UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended October 1, 2006
OR
Commission File Number 1-3671
GENERAL DYNAMICS CORPORATION
(Exact name of registrant as specified in its charter)
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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer þ Accelerated Filer ¨ Non-Accelerated Filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
404,644,310 shares of the registrant’s common stock, $1 par value per share, were outstanding at October 29, 2006.
INDEX
PART I - FINANCIAL INFORMATION
Item 1 -
Consolidated Financial Statements
Consolidated Balance Sheet
Consolidated Statement of Earnings (Three Months)
Consolidated Statement of Earnings (Nine Months)
Consolidated Statement of Cash Flows
Notes to Unaudited Consolidated Financial Statements
Item 2 -
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3 -
Quantitative and Qualitative Disclosures About Market Risk
Item 4 -
Controls and Procedures
FORWARD-LOOKING STATEMENTS
PART II - OTHER INFORMATION
Legal Proceedings
Item 1A -
Risk Factors
Item 6 -
Exhibits
SIGNATURES
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PART I – FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEET
Cash and equivalents
Accounts receivable
Contracts in process
Inventories
Assets of discontinued operations
Other current assets
Total Current Assets
Property, plant and equipment, net
Intangible assets, net
Goodwill
Other assets
Total Noncurrent Assets
Short-term debt and current portion of long-term debt
Accounts payable
Customer advances and deposits
Liabilities of discontinued operations
Other current liabilities
Total Current Liabilities
Long-term debt
Other liabilities
Commitments and contingencies (See Note L)
Total Noncurrent Liabilities
Common stock, including surplus
Retained earnings
Treasury stock
Accumulated other comprehensive income
Total Shareholders’ Equity
The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.
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CONSOLIDATED STATEMENT OF EARNINGS
(UNAUDITED)
October 1
2006
October 2
2005
Operating costs and expenses
Interest, net
Other, net
Provision for income taxes, net
Discontinued operations, net of tax
Continuing operations
Discontinued operations
Net Earnings
Dividends declared per share
General and administrative expenses included in operating costs and expenses
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CONSOLIDATED STATEMENT OF CASH FLOWS
Net earnings
Adjustments to reconcile net earnings to net cash provided by operating activities –
Depreciation, depletion and amortization of property, plant and equipment
Amortization of intangible assets
Stock-based compensation expense
Excess tax benefit from stock-based compensation
Deferred income tax provision
(Increase) decrease in assets, net of effects of business acquisitions –
Increase (decrease) in liabilities, net of effects of business acquisitions –
Net Cash Provided by Operating Activities from Continuing Operations
Net Cash (Used) Provided by Discontinued Operations - Operating Activities
Net Cash Provided by Operating Activities
Business acquisitions, net of cash acquired
Proceeds from sale of assets, net - continuing operations
Proceeds from sale of discontinued operations, net
Capital expenditures - continuing operations
Capital expenditures - discontinued operations
Net Cash Used by Investing Activities
Repayment of fixed-rate notes
Net proceeds from commercial paper
Dividends paid
Proceeds from option exercises
Purchases of common stock
Net Cash Used by Financing Activities
Cash payments for:
Income taxes
Interest
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions, except per share amounts or unless otherwise noted)
The Company
The term “company” or “General Dynamics” used in this document refers to General Dynamics Corporation and all of its wholly owned and majority-owned subsidiaries.
Interim Financial Statements
The unaudited Consolidated Financial Statements included in this Form 10-Q have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. 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.
Operating results for the three- and nine-month periods ended October 1, 2006, are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.
In management’s opinion, the unaudited Consolidated Financial Statements contain all adjustments, that are of a normal recurring nature, necessary for a fair statement of the results for the three- and nine-month periods ended October 1, 2006, and October 2, 2005.
These unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the company’s Annual Report on Form 10-K for the year ended December 31, 2005.
Classification
In 2006 and 2005, General Dynamics placed certain non-core businesses in discontinued operations, as discussed in Note C. In addition, on March 1, 2006, the company’s board of directors authorized a two-for-one stock split to be effected in the form of a 100 percent stock dividend distributed on March 24, 2006, to shareholders of record at the close of business on March 13, 2006. The unaudited Consolidated Financial Statements have been restated to report discontinued operations and to reflect the stock split. Additionally, some prior-year amounts have been reclassified among financial statement accounts to conform to the current-year presentation.
In the first nine months of 2006, the company acquired three businesses for an aggregate of $2.3 billion in cash.
Information Systems and Technology
Anteon International Corporation (Anteon) of Fairfax, Virginia, on June 8. Anteon is a leading systems integration company that provides mission, operational and information technology
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(IT) enterprise support to the U.S. government. As a condition of the acquisition, the company divested several of Anteon’s program management and engineering services contracts. The company received approximately $160 in after-tax proceeds from the sale of these contracts, resulting in a net purchase price of approximately $2.1 billion.
Combat Systems
In 2005, General Dynamics acquired three businesses for an aggregate of $280 in cash. Each of these businesses is included in the Information Systems and Technology group.
The operating results of these businesses have been included with General Dynamics’ results as of the respective closing dates of the acquisitions. The purchase prices of these businesses have been allocated to the estimated fair value of net tangible and intangible assets acquired, with any excess purchase price recorded as goodwill. Some of the estimates related to the Anteon and Scranton Operation acquisitions are still preliminary at October 1, 2006. The company is awaiting the completion of the identification and valuation of intangible assets acquired. The company expects these analyses to be completed during the first quarter of 2007.
Intangible assets consisted of the following:
December 31
Contract and program intangible assets
Other intangible assets
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The company amortizes contract and program intangible assets on a straight-line basis over two to 40 years. Other intangible assets consist primarily of aircraft product design, customer lists, software and licenses and are amortized over one to 21 years.
Amortization expense was $38 and $95 for the three- and nine-month periods ended October 1, 2006, and $25 and $76 for the three- and nine-month periods ended October 2, 2005. The company expects to record annual amortization expense over the next five years as follows:
2007
2008
2009
2010
The changes in the carrying amount of goodwill by business group for the nine months ended October 1, 2006, were as follows:
Marine Systems
Aerospace
On March 1, 2006, the company entered into a definitive agreement to sell its aggregates business. This transaction closed in the second quarter of 2006. The company received proceeds of approximately $310 from this transaction and recognized an after-tax gain of approximately $220 from the sale in 2006. In addition, the company has taken steps to sell its coal mining operation. With the sale of the aggregates business and the expected sale of the coal business within the next year, the operations previously identified for reporting purposes as Resources have been reclassified to discontinued operations.
In 2004, the company entered into definitive agreements to sell its aeronautical research and development business in the Information Systems and Technology group and its propulsion systems business in the Combat Systems group. These transactions closed in the first quarter of 2005. In addition to the 2004 agreements, the company sold two more businesses in the first quarter of 2005. These included the facilities research and development business and the airborne electronics systems business in the Information Systems and Technology group. The company received combined proceeds of approximately $320 and recognized an after-tax loss of $8 from these transactions in the first nine months of 2005.
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The financial statements for all periods have been restated to remove the sales of each of these businesses from the company’s consolidated net sales and present the results of their operations in discontinued operations.
The summary of operating results from discontinued operations follows:
Net sales
Operating expenses
Operating (loss)/earnings
(Loss)/gain on disposal
(Loss)/earnings before taxes
Tax (benefit)/provision
Assets and liabilities of discontinued operations consisted of the following:
Short-term debt
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Equity Compensation Overview
The company has various equity compensation plans for employees as well as non-employee members of the board of directors, including:
The purpose of the Equity Compensation Plan is to provide the company with an effective means of attracting, retaining and motivating officers, key employees and non-employee directors, and to provide them with incentives to enhance the growth and profitability of the company. Under the Equity Compensation Plan, awards may be granted to officers, employees or non-employee directors in common stock, options to purchase common stock, restricted shares of common stock, participation units or any combination of these.
Stock options may be granted either as incentive stock options, intended to qualify for capital gain treatment under Section 422 of the Internal Revenue Code of 1986, as amended (the Code), or as options not qualified under the Code. All options granted under the Equity Compensation Plan are issued with an exercise price at or above the fair market value of the common stock on the date of grant. Awards of stock options generally vest over two years, with 50 percent of the options vesting on the first anniversary of the date of grant and the remaining 50 percent vesting on the second anniversary of the date of grant. Stock options awarded under the Equity Compensation Plan may not have a term of more than five years. Since the early 1990s, it has been the company’s practice to grant stock options to participants in its equity compensation plans on the first Wednesday of March based on the average of the high and low stock price on that day as listed on the New York Stock Exchange.
Awards of restricted stock represent common stock that may not be sold, transferred, pledged, assigned or otherwise conveyed to another party except upon the passage of time, or upon satisfaction of performance goals or other conditions. However, during the period of restriction, the recipient of restricted shares is entitled to vote the restricted shares and to retain cash dividends paid on those shares. Awards of restricted stock generally vest 100 percent after four years.
Participation units are obligations of the company that have a value derived from or related to the value of the company’s common stock. These include stock appreciation rights, phantom stock units, and restricted stock units and are payable in cash and/or common stock.
The Equity Compensation Plan replaced, on a prospective basis, the Incentive Compensation Plan and the Directors’ Stock Plan (the prior plans) effective May 5, 2004. No new grant of awards will be made under the prior plans. Any awards previously granted under the prior plans will remain outstanding and will, among other things, continue to vest and become exercisable in accordance with their original terms and conditions.
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Under the U.K. Plan, company employees located in the United Kingdom may invest designated amounts in a savings account to be used to purchase a specified number of shares of common stock, based on option grants that the employee may receive, at an exercise price of not less than 80 percent of the fair market value of the common stock. The options may be exercised three, five or seven years after the date of grant depending on the terms of the specific award.
Options granted under the Gulfstream Plans prior to the company’s acquisition of Gulfstream were subject to different vesting periods based on the terms of the plans. At the time of the acquisition, substantially all of the outstanding Gulfstream options became fully vested options to purchase common stock of the company. No additional awards or grants may be made under the Gulfstream Plans.
The company issues common stock under its equity compensation plans from treasury stock. At October 1, 2006, in addition to the shares reserved for issuance upon the exercise of outstanding options, approximately 25 million shares have been authorized for options and restricted stock that may be granted in the future.
Stock-based Compensation Expense
On January 1, 2006, the company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123R). SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the financial statements based on their fair value at the grant date. The company adopted SFAS 123R in the first quarter of 2006 using the “modified prospective transition method.” Under this transition method, stock-based compensation expense is recognized for all share-based payments granted after the adoption of SFAS 123R and for the portion of any awards granted prior to the adoption of SFAS 123R that had not vested as of the adoption date. Accordingly, no prior periods have been restated to reflect stock option expense. The company implemented the provisions of the Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin No. 107 (SAB 107) in its adoption of SFAS 123R. SAB 107 provides the SEC staff’s interpretation of SFAS 123R and provides further guidance on the valuation of share-based payments. The company has also elected to adopt the alternative method of calculating the historical pool of tax benefits as permitted by FASB Staff Position No. SFAS 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.
The adoption of SFAS 123R resulted in a reduction of operating earnings and net earnings of $12 and $7, respectively, in the three-month period ended October 1, 2006, and $37 and $24, respectively, in the nine-month period ended October 1, 2006. The impact on earnings per share for the three- and nine-month periods ended October 1, 2006, was $0.02 and $0.06 per share, respectively.
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SFAS 123R also requires the excess tax benefits the company receives from stock option exercises to be classified as an outflow in cash flows from operating activities and an inflow in cash flows from financing activities on the Consolidated Statement of Cash Flows. Prior to the adoption of SFAS 123R, the company classified the excess tax benefits it received from the exercise of stock options as cash flows from operating activities in the Consolidated Statement of Cash Flows. The excess tax benefit recorded in the first nine months of 2006 was $35, including $33 resulting from stock option exercises.
The adoption of SFAS 123R did not impact the company’s determination of compensation expense for restricted stock.
The following table details the components of stock-based compensation expense recognized in earnings in the three- and nine-month periods ended October 1, 2006, and October 2, 2005:
Stock options
Restricted stock
Stock-based compensation expense is included in general and administrative expenses for all periods presented.
Prior to the adoption of SFAS 123R on January 1, 2006, the company accounted for its equity compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The company calculated compensation expense for stock options as the excess, if any, of the quoted market price of the company’s stock at the grant date over the exercise price.
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If compensation expense for stock options had been determined based on the fair value at the grant dates for awards under the company’s equity compensation plans, General Dynamics’ net earnings and net earnings per share for the three- and nine-month periods ended October 2, 2005, would have been reduced to the pro forma amounts indicated as follows:
Net earnings, as reported
Add: Stock-based compensation expense included in reported net earnings,net of tax*
Deduct: Total fair value-based compensation expense, net of tax
Pro forma net earnings
Net earnings per share - basic:
As reported
Pro forma
Net earnings per share - diluted:
Stock Options
The company recognizes compensation expense related to stock options on a straight-line basis over the vesting period of the awards, which is generally two years. The company estimates the fair value of options on the date of grant using the Black-Scholes option pricing model with the following assumptions:
Range of expected volatility
Weighted average expected volatility
Range of expected terms (in months)
Range of risk-free interest rates
The company estimates expected volatility using the historical volatility of its common stock over a period equal to the expected term of the option. The company estimates expected term using historical option exercise data to determine the expected employee exercise behavior. After consideration of the guidance provided by SFAS 123R and SAB 107 and upon review of the historical option exercise data, the company identified two employee populations that exhibit different exercise
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behaviors. As a result of this analysis, beginning in the first quarter of 2006, the company estimated different expected terms and determined a separate fair value for options granted for each of the two employee populations. The risk-free interest rate is the yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option at the grant date.
In the three- and nine-month periods ended October 1, 2006, the company recognized $7 and $24, respectively, of compensation expense related to stock options, net of income taxes. The total income tax benefit recognized in the third quarter and first nine months of 2006 related to stock option compensation expense was $5 and $13, respectively. Stock-based compensation expense for stock options is reported as a Corporate expense for segment reporting purposes (see Note N). As of October 1, 2006, the company had $57 of unrecognized compensation cost related to stock options, which is expected to be recognized over a weighted average period of 1.2 years.
A summary of option activity during the first nine months of 2006 follows:
AggregateIntrinsicValue
(in millions)
Granted
Exercised
Forfeited/Canceled
The weighted average fair value of options granted during the first nine months of 2006 and 2005 was $14.43 and $11.63, respectively. In the table above, intrinsic value is calculated as the difference between the market price of the company’s stock on the last trading day of the quarter and the exercise price of the options. For options exercised, intrinsic value is calculated as the difference between the market price on the date of exercise and the exercise price. The total intrinsic value of options exercised during the first nine months of 2006 and 2005 was $119 and $75, respectively. The company received cash of $192 from the exercise of stock options in the first nine months of 2006.
Restricted Stock
The company determines the fair value of restricted stock as the market price of the company’s stock on the date of grant. The company recognizes compensation expense related to restricted stock on a straight-line basis over the period during which the restriction lapses, which is generally four years.
In the third quarter and first nine months of 2006, the company recognized $2 and $6, respectively, of compensation expense related to restricted stock, net of income taxes, with a total income tax benefit of $1 and $3, respectively. As of October 1, 2006, the company had $40 of unrecognized compensation cost related to restricted stock, which is expected to be recognized over a weighted average period of 2.9 years.
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The following is a summary of restricted stock activity during the first nine months of 2006:
Vested
Forfeited
The total fair value of shares vested during the first nine months of 2006 and 2005 was $21 and $26, respectively.
Earnings per Share
General Dynamics computes basic earnings per share using net earnings for the respective period and the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporates the incremental shares issuable upon the assumed exercise of stock options and the issuance of contingently issuable shares.
Basic and diluted weighted average shares outstanding were as follows (in thousands):
Basic weighted average shares outstanding
Assumed exercise of stock options
Contingently issuable shares
Comprehensive Income
The company’s comprehensive income was $432 and $1,420 for the three- and nine-month periods ended October 1, 2006, respectively, and $437 and $1,049 for the three- and nine-month periods ended October 2, 2005, respectively.
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On March 1, 2006, the company’s board of directors authorized a two-for-one stock split to be effected in the form of a 100 percent stock dividend distributed on March 24, 2006, to shareholders of record at the close of business on March 13, 2006. All historical share and per share data, stock option data and market prices have been restated to reflect the stock split.
The total number of authorized common stock shares and par value were unchanged by this action. Shareholders’ equity has been restated to give retroactive recognition of the stock split for all periods presented by reclassifying from surplus to common stock the par value of the additional shares resulting from the split.
Contracts in process represent recoverable costs and, where applicable, accrued profit related to government contracts and consisted of the following:
Contract costs and estimated profits
Other contract costs
Less advances and progress payments
Contract costs consist primarily of production costs and related overhead and general and administrative expenses. Contract costs also reflect anticipated recoveries for matters such as contract changes, negotiated settlements and claims for unanticipated contract costs, which totaled $321 as of October 1, 2006, and $264 as of December 31, 2005. The most significant portion of these expected recoveries relates to the company’s request for equitable adjustment submitted to the Navy for work on its T-AKE combat logistics ship contract. The company is seeking a contract price adjustment for engineering- and design-related changes imposed by the customer. The company records revenue associated with these matters only when recovery can be estimated reliably and realization is probable.
Other contract costs represent amounts recorded under GAAP that are not currently allocable to contracts with the U.S. government, such as a portion of the company’s estimated workers’ compensation, other insurance-related assessments, pension and post-retirement benefits, and environmental expenses. These costs will become allocable to contracts generally when they are paid. The company expects to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. This business base includes numerous contracts for which the company is the sole source or is one of two suppliers on long-term defense programs. However, if the backlog in the future does not support the continued deferral of these costs, the profitability of the company’s remaining contracts could be adversely affected. The company expects to bill substantially all of its October 1, 2006, contracts-in-process balance, with the exception of these other contract costs, during the next 12 months.
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Inventories represent primarily commercial aircraft components and consisted of the following:
Work in process
Raw materials
Pre-owned aircraft
Other
I. Debt
Debt consisted of the following:
Fixed-rate notes
Notes due in May 2006
Notes due in May 2008
Notes due in August 2010
Notes due in May 2013
Notes due in August 2015
Commercial Paper
Senior notes due in 2008
Term debt due in 2008
Total debt
Less current portion
As of October 1, 2006, General Dynamics had outstanding $2.6 billion aggregate principal amount of fixed-rate notes. The sale of the fixed-rate notes was registered under the Securities Act of 1933, as amended (the Securities Act). The notes are fully and unconditionally guaranteed by several of the company’s 100-percent-owned subsidiaries. The company has the option to redeem the notes prior to their maturity in whole or in part at 100 percent of the outstanding principal plus any accrued but unpaid interest and any applicable make-whole amounts. See Note O for condensed consolidating financial statements.
As of October 1, 2006, the company had $322 of commercial paper outstanding at an average yield of 5.31 percent with an average maturity of 30 days. The company has $2 billion in bank credit facilities that provide backup liquidity to its commercial paper program. These credit facilities consist of a $1 billion 364-day facility expiring in December 2006 and a $1 billion multiyear facility expiring in July 2009. The company’s commercial paper issuances and the bank credit facilities are guaranteed by several of the company’s 100-percent-owned subsidiaries. Additionally, a number of the company’s international subsidiaries have available local bank credit facilities of approximately $805.
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The senior notes are privately placed U.S. dollar-denominated notes issued by one of the company’s Canadian subsidiaries. Interest is payable semiannually at an annual rate of 6.32 percent until maturity in September 2008. The subsidiary has a currency swap that fixes both the interest payments and principal at maturity of these notes. As of October 1, 2006, the fair value of this currency swap was a $50 liability, which offset the effect of changes in the currency exchange rate on the related debt. The senior notes are backed by a parent company guarantee.
The company assumed the term debt in connection with the acquisition of Primex Technologies, Inc., in 2001. Annual sinking fund payments of $5 are required in December of 2006 and 2007, with the remaining $20 payable in December 2008. Interest is payable in June and December at an annual rate of 7.5 percent.
As of October 1, 2006, other debt consisted primarily of a capital lease arrangement.
The company’s financing arrangements contain a number of customary covenants and restrictions. The company was in compliance with all material covenants as of October 1, 2006.
A summary of significant liabilities, by balance sheet caption, follows:
Retirement benefits (a)
Salaries and wages
Workers’ compensation
Other (b)
Deferred U.S. federal income taxes
Customer deposits on commercial contracts
Retirement benefits
Other (c)
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The company had a net deferred tax liability of $771 at October 1, 2006, and $644 at December 31, 2005. The current portion of the net deferred taxes was an asset of $100 at October 1, 2006, and $168 at December 31, 2005, and is included in other current assets on the Consolidated Balance Sheet.
On November 27, 2001, General Dynamics filed a refund suit in the U.S. Court of Federal Claims, titled General Dynamics v. United States, for the years 1991 to 1993. The company added the years 1994 to 1998 to the litigation on June 23, 2004. The suit seeks recovery of refund claims that were disallowed by the Internal Revenue Service (IRS) at the administrative level. On December 30, 2005, the court issued its opinion regarding one of the issues in the case. The court held that the company could not treat the A-12 contract as complete for federal income tax purposes in 1991, the year the contract was terminated. (See Note L for more information regarding the A-12 contract.) The company is considering whether to appeal this decision. With respect to the other issues in the suit, the company has reached a basis for settlement with the Department of Justice. However, the settlement is pending final approval by the Department of Justice and the Joint Committee on Taxation of the Congress. If the settlement is approved, the company expects the refund to be approximately $35, including after-tax interest. The company has recognized no income from this matter.
In 2005, General Dynamics and the IRS reached agreement on the examination of the company’s income tax returns for 1999 through 2002. With the completion of this audit cycle, the IRS has examined all of the company’s consolidated federal income tax returns through 2002. As a result of the resolution of the 1999-2002 audit, the company reassessed its tax contingencies during the first quarter of 2005 and recognized a non-cash benefit of $66, or $0.16 per share.
The IRS has begun its examination of General Dynamics’ 2003 and 2004 income tax returns, which the company expects to be completed in 2007. The company has recorded liabilities for tax contingencies for these open years. The company does not expect the resolution of tax matters for these years to have a material impact on its results of operations, financial condition or cash flows.
Litigation
Termination of A-12 Program. In January 1991, the U.S. Navy terminated the company’s A-12 aircraft contract for default. The A-12 contract was a fixed-price incentive contract for the full-scale development and initial production of the Navy’s carrier-based Advanced Tactical Aircraft. Both the company and McDonnell Douglas, now owned by The Boeing Company, (the contractors) were parties to the contract with the Navy. 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. As a consequence of the termination for default, the Navy demanded that the contractors repay $1.4 billion in unliquidated progress payments. The Navy agreed to defer collection of that amount pending a decision by the U.S. Court of Federal Claims (the trial court) on the contractors’ challenge to the termination for default, or a negotiated settlement.
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On December 19, 1995, the trial court issued an order converting the termination for default to a termination for convenience. On March 31, 1998, a final judgment was entered in favor of the contractors for $1.2 billion plus interest.
On July 1, 1999, the U.S. Court of Appeals for the Federal Circuit (the appeals court) remanded the case to the trial court for determination of whether the government’s default termination was justified. On August 31, 2001, following the trial on remand, the trial court upheld the default termination of the A-12 contract. In its opinion, the trial court rejected all of the government’s arguments to sustain the default termination except for the government’s schedule arguments, as to which the trial court held that the schedule the government unilaterally imposed was reasonable and enforceable, and that the government had not waived that schedule. On the sole ground that the contractors were not going to deliver the first aircraft on the date provided in the unilateral schedule, the trial court upheld the default termination and entered judgment for the government.
On January 9, 2003, the company’s appeal was argued before a three-judge panel of the appeals court. On March 17, 2003, the appeals court vacated the trial court’s judgment and remanded the case to the trial court for further proceedings. The appeals court found that the trial court had misapplied the controlling legal standard in concluding that the termination for default could be sustained solely on the basis of the contractors’ inability to complete the first flight of the first test aircraft by December 1991. Rather, the appeals court held that in order to uphold a termination for default the trial court would have to determine that there was no reasonable likelihood that the contractors could perform the entire contract effort within the time remaining for performance. The company does not believe the evidence supports such a determination. Pursuant to the direction of the appeals court, the trial court held further proceedings on June 29 and 30, 2004. On April 13 and April 17, 2006, the trial court issued orders requesting further arguments by the parties on various issues presented by the appeals court’s remand instructions. Those arguments were held in May 2006.
If, contrary to the company’s expectations, the default termination is ultimately sustained, the contractors could collectively be required to repay the government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.3 billion at October 1, 2006. This would result in a liability for the company of approximately $1.3 billion pretax. The company’s after-tax charge would be approximately $725, or $1.79 per share, to be recorded in discontinued operations. The company’s after-tax cash cost would be approximately $650. The company believes it has sufficient resources to satisfy its obligation if required.
Other. Various claims and other legal proceedings incidental to the normal course of business are pending or threatened against the company. While it cannot predict the outcome of these matters, the company believes any potential liabilities in these proceedings, individually or in the aggregate, will not have a material impact on its results of operations, financial condition or cash flows.
Environmental
General Dynamics is subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. The company is directly or indirectly involved in environmental investigation or remediation at some of its current and former facilities, and at third-party sites not owned by the company but where it has been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, the company expects that a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable contract costs and, therefore, reimbursed by the U.S. government.
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As required, the company provides financial assurance for certain sites undergoing or subject to investigation or remediation. Where applicable, the company seeks insurance recovery for costs related to environmental liability. The company does not record insurance recoveries before collection is considered probable. Based on all known facts and analyses, as well as current U.S. government policies relating to allowable costs, the company does not believe that its liability at any individual site, or in the aggregate, arising from such environmental conditions, will be material to its results of operations, financial condition or cash flows. The company also does not believe that the range of reasonably possible additional loss beyond what has been recorded would be material to its results of operations, financial condition or cash flows.
In the ordinary course of business, General Dynamics has entered into letters of credit and other similar arrangements with financial institutions and insurance carriers totaling approximately $1.4 billion at October 1, 2006. From time to time in the ordinary course of business, the company guarantees the payment or performance obligations of its subsidiaries arising under some of their contracts. The company is aware of no event of default that would require it to satisfy these guarantees.
As a government contractor, the company is occasionally subject to U.S. government investigations relating to its operations, including claims for fines, penalties, and compensatory and treble damages. The company believes, based on current available information, that the outcome of such ongoing government disputes and investigations will not have a material impact on its results of operations, financial condition or cash flows.
On June 5, 2001, General Dynamics acquired substantially all of the assets of Galaxy Aerospace Company LP. Pursuant to the purchase agreement, the selling parties have the contractual right to receive additional payments, up to a maximum of approximately $300 through December 31, 2006, contingent on the achievement of specific revenue targets. Based on current planned aircraft production rates, the company will not be required to make any future payments under this agreement.
As of October 1, 2006, in connection with orders for 20 Gulfstream aircraft in firm contract backlog, the company had offered customers trade-in options, which may or may not be exercised by the customers. If these options are exercised, the company will accept trade-in aircraft (both Gulfstream and competitor aircraft) at a predetermined minimum trade-in price as partial consideration in the new aircraft transaction. Any excess of the trade-in price above the fair market value is treated as a reduction of revenue upon recording of the new aircraft sales transaction. These option commitments last through 2008 and totaled $386 as of October 1, 2006, compared with $570 at December 31, 2005. Beyond these commitments, additional aircraft trade-ins are likely to be accepted in connection with future orders for new aircraft.
The company provides product warranties to its customers associated with certain product sales, particularly business-jet aircraft. The company records estimated warranty costs in the period in which the related products are delivered. The warranty liability recorded at each balance sheet date is based on the estimated number of months of warranty coverage remaining for products delivered and the average historical monthly warranty payments, and is included in other current liabilities and other liabilities on the Consolidated Balance Sheet.
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The changes in the carrying amount of warranty liabilities for the nine-month periods ended October 1, 2006, and October 2, 2005, were as follows:
Beginning balance
Warranty expense
Payments
Adjustments*
The company provides defined-benefit pension and other post-retirement benefits to eligible employees.
Net periodic pension and other post-retirement benefit costs for the three- and nine-month periods ended October 1, 2006, and October 2, 2005, consisted of the following:
Post-retirement Benefits
Service cost
Interest cost
Expected return on plan assets
Recognized net actuarial loss
Amortization of prior service cost
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Amortization of unrecognized transition obligation
General Dynamics’ contractual arrangements with the U.S. government provide for the recovery of contributions to the company’s pension plans covering its government contracting businesses. With respect to post-retirement benefit plans, the company’s contracts provide for the recovery of contributions to a Voluntary Employees’ Beneficiary Association trust and, for non-funded plans, recovery of claims paid. The net periodic pension and post-retirement benefit cost for some of these government plans exceeds the company’s cost currently allocable to contracts. To the extent recovery of the cost is considered probable based on the company’s backlog, the company defers the excess in contracts in process on the Consolidated Balance Sheet until such time that the cost is allocable to contracts. (See Note G for discussion of the company’s deferred contract costs.)
As of October 1, 2006, the Consolidated Balance Sheet also included pretax additional minimum pension liabilities of $150 related to certain of its defined benefit pension plans. This liability is charged directly to accumulated other comprehensive income within shareholders’ equity on the Consolidated Balance Sheet. Additional minimum pension liability is calculated on a plan-by-plan basis, and is required if the accumulated benefit obligation (ABO) of the plan exceeds the fair value of the plan assets and the difference between the ABO and the fair value of plan assets exceeds the plan’s accrued pension liabilities. The ABO is the actuarial present value of benefits attributed to employee services rendered to date excluding assumptions about future compensation levels.
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General Dynamics operates in four business groups: Information Systems and Technology, Combat Systems, Marine Systems and Aerospace. The company organizes and measures its business groups in accordance with the nature of products and services offered. These business groups derive their revenues from mission-critical information systems and technologies; land and expeditionary combat vehicles, armaments and munitions; shipbuilding and marine systems; and business aviation, respectively. The company measures each group’s profit based on operating earnings. As a result, the company does not allocate net interest, other income and expense items, and income taxes to its business groups.
Summary financial information for each of the company’s business groups follows:
Corporate (a)
Corporate (b)
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The fixed-rate notes described in Note I are fully and unconditionally guaranteed on an unsecured, joint and several basis by certain 100-percent-owned subsidiaries of General Dynamics Corporation (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 as of October 1, 2006, and December 31, 2005, for the balance sheet, as well as the statements of earnings and cash flows for the three- and nine-month periods ended October 1, 2006, and October 2, 2005.
Condensed Consolidating Statement of Earnings
Cost of sales
General and administrative expenses
Interest expense
Interest income
Earnings from Continuing Operations before Income Taxes
Provision for income taxes
Equity in net earnings of subsidiaries
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Condensed Consolidating Balance Sheet
Property, plant and equipment
Accumulated depreciation, depletion & amortization of PP&E
Intangible assets and goodwill
Accumulated amortization of intangible assets
Investment in subsidiaries
Other shareholders’ equity
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Condensed Consolidating Statement of Cash Flows
Proceeds from sale of assets, net
Cash sweep by parent
Net Decrease in Cash and Equivalents
Net Increase in Cash and Equivalents
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Overview
General Dynamics is a market leader in mission-critical information systems and technologies; land and expeditionary combat systems, armaments and munitions; shipbuilding and marine systems; and business aviation. The company operates through four business groups – Information Systems and Technology, Combat Systems, Marine Systems and Aerospace. General Dynamics’ primary customers are the U.S. military, other federal government organizations, the armed forces of allied nations, and a diverse base of corporate and individual buyers of business aircraft. The company operates in two primary markets – defense and business aviation. The majority of the company’s revenues are derived from contracts with the U.S. military. The following discussion should be read in conjunction with the company’s 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission and with the unaudited Consolidated Financial Statements included herein.
Results of Operations
Consolidated Overview
General Dynamics’ net sales for the third quarter of 2006 increased 14 percent over the third quarter of 2005 from $5.3 billion to $6.1 billion. Net sales grew 15 percent to $17.5 billion for the nine-month period ended October 1, 2006, compared with $15.2 billion in the same period in 2005. Each of the company’s business groups contributed to the sales growth in the third quarter and year-to-date in 2006. The principal drivers of the strong sales growth in 2006 were acquisitions in Information Systems and Technology; increased demand for the company’s combat vehicle, armament and munitions products in Combat Systems; early-stage ship construction programs in Marine Systems; and continued increases in new aircraft deliveries in Aerospace.
Operating earnings rose to $677 in the third quarter of 2006, an increase of 18 percent over the $575 reported in the third quarter of 2005. For the first nine months of 2006, operating earnings were up 23 percent to $1.9 billion compared with $1.6 billion in the same period in 2005. The increased volume across all business groups and significant performance improvements in the Marine Systems group drove the earnings growth in 2006.
The company continued to deliver strong operating margins in the third quarter and first nine months of 2006, reflecting the company’s emphasis on performance improvement. Operating margins exceeded 11 percent in the third quarter of 2006, reaching 11.2 percent – a 40 basis point increase over the third quarter of 2005. The company’s margins improved year-over-year for the sixth consecutive quarter. Year-to-date margins were 11.0 percent compared with 10.3 percent in 2005. General and administrative (G&A) expenses as a percentage of net sales in the first nine months of 2006 were 6.4 percent compared with 6.2 percent in the same period of 2005. The company expects G&A expenses as a percent of sales for the full-year 2006 to approximate the full-year 2005 rate of 6.2 percent.
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General Dynamics continued to generate strong cash flow from operations in the first nine months of 2006. Net cash provided by operating activities was $1.3 billion, compared with $1.2 billion in the same period in 2005. The company also generated approximately $310 in the first nine months of 2006 and $320 in the same period in 2005 from the sale of non-core businesses. The company used cash to fund acquisitions and capital expenditures, repurchase its common stock and pay dividends. The company’s net debt – debt less cash and equivalents and short-term investments – has increased only $426 since the third quarter of 2005 after taking into account $2.3 billion of acquisitions, $233 of share repurchases and $348 of dividends during the past 12 months.
The company’s effective tax rate for the nine-month period ended October 1, 2006, was 32.6 percent compared with 28.6 percent in the same period in 2005. The effective tax rate for the first nine months of 2005 was impacted favorably by the resolution of the company’s 1999-2002 federal income tax audit during the first quarter. This settlement resulted in a $66, or $0.16 per-share, non-cash benefit, which reduced the company’s effective tax rate for the first nine months of 2005 by 4.5 percent. Excluding the effect of the potential resolution of tax matters related to prior years, the company expects the effective tax rate for the full-year 2006 to be between 32 and 33 percent. For additional discussion of tax matters, see Note K to the unaudited Consolidated Financial Statements.
The company completed the sale of its aggregates operation in the second quarter of 2006. The company received approximately $310 in cash from the sale of this business and recognized an after-tax gain of approximately $220 in discontinued operations. In addition, the company has taken steps to sell its coal mining operation. With the sale of the aggregates business and the expected sale of the coal business within the next year, the operations previously reported as Resources have been reclassified to discontinued operations. The company’s reported net sales exclude the revenues associated with these businesses, and their operating results for the first nine months of 2006 and 2005 have been included in discontinued operations, net of income taxes. For additional discussion of the company’s divestiture activities and the results of discontinued operations, see Note C to the unaudited Consolidated Financial Statements.
The company’s total backlog increased 5 percent to $44.4 billion as of October 1, 2006, compared with $42.4 billion at July 2, 2006. Funded backlog grew 4 percent during the third quarter to $31.7 billion. The total backlog in the Aerospace group reached a new high of $8.8 billion at October 1, 2006, as orders continued at a record pace. The total backlog does not include work awarded under numerous indefinite delivery, indefinite quantity (IDIQ) contracts. The company’s potential value of these contracts, which may be realized over the next 15 years, increased 8 percent to $9.5 billion in the third quarter of 2006.
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Operating earnings
The Information Systems and Technology group’s net sales and earnings grew significantly in the third quarter of 2006 compared with the third quarter of 2005, largely the result of volume from businesses acquired within the last year. The group continued to experience growing demand for wireless networks and higher activity on its Intelligence Information, Command-and-Control Equipment and Enhancements (ICE2) program and Canadian Maritime Helicopter Project (MHP). These increases in the quarter were offset by an anticipated decline in activity on the United Kingdom’s BOWMAN program as the contract transitions from the production and installation phase to maintenance and long-term support activities. Under the ICE2 program, the company supports critical intelligence and command-and-control systems and networks for U.S. defense and intelligence operations worldwide. On MHP, the company provides the integrated mission systems for Canada’s new maritime helicopter. BOWMAN is the secure digital voice and data communications system for the U.K. armed forces.
In the first nine months of 2006, volume from acquisitions was the primary driver of the group’s sales and earnings growth over 2005. The group’s command-and-control and communications systems business and network infrastructure and information technology (IT) services business have generated modest organic sales growth to date in 2006. Delays in new program starts and a transition from production-phase programs to development-phase programs have slowed the group’s growth in 2006 after four years of double-digit organic growth.
Information Systems and Technology’s operating margins have declined in 2006 compared with 2005, though the group continues to produce double-digit margins. The group’s margins have been impacted by the addition of the lower-margin service-based contract mix from acquired businesses as well as a shift in contract mix from full-scale production programs to large new cost-reimbursement development programs.
On June 8, 2006, the company acquired Anteon International Corporation (Anteon) of Fairfax, Virginia. Anteon is a leading systems integration company that provides mission, operational and IT enterprise support to the U.S. government. On January 18, 2006, the company acquired FC Business Systems, Inc. (FCBS), of Fairfax, Virginia. FCBS provides a broad spectrum of engineering and IT services to government customers. Anteon and FCBS are included in the group’s network infrastructure and IT services business.
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The company expects sales growth in excess of 15 percent in the Information Systems and Technology group for the full-year 2006 compared with 2005, including the effect of acquisitions. The company expects the group’s margins to remain in the low-double-digit range, albeit down slightly from the full-year 2005.
The Combat Systems group’s net sales and operating earnings increased in the third quarter of 2006 compared with the same quarter in 2005 due primarily to volume in the group’s armaments and munitions businesses. The group experienced continued strong demand for systems that help protect U.S. combat forces, and activity increased on the small-caliber ammunition contract that was awarded to the company in late 2005. Volume from the group’s European combat vehicle programs, including the Leopard battle tank and the Piranha light armored vehicle (LAV), also drove the sales growth in the quarter. This growth was offset in part by a decline in volume on the U.S. Army’s Stryker wheeled combat vehicle program. The group continued to generate strong operating margins in 2006. While operating margins in the third quarter were down from the year-ago period, the group’s margins have increased sequentially in each quarter of 2006. The third quarter 2005 margins were unusually high due to program delays in the first half of 2005 that pushed activity into the second half of the year.
Combat Systems’ net sales and operating earnings increased significantly in the first nine months of 2006 compared with the same period in 2005. Higher production and delivery of vehicles under the Stryker program and increased demand in the group’s armaments business for systems that help protect U.S. combat forces contributed over half the sales growth in 2006. The sales and earnings growth was also driven by volume on the group’s small caliber ammunition contract and increased activity on several combat vehicle programs, including the Army’s Future Combat Systems modernization program, the U.S. Marine Corps’ Expeditionary Fighting Vehicle (EFV) program and the Leopard tank program. The group’s year-to-date 2006 operating margins increased 30 basis points over 2005 as a result of improved performance across the group, particularly in the armaments and munitions businesses.
On July 7, 2006, the company acquired Chamberlain Manufacturing Corporation’s Scranton, Pennsylvania, operation (Scranton Operation). The Scranton Operation, a supplier of large-caliber projectile metal parts to the U.S. government, is included in the group’s munitions business. The sales and earnings of the Scranton Operation did not have a significant impact on the group’s third quarter results.
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The company expects substantial sales growth in the Combat Systems group in the fourth quarter of 2006 over the third quarter volume, particularly in the group’s international business. For the full-year 2006, the company expects sales growth of approximately 17 percent over 2005 with operating margins consistent with the average margins achieved in 2005.
The Marine Systems group generated steady sales growth in the third quarter and first nine months of 2006 over the same periods in 2005. Volume increased on several early-stage design and production contracts for the U.S. Navy, including the T-AKE combat logistics ship, the Virginia-class submarine, the Littoral Combat Ship (LCS), and the DDG 1000 next-generation destroyer. Ships two, three and four of the current nine-ship T-AKE contract are currently under construction. The first ship under contract was delivered to the Navy on June 20. On the Virginia-class program the group is scheduled to deliver the third and fourth ships of the cost-reimbursable Block I contract in the fourth quarter of 2006 and the first quarter of 2008, respectively, and construction is in process for the first four ships of the fixed-price Block II contract. The growth on these programs was offset in part by declining activity on the SSGN submarine conversion program and the completion of the group’s four-ship commercial tanker contract.
Operating earnings and margins improved significantly for both the third quarter and first nine months of 2006 compared with the same periods in 2005. In the third quarter of 2006, the group’s operating margins exceeded 7 percent for the fourth consecutive quarter. The improvement in the group’s operating earnings and margins over 2005 resulted from three principal drivers:
In 2005 the group’s operating earnings and margins were negatively impacted by $50 in losses on the company’s contract to build four double-hull oil tankers. The second and third ships were delivered in 2005 and the final ship was delivered in the third quarter of 2006. Favorable labor-hour performance on the completion of the tanker contract and the final settlement of the contract with the customer also contributed to the improved earnings in 2006.
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In addition, in the first half of 2005, the group recorded losses totaling approximately $20 on two submarine maintenance and overhaul contracts. These losses resulted from customer-requested change orders that the group fulfilled prior to securing adequate contract protection. The company does not expect to have this type of exposure on future contracts, and performance in the group’s overhaul and repair business improved considerably in the first nine months of 2006.
The group has also continued to generate labor-hour efficiencies and cost savings on its Arleigh Burke-class destroyer construction program, which has increased the profitability of that contract in 2006. The group has seven ships remaining under contract with deliveries scheduled through 2011.
The group experienced cost growth in 2005 on the Navy’s T-AKE program primarily from engineering- and design-related changes imposed by the customer. The company has submitted a formal request for equitable adjustment with the customer seeking almost $600 of additional contract payments for the rework effort and scope growth caused by these changes. The company is recording revenue at a break-even level based on the assumed recovery of a portion of this claim (see Note G to the unaudited Consolidated Financial Statements). The company is in the process of substantiating to the Navy its entitlement to contractual relief and expects the resolution of this matter by early 2007. The first T-AKE was delivered in the second quarter of 2006 and as of October 1, 2006, the second, third and fourth ships were 91, 67 and 30 percent complete, respectively.
The company expects mid-single-digit sales growth in the Marine Systems group for the full-year 2006 over 2005 with operating margins in the range of 7 to 7.5 percent.
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Operating margin
Aircraft deliveries (in units):
Green
The Aerospace group continued to experience substantial sales growth in the third quarter of 2006, generating net sales in excess of $1 billion for the second consecutive quarter. Higher new-aircraft deliveries drove the increase in net sales in the three- and nine-month periods ended October 1, 2006, compared with the same periods in 2005. In the third quarter of 2006, the group delivered 5 additional green aircraft and 4 additional completions, increases of 21 and 18 percent, respectively. In the first nine months of 2006, green deliveries increased by 18 units, or 28 percent, and completions were up by 16 units, a 27 percent increase, compared with 2005. Aircraft-services volume also increased in the third quarter and first nine months of 2006. Pre-owned aircraft sales in the third quarter of 2006 were consistent with 2005, but were up 55 percent year-to-date over 2005 due to higher levels of customer trade-ins in connection with the increased new-aircraft sales.
Operating earnings increased in the third quarter of 2006 over the same quarter in 2005 due to the increase in new-aircraft sales volume. However, the group’s operating margins decreased from the third quarter of 2005 for two primary reasons – a shift in the mix of deliveries in the quarter to include more lower-margin, mid-size aircraft and increased product-development spending. Operating earnings and margins increased in the first nine months of 2006 compared with 2005 as a result of the increased volume, higher margins on pre-owned aircraft sales and moderate pricing improvements in new-aircraft sales. The year-to-date growth in operating earnings was offset in part by increased research and development spending and a less favorable mix of aircraft deliveries. In the first nine months of 2006, 12 of the 18 additional green deliveries were mid-size aircraft.
The company expects continued strong sales growth in the Aerospace group in the fourth quarter based on the group’s delivery schedule, which is sold out through 2006 and most of 2007. The company expects operating margins in the group to decrease slightly based on the mix of both green deliveries and completions and a sustained increase in product-development spending. (See Notes H and L to the unaudited Consolidated Financial Statements for additional information regarding the Aerospace group’s aircraft inventories and trade-in commitments.)
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Corporate
Corporate results consist primarily of compensation expense for stock options and a portion of the earnings from the company’s commercial pension plan. The company began expensing stock options on January 1, 2006. (See Note D to the unaudited Consolidated Financial Statements for additional information regarding the company’s stock options.)
In the second quarter of 2006, the company completed the sale of its aggregates business, as discussed in Note C to the Consolidated Financial Statements. In addition, the company has taken steps to sell its coal mining operation. With the sale of the aggregates business and the expected sale of the coal business, the operations previously identified for reporting purposes as Resources have been reclassified to discontinued operations.
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Backlog
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 2006:
Defense Businesses
The total backlog for the company’s defense businesses 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. The unfunded backlog represents firm orders for which funding has not been appropriated. The backlog does not include work awarded under indefinite delivery, indefinite quantity contracts. IDIQ contract value represents management’s estimate of the future contract value under these contracts. IDIQ contracts are used when the customer has not defined the exact timing and quantity of deliveries that will be required at the time the contract is executed. These agreements set forth the majority of the contractual terms, including prices, but are funded as delivery orders are placed. A significant portion of this IDIQ value represents contracts for which the company has been designated as the sole-source supplier over several years to design, develop, produce and integrate complex products and systems for the military or other government agencies. Management believes that the customers intend to fully implement these systems. However, because the value of these arrangements is subject to the customer’s future exercise of an indeterminate quantity of delivery orders, the company recognizes these contracts in backlog only when they are funded.
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Net orders received during the third quarter of 2006 were $7.8 billion. This included over $2.8 billion of order activity in the Information Systems and Technology group. The company received several notable contract awards during the third quarter of 2006.
Information Systems and Technology awards included the following:
In addition, the Information Systems and Technology group was awarded one of six World-Wide Satellite Systems (WWSS) prime contracts to provide a family of military satellite communications terminals under a five-year IDIQ program worth up to $5 billion. The program is intended to support federal communications missions, including disaster relief and homeland security efforts.
Combat Systems awards included the following:
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Marine Systems awards included the following:
The company has also received several significant contract awards since the end of the third quarter, including a U.S. Marine Corps award to the Combat Systems group worth approximately $190 for 151 eight-wheeled Light Armored Vehicles in various configurations. This award modifies a contract previously awarded in 2006 and brings the total contract value to over $300.
The Aerospace funded backlog includes orders for which the company has definitive purchase contracts and deposits from the customer. The Aerospace unfunded backlog consists of options to purchase new aircraft and agreements to provide future aircraft maintenance and support services.
The Aerospace group experienced substantial order activity in the third quarter of 2006, increasing its backlog to a new record level for the second consecutive quarter. A significant portion of the Aerospace backlog is with NetJets Inc. (NetJets), a unit of Berkshire Hathaway and the leader in the fractional aircraft market. NetJets purchases the aircraft for use in its fractional ownership program. As of the end of the third quarter of 2006, backlog with NetJets for all aircraft types represented 12 percent of the Aerospace funded backlog and 91 percent of the Aerospace unfunded backlog, compared with 32 percent and 90 percent, respectively, at the end of the third quarter of 2005.
Financial Condition, Liquidity and Capital Resources
Operating Activities
General Dynamics continued to generate strong cash flow from operating activities in the nine-month period ended October 1, 2006. Net cash provided by operating activities was $1.3 billion in the first nine months of 2006, compared with $1.2 billion in the same period in 2005. Earnings from continuing operations was the principal driver of the company’s cash flows from operations in the first nine months of both years.
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Free cash flow from operations for the first nine months of 2006 was $1.1 billion versus $989 for the same period in 2005. Management defines free cash flow from operations as net cash provided by operating activities less capital expenditures. Management believes free cash flow from operations is a useful measure for investors, because it portrays the company’s ability to generate cash from its core businesses for capital deployment purposes, including repaying maturing debt, funding business acquisitions, repurchasing the company’s outstanding shares and paying dividends. The following table reconciles the free cash flow from operations with net cash provided by operating activities, as classified on the unaudited Consolidated Statement of Cash Flows:
Net cash provided by operating activities
Capital expenditures
Cash flows as a percentage of earnings from continuing operations:
With free cash flow from operations projected to approximate earnings from continuing operations for the full-year 2006, General Dynamics expects to continue to generate funds from operations in excess of its short- and long-term liquidity needs. Management believes that the company has adequate funds on hand and sufficient borrowing capacity to execute its financial and operating strategy.
The company ended the third quarter of 2006 with a cash balance of $963 compared with $2.3 billion at the end of 2005. A significant portion of the company’s cash balance as of October 1, 2006, represents advance payments against some of the company’s non-U.S. contracts. The company intends to use this cash to fund the operations of its non-U.S. subsidiaries in the fulfillment of these contracts.
As discussed further in Note L to the unaudited Consolidated Financial Statements, litigation on the A-12 program termination has been ongoing since 1991. If, contrary to the company’s expectations, the default termination ultimately is sustained, the company and The Boeing Company could collectively be required to repay the U.S. government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.3 billion at October 1, 2006. If this were the outcome, the government contends the company would owe approximately $1.3 billion. The company’s after-tax cash obligation would be approximately $650. The company believes that it has sufficient resources to pay such an obligation, if required, while still retaining ample liquidity.
Investing Activities
Net cash used by investing activities was $2.4 billion for the nine-month period ended October 1, 2006, compared with $72 in the same period in 2005. In the first nine months of 2006, the company acquired Anteon, FCBS and the Scranton Operation for an aggregate of $2.3 billion in cash. The company used cash on hand and commercial paper to fund these acquisitions. As a condition of the
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Anteon acquisition, the company divested several of Anteon’s program management and engineering services contracts. The company received approximately $160 of after-tax proceeds from the sale of these contracts, resulting in a net purchase price of approximately $2.1 billion. The company also sold its aggregates business for approximately $310 in cash in the second quarter of 2006. In the first nine months of 2005, the company completed the sales of several small, non-core businesses, generating a total of approximately $320 in cash.
In the first quarter of 2006, the company entered into a definitive agreement to acquire SNC Technologies Inc. (SNC) for approximately $275. SNC is an ammunition system integrator that supplies small-, medium- and large-caliber ammunition and related products to armed forces and law enforcement agencies in North America and around the world. The company intends to finance this acquisition with cash on hand and expects the transaction to close in the fourth quarter of 2006.
Financing Activities
Financing activities used net cash of $307 in the first nine months of 2006 and $306 in the same period in 2005. The company’s typical financing activities include issuances and repayments of debt, payment of dividends and repurchases of common stock.
In the first nine months of 2006, the company repaid $500 of its fixed-rate debt on the scheduled maturity date. During the same nine-month period, the company received net proceeds of $319 from the issuance of commercial paper to fund the Anteon acquisition. The company does not have any significant scheduled debt repayments until 2008.
On March 1, 2006, the company’s board of directors declared an increased regular quarterly dividend of $0.23 per share – the ninth consecutive annual increase. The board had previously increased the regular quarterly dividend to $0.20 per share in March 2005.
In the first nine months of 2006, the company repurchased approximately 1.2 million shares at an average price of about $63 per share. In the first nine months of 2005, the company repurchased approximately 3.9 million shares at an average price of about $51 per share. On June 7, 2006, the company’s board of directors authorized management to repurchase up to 10 million additional shares of the company’s outstanding common stock on the open market. Including this authorization, the company has approximately 11.2 million remaining shares – 3 percent of the total shares outstanding – authorized for repurchase as of October 1, 2006.
Net cash from financing activities also includes proceeds received from stock option exercises.
Additional Financial Information
Environmental Matters and Other Contingencies
For a discussion of environmental matters and other contingencies, see Note L to the unaudited Consolidated Financial Statements. The company does not expect its aggregate liability with respect to these matters to have a material impact on its results of operations, financial condition or cash flows.
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Application of Critical Accounting Policies
Management’s Discussion and Analysis of the company’s Financial Condition and Results of Operations is based on the company’s unaudited Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to long-term contracts and programs, claims for unanticipated contract costs, goodwill and other intangible assets, income taxes, pensions and other post-retirement benefits, workers’ compensation, warranty obligations, pre-owned aircraft inventory, and contingencies and litigation. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. There were no significant changes in the company’s critical accounting policies during the third quarter of 2006.
New Accounting Standards
In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 clarifies the accounting for income taxes by setting forth the required methodology for recognizing income tax contingencies in the financial statements. FIN 48 is effective in the first quarter of 2007. The company is currently analyzing the expected impact of adoption of this Interpretation on its financial statements.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value and establishes a framework for measuring fair value in generally accepted accounting principles. SFAS 157 also expands the required disclosures regarding fair value measurements. SFAS 157 is effective in the first quarter of 2008. The company does not expect the adoption of SFAS 157 to have a material effect on its results of operations, financial condition or cash flows.
In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R) (SFAS 158). SFAS 158 requires companies to recognize an asset or liability in the balance sheet for the full overfunded or underfunded status of their defined benefit post-retirement plans. The additional charge or benefit associated with recognizing the full funded status of these plans on the balance sheet is recorded directly to accumulated other comprehensive income in shareholders’ equity on the balance sheet. SFAS 158 does not change the measurement or reporting of periodic pension or post-retirement benefit cost. SFAS 158 is effective for the company’s December 31, 2006 balance sheet. The company is currently analyzing the expected impact of adoption of this Statement on its financial statements.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes with respect to this item from the disclosure included in the company’s Annual Report on Form 10-K for the year ended December 31, 2005.
ITEM 4. CONTROLS AND PROCEDURES
The company’s management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of October 1, 2006. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of October 1, 2006, the company’s disclosure controls and procedures were effective.
There were no changes in the company’s internal controls over financial reporting that occurred during the quarter ended October 1, 2006, that have materially affected, or are reasonably likely to materially affect, the company’s internal controls over financial reporting.
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This quarterly report on Form 10-Q contains forward-looking statements that are based on management’s expectations, estimates, projections and assumptions. Words such as “expects,” “anticipates,” “plans,” “believes,” “scheduled,” “estimates” and variations of these words and similar expressions are intended to identify forward-looking statements, which include but are not limited to projections of revenues, earnings, segment performance, cash flows, contract awards, aircraft production, deliveries and backlog stability. Forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. These statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Therefore, actual future results and trends may differ materially from what is forecast in forward-looking statements due to a variety of factors, including, without limitation:
All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the company or any person acting on the company’s behalf are qualified by the cautionary statements in this section. The company does not undertake any obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.
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ITEM 1. LEGAL PROCEEDINGS
For information relating to legal proceedings, see Note L to the unaudited Consolidated Financial Statements contained in Part I, Item 1 of this quarterly report on Form 10-Q.
ITEM 1A. RISK FACTORS
ITEM 6. EXHIBITS
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
John W. Schwartz
Vice President and Controller
(Authorized Officer and Chief Accounting Officer)
Dated: November 2, 2006
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