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COL > SEC Filings for COL > Form 10-K on 13-Nov-2012All Recent SEC Filings

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Form 10-K for ROCKWELL COLLINS INC


13-Nov-2012

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto in Item 8 below. The following discussion and analysis contains forward-looking statements and estimates that involve risks and uncertainties. Actual results could differ materially from these estimates. Factors that could cause or contribute to differences from estimates include those discussed under "Cautionary Statement" and "Risk Factors" contained in Item 1A above.

We operate on a 52/53 week fiscal year ending on the Friday closest to September 30. For ease of presentation, September 30 is utilized consistently throughout Management's Discussion and Analysis of Financial Condition and Results of Operations to represent the fiscal year end date. 2012, 2011 and 2010 were all 52 week fiscal years. All date references contained herein relate to our fiscal year unless otherwise stated.

As discussed in Note 4 of the Notes to Consolidated Financial Statements, the Rollmet product line, formerly included within the Commercial Systems segment, has been accounted for as a discontinued operation for all periods presented and therefore certain prior period amounts have been reclassified to conform to the current year presentation. Unless otherwise noted, disclosures pertain to our continuing operations.

OVERVIEW AND OUTLOOK

We have a diversified and balanced business, serving both government and commercial markets. Both of these businesses faced challenges during 2012. In Government Systems, a downturn in U.S. defense spending contributed to the eight percent reduction in sales. In Commercial Systems, we experienced strong growth in the air transport market, while sales to the business aviation market were impacted by the bankruptcy of one of our business jet manufacturing customers. The seven percent increase in Commercial Systems revenues during 2012 was not enough to offset the reduction in our defense business, as total Company sales declined two percent for the year. Despite the revenue decline, earnings per share from continuing operations increased five percent and both businesses improved segment operating margins over 2011, with Commercial Systems posting a 150 basis point increase from the prior year and Government Systems posting a 90 basis point increase from the prior year.

As part of our continued response to these challenges we recorded a restructuring charge to reduce our cost structure and position us for improved performance in 2013 and beyond. We also exercised the flexibility of our balance sheet during 2012 and issued $250 million of 3.10 percent fixed rate debt. We used the proceeds from this debt, supplemented by available cash on hand, to repurchase approximately 13 million shares of common stock during the year, reducing our outstanding share count by 7 percent from 2011. In addition, in April 2012 our Board of Directors approved a 25 percent increase to our quarterly cash dividend paid on common stock, raising the amount to $0.30 per share.

We generated the following results for 2012:

sales of $4.73 billion

diluted earnings per share from continuing operations of $4.15

operating cash flow of $534 million

capital expenditures of $138 million

Looking forward to 2013, we anticipate the following:

total sales in the range of $4.6 billion to $4.7 billion

diluted earnings per share from continuing operations in the range of $4.30 to $4.50

cash provided by operating activities in the range of $500 million to $600 million

capital expenditures of about $140 million


Our Company remains financially strong and looking out over the next three to five years, we believe we are well positioned to take advantage of improved market conditions when they arrive. In Government Systems, we expect U.S. military budgets to eventually stabilize and we continue to enhance our international strategies and adjust our infrastructure when necessary. In Commercial Systems, we have key positions on several air transport platforms with Boeing and Airbus and expect to benefit from strong order backlogs for these aircraft. In the business and regional jet market, we have expanded our market share over the past several years, winning positions on a variety of aircraft with customers around the globe, including Bombardier, Embraer and Gulfstream.

We believe our Company has a proven ability both to react quickly to changing business conditions and to execute its business plans. Our fundamental strategies continue to serve us well: the balance between our commercial and government businesses; the diversification of our customer base and product offerings; our focus on innovation through R&D; and the integration of our business through our shared service operating model.

Balance-We feel our business is characterized by its balance, in terms of market segment, geographic regions and product and customer sales mix. We strive to maintain a balance between our Government and Commercial Systems businesses, believing that the segments are complementary to one another. Over the past three years, we have restored some of the balance between our business segments, as about 55 percent of our sales were attributable to the Government Systems business in 2012, compared to 62 percent in 2010. Looking forward to 2013, we expect this trend to continue as we anticipate Commercial Systems to account for nearly half of our revenues.

Diversification-Our business derives its revenue streams from a large number of customers, products, solutions, geographic regions and markets. Our Government Systems business executes against numerous programs every year for a variety of customers, including the U.S. Department of Defense, state and local governments, other government agencies, civil agencies, defense contractors and foreign ministries of defense. Our Commercial Systems business serves customers ranging from the world's largest aircraft manufacturers and airlines to individual aircraft owners within the general aviation marketplace. This diversification of revenue sources enables us to pursue numerous growth opportunities as business conditions vary across our portfolios.

Innovation-A well-funded and comprehensive R&D program is a foundational aspect of our Company. Our focus on developing unique solutions to address our customers' needs is evidenced by the large investment we dedicate towards R&D programs. This investment in R&D has allowed us to develop new systems, products and software solutions for our customers which will continue to be the growth engine for our Company.

Integration-We have a highly integrated business reliant upon a shared service operating platform. Under our shared service operating model, certain functions and processes are utilized for the benefit of the entire organization. The integrated nature of our business also allows us to leverage product and service capabilities across our segments in a manner we believe is unique in our industry. This integration is evidenced by our product and technology centers of excellence in areas such as displays, communication, navigation and surveillance, through which we apply our core competencies to solutions in both Government and Commercial Systems. Our cost structure includes substantial investments in company-funded R&D expense, leased facility and equipment costs and other non-variable items such as depreciation and amortization of intangible assets. By applying common tools and systems across our businesses, we can better manage our fixed cost structure and maximize our R&D investments as technological advancements developed by one side of our business may be shared with the other.

One of the key metrics that we often use to describe changes in operating income for each segment is the incremental (or reduced) earnings derived from higher (or lower) sales volumes. Similarly, the variable gross margin derived from these incremental (or reduced) earnings is often used to describe changes in operating margins (computed as segment operating earnings as a percent of segment sales). By leveraging the fixed costs present in our shared service operating model, we typically can deliver higher earnings on incremental sales volumes as variable gross margins for our core products and services in Commercial Systems tend to be approximately 40 to 50 percent. Variable gross margins in our Government Systems business can often approximate those realized in Commercial Systems, as a significant portion of Government Systems revenues are derived from firm-fixed price contracts with commercial terms. The variable gross margin realized by Government Systems on cost-reimbursable contracts and early stage development programs, however, tends to be lower. We calculate our variable gross margin as segment sales less direct cost of sales, which includes direct materials, labor and applicable overhead allocations. Other components of cost of sales, such as company-funded R&D expense are excluded from variable gross margins. In this regard, variable gross margins are typically in excess of total segment operating margins, as total segment operating earnings contemplate all segment costs, including company-funded R&D expense and selling, general and administrative costs.


See the following sections for further discussion of 2012 and anticipated 2013 results of operations. For additional disclosure on segment operating earnings see Note 24 of the Notes to Consolidated Financial Statements in Item 8 below. Please also see our Risk Factors and Cautionary Statement in Item 1A of this Form 10-K.

RESULTS OF OPERATIONS

The following management discussion and analysis of results of operations is based on reported financial results for 2010 through 2012 and should be read in conjunction with our consolidated financial statements and the notes thereto in Item 8 below.

As discussed in Note 4 of the Notes to Consolidated Financial Statements, the Rollmet product line, formerly included within the Commercial Systems segment, has been accounted for as a discontinued operation for all periods presented and certain prior period amounts have been reclassified to conform to the current year presentation. Unless otherwise noted, disclosures pertain to our continuing operations.

Consolidated Financial Results

Sales
(in millions)                    2012        2011        2010
U.S.                          $ 3,169      $ 3,356     $ 3,284
Non-U.S.(1)                     1,557        1,450       1,347
Total                         $ 4,726      $ 4,806     $ 4,631
Percent increase (decrease)        (2 )%         4 %

(1) Sales are attributed to geographic region based on the location of our customers.

Sales for 2012 compared to 2011

Total sales decreased $80 million, or 2 percent, primarily due to a $222 million reduction in Government Systems sales, partially offset by a $142 million increase in Commercial Systems sales. Refer to a detailed discussion of sales by segment in 2012 and 2011 in the Government Systems and Commercial Systems Financial Results sections below.

Domestic sales decreased $187 million, or 6 percent, primarily due to lower sales to the U.S. Government resulting from the adverse market conditions described in the Government Systems sales section below, and a reduction in sales to a domestic business jet manufacturer, Hawker Beechcraft, who declared bankruptcy in 2012. This reduction was partially offset by higher sales to Boeing across various platforms and increased sales of aftermarket products and services to commercial airlines and other domestic customers, as discussed in the Commercial Systems sales section below.

Non-U.S. sales increased by $107 million, or 7 percent, as sales to non-U.S. aircraft manufacturers like Airbus and Bombardier increased and aftermarket revenues to commercial customers outside the U.S. were higher. This increase was partially offset by a reduction in Government Systems sales resulting from lower sales to foreign ministries of defense.

Sales for 2011 compared to 2010

Total sales increased $175 million, or 4 percent, primarily due to a $223 million increase in Commercial Systems sales partially offset by a $48 million reduction in Government Systems sales. Incremental sales from acquisitions, principally the December 2009 acquisition of AR Group, Inc. (Air Routing), contributed $15 million, or less than 1 percentage point of revenue growth. A more detailed discussion of sales by segment in 2011 and 2010 is found in the Government Systems and Commercial Systems Financial Results sections below.

Domestic sales increased $72 million, or 2 percent, primarily attributable to higher Commercial Systems sales to Boeing and increased sales of our aftermarket products and services to commercial airlines and other domestic customers, including incremental service sales from the Air Routing acquisition, partially offset by lower sales to the U.S. Government resulting from the adverse market conditions described in the Government Systems sales section below.


Non-U.S. sales increased by $103 million, or 8 percent, primarily due to the combined impact of higher Commercial Systems sales to non-U.S. business original equipment manufacturers (OEMs) such as Bombardier and increased aftermarket revenues to commercial customers outside the U.S.

Cost of Sales

(in millions)              2012        2011        2010
Total cost of sales      $ 3,324     $ 3,427     $ 3,353
Percent of total sales      70.3 %      71.3 %      72.4 %

Cost of sales consists of all costs incurred to design and manufacture our products and includes R&D, raw material, labor, facility, product warranty, depreciation, amortization and other related expenses.

Cost of sales for 2012 compared to 2011

Total cost of sales decreased $103 million, or 3 percent, primarily due to the following:

$44 million decrease in cost of sales resulting from the $80 million reduction in sales volume, as discussed in the Government Systems and Commercial Systems Financial Results sections below

$56 million reduction from lower employee incentive compensation costs

$35 million reduction in company-funded R&D expense, as explained below

above items were partially offset by

?            $12 million increase from higher restructuring and asset impairment
             charges recorded in 2012 as compared to 2011. For 2012, $38 million
             of restructuring and asset impairment charges were classified within
             cost of sales, compared to $26 million in 2011, as discussed in Note
             23 of the Notes to Consolidated Financial Statements



?            $20 million increase primarily attributable to the $11 million
             increase in warranty cost detailed in Note 19 of the Notes to
             Consolidated Financial Statements and higher retirement benefit
             expenses, as described in the Retirement Plans section below

The decrease in cost of sales as a percent of revenues was primarily attributable to the lower employee incentive compensation costs and reduction in company-funded R&D expense.

Cost of sales for 2011 compared to 2010

Total cost of sales increased $74 million, or 2 percent, primarily due to the following:

$59 million increase resulted from the $175 million of net sales growth discussed in the Commercial Systems and Government Systems Financial Results sections below

$27 million increase was attributable to higher employee incentive compensation expenses

$26 million increase resulted from the restructuring and asset impairment charges recorded in 2011 which were classified within cost of sales, as discussed in Note 23 of the Notes to Consolidated Financial Statements

above items were partially offset by a $31 million reduction to cost of sales attributable to lower defined benefit pension expense, as discussed in the Retirement Plans section below

The decrease in cost of sales as a percent of revenues was primarily due to a favorable change in sales mix resulting from higher Commercial Systems sales and lower Government Systems revenue.


Research and development expense

R&D expense is included as a component of cost of sales and is summarized as follows:

(in millions)                             2012      2011      2010
Customer-funded:
Government Systems                       $ 420     $ 460     $ 437
Commercial Systems                          83        90        79
Total customer-funded                      503       550       516
Company-funded:
Government Systems                          82       116       115
Commercial Systems                         238       239       230
Total company-funded                       320       355       345
Total research and development expense   $ 823     $ 905     $ 861
Percent of total sales                    17.4 %    18.8 %    18.6 %

We make significant investments in research and development to allow our customers to benefit from the latest technological advancements. Total research and development expense is comprised of both company-funded and customer-funded R&D expenditures. Customer-funded R&D expenditures are incurred pursuant to contractual arrangements and are typically accounted for as contract costs within cost of sales with the reimbursement accounted for as a sale in accordance with the percentage-of-completion method of accounting. Company-funded R&D expenditures relate to the development of new products and the improvement of existing products and are expensed as incurred, as disclosed in Note 14 of the Notes to the Consolidated Financial Statements. Company-funded R&D expense consists primarily of payroll-related expenses of employees engaged in R&D activities, engineering-related product materials and equipment and subcontracting costs.

In addition to the R&D expenditures shown in the table above, we defer the cost of certain pre-production engineering effort incurred during the development phase of programs when the customer has provided us a long-term supply arrangement and a contractual guarantee for reimbursement. Refer to the Research and Development section found in Item 1 and the Critical Accounting Policies section found in Item 7 below for further discussion of our incremental investments in pre-production engineering effort.

Total R&D expense decreased $82 million from 2011 to 2012. The customer-funded portion of R&D expense decreased $47 million from 2011 to 2012. Government Systems accounted for $40 million of this decrease, as certain development programs were terminated for convenience by the U.S. Government and spending on other programs slowed during a transition out of the development phase into production. The $35 million decrease in company-funded R&D was also driven by Government Systems and was attributable to the completion of development effort for networked communication, airborne communication and navigation products, as well as savings realized from our previously announced decision to cease further discretionary investments in the public safety vehicle product line.

Total R&D expense increased $44 million from 2010 to 2011. The customer-funded portion of R&D expense increased $34 million from 2010 to 2011, primarily due to a $23 million increase within Government Systems that was largely attributable to effort on new development programs such as the KC-46A Tanker, E-6 special mission aircraft and the Common Range Integrated Instrumentation System (CRIIS) programs. An additional $11 million increase resulted from Commercial Systems, driven by increased effort on various business and regional jet platforms. The $10 million increase in company-funded R&D was primarily within Commercial Systems and was largely driven by increased effort towards development of next generation avionics for business aircraft and incremental effort related to our content on the Boeing 747-8 aircraft.

Looking forward to 2013, total R&D expense is expected to be approximately $800 million. We expect a reduction in customer-funded R&D expense, primarily within Government Systems, and anticipate company-funded R&D expenditures to be relatively flat when compared to 2012. In addition, we expect a $210 million net increase in pre-production engineering costs during 2013. Refer to additional discussion of pre-production engineering costs in the Critical Accounting Policies section found in Item 7 below.


Selling, General and Administrative Expenses

(in millions)                                   2012      2011      2010
Selling, general and administrative expenses   $ 543     $ 533     $ 476
Percent of total sales                          11.5 %    11.1 %    10.3 %

Selling, general and administrative (SG&A) expenses consist primarily of personnel, facility and other expenses related to employees not directly engaged in manufacturing or R&D activities. These activities include marketing and business development, finance, legal, information technology and other administrative and management functions.

Total SG&A expenses increased $10 million, or 2 percent, in 2012 compared to 2011, primarily due to the following:

$29 million due to higher bad debt expense resulting from the customer bankruptcies described in Note 5 of the Notes to Consolidated Financial Statements

partially offset by a $19 million reduction from lower employee incentive compensation and other savings attributable to headcount reduction and restructuring actions

Total SG&A expenses increased $57 million, or 12 percent, in 2011 compared to 2010, primarily due to the following:

$29 million from higher employee incentive compensation costs and merit pay increases

$18 million increase resulting from the combined impact of pursuing international business opportunities (including the opening and staffing of new offices internationally), higher bid and proposal costs and an increase in other selling costs and activities

$3 million of incremental SG&A expense from acquisitions, primarily Air Routing

Interest Expense
(in millions)       2012     2011     2010
Interest expense   $  27    $  19    $  20

Interest expense increased by $8 million in 2012 compared to 2011, primarily due to additional interest expense associated with the $250 million of long-term debt issued in November of 2011. See Note 10 of the Notes to the Consolidated Financial Statements in Item 8 below for more detail regarding outstanding debt.

Other Income, Net
(in millions)        2012      2011      2010
Other income, net   $ (25 )   $ (28 )   $ (14 )

For additional information regarding the fluctuations in Other income, net, see Note 15 of the Notes to Consolidated Financial Statements in Item 8 below.

Income Tax Expense from Continuing Operations

(in millions)                2012      2011      2010
Income tax expense          $ 248     $ 240     $ 239
Effective income tax rate    28.9 %    28.1 %    30.0 %


The effective income tax rate differed from the U.S. statutory tax rate as detailed below:

                                    2012      2011      2010
Statutory tax rate                 35.0  %   35.0  %   35.0  %
State and local income taxes        1.3       1.1       0.8
Research and development credit    (1.7 )    (4.7 )    (1.2 )
Domestic manufacturing deduction   (2.1 )    (1.9 )    (1.1 )
Tax settlements                    (2.2 )    (0.4 )    (2.4 )
Other                              (1.4 )    (1.0 )    (1.1 )
Effective income tax rate          28.9  %   28.1  %   30.0  %

The difference between our effective income tax rate in 2012 and the statutory tax rate is primarily due to the benefit from the settlement of certain tax matters, the tax benefits derived from the Federal Research and Development Tax Credit (Federal R&D Tax Credit), which provides a tax benefit on certain incremental R&D expenditures, and the Domestic Manufacturing Deduction under
Section 199 (DMD), which provides a tax benefit on U.S.-based manufacturing.

The effective income tax rate in 2012 increased from 2011 primarily due to the differences in the availability of the Federal R&D Tax Credit which expired December 31, 2011. This increase was partially offset by the favorable impact in 2012 of the Internal Revenue Service (IRS) completing its examination of the taxable years ended September 30, 2008 and 2009.

The effective income tax rate in 2011 decreased from 2010 primarily due to the retroactive reinstatement of the Federal R&D Tax Credit which had previously expired on December 31, 2009. On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was enacted which reinstated and extended the Federal R&D Tax Credit from January 1, 2010 to December 31, 2011 and reduced our 2011 effective income tax rate by about 2 percent.

The effective income tax rates for 2012, 2011 and 2010 include a tax benefit related to the DMD. The DMD tax benefit available in 2010 was being phased in by statute and was therefore lower than the full DMD tax benefit which became effective beginning in fiscal year 2011.

Net Income and Diluted Earnings Per Share

(in millions, except per share amounts)                     2012       2011       2010
Income from continuing operations                         $  609     $  615     $  557
Percent of sales                                            12.9 %     12.8 %     12.0 %

Income from discontinued operations, net of taxes              -         19          4
Net income                                                $  609     $  634     $  561

Diluted earnings per share from continuing operations     $ 4.15     $ 3.94     $ 3.50
Diluted earnings per share from discontinued operations        -       0.12       0.02
Diluted earnings per share                                $ 4.15     $ 4.06     $ 3.52

Weighted average diluted common shares                     146.8      156.1      159.2

Net income for 2012 decreased 4 percent to $609 million from net income of $634 million for 2011. Diluted earnings per share increased 2 percent to $4.15 for 2012 compared to $4.06 for 2011. The rate of increase in diluted earnings per share benefited from the positive impact of our share repurchase program.

Net income and earnings per share for 2012 includes a $38 million charge, or $0.26 per share, attributable to the net restructuring and asset impairment charges described in Note 23 of the Notes to Consolidated Financial Statements. Net income and earnings per share for 2011 includes a $17 million gain ($0.11 per share) from the divestiture of the Rollmet product line and also includes an offsetting charge of $17 million ($0.11 per share) related to restructuring actions.

. . .

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