General Dynamics Corporation — Q1 2012 Form 10-Q
Reporting period: Three months ended April 1, 2012; comparative period ended April 3, 2011. Unless otherwise noted, amounts are in millions of dollars. General Dynamics operates in Aerospace, Combat Systems, Marine Systems, and Information Systems and Technology, serving defense and business aviation markets.
Financial performance
| Metric | Q1 2012 | Q1 2011 | Change |
|---|---|---|---|
| Revenue | $7,579 | $7,798 | Down $219 (2.8%) |
| Operating earnings | $860 | $929 | Down $69 (7.4%) |
| Operating margin | 11.3% | 11.9% | Down 0.6 percentage points |
| Earnings before income taxes | $821 | $896 | Down $75 |
| Net earnings | $564 | $618 | Down $54 (8.7%) |
| Diluted EPS | $1.57 | $1.64 | Down $0.07 |
| Net cash from operating activities | $414 | $328 | Up $86 |
| Free cash flow from operations | $324 | $267 | Up $57 |
Product revenue fell 6.8% to $4,718, while service revenue rose 4.5% to $2,861. Management attributed the overall revenue and earnings decline mainly to lower tactical communications volume and a shift toward lower-margin IT services. Higher G650 deliveries partly offset the declines.
Segment results: Aerospace revenue was $1,623 and operating earnings $271 (margin 16.7%); Combat Systems $1,911 and $203 (10.6%); Marine Systems $1,605 and $185 (11.5%); Information Systems and Technology $2,440 and $218 (8.9%). The prior-year figures were, respectively, $1,353/$230, $1,955/$277, $1,676/$167, and $2,814/$276.
Balance sheet, liquidity and capital allocation
- At April 1, cash and equivalents were $2,632, total assets $35,309, and shareholders’ equity $13,854.
- Total debt was $3,908, including $3,905 of long-term debt; no commercial paper was outstanding. Net debt, as defined by management (debt less cash and equivalents and marketable securities), was $900, down from $1,000 at year-end 2011.
- Current assets were $15,510 and current liabilities $10,953. The company had $2 billion of bank credit facilities available as backup liquidity and reported compliance with material debt covenants.
- Operating cash flow increased to $414; capital expenditures were $90, producing management-defined free cash flow of $324. Management said working-capital movements largely reflected payment timing and were expected to largely reverse by year-end.
- Cash dividends paid were $169; the quarterly dividend was increased to $0.51 per share. The company repurchased 1.4 million shares at an average $72 per share and had approximately 8.6 million shares remaining under its authorization.
Material changes and management outlook
- Revenue declined 2.8% and operating margin contracted. Information Systems and Technology revenue fell 13.3%, primarily from tactical communications award delays and lower product sales; its margin fell to 8.9% from 9.8%.
- Aerospace revenue rose 20.0%, primarily on G650 deliveries. Management expected 2012 Aerospace revenue to increase approximately 15%, with margins in the mid-15% range.
- Combat Systems revenue declined 2.3% and earnings declined 26.7%, including the effect of $67 in prior-period adjustments. Management expected 2012 revenue of approximately $8.5 billion and a full-year margin in the high-13% range.
- Marine Systems revenue declined 4.2%, but earnings increased 10.8%, supported by favorable cost performance on the T-AKE program. Management expected 2012 revenue to decrease slightly and margins to be in the high-10% range.
- Management expected 2012 Information Systems and Technology revenue to decline approximately 5% and margins to be in the mid-9% range. Expected corporate operating costs were approximately $70 for 2012.
- Management forecast 2012 net interest expense of $155–$160 and an effective tax rate of approximately 32%, partly reflecting the R&D tax credit’s expiration absent congressional extension. Expected 2012 capital expenditures were approximately 2% of revenue.
- Total backlog was $55.2 billion at quarter-end, down from $57.4 billion at year-end 2011; estimated potential contract value was $26.9 billion, down from $28.0 billion. Management cited the U.S. Budget Control Act’s planned $487 billion defense reductions and possible additional sequestration cuts as uncertainties, with program-level effects not yet predictable.
Risks, contingencies and unusual items
- Prior-period adjustments: The company recorded $67 of first-quarter adjustments, reducing pretax earnings, after identifying improperly recorded contract receivables and inventory relief at a European subsidiary. Management concluded the effects on prior and current periods were not material. Separately, contract-estimate revisions increased operating earnings by $68 in Q1 2012, versus $90 in Q1 2011.
- A-12 litigation: The company and Boeing could face a joint-and-several government claim tied to approximately $1.6 billion of progress payments and interest. General Dynamics estimated its potential pretax share at approximately $1.5 billion, an after-tax charge of about $830 million ($2.31 per share) and after-tax cash cost of about $735 million. No accrual was recorded; the company said it expects a favorable outcome and believes it has resources to pay if required.
- Portugal contract: The company said restructuring of its Pandur vehicle contract was likely amid Portugal’s economic conditions. The outcome and timing were uncertain; $125 million related to the contract was included in contracts in process.
- SEC request: The SEC Division of Enforcement requested information concerning accounting practices for contract estimate revisions. The company is cooperating and said it cannot predict the outcome.
- Other identified risks include defense budget and contract changes, performance and cost-estimate risks on long-term fixed-price contracts, customer demand for business aircraft, and legal or regulatory proceedings. Management considered other litigation and environmental exposures not material based on information available.
Important facts for investors to verify
- Whether tactical communications awards and follow-on work recover, and whether the projected IT services mix and segment margins develop as expected.
- Progress against Aerospace delivery and margin expectations, including G650 certification and delivery plans.
- Resolution of the $67 million prior-period adjustments and the SEC inquiry into contract estimate revisions.
- Developments in the A-12 litigation and any changes to the potential financial exposure or accounting treatment.
- Outcome and financial effects of the potential Portugal contract restructuring, and the funding and conversion of backlog into revenue.
- Defense budget actions, including sequestration, and their impact on the company’s programs, awards and backlog.