Our contractual arrangements with the U.S. government provide for the recovery of contributions to our pension and other post-retirement benefit plans covering employees working in our defense business groups. For non-funded plans, our government contracts allow us to recover claims paid. Following payment, these recoverable amounts are allocated to contracts and billed to the customer in accordance with the Cost Accounting Standards and specific contractual terms. For some of these plans, the cumulative pension and post-retirement benefit cost exceeds the amount currently allocable to contracts. To the extent recovery of the cost is considered probable based on our backlog, we defer the excess in contracts in process on the Consolidated Balance Sheet until the cost is allocable to contracts. See Note E for discussion of our deferred contract costs. For other plans, the amount allocated to contracts and included in revenues has exceeded the plans’ cumulative benefit cost. We have deferred recognition of these excess earnings to provide a better matching of revenues and expenses. These deferrals have been classified against the plan assets on the Consolidated Balance Sheet.

 

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M. BUSINESS GROUP INFORMATION

We operate in four business groups: Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. We organize and measure our business groups in accordance with the nature of products and services offered. These business groups derive their revenues from business aviation; combat vehicles, weapons systems and munitions; military and commercial shipbuilding; and communications and information technology, respectively. We measure each group’s profit based on operating earnings. As a result, we do not allocate net interest, other income and expense items, and income taxes to our business groups.

Summary financial information for each of our business groups follows:

 

     Revenues      Operating Earnings  
Three Months Ended    October 3
2010
     October 2
2011
     October 3
2010
    October 2
2011
 

Aerospace

   $ 1,291       $ 1,412       $ 199      $ 217   

Combat Systems

     2,069         2,140         311        319   

Marine Systems

     1,700         1,621         169        173   

Information Systems and Technology

     2,951         2,680         306        310   

Corporate*

     —           —           (19     (21
     $ 8,011       $ 7,853       $ 966      $ 998   
     Revenues      Operating Earnings  
Nine Months Ended    October 3
2010
     October 2
2011
     October 3
2010
    October 2
2011
 

Aerospace

   $ 4,031       $ 4,141       $ 650      $ 656   

Combat Systems

     6,182         6,216         875        895   

Marine Systems

     4,976         4,873         497        501   

Information Systems and Technology

     8,676         8,300         908        885   

Corporate*

     —           —           (61     (61
     $ 23,865       $ 23,530       $ 2,869      $ 2,876   

 

  * Corporate operating results include our stock option expense and a portion of the operating results of our commercial pension plans.

 

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N. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

The fixed-rate notes described in Note G are fully and unconditionally guaranteed on an unsecured, joint and several basis by certain of our 100-percent-owned subsidiaries (the guarantors). The following condensed consolidating financial statements illustrate the composition of the parent, the guarantors on a combined basis (each guarantor together with its majority-owned subsidiaries) and all other subsidiaries on a combined basis.

Condensed Consolidating Statement of Earnings

 

Three Months Ended October 3, 2010          Parent           Guarantors
on a
Combined
Basis
    Other
Subsidiaries
on a
Combined
Basis
     Consolidating
Adjustments
    Total
Consolidated
 

Revenues

   $ —        $ 6,517      $ 1,494       $ —        $ 8,011   

Cost of sales

     2        5,352        1,210         —          6,564   

General and administrative expenses

     20        357        104         —          481   

Operating earnings

     (22     808        180         —          966   

Interest expense

     (38     (1     —           —          (39

Interest income

     —          (1     2         —          1   

Other, net

     1        (1     —           —          —     

Earnings from continuing operations before income taxes

     (59     805        182         —          928   

Provision for income taxes

     (22     272        29         —          279   

Discontinued operations, net of tax

     —          —          1         —          1   

Equity in net earnings of subsidiaries

     687        —          —           (687     —     

Net earnings

   $ 650      $ 533      $ 154       $ (687   $ 650   
Three Months Ended October 2, 2011                                     

Revenues

   $ —        $ 6,262      $ 1,591       $ —        $ 7,853   

Cost of sales

     (2     5,059        1,306         —          6,363   

General and administrative expenses

     23        368        101         —          492   

Operating earnings

     (21     835        184         —          998   

Interest expense

     (40     (1     —           —          (41

Interest income

     1        2        —           —          3   

Other, net

     1        (12     3         —          (8

Earnings from continuing operations before income taxes

     (59     824        187         —          952   

Provision for income taxes

     (21     267        41         —          287   

Discontinued operations, net of tax

     (13     —          —           —          (13

Equity in net earnings of subsidiaries

     703        —          —           (703     —     

Net earnings

   $ 652      $ 557      $ 146       $ (703   $ 652   

 

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Condensed Consolidating Statement of Earnings

 

Nine Months Ended October 3, 2010            Parent           Guarantors
on a
Combined
Basis
    Other
Subsidiaries
on a
Combined
Basis
    Consolidating
Adjustments
    Total
Consolidated
 

Revenues

   $ —        $ 19,665      $ 4,200      $ —        $ 23,865   

Cost of sales

     —          16,086        3,465        —          19,551   

General and administrative expenses

     61        1,098        286        —          1,445   

Operating earnings

     (61     2,481        449        —          2,869   

Interest expense

     (129     (1     (1     —          (131

Interest income

     2        2        3        —          7   

Other, net

     2        (1     1        —          2   

Earnings from continuing operations before income taxes

     (186     2,481        452        —          2,747   

Provision for income taxes

     (63     816        95        —          848   

Discontinued operations, net of tax

     —          —          (4     —          (4

Equity in net earnings of subsidiaries

     2,018        —          —          (2,018     —     

Net earnings

   $ 1,895      $ 1,665      $ 353      $ (2,018   $ 1,895   
Nine Months Ended October 2, 2011                                    

Revenues

   $ —        $ 19,007      $ 4,523      $ —        $ 23,530   

Cost of sales

     (7     15,399        3,756        —          19,148   

General and administrative expenses

     67        1,118        321        —          1,506   

Operating earnings

     (60     2,490        446        —          2,876   

Interest expense

     (112     (3     —          —          (115

Interest income

     8        3        1        —          12   

Other, net

     2        30        2        —          34   

Earnings from continuing operations before income taxes

     (162     2,520        449        —          2,807   

Provision for income taxes

     (53     790        121        —          858   

Discontinued operations, net of tax

     (26     —          —          —          (26

Equity in net earnings of subsidiaries

     2,058        —          —          (2,058     —     

Net earnings

   $ 1,923      $ 1,730      $ 328      $ (2,058   $ 1,923   

 

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Condensed Consolidating Balance Sheet

 

December 31, 2010            Parent           Guarantors
on a
Combined
Basis
    Other
Subsidiaries
on a
Combined
Basis
    Consolidating
Adjustments
    Total
Consolidated
 

ASSETS

          

Current assets:

          

Cash and equivalents

   $ 1,608      $ —        $ 1,005      $ —        $ 2,613   

Accounts receivable

     —          1,538        2,310        —          3,848   

Contracts in process

     263        3,205        1,405        —          4,873   

Inventories

          

Work in process

     —          1,090        34        —          1,124   

Raw materials

     —          808        157        —          965   

Finished goods

     —          36        33        —          69   

Other current assets

     143        147        404        —          694   

Total current assets

     2,014        6,824        5,348        —          14,186   

Noncurrent assets:

          

Property, plant and equipment

     147        4,687        1,125        —          5,959   

Accumulated depreciation of PP&E

     (42     (2,448     (498     —          (2,988

Intangible assets

     —          1,664        1,623        —          3,287   

Accumulated amortization of intangible assets

     —          (920     (375     —          (1,295

Goodwill

     —          8,322        4,327        —          12,649   

Other assets

     183        172        392        —          747   

Investment in subsidiaries

     30,580        —          —          (30,580     —     

Total noncurrent assets

     30,868        11,477        6,594        (30,580     18,359   

Total assets

   $ 32,882      $ 18,301      $ 11,942      $ (30,580   $ 32,545   

LIABILITIES AND SHAREHOLDERS’ EQUITY

          

Current liabilities:

          

Short-term debt

   $ 749      $ 21      $ 3      $ —        $ 773   

Customer advances and deposits

     —          2,182        2,283        —          4,465   

Other current liabilities

     596        3,397        1,946        —          5,939   

Total current liabilities

     1,345        5,600        4,232        —          11,177   

Noncurrent liabilities:

          

Long-term debt

     2,396        29        5        —          2,430   

Other liabilities

     2,774        2,242        606        —          5,622   

Total noncurrent liabilities

     5,170        2,271        611        —          8,052   

Intercompany

     13,051        (13,626     575        —          —     

Shareholders’ equity:

          

Common stock, including surplus

     2,211        6,786        2,360        (9,146     2,211   

Retained earnings

     17,076        18,175        3,097        (21,272     17,076   

Treasury stock

     (4,535     —          —          —          (4,535

Accumulated other comprehensive loss

     (1,436     (905     1,067        (162     (1,436

Total shareholders’ equity

     13,316        24,056        6,524        (30,580     13,316   

Total liabilities and shareholders’ equity

   $ 32,882      $ 18,301      $ 11,942      $ (30,580   $ 32,545   

 

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Condensed Consolidating Balance Sheet

 

October 2, 2011          Parent           Guarantors
on a
Combined
Basis
    Other
Subsidiaries
on a
Combined
Basis
    Consolidating
Adjustments
    Total
Consolidated
 

ASSETS

          

Current assets:

          

Cash and equivalents

   $ 682      $ —        $ 858      $ —        $ 1,540   

Accounts receivable

     —          1,521        2,598        —          4,119   

Contracts in process

     287        3,150        1,700        —          5,137   

Inventories

          

Work in process

     —          1,391        33        —          1,424   

Raw materials

     —          840        153        —          993   

Finished goods

     —          50        39        —          89   

Other current assets

     343        175        220        —          738   

Total current assets

     1,312        7,127        5,601        —          14,040   

Noncurrent assets:

          

Property, plant and equipment

     152        4,907        1,167        —          6,226   

Accumulated depreciation of PP&E

     (47     (2,558     (558     —          (3,163

Intangible assets

     —          1,864        1,642        —          3,506   

Accumulated amortization of intangible assets

     —          (1,000     (462     —          (1,462

Goodwill

     —          9,140        4,314        —          13,454   

Other assets

     233        200        374        —          807   

Investment in subsidiaries

     32,562        —          —          (32,562     —     

Total noncurrent assets

     32,900        12,553        6,477        (32,562     19,368   

Total assets

   $ 34,212      $ 19,680      $ 12,078      $ (32,562   $ 33,408   

LIABILITIES AND SHAREHOLDERS’ EQUITY

          

Current liabilities:

          

Short-term debt

   $ 200      $ 20      $ 2      $ —        $ 222   

Customer advances and deposits

     —          2,197        2,493        —          4,690   

Other current liabilities

     442        3,442        1,686        —          5,570   

Total current liabilities

     642        5,659        4,181        —          10,482   

Noncurrent liabilities:

          

Long-term debt

     3,895        9        3        —          3,907   

Other liabilities

     2,812        1,995        593        —          5,400   

Total noncurrent liabilities

     6,707        2,004        596        —          9,307   

Intercompany

     13,244        (13,833     589        —          —     

Shareholders’ equity:

          

Common stock, including surplus

     2,335        6,852        1,897        (8,749     2,335   

Retained earnings

     18,483        19,880        3,888        (23,768     18,483   

Treasury stock

     (5,758     —          —          —          (5,758

Accumulated other comprehensive loss

     (1,441     (882     927        (45     (1,441

Total shareholders’ equity

     13,619        25,850        6,712        (32,562     13,619   

Total liabilities and shareholders’ equity

   $ 34,212      $ 19,680      $ 12,078      $ (32,562   $ 33,408   

 

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Condensed Consolidating Statement of Cash Flows

 

Nine Months Ended October 3, 2010          Parent           Guarantors
on a
Combined
Basis
    Other
Subsidiaries
on a
Combined
Basis
    Consolidating
Adjustments
     Total
Consolidated
 

Net cash provided by operating activities

   $ (399   $ 1,893      $ 73      $ —         $ 1,567   

Cash flows from investing activities:

           

Maturities of held-to-maturity securities

     267        —          332        —           599   

Purchases of held-to-maturity securities

     (221     —          (231     —           (452

Business acquisitions, net of cash acquired

     —          (163     (70     —           (233

Other, net

     (19     (112     (44     —           (175

Net cash used by investing activities

     27        (275     (13     —           (261

Cash flows from financing activities:

           

Purchases of common stock

     (726     —          —          —           (726

Repayment of fixed-rate notes

     (700     —          —          —           (700

Dividends paid

     (471     —          —          —           (471

Other, net

     178        (1     (2     —           175   

Net cash used by financing activities

     (1,719     (1     (2     —           (1,722

Net cash used by discontinued operations

     —          —          (4     —           (4

Cash sweep/funding by parent

     1,826        (1,617     (209     —           —     

Net decrease in cash and equivalents

     (265     —          (155     —           (420

Cash and equivalents at beginning of period

     1,406        —          857        —           2,263   

Cash and equivalents at end of period

   $ 1,141      $ —        $ 702      $ —         $ 1,843   
Nine Months Ended October 2, 2011                                     

Net cash provided by operating activities

   $ (309   $ 1,708      $ (187   $ —         $ 1,212   

Cash flows from investing activities:

           

Business acquisitions, net of cash acquired

     —          (1,143     —          —           (1,143

Purchases of held-to-maturity securities

     (428     —          —          —           (428

Maturities of held-to-maturity securities

     215        —          107        —           322   

Purchases of available-for-sale securities

     (264     (86     —          —           (350

Other, net

     232        (39     (51     —           142   

Net cash used by investing activities

     (245     (1,268     56        —           (1,457

Cash flows from financing activities:

           

Proceeds from fixed-rate notes

     1,497        —          —          —           1,497   

Purchases of common stock

     (1,449     —          —          —           (1,449

Repayment of fixed-rate notes

     (750     —          —          —           (750

Dividends paid

     (504     —          —          —           (504

Net proceeds from commercial paper

     200        —          —          —           200   

Other, net

     203        (20     (3     —           180   

Net cash used by financing activities

     (803     (20     (3     —           (826

Net cash used by discontinued operations

     —          —          (2     —           (2

Cash sweep/funding by parent

     431        (420     (11     —           —     

Net decrease in cash and equivalents

     (926     —          (147     —           (1,073

Cash and equivalents at beginning of period

     1,608        —          1,005        —           2,613   

Cash and equivalents at end of period

   $ 682      $ —        $ 858      $ —         $ 1,540   

 

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Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollars in millions, except per share amounts or unless otherwise noted)

BUSINESS OVERVIEW

General Dynamics offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; military and commercial shipbuilding; and communications and information technology. We operate through four business groups: Aerospace and Combat Systems, Marine Systems and Information Systems and Technology (collectively, our defense groups). Our primary customers are the U.S. military, other U.S. government organizations, the armed forces of other nations, and a diverse base of corporate and individual buyers of business aircraft. We operate in two primary markets: defense and national security, and business aviation. The majority of our revenues are derived from contracts with the U.S. government. The following discussion should be read in conjunction with our 2010 Annual Report on Form 10-K, filed with the Securities and Exchange Commission, and with the unaudited Consolidated Financial Statements included in this Form 10-Q.

RESULTS OF OPERATIONS

Introduction

The majority of our revenues are recognized using the percentage-of-completion method of accounting. The following paragraphs explain how this method is applied in recognizing revenues and operating costs in our Aerospace and defense business groups. An understanding of these methods is important to the evaluation of our operating results.

In the Aerospace group, sales contracts for new aircraft have two major phases: the manufacture of the “green” aircraft and the aircraft’s outfitting, which includes exterior painting and installation of customer-selected interiors and avionics. We record revenues on these contracts at two milestones: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the outfitted aircraft. Revenues in the Aerospace group’s other original equipment manufacturers (OEMs) aircraft completions and service businesses are recognized as work progresses or upon delivery of the service. Changes in revenues result from the number and mix of new aircraft deliveries (both green and outfitted), progress on aircraft completions, the level of service activity during the period and the number of pre-owned aircraft sold.

The majority of the group’s operating costs relate to new aircraft production for firm orders and consist of labor, material and overhead costs. The costs are accumulated in production lots and recognized as operating costs at green and outfitted aircraft delivery based on the estimated average unit cost in a production lot. Thus, the level of operating costs reported in a given period is based largely on the number and type of aircraft delivered. To a much lesser extent, the level of operating costs is impacted by changes in the estimated average unit cost for a production lot. Operating costs in the Aerospace group’s aircraft completions operation and service businesses are generally recognized as incurred.

In general, operating earnings and margins in the Aerospace group are a function of the prices of our aircraft, our operational efficiency in manufacturing and outfitting the aircraft and the mix of aircraft deliveries between the higher-margin large-cabin and lower-margin mid-cabin aircraft. Additional factors affecting the group’s earnings and margins include the volume and profitability of completions and services work performed, the number and type of pre-owned aircraft sold and the level of general

 

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and administrative (G&A) costs incurred by the group, which include selling expenses and research and development (R&D) costs.

In the defense groups, revenue on long-term government contracts is recognized as work progresses, either as products are produced or as services are rendered. As a result, changes in revenues are discussed generally in terms of volume, typically measured by the level of costs incurred. Year-over-year variances attributed to volume indicate increases or decreases in revenues due to changes in production levels, delivery schedules or levels of services on individual contracts.

Operating costs for the defense groups consist of labor, material, subcontractor and overhead costs and are generally recognized as incurred. Variances in costs recognized from period to period primarily reflect increases and decreases in production or activity levels on individual contracts and, therefore, result largely from the same factors that drive variances in revenues.

Operating earnings and margins in the defense groups are driven by changes in volume, performance or contract mix (i.e., higher- vs. lower-margin work). Performance refers to changes in profitability during the period of performance based on revisions to estimates at completion on individual contracts. These revisions result from increases or decreases to the estimated value of the contract or the estimated costs required to complete the contract. Therefore, changes in costs incurred in the period do not necessarily impact profitability. It is only when total estimated costs at completion change that profitability may be impacted. Contract mix can result in higher or lower earnings and margins due to contract type (e.g., fixed-price/cost-reimbursable) or the phase of work (e.g., development/production).

Consolidated Overview

 

Three Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 8,011      $ 7,853           $ (158     (2.0 )% 

Operating costs and expenses

     7,045        6,855             (190     (2.7 )% 

Operating earnings

     966        998             32        3.3

Operating margin

     12.1     12.7                     
           
 
Nine Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 23,865      $ 23,530           $ (335     (1.4 )% 

Operating costs and expenses

     20,996        20,654             (342     (1.6 )% 

Operating earnings

     2,869        2,876             7        0.2

Operating margin

     12.0     12.2                     

Our revenues and operating costs were down in the third quarter and first nine months of 2011 compared with the prior-year periods driven primarily by lower activity in the Information Systems and Technology’s tactical communications business and, to a lesser extent, on several U.S. Navy programs in the Marine Systems group. Operating earnings were up in the third quarter and first nine months of 2011 compared with the same periods in 2010 despite the decrease in revenues. Operating margins increased 60 basis points in the third quarter due to higher margins in the Marine Systems and Information Systems and Technology groups. Margins were up slightly in the year-to-date period. The

 

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review of business groups that follows the consolidated overview section contains a discussion of full-year revenue and margin expectations for our business groups.

Product Revenues and Operating Costs

 

Three Months Ended    October 3
2010
     October 2
2011
           Variance  

Revenues

   $ 5,290       $ 5,070            $ (220     (4.2 )% 

Operating costs

     4,217         3,991              (226     (5.4 )% 
             
 
Nine Months Ended    October 3
2010
     October 2
2011
           Variance  

Revenues

   $ 15,867       $ 15,186            $ (681     (4.3 )% 

Operating costs

     12,690         12,005              (685     (5.4 )% 

Product revenues were lower in the third quarter and first nine months of 2011 compared with the prior-year periods. The decrease in product revenues consisted of the following:

 

      Third Quarter     Nine Months  

Tactical communication products

   $ (230   $ (385

Ship construction

     (124     (244

Aircraft manufacturing, outfitting and completions

     89        3   

Other, net

     45        (55

Total decrease

   $ (220   $ (681

In the third quarter and first nine months of 2011, tactical communication products revenues decreased, particularly on ruggedized computing products, including the Common Hardware/Software III (CHS-3) program, driven by a slowed customer acquisition cycle and the delayed passage of the 2011 U.S. defense budget. Revenues were also down on several ship construction programs, most significantly on the DDG-1000 and DDG-51 destroyer programs due to award delays and on the commercial product-carrier program, which was completed in 2010. Offsetting these decreases in the third quarter were higher Gulfstream aircraft manufacturing and outfitting revenues, largely the result of additional green aircraft deliveries. In the year-to-date period, higher green aircraft revenues were essentially offset by lower completions revenues at Jet Aviation as a result of delays on narrow- and wide-body commercial aircraft contracts and continued lower volume on business-jet aircraft manufactured by other OEMs.

Product operating costs were lower in the third quarter and first nine months of 2011 compared with the prior-year periods. The decrease in product operating costs consisted of the following:

 

      Third Quarter     Nine Months  

Tactical communication products

   $ (232   $ (378

Ship construction

     (132     (247

Aircraft manufacturing, outfitting and completions

     77        (17

Other, net

     61        (43

Total decrease

   $ (226   $ (685

 

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The primary driver of the changes in product operating costs in the third quarter and first nine months of 2011 is volume. To a much lesser extent, operating costs were also impacted by several other factors. Tactical communications products operating costs also decreased as a result of initiatives that reduced overhead costs and lower warranty expenses. Ship construction operating costs also trended down as labor hours required to build later ships in a program decreased due to production efficiencies, particularly on the mature T-AKE Navy ship contract. Offsetting these decreases, aircraft manufacturing, outfitting and completions operating costs increased due to labor-hour growth on narrow- and wide-body projects in Jet Aviation’s completions business.

Service Revenues and Operating Costs

 

Three Months Ended    October 3
2010
     October 2
2011
           Variance  

Revenues

   $ 2,721       $ 2,783            $ 62         2.3

Operating costs

     2,347         2,372              25         1.1
              
Nine Months Ended    October 3
2010
     October 2
2011
           Variance  

Revenues

   $ 7,998       $ 8,344            $ 346         4.3

Operating costs

     6,861         7,143              282         4.1

Service revenues increased in the third quarter and first nine months of 2011 compared with the prior-year periods. The increase in service revenues consisted of the following:

 

      Third Quarter     Nine Months  

Aircraft services

   $ 50      $ 145   

Ship engineering and repair

     45        140   

Information technology (IT) services

     11        209   

Other, net

     (44     (148

Total increase

   $ 62      $ 346   

In the third quarter and first nine months of 2011, the growing global installed base of business-jet aircraft and improving aircraft utilization resulted in higher aircraft services revenues in the Aerospace group. Revenues were also up on several U.S. Navy engineering and repair programs, most significantly on the next-generation ballistic-missile submarine (SSBN(X)) and on surface-ship repair programs. Additionally, growth in the first half of 2011 on IT support and modernization programs for the intelligence community and the Department of Defense, including the Walter Reed National Military Medical Center and Mark Center programs, resulted in higher year-to-date IT services revenues.

Service operating costs increased in the third quarter and first nine months of 2011 compared with the prior-year periods. The increase in service operating costs consisted of the following:

 

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Table of Contents
      Third Quarter     Nine Months  

Aircraft services

   $ 38      $ 130   

Ship engineering and repair

     42        126   

IT services

     3        205   

Other, net

     (58     (179

Total increase

   $ 25      $ 282   

Service operating costs increased in the third quarter and first nine months of 2011 due primarily to increased activity levels. Operating costs increased in the aircraft services business due primarily to higher customer demand. Higher labor hours on ship engineering and repair programs drove an increase in operating costs while increased volume of infrastructure material required under IT modernization contracts resulted in higher IT services operating costs. To a much lesser extent, operating costs also increased due to a higher allocation of overhead costs to Jet Aviation’s aircraft services work resulting from lower revenues in its completions business.

G&A Expenses

As a percentage of revenues, G&A expenses were 6.3 percent in the third quarter of 2011 and 6.4 percent in the year-to-date 2011 period, up slightly from 6.0 percent and 6.1 percent in the prior-year periods. G&A expenses as a percentage of revenues increased in 2011 due primarily to higher ongoing R&D efforts in our Aerospace group and lower overall revenues.

Interest Expense

Net interest expense in the first nine months of 2011 was $103 compared with $124 in the same period in 2010. The decrease was due largely to the repayment of $700 of fixed-rate notes in the third quarter of 2010, partially offset by interest expense associated with the $1.5 billion of fixed-rate notes issued in July 2011. We expect full-year 2011 net interest expense to be approximately $140.

Other Income

In 2011, other income consisted primarily of a gain from the sale of the detection systems portion of the weapons systems business in our Combat Systems group in the second quarter. The sale resulted in a pretax gain of $38. This gain was offset partially by $10 of transaction-related costs associated primarily with the Vangent, Inc. business acquisition we completed in the third quarter of 2011. For further discussion of acquisition activity, see Note B to the unaudited Consolidated Financial Statements.

Effective Tax Rate

Our effective tax rate for the first nine months of 2011 was 30.6 percent compared with 30.9 percent in the same period in 2010. We anticipate a full-year 2011 effective tax rate of approximately 31 percent, compared with 30.7 percent in 2010. For additional discussion of tax matters, see Note I to the unaudited Consolidated Financial Statements.

 

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Discontinued Operations

In the third quarter, we recognized a $13 loss, net of taxes, in discontinued operations from the settlement of an environmental matter associated with a former operation of the company. Additionally, the nine-month results reflect our estimate of the legal costs associated with the A-12 litigation recorded in the second quarter as a result of the U.S. Supreme Court’s decision that significantly extended the timeline associated with the litigation. See Note K to the unaudited Consolidated Financial Statements for further discussion of the A-12 litigation, which has been ongoing since 1991.

Review of Business Groups

Following is a discussion of operating results and outlook for each of our business groups. For the Aerospace group, results are analyzed with respect to specific lines of products and services, consistent with how the group is managed. For the defense groups, the discussion is based on the types of products and services each group offers with a supplemental discussion of specific contracts and programs when significant to the groups’ results. Information regarding our business groups also can be found in Note M to the unaudited Consolidated Financial Statements.

Aerospace

 

Three Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 1,291      $ 1,412           $ 121        9.4

Operating earnings

     199        217             18        9.0

Operating margin

     15.4     15.4                     

Gulfstream aircraft deliveries (in units):

             

Green

     23        25             2        8.7

Outfitted

     24        26             2        8.3
           
Nine Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 4,031      $ 4,141           $ 110        2.7

Operating earnings

     650        656             6        0.9

Operating margin

     16.1     15.8                     

Gulfstream aircraft deliveries (in units):

             

Green

     79        72             (7     (8.9 )% 

Outfitted

     65        72             7        10.8

Operating Results

The Aerospace group’s revenues increased in the third quarter and the first nine months of 2011 compared to the prior-year periods. The increase consisted of the following:

 

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      Third Quarter     Nine Months  

Aircraft manufacturing, outfitting and completions

   $ 89      $ (26

Aircraft services

     50        174   

Pre-owned aircraft

     (18     (38

Total increase in revenues

   $ 121      $ 110   

Aircraft manufacturing, outfitting and completions revenues include Gulfstream business-jet aircraft as well as Jet Aviation’s completions of aircraft produced by other OEMs. Gulfstream aircraft manufacturing and outfitting revenues increased in the third quarter and year-to-date due largely to delivery of additional large-cabin green and, to a lesser extent, outfitted aircraft. Offsetting this increase were lower completions revenues at Jet Aviation in both periods as a result of manufacturing delays on narrow- and wide-body commercial aircraft contracts and continued lower volume in business-jet aircraft manufactured by other OEMs.

Strong growth in aircraft services revenues in the first half of 2011 continued in the third quarter, reflecting the global installed base of business-jet aircraft and improving aircraft utilization.

Pre-owned aircraft sales decreased in the third quarter and first nine months of 2011. The group sold two aircraft in both the third quarter of 2010 and 2011 and four aircraft in the year-to-date 2011 period compared with six in the first nine months of 2010. The group ended the quarter with no pre-owned aircraft in inventory.

The group’s operating earnings increased slightly in the third quarter and first nine months of 2011 compared with 2010. The increase consisted of the following:

 

      Third Quarter     Nine Months  

Aircraft manufacturing, outfitting and completions

   $ 40      $ 61   

Aircraft services

     (9     4   

Pre-owned aircraft

     (1     —     

SG&A/other

     (12     (59

Total increase in operating earnings

   $ 18      $ 6   

Gulfstream’s aircraft manufacturing and outfitting earnings increased in both periods compared with 2010 primarily due to additional large-cabin deliveries and, to a lesser extent, slightly higher liquidated damages associated with customer defaults. Earnings from Jet Aviation’s completions business were down compared with the third quarter and first nine months of 2010 as a result of growth in labor hours on narrow- and wide-body completions projects and less aircraft completions work for other OEMs. Management has undertaken major business initiatives to improve performance in Jet Aviation’s completions business and expects to deliver the remaining aircraft that have experienced significant delays over the next few months. In addition, competitive pressures in the broader completions market persist and have impacted the profitability of this business. If these negative trends continue, they could impact our projected operating results and, therefore, may result in the review of related long-lived assets for possible impairment, including specifically identified intangible assets of $140 and property, plant and equipment of $50.

Aircraft service earnings were down in the third quarter, but up slightly in the first nine months of 2011. Margins were down in both periods due to competitive market pricing and an unfavorable mix

 

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of service work, including lower-margin maintenance and refurbishment. Jet Aviation’s aircraft service margins were also negatively impacted by a higher allocation of overhead costs to Jet Aviation’s aircraft services work resulting from lower revenues in its completions business. The group’s operating earnings in 2011 were also negatively impacted by higher selling and marketing expenses associated with increased order activity and higher ongoing R&D efforts. As a result of the factors discussed above, the group’s overall operating margins were steady in the quarter, but decreased 30 basis points year-to date compared with the same prior-year periods.

Outlook

We expect the full-year 2011 Aerospace group revenues to increase approximately 13 percent over 2010 and full-year operating margins to approximate 15 percent. The group expects Federal Aviation Administration (FAA) provisional type certification for Gulfstream’s new ultra-large-cabin, ultra-high speed G650 aircraft in the fourth quarter, keeping the program on track for entry into service in the first half of 2012. We expect 10 to 12 initial green deliveries of the G650 aircraft in the fourth quarter of 2011, resulting in higher revenues for the group.

Combat Systems

 

Three Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 2,069      $ 2,140           $ 71         3.4

Operating earnings

     311        319             8         2.6

Operating margin

     15.0     14.9                      
            
Nine Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 6,182      $ 6,216           $ 34         0.5

Operating earnings

     875        895             20         2.3

Operating margin

     14.2     14.4                      

Operating Results

Higher Combat Systems revenues in the third quarter of 2011 drove an increase in year-to-date revenues over the comparable 2010 periods. The increase consisted of the following:

 

      Third Quarter     Nine Months  

U.S. military vehicles

   $ (6   $ (135

Weapon systems and munitions

     42        59   

European military vehicles

     35        110   

Total increase in revenues

   $ 71      $ 34   

In the group’s U.S. military vehicles business, volume was up in both periods on a foreign military sales (FMS) contract to provide light armored vehicles (LAVs) for an international military customer. Offsetting this increase were a decline in Expeditionary Fighting Vehicle (EFV) activity as the system design and development contract nears completion, and refurbishment and upgrade work for the Abrams main battle tank, particularly in the first half of the year.

 

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Revenues in the group’s weapon systems and munitions businesses were up in the third quarter and first nine months of 2011 compared with the same prior-year periods. The growth resulted primarily from increased sales of heavy-payload axles in the military and commercial markets, particularly in the third quarter.

Revenue growth in the group’s European military vehicle business continued into the third quarter due largely to a higher volume of Duro and EAGLE wheeled military vehicles sales to a variety of European customers, including the Swiss and German governments, and the start-up of the Specialist Vehicle (SV) program for the United Kingdom. Offsetting this increase in both periods was lower activity on the group’s Pandur and Piranha vehicles contracts for various international customers.

The group’s operating earnings grew in the third quarter and first nine months of 2011, resulting in steady margins in the quarter-to-date period and slightly higher margins in the year-to-date period. The margin growth for the year is primarily due to productivity improvements in our U.S. military vehicles business, resulting in higher profitability on the Stryker, Abrams and FMS LAV programs.

Outlook

We expect full-year 2011 Combat Systems revenues to approach $9 billion as growth in international vehicle contracts offsets a reduction in volume on certain of the group’s U.S. vehicle programs. Given operating performance in the first nine months of the year, we expect full-year operating margins for the group to be approximately 14 percent.

Marine Systems

 

Three Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 1,700      $ 1,621           $ (79     (4.6 )% 

Operating earnings

     169        173             4        2.4

Operating margin

     9.9     10.7                     
           
Nine Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 4,976      $ 4,873           $ (103     (2.1 )% 

Operating earnings

     497        501             4        0.8

Operating margin

     10.0     10.3                     

 

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Operating Results

The Marine Systems group’s revenues decreased in the third quarter and first nine months of 2011 compared with the same prior-year periods. The decrease consisted of the following:

 

      Third Quarter     Nine Months  

Navy ship construction

   $ (98   $ (166

Navy ship engineering and repair services

     34        144   

Commercial ship construction

     (15     (81

Total decrease in revenues

   $ (79   $ (103

The group’s U.S. Navy ship-construction programs include Virginia-class submarines, DDG-1000 and DDG-51 destroyers, and T-AKE combat-logistics and Mobile Landing Platform (MLP) auxiliary support ships. The group has been increasing production levels on Virginia-class submarines over the past several years in preparation for the construction of two boats per year beginning this year. While this drove higher volume on the program in the first six months of 2011, revenues were down in the third quarter of 2011 due to timing of construction activity as we transition from the Block II to the Block III contract, resulting in lower year-to-date revenues in 2011. Deliveries of the remaining 10 Virginia-class submarines under contract are scheduled through 2018.

Late in the third quarter, the group received an award for its portion of the construction of the second and third ships in the DDG-1000 destroyer program. Due to a delay in the award, revenues were down on the program year-to-date. Deliveries of the three DDG-1000 ships now under contract are scheduled for 2014, 2015 and 2018. Volume was also lower on the DDG-51 program as the legacy multi-ship contract nears completion with the remaining destroyer scheduled for delivery in 2012. However, in the third quarter, the group received a competitive award for a DDG-51 destroyer scheduled for delivery in 2016 as well as an option for an additional destroyer in connection with the Navy’s restart of the DDG-51 program.

Volume increased on the MLP program in the quarter-to-date and year-to-date periods as the group continued construction on the first ship of the three-ship program, scheduled for delivery in 2013. The group also has received a construction contract for the second ship and long-lead funding for the third ship. Activity on the group’s T-AKE program was down in 2011 as the group delivered two ships and nears completion of the remaining two ships, scheduled for delivery through 2012.

While ship-construction revenues were down from 2010, volume on engineering and repair programs for the Navy was up in the third quarter and the first nine months of 2011 compared with the same prior-year periods. Revenues increased in 2011 on the group’s engineering work associated with the Navy’s next-generation ballistic-missile submarine (SSBN(X)), although growth was more modest in the third quarter than in the first half of the year. Additionally, the group’s repair work continued to increase in 2011, following significant growth in 2010, particularly on surface-ship repair programs. Subsequent to the end of the quarter, we completed the acquisition of Metro Machine Corp., a surface-ship repair company that will provide access to repair operations in a key East Coast naval port.

In 2010, the group completed construction of a five-ship commercial product-carrier program, resulting in a decrease in commercial shipbuilding revenues in 2011. Given the success of this program, the age of the fleet of Jones Act ships and environmental regulations that require double-hull tankers and

 

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impose emission control limits, we believe that additional commercial shipbuilding opportunities will be realized in the coming years as the economy recovers.

Despite the decrease in revenues, the group’s 2011 operating earnings were up slightly in the third quarter and first nine months of 2011, resulting in an 80 basis-point increase in operating margins in the quarter-to-date period and a 30 basis-point increase in 2011. Continued performance improvement on the mature T-AKE contract was offset by margin compression from a shift in program mix as we transition to new shipbuilding contracts and design work on the SSBN(X) program increases.

Outlook

We expect Marine Systems 2011 revenues to remain near 2010 levels of approximately $6.7 billion as increased Virginia-class production and submarine engineering activity are offset by lower destroyer, T-AKE and commercial volume. For the year, we expect the group to achieve operating margins that approximate 10 percent.

Information Systems and Technology

 

Three Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 2,951      $ 2,680           $ (271     (9.2 )% 

Operating earnings

     306        310             4        1.3

Operating margin

     10.4     11.6                     
           
Nine Months Ended    October 3
2010
    October 2
2011
          Variance  

Revenues

   $ 8,676      $ 8,300           $ (376     (4.3 )% 

Operating earnings

     908        885             (23     (2.5 )% 

Operating margin

     10.5     10.7                     

Operating Results

The Information Systems and Technology group’s revenues decreased in the third quarter and first nine months of 2011 compared with the same periods in 2010. The decrease consisted of the following:

 

      Third Quarter     Nine Months  

Tactical communication systems

   $ (286   $ (551

Information technology (IT) services

     26        226   

Intelligence, surveillance and reconnaissance (ISR) systems

     (11     (51

Total decrease in revenues

   $ (271   $ (376

Volume in the tactical communication systems business was unfavorably impacted by the delayed passage of the 2011 U.S. defense budget and a protracted customer acquisition cycle that slowed award activity. This resulted in lower revenues in 2011 compared with 2010, specifically on ruggedized computing products, including CHS-3, and other products with shorter-term delivery horizons. Additionally, revenues on the Canadian Maritime Helicopter Project (MHP) were down in

 

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both periods as the group transitions to the training and support phase of the program. In the group’s United Kingdom-based operation, revenues were up in both periods due to higher volume on the initial phase of the U.K. Ministry of Defence SV program and in our surveillance systems business acquired in 2010.

In the group’s IT services business, revenue was up slightly in the third quarter, due largely to the start up of St. Elizabeths Hospital IT infrastructure program. The year-to-date increase was driven largely by growth in the first half of 2011 on IT support and modernization programs for the intelligence community and the Department of Defense (DoD), including the New Campus East, Walter Reed National Military Medical Center and Mark Center programs.

Revenues were down in the third quarter and first nine months of 2011 compared with the prior-year periods in the group’s ISR business due to lower optical products volume and, in the year-to-date period, the sale of a satellite facility in the first quarter of 2010.

Despite the decrease in revenues in the third quarter, the group’s operating earnings were up slightly. The increase in operating earnings resulted in 120-basis point margin growth in the quarter compared with the prior-year period. The margin expansion is largely due to our tactical communications business, and is the result of initiatives that reduced overhead costs, lower warranty expenses and favorable contract mix, including high-margin encryption and battlefield communications network products. While operating earnings were down year-to-date in 2011, operating margins were up 20 basis points as performance improvement in the tactical communications business was offset by sales growth in our lower-margin IT services business.

Outlook

We expect full-year 2011 revenues in the Information Systems and Technology group to be down 2 to 3 percent from 2010 levels. Organic growth in IT services and additional revenues from our 2011 acquisitions, most significantly Vangent, Inc., will be offset by lower than expected revenues in our tactical communication systems business. We expect the group to achieve operating margins in the mid-10 percent range.

Corporate

Corporate results consist primarily of compensation expense for stock options. Corporate operating costs totaled $21 in the third quarter of 2011 compared with $19 in the third quarter of 2010. Corporate operating costs were $61 through the first nine months of 2010 and 2011. We expect 2011 full-year Corporate operating costs of approximately $85.

BACKLOG

Our total backlog was $58.5 billion on October 2, 2011, up 2 percent from the second quarter of 2011. Third-quarter order activity was healthy across the business, with our Aerospace, Marine Systems and Information Systems and Technology groups generating a book-to-bill ratio (orders divided by revenue) greater than one-to-one. Our backlog does not include work awarded under unfunded indefinite delivery, indefinite quantity (IDIQ) contracts or unexercised options associated with existing firm contracts, which we refer to collectively as estimated potential contract value. The estimated potential contract value represents our estimate of the ultimate value we expect to receive under these arrangements. At the end of the third quarter of 2011, our estimate of this potential contract value was $27 billion, up nearly 30 percent from the end of the second quarter, with increases in the Marine

 

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Systems and Information Systems and Technology groups due largely to the DDG-51 and DDG-1000 and Common Hardware Systems-4 (CHS-4) contract awards, respectively. The acquisition of Vangent, Inc. in the quarter also added approximately $1.2 billion to the Information Systems and Technology group’s estimated potential contract value.

The following table details the backlog and the total estimated contract value of each business group at the end of the third and second quarters of 2011:

 

October 2, 2011    Funded      Unfunded      Total
Backlog
     Estimated
Potential
Contract
Value
     Total
Estimated
Contract
Value
 

Aerospace

   $ 18,306       $ 318       $ 18,624       $ —         $ 18,624   

Combat Systems

     9,078         1,304         10,382         3,763         14,145   

Marine Systems

     10,269         8,611         18,880         2,044         20,924   

Information Systems and Technology

     8,248         2,389         10,637         21,429         32,066   

Total

   $ 45,901       $ 12,622       $ 58,523       $ 27,236       $ 85,759   
              
July 3, 2011                                        

Aerospace

   $ 17,948       $ 340       $ 18,288       $ —         $ 18,288   

Combat Systems

     9,657         1,135         10,792         4,370         15,162   

Marine Systems

     9,191         9,209         18,400         1,097         19,497   

Information Systems and Technology

     7,468         2,168         9,636         15,697         25,333   

Total

   $ 44,264       $ 12,852       $ 57,116       $ 21,164       $ 78,280   

Aerospace

Aerospace funded backlog represents orders for which we have definitive purchase contracts and deposits from customers. Aerospace unfunded backlog consists of agreements to provide future aircraft maintenance and support services. The group ended the third quarter of 2011 with $18.6 billion of backlog, the fourth consecutive quarterly increase. Order activity in 2011 has been very strong across the portfolio but particularly for large-cabin aircraft, and customer defaults remain at low levels. In the group’s large-cabin segment, backlog remains well-positioned, with an 18- to 24-month period between customer order and delivery of in-service aircraft and approximately five years of backlog for the G650. Approximately 75 percent of the group’s orders in 2011 were from international customers, with significant growth in orders from the Asia-Pacific region. In the third quarter of 2011, Gulfstream received an initial $810 order under the memorandum of understanding (MOU) with Minsheng Financial Leasing, the Chinese financial leasing company of Minsheng Bank. The order was for the purchase of 20 Gulfstream aircraft across the product portfolio.

 

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Defense Groups

The total backlog for our defense groups represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are similarly approved and funded by their governments. While there is no guarantee that future budgets and appropriations will provide funding for a given program, we have included only firm contracts we believe are likely to receive funding.

Backlog in our defense groups was $39.9 billion on October 2, 2011, up 3 percent from the second quarter of 2011. Backlog increased in the Marine Systems and Information Systems and Technology groups, but was down slightly in the Combat Systems group. Our defense groups each received notable contract awards in the third quarter, including several that were delayed from the first half of the year.

Combat Systems awards included the following:

 

   

$440 from the U.S. Army for the Technology Development phase of the Army’s Ground Combat Vehicle (GCV) Infantry Fighting Vehicle program.

 

   

$250 from the Army to produce 115 Stryker double-V-hulled vehicles.

 

   

$205 from the U.S. Marine Corps under the MRAP vehicle program for upgrade kits for previously delivered RG-31 vehicles.

 

   

$135 from the Canadian government to supply various calibers of ammunition.

 

   

$60 from the Army to produce medium-caliber ammunition.

Marine Systems awards included the following:

 

   

$1.8 billion from the U.S. Navy for engineering, design and construction of two DDG-1000 destroyers.

 

   

$565 from the Navy for construction of a DDG-51 destroyer under the destroyer construction continuation program. The award also includes a $665 option to build an additional ship.

Information Systems and Technology awards included the following:

 

   

$85 from the Army for ruggedized computing equipment under the CHS-3 program.

 

   

$85 from the Army under the Warfighter Information Network-Tactical (WIN-T) program for Increment 1 equipment.

 

   

$55 under the Defense Intelligence Agency’s (DIA) Solutions for the Information Technology Enterprise (SITE) contract for enterprise communication services.

 

   

An IDIQ contract from the Army for ruggedized computing equipment under the CHS-4 program. The program has a maximum potential value of approximately $3.7 billion over ten years.

 

   

An IDIQ contract from the U.S. Air Force under the Global Broadcast Service (GBS) program for the production of Transportable Ground Receive Suites (TGRS) and delivery of retrofit kits for previously delivered systems. The program has a maximum potential value of $900 over five years.

 

   

An IDIQ contract from the Army to provide information systems engineering and IT support services to the Army’s Information Systems Engineering Command (ISEC). The program has a maximum potential value among the three awardees of close to $900 over five years.

 

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Subsequent to the end of the quarter, the Combat Systems group received an order to modernize 550 LAV III combat vehicles for the Canadian government. The contract has a value of $1 billion over six years.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

We ended the third quarter of 2011 with a cash balance of $1.5 billion, compared with $2.6 billion at the end of 2010. Our net debt – debt less cash and equivalents and marketable securities – was $2.3 billion at the end of the third quarter of 2011, up by $1.9 billion from $378 at the end of 2010 due largely to the issuance of fixed-rate notes in the third quarter of 2011 and other capital deployment activities. Following is a discussion of the major components of our operating, investing and financing activities, as classified on the Consolidated Statement of Cash Flows, in the first nine months of 2010 and 2011.

Operating Activities

We generated cash from operating activities of $1.2 billion in the first nine months of 2011 compared with $1.6 billion in the same period in 2010. The primary driver of cash flows in both periods was net earnings, offset in part by growth in operating working capital (OWC). The increase in OWC in the first nine months of 2011 is largely due to an increase in inventories associated with the ramp toward initial green deliveries of the G650 aircraft in the fourth quarter of 2011 and early 2012. Significant cash flows associated with receipt of provisional type certification of the G650 are expected in the fourth quarter of 2011, mitigating this growth by year end as customer deposits are received. Cash from operating activities in the first nine months of 2011 included a $300 contribution to our pension plans, as compared to a $270 contribution in 2010.

As discussed further in Note K to the unaudited Consolidated Financial Statements, litigation on the A-12 contract termination has been ongoing since 1991. If, contrary to our expectations, the default termination is sustained and the government prevails on its recovery theories, we, along with The Boeing Company, could collectively be required to repay the U.S. govern