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GD > SEC Filings for GD > Form 10-K on 7-Feb-2014All Recent SEC Filings

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Form 10-K for GENERAL DYNAMICS CORP


7-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For an overview of our business groups, including a discussion of products and services provided, see the Business discussion contained in Item 1.

BUSINESS ENVIRONMENT
More than 60 percent of our revenues are from the U.S. government. Accordingly, our financial performance is impacted by U.S. government spending levels, particularly defense spending. Over the past several years, U.S. defense spending has been reduced, due in part to the country's fiscal shortfall. To address this shortfall, the Budget Control Act of 2011 (BCA) mandated a $487 billion, or 8 percent, reduction to previously-planned defense funding over 10 years. The BCA also included a mechanism, referred to as the sequester, that can impose additional defense cuts of up to $500 billion, or 9 percent, over nine years starting in fiscal year (FY) 2013.
The Bipartisan Budget Act of 2013 (BBA) prescribed defense top-line funding for FY 2014 and 2015 at levels generally consistent with FY 2013, reducing budget uncertainties and providing near-term stability. The BBA also included sequester reductions of approximately $30 billion in FY 2014 and $43 billion in FY 2015, less than the amounts imposed by the BCA.
In adherence to the BBA, Congress appropriated $497 billion in FY 2014 for the Department of Defense (DoD), including approximately $156 billion for procurement and research and development (R&D) budgets, also known as investment accounts, relatively consistent with FY 2013. These investment accounts are the source of the majority of our U.S. government revenues.
The long-term outlook for our U.S. defense business is buoyed by the relevance of our programs to the U.S. military's funding priorities, the diversity of our programs and customers, our insight into customer requirements stemming from our incumbency on core programs, our ability to evolve our products to address a fast-changing threat environment and our proven track record of successful contract execution.
We continue to pursue opportunities outside the U.S. presented by demand for military equipment and information technologies from our international operations and through exports from our North American businesses. While the revenue potential can be significant, our work for these customers is subject to changing budget priorities and overall spending pressures, as well as timing of contract awards.
In our Aerospace group, business-jet market conditions were strong in 2013. The group benefited from improved order interest across the group's range of customers and lower customer contract defaults. We expect our continued investment in new aircraft products to support Aerospace's long-term growth. Similarly, we believe aircraft-service revenues provide the group diversified exposure to aftermarket sales fueled by the global installed business-jet fleet.


RESULTS OF OPERATIONS
INTRODUCTION
An understanding of our accounting practices is important to evaluate our operating results. We recognize the majority of our revenues using the percentage-of-completion method of accounting. The following paragraphs explain how this method is applied in recognizing revenues and operating costs in our Aerospace and defense groups.
In the Aerospace group, contracts for new aircraft have two major phases: the manufacture of the "green" aircraft and the aircraft's outfitting, which includes exterior painting and installation of customer-selected interiors. We record revenues on these contracts at the completion of these two phases: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the outfitted aircraft. Revenues in the Aerospace group's other original equipment manufacturers (OEMs) completions and services businesses are recognized as work progresses or upon delivery of services. Changes in revenues result from the number and mix of new aircraft deliveries (green and outfitted), progress on aircraft completions and the level of aircraft service activity during the period.
The majority of the Aerospace group's operating costs relates to new aircraft production for firm orders and consists of labor, material and overhead costs. The costs are accumulated in production lots and recognized as operating costs at green aircraft delivery based on the estimated average unit cost in a production lot. While changes in the estimated average unit cost for a production lot impact the level of operating costs, the amount of operating costs reported in a given period is based largely on the number and type of aircraft delivered. Operating costs in the Aerospace group's completions and services businesses are generally recognized as incurred.
For new aircraft, operating earnings and margins are a function of the prices of our aircraft, our operational efficiency in manufacturing and outfitting the aircraft, and the mix of aircraft deliveries between the higher-margin large-cabin and lower-margin mid-cabin aircraft. Additional factors affecting the group's earnings and margins include the volume, mix and profitability of completions and services work performed, the market for pre-owned aircraft, and the level of general and administrative (G&A) and net R&D costs incurred by the group.
In the defense groups, revenue on long-term government contracts is recognized as work progresses, either as products are produced or services are rendered. As a result, changes in revenues are discussed generally in terms of volume, typically measured by the level of activity on individual contracts or programs. Year-over-year variances attributed to volume are due to changes in production or service levels and delivery schedules.
Operating costs for the defense groups consist of labor, material, subcontractor, overhead and G&A costs and are recognized generally as incurred. Variances in costs recognized from period to period primarily reflect increases and decreases in production or activity levels on individual contracts and, therefore, result largely from the same factors that drive variances in revenues.
Operating earnings and margins in the defense groups are driven by changes in volume, performance or contract mix. Performance refers to changes in profitability based on revisions to estimates at completion on individual contracts. These revisions result from increases or decreases to the estimated value of the contract, the estimated costs to complete or both. Therefore, changes in costs incurred in the period compared with prior periods do not necessarily impact profitability. It is only when total estimated costs at completion on a given contract change without a corresponding change in the value of that contract that the profitability of that contract may be impacted. Contract mix refers to changes in the volume of higher- vs. lower-margin


work. Additionally, higher or lower margins can be inherent in the contract type (e.g., fixed-price/cost-reimbursable) or type of work (e.g., development/production).

CONSOLIDATED OVERVIEW
REVIEW OF 2012 VS. 2013
Year Ended December 31          2012         2013           Variance
Revenues                     $ 31,513     $ 31,218     $ (295 )    (0.9 )%
Operating costs and expenses   30,680       27,533      3,147      10.3  %
Operating earnings                833        3,685      2,852     342.4  %
Operating margins                 2.6 %       11.8 %

Our revenues were essentially flat in 2013 compared with 2012 despite a challenging business environment that included a 16-day partial U.S. government shutdown. We experienced lower volume in our Combat Systems business as a result of decreased U.S. Army spending and delays in international orders. This was largely offset by higher revenues in our Aerospace group from increased deliveries of G650 and G280 aircraft. Revenues increased slightly in our Marine Systems and Information Systems and Technology groups in 2013. Operating costs were lower in 2013 due to several discrete charges in 2012, most significantly a $2 billion goodwill impairment recorded in the Information Systems and Technology group. These charges are discussed below in conjunction with our business groups' operating results. Operating earnings and margins increased significantly in 2013 due to improved operating performance.

REVIEW OF 2011 VS. 2012
Year Ended December 31          2011         2012            Variance
Revenues                     $ 32,677     $ 31,513     $ (1,164 )    (3.6 )%
Operating costs and expenses   28,851       30,680       (1,829 )    (6.3 )%
Operating earnings              3,826          833       (2,993 )   (78.2 )%
Operating margins                11.7 %        2.6 %

Our revenues decreased in 2012 compared with 2011 due to lower volume in the Information Systems and Technology group's mobile communication systems business and on several European wheeled vehicle contracts in the Combat Systems group. These decreases were partially offset by higher revenues in the Aerospace group due to increased deliveries of G650 aircraft. Operating costs increased in 2012 due to the discrete charges referenced above, resulting in lower operating earnings and margins.


REVIEW OF BUSINESS GROUPS
Year Ended December 31                  2011                        2012                         2013
                              Revenues      Operating      Revenues      Operating     Revenues      Operating
                                             Earnings                     Earnings                    Earnings
Aerospace                    $   5,998     $      729     $   6,912     $     858     $   8,118     $     1,416
Combat Systems                   8,827          1,283         7,992           663         6,120             904
Marine Systems                   6,631            691         6,592           750         6,712             666
Information Systems and
Technology                      11,221          1,200        10,017        (1,369 )      10,268             795
Corporate                            -            (77 )           -           (69 )           -             (96 )
                             $  32,677     $    3,826     $  31,513     $     833     $  31,218     $     3,685

Following is a discussion of operating results and outlook for each of our business groups. For the Aerospace group, results are analyzed with respect to specific lines of products and services, consistent with how the group is managed. For the defense groups, the discussion is based on the types of products and services each group offers with a supplemental discussion of specific contracts and programs when significant to the group's results. Information regarding our business groups also can be found in Note Q to the Consolidated Financial Statements in Item 8.

AEROSPACE
Review of 2012 vs. 2013
Year Ended December 31                       2012        2013          Variance
Revenues                                   $ 6,912     $ 8,118     $ 1,206    17.4 %
Operating earnings                             858       1,416         558    65.0 %
Operating margins                             12.4 %      17.4 %

Gulfstream aircraft deliveries (in units):
Green                                            121         139        18    14.9 %
Outfitted                                         94         144        50    53.2 %

The increase in the Aerospace group's revenues in 2013 consisted of the following:

Aircraft manufacturing, outfitting and completions $ 1,061
Aircraft services                                       39
Pre-owned aircraft                                     106
Total increase                                     $ 1,206

Aircraft manufacturing, outfitting and completions revenues increased in 2013 primarily due to additional deliveries of G650 and G280 aircraft. Production rates for these aircraft have been ramping up since their initial green deliveries in 2011 and 2012, respectively. Pre-owned aircraft sales increased as we sold 11 aircraft in 2013 as compared to three in 2012. The group had one pre-owned aircraft available for sale on December 31, 2013. The increase in the group's operating earnings in 2013 consisted of the following:


Aircraft manufacturing, outfitting and completions $ 376
Aircraft services                                    222
Pre-owned aircraft                                    (9 )
G&A/other expenses                                   (31 )
Total increase                                     $ 558

Aircraft manufacturing, outfitting and completions earnings increased in 2013 primarily due to the increase in aircraft deliveries discussed above. In addition to improved performance, aircraft services earnings increased in 2013 primarily due to the impairment charge taken in 2012 discussed below. In the completions and maintenance businesses, Jet Aviation made positive contributions throughout 2013 following actions to reduce costs and improve operational processes.

Review of 2011 vs. 2012
Year Ended December 31                       2011        2012          Variance
Revenues                                   $ 5,998     $ 6,912     $ 914     15.2  %
Operating earnings                             729         858       129     17.7  %
Operating margins                             12.2 %      12.4 %
Gulfstream aircraft deliveries (in units):
  Green                                          107       121        14     13.1  %

Outfitted 99 94 (5 ) (5.1 )%

The Aerospace group's revenues and operating earnings increased in 2012 primarily due to increased green deliveries of G650 aircraft, which began in the fourth quarter of 2011. Losses in Jet Aviation's completions business in 2011 included a $111 impairment of the completions business intangible asset and $78 of project losses, while 2012 was negatively impacted by a $191 impairment of the maintenance business intangible assets. During 2011 and 2012, Jet Aviation's completions and maintenance businesses suffered from an increasingly competitive marketplace and performance issues.
2014 Outlook
With continued growth in deliveries of newer Gulfstream aircraft models, we expect an increase of approximately 11 percent in the group's revenues in 2014 compared with 2013. Operating margins are expected to be around 17 percent.

COMBAT SYSTEMS
Review of 2012 vs. 2013
Year Ended December 31   2012        2013            Variance
Revenues               $ 7,992     $ 6,120     $ (1,872 )   (23.4 )%
Operating earnings         663         904          241      36.3  %
Operating margins          8.3 %      14.8 %

The decrease in the Combat Systems group's revenues in 2013 consisted of the following:

U.S. military vehicles        $ (1,389 )
Weapons systems and munitions     (439 )
European military vehicles         (44 )
Total decrease                $ (1,872 )


In 2013, revenues were down as a result of decreased U.S. Army spending, in part due to sequestration and the government shutdown. This impacted U.S. military vehicle programs, including Stryker, Abrams and Mine-Resistant, Ambush-Protected (MRAP), and weapons systems and munitions, including axles, Hydra-70 rockets, guns and ammunition. In addition, revenues in the group's European military vehicles business were down slightly due to final vehicle deliveries in 2012 on Duro and Eagle wheeled vehicle contracts for the Swiss and German governments, respectively.
In response to decreased customer spending and to align our business with anticipated future demand, we implemented cost reduction initiatives in 2013 throughout the group. We reduced headcount by more than 25 percent in our U.S. and European military vehicles businesses. Additionally, we consolidated our weapons systems and munitions businesses. Our actions are intended to help us remain competitively positioned for the future while creating opportunities for margin improvement.
The Combat Systems group's operating earnings and margins increased in 2013 primarily due to the 2012 discrete charges in our European military vehicles business discussed below that reduced the group's operating margins approximately 530 basis points. Operating earnings and margins also increased 120 basis points in 2013 due to strong performance across our U.S. businesses and the favorable impact of cost savings associated with restructuring activities in our European military vehicles business. Review of 2011 vs. 2012

Year Ended December 31   2011        2012           Variance
Revenues               $ 8,827     $ 7,992     $ (835 )    (9.5 )%
Operating earnings       1,283         663       (620 )   (48.3 )%
Operating margins         14.5 %       8.3 %

The Combat Systems group's revenues decreased in 2012 compared with 2011 due to lower volume in the group's European military vehicles and weapons systems and munitions businesses. In the group's European military vehicles business, revenues were down in 2012 on contracts with various international customers that were nearing completion, including contracts for Piranha, Duro and Eagle vehicles. Volume was down across several U.S. armament and munitions programs in 2012 due to slowed defense spending, including vehicle armor, MK47 grenade launchers and Hydra-70 rockets. The sale of the detection systems business in the second quarter of 2011 also resulted in lower revenues in the weapons systems and munitions business in 2012.
The Combat Systems group's operating earnings and margins decreased significantly in 2012 due to the negative impact of three discrete charges in our European military vehicles business:
$292 for contract dispute accruals, primarily related to the termination of the contract to provide Pandur vehicles for Portugal ($169 of this amount was recorded as a reduction of revenues);

$98 of restructuring-related charges, primarily severance, for activities associated with eliminating excess capacity; and

$67 of out-of-period adjustments recorded in the first quarter of 2012 ($48 of this amount was recorded as a reduction of revenues).

2014 Outlook
We expect the Combat Systems group's revenues in 2014 to decrease 4 to 4.5 percent from 2013 with operating margins approximating 14 percent. Our outlook assumes approximately $1.2 billion in revenues from an international order expected in the first quarter of 2014.


MARINE SYSTEMS
Review of 2012 vs. 2013
Year Ended December 31   2012        2013           Variance
Revenues               $ 6,592     $ 6,712     $ 120       1.8  %
Operating earnings         750         666       (84 )   (11.2 )%
Operating margins         11.4 %       9.9 %

The increase in the Marine Systems group's revenues in 2013 consisted of the following:

Navy ship construction                           $ (150 )
Navy ship engineering, repair and other services    178
Commercial ship construction                         92
Total increase                                   $  120

The group's U.S. Navy ship-construction programs include Virginia-class submarines, DDG-1000 and DDG-51 destroyers, and Mobile Landing Platform (MLP) auxiliary support ships. The decrease in 2013 construction revenues is due to the completion of the T-AKE combat-logistics ship program in late 2012. Partially offsetting this decrease, revenues increased on the Virginia-class program, primarily due to long-lead material for the initial boats on the next block of submarines. Revenues were higher on engineering and repair programs for the Navy in 2013 due to increased submarine overhaul and repair work. Commercial ship construction revenues increased as work commenced on contracts for Jones Act ships secured in late 2012 and 2013.
Operating earnings and margins decreased in 2013 due to the completion of the mature, higher-margin T-AKE program in 2012. Excluding the impact of this program, operating margins improved in 2013. Review of 2011 vs. 2012

Year Ended December 31   2011        2012          Variance
Revenues               $ 6,631     $ 6,592     $ (39 )   (0.6 )%
Operating earnings         691         750        59      8.5  %
Operating margins         10.4 %      11.4 %

Revenues in the Marine Systems group decreased slightly in 2012 as lower Navy ship construction revenues were largely offset by higher revenues on engineering and repair programs for the Navy. Decreased Navy ship construction revenues on the Virginia-class and the T-AKE programs were partially offset by an increase on the MLP and DDG programs. Higher revenues on Navy engineering and repair programs were driven by the acquisition of two East Coast surface-ship repair operations and higher volume on the Ohio-class replacement engineering program. Despite the decline in revenues, the Marine Systems group's operating earnings increased in 2012. Increases in the T-AKE profit rate contributed $53 to the operating earnings growth, approximately 70 basis points of margin expansion, as the program continued to experience favorable cost performance through construction and delivery of the final ship.


2014 Outlook
We expect the Marine Systems group's 2014 revenues to increase 2.5 percent from
2013 with operating margins approximating 9.5 percent.
INFORMATION SYSTEMS AND TECHNOLOGY
Review of 2012 vs. 2013
Year Ended December 31       2012          2013          Variance
Revenues                  $ 10,017      $ 10,268     $  251      2.5 %

Operating earnings (loss) (1,369 ) 795 2,164 158.1 % Operating margins (13.7 )% 7.7 %

The increase in the Information Systems and Technology group's revenues in 2013 consisted of the following:

Mobile communication systems                                       $ 232
Information technology (IT) solutions and mission support services   189
Intelligence, surveillance and reconnaissance (ISR) systems         (170 )
Total increase                                                     $ 251

Revenues increased in 2013 in the mobile communication systems business due to higher volume on key programs that received significant production awards in late 2012 or 2013, including the Warfighter Information Network-Tactical (WIN-T), Handheld, Manpack and Small Form-Fit (HMS) and Common Hardware Systems-4 (CHS-4) programs. The IT services business added more than 8,000 employees throughout the year to meet commercial wireless customers' accelerated schedules for IT infrastructure services and to start work on a contract to provide contact-center services for the Centers for Medicare & Medicaid Services, resulting in increased revenues in 2013. Revenues decreased in 2013 across the ISR business driven by lower U.S. defense spending and a slower-than-expected transition to related follow-on work.
The Information Systems and Technology group's operating earnings and margins increased in 2013 due to several discrete charges taken in 2012 discussed below. Excluding these charges, operating margins decreased slightly in 2013 primarily due to growth in the lower-margin IT services business and performance challenges in the group's U.K. business. The U.K. business was consolidated into our North American mobile communication systems business in 2013. Review of 2011 vs. 2012

Year Ended December 31    2011         2012              Variance
Revenues               $ 11,221     $ 10,017      $ (1,204 )    (10.7 )%
Operating earnings        1,200       (1,369 )      (2,569 )   (214.1 )%
Operating margins          10.7 %      (13.7 )%

The Information Systems and Technology group's revenues were down in 2012 compared with 2011, driven primarily by lower revenues in the mobile communication systems business. Revenues in this business were impacted unfavorably by slowed defense spending and protracted U.S. customer acquisition cycles. This resulted in lower revenues in 2012 on key programs including WIN-T and CHS, and in encryption and ruggedized hardware products. In addition, more than 10 percent of the decline in the group's revenues


was due to lower volume on the U.K.-based Bowman communication system program, which was fielded successfully and moved into maintenance and long-term support. Operating earnings and margins decreased significantly in 2012 compared with 2011 driven by the negative impact of four discrete charges:
$2 billion goodwill impairment resulting from a decline in the estimated fair value of the group caused by topline pressure from slowed defense spending and the threat of sequestration, coupled with margin compression due to a shift in the group's contract mix impacting projected cash flows;

$110 of intangible asset impairments on several assets in our optical products business, most significantly the contract and program intangible asset, as a result of competitive losses and delays in 2012 indicative of lower overall demand caused by the economic downturn;

$58 write-down of substantially all of the remaining ruggedized hardware inventory based on anticipated remaining demand for products that ceased production in 2012; and

$26 for cost growth associated with the demonstration phase of the U.K. Specialist Vehicle (SV) program.

2014 Outlook
We expect 2014 revenues in the Information Systems and Technology group to decrease nearly 20 percent from 2013, largely due to award delays and slowed defense spending on major production programs in the mobile communication systems business. Operating margins are expected to be in the low-8 percent range.

CORPORATE
Corporate results consist primarily of compensation expense for stock options.
Corporate operating costs totaled $77 in 2011, $69 in 2012 and $96 in 2013. We
expect 2014 Corporate operating costs of approximately $85.
OTHER INFORMATION
PRODUCT AND SERVICE REVENUES AND OPERATING COSTS
Review of 2012 vs. 2013
Year Ended December 31   2012        2013           Variance
Revenues:
Products               $ 19,784    $ 19,371    $ (413 )   (2.1 )%
Services                 11,729      11,847       118      1.0  %

Operating Costs:
Products               $ 16,228    $ 15,296    $ (932 )   (5.7 )%
Services                 10,182      10,158       (24 )   (0.2 )%

The decrease in product revenues in 2013 consisted of the following:

. . .

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