Business context and reporting period
General Dynamics Corporation’s unaudited Form 10-Q covers the quarter and nine months ended September 30, 2012, compared with periods ended October 2, 2011. The company operates in Aerospace, Combat Systems, Marine Systems, and Information Systems and Technology, serving defense, government, and business-aviation markets. More than two-thirds of revenue comes from the U.S. government.
Financial performance
Amounts are in millions of dollars, except per-share data and percentages.
| Metric | Third quarter 2012 | Third quarter 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Revenue | $7,934 | $7,853 | $23,435 | $23,530 |
| Operating earnings | $905 | $998 | $2,735 | $2,876 |
| Operating margin | 11.4% | 12.7% | 11.7% | 12.2% |
| Earnings from continuing operations | $600 | $665 | $1,798 | $1,949 |
| Net earnings | $600 | $652 | $1,798 | $1,923 |
| Diluted EPS | $1.70 | $1.80 | $5.04 | $5.19 |
| Net cash from operations | Not presented by quarter | $1,907 | $1,216 |
Quarterly revenue increased 1.0%, while operating earnings declined 9.3%; nine-month revenue declined 0.4% and operating earnings declined 4.9%. Management attributed earnings and margin pressure chiefly to lower tactical-communications volume and a shift toward lower-margin IT services. Contract-estimate revisions increased operating earnings by $45 in the quarter and $203 in the nine-month period; no individual revision was material.
Business-group results
| Group | Q3 revenue / operating earnings | Nine-month revenue / operating earnings | Management’s 2012 outlook |
|---|---|---|---|
| Aerospace | $1,836 / $261; margin 14.2% | $5,051 / $789; margin 15.6% | Revenue growth of approximately 16–17%; margin in the mid-15% range. |
| Combat Systems | $1,956 / $274; margin 14.0% | $6,016 / $799; margin 13.3% | Revenue approximately $8.5 billion; margin in the mid-13% range, excluding potential Portugal-contract effects. |
| Marine Systems | $1,670 / $186; margin 11.1% | $4,928 / $554; margin 11.2% | Revenue expected to decrease slightly from 2011; margin in the mid-11% range. |
| Information Systems and Technology | $2,472 / $201; margin 8.1% | $7,440 / $645; margin 8.7% | Revenue down 8–9% from 2011; margin approximately 9%. |
Cash, debt, and liquidity
- Cash and equivalents were $2.874 billion at September 30, up $225 million from year-end 2011. Cash plus marketable securities totaled $3.1 billion; net debt was $874 million, down $159 million from year-end.
- Nine-month operating cash flow was $1.907 billion; capital expenditures were $286 million, yielding management-defined free cash flow of $1.621 billion, or 90% of continuing-operations earnings. Prior-year free cash flow was $943 million, or 48%.
- Total debt was $3.925 billion, compared with $3.930 billion at year-end 2011. The current portion rose to $1.001 billion, principally reflecting $1 billion of notes due May 2013; long-term debt was $2.924 billion. No commercial paper was outstanding.
- The company had $2 billion of bank credit facilities available and reported compliance with material debt covenants. Nine-month dividends paid were $533 million; share repurchases were $602 million, covering 9.1 million shares at an average $66 per share.
Material changes, outlook, and risks
- Aerospace growth reflected G650 green-aircraft deliveries, while fewer outfitted deliveries partly offset earnings growth. Combat Systems faced lower vehicle and munitions volumes; Marine Systems benefited from ship repair and favorable T-AKE cost performance. Information Systems and Technology experienced materially lower tactical-communications sales and weaker margins as lower-margin IT services formed a larger revenue share.
- U.S. defense spending uncertainty is a central risk. Congress had not approved the FY2013 budget; a continuing resolution funded operations at FY2012 levels through March 2013. Management warned that potential sequestration cuts could materially affect programs, revenue, earnings, cash flow, orders, backlog, and long-lived-asset values.
- Total backlog was $51.458 billion at quarter-end, down from $52.362 billion at the prior quarter-end. Estimated potential contract value was $26.061 billion; this includes unfunded IDIQ amounts and options and is not equivalent to funded backlog.
- The Portugal Pandur-vehicle contract was under dispute: the customer’s minister publicly indicated an intent to terminate, while the company said it had received no formal notice and believed it was not in breach. The company sought arbitration and reported approximately $130 million of receivables and contracts in process related to the program.
- The long-running A-12 litigation remained unresolved. If the government ultimately prevails, General Dynamics estimated its pretax share at approximately $1.5 billion, after-tax charge at $835 million, and after-tax cash cost at $740 million; no accrual was recorded. The company believes it has sufficient resources if payment is required.
- The SEC had requested information concerning contract-estimate revisions; the company was cooperating and could not predict the outcome. Management also identified possible impairment exposure for specified optical-products assets if anticipated orders are delayed or smaller than expected, and noted a $25 million reduction in ruggedized-hardware inventory with potential for further reductions.
- Management expected a full-year effective tax rate slightly below 32% and net interest expense of approximately $155 million. It planned to submit approximately $170 million in pension-cost recovery requests in Q4. The annual goodwill impairment test was scheduled for Q4, with Information Systems and Technology identified as the reporting unit most likely to be affected by defense-market uncertainty and recent trends.
Most important facts for investors to verify
- Whether defense-budget, continuing-resolution, or sequestration developments alter funding, contract awards, backlog conversion, or the company’s outlook.
- Whether Information Systems and Technology stabilizes tactical-communications demand, margins, inventory, and the identified long-lived assets.
- Developments in the Portugal contract arbitration and the A-12 litigation, including any change in potential financial exposure.
- Progress against segment outlooks, especially G650 deliveries, Combat Systems margins, and Information Systems and Technology revenue expectations.
- Funding and refinancing plans for the $1 billion notes due May 2013, and the sustainability of cash generation, dividends, and repurchases.