General Dynamics 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
For the quarterly period ended July 3, 2005
Commission File Number 1-3671
(Exact name of registrant as specified in its charter)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨.
201,019,710 shares of the registrants common stock, $1 par value per share, were outstanding at July 31, 2005.
GENERAL DYNAMICS CORPORATION
PART I FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF EARNINGS
(Dollars in millions, except per share amounts)
The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF EARNINGS
(Dollars in millions, except per share amounts)
The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions, except per share amounts or unless otherwise noted)
The term company or General Dynamics refers to General Dynamics Corporation and all of its wholly-owned and majority-owned subsidiaries. The unaudited Consolidated Financial Statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to such rules and regulations. Operating results for the three- and six-month periods ended July 3, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. These unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the companys Annual Report on Form 10-K for the year ended December 31, 2004.
In managements opinion, the unaudited Consolidated Financial Statements contain all adjustments, that are of a normal recurring nature, necessary for a fair statement of the results for the three- and six-month periods ended July 3, 2005, and July 4, 2004. In 2004 and 2005, General Dynamics sold certain non-core businesses, as discussed in Note C. The unaudited Consolidated Financial Statements have been restated to reflect the results of operations of these businesses in discontinued operations. Additionally, some prior-year amounts have been reclassified among financial statement accounts to conform to the current-year presentation.
Intangible assets consisted of the following:
The company amortizes contract and program intangible assets on a straight-line basis over 5 to 40 years. Other intangible assets consist primarily of aircraft product design, customer lists, software and licenses and are amortized over 3 to 21 years.
Amortization expense was $25 and $51 for the three- and six-month periods ended July 3, 2005, and $23 and $45 for the three- and six-month periods ended July 4, 2004. The company expects to record annual amortization expense over the next five years as follows:
The changes in the carrying amount of goodwill by business group for the six months ended July 3, 2005, were as follows:
In 2004, General Dynamics reviewed its businesses to identify operations that were not core to the company and could be divested. As a result, the company completed the sale of two businesses in the third quarter of 2004 and recognized an after-tax loss of $2. In the Information Systems and Technology group, the company sold its business specializing in the development of software products and customized solutions for the automotive and airline industries. In the Combat Systems group, the company sold its business specializing in the design and manufacture of electrical equipment for specialty vehicles.
Also in 2004, the company entered into definitive agreements to sell two additional businesses. The company entered into agreements to sell its aeronautical research and development business in the Information Systems and Technology group and its propulsion systems business in the Combat Systems group. These transactions closed in the first quarter of 2005. In addition to the 2004 activity, the company sold two more businesses in the first quarter of 2005. These included the facilities research and development business and the airborne electronics systems business in the Information Systems and
Technology group. The company recognized an after-tax loss of $8 from the sale of these businesses in discontinued operations in 2005. The company received combined net proceeds from these transactions of $344 in 2005.
The financial statements for all periods have been restated to present the results of operations of these businesses in discontinued operations.
The summary of operating results from discontinued operations follows:
The company accounts for its incentive compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The company measures compensation expense for stock options as the excess, if any, of the quoted market price of the companys stock at the measurement date over the exercise price. The company records stock awards at fair value at the date of the award.
If compensation expense for stock options had been determined based on the fair value at the grant dates for awards under the companys equity compensation plans, General Dynamics net earnings and net earnings per share would have been reduced to the pro forma amounts indicated as follows:
The weighted average fair value of each stock option included in the preceding pro forma amounts was estimated using the Black-Scholes option pricing model and is amortized over the vesting period of the underlying options.
Comprehensive income consisted of the following:
General Dynamics computes basic earnings per share using net earnings for the respective period and the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporates the incremental shares issuable upon the assumed exercise of stock options and the issuance of contingently issuable shares.
Basic and diluted weighted average shares outstanding were as follows (in thousands):
Contracts in process represent recoverable costs and, where applicable, accrued profit related to long-term government contracts and consisted of the following:
Contract costs consist primarily of production costs and related overhead, such as general and administrative expenses. Contract costs also include contract recoveries for matters such as contract changes, negotiated settlements and claims for unanticipated contract costs, which totaled $42 as of July 3, 2005, and $37 as of December 31, 2004. The company records revenue associated with these matters only when recovery can be estimated reliably and realization is probable.
Other contract costs represent amounts recorded under GAAP that are not currently allocable to contracts, such as a portion of the companys estimated workers compensation, other insurance-related assessments, retirement benefits and environmental expenses. These costs will become allocable to contracts when they are paid. The company expects to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. This business base includes numerous contracts for which the company is the sole source or is one of two suppliers on long-term defense programs. However, if the backlog in the future does not support the continued deferral of these costs, the profitability of the companys remaining contracts could be adversely affected.
Inventories represent primarily commercial aircraft components and consisted of the following:
Debt consisted of the following:
As of July 3, 2005, General Dynamics had outstanding $3.1 billion aggregate principal amount of fixed-rate notes. The offer and sale of the fixed-rate notes was registered under the Securities Act of 1933, as amended (the Securities Act). The notes consist of the following:
The fixed-rate notes are fully and unconditionally guaranteed by several of the companys 100-percent-owned subsidiaries. The company has the option to redeem the notes prior to their maturity in whole or in part at 100 percent of the principal plus accrued but unpaid interest and any applicable make-whole amounts. See Note O for condensed consolidating financial statements.
The senior notes are privately placed U.S. dollar-denominated notes issued by one of the companys Canadian subsidiaries. Interest is payable semiannually at an annual rate of 6.32 percent, until maturity in September 2008. The subsidiary has a currency swap that fixes both the interest payments and principal at maturity of these notes. As of July 3, 2005, the fair value of this currency swap was a $34 liability, which offset the effect of changes in the currency exchange rate on the related debt. The senior notes are backed by a parent company guarantee.
The company assumed the term debt in connection with the acquisition of Primex Technologies, Inc., in 2001. Annual sinking fund payments of $5 are required in December 2005 through 2007, with the remaining $20 payable in December 2008. Interest is payable in June and December at the rate of 7.5 percent annually.
As of July 3, 2005, other debt consisted primarily of two capital lease arrangements totaling $9.
As of July 3, 2005, the company had no commercial paper outstanding but maintains the ability to access the market. The company has $2 billion in bank credit facilities that provide backup liquidity to the
commercial paper program. These credit facilities consist of a $1 billion multiyear facility expiring in July 2006 and a $1 billion multiyear facility expiring in July 2009. The companys commercial paper issuances and the bank credit facilities are guaranteed by several of the companys 100-percent-owned subsidiaries. Additionally, a number of the companys international subsidiaries have available local bank credit facilities of approximately $565.
The companys financing arrangements contain a number of customary covenants and restrictions. In particular, the companys bank credit facilities include a minimum net worth threshold, which the company exceeds by a margin in excess of $2 billion. The company was in compliance with all material covenants as of July 3, 2005.
A summary of significant liabilities, by balance sheet caption, follows:
The company had a net deferred tax liability of $441 at July 3, 2005, and $432 at December 31, 2004. The current portion of the net deferred taxes was an asset of $188 at July 3, 2005, and $217 at December 31, 2004, and is included in other current assets on the Consolidated Balance Sheet.
On November 27, 2001, General Dynamics filed a refund suit in the U.S. Court of Federal Claims for the years 1991 to 1993. The company added the years 1994 to 1998 to this suit on June 23, 2004. The company anticipates that years 1999 to 2002 will be added to this suit. The suit seeks recovery of refund claims that were disallowed by the IRS at the administrative level. If the court awards a full recovery to the company, the refund could exceed $100, including after-tax interest. The company expects the litigation to take several years to resolve and has recognized no income from this matter.
In the first quarter of 2005, the company and the IRS reached agreement on the examination of the companys income tax returns for 1999 through 2002. As a result of the resolution of the 1999-2002 audit cycle, the company reassessed its tax contingencies during the first quarter and recognized a non-cash benefit of $66, or $.33 per share. The company has recorded liabilities for tax contingencies for open years. The company does not expect the resolution of tax matters for these years to have a material impact on its results of operations, financial condition or cash flows.
Termination of A-12 Program. In January 1991, the Navy terminated the companys A-12 aircraft contract for default. The A-12 contract was a fixed-price incentive contract for the full-scale development and initial production of the Navys carrier-based Advanced Tactical Aircraft. Both the company and McDonnell Douglas, now owned by The Boeing Company, (the contractors) were parties to the contract with the Navy. Both contractors had full responsibility to the Navy for performance under the contract, and both are jointly and severally liable for potential liabilities arising from the termination. As a consequence of the termination for default, the Navy demanded that the contractors repay $1.4 billion in unliquidated progress payments. The Navy agreed to defer collection of that amount pending a decision by the U.S. Court of Federal Claims on the contractors challenge to the termination for default, or a negotiated settlement.
On December 19, 1995, the U.S. Court of Federal Claims (the trial court) issued an order converting the termination for default to a termination for convenience. On March 31, 1998, a final judgment was entered in favor of the contractors for $1.2 billion plus interest.
On July 1, 1999, the U.S. Appeals court for the Federal Circuit (the appeals court) remanded the case to the trial court for determination of whether the governments default termination was justified. On August 31, 2001, following the trial on remand, the trial court upheld the default termination of the A-12 contract. In its opinion, the trial court rejected all of the governments arguments to sustain the default termination except for the governments schedule arguments, as to which the trial court held that the schedule the government unilaterally imposed was reasonable and enforceable, and that the government had not waived that schedule. On the sole ground that the contractors were not going to deliver the first aircraft on the date provided in the unilateral schedule, the trial court upheld the default termination and entered judgment for the government.
On January 9, 2003, the companys appeal was argued before a three-judge panel of the appeals court. On March 17, 2003, the appeals court vacated the trial courts judgment and remanded the case to the trial court for further proceedings. The appeals court found that the trial court had misapplied the controlling legal standard in concluding that the termination for default could be sustained solely on the basis of the contractors inability to complete the first flight of the first test aircraft by December 1991. Rather, the appeals court held that in order to uphold a termination for default the trial court would have to determine that there was no reasonable likelihood that the contractors could perform the entire contract effort within the time remaining for performance. The company does not believe the evidence supports such a determination. Pursuant to the direction of the appeals court, the trial court held further proceedings on June 29 and 30, 2004. The matter is pending before the trial court for decision.
If, contrary to the companys expectations, the default termination is ultimately sustained, the contractors could collectively be required to repay the government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.2 billion at July 3, 2005. This would result in a liability for the company of approximately $1.3 billion pretax, or approximately $700 after-tax, to be taken as a charge against discontinued operations. The company believes it has sufficient resources to pay such an obligation if required.
Final Analysis. On May 28, 2003, Final Analysis Communication Systems, Inc. (FACS), a Maryland corporation, served the company with a complaint it filed in the U.S. District Court for the District of Maryland. On October 14, 2004, FACS filed a second amended complaint alleging that the company breached contracts among the company, FACS and FACS then-corporate parent, Final Analysis, Inc. (FAI), a Maryland corporation. FAI is currently a debtor in the Bankruptcy Court for the District of Maryland. FACS also alleged tort claims for fraud, tortious interference with contractual and business relations, fraudulent inducement, negligent misrepresentation and a claim for breach of warranty, but on April 4, 2005, the District Court granted the companys motion for summary judgment on all such FACS claims. The second amended complaint alleges monetary damages in excess of $500, plus punitive damages. The company has denied liability to FACS and asserts counterclaims. The trial on this matter began on July 19, 2005, and is expected to conclude during the third quarter. The company believes the outcome of this matter will not have a material impact on its results of operations, financial condition or cash flows.
Other. Various claims and other legal proceedings incidental to the normal course of business are pending or threatened against the company. While it cannot predict the outcome of these matters, the company believes any potential liabilities in these proceedings, individually or in the aggregate, will not have a material impact on its results of operations, financial condition or cash flows.
General Dynamics is subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. The company is directly or indirectly involved in environmental investigation or remediation at some of its current and former facilities, and at third-party sites not owned by the company but where it has been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, the company expects that a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable costs and, therefore, reimbursed by the U.S. government. As required, the company provides financial assurance for certain sites undergoing or subject to investigation or remediation. Where applicable, the company seeks insurance recovery for costs related to environmental liability. The company does not record insurance recoveries before collection is considered probable. Based on all known facts and analyses, as well as current U.S. government policies relating to allowable costs, the company does not believe that its liability at any individual site, or in the aggregate, arising from such sites at which there is a known environmental condition, or Superfund or other multi-party sites at which the company is a PRP, will be material to its results of operations, financial condition or cash flows. Nor does the company believe that the range of reasonably possible additional loss beyond what has been recorded would be material to its results of operations, financial condition or cash flows.
In the ordinary course of business, General Dynamics has entered into letters of credit and other similar arrangements with financial institutions and insurance carriers totaling approximately $1.4 billion at July 3, 2005. The company, from time to time in the ordinary course of business, guarantees the payment or performance obligations of its subsidiaries arising under certain contracts. The company is aware of no event of default that would require it to satisfy these guarantees.
As a government contractor, the company is occasionally subject to U.S. government investigations relating to its operations, including claims for fines, penalties and compensatory and treble damages. The company believes, based on currently available information, that the outcome of such ongoing government disputes and investigations will not have a material impact on its results of operations, financial condition or cash flows.
On June 5, 2001, General Dynamics acquired substantially all of the assets of Galaxy Aerospace Company LP. Pursuant to the purchase agreement, the selling parties have the contractual right to receive additional payments, up to a maximum of approximately $300 through 2006, contingent on the achievement of specific revenue targets. No amounts have been paid to date, and based on current planned aircraft production rates, the company does not anticipate having to make any future payments under this agreement.
As of July 3, 2005, in connection with orders for 21 Gulfstream aircraft in firm contract backlog, the company had offered customers trade-in options, which may or may not be exercised by the customers. If these options are exercised, the company will accept trade-in aircraft (both Gulfstream and competitor aircraft) at a predetermined minimum trade-in price as partial consideration in the new aircraft transaction. Any excess of the trade-in price above the fair market value is treated as a reduction of revenue upon recording of the new aircraft sales transaction. These option commitments last through 2007 and totaled $406 as of July 3, 2005, versus $301 at December 31, 2004. Beyond these commitments, additional aircraft trade-ins are likely to be accepted in connection with future orders for new aircraft.
The company provides product warranties to its customers associated with certain product sales, particularly business-jet aircraft. The company records estimated warranty costs in the period in which the related products are delivered. The warranty liability recorded at each balance sheet date is based on the estimated number of months of warranty coverage remaining for products delivered and the average historical monthly warranty payments, and is included in other current liabilities and other liabilities on the Consolidated Balance Sheet.
The changes in the carrying amount of warranty liabilities for the six-month periods ended July 3, 2005, and July 4, 2004, were as follows:
The company provides defined-benefit pension and other post-retirement benefits to certain eligible employees.
Net periodic pension and other post-retirement benefit costs for the three- and six-month periods ended July 3, 2005, and July 4, 2004, consisted of the following:
Pension Benefits. General Dynamics contractual arrangements with the U.S. government provide for the recovery of contributions to the companys government plans. The amount contributed to certain plans, charged to contracts and included in net sales has exceeded the net periodic pension cost as determined under Statement of Financial Accounting Standards No. 87, Employers Accounting for Pensions. The company has deferred recognition of earnings resulting from this difference to provide a better matching of revenues and expenses. Similarly, pension settlements and curtailments under the government plans have also been deferred. These deferrals have been classified against the prepaid pension cost related to these plans.
Other Post-retirement Benefits. The companys contractual arrangements with the U.S. government provide for the recovery of contributions to a Voluntary Employees Beneficiary Association trust and, for non-funded plans, recovery of claims paid. The net periodic post-retirement benefit cost exceeds the companys cost currently allocable to contracts. To the extent recovery of the cost is considered probable based on the companys backlog, the company defers the excess in contracts in process until such time that the cost is allocable to contracts.
The company adopted Financial Accounting Standards Board Staff Position (FSP) No. FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, (which superseded FSP No. FAS 106-1) effective December 31, 2004. This FSP provides guidance on the accounting for the federal subsidy and other provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The effects of these provisions resulted in a reduction of $65 in the companys accumulated post-retirement obligation for benefits attributed to past service as of December 31, 2004, and an expected reduction of $8 in the companys 2005 net periodic post-retirement benefit cost. The federal government will begin making the subsidy payments to employers in 2006.
General Dynamics operates in four primary business groups: Information Systems and Technology, Combat Systems, Marine Systems and Aerospace. The company organizes and measures its business groups in accordance with the nature of products and services offered. These business groups derive their revenues from mission-critical information systems and technologies; land and expeditionary combat vehicles, armaments and munitions; shipbuilding and marine systems; and business aviation, respectively. The company also owns certain commercial operations that are identified for reporting purposes as Resources. The company measures each groups profit based on operating earnings. As a result, the company does not allocate net interest, other income and expense items, and income taxes to its business groups.
Summary financial information for each of the companys business groups follows:
The fixed-rate notes described in Note I are fully and unconditionally guaranteed on an unsecured, joint and several basis by certain 100-percent-owned subsidiaries of General Dynamics Corporation (the guarantors). The following condensed consolidating financial statements illustrate the composition of the parent, the guarantors on a combined basis (each guarantor together with its majority-owned subsidiaries) and all other subsidiaries on a combined basis as of July 3, 2005, and December 31, 2004, for the balance sheet, as well as the statements of earnings and cash flows for the three- and six-month periods ended July 3, 2005, and July 4, 2004.
Condensed Consolidating Statement of Earnings
Condensed Consolidating Statement of Earnings
Condensed Consolidating Balance Sheet
Condensed Consolidating Balance Sheet
Condensed Consolidating Statement of Cash Flows
GENERAL DYNAMICS CORPORATION
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
July 3, 2005
(Dollars in millions, except per share amounts)
General Dynamics designs, develops, manufactures and supports leading-edge technology products and services for mission-critical information systems and technologies; land and expeditionary combat vehicles, armaments and munitions; shipbuilding and marine systems; and business aviation. The companys primary customers are the U.S. military, other government organizations, the armed forces of allied nations and a diverse base of corporate and industrial buyers. It operates through four primary business groups Information Systems and Technology, Combat Systems, Marine Systems and Aerospace and a small Resources group. The following discussion should be read in conjunction with the companys 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission and with the unaudited Consolidated Financial Statements included herein.
Results of Operations
General Dynamics net sales for the second quarter of 2005 were $5.2 billion, an increase of 12 percent over the second quarter of 2004. This increase resulted primarily from sales growth in the Information Systems and Technology and Combat Systems groups. Operating earnings for the second quarter of 2005 were up 13 percent to $549 compared with $485 in the same quarter in 2004. The major drivers of the rise in operating earnings were improved performance in the Aerospace group and increased volume in the Information Systems and Technology group.
Net sales grew 8 percent to $10 billion for the six-month period ended July 3, 2005, compared with the same period in 2004. Sales growth in the Information Systems and Technology, Aerospace and Combat Systems groups was offset in part by lower activity in the Marine Systems group. Operating earnings also rose 8 percent over the first six months of 2004, reaching $1 billion in the first half of 2005. The growth in operating earnings resulted from the increased volume and improved performance in the Information Systems and Technology and Aerospace groups, but was reduced by lower activity and contract losses in the Marine Systems group.
General Dynamics repeated the strong operating margin performance achieved in the first half of 2004 in the current period, generating margins of 10.5 percent in the second quarter and 9.9 percent in the first half of 2005. General and administrative (G&A) expenses as a percentage of net sales increased slightly to 6.3 percent in the first half of 2005 from 6.0 percent in the same period in 2004. The company expects G&A expenses as a percent of sales for the full year 2005 to be consistent with the full year 2004.
General Dynamics continued to generate strong cash flow from operations in the first six months of 2005. Net cash provided by operating activities was $557, compared with $685 in the same period in 2004. In addition, during the first half of 2005 the company generated $349 from the sale of several non-core businesses. The company used its cash to fund acquisitions and capital expenditures, repurchase its common stock and pay dividends.
The companys effective tax rate for the six-month period ended July 3, 2005, was 26.3 percent compared with 33.2 percent for the first half of 2004. The companys effective tax rate for the first half of 2005 was impacted favorably by the resolution of the companys 1999-2002 federal income tax audit during the first quarter. This settlement resulted in a $66, or $.33 per-share non-cash benefit, which reduced the companys effective tax rate for the first half of 2005 by 7 percent. Excluding the effect of the resolution of tax matters related to prior years, the company expects the effective tax rate for the full year to be consistent with the 2004 rate. For additional discussion of tax matters, as well as a discussion of the net deferred tax liability, see Note K to the unaudited Consolidated Financial Statements.
In 2004, the company reviewed its businesses to identify operations that were not core to the company and could be divested. In connection with this process, the company completed the sales of several small businesses in the first quarter of 2005. The companys reported net sales exclude the revenues associated with these businesses. The company received $344 in cash, net of taxes, in the first half of 2005 from the sale of these businesses and recognized an after-tax loss of $8 in discontinued operations in the six-month period ended July 3, 2005, related to the divestiture activities. For additional discussion of these divestiture activities, see Note C to the unaudited Consolidated Financial Statements.
The companys total backlog decreased slightly to $43.6 billion as of July 3, 2005, compared with $44.7 billion at the end of the first quarter of 2005, as the company executes the substantial backlog that has resulted from a number of significant awards over the past several quarters. The total backlog as of the end of the quarter increased 7 percent, and the funded backlog 14 percent, over the same point in 2004. New orders received during the second quarter of 2005 were $4.2 billion, including over $1 billion of order activity in the Aerospace group. The total backlog does not include work awarded under numerous indefinite delivery, indefinite quantity (IDIQ) contracts. The total potential value of these contracts, which may be realized over the next 15 years, was approximately $5.7 billion as of July 3, 2005.
Information Systems and Technology
The Information Systems and Technology group generated significant growth in sales and operating earnings for both the three- and six-month periods ended July 3, 2005, compared with the same prior-year periods. The growth resulted from increased sales volume in each of the groups principal markets, as well as from businesses acquired in the second half of 2004. Several significant programs led the groups strong sales and earnings growth, including the following:
In addition to these early-stage contracts, continued growth on many of the groups ongoing programs, including the BOWMAN contract for the United Kingdoms armed forces and the Pentagon renovation program, contributed to the increase in sales and earnings in 2005.
Operating margins for the second quarter of 2005 were down somewhat from the same period in 2004 reflecting the variability that results from the timing and mix of contract performance phases and customer deliveries. Margins for the first six months of 2005 improved slightly over 2004 and have remained consistent through the first half of the year.
The company expects high-single-digit sales growth in the Information Systems and Technology group for the full year 2005. While margins may fluctuate from quarter to quarter as discussed above, the company expects the groups full-year operating margins to remain in the low-double-digit range.
The Combat Systems groups net sales and operating earnings improved in the second quarter of 2005 versus the second quarter of 2004 on the strength of several combat vehicle production programs, including the Stryker wheeled combat vehicle, the Leopard battle tank and the Pizarro Advanced Infantry Fighting Vehicle. The group also experienced increased sales on its M1A2 Abrams main battle tank upgrade program and its large and medium caliber munitions replenishment contracts. These increases were offset in part by lower activity on certain combat vehicle production programs due to either their completion or the timing of customer requirements, including the completion of the companys Australian and New Zealand light armored vehicle contracts. The groups operating margins for the quarter were consistent with the performance delivered in the same period in 2004.
The net sales growth in the Combat Systems group for the first six months of 2005 compared with the same period in 2004 resulted from an increase in activity on a number of combat vehicle programs, including Stryker, Leopard and the M1A2 Abrams upgrades. The group also experienced growing volume in its armaments and munitions businesses, including reactive armor and munitions replenishment contracts. Operating earnings for the six-month period ended July 3, 2005, were up slightly compared with the same period in 2004. Margins were down slightly due to a shift in product mix and the timing of deliveries in the groups European business.
The company expects further revenue growth in the second half of the year for the Combat Systems group based on the cyclical nature of the groups international businesses and the timing of customer requirements. For the full year 2005, the company expects that operating margins will be consistent with the average margins experienced in 2004.
The Marine Systems groups net sales in the second quarter of 2005 were consistent with the same three-month period in 2004. Increased volume on the Virginia-class submarine program and the T-AKE combat logistics ships was offset by a decrease in activity on engineering and repair contracts, which experienced a surge of activity in the first half of 2004, and the completion of the Seawolf submarine program.
Net sales for the first six months of 2005 were down slightly compared with the same prior-year period. Declining volume on engineering and repair contracts, mature production programs and commercial production contracts more than offset increased activity on early-stage defense design and production contracts, including the Virginia-class, T-AKE and SSGN programs.
Operating earnings and margins decreased significantly in the second quarter and first half of 2005 versus the same periods in 2004. These declines resulted from losses incurred on some of the groups programs and a shift in the mix of the groups contracts from fixed-price production to cost-type design and production. In the first six months of 2005, the company recorded losses on two submarine maintenance and overhaul contracts totaling approximately $20. These losses resulted from customer-requested change orders that the group fulfilled prior to securing adequate contract protection. The company is negotiating with the customer to recover some of its costs incurred and does not expect to have this type of exposure on future contracts.
In the first quarter of 2005, the company experienced schedule delays on its contract to build four double-hull oil tankers due primarily to adverse weather conditions at the shipyard. These conditions caused labor and material cost growth, resulting in an additional loss of $19 on the program in the first quarter. The programs estimates at completion remained firm in the second quarter. As a result, the company did not record any losses on this program in the second quarter of 2005. The third and fourth ships are scheduled to be delivered in the fourth quarter of 2005 and the third quarter of 2006, respectively. Management continues to monitor closely the estimates to complete the program in order to mitigate the risk that will remain until the final ship is delivered.
The Marine Systems groups operating margins improved markedly in the second quarter over the first quarter of 2005, and the company expects continued performance improvement in the group over time on gradually declining volume, assuming no further deterioration in the commercial tanker program.
The Aerospace groups net sales for the second quarter of 2005 increased moderately over the same period in 2004. The group delivered one additional green aircraft and four additional completions in the second quarter of 2005. In addition, the group delivered a more favorable mix of new aircraft and began to experience improved pricing on its aircraft deliveries. The effects of these increases were reduced by lower sales of pre-owned aircraft. Operating earnings and margins in the same period increased significantly over 2004 as a result of the improved pricing, the favorable mix of deliveries and the ongoing benefits of the groups cost containment activities.
The group experienced strong sales growth in the first half of 2005 compared with 2004 as green aircraft deliveries increased over 10 percent and completions increased over 20 percent. Improved pricing and higher aircraft services volume also contributed to the sales growth. Like the second quarter, earnings and margins in the first six months of 2005 were up substantially over 2004 due to the increased volume, significantly reduced costs and pricing improvements.
The company expects the Aerospace groups volume to increase steadily in the second half of the year. The company expects a gradual increase in the groups full-year margins over the level achieved in 2004, though the margin rate from quarter to quarter may fluctuate based on the mix of aircraft deliveries. (See Notes H and L to the unaudited Consolidated Financial Statements for additional information regarding the Aerospace groups aircraft inventories and trade-in commitments.)
The Resources groups net sales and operating earnings increased significantly in the three- and six-month periods ended July 3, 2005, compared with the same periods in 2004 due to higher volume and improved performance in the groups coal mining and aggregates businesses. Operating earnings in the first six months of 2005 were also impacted by favorable adjustments to certain of the groups coal-related liabilities.
The following table details the backlog and the total estimated contract value of each business group at the end of the second and first quarters of 2005:
The total backlog for the companys defense businesses represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are also approved and funded by their governments. The unfunded backlog represents firm orders for which funding has not been appropriated. The backlog does not include work awarded under IDIQ contracts. IDIQ contract value represents managements estimate of the future contract value under existing indefinite delivery, indefinite quantity contracts. Because the value in these arrangements is subject to the customers future exercise of an indeterminate quantity of delivery orders, these contracts are recognized in the backlog only when funded.
The company received several notable contract awards during the second quarter of 2005, including the following:
The Combat Systems group received orders worth approximately $150 for the production of Hydra-70 rockets, motors and warheads. These orders are part of a five-year requirements contract with an estimated value of $900.
The company was awarded modifications to several of its contracts under the U.S. Armys Future Combat Systems (FCS) program. The Combat Systems group was awarded a $282 modification to its $2 billion contract for the engineering development and demonstration of a family of manned ground vehicles for the FCS program. The modification extends the contract through 2012. The Combat Systems group also received a modification valued at approximately $50 under its contract to develop the autonomous navigation system for FCS ground vehicles. In addition, the Information Systems and Technology group was awarded a modification worth $154 to accelerate technology development of the integrated computer system (ICS) two years earlier than originally planned. The modification brings the total ICS contract value to approximately $430.
The Combat Systems group received an order worth approximately $140 under the Stryker wheeled combat vehicle production program for 99 Stryker vehicles to meet additional Army requirements.
The Combat Systems group was awarded a contract worth $141 to upgrade 60 M1A2 Abrams tanks to the M1A2 System Enhancement Program (SEP) configuration. Through this program, the company retrofits M1A2 tanks with an enhanced electronics package that is designed to improve the tanks effectiveness.
The Information Systems and Technology group received an order from the Army to integrate up to 500 Land Warrior soldier ensembles into a Stryker experimental battalion. Land Warrior is an integrated fighting system that uses technology to enhance individual soldiers tactical awareness, lethality and survivability. This $30 award is part of a contract valued at approximately $260. In the first quarter of 2005, the Army merged the Land Warrior program with its Future Force Warrior program under a contract managed by General Dynamics to expedite the fielding of this integrated system.
The company also has received several significant contract awards since the end of the second quarter, including the following:
The Information Systems and Technology group received a $169 contract to design, manufacture and deliver 25 12-meter antennas for an advanced radio telescope array at an international astronomy facility.
The Information Systems and Technology group received a contract from the Royal Netherlands Navy worth approximately $115 to supply the New Integrated Marines Communications and Information Systems (NIMCIS). NIMCIS is a two-year program to equip the Royal Netherlands Marine Corps with the BOWMAN communications system, which the company is currently providing to the U.K. armed forces.
The Aerospace funded backlog includes orders for which the company has definitive purchase contracts and deposits from the customer. The Aerospace unfunded backlog consists of options to purchase new aircraft and agreements to provide future aircraft maintenance and support services.
The group continued to experience strong order activity in the second quarter of 2005 amid improving market conditions, as orders exceeded sales for the fourth consecutive quarter. A significant portion of the Aerospace backlog is with an unaffiliated customer, NetJets Inc. (NetJets), a unit of Berkshire Hathaway and the leader in the fractional aircraft market. NetJets purchases the aircraft for use in its fractional ownership program. As of the end of the second quarter of 2005, backlog with NetJets for all aircraft types represented 35 percent of the Aerospace funded backlog and 90 percent of the Aerospace unfunded backlog.
Financial Condition, Liquidity and Capital Resources
General Dynamics continued to generate strong cash flow from operating activities in the first half of 2005. Net cash provided by operating activities was $557 for the six-month period ended July 3, 2005, compared with $685 in the same period in 2004. Net earnings was the primary driver of the companys strong cash flows from operations in the first half of both 2005 and 2004. In 2004, cash flows were favorably impacted by a refund of 2003 income taxes.
Free cash flow from operations for the first six months of 2005 was $462 versus $568 for the same period in 2004. Management defines free cash flow from operations as net cash provided by operating activities less capital expenditures. Management believes free cash flow from operations is a useful measure for investors, because it portrays the companys ability to generate cash from its core businesses for purposes such as repaying maturing debt, funding business acquisitions, repurchasing the companys outstanding shares and paying dividends. The following table reconciles the free cash flow from operations with net cash provided by operating activities, as classified on the unaudited Consolidated Statement of Cash Flows:
With free cash flow from operations projected to approximate net earnings for the full year 2005, General Dynamics expects to continue to generate funds from operations in excess of its short- and long-term liquidity needs. Management believes that the company has adequate funds on hand and sufficient borrowing capacity to execute its financial and operating strategy.
As discussed further in Note L to the unaudited Consolidated Financial Statements, litigation on the A-12 program termination has been ongoing since 1991. If, contrary to the companys expectations, the default termination is ultimately sustained, the company and The Boeing Company could collectively be required to repay the U.S. government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.2 billion at July 3, 2005. In this outcome, the government contends the companys liability would be approximately $1.3 billion pretax, or approximately $700 after-tax. The company believes it has sufficient resources to pay such an obligation, if required, while still retaining ample liquidity.
Investing activities provided net cash of $161 in the first half of 2005, and used cash of $137 in the same period in 2004. In the first half of 2005, the company completed the sales of several small, non-core businesses. The company received $349 in cash, net of tax payments, from these divestiture activities. The primary uses of cash in the first six months of 2005 and 2004 were capital expenditures and acquisitions.
Net cash used by financing activities was $256 for the six-month period ended July 3, 2005, compared with $312 in the same period in 2004. The companys typical financing activities include issuances and repayments of debt, payment of dividends and repurchases of common stock. In the first half of 2004, the company repaid $227 of its outstanding debt. The company made no debt payments in the first six months of 2005 and has virtually no maturing debt in the remainder of 2005.
On March 2, 2005, the companys board of directors declared an increased regular quarterly dividend of $.40 per share the eighth consecutive annual increase. The board had previously increased the regular quarterly dividend to $.36 per share in March 2004.
In the first six months of 2005, the company repurchased two million shares at an average price of about $102 per share. The company did not repurchase any shares during the first half of 2004. The company has approximately 2.5 million remaining shares authorized for repurchase as of July 3, 2005.
Additional Financial Information
Environmental Matters and Other Contingencies
For a discussion of environmental matters and other contingencies, see Note L to the unaudited Consolidated Financial Statements. The company does not expect its liability, in the aggregate, with respect to these matters to have a material impact on its results of operations, financial condition or cash flows.
Application of Critical Accounting Policies
Managements Discussion and Analysis of the companys Financial Condition and Results of Operations is based on the companys unaudited Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to long-term contracts and programs, goodwill and other intangible assets, income taxes, pensions and other post-retirement benefits, workers compensation, warranty obligations, pre-owned aircraft inventory, and contingencies and litigation. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. There were no significant changes in the companys critical accounting policies during the second quarter of 2005.
New Accounting Standards
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123(R)). SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair value. SFAS 123(R) is effective in the first quarter of 2006. The company is analyzing the expected impact of adoption of this Statement and, based on available information, currently expects the adoption of SFAS 123(R) to reduce its net earnings by approximately $35 in 2006.
In March 2005, the FASB issued Interpretation No. (FIN) 47, Accounting for Conditional Asset Retirement Obligations an Interpretation of FASB Statement No. 143. FIN 47 clarifies the definition of a conditional asset retirement obligation, as used in SFAS No. 143, as a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 requires a liability to be recorded if the fair value of the obligation can be reasonably estimated. The Interpretation is effective no later than December 31, 2005. The company is currently analyzing the expected impact of adoption of this Interpretation on it financial statements.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 requires retrospective application to prior period financial statements of a voluntary change in accounting principle and is effective in the first quarter of 2006. The company does not expect the adoption of SFAS 154 to have a material effect on its results of operations, financial condition or cash flows.
GENERAL DYNAMICS CORPORATION
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
July 3, 2005
There were no material changes with respect to this item from the disclosure included in the companys Annual Report on Form 10-K for the year ended December 31, 2004.
ITEM 4. CONTROLS AND PROCEDURES
The companys management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the companys disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of July 3, 2005. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of July 3, 2005, the companys disclosure controls and procedures were effective.
There were no changes in the companys internal controls over financial reporting that occurred during the quarter ended July 3, 2005, that have materially affected, or are reasonably likely to materially affect, the companys internal controls over financial reporting.
This quarterly report on Form 10-Q contains forward-looking statements that are based on managements expectations, estimates, projections and assumptions. Words such as expects, anticipates, plans, believes, scheduled, estimates and variations of these words and similar expressions are intended to identify forward-looking statements, which include but are not limited to projections of revenues, earnings, segment performance, cash flows, contract awards, aircraft production, deliveries and backlog stability. Forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. These statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Therefore, actual future results and trends may differ materially from what is forecast in forward-looking statements due to a variety of factors, including, without limitation:
All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the company or any person acting on the companys behalf are qualified by the cautionary statements in this section. The company does not undertake any obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.
GENERAL DYNAMICS CORPORATION
PART II - OTHER INFORMATION
July 3, 2005
ITEM 1. LEGAL PROCEEDINGS
For information relating to legal proceedings, see Note L to the unaudited Consolidated Financial Statements contained in Part I, Item 1 of this quarterly report on Form 10-Q.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(c) The following table provides information about purchases made during the quarter ended July 3, 2005, of equity securities that are registered pursuant to Section 12 of the Exchange Act:
Issuer Purchases of Equity Securities