General Dynamics Corporation — Q3 2009 Form 10-Q
Reporting period: Three and nine months ended October 4, 2009; comparative periods ended September 28, 2008. Financial statements are unaudited. Dollar amounts are in millions unless otherwise noted.
Business context
General Dynamics operates in Aerospace, Combat Systems, Marine Systems, and Information Systems and Technology, serving defense, government, and business-aviation markets. Most revenue is derived from U.S. military contracts. The quarter included acquisitions in Information Systems and Technology, while business aviation continued to face a weak market.
Key financial results
| Metric | Q3 2009 | Q3 2008 | Nine months 2009 | Nine months 2008 |
|---|---|---|---|---|
| Revenue | $7,719 | $7,140 | $24,083 | $21,448 |
| Operating earnings | $874 | $933 | $2,724 | $2,715 |
| Operating margin | 11.3% | 13.1% | 11.3% | 12.7% |
| Continuing-operations earnings | $575 | $634 | $1,789 | $1,848 |
| Net earnings | $572 | $634 | $1,780 | $1,847 |
| Diluted EPS | $1.47 | $1.59 | $4.60 | $4.60 |
Quarterly revenue rose 8.1%, but operating earnings fell 6.3% and operating margin contracted 180 basis points. For the first nine months, revenue rose 12.3%, operating earnings were nearly flat, and margin declined 140 basis points. Higher net interest expense was a significant earnings headwind: $40 in Q3 versus $11, and $117 year to date versus $42.
Operating cash flow from continuing operations was $1,357 for the first nine months, down from $2,319; free cash flow from operations, as defined by the company, was $1,106 versus $2,005. The filing attributes the lower operating cash flow in part to reduced customer deposits, compared with a substantial deposit build in 2008, and a $250 pension contribution in Q3. Cash and equivalents ended at $1,409, compared with $1,621 at year-end 2008. Total debt was $3,864; management reported net debt of $2.4 billion, slightly above $2.3 billion at year-end.
Current assets were $12,228 and current liabilities $9,827 at October 4. The company had no commercial paper outstanding and reported approximately $1.8 billion of undrawn bank credit facilities; it was in compliance with material debt covenants. The current ratio is approximately 1.24, based on reported balances.
Material changes and segment trends
- Aerospace: Q3 revenue fell 18.4% and operating earnings fell 55.5%; year-to-date revenue was nearly unchanged while earnings declined 28.7%. Gulfstream deliveries and aircraft-services activity weakened amid the economic downturn. Pre-owned aircraft pricing fell, and the group wrote down inventory.
- Combat Systems: Q3 revenue increased 26.9% and earnings 20.6%; nine-month revenue rose 22.1% and earnings 11.5%. Growth reflected U.S. and European vehicle programs, weapons systems, and the AxleTech acquisition. Margins eased from unusually high 2008 levels.
- Marine Systems: Q3 revenue rose 8.1% and earnings 10.7%; nine-month revenue rose 15.2% and earnings 24.9%. Management cited greater shipbuilding and repair activity and improved shipyard performance.
- Information Systems and Technology: Q3 revenue rose 8.8% and earnings 9.6%; nine-month revenue rose 9.3% and earnings 5.7%. Acquisitions and organic growth contributed; year-to-date margins were lower due partly to contract mix.
The company spent $805 on two acquisitions during the first nine months, including Axsys Technologies and a classified-customer business. Goodwill increased to $12,410 from $11,413 at year-end 2008. Some acquisition purchase-price allocations remained preliminary.
Total backlog was $66.2 billion, up 10% from a year earlier but down 2% from Q2; funded backlog was $46.8 billion, also down 2% sequentially. Estimated potential contract value outside reported backlog was $18.2 billion. Defense businesses received more than $6 billion of new awards in the quarter.
Outlook, commentary, and risks
- Management expected 2009 Aerospace revenue to decline approximately 4%, with operating margin of 13.2%–13.4%; Combat Systems revenue growth of approximately 21%, with margin of 12.5%–12.7%; Marine Systems revenue growth of approximately 15%, with margin around 10%; and Information Systems and Technology revenue growth of 8%–9%, with margin of 10.4%–10.5%.
- Management expected full-year G&A expense at approximately 6% of sales, net interest expense of approximately $160, and an effective tax rate of approximately 31.5%. Capital expenditures were expected to be less than 2% of revenue. The filing does not provide a clear consolidated full-year revenue or EPS forecast.
- Business-jet demand, aircraft pricing, customer defaults, and production requirements remained uncertain. The company said it would adjust production as market and backlog conditions warranted. Risks also include defense-budget changes, fixed-price contract execution and cost estimates, contract funding, supplier performance, commodity and labor costs, and legal or regulatory outcomes.
- A-12 litigation: The company sought rehearing after an appeals-court panel affirmed the government’s default termination. If the default is ultimately sustained, the filing estimates a company pretax liability of approximately $1.4 billion, an after-tax charge of approximately $795 ($2.05 per share), and after-tax cash cost of approximately $710. Management disputed the termination and said it believed resources would be sufficient if payment were required.
- Other legal, environmental, government-contract, and guarantee matters were not expected by management to have a material effect. Letters of credit and similar arrangements totaled approximately $2.0 billion. The filing also disclosed aircraft trade-in commitments, including two unexercised minimum-price options totaling $48.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. The filing states that interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Whether operating margins and cash generation stabilize, particularly as Aerospace demand and pre-owned aircraft values evolve.
- Whether funded backlog converts to revenue and whether defense awards receive expected appropriations and funding.
- Acquisition integration, final purchase-price allocations, and the effect of acquired businesses on margins, amortization, and goodwill.
- Developments in the A-12 appeal and the potential liability, charge, and cash exposure described in the filing.
- Working-capital trends, including customer advances and deposits, and the company’s ability to maintain liquidity while funding pension contributions, dividends, acquisitions, and debt maturities.