General Dynamics 10-K 2010
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2009
For the transition period from to
Commission file number 1-3671
GENERAL DYNAMICS CORPORATION
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
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 x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during
the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and
will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment of this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in
Rule 12b-2 of the Exchange Act.
Large Accelerated Filer x Accelerated Filer ¨ Non-Accelerated Filer ¨ Smaller Reporting Company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the voting common equity held by non-affiliates of the registrant was $19,653,090,757
as of July 5, 2009 (based on the closing price of the shares on the New York Stock Exchange).
385,725,209 shares of the registrants common stock were outstanding on January 31, 2010.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III incorporates by reference information from certain portions of the registrants definitive proxy statement for the 2010 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year.
2 General Dynamics 2009 Annual Report
(Dollars in millions, unless otherwise noted)
ITEM 1. BUSINESS
General Dynamics offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding design, repair and construction; and information systems, technologies and services. Incorporated in Delaware, we employ approximately 91,700 people and have a global presence.
We are dedicated to delivering consistently superior shareholder returns. Shareholder value is created by excellent program execution, organic growth, margin improvement, cash-flow generation and capital deployment. To drive growth, we identify fast currents in our core markets, new customers and attractive opportunities in adjacent markets. We deploy capital through acquisitions and divestitures, dividends, internal investment and, when appropriate, the repurchase of company shares on the open market.
In addition to creating shareholder value and delivering the highest quality products and services, management fosters a culture centered on continuous improvement, innovation, ethical behavior and integrity. This culture is evident in how we interact with shareholders, employees, customers, partners and the communities in which we operate.
Formed in 1952 through the combination of Electric Boat Company, Consolidated Vultee (CONVAIR) and other companies, General Dynamics grew organically and through acquisitions until the early 1990s, when we sold nearly all of our divisions except Electric Boat and Land Systems. Beginning in 1995, we expanded those two core defense businesses by acquiring additional shipyards and combat vehicle-related businesses. In 1997, to reach a new, expanding market, we began acquiring companies with expertise in information technology products and services. In 1999, we purchased Gulfstream Aerospace Corporation, a business-jet aircraft and aviation support-services company. Since 1995, we have acquired and successfully integrated 54 businesses, including two in 2009.
General Dynamics operates through four business groups Aerospace, Combat Systems, Marine Systems and Information Systems and Technology.
Our Aerospace group designs, manufactures and outfits a comprehensive family of mid-size and large-cabin Gulfstream business-jet aircraft, and provides maintenance, refurbishment, outfitting and aircraft services for a variety of business-jet, narrow-body and wide-body aircraft customers globally. With more than 50 years of experience at the forefront of the business-jet aviation market, the Aerospace group is noted for:
The groups Gulfstream products include eight aircraft across a spectrum of price and performance options. The varying ranges, speeds and cabin dimensions are well-suited to the transportation needs of an increasingly diverse global customer base. The large-cabin models are manufactured at Gulfstreams headquarters in Savannah, Georgia, and outfitted at one of the groups U.S. completion facilities. A supplier is responsible for construction of the mid-size models. Gulfstream then outfits these models in one of the groups U.S. completion centers.
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The Aerospace groups customers have become increasingly diverse in recent years. International customers now comprise almost 60 percent of the groups order backlog, with strong interest across the globe in Europe, the Middle East, Latin America and the Asia-Pacific region. The groups customer base has also shifted toward private companies and individual customers, which collectively represent more than two-thirds of total orders. Gulfstream remains a leading provider of aircraft for government and military service around the world, with aircraft operating in 37 nations. These government aircraft are used for head-of-state/ executive transportation and a variety of special-mission applications, including aerial reconnaissance, maritime surveillance, weather research and astronaut training.
To maximize profitability, management has adjusted aircraft production rates, invested in innovative product development and facilities, and enhanced the groups global service network. In recent years, Gulfstream amassed a multi-year large-cabin backlog by making measured increases in aircraft production that consciously lagged strong global customer demand. This backlog provided Gulfstream increased flexibility when global economic turmoil began to negatively impact the business-jet market in late 2008 and early 2009. In response to this sudden market deterioration, we aggressively cut production levels. These production cuts were designed to stabilize the backlog and level-load production through 2009 and 2010.
The Aerospace group continuously invests in research and development (R&D) over the course of each aircraft models lifecycle to introduce new products and first-to-market enhancements that broaden customer choice, improve aircraft performance and set new standards for customer safety, comfort and in-flight productivity. The two newest aircraft to join the Gulfstream family, the super-mid-size G250 and the ultra-large-cabin G650, demonstrate this innovation. The G250, which will replace the G200, offers the largest cabin and the longest range at the fastest speed in its class. The G650, a completely new platform at the top of the business-jet market, has the longest range, fastest speed, largest cabin and most advanced cockpit in the Gulfstream fleet. Scheduled to enter service in late 2011 and 2012, respectively, both of these aircraft met their first-flight milestones on schedule in 2009. Gulfstreams new and upgraded aircraft models are designed to minimize lifecycle costs while maximizing the commonality of parts and pilot-type ratings among the various models. For multiple-aircraft fleet operators, this uniformity reduces training and maintenance costs and enhances safety in the operation of the aircraft.
Current product-enhancement and development efforts include initiatives in advanced avionics, composites, flight-control systems, acoustics, cabin technologies and enhanced vision systems. Recent innovations include the second-generation Enhanced Vision System (EVS II) and the new Synthetic Vision-Primary Flight Display (SV-PFD), both of which assist the pilot during low-visibility conditions. EVS II, now certified for use on every Gulfstream aircraft, is a specially designed, forward-looking infrared (FLIR) camera that projects a real-world infrared image on the pilots head-up display (HUD), while Synthetic Vision provides three-dimensional images of the terrain, runway environment and obstacles on the pilots primary head-down display. These products work in tandem to provide pilots with unparalleled situational awareness regardless of weather, terrain or landing-field conditions.
In March 2006, we embarked on a $400 facilities project designed to create additional R&D offices and laboratories, improve the customer sales and design center, increase aircraft-service capacity and create facilities to build next-generation aircraft in Savannah. With the completion of the new Service Center in Savannah, this multi-year project is complete. This investment is integral to Gulfstreams development and production efforts as the new purpose-built G650 manufacturing facility, which opened in March 2008, successfully produced the first three G650 test articles in 2009.
In addition to the increased service capacity in Savannah, Gulfstreams Product Support team continues to deploy a team of technicians to airports in the western hemisphere in support of emergent customer-service requirements. With the addition of Jet Aviation in 2008, we expanded the groups global service-support network to address the needs of the growing international installed fleet. An aviation services provider with aircraft service centers in more than 20 locations worldwide, Jet Aviation has enabled the Aerospace group to uphold its commitment to provide customers worldwide first-in-class service and support 24 hours a day.
Jet Aviation also expanded the Aerospace groups portfolio to include premium aircraft-outfitting operations for airframes produced by other original equipment manufacturers (OEMs). Jet Aviation performs aircraft completions and refurbishments for business jets and narrow- and wide-body commercial aircraft at locations in Europe and the United States. As a trusted provider of turnkey aircraft management and fixed-base operations (FBO) services to a broad global customer base, Jet Aviation supports the continued growth and diversification of the Aerospace portfolio.
A market leader in the business-aviation industry, the Aerospace group remains focused on:
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Revenues for the Aerospace group were 16 percent of our consolidated revenues in 2009, 19 percent in 2008 and 18 percent in 2007. Revenues by major products and services were as follows:
Our Combat Systems group is a global leader in the design, development, production, support and enhancement of tracked and wheeled military vehicles, weapons systems and munitions for the United States and its allies. The groups product lines include:
Combat Systems has a strong foundation of products that are core platforms for customers across the combat vehicle, armaments and munitions markets. These long-term production programs have large, durable backlogs, providing the groups management the opportunity to pursue continuous process and productivity improvements to increase customer satisfaction, reduce product lifecycle costs and improve the groups financial performance. At the same time, the group applies its design and engineering expertise to develop product improvements that advance the utility and performance of these systems, while identifying and positioning itself for opportunities in emerging and adjacent markets.
Combat Systems core military vehicle platforms consist of a variety of wheeled combat vehicles and main battle tanks. At the heart of these programs are the Stryker wheeled combat vehicle and the Abrams main battle tank. The group is the sole provider of these vehicles two of the key ground-force assets for its primary customer, the U.S. Army. Both of these vehicles are expected to be cornerstones of the Armys force structure for the foreseeable future and offer significant opportunities for modernization and enhancements to meet the warfighters evolving requirements. Their proven effectiveness in multiple threat environments has also created opportunities for these vehicles in international markets.
Combat Systems produces Strykers under a contract awarded in 2001, which has been modified to support the Armys vision for expanded deployment of the vehicle in new roles throughout the force. The Stryker supports numerous missions with 10 variants: infantry carrier; command and control; medical evacuation; fire support; engineering; anti-tank; mortar carrier; reconnaissance; mobile gun system (MGS); and nuclear, biological and chemical reconnaissance vehicle (NBCRV). Combat Systems is now working on a Stryker modernization contract to increase the capabilities of the fleet and ensure future compatibility with light and heavy forces.
Combat Systems continues to support the Armys evolving needs for the most capable main battle tank with technological upgrades to the Abrams, including the System Enhancement Package (SEP) and the Tank Urban Survivability Kit (TUSK). The SEP-configured tank is a digital platform with an enhanced command-and-control system, second-generation thermal sights and improved armor. The TUSK increases the tanks utility and crew survivability in urban warfare environments. In addition, through an innovative partnership with the Anniston Army Depot, the groups Abrams Integrated Management (AIM) program refurbishes the oldest M1A1 Abrams tanks to a like-new condition.
Complementing these combat-vehicle programs are Combat Systems armor, weapons-system and munitions programs. The group manufactures the M2 heavy machine gun and the MK19 and MK47 grenade launchers, as well as weapons for most U.S. fighter aircraft, including all high-speed Gatling guns for fixed-wing aircraft and the Hydra-70 family of rockets. The group also holds leading or sole-source munitions supply positions for products such as:
In addition, Combat Systems is the principal second source for the U.S. militarys small-caliber ammunition needs.
Beyond these long-term platform and supply programs, Combat Systems has been active in providing logistics support in the United States ongoing operations in Iraq and Afghanistan. In addition to these revenues associated with the past seven years of warfare, the group also has opportunities associated with the refurbishment of battle-damaged vehicles, the replacement of equipment that has reached the end of its service life and the replenishment of ammunition and other supplies for the U.S. armed forces. As the principal contractor for the maintenance, repair and reset of Abrams tanks and Stryker vehicles and a major U.S. munitions supplier, we expect the sustaining, recapitalizing and upgrading of U.S. forces to generate significant revenues for Combat Systems in the coming years.
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The Combat Systems group is also focused on innovative technologies and is well-positioned to participate in future development programs. For the U.S. Marine Corps, the group continues the design and testing of the Expeditionary Fighting Vehicle (EFV), an expeditionary combat platform designed to replace the services current craft. With the EFV, the Marine Corps can launch forces from ships located beyond the horizon and proceed directly to inland objectives. The EFV offers sea maneuverability at speeds three times the current platforms capability and ground mobility equaling that of the Abrams tank, providing a level of flexibility and tactical surprise unparalleled in the current force structure. We are building seven new prototypes as part of a system design and development contract, which we expect to deliver in 2010.
The group is also a member of one of three teams awarded technology demonstration contracts for the Joint Light Tactical Vehicle (JLTV), which is intended to replace a portion of the Armys fleet of High Mobility Multi-purpose Wheeled Vehicles (HMMWV). The Combat Systems team was the first to complete its critical design review for the JLTV in 2009. In addition, we are well-positioned to compete for work on the Armys next-generation Ground Combat Vehicle program, for which the customer expects to award development contracts late in 2010.
Combat Systems has a significant presence internationally and is a recognized military-vehicle integrator and leading defense-materiel provider worldwide. It has manufacturing facilities in Australia, Austria, Brazil, Canada, France, Germany, Spain and Switzerland, and has customers in more than 30 countries. The groups European business offers a broad range of products, including light- and medium-weight tracked and wheeled tactical vehicles, amphibious bridge systems, artillery systems, light weapons, ammunition and propellants. Like the groups U.S. products, many of these systems constitute key platforms employed by its customers military forces. These include the Leopard 2E tank and the Pizarro tracked infantry vehicle, produced for the Spanish army; the Pandur II armored combat vehicle, produced for the Portuguese army and navy; the Eagle wheeled vehicle for Germany; and the Piranha wheeled armored vehicle, which the group has sold to several European countries.
Combat Systems also is experiencing increased international demand beyond Europe as a result of the demonstrated success of its fielded products. In particular, the group has contracts to provide Abrams tanks and light armored vehicles to a number of U.S. allies in the Middle East. The group is also a global manufacturer and supplier of highly engineered axles, suspensions, brakes and aftermarket parts for heavy-payload vehicles for a variety of military and commercial customers.
The Combat Systems group continues to focus on operational execution across the business as it delivers on its substantial backlog. In an environment of continuously expanding threats and evolving customer needs, including an increased emphasis on speed to market, the group remains focused on its customers requirements and the opportunities they present.
Revenues for the Combat Systems group were 30 percent of our consolidated revenues in 2009, 28 percent in 2008 and 29 percent in 2007. Revenues by major products and services were as follows:
Our Marine Systems group designs, builds and supports submarines and surface ships for the U.S. Navy and commercial ships for Jones Act customers. The group is one of two primary shipbuilders for the Navy. The groups diverse portfolio of platforms and capabilities includes:
The substantial majority of Marine Systems workload supports the U.S. Navy. These efforts include the construction of new ships and the design and development of next-generation platforms to help the customer meet evolving missions and maintain its desired fleet size, as well as maintenance and repair services to maximize the life and effectiveness of in-service ships. This business consists primarily of major ship-construction programs awarded under large, multi-ship contracts that span several years. The groups mature Navy construction programs consist of the fast-attack Virginia-class nuclear-powered submarine, the Arleigh Burke-class (DDG-51) guided-missile destroyer and the Lewis and Clark-class (T-AKE) dry cargo/ammunition combat-logistics ship.
The Virginia-class submarine is the first U.S. submarine designed to address post-Cold War threats, including capabilities tailored for both open-ocean and littoral missions. These stealthy ships are well-suited for a variety of global assignments, including intelligence gathering, special-operations missions and sea-based missile launch.
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The Virginia-class program includes 30 submarines, which the customer is procuring in multi-ship blocks. The group, in conjunction with an industry partner that shares in the construction of these vessels, has delivered the first six of 18 boats under contract. The remaining 12 boats extend deliveries through 2018. As a result of U.S. combatant-commander requirements, strong congressional support, innovative cost-saving design and production efforts, and successful program execution, the group is scheduled to build two submarines per year starting in 2011, which will double the current submarine workload.
Marine Systems also is the lead designer and producer of Arleigh Burke destroyers, a sophisticated class of surface combatants and the only active destroyer in the Navys global surface fleet. During 2009, we delivered USS Wayne E. Meyer, the 31st of 34 DDG-51 ships the Navy has contracted with us to build. The three remaining ships are scheduled for delivery in 2010 and 2011.
The groups T-AKE combat-logistics ship supports multiple missions for the Navy, including replenishment at sea for U.S. and NATO operating forces around the world. T-AKE is the first Navy ship to incorporate proven commercial marine technologies such as integrated electric-drive propulsion. These technologies are designed to minimize T-AKE operations and maintenance costs over an expected 40-year life. The group has delivered the first eight of these ships, including two in 2009. Work is underway on the remaining four ships currently under contract, with deliveries scheduled through 2011. The Navy funded long-lead material procurement in 2009 for two additional ships under the contract, and we expect to receive construction contracts for these two ships in 2010.
The Marine Systems group participates in the development of technologies and naval platforms for the future. The group continues to apply its design and engineering expertise to advance next-generation submarine capabilities. These efforts include initial concept studies for the development of the next-generation ballistic missile submarine (SSBN). This new class of SSBN is expected to replace the current Ohio Class of ballistic missile submarines. Marine Systems also leads a joint Navy-Defense Advanced Research Projects Agency (DARPA) initiative to reduce the cost of future submarines by identifying and overcoming technological barriers. Under this initiative, the group is developing technologies to propel submarines with external electric motors, reduce the ships infrastructure and improve its sensors.
Marine Systems also is participating in a number of programs in support of the Navys efforts to renew its surface combatant fleet. The group is completing the design and has started construction of the next-generation guided-missile destroyer, the DDG-1000 Zumwalt Class. The group is building the first DDG-1000 destroyer at its Bath, Maine, shipyard and is negotiating contracts with the Navy for construction of the second and third ships, both of which have been fully funded.
Marine Systems leads one of two industry teams awarded contracts for the design and construction of the Littoral Combat Ship (LCS), a new high-speed surface warship designed to address emerging coastal-water threats. Marine Systems LCS is well-suited to accommodate the speed, draft and cargo capacity requirements of this new class of warship. The group delivered its first ship in the fourth quarter of 2009. We are currently working on the remaining ship in backlog, which is scheduled to be delivered in 2012.
In addition to these design and construction programs, the Marine Systems group provides comprehensive ship and submarine overhaul, repair and lifecycle support services to extend the service life of these vessels and maximize the value of these ships to the customer. The group operates the only full-service maintenance and repair shipyard on the West Coast, positioning us to support the Navys rebalancing of its surface force toward the Pacific Fleet. The group also provides international allies with program management, planning and engineering design support for submarine and surface-ship construction programs.
Beyond its Navy programs, Marine Systems designs and produces ships for commercial customers to meet the Jones Act requirement that ships carrying cargo between U.S. ports be built in U.S. shipyards. Marine Systems currently has a contract to build five product-carrier ships. These product carriers are based on a design the group obtained through a strategic partnership with an experienced international commercial shipyard. The partnership allows Marine Systems to offer proven commercial ship designs to customers, to share best practices that improve efficiency and throughput, and to achieve cost savings on materials procured through the partnership. The group has delivered the first three ships and expects to deliver the remaining ships by the end of 2010. With the existing fleet of Jones Act ships in need of replacement due to age and environmental regulations, we are marketing this proven product to new customers.
To further the groups goals of efficiency and continuous process improvement, we are committed to strategic investments in our shipyards in partnership with the Navy and local governments. In addition, the Marine Systems group continues to leverage its design and engineering expertise across its shipyards to improve program execution and generate cost savings. This knowledge sharing enables the group to use resources more efficiently and drive process improvements throughout the business. The group is well-positioned to effectively fulfill the long-term ship-construction and support requirements of its Navy and commercial customers.
Revenues for the Marine Systems group were 20 percent of our consolidated revenues in 2009, 19 percent in 2008 and 18 percent in 2007. Revenues by major products and services were as follows:
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INFORMATION SYSTEMS AND TECHNOLOGY
Our Information Systems and Technology group provides technologies, products and services that support a wide range of government and commercial digital-communication and information-sharing needs. Since we created the group in 1998, we have evolved its product and service offerings through almost 30 acquisitions and internal development into a three-part portfolio that includes tactical and strategic mission systems, information technology and mission services, and intelligence mission systems.
Tactical and strategic mission systems The group designs, manufactures and delivers trusted and secure communications network systems, ruggedized computers, command-and-control systems and operational hardware to customers within the U.S. Department of Defense, the intelligence community and federal civilian agencies, and to international customers.
This market is characterized by programs designed to enhance warfighter communication, such as the U.S. Armys Warfighter Information Network-Tactical (WIN-T) and the Joint Tactical Radio System (JTRS) Handheld, Manpack, Small Form Fit (HMS) network radios. WIN-T is the Armys primary battlefield communications network. As the prime contractor for this program, we are responsible for the design, engineering, integration, production, program management and support of the network. Using ground and satellite communications links, WIN-T provides commanders with the digital communications services they need to access intelligence information, initiate battle plans, collaborate with other military elements, issue orders and monitor the status of their forces.
The JTRS program provides interoperable communications among all branches of the U.S. military on multi-channel, software-defined radios. The group is developing JTRS HMS radios, which connect soldiers, sensors and robotics platforms to the Armys network, enhancing the dismounted soldiers situational awareness and combat effectiveness. The JTRS HMS program successfully navigated several milestones in 2009, including intensive customer testing and the successful addition of the Soldier Radio Waveform, in preparation for initial production.
The group provides many of these capabilities to non-U.S. customers as well, including the United Kingdoms Ministry of Defence, the Canadian Department of National Defence, the Royal Netherlands Marine Corps and the Romanian Ministry of Defense.
Information Systems and Technologys leadership in this market results from decades of experience in designing, building and supporting previous generations of communications technologies. The groups expertise and record of innovation encompass the key technologies that enable design and deployment of tactical networking systems. These include:
In addition to the work we do for the defense and intelligence communities, Information Systems and Technology provides significant support to the Department of Homeland Security and federal civilian markets through programs such as Rescue 21 and the Integrated Wireless Network (IWN) contract. Rescue 21, a state-of-the-art search-and-rescue system that the U.S. Coast Guard uses to locate distressed mariners and manage rescue assets, has been deployed to 24 Coast Guard sectors covering nearly 35,000 miles of U.S. coastline. The IWN program is a joint effort by the Departments of Justice, Homeland Security and the Treasury to provide a nationwide, interoperable wireless communications service in support of federal law enforcement, homeland security and first-responder operations.
Information technology and mission services The group provides mission-critical information technology (IT) and skilled mission-support services to U.S. defense and intelligence communities, federal civilian agencies and select commercial customers. The group also specializes in:
In this market, Information Systems and Technology has a long-standing reputation for excellence in providing technical-support personnel and domain specialists who enable customers to execute their missions effectively. For many customers, the groups employees are the on-call staff that provide technical support for both commercial desktop technology and mission-specific hardware. For other customers, our employees conceive, install and operate mission systems on a day-to-day basis. In Fort Huachuca, Arizona, for example, Information Systems and Technology employees provide training and IT support services for critical Army intelligence missions, merging live data with network-centric computer-based simulations. The group also has provided enterprise-wide IT and information management services to Naval Air Systems Command for more than 10 years as the customers primary logistics-support contractor.
Information Systems and Technology also supplies network-modernization and IT infrastructure services to U.S. government customers. As one of the U.S. Air Forces leading partners for network modernization, for example, the group has provided IT support services to more than 75 Air Force bases. It currently supports all Air Force main operating bases. The group also has provided continuous enterprise-wide IT services and support to the U.S. Senate for more than five years.
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Information Systems and Technology is a leading provider of high-end healthcare technology solutions, including data management, analytics, claims fraud prevention and detection software, decision support and process automation that support the fast-growing needs for technology modernization of both U.S. federal agencies and commercial healthcare organizations. In Iraq, the group supports the Armys military healthcare IT mission, helping ensure continuity of care for injured soldiers by providing accurate, timely information to medical staff both in the field and at treatment facilities.
Intelligence mission systems The group provides mission-related systems integration, development and operations support to customers in the U.S. defense, intelligence, space and homeland security communities, and select allies. These include:
One of the groups businesses has a 50-year legacy of providing advanced fire control systems for Navy submarine programs. Capitalizing on the breadth of this maritime-domain expertise, the group developed the core mission system for the General Dynamics teams entry in the Navys Littoral Combat Ship (LCS) competition, and it is the ship mission systems integrator on the new Joint High Speed Vessel program for the Army and the Navy.
Information Systems and Technology also is a leading provider of personnel with mission-specific experience in executing programs in the intelligence field. In partnership with the U.S. Joint Forces Command, for example, the group integrates collaborative command, control, communications, computing, intelligence, surveillance and reconnaissance (C4ISR) environments in support of worldwide training exercises.
In 2009, we acquired Axsys Technologies, Inc., expanding the groups footprint to include sensors and optical components for defense, aerospace, homeland security and high-performance commercial systems. Combining these sensors with our existing sensing and exploitation capabilities enables the group to significantly enhance customer product offerings.
The groups contracts in securing and protecting organizations from network attacks have resulted in a market-leading position in government cyber security, computer forensics, countering identity theft and preventing credit card fraud. Information Systems and Technology is the principal support contractor for the U.S. Computer Emergency Response Team (US-CERT), for example, which provides response support and defense against cyber attacks for U.S. executive branch agencies, and information sharing and collaboration with state and local government, industry and international partners. The groups capabilities in information operations, computer network defense and multi-level C4ISR-system security position it to meet emerging requirements to protect the national information infrastructure against infiltration and corruption.
The groups increasingly diversified customer base has stimulated new opportunities in each of its three principal markets, including:
Revenues for the Information Systems and Technology group were 34 percent of our consolidated revenues in 2009 and 2008, and 35 percent in 2007. Revenues by major products and services were as follows:
In 2009, 71 percent of our revenues were from the U.S. government; 10 percent were from U.S. commercial customers; 9 percent were directly from international defense customers; and the remaining 10 percent were from international commercial customers.
Our primary customers are the U.S. Department of Defense and intelligence community. We have also developed relationships with other U.S. government customers, including the Department of Homeland Security and several first-responder agencies. Our revenues from the U.S. government were as follows:
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We perform our U.S. government business under cost-reimbursement, time-and-materials and fixed-price contracts. Contracts for research, engineering, prototypes, repair and maintenance are typically cost-reimbursement or time-and-materials. Under cost-reimbursement contracts, the customer reimburses us for allowable costs and pays a fixed fee and/or an incentive- or award-based fee. These fees are determined by our ability to achieve targets set in the contract, such as cost, quality, schedule and performance. Under time-and-materials contracts, the customer pays a fixed hourly rate for direct labor and reimburses us for materials costs. Our production contracts are primarily fixed-price. Under these contracts, we agree to perform a specific scope of work for a fixed amount.
Cost-reimbursement contracts accounted for approximately 38 percent of our U.S. government business in both 2009 and 2008; time-and-materials contracts accounted for approximately 7 percent in both years; and fixed-price contracts accounted for approximately 55 percent in both years.
Each of these contract types presents advantages and disadvantages. Cost-reimbursement contracts generally subject us to lower risk. They also can include fee schedules that allow the customer to make additional payments when we satisfy certain performance criteria. However, not all costs are reimbursed under these types of contracts, and the government carefully reviews the costs we charge. In addition, negotiated base fees are generally lower, consistent with our lower risk. Under time-and-materials contracts, our profit may vary if actual labor hour costs vary significantly from the negotiated rates. Additionally, because we often charge materials costs with little or no fee, the content mix can impact the profit margins associated with these contracts. Fixed-price contracts typically have higher fee levels in recognition of the higher risk and offer us additional profits if we can complete the work for less than the contract amount. Fixed-price contracts require that we absorb cost overruns, should they occur.
Our U.S. commercial revenues were $3.3 billion in 2009, $4.1 billion in 2008 and $3.7 billion in 2007. This represented approximately 10 percent of our consolidated revenues in 2009 and 14 percent in each of 2008 and 2007. The majority of these sales are for Gulfstream aircraft. This customer base consists of individuals and public and privately held companies representing a wide range of industries.
Our direct revenues from government and commercial customers outside the United States were $6 billion in 2009, $5.1 billion in 2008 and $4.8 billion in 2007. This represented approximately 19 percent of our consolidated revenues in 2009 and 17 percent in each of 2008 and 2007.
We conduct business with government customers around the world with subsidiary operations in Australia, Austria, Brazil, Canada, France, Germany, Italy, Mexico, Spain, Switzerland and the United Kingdom. Our non-U.S. defense subsidiaries are committed to developing long-term relationships with their respective governments and have distinguished themselves as principal regional suppliers.
Our international commercial business consists primarily of business-jet aircraft exports and the delivery of aircraft support from a worldwide service network. The market for business-jet aircraft and related services outside North America has expanded significantly in recent years, particularly in Europe, the Middle East, and Asia-Pacific. While the United States continues to be our largest market for business aircraft, orders from customers outside North America represent a growing segment of our aircraft business, approaching 60 percent of total orders and total backlog in 2009.
For a discussion of the risks associated with conducting business in international locations, see Risk Factors contained in Part I, Item 1A, of this Annual Report on Form 10-K. For information regarding revenues and assets by geographic region, see Note Q to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.
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Several factors determine our ability to compete successfully in both the defense and business-jet aircraft markets. While customers evaluation criteria vary, the principal competitive elements include:
The U.S. government contracts with numerous domestic and foreign companies for defense products and services. We compete against other large platform and system-integration contractors, as well as smaller companies that specialize in a particular technology or capability. Internationally, we compete with global defense contractors exports and the offerings of private and state-owned defense manufacturers operating in the local countries. Our Combat Systems group competes with a large number of domestic and foreign businesses. Our Marine Systems group has only one primary competitor, Northrop Grumman Corporation, with which it also partners or subcontracts on several programs, including the Virginia-class submarine. Our Information Systems and Technology group competes with many companies, from large defense companies to small niche competitors with specialized technologies. The defense markets contract-based procurement relationships and the long-term operating cycle of many of our major platform programs can result in sustained periods of program continuity when we perform successfully.
We also are involved in teaming and subcontracting relationships with some of our competitors. Competitions for major defense programs often require companies to form teams to bring together broad capabilities to meet the customers requirements. Opportunities associated with these programs include roles as the programs system integrator, overseeing and coordinating the efforts of all participants in the team, or as a provider of a specific hardware, such as military vehicles provided by Combat Systems, or a subsystem element, such as core mission systems provided by Information Systems and Technology.
Another competitive factor in the defense market is the U.S. governments use of multiple-award indefinite delivery, indefinite quantity (IDIQ) contracts to provide customers with flexible procurement options. IDIQ contracts allow the government to select a group of eligible contractors for a program and establish an overall spending limit. When the government awards IDIQ contracts to multiple bidders under the same program, we must compete to be selected as a participant in the program and subsequently compete for individual delivery orders. This contracting model is most common among our Information Systems and Technology groups customers but is also being used in programs for which our Combat Systems group competes.
BUSINESS-JET AIRCRAFT MARKET
The business-jet aircraft manufacturing market is divided into segments based on aircraft range, price and cabin size. Gulfstream has at least one competitor for each of its products currently in production, with more competitors for the shorter-range aircraft. There are currently no competitors in the groups ultra-large-cabin market (G650). Key competitive factors include aircraft safety, reliability and performance; comfort and in-flight productivity; service quality and timeliness; technological and new-product innovation; and price. We believe Gulfstream competes effectively in all of these areas.
The Aerospace group competes in its business-jet aircraft services business primarily on the basis of price, service quality and timeliness. In its maintenance, repair and overhaul (MRO) and fixed-base operations (FBO) business, the group competes worldwide with several other large companies, as well as a large number of smaller companies, particularly in the maintenance business. In its completions business, the Aerospace group competes with original equipment manufacturers (OEMs) as well as other third-party providers.
RESEARCH AND DEVELOPMENT
We conduct independent R&D activities as part of our normal business operations. Over the past three years, the majority of our company-sponsored R&D expenditures was in the defense business. In accordance with government regulations, we recover a significant portion of these expenditures through overhead charges to U.S. government contracts. We also conduct customer-sponsored R&D activities under U.S. government contracts. In the commercial sector, most of our Aerospace groups R&D activities support Gulfstreams product enhancement and development programs. For more information on our R&D activities, including our expenditures for the past three years, see Note A to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.
On December 31, 2009, we had approximately 91,700 employees, 22 percent of whom work under collective bargaining agreements with various labor representatives. Agreements covering approximately 7 percent of total employees are due to expire during 2010. Historically, we have renegotiated labor agreements without any significant disruption of operating activities.
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Our total backlog represents the estimated remaining sales value of work to be performed under firm contracts and includes funded and unfunded portions. For additional discussion of backlog, see Managements Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7, of this Annual Report on Form 10-K.
Summary backlog information for each of our business groups follows:
RAW MATERIALS, SUPPLIERS AND SEASONALITY
We depend on suppliers and subcontractors for raw materials and components. These supply networks can experience price fluctuations and capacity constraints, which can put pressure on pricing. Effective management and oversight of suppliers and subcontractors is an important element of our successful performance. We attempt to mitigate these risks through long-term agreements with our suppliers or by negotiating flexible pricing terms in our customer contracts. We have not experienced, and do not foresee, significant difficulties in obtaining the materials, components or supplies necessary for our business operations.
Our business is not seasonal in nature. The timing of contract awards, the availability of funding from the customer, the incurrence of contract costs and unit deliveries are the primary drivers of our revenue recognition. In the United States, these factors are influenced by the federal governments October-to-September fiscal year. This process has historically resulted in higher revenues in the latter half of the year. Internationally, many of our government customers schedule deliveries toward the end of the calendar year, resulting in increasing revenues and earnings over the course of the year.
We are a leader in the development of innovative products, manufacturing technologies and systems-integration practices. In addition to owning a large portfolio of proprietary intellectual property, we license some intellectual property rights to and from others. The U.S. government holds licenses to our patents developed in the performance of U.S. government contracts, and it may use or authorize others to use the inventions covered by our patents. Although these intellectual property rights are important to the operation of our business, no existing patent, license or other intellectual property right is of such importance that its loss or termination would, in our opinion, have a material impact on our business.
U.S. GOVERNMENT CONTRACTS
U.S. government contracts are subject to procurement laws and regulations. The Federal Acquisition Regulation (FAR) and the Cost Accounting Standards (CAS) govern the majority of our contracts. The FAR mandates uniform policies and procedures for U.S. government acquisitions and purchased services. Also, individual agencies can have acquisition regulations that provide implementing language for the FAR, or that supplement the FAR. For example, the Department of Defense implements the FAR through the Defense Federal Acquisition Regulation supplement (DFARs). For all federal government entities, the FAR regulates the phases of any product or service acquisition, including:
In addition, the FAR addresses the allowability of our costs, while the CAS address how those costs can be allocated to contracts. The FAR also subjects us to audits and other government reviews. These reviews cover issues such as cost, performance and accounting practices relating to our contracts. The government may use information from these reviews to challenge our contract-related costs and fees. Failure to comply with procurement laws or regulations can result in civil, criminal
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or administrative proceedings. These might involve fines, penalties, suspension of payments, or suspension or debarment from government contracting or subcontracting for a period of time.
Our international sales are subject to the applicable foreign government regulations and procurement policies and practices, as well as certain U.S. policies and regulations, including the Foreign Corrupt Practices Act (FCPA). We are also subject to regulations governing investments, exchange controls, repatriation of earnings and import-export control, including the International Traffic in Arms Regulations (ITAR). Other factors that can affect international sales include currency exchange fluctuations and political and economic risks.
The Aerospace group is subject to Federal Aviation Administration (FAA) regulation in the United States and other similar aviation regulatory authorities internationally. For an aircraft to be manufactured and sold, the model must receive a type certificate from the appropriate aviation authority, and each aircraft must receive a certificate of airworthiness. Aircraft completions also require approval by the appropriate aviation authority, which often is accomplished through a supplemental type certificate. Aviation authorities can require changes to a specific aircraft or model type for safety reasons if they believe the aircraft does not meet their standards. Maintenance facilities and charter operations must be licensed by aviation authorities as well.
We are subject to a variety of federal, state, local and foreign environmental laws and regulations. These laws and regulations cover the discharge, treatment, storage, disposal, investigation and remediation of some materials, substances and wastes. We are directly or indirectly involved in environmental investigations or remediation at some of our current and former facilities, and at third-party sites that we do not own but where we have been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. As a PRP, we potentially are liable to the government or third parties for the full cost of remediating contamination at a relevant site. In cases where we have been designated a PRP, generally we seek to mitigate these environmental liabilities through available insurance coverage and by pursuing appropriate cost-recovery actions. In the unlikely event we are required to fully fund the remediation of a site, the current statutory framework would allow us to pursue contributions from other PRPs. We regularly assess our compliance status and management of environmental matters.
Operating and maintenance costs associated with environmental compliance and management of contaminated sites are a normal, recurring part of our operations. Historically, these costs have not been material. Environmental costs often are allowable and recoverable under our contracts with the U.S. government. Based on information currently available and current U.S. government policies relating to allowable costs, we do not expect continued compliance with environmental regulations to have a material impact on our results of operations, financial condition or cash flows. For additional information relating to the impact of environmental controls, see Note N to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.
We file several types of reports and other information with the Securities and Exchange Commission (SEC) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. These reports and information include an annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements. Free copies of these items are made available on our website (www.generaldynamics.com) as soon as practicable and through the General Dynamics investor relations office at (703) 876-3152.
These items also can be read and copied at the SECs Public Reference Room at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room is available by calling the SEC at (800) SEC-0330. The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.
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ITEM 1A. RISK FACTORS
An investment in our common stock or debt securities is, of course, subject to risks and uncertainties. Investors should consider the following factors, in addition to the other information contained in this Annual Report on Form 10-K, before deciding whether to purchase our securities.
Investment risks can be market-wide as well as unique to a specific industry or company. The market risks faced by an investor in our stock are similar to the uncertainties faced by investors in a broad range of industries. There are, however, some risks that apply more specifically to General Dynamics based on our type of business.
Because three of our four business groups serve the defense market, our revenues are concentrated with the U.S. government. This customer relationship involves certain unique risks. In addition, our sales to international customers expose us to different financial and legal risks. In our Aerospace groups market, we face risks tied to U.S. and global economic conditions. Despite the varying nature of our U.S. and international defense and business-aviation operations and the markets they serve, each group shares some common risks, such as the ongoing development of high-technology products and the price, availability and quality of commodities and subsystems.
We depend on the U.S. government for a significant portion of our revenues. In each of the past three years, over two-thirds of our revenues were from the U.S. government. U.S. defense spending historically has been driven by perceived threats to national security. While the country has been under a sustained elevated threat level in recent years, there is no assurance that defense budgets will continue to grow at the pace seen over the past decade. In addition, competing demands for federal funds could put pressure on all areas of spending, which could impact the defense budget.
A decrease in U.S. government defense spending or changes in spending allocation could result in one or more of our programs being reduced, delayed or terminated. Reductions in our existing programs could adversely affect our future revenues and earnings.
U.S. government contracts generally are not fully funded at inception and are subject to termination. Our U.S. government revenues are funded by agency budgets that operate on an October-to-September fiscal year. In February of each year, the President of the United States presents to the Congress the budget for the upcoming fiscal year. This budget proposes funding levels for every federal agency and is the result of months of policy and program reviews throughout the Executive branch. From February through September of each year, the appropriations and authorization committees of the Congress review the Presidents budget proposals and establish the funding levels for the upcoming fiscal year. Once these levels are enacted into law, the Executive Office of the President administers the funds to the agencies.
There are two primary risks associated with this process. First, the process may be delayed or disrupted. Changes in congressional schedules, negotiations for program funding levels or unforeseen world events can interrupt the funding for a program or contract. Second, future revenues under existing multi-year contracts are conditioned on the continuing availability of congressional appropriations. The Congress typically appropriates funds on a fiscal-year basis, even though contract performance may extend over many years. Changes in appropriations in subsequent years may impact the funding available for these programs. Delays or changes in funding can impact the timing of available funds or lead to changes in program content.
In addition, U.S. government contracts generally permit the government to terminate a contract, in whole or in part, for convenience. If a contract is terminated for convenience, a contractor usually is entitled to receive payments for its allowable costs and the proportionate share of fees or earnings for the work performed. The government may also terminate a contract for default in the event of a breach by the contractor. If a contract is terminated for default, the government in most cases pays only for the work it has accepted. The loss of anticipated funding or the termination of multiple or large programs could have an adverse effect on future revenues and earnings.
Our Aerospace group is subject to changing customer demand for business aircraft. Our Aerospace groups business-jet market is driven by the demand for business-aviation products and services by U.S. and foreign businesses, the U.S. and other governments, and individual customers. The groups future results also depend on other factors, including general economic conditions, the availability of credit and trends in capital goods markets. If our Aerospace group is unable to replace contracts terminated due to customer defaults with existing contracts in the backlog or new contracts, the groups anticipated revenues and profitability could be reduced as a result.
Our earnings and margins depend on our ability to perform under our contracts. When agreeing to contractual terms, our management makes assumptions and projections about future conditions or events. These projections assess:
If there is a significant change in one or more of these circumstances or estimates, or if we face unexpected contract costs, the profitability of one or more of these contracts may be adversely affected. This could affect our earnings and margins.
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Our earnings and margins depend in part on subcontractor performance, as well as raw material and component availability and pricing. We rely on other companies to provide raw materials, major components and subsystems for our products. Subcontractors perform some of the services that we provide to our customers. We depend on these subcontractors and vendors to meet our contractual obligations in full compliance with customer requirements. Occasionally, we rely on only one or two sources of supply that, if disrupted, could have an adverse effect on our ability to meet our commitments to customers. Our ability to perform our obligations as a prime contractor may be adversely affected if one or more of these suppliers is unable to provide the agreed-upon supplies or perform the agreed-upon services in a timely and cost-effective manner.
International sales and operations are subject to greater risks that sometimes are associated with doing business in foreign countries. Our international business may pose different risks than our business in the United States. In some countries there is increased chance for economic, legal or political changes. Government customers in newly formed free-market economies typically have procurement procedures that are less mature, which can complicate the contracting process. In this context, our international business may be sensitive to changes in a foreign governments leadership, national priorities and budgets. International transactions can involve increased financial and legal risks arising from foreign exchange-rate variability and differing legal systems. In addition, some international government customers require contractors to agree to specific in-country purchases, manufacturing agreements or financial support arrangements, known as offsets, as a condition for a contract award. The contracts may include penalties if we fail to meet the offset requirements. An unfavorable event or trend in any one or more of these factors could adversely affect our revenues and earnings associated with our international business.
Our future success will depend, in part, on our ability to develop new products and maintain a qualified workforce to meet the needs of our customers. Virtually all of the products that we produce and sell are highly engineered and require sophisticated manufacturing and system-integration techniques and capabilities. The commercial and government markets in which we operate are characterized by rapidly changing technologies. The product and program needs of our government and commercial customers change and evolve regularly. Accordingly, our future performance depends in part on our ability to develop and manufacture competitive products, and bring those products to market quickly at cost-effective prices. In addition, because of the highly specialized nature of our business, we must be able to hire and retain the skilled and qualified personnel necessary to perform the services required by our customers. If we are unable to develop new products that meet customers changing needs or successfully attract and retain qualified personnel, our future revenues and earnings may be adversely affected.
Developing new technologies entails significant risks and uncertainties that may not be covered by indemnity or insurance. While we maintain insurance for some business risks, it is not practicable to obtain coverage to protect against all operational risks and liabilities. Where permitted by applicable laws, we seek indemnification from the U.S. government. In addition, we may seek limitation of potential liability related to the sale and use of our homeland security products and services through qualification by the Department of Homeland Security under the SAFETY Act provisions of the Homeland Security Act of 2002. We may elect to provide products or services even in instances where we are unable to obtain such indemnification or qualification.
This Annual Report on Form 10-K contains forward-looking statements that are based on managements expectations, estimates, projections and assumptions. Words such as expects, anticipates, plans, believes, scheduled, estimates, should and variations of these words and similar expressions are intended to identify forward-looking statements. These 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 that 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, the risk factors discussed in this section.
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 General Dynamics or any person acting on our behalf are qualified by the cautionary statements in this section. We do 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 2. PROPERTIES
We operate in a number of offices, manufacturing plants, laboratories, warehouses and other facilities in the United States and abroad. We believe our main facilities are adequate for our present needs and, given planned improvements and construction, expect them to remain adequate for the foreseeable future.
On December 31, 2009, our business groups had major operations at the following locations:
A summary of floor space by business group on December 31, 2009, follows:
ITEM 3. LEGAL PROCEEDINGS
For information relating to legal proceedings, see Note N to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the fourth quarter of 2009.
ITEM 5. MARKET FOR THE COMPANYS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed on the New York Stock Exchange.
The high and low sales prices of our common stock and the cash dividends declared on our common stock for each quarter of 2009 and 2008 are included in the Supplementary Data contained in Part II, Item 8, of this Annual Report on Form 10-K.
On January 31, 2010, there were approximately 14,000 holders of record of our common stock.
For information regarding securities authorized for issuance under our equity compensation plans, see Note O to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.
We did not make any unregistered sales of equity securities in 2009.
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The following table provides information about our fourth quarter repurchases of equity securities that are registered pursuant to Section 12 of the Exchange Act:
For additional information relating to our repurchases of common stock during the past three years, see Financial Condition, Liquidity and Capital Resources Financing Activities Share Repurchases contained in Part II, Item 7, of this Annual Report on Form 10-K.
The following performance graph compares the cumulative total return to shareholders on our common stock, assuming reinvestment of dividends, with similar returns for the Standard & Poors® 500 Index and the Standard & Poors® Aerospace & Defense Index, both of which include General Dynamics.
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ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial data derived from the audited Consolidated Financial Statements and other company information for each of the five years presented. This information should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and the audited Consolidated Financial Statements and the Notes thereto.
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(Dollars in millions, except per-share amounts or unless otherwise noted)
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(For an overview of our business groups, including a discussion of products and services provided, see the Business discussion contained in Part I, Item 1, of this Annual Report on Form 10-K.)
General Dynamics offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding design, repair and construction; and information systems, technologies and services. We operate through four business groups Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. Our primary customers are the U.S. military, other U.S. government organizations, the armed forces of other nations, and a diverse base of corporate, government and individual buyers of business aircraft. We operate in two primary markets: defense and national security, and business aviation. The majority of our revenues derive from contracts with the U.S. military.
The nations engagement in combating terrorism around the world, coupled with the need to grow and modernize U.S. military forces, has driven Department of Defense funding levels since 2001. In particular, procurement and research and development (R&D) budgets, also known as investment accounts, provide the majority of our revenues. For fiscal year 2010, the Congress appropriated $531 billion for the Department of Defense, including approximately $185 billion for procurement and R&D. Budget expenditures generally lag congressional funding, and we expect that expenditures applied toward programs over the next few years will be consistent with defense funding appropriated in recent years.
To fund the wars in Afghanistan and Iraq, defense budgets have also included supplemental funding. While some of our programs have received supplemental funds, most of our funding is now derived from base budgets. For fiscal year 2010, the Congress has appropriated approximately $130 billion in supplemental funding, including approximately 20 percent for investment accounts. The Defense Department has requested another $33 billion of supplemental funding in 2010. If this second supplemental is approved, defense funding for fiscal year 2010 will total approximately $693 billion. For fiscal year 2011, the President has requested total defense funding of $708 billion, including $159 billion in supplemental funding. The 2011 budget requests $189 billion for investment accounts, an increase of 2 percent over the fiscal year 2010 appropriation, including a nearly 8 percent increase in procurement funding.
In February 2010, the Department of Defense published the Quadrennial Defense Review (QDR), an analysis of military priorities that shapes defense funding over the ensuing four years. This review reiterated the need for the military to prepare for a broad range of security challenges, and it prioritized continued investment in warfighting capabilities served by our portfolio of defense programs. The Pentagons five-year spending plan, also submitted to the Congress in February, reflects the slow, steady growth requirements set forth in the QDR. Through 2015, the base defense budget is expected to grow at a low-single-digit rate. Investment accounts are also projected to display low-single-digit inflation-adjusted growth, with procurement funding for mature programs growing and R&D funding for new programs declining over the period. This five-year plan also forecasts a reduction in future supplemental funding levels consistent with the administrations plan to reduce troop levels in Iraq, offset somewhat by an increased footprint in Afghanistan.
Our future growth in the U.S. defense market is driven by the size and allocation of the defense budget, the diversity of our exposure to different programs and customers within the budget, our ability to evolve our products to address a fast-changing threat environment, and our successful execution of the contracts we are awarded. While the landscape will continue to evolve in conjunction with dynamic macroeconomic and geopolitical conditions, we expect defense funding to continue to be driven by the following:
Beyond the U.S. defense market, governments around the world continue to fund weapons and equipment modernization programs, leading to significant defense export opportunities. We are committed to pursuing opportunities presented by international demand for military hardware and information technologies. While the revenue potential can be significant, international defense budgets are subject to unpredictable issues of contract award timing, changing priorities and overall spending pressures. As we broaden the customer base for our defense products around the world, we expect our international sales and exports to grow.
The deterioration in the global economic environment in late 2008 and early 2009 significantly impacted the business-aviation market. Difficult economic conditions, tight credit markets and negative business-jet rhetoric
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in the first half of 2009 caused new-aircraft orders to decline, customers to default on aircraft contracts and pre-owned aircraft inventories to grow.
Business-jet market conditions began to improve in the second half of 2009, in line with the broader financial market recovery. Improved flying hours, increased new-aircraft order interest, particularly for large-cabin aircraft, abating customer defaults and higher aircraft service activity helped to stabilize our Aerospace business. Barring any further economic turmoil, we believe the diversity and duration of our business-jet order book positions the Aerospace group for further improvement in 2010. Continued investment in new aircraft products is expected to drive the Aerospace groups long-term growth, particularly when it begins delivering its newest aircraft offerings, the G250 (scheduled to enter service in 2011) and the G650 (scheduled to enter service in 2012). Similarly, we believe that aircraft-service revenues provide the group diversified exposure to aftermarket sales fueled by continued growth in the global installed business-jet fleet.
We are committed to creating shareholder value through ethical business practices, disciplined program management and continuous operational improvements. Our solid performance is measured in our sustained revenue and earnings growth and strong cash flow. General Dynamics record as an industry leader in cash-flow generation has provided us the flexibility to execute our operational strategy and enabled us consistently to deploy resources to further enhance shareholder returns through acquisitions, payment of dividends and share repurchases.
The following discussion of our results of operations is based on operating performance at the business group level. The disclosures focus on the material financial measures we use to evaluate the performance of each of our four business groups, including revenues, operating earnings and margins, cash flow, and orders and backlog. For the defense business groups, the discussion of results of operations is based on specific contracts and programs that drive the groups results rather than types of products and services, which often comprise multiple contracts with different customers. For the Aerospace group, the results are analyzed with respect to specific lines of products and services, consistent with how the group is managed.
In the defense business groups, the majority of the revenues are generated by long-term government contracts. As discussed further in the Application of Critical Accounting Policies section, we account for revenues under these contracts using the percentage-of-completion method of accounting. Under this method, revenue is recognized as work progresses, either as products are produced and delivered or as services are rendered. As a result, changes in revenues are generally discussed in terms of volume. Volume indicates increases or decreases in revenues due to changes in production or construction activity levels, delivery schedules or levels of services on individual contracts.
In the Aerospace group, we recognize revenue using the percentage-of-completion method. Sales contracts for new aircraft have two major phases: the manufacture of the green aircraft and the aircrafts completion, which includes exterior painting and installation of customer-selected interiors and optional avionics. We record revenues on these contracts at two milestones: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the aircraft. Revenues in the Aerospace groups aircraft outfitting and services businesses are recognized as work progresses or upon delivery of the service, similar to our defense businesses. Changes in revenues in this group result from the number of new aircraft deliveries (both green and completion), the progress toward completion of aircraft outfitting activities, the level of service activity during the period and the number of pre-owned aircraft sold.
Operating earnings and margins in the defense business groups are discussed in terms of changes in revenue volume, performance, the mix of contracts (e.g., fixed-price/cost-reimbursable) and the phases of work within those contracts (e.g., development/production). Performance refers to changes in contract earnings rates during the term of the contract based on revisions to estimates of profit at completion on individual contracts. These revisions result from increases or decreases to the estimated value of the contract and/or the estimated costs required to complete the contract. The following discussion of results provides additional disclosure to the extent that a material or unusual event causes a change in the profitability of a contract.
In general, operating earnings and margins in the Aerospace group are a function of the prices we charge for our aircraft, our operational efficiency in manufacturing and completing the aircraft, and the mix of aircraft deliveries among the higher-margin large-cabin and lower-margin mid-size aircraft. Additional factors affecting the groups earnings and margins include the volume and profitability of services work performed, the number and type of pre-owned aircraft sold, and the level of general and administrative costs incurred by the group, which include selling expenses and research and development costs.
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Review of 2009 vs. 2008
General Dynamics revenues increased significantly in 2009 compared with 2008, as strong performance in each of our defense businesses more than offset the decline in the business-jet market. The Combat Systems group generated the strongest revenue growth from higher volume in its U.S. and European military vehicle programs and the acquisition of AxleTech International in December 2008. The Marine Systems groups revenues were up significantly because of increased activity on U.S. Navy and commercial shipbuilding and repair programs across our shipyards. In the Information Systems and Technology group, increased volume in each of the groups U.S. operations and recent acquisitions drove the groups revenue growth. Revenues decreased in the Aerospace group in 2009 following our decision to cut aircraft production and deliveries principally mid-size aircraft in response to a significant downturn in the business-jet market in the first half of the year. This decline was offset partially by the acquisition of Jet Aviation in November 2008.
Our operating earnings increased slightly in 2009 over 2008. Earnings growth in each of our defense businesses was mostly offset by reduced earnings in Aerospace. Operating margins were up significantly in the Marine Systems group because of improved operating performance at each of our shipyards during the year. In the Information Systems and Technology group, margins remained consistent with those achieved in 2008. A shift in contract mix in the Combat Systems group led to reduced margins compared with the prior year. The Aerospace groups margins were reduced by a five-week furlough at the groups aircraft assembly operations in the third quarter of 2009, losses associated with pre-owned aircraft activities and the addition of lower-margin business at Jet Aviation. As a result, our overall operating margins decreased by 100 basis points in 2009 compared with 2008.
Review of 2008 vs. 2007
We generated solid revenue growth in 2008 compared with 2007, and operating earnings increased at more than twice the rate of revenue growth. The Aerospace and Marine Systems groups achieved the most significant jump in revenues as a result of increases in business-jet deliveries and higher activity on shipbuilding programs. Revenues increased in the Combat Systems group due to strong demand for U.S. military vehicles and related support services. Higher activity in tactical and strategic mission systems contributed the majority of the revenue growth in the Information Systems and Technology group. Our operating earnings increased significantly in 2008, and three of our four business groups reported earnings in excess of $1 billion. Growth in operating earnings exceeded the revenue growth in each of our business groups due to strong program execution and a continued focus on operating performance. Overall, our operating margins increased 110 basis points to 12.5 percent in 2008.
Cash flows from operations in 2009 exceeded net earnings for the 11th consecutive year. Net cash provided by operating activities was $2.9 billion in 2009, $3.1 billion in 2008 and $3 billion in 2007. Over the three-year period, we deployed our cash to fund acquisitions and capital expenditures, repurchase our common stock, pay dividends and repay maturing debt. Our net debt debt less cash and equivalents and marketable securities was $1.2 billion at year-end 2009 compared with $2.3 billion at the end of 2008. This $1.1 billion decrease in net debt was achieved after the following capital deployments: $811 spent on acquisitions, $577 of dividends paid, $520 of company-sponsored research and development, $385 of capital expenditures, approximately $330 of contributions to our retirement plans and $209 of share repurchases during the year.
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Other Financial Information
General and administrative (G&A) expenses as a percentage of revenues were 6.1 percent in 2009, 5.9 percent in 2008 and 6 percent in 2007. G&A expenses were $2 billion in 2009, $1.7 billion in 2008 and $1.6 billion in 2007. We expect 2010 G&A to be approximately 6 percent of revenues.
Net interest expense increased to $160 in 2009 compared with $66 in 2008 and $70 in 2007 due to the issuance of additional debt in 2008 and 2009 and lower interest income, reflecting lower market interest rates and a reduced invested cash balance during the year. We expect net interest expense of approximately $150 in 2010, subject to capital deployment activities during the year.
Our effective tax rate was 31.5 percent in 2009, 31.2 percent in 2008 and 31.7 percent in 2007. The 2008 rate included a $35, or approximately $0.09 per-share, benefit from the settlement of tax refund litigation, which reduced the 2008 tax rate by 100 basis points. Our effective tax rate in 2007 was impacted favorably by the resolution of our 2003 to 2004 federal income tax audit with the Internal Revenue Service. This settlement resulted in a benefit of $18, or approximately $0.04 per share, which reduced our effective tax rate by 60 basis points. We anticipate an effective tax rate of approximately 31.5 to 32 percent in 2010. For additional discussion of tax matters, see Note E to the Consolidated Financial Statements.
In 2008, we entered into an agreement to sell our Spanish nitrocellulose operation and recognized a pretax loss of $11 in discontinued operations in anticipation of the sale. We are awaiting Spanish government approval and expect the sale to close in 2010. In 2007, we completed the sale of our coal mining operation and received proceeds of approximately $25. Our reported revenues exclude the revenues associated with these divested businesses. We have presented their operating results, along with the gains and losses from the transactions discussed above, as discontinued operations, net of income taxes.
Backlog and Estimated Potential Contract Value
Our total backlog was $65.5 billion at the end of 2009 compared to $74.1 billion at year-end 2008. Funded backlog was $45.9 billion at year end, down from $51.7 billion at the end of 2008. We received $26.4 billion of new orders in 2009. The Information Systems and Technology groups orders were particularly strong in 2009, resulting in a book-to-bill ratio (orders divided by revenues) greater than one-to-one for the second consecutive year. Combat Systems also had another strong order year, driven in part by growing international order activity late in the year.
The total backlog for our defense businesses decreased in 2009 to $46.2 billion at the end of the year, compared with $51.6 billion at the end of 2008. The defense backlog represents the estimated remaining sales value of work to be performed under firm contracts. About three-quarters of the decline in our defense backlog during 2009 was in Marine Systems, which traditionally receives large, multi-year awards and works down that backlog in subsequent periods. The funded portion of the defense backlog was $27 billion at the end of 2009, down from $29.9 billion in December 2008. This includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are similarly approved and funded by their governments. While there is no guarantee that future budgets and appropriations will provide funding for a given program, we have included in the backlog only firm contracts we believe are likely to receive funding.
The Aerospace groups total backlog was $19.3 billion at the end of 2009 following a record level of $22.5 billion at year-end 2008. Aerospace funded backlog was $18.9 billion at the end of 2009 compared to $21.9 billion at the end of 2008. Aerospace funded backlog represents orders for which we have definitive purchase contracts and deposits from the customer. The Aerospace unfunded backlog of $433 at the end of 2009 consists of agreements to provide future aircraft maintenance and support services.
Our backlog does not include work awarded under unfunded indefinite delivery, indefinite quantity (IDIQ) contracts, unexercised options associated with existing firm contracts or options to purchase new aircraft, which we refer to collectively as estimated potential contract value.
Customers use IDIQ contracts when they have not defined the exact timing and quantity of deliveries that will be required at the time the contract is executed. These agreements, which set forth the majority of the contractual terms, including prices, are funded as delivery orders are placed. A significant portion of our estimated potential contract value includes our estimate of the value we will receive under multiple-award IDIQ contracts in which we are one of several companies competing for task orders. The estimated contract value also includes IDIQ contracts for which we have been designated as the sole-source supplier to design, develop, produce and integrate complex products and systems over several years for the military or other government agencies. We believe the customers intend to fully implement these systems. Because the value of these arrangements is subject to the customers future exercise of an indeterminate quantity of delivery orders, we recognize these contracts in backlog only when they are funded.
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Contract options in our defense businesses represent agreements to perform additional work beyond the products and services associated with firm contracts, if the customer exercises the option. These options are negotiated in conjunction with a firm contract and provide the terms under which the customer may elect to procure additional units or services at a future date. Contract options in the Aerospace group represent options to purchase new aircraft and long-term agreements with fleet customers. We recognize options in backlog when the customer exercises the option and establishes a firm order.
On December 31, 2009, the estimated potential value associated with these IDIQ contracts and contract options was approximately $17.6 billion, up from $16.8 billion at the end of 2008. This represents our estimate of the potential value we will receive. The actual amount of funding received in the future may be higher or lower. We expect to realize this value over the next 10 to 15 years.
REVIEW OF OPERATING SEGMENTS
Review of 2009 vs. 2008
The Aerospace groups revenues decreased in 2009, the net result of a 24 percent decline in Gulfstream revenues that was offset in part by revenues from Jet Aviation, which we acquired in the fourth quarter of 2008. The combination of the global economic deterioration and credit crisis along with negative business-jet rhetoric had a significant impact on the business-jet market in 2009. To adjust to the economic conditions and weakened demand, we reduced Gulfstreams 2009 aircraft production and delivery schedule, primarily in the groups mid-size models, to bridge the market downturn. This included a five-week furlough at the groups production center in Savannah, Georgia, in July and August. As a result, aircraft-manufacturing revenues decreased 28 percent in 2009 compared with 2008. The economic environment also impacted the groups aircraft services business. Organic aircraft-services revenues were down 15 percent in 2009 resulting from reduced flying hours and customer deferral of aircraft maintenance. The decline in aircraft manufacturing and services revenues was slightly offset by higher pre-owned aircraft revenues in 2009. The group sold six pre-owned aircraft for $124 in 2009 compared with two sales for $18 in 2008.
The groups operating earnings declined in 2009 compared with 2008 due primarily to the factors noted above. The components of the reduction in earnings were as follows:
The net decrease in the groups aircraft manufacturing and completions earnings in 2009 resulted from the reduction in Gulfstream aircraft deliveries offset in part by the addition of Jet Aviations aircraft completions and refurbishing business. The earnings decline associated with the decreased Gulfstream volume was mitigated by cost-reduction initiatives, a shift in the mix of aircraft deliveries toward large-cabin aircraft, and liquidated damages collected on defaulted aircraft contracts. As a result, aircraft manufacturing margins increased in 2009 over 2008 despite the decline in volume during the year. The group continues to focus on reducing costs through production improvements and operational efficiencies to maintain aircraft-manufacturing margins.
In late 2008 and early 2009, the supply in the global pre-owned aircraft market increased significantly, putting considerable pressure on pricing. As a result, the group wrote down the carrying value of its pre-owned aircraft inventory in 2009. Pricing in the pre-owned market appears to have stabilized in the second half of 2009, particularly for large-cabin aircraft. The group continues to work to minimize its pre-owned aircraft exposure, with four pre-owned aircraft valued at $60 remaining in inventory at the end of 2009.
Aircraft services earnings were steady in 2009 compared with 2008 as the addition of Jet Aviations maintenance and repair activities, fixed-base operations and aircraft management services offset a decrease in organic aircraft services earnings. A significant reduction in flight hours in the business-jet market put competitive pressure on aircraft maintenance and repair earnings in 2009.
The groups operating earnings also were impacted negatively in 2009 by severance costs associated with workforce reduction activities and intangible asset amortization related to the Jet Aviation acquisition.
The factors discussed above and the addition of lower-margin Jet Aviation business caused the groups overall operating margins to decrease 480 basis points in 2009 compared with 2008.
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Review of 2008 vs. 2007
The Aerospace group generated significant revenue growth in 2008, attributable primarily to increased aircraft deliveries compared with 2007. New aircraft revenues were up 12 percent in 2008 as a result of the increased aircraft production. Aircraft services volume increased 8 percent over 2007. The acquisition of Jet Aviation in November 2008 contributed approximately one-quarter of the groups increase in revenues. The groups pre-owned aircraft revenues were $18 in 2008, down from $78 in 2007.
The Aerospace groups operating earnings increased at a significantly higher rate than revenues in 2008. Approximately $157 of the earnings growth resulted from higher new-aircraft and aircraft-services volume. Improved pricing, a favorable delivery mix and productivity improvements in the aircraft assembly and outfitting processes increased earnings by approximately $105. Reduced sales of pre-owned aircraft and write-downs of pre-owned aircraft inventory reduced the groups earnings growth by $25. Increased selling expenses from strong order activity and higher product-development costs associated with the introduction of two new aircraft models in 2008 also reduced the groups earnings growth by $26.
Backlog and Estimated Potential Contract Value
The economic turmoil of late 2008 and early 2009 had a significant impact on the business-jet market. The collapse of the global economy led some customers in the backlog to default on their contracts and caused some prospective customers to delay aircraft orders. Both the large-cabin and mid-size segments experienced a decline in orders in late 2008 and early 2009. However, the mid-size market experienced the greatest impact. Large-cabin orders improved steadily throughout the year. Excluding the introduction of the new G650, large-cabin orders in the fourth quarter of 2009 reached their highest level since the second quarter of 2008. Despite the rebound in order activity resulting in a full-year book-to-bill ratio (orders divided by revenues) greater than one-to-one, the customer defaults led to a 14 percent decline in the groups backlog from the end of 2008. The Aerospace group ended 2009 with $19.3 billion of backlog, of which $18.9 billion was funded. Scheduled large-cabin deliveries are sold out through 2010 and well into 2011. Conditions in the mid-size market remain challenging. However, these aircraft represent a declining proportion of our portfolio. We continually assess aircraft production requirements and will modify the groups production and delivery schedule as necessary based on the state of the backlog and the business-jet market.
Over the past few years, the groups customer base has become increasingly diverse, both in customer type and geographic region. The groups year-end backlog is divided approximately evenly among public companies, private companies and individual buyers. No one customer represents more than 1 percent of the groups backlog. In addition, the backlog has shifted toward the international market, with customers outside North America comprising almost 60 percent of the backlog. The Aerospace backlog has also been diversified to include orders for the groups newest aircraft models the G650 and the G250. Both of these aircraft were introduced in 2008 and achieved their scheduled first flight in the fourth quarter of 2009. Initial green deliveries for each are scheduled to begin in 2011.
The backlog does not include options to purchase new aircraft or long-term agreements with fleet customers. These arrangements totaled $1.4 billion at the end of 2009 and are included in estimated potential contract value.
We expect a low- to mid-single-digit percentage increase in the Aerospace groups revenues in 2010 compared with 2009. We expect to deliver approximately the same number of aircraft, with a further shift toward the large-cabin models. We also anticipate a modest increase in aircraft services activity in 2010. Based on the favorable mix of aircraft deliveries and the stabilization of the pre-owned aircraft market, tempered by the pace of ongoing operational improvement efforts at Jet Aviation, we expect the Aerospace groups margins to improve slightly over 2009 to approximately 14 percent. These expectations do not assume any recovery in the mid-size market in 2010.
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Review of 2009 vs. 2008
The Combat Systems groups revenues increased significantly in 2009 compared with 2008. The increase in revenues was driven by 12.5 percent organic growth and the acquisition of AxleTech International in December 2008. The group received strong contributions to this growth from each of its markets:
Increased volume on the Stryker wheeled combat vehicle and Abrams main battle tank programs generated over half of the groups revenue growth in 2009. The higher Stryker activity was due to increased vehicle production and modernization work. Under the Abrams program, the group continued to upgrade M1A1 tanks to the M1A2 System Enhancement Package (SEP) configuration for the U.S. Army and produced more Abrams tank kits for Egypt. The revenue growth in the U.S. military vehicles business was tempered somewhat by lower volume on the groups mine-resistant, ambush-protected (MRAP) vehicle deliveries, which were completed in the second quarter of 2009.
Organic revenues were up in the groups weapons systems and munitions businesses due to increased production of armor kits for Stryker vehicles, an increase in deliveries of Hydra-70 rockets and higher volume on munitions supply contracts for the United States and Canada.
The groups European military vehicle business generated strong revenue growth in 2009. Revenues increased as a result of higher activity on several wheeled armored vehicle production programs, including the Piranha for Belgium and Spain and the Eagle for Germany. Volume also increased on the groups European arms and munitions and mobile bridge programs, while activity was down on the Leopard tank program with the Spanish government.
The Combat Systems groups operating earnings grew in 2009, though at a lower rate than revenues, resulting in a 50 basis-point decrease in operating margins compared with 2008. The groups margins in 2008 were unusually high because of a favorable program mix in the U.S. military vehicles business.
Review of 2008 vs. 2007
In 2008, the Combat Systems groups revenues were up compared with 2007 due to strength in the groups U.S. military vehicles business. The majority of the revenue growth was generated by higher activity on the MRAP vehicle program, which emerged in late 2007, and several contracts in support of the groups Abrams main battle tank modernization efforts, including the SEP upgrade and repair and reset work for battle-damaged M1 tanks. Revenues in the groups weapons systems business decreased in 2008 due to fewer deliveries of systems that help protect U.S. combat forces from improvised explosive devices (IEDs). Revenues increased slightly on the groups munitions programs over 2007. In the groups European military vehicles business, volume was lower during the year on several international military vehicle programs, including the Leopard tank program.
The groups operating earnings grew significantly in 2008, increasing at more than four times the rate of revenue growth during the year. While the most significant driver of the groups earnings growth was improved performance in the U.S. military vehicle business, particularly on the MRAP and Abrams programs, each of the groups businesses generated at least a 100 basis-point increase in margins in 2008. The operating leverage achieved across Combat Systems operations in 2008 produced an overall 190 basis-point improvement in the groups operating margins compared with 2007.
Backlog and Estimated Potential Contract Value
The Combat Systems groups total backlog was $13.4 billion at the end of 2009, down 10 percent from $15 billion at year-end 2008. Funded backlog decreased 6 percent in 2009 to $11.4 billion at year end. Approximately $930, or 60 percent, of the year-over-year decline in the groups backlog is attributable to the Armys termination for convenience of the manned ground vehicle portion of the Future Combat Systems (FCS) program. The Army currently is considering its alternatives for ground combat
General Dynamics 2009 Annual Report 25
vehicle requirements, which we expect will provide additional opportunities for Combat Systems, including the addition of an eighth Stryker Brigade. The group received $8.6 billion of new orders in 2009. The groups backlog consists primarily of long-term production contracts that have scheduled deliveries through 2015.
The groups backlog at the end of 2009 included approximately $2.8 billion for M1 Abrams main battle tank modernization and upgrade programs. These include the M1A2 SEP, System Technical Support (STS) and Tank Urban Survivability Kit (TUSK) programs. Under the SEP program, we retrofit Abrams main battle tanks with improved electronics, command-and-control capabilities and armor enhancements that are designed to improve the tanks effectiveness. The group continued work in 2009 on a multi-year contract awarded in 2008 to upgrade the remaining M1A1 Abrams tanks to the SEP configuration. Approximately 50 percent of the groups Abrams backlog at year end was for the SEP program. Under the STS program, we identify improvements and replace obsolete parts on Abrams tanks to maintain the tanks at high operational readiness rates. TUSK is a technological upgrade that improves the effectiveness of the tank in urban warfare environments. At year end, the Abrams backlog included a combined $620 for the STS and TUSK programs. In 2009, the group received awards from the Army totaling $580 for all Abrams-related programs, including awards to build M1A1 Situational Awareness (SA) tanks for the Iraqi army and for M1A2 upgrades for Saudi Arabia.
The Armys Stryker wheeled combat vehicle program comprised over $2 billion of the groups backlog at year end, including the production of approximately 700 vehicles scheduled for delivery through 2012. The group received over $2.1 billion of Stryker orders in 2009, including awards worth approximately $930 for vehicle production, $590 for contractor logistics support and $500 for Stryker modernization. In January 2010, the Army awarded the group a contract worth an additional $85 for battle-damage assessment, repair services and materials for Stryker brigades deployed to Iraq and Afghanistan. In February 2010, the Army awarded the group an additional $250 to continue Stryker logistics support and requested funds to establish an additional Stryker Brigade Combat Team.
Almost $500 of the groups backlog at the end of 2009 was for the U.S. Marine Corps Expeditionary Fighting Vehicle (EFV) program. The group is building seven new prototypes under the system design and development phase of the EFV program, which the group expects to deliver in 2010.
The Combat Systems group has several significant international military vehicle production contracts in backlog. The backlog at the end of the year included:
In addition, Combat Systems was selected in 2009 as the prime contractor and systems integrator for the Canadian governments LAV III upgrade program. The program has a potential value of $850, and we expect to receive a contract in 2010.
The Combat Systems groups backlog at year end also included approximately $2.6 billion in weapons systems, munitions, detection systems and composite-structures programs. In 2009, the group received awards totaling $210 for the production of Hydra-70 rockets, bringing the total contract value to date to over $1 billion. The group also received awards worth approximately $115 from the Canadian government to supply various calibers of training and tactical ammunition and $75 from the Army for production of M2HB machine guns.
We expect 4 to 5 percent revenue growth in Combat Systems in 2010 attributable largely to international vehicle contracts and to growing activity in U.S. armament and munitions programs. We anticipate a slight decline in the groups operating margins to the high-12 percent range due to a shift in program mix, including the start-up of several new contracts.
Review of 2009 vs. 2008
Each of the Marine Systems groups shipyards contributed to the groups strong growth in revenues and operating earnings in 2009 over the prior year. The increase in revenues consisted of the following:
The groups multi-year ship-construction programs for the U.S. Navy include Virginia-class submarines, T-AKE combat-logistics ships and
26 General Dynamics 2009 Annual Report
DDG-51 and DDG-1000 destroyers. The Virginia-class program contributed almost two-thirds of the groups increase in revenues. The group delivered the sixth boat under the program in 2009 and continued construction on the next five of the remaining 12 boats under contract. Virginia activity is expected to continue to ramp up as the group moves toward construction of two ships per year starting in 2011 with deliveries scheduled through 2018. Activity was down slightly on the T-AKE program in 2009 as the group continued construction on the ninth through 12th ships. The group delivered the seventh and eighth ships in 2009, and deliveries of the remaining four ships awarded to date are scheduled through 2011 with ships 13 and 14 in 2012. On the destroyer programs, revenues were up in 2009 as activity increased significantly on the groups design and production contracts for the DDG-1000 next-generation destroyer, while volume on the DDG-51 Arleigh Burke-class program decreased, consistent with our expectations. The first DDG-1000 delivery is scheduled in 2014, and the remaining three DDG-51 destroyers under contract are scheduled for delivery through 2011.
In addition to these ship-construction programs, volume was up significantly in 2009 on engineering and repair programs for the Navy. The growing service requirements of the Navys aging fleet, along with the rebalancing of the fleet to position more ships on the West Coast, generated significant additional repair volume for our West Coast operations.
The groups commercial shipbuilding activity consists of a five-ship product carrier program. Activity on this program increased slightly in 2009 as the first three ships were delivered and construction continued on the remaining two ships, which are scheduled for delivery in 2010.
The Marine Systems groups operating earnings increased significantly in 2009. Each of the groups shipyards has focused on operational efficiency and achieved significant labor and material cost reductions during the year. These efforts resulted in higher earnings rates on several key programs in 2009, including the Virginia-class, DDG-51, DDG-1000 and commercial product carrier programs. As a result, the groups operating margins increased 70 basis points over 2008 to 10.1 percent. The groups significant improvement in 2009 followed a 100-basis point increase in margins in 2008 over 2007.
Review of 2008 vs. 2007
Revenues in the Marine Systems group were up in 2008 as a result of increased activity at each of the groups shipyards. Activity increased on the Virginia-class program as the group delivered the fourth and fifth boats in the program in 2008. Volume also increased on the T-AKE and DDG-1000 programs. Commercial shipbuilding volume was up in 2008 as the group ramped up construction of the first three of its product-carrier ships. Slightly lower activity on the DDG-51 destroyer program and the completion of the groups SSGN submarine conversion contract in the fourth quarter of 2007 slightly offset the other volume increases in the group in 2008. The Marine Systems group improved its performance significantly in 2008, increasing operating earnings at double the rate of revenue growth. As a result of operational efficiencies realized at each of its shipyards, the group increased program earnings rates in 2008 on the Virginia, DDG-51, T-AKE and commercial product carrier programs. These improvements increased the groups overall margins by 100 basis points in 2008.
Backlog and Estimated Potential Contract Value
The Marine Systems groups backlog consists of long-term submarine and ship construction programs, as well as numerous repair and engineering contracts. The group generally receives large contract awards that provide backlog for several years. For example, in 2008 the group received a $14 billion contract for the construction of eight Virginia-class submarines to be delivered through 2018. After reaching an all-time high of $26.4 billion at the end of 2008, the groups backlog decreased to $22.5 billion at year-end 2009, consistent with this historical pattern. The groups funded backlog at the end of 2009 was $7.1 billion, down from $10.5 billion at year-end 2008. The current backlog includes shipbuilding deliveries through 2018.
The Virginia-class submarine program was our largest single program in 2009 and is the largest contract in the groups backlog. The groups backlog at year end included $16.3 billion for 12 Virginia-class submarines. As the prime contractor on the Virginia-class program, we report the entire backlog and revenues associated with the program but share the construction activity and the earnings equally with our teaming partner. The current Navy plan calls for construction of one submarine in 2010 and two per year beginning in 2011.
Navy destroyer programs represent another significant component of the groups backlog. These include the Arleigh Burke-class DDG-51 and Zumwalt-class DDG-1000 destroyer programs. The groups backlog at the end of 2009 included $1.2 billion for the ongoing design effort and construction of the first DDG-1000. In 2009, the group received approximately $300 in orders under the DDG-1000 program,
General Dynamics 2009 Annual Report 27
including approximately $160 for Class Common Equipment (CCE) material to begin construction of the first ship. At year end, the backlog included approximately $365 for the remaining three DDG-51 destroyers under contract. We anticipate receiving funding for long-lead materials for an additional DDG-51 in 2010. The group is currently negotiating contracts with the Navy for the construction of two additional DDG-1000s. We expect these awards to provide stability to the groups destroyer production for the foreseeable future.
The Marine Systems groups backlog at year end also included $880 for four of the remaining six ships under the Navys T-AKE combat-logistics ship program, including $200 of long-lead materials for the last two ships. These two ships have been authorized and appropriated by the Congress, and we expect to receive construction contracts in 2010. The year-end backlog included $390 for the Navys Littoral Combat Ship (LCS) program. In 2009, the group delivered its first LCS and received an order worth approximately $410 from the Navy for the second ship, scheduled for delivery in 2012.
At the end of 2009, the groups backlog included approximately $125 for the remaining effort on the groups product carrier contract.
In addition, the Marine Systems groups backlog at year end included approximately $3.2 billion for engineering, repair, overhaul and other services. In January 2010, the Navy awarded the group an additional $120 to continue a development contract for concept studies, engineering and design of a Common Missile Compartment for the next-generation ballistic missile submarines under development for the Navy and the Royal Navy of the United Kingdom.
We expect 7 to 8 percent revenue growth in Marine Systems in 2010 as activity continues to ramp up on the Virginia-class and DDG-1000 construction programs, as well as submarine engineering activities. The groups operating margins should moderate somewhat to the mid-9 percent range due to a shift in contract mix from more mature programs to earlier-stage construction, particularly among the groups destroyer programs.
INFORMATION SYSTEMS AND TECHNOLOGY
Review of 2009 vs. 2008
The Information Systems and Technology groups revenues reached the highest level in the groups history in 2009, with revenue growth generated in each of the groups market segments. The groups organic revenue growth was over 4 percent in 2009 with the remainder of the growth provided by acquisitions in the groups information technology (IT) services and intelligence mission systems businesses. The overall increase in revenues in 2009 was well-distributed across the groups businesses:
In the groups IT services business, approximately 20 percent of the revenue growth in 2009 was organic and resulted primarily from higher volume on several IT infrastructure and support programs, including the New Campus East (NCE) contract for the National Geospatial Intelligence Agency, the Network-Centric Solutions (NETCENTS) program for U.S. federal agencies and the Technology Operations and Maintenance Infrastructure Support (TOMIS) contract for the U.S. Bureau of Citizenship and Immigration. The revenue growth on these programs was partially offset by lower activity in the commercial wireless market.
The most notable performance drivers in the groups tactical and strategic mission systems business were higher volume on the Warfighter Information Network Tactical (WIN-T) program and ground-based satellite communications programs, as well as increased sales of encryption products. Volume in the groups United Kingdom-based tactical communications operations was steady compared with 2008.
The intelligence systems business had the highest revenue growth rate in 2009, the result of organic growth in each of its business areas and the acquisition of Axsys Technologies, Inc., in September 2009. Approximately 60 percent of the revenue growth in this business was organic. Higher activity on cyber security and several classified programs, as well as increased volume on a contract to build the spacecraft for NASAs Landsat Data Continuity Mission, contributed the majority of this growth.
The Information Systems and Technology groups operating earnings increased in line with revenues in 2009. As a result, the group achieved operating margins of 10.7 percent, consistent with 2008. Margins increased in the tactical systems and intelligence systems businesses due to improved performance and a favorable shift in contract mix, but margins were down in the IT services business as a result of contract mix.
Review of 2008 vs. 2007
Revenues in the Information Systems and Technology group increased in 2008, with the most significant growth over 2007 coming from the groups tactical and strategic mission systems business. This growth
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resulted from increased activity on several key U.S. military programs, such as the WIN-T program and the Common Hardware/Software III (CHS-3) program, as well as higher volume on the groups ground-based satellite communications programs. Revenues were up in the groups core IT services business due primarily to the ramp-up of activity on several new programs, including the TOMIS contract and the Warfighter Field Operations Customer Support (FOCUS) Army training contract. Within the IT services business, the groups commercial wireless operations experienced significantly lower activity in 2008 due to reduced demand in the market. Revenues in the groups intelligence mission systems business remained steady compared with 2007. Revenues decreased in the groups U.K. business due to a scheduled decline in activity on the BOWMAN communications program for the U.K. armed forces, offset in part by higher activity on other command, control, communications, computing and intelligence systems (C4I) programs.
Operating margins remained steady compared with 2007, as improved performance on the groups tactical communications programs offset an increased proportion of lower-margin service work in the groups portfolio.
Backlog and Estimated Potential Contract Value
The Information Systems and Technology group generated a book-to-bill ratio (orders divided by revenues) greater than one-to-one in 2009 for the second consecutive year. As a result, the groups backlog edged up slightly to $10.3 billion at year end after reporting record-level revenues in 2009. The groups funded backlog grew 16 percent over year-end 2008 to $8.4 billion at the end of 2009. Unlike our other defense businesses, the Information Systems and Technology groups backlog consists of thousands of contracts that have to be reconstituted each year with new program and task order awards, and relatively few large-scale, long-term programs. Some of the more significant programs are highlighted below.
The groups backlog at year-end 2009 included approximately $860 for the Armys WIN-T program. Information Systems and Technology is the prime contractor on this battlefield communications network program that is designed to provide warfighters with fast, secure, mobile command-and-control capabilities. In 2009, the group received almost $500 of awards for WIN-T, bringing the total program value to $2.1 billion.
Approximately $670 of the groups backlog at year end was for the Canadian Maritime Helicopter Project (MHP). Under the MHP program, the group is scheduled to provide integrated mission systems, training and support for 28 state-of-the-art helicopters that are intended to replace Canadas aging fleet of marine helicopters.
The groups backlog at year end also included approximately $400 for maintenance and long-term support activities for the United Kingdoms BOWMAN communications program. BOWMAN is the secure digital voice and data communications system for the U.K. armed forces. In 2009, the group received almost $500 in orders under this program, including an award to upgrade the systems capabilities and provide long-term technical support.
The Intelligence Information, Command-and-Control Equipment and Enhancements (ICE2) program comprised over $325 of the groups backlog at the end of 2009. ICE2 supports critical intelligence and command-and-control systems and networks for U.S. defense and intelligence operations worldwide.
Approximately $215 of the groups backlog at year end was for the Warfighter FOCUS program. The group provides support for the Armys live, virtual and constructive training operations under this contract.
In addition to these programs, the group received a number of significant contract awards in 2009, including the following:
General Dynamics 2009 Annual Report 29
The groups backlog does not include approximately $12.8 billion of estimated potential contract value associated with its anticipated share of IDIQ contracts and unexercised options. The value of these arrangements may be realized over the next 12 years. In 2009, funding under IDIQ contracts and options contributed over $3.6 billion, more than one-third of the groups orders, to the groups backlog, most notably from WIN-T, CHS-3, NETCENTS and Warfighter FOCUS.
Information Systems and Technology was awarded several significant IDIQ contracts during 2009, including the following:
Shortly after the end of the year, the group received two significant contracts from the Army one for training support services and one for healthcare IT services. The first is an IDIQ contract to provide technical, management and engineering support services for constructive training systems. It has a maximum potential value of approximately $390. The second is a contract to provide support for the Armys Medical Communications for Combat Casualty Care. The contract is worth more than $150 if all options are exercised.
We expect revenues in the Information Systems and Technology group to grow by 8 to 9 percent in 2010. We expect each of the groups businesses to contribute to the growth, particularly in the areas of IT support for intelligence and federal civilian customers, and intelligence, surveillance and reconnaissance work, including cyber security. The groups operating margins should decline slightly but remain in the mid-10 percent range based on the projected contract mix in 2010.
Corporate results consist primarily of compensation expense for stock options and a portion of the results from our commercial pension plans. Corporate operating expenses totaled $87 in 2009, $75 in 2008 and $61 in 2007. The increases in Corporate operating expenses in 2009 and 2008 resulted primarily from increased stock option expense. (See Note O to the Consolidated Financial Statements for additional information regarding our stock options.) We expect 2010 Corporate operating expenses of approximately $95.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
In the mid-1990s, General Dynamics embarked on a strategy of disciplined capital deployment, generating strong cash flow to enable a series of acquisitions designed to grow the company beyond our core platform businesses. This has resulted in a larger, more diversified company incorporating new products and technologies that meet the needs of an expanded customer base. We continue to place a strong emphasis on cash generation and capital allocation and deployment. This focus has afforded us the financial flexibility to deploy our cash resources to generate shareholder value while preserving a strong balance sheet to position us for the future.
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Our cash balances are invested primarily in time deposits from highly rated banks, commercial paper rated A1/P1 or higher and repurchase agreements with direct obligations of the Spanish government as collateral. Our marketable securities balances are invested primarily in term deposits and high-quality corporate, municipal and U.S. government-sponsored debt securities. The marketable securities have an average duration of six months and an average credit rating of AA-. We have not incurred any material losses associated with these investments.
The following is a discussion of our major operating, investing and financing activities for each of the past three years, as classified on the Consolidated Statement of Cash Flows.
We generated cash from operating activities of $2.9 billion in 2009, $3.1 billion in 2008 and $3 billion in 2007. In all three years, the operating cash flow was attributed primarily to net earnings and increasing levels of customer deposits, particularly in the Aerospace group. In 2009, cash from operating activities also reflected the collection of approximately $150 from the Czech Republic after we signed a renegotiated contract to provide Pandur II wheeled vehicles. In 2007, the cash flows from operating activities included the collection of approximately $270 of contract funds upon resolution of the Marine Systems groups request for equitable adjustment on the T-AKE contract.
Termination of A-12 Program. As discussed further in Note N to the Consolidated Financial Statements, litigation on the A-12 program termination has been ongoing since 1991. If, contrary to our expectations, the default termination ultimately is sustained and the government prevails on its recovery theories, we, along with The Boeing Company, could collectively be required to repay the U.S. government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.5 billion at December 31, 2009. If this were the outcome, we would owe half of the total, or approximately $1.4 billion pretax. Our after-tax cash obligation would be approximately $715. We believe we have sufficient resources, including access to capital markets, to pay such an obligation, if required.
We used $1.4 billion in 2009, $3.7 billion in 2008 and $875 in 2007 for investing activities. The primary uses of cash in investing activities were business acquisitions and capital expenditures.
Business Acquisitions. In 2009, we completed two acquisitions for $811. In 2008, we completed five acquisitions for a total of $3.2 billion. In 2007, we completed four acquisitions for a total of $330. We financed these acquisitions using cash on hand and commercial paper. (See Note B to the Consolidated Financial Statements for additional information regarding the acquisitions.)
Capital Expenditures. Capital expenditures were $385 in 2009, $490 in 2008 and $474 in 2007. The decrease in 2009 compared with 2008 resulted from the completion of several major facility improvement projects in the Aerospace and Marine Systems groups. We expect capital expenditures of approximately $450 in 2010, less than 2 percent of revenues. We had no material commitments for capital expenditures on December 31, 2009.
Marketable Securities. As a result of lower market interest rates, we have expanded our investments in available-for-sale and held-to-maturity securities in recent years to generate additional return. Net purchases of these securities were $235 in 2009 compared with net sales of $17 in 2008 and net purchases of $179 in 2007.
We used $806 in 2009, $718 in 2008 and $786 in 2007 for financing activities. Our typical financing activities are issuances and repayments of debt, payment of dividends and repurchases of common stock. Net cash from financing activities also includes proceeds received from stock option exercises.
Debt Proceeds, Net. We had no material debt issuances or repayments in 2007. In 2008, we issued $904 of commercial paper, primarily to fund acquisitions during the year. During that year we also repaid $500 of fixed-rate notes, $150 of senior notes and $20 of term debt on the scheduled maturity dates. We issued $1 billion of five-year fixed-rate notes in December 2008 and another $750 of two-year fixed-rate notes in June 2009. We used the proceeds from the fixed-rate notes for general corporate purposes, including working capital requirements, capital expenditures and to term out our commercial paper borrowings. We ended 2009 with no commercial paper outstanding, and our total debt balance was down by $160 from 2008. We have approximately $1.8 billion in bank credit facilities that have not been drawn upon. These facilities provide backup liquidity to our commercial paper program. The next material repayment of long-term debt is $700 of fixed-rate notes scheduled in the third quarter of 2010. (See Note J to the Consolidated Financial Statements for additional information regarding our debt obligations, including scheduled debt maturities.)
Dividends. Our board of directors declared an increased quarterly dividend of $0.38 per share on March 4, 2009, the 12th consecutive annual increase. The board had previously increased the quarterly dividend to $0.35 per share in March 2008 and $0.29 per share in March 2007.
Share Repurchases. In 2009, we repurchased 3.6 million of our outstanding shares on the open market. We repurchased 20 million shares in 2008 and 6.5 million shares in 2007 on the open market. On December 31, 2009, approximately 9.4 million shares remained authorized for repurchase by our board of directors about 2 percent of our total shares outstanding.
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Non-GAAP Management Metrics
Return on Invested Capital. We emphasize the efficient conversion of net earnings into cash and the deployment of that cash to maximize shareholder returns. In 2009, for the 11th consecutive year, net cash provided by operating activities exceeded net earnings. We deployed this cash to complete acquisitions, continue our trend of annual dividend increases and repurchase our outstanding shares. As a result of this continued focus on cash generation and disciplined capital deployment, our return on invested capital (ROIC) has grown 290 basis points since 2005.
We believe ROIC is a useful measure for investors, because it reflects our ability to generate returns from the capital we have deployed in our operations. We use ROIC to evaluate investment decisions and as a performance measure in evaluating management. We define ROIC as net operating profit after taxes divided by the sum of the average debt and shareholders equity for the year. Net operating profit after taxes is defined as earnings from continuing operations plus after-tax interest and amortization expense. ROIC in 2008 and 2009 was impacted by the reduction and increase, respectively, in our shareholders equity associated with the returns on our retirement plan assets. (See Note P to the Consolidated Financial Statements for additional discussion of our retirement plans.) ROIC for 2005 through 2009 is calculated as follows:
Free Cash Flow. Our free cash flow from operations was $2.5 billion in 2009, $2.6 billion in 2008, $2.5 billion in 2007 and $1.8 billion in each of 2006 and 2005. We define free cash flow from operations as net cash provided by operating activities less capital expenditures. We believe free cash flow from operations is a useful measure for investors, because it portrays our ability to generate cash from our core businesses for purposes such as repaying maturing debt, funding business acquisitions, repurchasing our common stock and paying dividends. We use free cash flow from operations to assess the quality of our earnings and as a performance measure in evaluating management. The following table reconciles the free cash flow from operations with net cash provided by operating activities, as classified on the Consolidated Statement of Cash Flows:
Over the past five years, we have generated free cash flow from operations well in excess of our earnings from continuing operations during the period an average 110 percent conversion rate. We expect to continue to generate funds in excess of our short- and long-term liquidity needs. We believe we have adequate funds on hand and sufficient borrowing capacity to execute our financial and operating strategy.
ADDITIONAL FINANCIAL INFORMATION
Off-balance Sheet Arrangements
On December 31, 2009, other than operating leases, we had no material off-balance sheet arrangements, including guarantees; retained or contingent interests in assets transferred to unconsolidated entities; derivative instruments indexed to our stock and classified in shareholders equity on the Consolidated Balance Sheet; or variable interests in entities that provide us with financing, liquidity, market risk or credit risk support or engage with us in leasing, hedging or research and development services.
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Contractual Obligations and Commercial Commitments
The following tables present information about our contractual obligations and commercial commitments on December 31, 2009:
Application of Critical Accounting Policies
Managements Discussion and Analysis of our Financial Condition and Results of Operations is based on our 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 that we 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, we evaluate our estimates, including those related to long-term contracts and programs, 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. We base our estimates on historical experience and on various other assumptions that we believe 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.
We believe the following policies are critical and require the use of significant business judgment in their application:
Revenue Recognition. We account for revenues and earnings in our defense and aerospace businesses using the percentage-of-completion method of accounting. Under the percentage-of-completion method, we recognize contract revenue as the work progresses either as the products are produced and delivered or as services are rendered, as applicable. We estimate profit as the difference between total estimated revenue and total estimated cost of a contract and recognize that profit over the remaining life of the contract based on either input measures (e.g., costs incurred) or output measures (e.g., contract milestones or units delivered), as appropriate to the circumstances. Where an interim output measure is reliably determinable and representative of progress toward completion, we use such output measures. Otherwise, we use input measures.
We generally measure progress toward completion on contracts in our defense businesses based on the proportion of costs incurred to date relative to total estimated costs at completion or based on unit deliveries under the contract. Our contracts for the manufacture of business-jet aircraft usually provide for two major phases: the manufacture of the green aircraft (i.e., before exterior painting and installation of customer-selected interiors and optional avionics) and its completion. We record revenue at two contractual milestones: when green aircraft are delivered
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to, and accepted by, the customer and when the customer accepts final delivery of the fully outfitted aircraft. We do not recognize revenue at green delivery unless (1) a contract has been executed with the customer and (2) the customer can be expected to satisfy its obligations under the contract, as evidenced by the receipt of deposits from the customer and other factors.
We include revisions of estimated profits on contracts in earnings under the reallocation method rather than the cumulative catch-up method. Under the reallocation method, the impact of revisions in estimates is recognized prospectively over the remaining contract term, while under the cumulative catch-up method such impact would be recognized immediately. If a revised estimate of contract profitability reveals an anticipated loss on the contract, we recognize the loss in the period it is identified. Anticipated losses cover all costs allocable to the contracts, including G&A expenses on government contracts.
We use the reallocation method because we believe the majority of factors that typically result in changes in estimates of total contract revenue, total costs or the extent of progress toward completion on our long-term contracts affect both the period in which the change is identified and future periods. We believe these changes generally reflect expectations as to future performance and, therefore, the reallocation method is the method that best matches our revenues and earnings in the periods in which they are earned. While we have applied this method consistently for more than 30 years, most contractors use the cumulative catch-up method.
The percentage-of-completion method of accounting involves the use of various estimating techniques to project costs at completion, and in some cases includes estimates of recoveries asserted against the customer for changes in specifications or other disputes. Contract estimates involve various assumptions and projections relative to the outcome of future events over a period of several years, including future labor productivity and availability, the nature and complexity of the work to be performed, the cost and availability of materials, the impact of delayed performance, the availability and timing of funding from the customer, and the timing of product deliveries. These estimates are based on our best judgment. A significant change in one or more of these estimates could affect the profitability of one or more of our contracts. We review our contract estimates periodically to assess revisions in contract values and estimated costs at completion and reflect changes in estimates in the current and future periods under the reallocation method.
We recognize revenue arising from claims either as income or as an offset against a potential loss only when the amount of the claim can be estimated reliably and its realization is probable. In evaluating these criteria, we consider the contractual/legal basis for the claim, the cause of any additional costs incurred, the reasonableness of those costs and the objective evidence available to support the claim. We recognize revenue from award or incentive fees when there is a basis to reasonably estimate the amount of the fee. Estimates of award or incentive fees are based on actual award experience and anticipated performance.
Goodwill. Since 1995, we have acquired 54 businesses at a total cost of approximately $21 billion, including two in 2009. In connection with these acquisitions, we have recognized $12.3 billion of goodwill. Goodwill represents the purchase price paid in excess of the fair value of identifiable net tangible and intangible assets acquired. Goodwill is not amortized but is subject to an impairment test on an annual basis and when circumstances indicate that an impairment is more likely than not.
The test for goodwill impairment is a two-step process that requires a significant level of estimation by management, particularly the estimate of the fair value of our reporting units. These estimates require the use of judgment. We estimate the fair value of our reporting units based on the discounted projected cash flows of the underlying operations. This requires numerous assumptions, including the timing of work embedded in our backlog, our performance and profitability under our contracts, our success in securing future business, and the appropriate interest rate used to discount the projected cash flows. This discounted cash flow analysis is corroborated by top-down analyses, including a market assessment of our enterprise value. Beyond the annual impairment test, we review for factors on a quarterly basis that may lead us to perform a goodwill impairment test, such as a significant adverse change in the business climate for one of our reporting units or a decision to dispose of a reporting unit or a significant portion of a reporting unit. We have recorded no goodwill impairment to date and do not anticipate any reasonably possible circumstances that would lead to an impairment in the foreseeable future. The fair value of each of our reporting units on December 31, 2009, substantially exceeded its carrying value.
Commitments and Contingencies. We are subject to litigation and other legal proceedings arising either out of the ordinary course of our business or under provisions relating to the protection of the environment. Estimating liabilities and costs associated with these matters requires the use of judgment. We record a charge against earnings when a liability associated with claims or pending or threatened litigation matters is probable and when our exposure is reasonably estimable. The ultimate resolution of our exposure related to these matters may change as further facts and circumstances become known.
Deferred Contract Costs. Certain costs incurred in the performance of our government contracts are recorded under GAAP but are not currently allocable to contracts. Such costs include a portion of our estimated workers compensation obligations, other insurance-related assessments, pension and other post-retirement benefits, and environmental expenses. These costs will become allocable to contracts generally when they are paid. We have elected to defer (or inventory) these costs in contracts in process until they are paid, at which time the costs are charged to contracts and recovered from the government. We expect to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. This business base includes numerous contracts for which we are the sole source or one of two suppliers on long-term defense programs. We regularly assess the probability of recovery of these costs under our current and probable follow-on contracts. This assessment requires that we make assumptions about future contract costs, the extent of cost recovery under
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our contracts and the amount of future contract activity. These estimates are based on our best judgment. If the backlog in the future does not support the continued deferral of these costs, the profitability of our remaining contracts could be adversely affected.
Retirement Plans. Our defined-benefit pension and other post-retirement benefit costs and obligations depend on a series of assumptions and estimates. The key assumptions relate to the interest rates used to discount estimated future liabilities and projected long-term rates of return on plan assets. We determine the discount rate used each year based on the rate of return currently available on a portfolio of high-quality fixed-income investments with a maturity that is consistent with the projected benefit payout period. We determine the long-term rate of return on assets based on historical returns and the current and expected asset allocation strategy. These estimates are based on our best judgment, including consideration of current and future market conditions. In the event a change in any of the assumptions is warranted, future pension and post-retirement benefit cost could increase or decrease. For the impact of hypothetical changes in the discount rate and expected long-term rate of return on plan assets for our commercial pension and post-retirement benefit plans, see Note P to the Consolidated Financial Statements.
As discussed under Deferred Contract Costs, our contractual arrangements with the U.S. government provide for the recovery of contributions to our government retirement plans. We have elected to defer recognition of the cumulative net unfunded benefit cost in our government plans to provide a better matching of revenues and expenses. Accordingly, the impact on the retirement benefit cost for these plans that results from annual changes in assumptions does not impact our future earnings either positively or negatively.
We believe that our judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented.
New Accounting Standards
In December 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. ASU 2009-17 provides additional guidance with respect to the requirements for consolidation of a variable interest entity that is insufficiently capitalized or is not controlled through voting rights. The standard also requires new disclosures regarding variable interest entities. ASU 2009-17 is effective in the first quarter of 2010. We do not expect the adoption of ASU 2009-17 to have a material effect on our results of operations, financial condition or cash flows.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 requires new disclosures and clarifies some existing disclosures regarding fair value measurements. ASU 2010-06 is effective in the first quarter of 2010.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risk, primarily from foreign currency exchange rates, interest rates, commodity prices and investments. See Note M to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K for a discussion of these risks. The following discussion quantifies the market risk exposure arising from hypothetical changes in foreign currency exchange rates and interest rates.
Foreign Currency Risk
We had $1.8 billion in notional forward foreign exchange contracts outstanding on December 31, 2009, and $2.4 billion on December 31, 2008. A 10 percent unfavorable exchange rate movement in our portfolio of foreign currency forward contracts would have resulted in the following incremental pretax gains and losses:
This exchange-rate sensitivity relates primarily to changes in the U.S. dollar/Canadian dollar, euro/Swiss franc and U.S. dollar/Swiss franc exchange rates. We believe these hypothetical recognized and unrecognized gains and losses would be offset by corresponding losses and gains in the remeasurement of the underlying transactions being hedged. We believe these forward contracts and the offsetting underlying commitments, when taken together, do not create material market risk.
Interest Rate Risk
Our financial instruments subject to interest rate risk include fixed-rate long-term debt obligations and variable-rate commercial paper. On December 31, 2009, we had $3.9 billion par value of fixed-rate debt. We had no commercial paper outstanding. Our fixed-rate debt obligations are not putable, and we do not trade these securities in the market. A 10 percent unfavorable interest rate movement would not have a material impact on the fair value of our debt obligations.
Our investment policy allows for purchases of fixed-income securities with an investment-grade rating and a maximum maturity of one year. On December 31, 2009, we held $2.6 billion in cash and equivalents and marketable securities to be used for general corporate purposes. Our marketable securities have an average duration of six months and an average credit rating of AA-. Given that our investments had an aggregate weighted average maturity of 57 days on December 31, 2009, a 10 percent unfavorable interest rate movement would have no immediate material impact on the value of the holdings. Historically, we have not experienced material gains or losses on these instruments due to changes in interest rates or market values.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Statement of Earnings
The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.
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Consolidated Balance Sheet
The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.
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Consolidated Statement of Cash Flows
The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.
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