Textron - 10-Q quarterly report FY

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

_______________

FORM 10-Q

Commission File Number: 1-5480

Textron Inc.

(Exact name of registrant as specified in its charter)

 

(401) 421-2800

(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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  ü   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 definitions of “Large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  [  ü]                                                         Accelerated filer  [   ]

Non-accelerated filer    [  ]                                                         Smaller reporting company   [   ]

(Do not check if a 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 ü

Common stock outstanding at July 12, 2008 - 248,538,061 shares

 

TEXTRON INC.

INDEX

Note 6:  Retirement Plans

We provide defined benefit pension plans and other postretirement benefits to eligible employees.  The components of net periodic benefit cost for these plans for the three months ended June 28, 2008 and June 30, 2007 are as follows:

The components of net periodic benefit cost for the six months ended June 28, 2008 and June 30, 2007 are as follows:

Note 7:  Commitments and Contingencies

We are subject to legal proceedings and other claims arising out of the conduct of our business, including proceedings and claims relating to private sector transactions; government contracts; compliance with applicable laws and regulations; production partners; product liability; employment; and environmental, safety and health matters. Some of these legal proceedings and claims seek damages, fines or penalties in substantial amounts or

remediation of environmental contamination. As a government contractor, we are subject to audits, reviews and investigations to determine whether our operations are being conducted in accordance with applicable regulatory requirements.  Under federal government procurement regulations, certain claims brought by the U.S. Government could result in our being suspended or debarred from U.S. Government contracting for a period of time. On the basis of information presently available, we do not believe that existing proceedings and claims will have a material effect on our financial position or results of operations.

The Internal Revenue Service (IRS) has challenged our tax positions related to certain leveraged and finance lease transactions within the Finance segment.  The leveraged lease transactions had an initial investment of approximately $209 million and the finance lease transaction had an investment balance of $34 million at June 28, 2008.  Resolution of these issues may result in an adjustment to the timing of taxable income and deductions that reduce the effective yield of these lease transactions. In addition, resolution of these issues could result in the acceleration of cash payments to the IRS.  Deferred tax liabilities of $216 million are recorded on our consolidated balance sheet related to these leases at June 28, 2008. Despite certain recent court decisions, which were in favor of the IRS, we believe that the proposed IRS adjustments are inconsistent with the tax law in existence at the time the leases were originated.

Armed Reconnaissance Helicopter (ARH) Program — The ARH program includes a development phase, covered by the System Development and Demonstration (SDD) contract, and a production phase.  The SDD contract is a cost plus incentive fee contract under which our eligibility to earn fees is reduced as total contract costs increase.  Since 2006, the costs of the SDD contract have exceeded the threshold at which we are eligible to earn profit.  In December 2007, we agreed to expand the scope of the development contract efforts on a funded basis.  In April 2008, the SDD contract was modified to define the additional scope, raising the total contract value to $589 million from the original contract value of $210 million.

During 2007, we continued to restructure the production portion of this program through negotiations with the U.S. Government, which included reducing the number of units and modifying the pricing and delivery schedules. Based on the status of the negotiations during the year and contractual commitments with our vendors related to materials for the anticipated production units procured in advance of the low-rate initial production (LRIP) contract awards, we established reserves in 2007 representing our best estimate of the expected loss for this program.  At December 29, 2007, reserves for this program totaled $50 million.

Based on the latest estimate of projected program costs, the ARH program is now required to be certified under the Nunn-McCurdy Act in order for the program to continue.  The U.S. Government has begun the certification process, which we expect will be completed by the end of 2008.

In the second quarter of 2008, we submitted our proposal to the U.S. Government for the first restructured LRIP program.  We do not anticipate that any contract awards will be finalized until the program is certified.  Based on our vendor obligations and current expectations for the anticipated LRIP contracts, the $50 million reserve recorded in 2007 remains our best estimate of the expected loss at this time.

We expect to continue to receive inventory and incur additional vendor obligations for long-lead time materials related to the anticipated LRIP contracts.  ARH production inventory and vendor obligations are anticipated to be in the range of an additional $7 million to $9 million each month.  The continued expenditure and recoverability of these additional costs will be monitored and evaluated based on the progress of the certification process.

R&D Arrangements - In 2008, we entered into a risk-sharing arrangement with a supplier for the development of the Columbus aircraft.  The arrangement requires periodic contributions from the supplier totaling $50 million, which are due in installments as the development effort reaches certain predetermined milestones.  The contributions will be recognized as a reduction of research and development costs ratably as development costs are incurred.  Based on development activities completed and costs incurred, we recorded income of less than $1 million in the second quarter of 2008.

 

certain predetermined milestones. The related development costs are accrued as the milestones are completed.  Based on the milestone progress achieved, we recorded expense of $5 million in the second quarter of 2008 related to these arrangements.

Note 8:  Guarantees and Indemnifications

As disclosed under the caption “Guarantees and Indemnifications” in Note 17 to the Consolidated Financial Statements in Textron’s 2007 Annual Report on Form 10-K, we have issued or are party to certain guarantees.  As of June 28, 2008, there has been no material change to these guarantees.

We provide limited warranty and product maintenance programs, including parts and labor, for certain products for periods ranging from one to five years.  We estimate the costs that may be incurred under warranty programs and record a liability in the amount of such costs at the time product revenue is recognized.  Factors that affect this liability include the number of products sold, historical and anticipated rates of warranty claims, and cost per claim.  We assess the adequacy of our recorded warranty and product maintenance liabilities periodically and adjust the amounts as necessary.

Changes in our warranty and product maintenance liabilities are as follows:

Note 9:  Fair Values of Assets and Liabilities

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements,” effective for financial statements issued for fiscal years beginning after November 15, 2007.  SFAS No. 157 replaces multiple existing definitions of fair value with a single definition, establishes a consistent framework for measuring fair value and expands financial statement disclosures regarding fair value measurements. This Statement applies only to fair value measurements that already are required or permitted by other accounting standards and does not require any new fair value measurements.  In February 2008, the FASB issued FASB Staff Position (FSP) No. 157-2, which delayed until the first quarter of 2009 the effective date of SFAS No. 157 for nonfinancial assets and liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis.

The adoption of SFAS No. 157 for our financial assets and liabilities in the first quarter of 2008 did not have a material impact on our financial position or results of operations. Our nonfinancial assets and liabilities that meet the deferral criteria set forth in FSP No. 157-2 include goodwill, intangible assets, property, plant and equipment and other long-term investments, which primarily represent collateral that is received by the Finance group in satisfaction of troubled loans.  We do not expect that the adoption of SFAS No. 157 for these nonfinancial assets and liabilities will have a material impact on our financial position or results of operations.

In accordance with the provisions of SFAS No. 157, we measure fair value at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  The Statement prioritizes the assumptions that market participants would use in pricing the asset or liability (the “inputs”) into a three-tier fair value hierarchy.  This fair value hierarchy gives the highest priority (Level 1) to quoted prices in active markets for identical assets or liabilities and the lowest priority (Level 3) to unobservable inputs in which little or no market data exists, requiring companies to develop their own assumptions.  Observable inputs that do not meet the criteria of Level 1, and include quoted prices for similar assets or liabilities in active

markets or quoted prices for identical assets and liabilities in markets that are not active, are categorized as Level 2.  Level 3 inputs are those that reflect our estimates about the assumptions market participants would use in pricing the asset or liability, based on the best information available in the circumstances.  Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach, and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data.  These unobservable inputs are only utilized to the extent that observable inputs are not available or cost-effective to obtain.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the assets and liabilities measured at fair value on a recurring basis at June 28, 2008 categorized by the level of inputs used in the valuation of each asset and liability.

Valuation Techniques

Foreign exchange rate forward contracts are measured at fair value using the market method valuation technique.  The inputs to this technique utilize current foreign exchange forward market rates published by third-party leading financial news and data providers.  This is observable data that represents the rates that the financial institution uses for contracts entered into at that date; however, they are not based on actual transactions so they are classified as Level 2. We record changes in the fair value of these contracts, to the extent they are effective as hedges, in other comprehensive income. If a contract does not qualify for hedge accounting or is designated as a fair value hedge, changes in the fair value of the contract are recorded in income.

Cash settlement forward contracts on our common stock are used to manage the expense related to stock-based compensation awards.  The use of these forward contracts modifies compensation expense exposure to changes in the stock price with the intent of reducing potential variability.  These contracts are measured at fair value using the market method valuation technique.  Since the input to this technique is based on the quoted price of our common stock at the measurement date, it is classified as Level 1.  Gains or losses on these instruments are recorded as an adjustment to compensation expense.

Interest-only strips are generally retained upon the sale of finance receivables to qualified special purpose trusts. These interest-only strips are initially recorded at the allocated carrying value, which is determined based on the relative fair values of the finance receivables sold and the interests retained.  We estimate fair value upon the initial recognition of the retained interest based on the present value of expected future cash flows using our best estimates of key assumptions – credit losses, prepayment speeds, forward interest rate yield curves and discount rates commensurate with the risks involved.  These inputs are classified as Level 3 since they reflect our own assumptions about the assumptions market participants would use in pricing these assets based on the best information available in the circumstances.  We review the fair values of the interest-only strips quarterly using a discounted cash flow model and updated assumptions, and compare such amounts with the carrying value. When a change in fair value is deemed temporary, we record a corresponding credit or charge to other comprehensive income for any unrealized gains or losses.  If a decline in the fair value is determined to be other than temporary, we record a corresponding charge to income.

Derivative financial instruments are measured at fair value based on observable market inputs for various interest and foreign currency rates published by third-party leading financial news and data providers.  This is observable data that represents the rates used by market participants for instruments entered into at that date; however, they are not based on actual transactions so they are classified as Level 2. Changes in fair value for these instruments are primarily recorded in interest expense.

Changes in Fair Value for Unobservable Inputs

The table below presents the change in fair value measurements for our interest-only strips for which we used significant unobservable inputs (Level 3) during the periods ended June 28, 2008:

Note 10: Recently Issued Accounting Pronouncements

In June 2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments Granted In Share-Based Payment Transactions Are Participating Securities.”  This FSP concludes that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and must be included in the computation of basic earnings per share using the two-class method.  This FSP is effective in the first quarter of 2009 and is to be applied on a retrospective basis to all periods presented.  In the first quarter of 2008, we granted restricted stock units which include nonforfeitable rights to dividends. Accordingly, restricted stock units awarded since the beginning of 2008 will be considered participating securities and will be included in our earnings per share calculation upon the adoption of this FSP.  The adoption of this FSP will not have a material impact on our earnings per share and it will have no impact on our financial position or results of operations.

Other new pronouncements issued but not effective until after June 29, 2008 are not expected to have a significant effect on our consolidated financial position or results of operations.

Note 11:  Segment Information

Effective at the beginning of fiscal 2008, we changed our segment reporting by separating the former Bell segment into two segments: the Bell segment and the Defense & Intelligence segment.  We now operate in, and will report financial information for, the following five business segments: Cessna, Bell, Defense & Intelligence, Industrial and Finance. These segments reflect the manner in which we now manage our operations. Prior periods have been restated to reflect the new segment reporting structure.

Segment profit is an important measure used for evaluating performance and for decision-making purposes.  Segment profit for the manufacturing segments excludes interest expense and certain corporate expenses.  The measurement for the Finance segment includes interest income and expense.  Provisions for losses on finance receivables involving the sale or lease of our products are recorded by the selling manufacturing division when our Finance group has recourse to the Manufacturing group.

Our revenues by segment and a reconciliation of segment profit to income from continuing operations before income taxes are as follows:

Consolidated Results of Operations

Revenues and Segment Profit

Revenues increased $684 million, or 21%, to $3.9 billion in the second quarter of 2008, compared with the second quarter in 2007.  This increase is primarily due to higher manufacturing volume and product mix of $371 million, revenues from newly acquired businesses of $202 million, higher pricing of $109 million and favorable foreign exchange in the Industrial segment of $64 million.  These increases were partially offset by lower revenue for the Finance segment of $62 million.

Segment profit increased $82 million, or 21%, to $468 million in the second quarter of 2008, compared with the second quarter in 2007.  This increase is primarily due to the benefit from higher volume and mix of $72 million, higher pricing in excess of inflation of $24 million, favorable cost performance of $22 million and the benefit from newly acquired businesses of $14 million, partially offset by lower profit in the Finance segment of $55 million.  Favorable cost performance includes the impact of a $48 million net charge related to Bell’s Armed Reconnaissance Helicopter (“ARH”) program in the second quarter of 2007.

Revenues increased $1,238 million, or 20%, to $7.4 billion in the first half of 2008 compared with the first half of 2007.  This increase is primarily due to higher manufacturing volume and product mix of $551 million, revenues from newly acquired businesses of $465 million, higher pricing of $192 million and favorable foreign exchange in the Industrial segment of $116 million.  These increases were partially offset by lower revenue in the Finance Segment of $58 million and the impact of last year’s reimbursement of costs related to Hurricane Katrina of $28 million.

Segment profit increased $147 million, or 20%, to $891 million in the first half of 2008, compared with the first half of 2007.  This increase is primarily due to the benefit from higher volume and mix of $98 million, favorable cost performance of $42 million, higher pricing in excess of inflation of $38 million and the benefit from newly acquired businesses of $27 million, partially offset by lower profit in the Finance segment of $65 million.  Favorable cost performance includes the impact of $73 million in net charges in 2007 related to the ARH program, partially offset by last year’s reimbursement of costs related to Hurricane Katrina of $28 million.

Backlog

Backlog in the aircraft and defense businesses grew by $4.7 billion to $23.5 billion at the end of the second quarter of 2008, compared to the end of 2007.  Approximately $3.4 billion of this increase was at Cessna and $1.4 billion at Bell.  At Cessna, approximately 70% of the new business jet orders were from international customers in the first half of 2008, compared with approximately 45% in the first half of 2007.  Approximately $2.2 billion of Cessna’s backlog relates to the Columbus aircraft with initial customer deliveries expected to begin in 2014.  Bell’s backlog increased as a result of a multi-year procurement contract entered into in March for the V-22 tiltrotor aircraft, which added $1.1 billion to backlog for the first funded lot and certain advanced procurement for additional lots.  The remaining contract value of $4.7 billion will be reflected in backlog as each subsequent production lot is funded.

Corporate Expenses and Other, net

Corporate expenses and other, net decreased $18 million and $28 million in the second quarter and first half of 2008, respectively, compared with the corresponding periods of 2007, primarily due to lower pre-tax share-based compensation expense largely attributable to depreciation in our stock price.

Income Taxes

A reconciliation of the federal statutory income tax rate to the effective income tax rate is provided below:

In the second quarter of 2008, due to court decisions involving other companies addressing the tax treatment of certain lease transactions, we increased the accrual for interest on tax contingencies related to similar lease transactions in the Finance segment.  This change in assessment was also the primary factor in lowering our state income taxes and increasing the foreign tax rate differential.

Segment Analysis

Effective at the beginning of fiscal 2008, we changed our segment reporting by separating the former Bell segment into two segments: the Bell segment and the Defense & Intelligence segment.  We now operate in, and report financial information for, the following five business segments: Cessna, Bell, Defense & Intelligence, Industrial and Finance. These segments reflect the manner in which we now manage our operations. Prior periods have been recast to reflect the new segment reporting structure.

Segment profit is an important measure used to evaluate performance and for decision-making purposes.  Segment profit for the manufacturing segments excludes interest expense and certain corporate expenses.  The measurement for the Finance segment includes interest income and expense.

Cessna

In the second quarter of 2008, Cessna’s revenues and segment profit increased $298 million and $62 million, respectively, compared with the second quarter of 2007.  Revenues increased largely due to higher volume of $212 million, reflecting higher Citation business jet deliveries, improved pricing of $69 million and a $17 million benefit from a newly acquired business.  We delivered 117 jets in the second quarter, compared with 95 jets in the second quarter of 2007.  Segment profit increased primarily due to the $63 million impact from higher volume and pricing in excess of inflation of $31 million, partially offset by higher engineering and product development expense of $16 million.

In the first half of 2008, Cessna’s revenues and segment profit increased $576 million and $114 million, respectively, compared with the first half of 2007.  Revenues increased largely due to higher volume of $424 million, reflecting higher Citation business jet deliveries, improved pricing of $127 million and a $25 million

benefit from a newly acquired business.  We delivered 212 jets in the first half of 2008, compared with 162 jets in the first half of 2007.  Segment profit increased primarily due to the $107 million impact from higher volume, pricing in excess of inflation of $57 million and favorable warranty performance of $16 million, partially offset by  higher engineering and product development expense of $34 million.

Revenues and segment profit for Bell’s U.S. Government business increased $97 million and $64 million, respectively, in the second quarter of 2008, compared with the second quarter of 2007.  The increase in revenues is mainly due to higher H-1 program revenue of $47 million, higher V-22 volume of $30 million and higher spares and service volume of $12 million.  Segment profit increased primarily due to improved cost performance of $59 million, largely due to the impact of a $48 million net charge related to the ARH program in the second quarter of 2007, and a $5 million contribution from higher volume and mix.

In the first half of 2008, revenues and segment profit for this business increased $147 million and $91 million, respectively, compared with the first half of 2007.  The increase in revenues is mainly due to higher V-22 volume of $79 million, higher H-1 program revenue of $36 million and higher spares and service volume of $19 million.  Segment profit increased primarily due to improved cost performance of $78 million, largely due to the impact of $73 million in net charges related to the ARH program in the first half of 2007, and a $13 million contribution from higher volume and mix.

ARH Program — The ARH program includes a development phase, covered by the System Development and Demonstration (SDD) contract, and a production phase.  The SDD contract is a cost plus incentive fee contract under which our eligibility to earn fees is reduced as total contract costs increase.  Since 2006, the costs of the SDD contract have exceeded the threshold at which we are eligible to earn profit.  In December 2007, we agreed to expand the scope of the development contract efforts on a funded basis.  In April 2008, the SDD contract was modified to define the additional scope, raising the total contract value to $589 million from the original contract value of $210 million.

During 2007, we continued to restructure the production portion of this program through negotiations with the U.S. Government, which included reducing the number of units and modifying the pricing and delivery schedules. Based on the status of the negotiations during the year and contractual commitments with our vendors related to materials for the anticipated production units procured in advance of the low-rate initial production (LRIP) contract awards, we established reserves in 2007 representing our best estimate of the expected loss for this program.  At December 29, 2007, reserves for this program totaled $50 million.

Based on the latest estimate of projected program costs, the ARH program is now required to be certified under the Nunn-McCurdy Act in order for the program to continue.  The U.S. Government has begun the certification process, which we expect will be completed by the end of 2008.

In the second quarter of 2008, we submitted our proposal to the U.S. Government for the first restructured LRIP program.  We do not anticipate that any contract awards will be finalized until the program is certified.  Based on our vendor obligations and current expectations for the anticipated LRIP contracts, the $50 million reserve recorded in 2007 remains our best estimate of the expected loss at this time.

We expect to continue to receive inventory and incur additional vendor obligations for long-lead time materials related to the anticipated LRIP contracts.  ARH production inventory and vendor obligations are anticipated to be in the range of an additional $7 million to $9 million each month.  The continued expenditure and recoverability of these additional costs will be monitored and evaluated based on the progress of the certification process.

Revenues for Bell’s commercial business increased $5 million, while segment profit decreased $3 million in the second quarter of 2008, compared with the second quarter of 2007.  The increase in revenues for this business is primarily due to higher pricing of $17 million and revenues from newly acquired businesses of $5 million, partially offset by lower helicopter volume of $19 million.  The decrease in segment profit reflects unfavorable cost performance of $5 million and lower volume of $3 million, partially offset by higher pricing in excess of inflation of $6 million.

In the first half of 2008, revenues and segment profit for Bell’s commercial business decreased $51 million and $2 million, respectively, compared with the first half of 2007.  The decrease in revenues for this business is primarily due to lower helicopter volume of $95 million, partially offset by higher pricing of $30 million and revenues from newly acquired businesses of $11 million. The decrease in segment profit reflects lower volume of $20 million, partially offset by favorable cost performance of $10 million and higher pricing in excess of inflation of $9 million.

Revenues and segment profit increased $209 million and $15 million, respectively, in the second quarter of 2008, compared with the second quarter of 2007.  The increase in revenues is primarily due to $175 million in revenues from our newly acquired AAI business and $39 million in higher volume for our Armored Security Vehicle (“ASV”) aftermarket products and Intelligent Battlefield Systems, Joint Direct Attack Munitions and Lycoming products, partially offset by lower Sensor Fused Weapon volume of $17 million. Segment profit increased primarily due to the benefit from the newly acquired AAI business of $16 million, partially offset by unfavorable cost performance of $6 million.

In the first half of 2008, revenues and segment profit increased $425 million and $20 million, respectively, compared with the first half of 2007.  The increase in revenues is primarily due to $420 million in revenues from our newly acquired AAI business and $55 million in higher volume for our ASV aftermarket products and Lycoming, Intelligent Battlefield Systems and Joint Direct Attack Munitions products, partially offset by lower Sensor Fused Weapon volume of $31 million and a $28 million reimbursement of costs in the first half of 2007 related to Hurricane Katrina.

Segment profit increased in the first half of 2008 primarily due to the benefit from the newly acquired AAI business of $34 million, partially offset by unfavorable cost performance of $12 million.  Cost performance reflects a 2007 cost reimbursement related to Hurricane Katrina of $28 million, partially offset by $17 million in favorable performance for the ASV, which includes $5 million related to the resolution of several customer and vendor claims in the first quarter of 2008.

 

In the first half of 2008, revenues in the Industrial segment increased $199 million, while segment profit decreased $11 million compared to the first half of 2007.  Revenues increased primarily due to a favorable foreign exchange impact of $117 million, higher volume of $49 million and higher pricing of $25 million.  Segment profit decreased primarily due to inflation in excess of higher pricing of $26 million, partially offset by improved cost performance of $9 million and a favorable foreign exchange impact of $8 million.

Revenues decreased $62 million and $58 million in the second quarter and first half of 2008, respectively, compared with the corresponding periods of 2007, primarily due to the following:

In the second quarter of 2008, our revenues and segment profit were reduced to reflect a cumulative adjustment due to a change in estimate of the timing of tax-related cash flows on our leveraged lease portfolio.  This change was based on court decisions involving other companies that addressed the tax treatment of certain lease transactions challenged by the Internal Revenue Service.

Segment profit decreased $55 million and $65 million in the second quarter and first half of 2008, respectively, compared with the corresponding periods of 2007, primarily due to the following:

We have experienced higher borrowing costs relative to various market rate indices due to continued volatility in the credit markets.  Dramatic reductions in the target Federal Funds rate from January through April were generally reflected in our finance receivable portfolio yield in advance of being reflected in our borrowing costs.  In addition, LIBOR rates, on which the majority of our variable-rate debt portfolio is based, have remained high relative to the Federal Funds rate and credit spreads have widened on issuances of commercial paper and term debt as compared to 2007.

 

The following table presents information about the Finance segment’s credit performance:

The increase in nonperforming assets and nonaccrual finance receivables is primarily attributable to one account in the asset-based lending portfolio and one account in the golf finance portfolio.  In addition, nonperforming assets and net charge-offs increased in the distribution finance portfolio reflecting weakening U.S. economic conditions. For the first half of 2008, net charge-offs totaled $30 million, compared with $23 million in the first half of 2007.    For the remainder of 2008, we expect nonperforming assets and charge-offs to remain high relative to the strong portfolio quality performance of 2007.

Liquidity and Capital Resources

Our financings are conducted through two separate borrowing groups. The Manufacturing group consists of Textron Inc., consolidated with the entities that operate in the Cessna, Bell, Defense & Intelligence and Industrial segments, while the Finance group consists of the Finance segment, comprised of Textron Financial Corporation and its subsidiaries. We designed this framework to enhance our borrowing power by separating the Finance group. Our Manufacturing group operations include the development, production and delivery of tangible goods and services, while our Finance group provides financial services. Due to the fundamental differences between each borrowing group’s activities, investors, rating agencies and analysts use different measures to evaluate each group’s performance. To support those evaluations, we present balance sheet and cash flow information for each borrowing group within the Consolidated Financial Statements.

We assess liquidity for our Manufacturing group in terms of our ability to provide adequate cash to fund our operating, investing and financing activities. Our principal source of liquidity is operating cash flows. We also have liquidity available to us via the commercial paper market and committed bank lines of credit, as well as access to the public capital markets that provide us with long-term capital at satisfactory terms.

Our Finance group mitigates liquidity risk (i.e., the risk that we will be unable to fund maturing liabilities or the origination of new finance receivables) by developing and preserving reliable sources of capital. We use a variety of financial resources to meet these capital needs. Cash for the Finance group is provided from finance receivable collections, sales and securitizations, as well as the issuance of commercial paper and term debt in the public and private markets. This diversity of capital resources enhances its funding flexibility, limits dependence on any one source of funds, and results in cost-effective funding. The Finance group also can borrow from the Manufacturing group when the availability of such borrowings creates an economic advantage to Textron in comparison with borrowings from other sources. In making particular funding decisions, management considers market conditions, prevailing interest rates and credit spreads, and the maturity profile of its assets and liabilities.

 

Manufacturing Group Cash Flows of Continuing Operations

Operating cash flows for the Manufacturing group increased primarily due to earnings growth.  Changes in our working capital components resulted in a $442 million use of cash in the first half of 2008, compared to a $375 million use of cash in the first half of 2007.  Cash used for inventories continues to be a significant use of operating cash due to increased production and inventory build-up primarily to support increasing sales at Bell and Cessna.

The Manufacturing group used more cash for investing activities primarily due to $100 million in cash payments made in 2008 largely related to the acquisition of AAI at the end of 2007 and a $56 million increase in capital expenditures.

Less cash was used by the Manufacturing group for financing activities primarily due to an $87 million reduction in cash used to repurchase our stock. Financing cash outflows also decreased due to $79 million of incremental borrowings, partially offset by $31 million in lower proceeds from stock option exercises.  The decrease in share repurchases is due to a 1 million reduction in the number of shares repurchased in the first half of 2008 compared with 2007, and due to the timing of cash payments.  In the first half of 2008, we repurchased 3.5 million shares for $190 million with $56 million in unsettled transactions at June 28, 2008. In the first half of 2007, we repurchased 4.5 million shares for $219 million with only $7 million payable at the end of the quarter due to unsettled trades.

Based on current market conditions, we plan to accelerate the pace of our share repurchase program.  In the second half of 2008, we expect to utilize up to $500 million to repurchase common stock under our previously authorized share repurchase program.  We anticipate that these additional repurchases will be funded through cash generated from operating activities, supplemented by the issuance of debt, including commercial paper, as required.

Finance Group Cash Flows of Continuing Operations

For the Finance group, lower earnings in the first half of 2008 resulted in less cash provided by operating activities.  The Finance group used more cash for investing activities primarily due to the purchase of notes receivable issued by securitization trusts of $98 million and the $48 million impact of lower repayments and proceeds received from receivable sales, including securitizations to fund originations.  Financing activities generated more cash for the Finance group primarily due to higher incremental borrowings as we relied less on proceeds from receivable sales, including securitizations to fund our growth in finance assets in the first half of 2008 compared with the corresponding period of 2007.

 

Consolidated Cash Flows of Continuing Operations

Operating cash flows increased primarily due to earnings growth in the Manufacturing group and a $189 million increase in cash received from captive finance receivables, partially offset by working capital growth.

Cash used for investing activities increased primarily due to the $242 million impact of lower repayments and proceeds received from receivable sales, including securitizations to fund originations.  In addition, we made $100 million in payments in 2008, largely related to the acquisition of AAI at the end of 2007, purchased notes receivable issued by securitization trusts of $98 million in 2008 and spent an additional $56 million in capital expenditures.

We received more cash from financing activities during the first half of 2008, compared with the first half of 2007, largely related to higher incremental borrowings. In addition, we used $87 million less cash to repurchase our stock.

Captive Financing

Through our Finance group, we provide diversified commercial financing to third parties. In addition, this group finances retail purchases and leases for new and used aircraft and equipment manufactured by our Manufacturing group, otherwise known as captive financing. In the Consolidated Statements of Cash Flows, cash received from customers or from securitizations is reflected as operating activities when received from third parties. However, in the cash flow information provided for the separate borrowing groups, cash flows related to captive financing activities are reflected based on the operations of each group. For example, when product is sold by our Manufacturing group to a customer and is financed by the Finance group, the origination of the finance receivable is recorded within investing activities as a cash outflow in the Finance group’s Statement of Cash Flows. Meanwhile, in the Manufacturing group’s Statement of Cash Flows, the cash received from the Finance group on the customer’s behalf is recorded within operating cash flows as a cash inflow. Although cash is transferred between the two borrowing groups, there is no cash transaction reported in the consolidated cash flows at the time of the original financing. These captive financing activities, along with all significant intercompany transactions, are reclassified or eliminated from the Consolidated Statements of Cash Flows.

Reclassification and elimination adjustments included in the Consolidated Statement of Cash Flows are summarized below:

 

Capital Resources

The debt (net of cash)-to-capital ratio for our Manufacturing group was 32% at June 28, 2008 and December 29, 2007, and the gross debt-to-capital ratio at June 28, 2008 was 37% compared with 38% at December 29, 2007.

Under separate shelf registration statements filed with the Securities and Exchange Commission, the Manufacturing group may issue public debt and other securities in one or more offerings up to a total maximum offering of $2.0 billion, and the Finance group may issue an unlimited amount of public debt securities. At June 28, 2008, we had $1.2 billion available under our registration statement. During the first half of 2008, the Finance group issued $675 million of term debt under its registration statement.

We have a policy of maintaining unused committed bank lines of credit in an amount not less than outstanding commercial paper balances. These facilities are in support of commercial paper and letters of credit issuances only, and neither of these lines of credit was drawn at June 28, 2008 or December 29, 2007.

Our primary committed credit facilities at June 28, 2008 include the following:

At June 28, 2008, our Finance group had $2.7 billion in debt and $447 million in other liabilities that are payable within the next 12 months.

Foreign Exchange Risks

Our financial results are affected by changes in foreign currency exchange rates and economic conditions in the foreign markets in which our products are manufactured and/or sold.  For the first half of 2008, the impact of foreign exchange rate changes from the first half of 2007 increased revenues by approximately $117 million (1.9%) and increased segment profit by approximately $8 million (1.0%).

Forward-Looking Information

Certain statements in this Quarterly Report on Form 10-Q and other oral and written statements made by us from time to time are forward-looking statements, including those that discuss strategies, goals, outlook or other non-historical matters, or project revenues, income, returns or other financial measures. These forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements, such as the Risk Factors contained in our 2007 Annual Report on Form 10-K and including the following: (a) changes in worldwide economic and political conditions that impact demand for our products, interest rates and foreign exchange rates; (b) the interruption of production at our facilities or our customers or suppliers; (c) performance issues with key suppliers, subcontractors and business partners; (d) our ability to perform as anticipated and to control costs under contracts with the U.S. Government; (e) the U.S. Government’s ability to unilaterally modify or terminate its

contracts with us for the U.S. Government’s convenience or for our failure to perform, to change applicable procurement and accounting policies, and, under certain circumstances, to suspend or debar us as a contractor eligible to receive future contract awards; (f) changing priorities or reductions in the U.S. Government defense budget, including those related to Operation Iraqi Freedom, Operation Enduring Freedom and the Global War on Terrorism; (g) changes in national or international funding priorities, U.S. and foreign military budget constraints and determinations, and government policies on the export and import of military and commercial products; (h) legislative or regulatory actions impacting defense operations; (i) the ability to control costs and successful implementation of various cost-reduction programs; (j) the timing of new product launches and certifications of new aircraft products; (k) the occurrence of slowdowns or downturns in customer markets in which our products are sold or supplied or where Textron Financial Corporation offers financing; (l) changes in aircraft delivery schedules or cancellation of orders; (m) the impact of changes in tax legislation; (n) the extent to which we are able to pass raw material price increases through to customers or offset such price increases by reducing other costs; (o) our ability to offset, through cost reductions, pricing pressure brought by original equipment manufacturer customers; (p) our ability to realize full value of receivables; (q) the availability and cost of insurance; (r) increases in pension expenses and other postretirement employee costs; (s) Textron Financial Corporation’s ability to maintain portfolio credit quality; (t) Textron Financial Corporation’s access to financing, including securitizations, at competitive rates; (u) uncertainty in estimating contingent liabilities and establishing reserves to address such contingencies; (v) risks and uncertainties related to acquisitions and dispositions, including difficulties or unanticipated expenses in connection with the consummation of acquisitions or dispositions, the disruption of current plans and operations, or the failure to achieve anticipated synergies and opportunities; (w) the efficacy of research and development investments to develop new products; (x) the launching of significant new products or programs which could result in unanticipated expenses; and (y) bankruptcy or other financial problems at major suppliers or customers that could cause disruptions in our supply chain or difficulty in collecting amounts owed by such customers.

There has been no significant change in our exposure to market risk during the six months ended June 28, 2008.  For discussion of our exposure to market risk, refer to Item 7A. Quantitative and Qualitative Disclosures about Market Risk contained in Textron’s 2007 Annual Report on Form 10-K.

We have carried out an evaluation, under the supervision and with the participation of our management, including our Chairman, President and Chief Executive Officer (the CEO) and our Executive Vice President and Chief Financial Officer (the CFO), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) as of the end of the fiscal quarter covered by this report.  Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (b) such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

There were no changes in our internal control over financial reporting during the fiscal quarter ended June 28, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II.  OTHER INFORMATION