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| RTN > SEC Filings for RTN > Form 10-K on 25-Feb-2009 | All Recent SEC Filings |
25-Feb-2009
Annual Report
OVERVIEW
Introduction
Raytheon Company develops technologically advanced, integrated products, services and solutions in four core defense markets: Sensing; Effects; Command, Control, Communications and Intelligence (C3I) and Mission Support. We serve all branches of the U.S. military and numerous other U.S. Government agencies, the North Atlantic Treaty Organization (NATO) and many allied governments.
We operate in six business segments: Integrated Defense Systems (IDS), Intelligence and Information Systems (IIS), Missile Systems (MS), Network Centric Systems (NCS), Space and Airborne Systems (SAS) and Technical Services (TS). For a more detailed description of our segments, see "Business Segments" within Item 1 of this Form 10-K.
In this section, we discuss our industry and how certain factors may affect our business, key elements of our strategy, how our financial performance is assessed and measured by management, and other business considerations, including certain risks and challenges to our business. Next, we discuss our critical accounting estimates, which are those estimates that are most important to both the reporting of our financial condition and results of operations and require management's most difficult or subjective judgment. We then review our results of operations for 2008, 2007 and 2006 beginning with an overview of our total company results, followed by a more detailed review of those results by business segment. We also review our financial condition and liquidity including our capital structure and resources, off-balance sheet arrangements, commitments and contingencies, and conclude with a discussion of our exposure to various market risks.
Industry Considerations
Domestic Considerations
In 2008, U.S. Government sales accounted for approximately 87% of our sales, primarily through defense-related programs with the U.S. Department of Defense (DoD) (which accounted for approximately 83% of our sales). Accordingly, the DoD budget and priorities are critical considerations for our domestic business. DoD funding has grown substantially since 2001. The DoD base budget, which excludes emergency funding for operations in Afghanistan and Iraq, has grown from $300 billion in fiscal year (FY) 2001 to $512 billion in FY 2009, or 7% compounded annually. The FY 2009 budget is 7% or $32 billion higher than the FY 2008 level.
DoD modernization funding, which consists of procurement and research and development (R&D), is of particular importance to defense contractors. Modernization funding in the base budget has grown at an annual rate of 7% since FY 2001. The FY 2009 modernization level of $181 billion is 3% or $6 billion higher than the FY 2008 level. A major reason for this relatively consistent growth is the need to replace aging inventory of planes, ships, ground combat vehicles and other necessary warfighting equipment, often referred to by DoD officials as recapitalization.
The DoD Operations and Maintenance Account (O&M), which includes funding for training, services and other logistical support functions, is the other major account of importance to the defense industry. O&M in the DoD base budget has grown at an annual rate of 6% since FY 2001. The FY 2009 level of $179 billion is 9% or $15 billion higher than the FY 2008 level. The decision to increase active duty ground forces by 92,000 will likely increase O&M funding requirements in the near future.
Funding for the operations in Afghanistan and Iraq have largely occurred through emergency supplemental appropriations rather than in the base budget appropriations. These emergency supplemental appropriations have risen from $63 billion in FY 2003 to $183 billion for FY 2008, or 24% compounded annually. Congress has already appropriated $66 billion for FY 2009, and a second emergency FY 2009 supplemental appropriation is expected in the spring of 2009.
The share of funding devoted to the modernization accounts, primarily procurement, within these emergency supplemental appropriations has steadily grown. Of the $183 billion of FY 2008 emergency funding, $67 billion or 37% is
for modernization, which is 31% or $16 billion higher than the FY 2007 level. This growth is fueled by a greater need for force protection of the warfighter as well as the growing need to replace or extensively refurbish equipment which is wearing down due to operations in Afghanistan and Iraq.
Looking forward, based on the enacted levels of DoD funding for FY 2009, we expect continued robust levels of defense spending in the near-term. However, projected defense spending levels are uncertain and become increasingly difficult to predict for periods beyond the near-term due to numerous factors. We believe that the DoD budget and priorities will be affected by several factors, including the following:
- External threats to our national security, including potential security threats posed by terrorists, emerging nuclear states and other countries;
- Funding for on-going operations in Iraq and, to a lesser extent, Afghanistan, which will require funding above and beyond the DoD base budget for their duration;
- Future priorities of the new Administration which could result in significant changes in the DoD budget overall and various allocations within the budget; and
- The overall health of the U.S. and world economies and the state of governmental finances.
With respect to other U.S. Government agencies, the U.S. Department of Homeland Security (DHS) budget and priorities also are important considerations for our domestic business. DHS funding has grown rapidly since DHS was established in 2003. Appropriations for DHS have increased from $23 billion for FY 2003 to $40 billion for FY 2009, or 9% compounded annually. While there is less visibility into the future funding plans of DHS compared to the DoD, we expect continued robust funding levels for DHS in the near-term. We believe that the DHS budget will be affected by several factors, including some of the same factors that affect the DoD budget, such as the threat of terrorism, which is not expected to diminish greatly in the next several years, the overall health of the U.S. and world economies and the U.S. Government's finances, and the future priorities of the new Administration. In addition, DHS enjoys strong bipartisan support for robust levels of funding.
For more information on the risks and uncertainties that could impact the U.S. Government's demand for our products and services, see Item 1A "Risk Factors" of this Form 10-K.
International Considerations
In 2008, our sales to customers outside of the U.S. accounted for approximately 20% of our sales (including foreign military sales through the U.S. Government). Internationally, the growing threat of additional terrorist activity, emerging nuclear states and conventional military threats have led to an increase in demand for defense products and services and homeland security solutions. We currently anticipate that overall international defense budgets will grow slightly faster than domestic budgets. International customers are expected to also continue to adopt similar defense transformation initiatives as the DoD's initiatives. We believe that this trend will continue because many international customers are facing the same threat environment changes as the United States and they wish to assure that their forces and systems will be interoperable with U.S. and NATO forces. However, international demand is sensitive to changes in the priorities and budgets of international customers, which may be driven by changes in threat environments and potentially volatile worldwide economic conditions, regional and local economic and political factors, as well as U.S. foreign policy. For more information on the risks and uncertainties that could impact international demand for our products and services, see Item 1A "Risk Factors" of this Form 10-K.
Our Strategy and Opportunities
The following are the key elements of our strategy:
- Focus on key strategic pursuits, technology and mission assurance to protect and grow our position in our four core defense markets, Sensing, Effects, C3I and Mission Support.
- Leverage our domain knowledge in these core defense markets, as well as in Mission Systems Integration, Homeland Security, and Information Assurance/Information Operations.
- Expand our international business by broadening our regional focus and expanding our presence in core and adjacent markets, especially Border Security and Mission Support.
- Be a Customer-focused company based on performance, relationships, and solutions.
Our Markets
We believe that our technologies, domain knowledge and key capabilities and their alignment with customer needs in our core defense markets position us favorably to continue to grow and increase our market share. Our core markets also serve as a solid base from which to expand into adjacent and emerging markets, such as in Homeland Security and Information Assurance/Information Operations. We continually explore opportunities to use our existing capabilities or develop or acquire additional ones to expand into closely adjacent markets.
- Sensing-Sensing encompasses technologies that acquire precise situational data across air, space, ground and underwater domains and then generate the information needed for effective battlespace decisions. Our sensing technologies span the full electromagnetic spectrum, from traditional radio frequency (RF) and electro-optical (EF) to hyperspectral, acoustic and ultraviolet sensors. We are focused on leveraging our sensing technologies to provide a broad range of capabilities as well as expanding into adjacent markets such as sensors to detect Weapons of Mass Destruction.
- Effects-Effects technologies achieve specific military actions or outcomes, from striking targets or disabling hostile information systems to using directed energy in urban warfare. We are focused on moving beyond kinetic energy weapons to provide a broader range of systems that generate desired effects on an enemy, including using the missile as a node in the network, directed energy, lethal and non-lethal applications and information operations. Our Effects capabilities include advanced airframes, guidance and navigation systems, high-resolution sensors, targeting and netted systems.
- Command, Control, Communication and Intelligence (C3I)-C3I systems provide integrated real-time support to decision-makers on and off the battlefield, transforming raw data into actionable intelligence. We are seeking to continue to grow our market presence in C3I and also expand our knowledge management and discovery capabilities. Our C3I capabilities include situational awareness, persistent surveillance, communications, mission planning, battle management command and control, intelligence and analysis, and integrated ground solutions.
- Mission Support-We are focused on enabling customer success through total life-cycle support that predicts customer needs, senses potential problems and proactively responds with the most appropriate solutions. Our Mission Support capabilities include technical services, system engineering, logistics, training, operations and maintenance.
- Mission Systems Integration-We believe that our expanding Mission Systems Integration (MSI) role will be a key differentiator for us. MSI is the integration of multiple systems (e.g., sensors, C3I, effects) to deliver a solution designed to accomplish a specific mission for a customer. MSI requires a thorough understanding of the customer's mission, the systems being integrated and the concept of operations. Our customer focus, program execution and the ability of our businesses to effectively work together on broad and complex initiatives are important factors in our ability to continue to expand our MSI role.
- Homeland Security-We also intend to continue to grow our presence in the domestic and international homeland security markets, focusing on transportation security, critical infrastructure protection, energy security, intelligence program support, law enforcement solutions, and emergency preparedness and response.
- Information Assurance/Information Operations-In 2008, we established the Information Security Solutions product line within our IIS business segment. We also acquired two information security companies: SI Government Solutions and Telemus Solutions, Inc. Both provide information security solutions and services to the intelligence community and DoD.
International Growth
Because of the breadth of our offerings, our systems integration capability and our strong legacy in the international marketplace, we believe that we are well-positioned to continue to grow our international business. As discussed under "International Considerations," we believe that demand is growing for solutions in air and missile defense, homeland security including border surveillance, air traffic management, precision engagement, naval systems integration and
intelligence and surveillance and reconnaissance. In addition, as coalition forces increasingly integrate military operations worldwide, we believe that our leadership in network centric operations will continue to be a key discriminator.
In 2008, our international bookings grew to $7.6 billion from $6.7 billion in 2007. Notable international awards include:
- A significant order for the design, development and support of Patriot systems in the United Arab Emirates, as well as awards in Korea, Kuwait and Taiwan;
- Contract to provide Standard Missile-3s to Japan; and
- Follow-on orders for the e-Borders program in the UK and the Hobart Class Air Warfare Destroyer program in Australia.
Focus on the Customer and Execution
Our customer focus continues to be a critical part of our strategy-underpinned by a focus on performance, relationships and solutions. Performance means being able to meet customer commitments and is ensured through strong processes, metrics and oversight. We maintain a "process architecture" that spans our broad programs and pursuits. It consists of processes such as Integrated Product Development System (IPDS) which assures consistency of evaluation and execution at each step in a program's life-cycle. These processes are linked to an array of front-end and back-end metrics. With this structure, we are able to track results and be alerted to potential issues through numerous oversight mechanisms, including operating reviews and annual operating plan reviews.
We are also continuing to build strong customer relationships by listening to customers, working with them as partners and including them on Raytheon Six SigmaTM teams to jointly improve their programs and processes. We are increasingly focused on responding to our customers' changing requirements with rapid and effective solutions to real problems.
Other Business Considerations
We currently are involved in approximately 15,000 contracts. Our largest contract in 2008 was for the Zumwalt Class Destroyer program (DDG 1000), which accounted for less than 5% of total Net sales in 2008. We believe that our diverse portfolio of programs and capabilities is well suited to a changing defense environment. However, we face numerous challenges and risks, as discussed below and under Item 1A "Risk Factors" of this Form 10-K.
We remain dependent on the U.S. Government for a substantial portion of our business. Sales to the U.S. Government may be affected by changes in procurement policies, budget/economic considerations, changing defense requirements and political developments such as changes in Congress and the Administration. The influence of these factors, which are largely beyond our control, could impact our financial position and results of operations. In addition, we operate in highly competitive markets. These markets are becoming increasingly more concentrated in response to the trend of certain customers awarding a smaller number of large multi-service contracts. Additionally, the DoD and international customers are increasingly turning to commercial contractors for IT and other support work.
Our future success is dependent on our ability to execute our business strategies. First, we must continue to perform on existing programs, as past performance is an important selection criteria for new competitive awards. Second, we must successfully execute our growth strategies, as discussed above. In order to execute, we must be able to identify the most appropriate opportunities to leverage our capabilities and technologies, as well as emerging customer trends in these markets. We then must successfully develop, market and support new offerings and technologies for those markets which will require the investment of significant financial resources and substantial management attention.
We also focus on significant changes in our estimates of contract sales, costs and profits, to assess program performance and the potential impact of such changes on our results of operations. As discussed in greater detail in "Critical Accounting Estimates", our method of accounting for our contracts requires that we estimate contract revenues and costs. Due to the size, length of time and nature of the work required to be performed on many of our contracts, our estimates are complicated and subject to many variables. We review our contract estimates periodically to assess whether revisions are warranted and make revisions and adjustments to our estimates in the ordinary course. Changes in estimates of contract sales, costs and profits are recognized using a cumulative catch-up, which recognizes in the current period the cumulative effect of the changes on current and prior periods. A significant change in one or more of these estimates could affect the profitability of one or more of our contracts. In addition, given our number of contracts and
our accounting methods, we may recognize changes in multiple contracts in a fiscal quarter that, individually, may be significant, but that result, on a net basis, in no impact on our results of operations. Alternatively, we may recognize changes in numerous contracts in a fiscal quarter that, individually, may be immaterial, but that result, collectively, in a significant change to our results of operations.
FINANCIAL SUMMARY
Management is focused on the following financial indicators:
- Bookings-a forward-looking metric that measures the value of new contracts awarded to us during the year.
- Net Sales-a growth metric that measures our revenue for the current year.
- Operating Income-which measures our profit from continuing operations for the year, before interest and taxes.
- Free Cash Flow-a measure of the cash generated in a given year that we can use to make strategic investments to grow our business or return to our shareholders.
- Return on Invested Capital (ROIC)-a measure of the efficiency and effectiveness of our use of capital.
Considered in the aggregate, we believe these five metrics are strong indicators of our overall performance and our ability to create shareholder value. We feel these measures are balanced among long-term and short-term performance, growth and efficiency. We use these and other performance metrics for executive compensation purposes.
In addition, we maintain a strong focus on program execution and the prudent management of capital and investments in order to maximize operating income and cash and to continue to improve ROIC. We pursue a capital deployment strategy that balances funding for growing our business, including capital expenditures, acquisitions, and research and development; managing our balance sheet, including debt repayments and pension contributions; and returning cash to our stockholders, including dividend payments and share repurchases.
Bookings were $26.8 billion in 2008, $25.5 billion in 2007 and $22.4 billion in 2006, resulting in backlog of $38.9 billion, $36.6 billion and $33.8 billion at December 31, 2008, 2007 and 2006, respectively. Backlog represents future sales expected to be recognized over the contract period, which is generally the next several years. Depending upon the customer and its funding sources, our orders might be structured as annual follow-on contracts, or as one large multi-year order or long-term award. As a result, period-to-period comparisons of backlog are not necessarily indicative of future workloads.
Net sales were $23.2 billion in 2008, $21.3 billion in 2007 and $19.7 billion in 2006.
Operating income was $2.6 billion in 2008, $2.3 billion in 2007 and $1.9 billion in 2006. Operating margin, operating income as a percentage of net sales, was 11.2%, 10.9% and 9.9% in 2008, 2007 and 2006, respectively. Included in operating income was a FAS/CAS Pension Adjustment, described below in Critical Accounting Estimates, of $123 million, $259 million and $362 million of expense in 2008, 2007 and 2006, respectively.
Operating cash flow from continuing operations was $2.0 billion in 2008, $1.2 billion in 2007 and $2.5 billion in 2006.
A discussion of our results follows below in Consolidated Results of Operations; Segment Results; Financial Condition and Liquidity; and Capital Resources.
CRITICAL ACCOUNTING ESTIMATES
Our consolidated financial statements are based on the application of accounting principles generally accepted in the United States of America (GAAP), which require us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our consolidated financial statements. We believe the estimates set forth below may involve a higher degree of judgment and complexity in their application than our other accounting estimates and represent the critical accounting estimates used in the preparation of our consolidated financial statements. We believe our judgments related to these accounting estimates are appropriate.
However, if different assumptions or conditions were to prevail, the results could be materially different from the amounts recorded.
Revenue Recognition
We determine the appropriate method by which we recognize revenue by analyzing the type, terms and conditions of each contract or arrangement entered into with our customers. The significant estimates we consider in recognizing revenue for the types of revenue-generating activities in which we are involved are described below. We classify contract revenues as product or service according to the predominant attributes of the relevant underlying contracts unless the contract can clearly be split between product and service. We define service revenue as revenue from activities which are not associated with the design, development or production of tangible assets, and the delivery of software code or a specific capability. Service revenue represented less than 10% of our total revenues in 2008, 2007 and 2006.
Percentage of Completion Accounting-We account for our contracts associated with the design, development, manufacture, or modification of complex aerospace or electronic equipment and related services, or those otherwise within the scope of Chapter 11 of Accounting Research Bulletin No. 43, Government Contracts (ARB No. 43) or Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1), such as certain cost-plus service contracts, using the percentage-of-completion accounting method. Under this method, revenue is recognized based on the extent of progress towards completion of the long-term contract. The selection of the method by which to measure such progress towards completion requires judgment and is based on the nature of the products or services to be provided. Our analysis of these contracts also contemplates whether contracts should be combined or segmented. The combination of two or more contracts requires significant judgment in determining whether the intent of entering into the contracts was effectively to enter into a single project, which should be combined to reflect an overall profit rate. Additionally, judgment is involved in determining whether a single contract or group of contracts may be segmented based on how the contract was negotiated and the performance criteria. The decision to combine a group of contracts or segment a contract could change the amount of revenue and gross profit recorded in a given period had consideration not been given to these factors. We combine closely related contracts when all the applicable criteria under SOP 81-1 are met. Similarly, we may segment a project, which may consist of a single contract or a group of contracts, with varying rates of profitability, only if all the applicable criteria under SOP 81-1 are met.
We generally use the cost-to-cost measure of progress for all our long-term contracts unless we believe another method more clearly measures progress towards completion of the contract. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred-to-date to the total estimated costs at completion of the contract. Contract costs include material, labor and subcontracting costs, as well as an allocation of indirect costs. Revenues, including estimated earned fees or profits, are recorded as costs are incurred. Due to the nature of the work required to be performed on many of our contracts, the estimation of total revenue and cost at completion is complex and subject to many variables. Management must make various assumptions and estimates related to contract deliverables including design requirements, performance of subcontractors, cost and availability of materials, productivity and manufacturing efficiency and labor availability. Incentive and award fees are generally awarded at the discretion of the customer or upon achievement of certain program milestones or cost targets. Incentive and award fees, as well as penalties related to contract performance, are considered in estimating profit rates. Estimates of award fees are based on actual awards and anticipated performance which may include the performance of subcontractor or partners depending upon the individual contract requirements. Incentive provisions that increase or decrease earnings based solely on a single significant event are generally not recognized until the event occurs. Such incentives and penalties are recorded when there is sufficient information for us to assess anticipated performance. Our claims on contracts are recorded only if it is probable the claim will result in additional contract revenue and the amounts can be reliably estimated.
We have a standard quarterly process in which management reviews the progress and performance of our significant contracts. As part of this process, management reviews include, but are not limited to, any outstanding key contract matters, progress towards completion and the related program schedule, identified risks and opportunities, and the related changes in estimates of revenues and costs. Based on this analysis, any adjustments to sales, costs of sales and profit are recorded as necessary in the period they become known. Changes in estimates of contract sales, costs of sales
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