10-K 1 col_9302012x10k.htm 10-K COL_9.30.2012_10K


  
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
 R ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2012

£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-16445  
 
Rockwell Collins, Inc.
(Exact name of registrant as specified in its charter)
Delaware
52-2314475
(State or other jurisdiction
(I.R.S. Employer
of incorporation or organization)
Identification No.)
 
 
400 Collins Road NE
 
Cedar Rapids, Iowa
52498
(Address of principal executive offices)
(Zip Code)
Registrant's telephone number, including area code: (319) 295-1000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Title of each class
Name of each exchange on which registered
Common Stock, par value $.01 per share
New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý    No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer R
 
Accelerated filer £
Non-accelerated filer  £
(Do not check if a smaller reporting company)
Smaller reporting company £
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No  R
The aggregate market value of the registrant's voting stock held by non-affiliates of the registrant on March 30, 2012 was approximately $8.3 billion. For purposes of this calculation, the registrant has assumed that its directors and executive officers are affiliates.
140,213,241 shares of the registrant's Common Stock were outstanding on October 31, 2012.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information contained in the Proxy Statement for the Annual Meeting of Shareowners of the registrant to be held on February 7, 2013 is incorporated by reference into Part III.
 



ROCKWELL COLLINS, INC.

Annual Report on Form 10-K

Table of contents

 
 
 
Page No.
 
 
 
 
 1
 
 8
 
 
 13
 
 
 14
 
 
 
 
 
 
 
 
 
 16
 
 
 18
 
 
 45
 
 
 90
 
 
 
 
 
 
 
 
 
 92
 
 
 93
 
 
 
 
 
 
 
 
 
 
 
 
 


i



PART I


Item 1.
Business.

General

Rockwell Collins, Inc. is a leader in the design, production and support of communications and aviation electronics for commercial and military customers worldwide. While our products and systems are primarily focused on aviation applications, our Government Systems business also offers products and systems for ground and shipboard applications. The integrated system solutions and products we provide to our served markets are oriented around a set of core competencies: communications, navigation, automated flight control, displays/surveillance, simulation and training, integrated electronics and information management systems. We also provide a wide range of services and support to our customers through a worldwide network of service centers, including equipment repair and overhaul, service parts, field service engineering, training, technical information services and aftermarket used equipment sales. The structure of our business allows us to leverage these core competencies across markets and applications to bring high value solutions to customers. We operate in multiple countries and are headquartered in Cedar Rapids, Iowa.

Our Company's heritage is rooted in the Collins Radio Company, established in 1933. Rockwell Collins, Inc., the parent company, is incorporated in Delaware. As used herein, the terms "we", "us", "our", "Rockwell Collins" or the "Company" include subsidiaries and predecessors unless the context indicates otherwise.

Whenever reference is made in any Item of this Annual Report on Form 10-K to information under specific captions of our 2012 Annual Report to Shareowners (2012 Annual Report) or to information in our Proxy Statement for the Annual Meeting of Shareowners to be held on February 7, 2013 (2013 Proxy Statement), such information shall be deemed to be incorporated herein by such reference.

All date references contained herein relate to our fiscal year ending on the Friday closest to September 30 unless otherwise stated. For ease of presentation, September 30 is utilized consistently throughout this report to represent the fiscal year end date. Each of 2012, 2011 and 2010 was a 52-week fiscal year.

Financial Information About Our Business Segments

Financial information with respect to our business segments, including product line disclosures, revenues, operating earnings and total assets, is contained under the caption Segment Financial Results in Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 below and in Note 24 of the Notes to Consolidated Financial Statements in Item 8 below.

Access to the Company's Reports and Governance Information

We maintain an internet website at www.rockwellcollins.com. Our annual reports on Form 10-K, quarterly reports on Form  10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on this site as soon as reasonably practicable after the reports are filed with or furnished to the Securities and Exchange Commission (SEC). All reports we file with the SEC are also available free of charge via EDGAR through the SEC's website at www.sec.gov. We also post corporate governance information (including our corporate governance guidelines and Board committee charters) and other information related to our Company on our internet website where it is available free of charge. We will provide, without charge, upon written request, copies of our SEC reports and corporate governance information. Our internet website and the information contained therein or connected thereto are not incorporated into this Annual Report on Form 10-K.

Description of Business by Segment

We serve a worldwide customer base through our Government Systems and Commercial Systems business segments. These two segments are described in detail below.


1



Government Systems

Our Government Systems business provides a broad range of electronic products, systems and services to customers including the U.S. Department of Defense, other ministries of defense, other government agencies and defense contractors around the world. Our defense electronic solutions are designed to meet a wide range of customer requirements, but tend to share certain characteristics including design for rugged environments for use in size, weight and power constrained applications. These applications also typically have stringent product integrity and certification requirements with a high degree of customer oversight. These products, systems and services support airborne, precision weapon, ground and maritime applications and are used in line-fit applications on new equipment as well as in retrofit and upgrade applications designed to extend the effective life and enhance the capability of existing aircraft, vehicle and weapon platforms.

Our defense-related systems, products and services include:

communications systems and products designed to enable the transmission of information across the communications spectrum, including satellite communications

navigation products and systems, including radio navigation products, global positioning system (GPS) equipment, handheld navigation devices and multi-mode receivers

avionics sub-systems for aircraft flight decks that combine flight operations with navigation and guidance functions that can include flight controls and displays, information/data processing and communications, navigation, safety and surveillance systems

cockpit display products, including multipurpose flat panel head-down displays, wide field of view head-up and helmet-mounted displays

simulation and training systems, including visual system products, training systems and services

maintenance, repair, parts and after-sales support services

Government Systems sales are categorized into avionics, communication products, surface solutions and navigation products. Product category sales are delineated based upon the difference in the underlying product technologies and markets served.

Avionics consists of electronic solutions for a broad range of airborne platforms including fixed and rotary wing aircraft, unmanned aerial vehicles (UAVs) and the associated aircrew and maintenance training devices and services. We provide complete avionics solutions (including cockpit avionics, mission system applications and system integration) and also provide individual avionics products to platform integrators. We serve various roles within these markets including system and subsystems integrator as well as provider of various electronic products. For the UAV market we provide cost effective, high performance integrated flight control, navigation, communication and sensor capabilities. Simulation and training solutions are provided for both fixed wing and rotary wing aircraft.

Communication products include full spectrum voice and data connectivity for government and military use in the air, on the ground and at sea. The products support military user requirements for high availability, highly secure, jam resistant wireless communication capability. Products include radio communication, data links, networking devices and satellite communication terminals.

Surface solutions include electronic systems applied to a variety of non-airborne market segments. This includes products and solutions for ground forces, maritime applications, precision targeting systems and surface-based communication network integration programs.

Navigation products are primarily comprised of GPS-based products delivered for precision navigation applications including handheld navigation devices (e.g., DAGR), precision-guided weapons (e.g., JDAM) and other embedded GPS applications.


2



Commercial Systems

Our Commercial Systems business supplies aviation electronics systems, products and services to customers located throughout the world. The customer base is comprised of original equipment manufacturers (OEMs) of commercial air transport, business and regional aircraft, commercial airlines and business aircraft operators. Our systems and products are used in both OEM applications as well as in retrofit and upgrade applications designed to increase the efficiency and enhance the value of existing aircraft.

Our commercial aviation electronics systems, products and services include:

integrated avionics systems, such as Pro Line Fusion®, which provide advanced avionics capabilities to meet the challenges of operating in the next generation global airspace. Capabilities include synthetic and enhanced vision enabled flight displays, advanced flight and performance management systems, fly-by-wire integrated flight controls and information management solutions to improve operational efficiency

integrated cabin electronics systems, including cabin management systems, passenger connectivity and entertainment solutions, business support systems to improve passenger productivity and passenger flight information systems

communications systems and products, such as data link, high frequency, very high frequency and satellite communications systems

navigation systems and products, including landing sensors to enable fully automatic landings, radio navigation and geophysical sensors, as well as flight management systems

situational awareness and surveillance systems and products, such as synthetic and enhanced vision systems, surface surveillance and guidance solutions, head-up guidance systems, weather radar and collision avoidance systems

integrated information management solutions to improve the overall efficiency of flight, maintenance and cabin operations. These include on-board information management systems and connectivity solutions, airborne and ground applications and services, and ground infrastructure and services

electro-mechanical systems, including integrated pilot control solutions and primary and secondary actuation systems

simulation and training systems, including full-flight simulators for crew training, visual system products, training systems and engineering services

maintenance, repair, parts, after-sales support services and aftermarket used equipment

Commercial Systems sales are categorized into air transport aviation electronics and business and regional aviation electronics. Product category sales are delineated based upon the difference in the underlying customer base, size of aircraft and markets served.

Air transport aviation electronics include avionics, cabin systems and flight control systems for large commercial transport aircraft platforms. We design these items as sub-systems and work with OEMs to integrate our and other suppliers' products into the flight deck and broader aircraft systems. Our products offered for OEM applications in the air transport category are marketed directly to aircraft OEMs and airline operators, while our products offered for aftermarket applications are primarily marketed to the airline operators.

Business and regional aviation electronics include integrated avionics, cabin management and flight control systems for application on regional and business aircraft platforms. We develop integrated avionics, cabin and flight control solutions for business and regional aircraft OEMs and support them with the integration into other aircraft systems. Products offered for OEM applications in the business and regional aircraft category are marketed directly to the aircraft OEMs. Products offered for aftermarket applications are primarily marketed through distributors for business aviation and directly to regional airline operators. Our integrated information management solutions for business aircraft are offered directly to flight departments.


3



Customers, Sales and Marketing

We serve a broad range of customers worldwide, including the U.S. Department of Defense, U.S. Coast Guard, civil agencies, defense contractors, foreign ministries of defense, manufacturers of commercial air transport, business and regional aircraft, commercial airlines and fractional and other business jet operators. We market our systems, products and services directly to Government Systems and Commercial Systems customers through an internal marketing and sales force. In addition, we utilize a worldwide dealer network to distribute our products and international sales representatives to assist with international sales and marketing. In 2012 various branches of the U.S. Government, both directly and indirectly through subcontracts, accounted for 38 percent of our total sales.
 
Our largest customers have substantial bargaining power with respect to price and other commercial terms. Although we believe that we generally enjoy good relations with our customers, the loss of all or a substantial portion of our sales to any of our large volume customers for any reason, including the loss of contracts, bankruptcy, reduced or delayed customer requirements or strikes or other work stoppages affecting production by these customers, could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Competition

We operate in a highly competitive environment. Principal competitive factors include total cost of ownership, product and system performance, quality, service, warranty and indemnification terms, technology, design engineering capabilities, new product innovation and timely delivery. We compete worldwide with a number of U.S. and non-U.S. companies in each of our Government Systems and Commercial Systems businesses. Many of these competitors are also our suppliers or customers on some of our programs. Some of our principal competitors include Honeywell International, Inc., Thales S.A., Panasonic, Raytheon Co., Harris Corp., BAE Systems Aerospace, Inc., General Dynamics Corporation, L3 Communications, Inc., The Boeing Company, Northrop Grumman Corp., CAE Inc., General Electric Co. and Garmin International Inc. Several of our competitors are significantly larger than us in terms of resources and market share, and can offer a broader range of products. Some of our competitors have more extensive or more specialized engineering, manufacturing and marketing capabilities than we do in some areas. In addition, some of our competitors offer avionics and communications solutions with fewer features and lower prices that may compete with our solutions. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or may be able to devote greater resources to the development, promotion and sale of their products. Furthermore, competitors who have greater financial resources may be better able to provide a broader range of financing alternatives to their customers in connection with sales of their products. We believe, however, that our systems, products and services are well positioned to compete in our served markets.

Industry consolidation has had a major impact on the competitive environment in which we operate. Our competitors periodically undertake mergers, alliances and realignments that contribute to a dynamic competitive landscape. During the past three years, we have completed three acquisitions and entered into several strategic alliances to improve our competitive position and expand our market reach.

Raw Materials, Supplies and Working Capital

We believe we have adequate sources for the supply of raw materials and components for our manufacturing and service needs with suppliers located around the world. Electronic components and other raw materials used in the manufacture of our products are generally available from several suppliers. We continue to work with our supply base for raw materials and components to ensure an adequate source of supply, utilizing strategic alliances, dual sourcing, identification of substitute or alternate parts that meet performance requirements and life-time buys. These life-time buys involve purchases of multiple years of supply in order to meet production and service requirements over the life span of a product. Although historically we have not experienced any significant difficulties in obtaining an adequate supply of raw materials and components necessary for our manufacturing operations or service needs, the loss of a significant supplier or the inability of a supplier to meet performance and quality specifications or delivery schedules could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Our investment in inventory is a significant part of our working capital, and historically we have maintained sufficient inventory to meet our customers' requirements on a timely basis. This investment includes production stock, work-in-process, pre-production engineering costs, finished goods, spare parts and goods on consignment with airlines. Our accounts receivable also constitute a significant part of our working capital. Accounts receivable includes unbilled receivables primarily related to sales recorded under the percentage-of-completion method of accounting that have not been billed to customers in accordance with applicable contract terms. The critical accounting policies involving pre-production engineering costs, inventory valuation reserves and long-term contracts are discussed under the caption Management's Discussion and Analysis of Financial

4



Condition and Results of Operations in Item 7 below. Additional information relating to accounts receivable and inventory is contained in Notes 2, 5 and 6 of the Notes to Consolidated Financial Statements in Item 8 below.

Backlog

The following table summarizes our backlog:
 
 
September 30
(in billions)
 
2012
 
2011
Government Systems:
 
 
 
 
Funded orders
 
$
2.8

 
$
2.9

Unfunded orders
 
0.5

 
0.1

Commercial Systems
 
1.5

 
1.4

Total backlog
 
$
4.8

 
$
4.4


Our backlog represents the aggregate of the sales price of orders received from customers, but not recognized as revenue, and excludes unexercised options. Although we believe that the orders included in backlog are firm, most of our backlog involves orders that can be modified or terminated by the customer. Our backlog at September 30, 2012 includes approximately $2.4 billion of orders that are expected to be filled by us after fiscal year 2013.

Joint Ventures

Joint ventures, strategic investments and other cooperative arrangements are part of our business strategies to broaden the market for our products and develop new technologies.

We have a 50 percent ownership interest in each of the following:

Data Link Solutions LLC (DLS), a joint venture with BAE Systems, plc, for joint pursuit of the worldwide military data link market

Vision Systems International, LLC (VSI), a joint venture with Elbit Systems, Ltd., for joint pursuit of helmet-mounted cueing systems for the worldwide military fixed wing aircraft market

Integrated Guidance Systems LLC (IGS), a joint venture with Honeywell International, Inc., for joint pursuit of the development of weapons guidance and navigation solutions

Quest Flight Training Limited, a joint venture with Quadrant Group plc, which provides aircrew training services primarily for the United Kingdom Ministry of Defence

Acquisitions and Dispositions

We continually consider various business opportunities, including strategic acquisitions and alliances, licenses and marketing arrangements, and we review the prospects of our existing businesses to determine whether any of them should be modified, sold or otherwise discontinued.

We completed three acquisitions in the past three years to augment our internal growth plans. These acquisitions were:

flight operations management solutions: January 2011 acquisition of Computing Technologies for Aviation, Inc.

high-performance sensor simulation training applications: December 2010 acquisition of Blue Ridge Simulation, Inc.

corporate flight handling and trip support services: December 2009 acquisition of AR Group, Inc.

In July 2011, we divested the Rollmet business, which provided seamless alloy and stainless steel pipes and propulsion system components for the energy, petrochemical and defense industries.

Additional information relating to our acquisitions, dispositions and joint ventures is contained in Notes 3, 4, 8 and 9 of the Notes to Consolidated Financial Statements in Item 8 below.

5




Research and Development

We have significant research, development, engineering and product design capabilities. At September 30, 2012, we employed approximately 6,350 engineers.

Amounts attributed to our research and development (R&D) investment are as follows:
(in millions)
 
2012
 
2011
 
2010
Customer-funded (1)
 
$
503

 
$
550

 
$
516

Company-funded
 
320

 
355

 
345

Total research and development expense
 
823

 
905

 
861

Increase in pre-production engineering costs
 
123

 
126

 
80

Total research and development investment (2)
 
$
946

 
$
1,031

 
$
941


(1)
Customer-funded R&D includes activities relating to the development of new products and the improvement of existing products for which we are reimbursed by our customers. Customer-funded R&D includes amortization of pre-production engineering costs as disclosed in Note 6 of the Notes to Consolidated Financial Statements in Item 8 below.
(2)
Total research and development investment consists of company and customer-funded research and development expenditures as well as the net increase in pre-production engineering costs capitalized within inventory. As disclosed in Note 6 of the Notes to Consolidated Financial Statements in Item 8 below, pre-production engineering costs capitalized within inventory were $569 million and $446 million at September 30, 2012 and September 30, 2011, respectively. The net increase in pre-production engineering costs during 2012 was therefore $123 million. This increase, and a description of the critical accounting policies involving pre-production engineering, are discussed under the caption Management's Discussion and Analysis of the Financial Condition and Results of Operations in Item 7 below.

Intellectual Property

We own numerous U.S. and foreign patents and have numerous pending patent applications, including patents and patent applications purchased in our acquisitions. We also license certain patents relating to our manufacturing and other activities. While in the aggregate we consider our patents and licenses important to the operation of our business, we do not consider any individual patent or license to be of such importance that the loss or termination of any one patent or license would materially affect us.

Rockwell Automation, Inc. (Rockwell) owns the "Rockwell" name. In connection with our spin-off from Rockwell in 2001, we were granted the exclusive right to continue to use the Rockwell Collins name for use in our business other than in connection with the Rockwell Automation business or industrial automation products. This exclusive right would terminate following certain change of control events applicable to us as described in our distribution agreement with Rockwell.

Employees

As of September 30, 2012, we had approximately 19,000 employees. Collective bargaining agreements expire in May 2013 with approximately 1,900 of our 1,950 U.S. collective bargaining unit employees. These expiring agreements are with each of (1) International Brotherhood of Electrical Workers, Local Union No. 1362, (2) International Brotherhood of Electrical Workers, Local Union No. 1634 and (3) International Union of Electronic, Electrical, Salaried, Machine and Furniture Workers, Local Union No. 787. Failure to reach new agreements with these bargaining units could result in work stoppages which could adversely affect our business, financial condition, operating results and cash flows. In certain of our non-U.S. subsidiaries, many of our employees are represented by workers' councils or statutory labor unions.


6



Cyclicality and Seasonality

The avionics and communications markets in which we sell our products are, to varying degrees, cyclical and have experienced periodic upswings and downturns. For example, markets for our commercial aviation electronic products have experienced downturns during periods of slowdowns in the commercial airline industry and during periods of weak conditions in the economy in general, as demand for new aircraft generally declines during these periods. We believe that we are currently benefiting from a commercial aviation upswing especially with production rate increases anticipated by various aircraft manufacturers to meet significant backlogs. Our Government Systems business is also subject to some cyclicality primarily as a result of U.S. Government defense budget cycles. While we believe our Government Systems business is well positioned, the U.S. Government defense budget is expected to decline this year and to decline further in the coming years. Additional information related to the defense budget environment, including the potential impacts from sequestration, can be found under the caption Risk Factors in Item 1A below.

Our business tends to be seasonal with our fourth quarter usually producing relatively higher sales and cash flow and our first quarter usually producing relatively lower sales and cash flow. A large part of this seasonality variance is attributable to our Government Systems business and relates to the U.S. Government procurement cycle.

Regulatory Matters

As a defense contractor, our contract costs are audited and reviewed on a continual basis by the Defense Contract Audit Agency. Audits and investigations are conducted from time to time to determine if our performance and administration of our U.S. Government contracts are compliant with applicable contractual requirements and procurement regulations and other applicable federal statutes and regulations. Under present U.S. Government procurement regulations, if indicted or adjudged in violation of procurement or other federal civil laws, a contractor, such as us, could be subject to fines, penalties, repayments or other damages. U.S. Government regulations also provide that certain findings against a contractor may lead to suspension or debarment from eligibility for awards of new U.S. Government contracts for up to three years.

The sale, installation and operation of our products in commercial aviation applications is subject to continued compliance with applicable regulatory requirements and future changes to those requirements. In the U.S., our commercial aviation products are required to comply with Federal Aviation Administration regulations governing production and quality systems, airworthiness and installation approvals, repair procedures and continuing operational safety. Some of our products, such as radio frequency transmitters and receivers, must also comply with Federal Communications Commission regulations governing authorization and operational approval of telecommunications equipment.

Internationally, similar requirements exist for airworthiness, installation and operational approvals. These requirements are administered by the national aviation authorities of each country and, in the case of Europe, coordinated by the European Joint Aviation Authorities. Many countries also impose specific telecommunications equipment requirements, administered through their national aviation authorities or telecommunications authorities. In Europe, approval to import products also requires compliance with European Commission directives, such as those associated with electrical safety, electro-magnetic compatibility, use of metric units of measurement and restrictions on the use of lead.

Products already in service may also become subject to mandatory changes for continued regulatory compliance as a result of any identified safety issue, which can arise from an aircraft accident, incident or service difficulty report.

Our products and technical data are controlled for export and import under various regulatory agencies. Audits and investigations by these agencies are a regular occurrence to ensure compliance with applicable federal statutes and regulations. Violations, including as a successor to an acquired business, can result in fines and penalties assessed against the Company as well as individuals, and the most egregious acts may result in a complete loss of export privileges.

Although we do not have any significant regulatory action pending against us, any such action could have a material adverse impact on our business, financial condition, results of operations and cash flows.


7



Environmental Matters

Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes and other activities affecting the environment have had and will continue to have an impact on our manufacturing operations. To date, compliance with environmental requirements and resolution of environmental claims have been accomplished without material effect on our liquidity and capital resources, competitive position or financial condition. We believe that our expenditures for environmental capital investment and remediation necessary to comply with present regulations governing environmental protection and other expenditures for the resolution of environmental claims will not have a material adverse effect on our business or financial condition, but could possibly be material to the results of operations or cash flows of any one period. Additional information on environmental matters is contained in Note 21 of the Notes to Consolidated Financial Statements in Item 8 below.

Geographic Information

Our principal markets outside the U.S are in France, Canada, the United Kingdom, Germany, Japan, Australia, China, Italy, Sweden, Spain, Singapore, Brazil, United Arab Emirates, India and Saudi Arabia. In addition to normal business risks, operations outside the U.S. are subject to other risks, including political, economic and social environments, governmental laws and regulations and currency revaluations and fluctuations.

Selected financial information by major geographic area for each of the three years in the period ended September 30, 2012 is contained in Note 24 of the Notes to Consolidated Financial Statements in Item 8 below.

Item 1A.
Risk Factors.

Reduction in U.S. Government spending may adversely impact Government Systems sales and profitability.

In 2012, 38 percent of our sales were derived from U.S. Government contracts, both directly and indirectly through subcontracts. Defense funding by the U.S. Government faces significant pressures and is expected to decline over the next few years due to the overall economic environment, budget deficits and competing budget priorities. Cost cutting, efficiency initiatives, reprioritization and other affordability analysis by the U.S. Government on defense spending could present some additional opportunities for us, but overall may adversely impact our Government Systems sales and profitability.

Unless the U.S. Government takes further action, the Budget Control Act of 2011 (Budget Act) will trigger substantial, automatic reductions in both defense and discretionary spending in January 2013. While the impact of sequestration is yet to be determined, automatic across-the-board cuts would be in addition to reductions already reflected in the defense funding over a ten-year period. The resulting automatic across-the-board budget cuts in sequestration could have significant consequences to our business and industry. There could be disruption of ongoing programs and initiatives and personnel reductions that could severely impact advanced manufacturing operations and engineering expertise, and accelerate the loss of skills and knowledge.

We offer a diverse range of defense products and services. We believe that this makes it less likely that cuts in any specific contract or program will have a long-term effect on our business; however, termination of multiple or large programs or contracts could adversely affect our business and future financial performance. Potential changes in funding priorities may afford new or additional opportunities for our businesses in terms of existing, follow-on or replacement programs. While we would expect to compete, and be well positioned as the incumbent on existing programs, we may not be successful, and any replacement programs may be funded at lower levels.

In years when the U.S. Government does not complete its budget process before the end of its fiscal year (September 30), government operations typically are funded through a continuing resolution that authorizes agencies of the U.S. Government to continue to operate, but does not authorize new spending initiatives. When the U.S. Government operates under a continuing resolution, delays can occur in the procurement of products and services. Should a continuing resolution be prolonged further or extended through all or a large part of the government fiscal year, it may cause procurement awards to shift and cause our revenues to vary between periods.

During periods covered by continuing resolutions (or until the regular appropriation bills are passed), we may experience delays in procurement of products and services due to lack of funding, and those delays may affect our results of operations. At times, we may continue to work without funding, and use our own funds in order to meet our customer's desired delivery dates for products or services. It is uncertain at this time which of our programs' funding could be reduced in future years or whether new legislation will be passed by Congress in the next fiscal year that could result in additional or alternative funding cuts.


8



We depend to a significant degree on U.S. Government contracts, which are subject to unique risks.

In addition to normal business risks, our supply of systems and products to the U.S. Government is subject to unique risks which are largely beyond our control. These risks include:

dependence on Congressional appropriations and administrative allotment of funds

the ability of the U.S. Government to terminate, without prior notice, partially completed government programs and contracts that were previously authorized

changes in governmental procurement legislation and regulations and other policies which may reflect military and political developments

significant changes in contract scheduling or program structure, which generally result in delays or reductions in deliveries

intense competition for available U.S. Government business necessitating increases in time and investment for design and development

difficulty of forecasting costs and schedules when bidding on developmental and highly sophisticated technical work

changes over the life of U.S. Government contracts, particularly development contracts, which generally result in adjustments of contract prices

claims based on U.S. Government work and violation of associated compliance and other requirements, which may result in fines, the cancellation or suspension of payments or suspension or debarment proceedings affecting potential further business with the U.S. Government

International conflicts and terrorism may adversely affect our business.

International conflicts such as the war in Afghanistan, political turmoil in the Middle and Far East and the possibility of future terrorist attacks cause significant uncertainty with respect to U.S. and other business and financial markets and may adversely affect our business. These international conflicts also affect the price of oil, which has a significant impact on the financial health of our commercial customers. Although our Government Systems business may experience greater demand for its products as a result of increased government defense spending, factors arising (directly or indirectly) from international conflicts or terrorism which may adversely affect our commercial business include reduced aircraft build rates, upgrades, maintenance and spending on discretionary products such as in-flight entertainment, as well as increases in the cost of property and aviation products insurance and increased restrictions placed on our insurance policies.

Our business is heavily concentrated in the aviation industry.

As a provider of products and services to the aviation industry, we are significantly affected by the overall economic condition of that industry. The aviation industry is historically cyclical.

Our business, financial condition, results of operations and cash flows may be adversely impacted, among other things, by the following:

reductions in demand for aircraft and delayed aircraft delivery schedules

challenges in the financial condition of some of our existing and potential customers

reductions in the need for, or the deferral of, aircraft maintenance and repair services and spare parts support

retirement or storage of older generation aircraft, resulting in fewer retrofits and less demand for services for those aircraft

limited availability of financing for airlines or aircraft

high fuel costs

9




health pandemics or other disruptions to commercial air travel demand

New airspace management technologies may impact future sales.

The aerospace industry is experiencing a global transition from traditional communications, navigation, surveillance and air traffic control systems to air traffic management systems utilizing satellite-based technologies that will allow pilots to fly at desired paths and speeds selected in real time, while still complying with instrument flight regulations. The transition to these technologies will require the use of digital communications systems, global positioning system navigation, satellite surveillance techniques and ground surveillance systems. These technologies are expected to result in more direct and efficient flight routes, fewer flight delays and reduced airport congestion. Although we believe that we are well positioned to participate in this market evolution, our ability to capitalize on the transition to these airspace management technologies is subject to various risks, including:

delays in the development of the necessary satellite and ground infrastructure by the U.S. and other governments

delays in adopting national and international regulatory standards

competitors developing better products

failure of our product development investments in communications, navigation and surveillance products that enable airspace management technologies to coincide with market evolution to, and demand for, these products

the ability and desire of customers to invest in products enabling airspace management technologies
 
A global or regional recession may adversely affect us.

If a recession emerges that impacts where we do business, risks may include:

declines in revenues, profitability and cash flows from reduced orders, payment delays or other factors caused by the economic problems of our customers

adverse impacts on our access to short-term commercial paper borrowings or other credit sources

supply problems associated with any financial constraints faced by our suppliers

We derive a significant portion of our revenues from international sales and are subject to the risks of doing business outside the U.S.

In 2012, 33 percent of our total revenues were from sales of our products and services internationally. We expect that international sales will continue to account for a significant portion of our total sales. As a result, we are subject to risks of doing business internationally, including:

laws, regulations and policies of non-U.S. governments relating to investments and operations, as well as U.S. laws affecting the activities of U.S. companies abroad

regulatory requirements and potential changes, including imposition of tariffs or embargoes, export controls and other trade restrictions and antitrust and data privacy requirements

changes in government spending on defense programs, including the potential spending decline in European countries

uncertainties and restrictions concerning the availability of funding, credit or guarantees

requirements of certain customers which obligate us to specified levels of in-country purchases, manufacturing or investments, known as offsets, and penalties in the event we fail to perform in accordance with the offset requirements

import and export licensing requirements and regulations

uncertainties as to local laws and enforcement of contract and intellectual property rights

10




rapid changes in government, economic and political policies, political or civil unrest or the threat of international boycotts or U.S. anti-boycott legislation

We have made, and expect to continue to make, strategic acquisitions that involve significant risks and uncertainties.

We completed three acquisitions in the last three years and we intend to make acquisitions in the future in an effort to enhance shareowner value. Acquisitions involve a certain amount of risks and uncertainties such as:

the difficulty in integrating newly-acquired businesses and operations in an efficient and cost-effective manner and the risk that we encounter significant unanticipated costs or other problems associated with integration

the challenges in achieving strategic objectives, cost savings and other benefits expected from acquisitions

the risk that our markets do not evolve as anticipated and that the technologies acquired do not prove to be those needed to be successful in those markets

the risk that we assume significant liabilities that exceed the limitations of any applicable indemnification provisions or the financial resources of any indemnifying parties

the potential loss of key employees of the acquired businesses

the risk of diverting the attention of senior management from our existing operations

We enter into fixed-price contracts that could subject us to losses in the event that we have cost overruns.

During 2012, approximately 93 percent of our total sales were from, and a significant portion of our anticipated future sales will be from, fixed-price contracts. This allows us to benefit from cost savings, but it carries the burden of potential cost overruns since we assume all of the cost risk. If our initial cost estimates are incorrect, we can incur losses on these contracts. These fixed-price contracts can expose us to potentially large losses because the customer may compel us to complete a project or, in the event of a termination for default, pay the entire incremental cost of its replacement by another provider regardless of the size of any cost overruns that occur over the life of the contract. Because many of these projects involve new technologies and applications and can last for years, unforeseen events such as technological difficulties, fluctuations in the price of raw
materials, problems with subcontractors and cost overruns can result in the contractual price becoming less favorable or even unprofitable to us over time. Furthermore, if we do not meet project deadlines or specifications, we may need to renegotiate contracts on less favorable terms, be forced to pay penalties or liquidated damages or suffer major losses if the customer exercises its right to terminate. In addition, some of our contracts have provisions relating to cost controls and audit rights, and if we fail to meet the terms specified in those contracts we may not realize their full benefits. Our results of operations are dependent on our ability to maximize our earnings from our contracts. Lower earnings caused by cost overruns could have an adverse impact on our financial condition, operating results and cash flows.

Costs of certain employee and retiree benefits may continue to rise.

Although we have taken action seeking to contain volatility in the costs related to medical and pension benefits, there are risks that our costs for these benefits will increase as a result of:

continued increases in medical costs related to current employees due to increased usage of medical benefits, medical inflation and the impact of recent U.S. Government health care legislation

material changes in legislation or market dynamics as a result impacting medical or pension matters

the effect declines in the stock and bond markets have on the performance of our pension plan assets

potential reductions in the discount rate used to determine the present value of our retirement benefit obligations


11



Tax changes could affect our effective tax rate and future profitability.

Our future results could be adversely affected by changes in the effective tax rate as a result of changes in our overall profitability and changes in the mix of earnings in countries with differing statutory tax rates, changes in tax legislation, the results of audits and examination of previously filed tax returns and continuing assessment of our tax exposures.

We depend on critical suppliers and subcontractors.

We do not always have alternate sources of supply readily available for certain goods or services, such as liquid crystal displays. The loss of a significant supplier or subcontractor or their inability to meet performance, quality or delivery requirements could have a material adverse effect on our business, financial condition, results of operation and cash flows.

We depend on specialized test equipment.

Some of our specialized test equipment that supports the reliability of our products and systems is the result of significant investment. Back-up test equipment may not be readily available. Damage to our specialized test equipment may result in protracted production recovery.

A cybersecurity incident could have negative impact.

A cyber-attack that bypasses our information technology (IT) security systems causing an IT security breach, may lead to a material disruption of our IT business systems and/or the loss of business information resulting in adverse business impact. Risks may include:
 
future results could be adversely affected due to the theft, destruction, loss, misappropriation or release of confidential data or intellectual property
 
operational or business delays resulting from the disruption of IT systems and subsequent mitigation activities

negative publicity resulting in reputation or brand damage with our customers, partners or industry peers

Cautionary Statement

This Annual Report on Form 10-K, and documents that are incorporated by reference in this Annual Report on Form 10-K, contain statements, including certain projections and business trends, that are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to the financial condition of our customers, including bankruptcies; the health of the global economy, including potential deterioration in economic and financial market conditions; the rate of recovery of the commercial OEM production rates and the aftermarket; the impacts of natural disasters, including operational disruption, potential supply shortages and other economic impacts; cybersecurity threats, including the potential misappropriation of assets or other sensitive information, corruption of data or operational disruption; delays related to the award of domestic and international contracts; unanticipated impacts of sequestration and other provisions of the Budget Control Act of 2011 that are set to be implemented in January 2013; the discontinuance of support for military transformation and modernization programs; potential adverse impact of oil prices on the commercial aerospace industry; the impact of terrorist events on the commercial aerospace industry; declining defense budgets resulting from budget deficits in the U.S. and abroad; changes in domestic and foreign government spending, budgetary, procurement and trade policies adverse to our businesses; market acceptance of our new and existing technologies, products and services; reliability of and customer satisfaction with our products and services; favorable outcomes on or potential cancellation or restructuring of contracts, orders or program priorities by our customers; timing of international contract awards; recruitment and retention of qualified personnel; regulatory restrictions on air travel due to environmental concerns; effective negotiation of collective bargaining agreements by us and our customers, including our collective bargaining agreements set to expire in May 2013; performance of our customers and subcontractors; risks inherent in development and fixed-price contracts, particularly the risk of cost overruns; risk of significant reduction to air travel or aircraft capacity beyond our forecasts; our ability to execute to our internal performance plans such as our productivity and quality improvements and cost reduction initiatives; achievement of our acquisition and related integration plans; continuing to maintain our planned effective tax rates; our ability to develop contract compliant systems and products on schedule and within anticipated cost estimates; risk of fines and penalties related to noncompliance with laws and regulations including export control and environmental regulations; risk of asset impairments; our ability to win new business and convert those orders to sales within the fiscal year in accordance with our annual operating plan; and the uncertainties of the outcome of lawsuits, claims and legal proceedings, as well as other risks and uncertainties, including but not limited to those detailed

12



herein and from time to time in our Securities and Exchange Commission filings. These forward-looking statements are made only as of the date hereof and the company assumes no obligation to update any forward-looking statement.

Item 1B.
Unresolved Staff Comments.

None

Item 2.
Properties.

As of September 30, 2012, we operated approximately 20 manufacturing facilities throughout the U.S. and various manufacturing facilities in Mexico, France, Germany and the United Kingdom. The Company also had engineering facilities, sales offices, warehouses and service locations in approximately 20 countries around the world. These facilities have aggregate floor space of approximately 7 million square feet. Of this floor space, approximately 55 percent is owned and approximately 45 percent is leased. There are no major encumbrances on any of our plants or equipment, other than financing arrangements which in the aggregate are not significant. In the opinion of management, our properties have been well maintained, are in sound operating condition and contain all equipment and facilities necessary to operate at present levels. A summary of floor space of these facilities at September 30, 2012 is as follows:
Location
 
Owned
Facilities
 
Leased
Facilities
 
Total
(in thousands of square feet)
 
 
 
 
 
 
U.S. 
 
3,362

 
2,378

 
5,740

Europe
 
329

 
300

 
629

Canada and Mexico
 

 
132

 
132

Asia Pacific
 

 
204

 
204

South America
 

 
9

 
9

Total
 
3,691

 
3,023

 
6,714

Type of Facility
 
Owned
Facilities
 
Leased
Facilities
 
Total
(in thousands of square feet)
 
 
 
 
 
 
Manufacturing and service
 
1,852

 
1,300

 
3,152

Sales, engineering and general office space
 
1,839

 
1,723

 
3,562

Total
 
3,691

 
3,023

 
6,714


We have facilities with a total of at least 100,000 square feet in the following cities: Cedar Rapids, Iowa (3,200,000 square feet), Richardson, Texas (390,000 square feet), Melbourne, Florida (380,000 square feet), Heidelberg, Germany (240,000 square feet), Tustin, California (215,000 square feet), Sterling, Virginia (210,000 square feet), Coralville, Iowa (180,000 square feet), Wilsonville, Oregon (180,000 square feet), Duluth, Georgia (160,000 square feet), Toulouse, France (160,000 square feet), Salt Lake City, Utah (120,000 square feet), Hyderabad, India (115,000 square feet) and Mexicali, Mexico (105,000 square feet). Most of our facilities are generally shared for the benefit of our Government Systems and Commercial Systems businesses.

We purchase property insurance covering physical damage to our facilities and resulting business interruption from the perils of fire, windstorm, flood and earthquake. This insurance generally provides replacement cost coverage subject to a $10 million deductible with certain exceptions, including earthquake and high windstorm prone locations that could impose a higher deductible. For example, certain of our facilities, including those located in California and Mexico, are located near major earthquake fault lines. For those facilities we maintain earthquake insurance with limits that may be less than full replacement cost and a $25 million deductible. These exceptions are largely driven by the availability and cost of catastrophe coverage from the insurance markets.


13


Item 3.
Legal Proceedings.

Various lawsuits, claims and proceedings have been or may be instituted or asserted against us relating to the conduct of our business, including those pertaining to product liability, intellectual property, environmental, safety and health, exporting or importing, contract, employment and regulatory matters. Although the outcome of litigation cannot be predicted with certainty and some lawsuits, claims or proceedings may be disposed of unfavorably to us, management believes the disposition of matters that are pending or asserted will not have a material adverse effect on our business or financial condition, but could possibly be material to the results of operations or cash flows of any one quarter.

Item 4.
Mine Safety Disclosures.

Not applicable.


14


Item 4A.
Executive Officers of the Company.

The name, age, office and position held with us, and principal occupations and employment during the past five years of each of our executive officers as of November 13, 2012 are as follows:
Name, Office and Position, and Principal Occupations and Employment
 
Age
Clayton M. Jones—Chairman of the Board of Rockwell Collins since June 2002; Chief Executive Officer of Rockwell Collins since June 2001; President of Rockwell Collins from June 2001 to September 2012
 
63
Robert K. Ortberg—President of Rockwell Collins since September 2012; Executive Vice President and Chief Operating Officer, Government Systems from February 2010 to September 2012; Executive Vice President and Chief Operating Officer, Commercial Systems of Rockwell Collins prior thereto
 
52
Barry M. Abzug—Senior Vice President, Corporate Development of Rockwell Collins since October 2001
 
60
Patrick E. Allen—Senior Vice President and Chief Financial Officer of Rockwell Collins since January 2005
 
48
John-Paul E. Besong—Senior Vice President, e-Business of Rockwell Collins since April 2007; Senior Vice President of e-Business & Lean Electronics of Rockwell Collins prior thereto
 
59
Gary R. Chadick—Senior Vice President, General Counsel and Secretary of Rockwell Collins since July 2001
 
51
Gregory S. Churchill—Executive Vice President, International and Service Solutions since February 2010; Executive Vice President and Chief Operating Officer, Government Systems of Rockwell Collins prior thereto
 
55
Philip J. Jasper—Executive Vice President and Chief Operating Officer, Government Systems since September 2012; Vice President, Business Development, Government Systems from May 2010 to September 2012; Vice President & General Manager, Mobility and Rotary Wing Solutions of Rockwell Collins prior thereto.
 
44
Bruce M. King—Senior Vice President, Operations of Rockwell Collins since May 2011; Vice President and General Manager Communications Products of Rockwell Collins from September 2010 to May 2011; Vice President and General Manager, Surface Solutions of Rockwell Collins from January 2008 to September 2010; Vice President and General Manager, Communication Systems of Rockwell Collins prior thereto
 
51
Ronald W. Kirchenbauer—Senior Vice President, Human Resources of Rockwell Collins since April 2003
 
65
Nan Mattai—Senior Vice President, Engineering and Technology of Rockwell Collins since November 2004
 
60
Marsha A. Schulte—Vice President, Finance & Controller of Rockwell Collins since May 2006
 
55
Kent L. Statler—Executive Vice President and Chief Operating Officer, Commercial Systems since February 2010; Executive Vice President, Rockwell Collins Services of Rockwell Collins prior thereto
 
47
Douglas E. Stenske—Vice President, Treasurer and Financial Planning of Rockwell Collins since March 2011; Vice President and General Auditor of Rockwell Collins from May 2008 to March 2011; Treasurer of Rockwell Collins prior thereto
 
46
Robert A. Sturgell—Senior Vice President, Washington Operations since April 2009; Acting Administrator of the Federal Aviation Administration (FAA) prior thereto
 
53

There are no family relationships, as defined, between any of the above executive officers and any other executive officer or any director. No officer was selected pursuant to any arrangement or understanding between the officer and any person other than us. All executive officers are elected annually.


15



PART II


Item 5.
Market for the Company's Common Equity, Related Stockholder Matters and Company Purchases of Equity Securities.

Market Information

Our common stock, par value $.01 per share, is listed on the New York Stock Exchange and trades under the symbol COL. On October 31, 2012, there were 20,984 shareowners of record of our common stock.

The following table sets forth the high and low sales price of our common stock on the New York Stock Exchange—Composite Transactions reporting system during each quarter of our years ended September 30, 2012 and 2011:
 
 
2012
 
2011
Fiscal Quarters
 
High
 
Low
 
High
 
Low
First
 
$
57.34

 
$
50.04

 
$
62.25

 
$
54.10

Second
 
61.46

 
55.32

 
67.29

 
57.87

Third
 
58.94

 
46.78

 
65.20

 
58.57

Fourth
 
54.34

 
46.37

 
62.82

 
43.82


Dividends

The following table sets forth the cash dividends per share paid by us during each quarter of our years ended September 30, 2012 and 2011:
Fiscal Quarters
 
2012
 
2011
First
 
$
0.24

 
$
0.24

Second
 
0.24

 
0.24

Third
 
0.30

 
0.24

Fourth
 
0.30

 
0.24


Based on our current dividend policy, we have been paying quarterly cash dividends which, on an annual basis, equal $1.20 per share. The declaration and payment of dividends, however, will be at the sole discretion of our Board of Directors.

Repurchases

Our Board of Directors has authorized certain repurchases of our common stock. During 2012, we repurchased approximately 13.3 million shares of our common stock at a total cost of $723 million, at a weighted average cost of $54.41 per share. During 2011, we repurchased approximately 5.5 million shares at a total cost of $322 million, at a weighted average cost of $58.50 per share.

The following table provides information with respect to purchases made by or on behalf of us or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) of shares of our common stock during the three months ended September 30, 2012:
Period
 
Total
Number of
Shares
Purchased
 
Average Price
Paid per Share
 
Total Number of
Shares Purchased as
Part of Publicly
Announced
Plans or Programs
 
Maximum Number
(or Approximate
Dollar Value) of
Shares that May Yet
Be Purchased Under the
Plans or Programs(1)
July 1, 2012 through July 31, 2012
 

 
$

 

 
$
502 million
August 1, 2012 through August 31, 2012
 

 
$

 

 
$
502 million
September 1, 2012 through September 30, 2012
 
400,000

 
$
53.24

 
400,000

 
$
481 million
Total/Average
 
400,000

 
$

 
400,000

 
 
 

(1)
On July 23, 2012 our Board authorized the repurchase of an additional $500 million of our common stock, as reflected in the table above. The authorization has no stated expiration.


16


Item 6.
Selected Financial Data.

The following selected financial data should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 below. The Statement of Operations, Statement of Financial Position and other data has been derived from our audited financial statements. Certain prior period information has been reclassified to conform to the current year presentation and to reflect the results of the divested Rollmet business as a discontinued operation.
 
 
Years Ended September 30
 
 
2012(a)
 
2011(b)
 
2010(c)
 
2009(d)
 
2008(e)
(dollars in millions, except per share amounts)
 
 
 
 
 
 
 
 
 
 
Statement of Operations Data:
 
 
 
 
 
 
 
 
 
 
Sales
 
$
4,726

 
$
4,806

 
$
4,631

 
$
4,428

 
$
4,734

Cost of sales
 
3,324

 
3,427

 
3,353

 
3,118

 
3,308

Selling, general and administrative expenses
 
543

 
533

 
476

 
457

 
484

Income from continuing operations
 
609

 
615

 
557

 
589

 
673

Income from discontinued operations, net of taxes
 

 
19

 
4

 
5

 
5

Net income
 
609

 
634

 
561

 
594

 
678

Net income as a percent of sales
 
12.9
%
 
13.2
%
 
12.1
%
 
13.4
%
 
14.3
%
Diluted earnings per share from continuing operations
 
4.15

 
3.94

 
3.50

 
3.70

 
4.13

Statement of Financial Position Data:
 
 
 
 
 
 
 
 
 
 
Working capital(f)
 
$
1,347

 
$
1,394

 
$
1,237

 
$
1,003

 
$
598

Property
 
773

 
754

 
707

 
719

 
680

Goodwill and intangible assets
 
1,071

 
1,088

 
1,072

 
964

 
807

Total assets
 
5,314

 
5,389

 
5,064

 
4,645

 
4,144

Short-term debt
 

 

 
24

 

 
287

Long-term debt
 
779

 
528

 
525

 
532

 
228

Shareowners' equity
 
1,259

 
1,523

 
1,482

 
1,292

 
1,408

Other Data:
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
$
138

 
$
152

 
$
109

 
$
153

 
$
171

Depreciation and amortization
 
174

 
159

 
167

 
151

 
138

Dividends per share
 
1.08

 
0.96

 
0.96

 
0.96

 
0.80

Stock Price:
 
 
 
 
 
 
 
 
 
 
High
 
$
61.46

 
$
67.29

 
$
68.04

 
$
51.37

 
$
76.00

Low
 
46.37

 
43.82

 
47.19

 
27.67

 
43.26


(a)
Net income includes $38 million of net restructuring and asset impairment charges ($58 million before income taxes), primarily related to employee severance costs and certain customer bankruptcy charges. Approximately $38 million of the pre-tax charge was recorded in cost of sales, $25 million was included within selling, general and administrative expenses, and $5 million was classified as a gain within Other income. Net income also includes a $19 million income tax benefit related to the favorable resolution of certain tax matters in 2012.
(b)
Income from discontinued operations includes a $17 million gain ($27 million before income taxes) resulting from the sale of the Rollmet business. In addition, income from continuing operations includes $17 million of restructuring and asset impairment charges ($27 million before income taxes) primarily related to real estate lease and contract termination charges, asset impairment charges and employee severance costs. $26 million of the pre-tax restructuring and asset impairment charge was recorded in cost of sales and the remaining $1 million was included in selling, general and administrative expenses. Net income also includes a $16 million income tax benefit related to the retroactive reinstatement of the previously expired Federal Research and Development Tax Credit.
(c)
Includes a $20 million income tax benefit related to the favorable resolution of certain tax matters in 2010.
(d)
Includes $21 million of restructuring and asset impairment charges primarily related to reductions in workforce and decisions to implement certain facility rationalization actions ($14 million after taxes). Of the total restructuring and asset impairment charge, $19 million was recorded in cost of sales and the remaining $2 million was included in selling, general and administrative expenses.
(e)
Includes a $22 million income tax benefit related to the favorable resolution of certain tax matters.
(f)
Working capital consists of all current assets and liabilities, including cash and short-term debt.

17



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


18


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.

19


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.


20



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.



21



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.


22



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
%


23



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.


24



Net income and earnings per share for 2012 benefited from higher earnings in Commercial Systems as discussed in the Commercial Systems Financial Results section below. This benefit was partially offset by higher income tax expense, as explained in the Income Tax section above, and the reduction in Government Systems segment earnings described in the Government Systems Financial Results section below.

Net income for 2011 increased 13 percent to $634 million from net income of $561 million for 2010. Diluted earnings per share increased 15 percent to $4.06 for 2011 compared to $3.52 for 2010. 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 certain restructuring and asset impairment charges discussed in Note 23 of the Notes to Consolidated Financial Statements. The increase in net income and diluted earnings per share was primarily the result of higher earnings from Commercial Systems as discussed in the Commercial Systems Financial Results section below, partially offset by a reduction in Government Systems earnings as discussed in the Government Systems Financial Results section below. The impact of the 2011 restructuring and asset impairment charge was included in income from continuing operations while the gain on sale of the divested Rollmet product line was included in discontinued operations. The increase in diluted earnings per share was greater than the increase in net income due to the positive impact of our share repurchase program.


Segment Financial Results

Government Systems

Overview and Outlook

Our Government Systems business provides avionics, communication products, surface solutions and navigation products to the U.S. Department of Defense, other ministries of defense, other government agencies and defense contractors around the world. These systems, products and services support airborne (fixed and rotary wing), ground and shipboard applications. The short and long-term performance of our Government Systems business is affected by a number of factors, including the amount and prioritization of defense spending by the U.S. and non-U.S. governments, which is generally based on the security environment and underlying political landscape resulting from budget deficits.
In August 2011, Congress enacted the Budget Control Act of 2011 which imposes spending caps and certain reductions in security spending over a ten-year period through 2021. Absent additional Congressional action, further budget cuts (or sequestration) as outlined in the Budget Act will be implemented on January 3, 2013. If the sequestration process is implemented in January 2013 as currently mandated, there could be a significant adverse impact to our Company and to the defense industry in general.

Further, in years when the U.S. Government does not complete its budget process before the end of its fiscal year (September 30), government operations typically are funded through a continuing resolution that authorizes agencies of the U.S. Government to continue to operate, but does not authorize new spending initiatives. During periods covered by continuing resolutions (or until the regular appropriation bills are passed), we may experience delays in procurement of products and services which can adversely impact our results of operations and cause variability in the timing of revenue between periods.
Our fiscal year 2013 guidance for Government Systems incorporates the anticipated impact of sequestration. We expect Government Systems revenues to decrease by approximately 10 percent in 2013 as compared to 2012, with about half of the year-over-year decline resulting from the impact of sequestration. The remaining expected net decline is primarily driven by:

approximately $100 million reduction resulting from programs transitioning out of the development phase, with full scale production not expected to occur until after 2013

lower product deliveries of our Defense Advanced GPS Receivers and satellite communication terminals

delays in the Eurofighter Tranche III and reductions from lower sales of joint helmet mounted cueing systems for military fixed wing aircraft

items above are expected to be partially offset by increased deliveries of Joint Tactical Radio System
Manpack radios and Firestorm targeting systems and higher sales on tanker/transport aircraft platforms

We project Government Systems 2013 segment operating margins to be approximately 21 percent, as the benefits from restructuring actions and other cost reduction initiatives should mostly offset the adverse impact from lower revenue.

25



Risks affecting future performance of our Government Systems business include:

overall funding and prioritization of the U.S. and non-U.S. defense budgets, including unanticipated impacts of sequestration and other provisions of the Budget Control Act of 2011 that are set to be implemented in January 2013

delayed, reduced or canceled funding for programs we have won

potential impact of geopolitical and economic events

our ability to execute to our internal performance plans and cost reduction initiatives

our ability to win new business, successfully develop products and execute on programs pursuant to contractual requirements

For additional disclosure on Government Systems segment results see Note 24 of the Notes to Consolidated Financial Statements in Item 8 below.

Government Systems Sales
 
The following table presents Government Systems sales by product category:
 
(in millions)
 
2012
 
2011
 
2010
Avionics
 
$
1,476

 
$
1,434

 
$
1,389

Communication products
 
652

 
698

 
749

Surface solutions
 
226

 
377

 
408

Navigation products
 
237

 
304

 
315

Total
 
$
2,591

 
$
2,813

 
$
2,861

Percent (decrease)
 
(8
)%
 
(2
)%
 
 


Beginning in 2011, we began presenting sales for Government Systems based upon differences in the underlying product technologies and markets served. Government Systems sales for the year ended September 30, 2010 have been reclassified to conform to the current year presentation.

Government Systems Sales for 2012 compared to 2011

Avionics sales increased $42 million, or 3 percent, primarily due to the following:

$80 million increase resulting from the combined impact of development effort on the KC-46A, KC-10 and KC-390 tanker programs

$49 million increase in sales on the Saudi F-15 fighter program

partially offset by reductions to revenue of $87 million, primarily attributable to decreased sales for the KC-135 Global Air Traffic Management program and lower deliveries on C-17 transport, CH-53 rotary wing and P-3 special mission aircraft

Communication products sales decreased $46 million, or 7 percent, primarily due to the following:

$21 million reduction due to the completion of a program to provide transportable cellular capabilities in Afghanistan

$21 million decrease resulting from the combined impact of a program termination for Ground Mobile Radios and reduced funding authorizations on the U.S. Department of Defense FAB-T (Family of Advanced Beyond Line-of Sight terminals) initiative


26



Surface solutions sales decreased $151 million, or 40 percent, primarily due to the following:

$52 million reduction attributable to the combined impact of two programs that were terminated for convenience by the U.S. Government during 2011

$52 million decrease resulting from the combined impact of fewer deliveries of iForce public safety vehicle systems as we exited this product line and a reduction in Joint Precision Approach and Landing System program revenues as it transitions from development into production

remaining decrease of $47 million was due to a variety of items, including fewer deliveries of soldier optronics products and a decline in electronic warfare solution program revenues

Navigation products sales decreased $67 million, or 22 percent, primarily due to an $81 million reduction in revenue from fewer deliveries of our Defense Advanced GPS Receiver products as troop deployments wind down in Afghanistan and Iraq.

Government Systems Sales for 2011 compared to 2010

Avionics sales increased $45 million, or 3 percent, primarily due to the following:

$69 million increase resulting from the combined impact of low-rate initial production sales on an E-6 special mission aircraft program and development effort on the recently awarded KC-46A Tanker program

$43 million increase from higher rotary wing avionics sales on various platforms

above items were partially offset by a $66 million reduction in sales from the completion of the KC-135 Global Air Traffic Management program

Communication products sales decreased $51 million, or 7 percent, primarily due to a $60 million net reduction in satellite communication program revenues, driven by the combined impact of a recently completed upgrade program and the adverse impact of delayed funding authorizations from the U.S. Government.

Surface solutions sales decreased $31 million, or 8 percent, primarily due to the following:

$63 million reduction attributable to the combined impact of two programs that were terminated for convenience by the U.S. Government and lower sales of soldier system optronics products that were adversely impacted by delayed funding authorizations from the U.S. Government

$13 million decrease resulting from lower deliveries of iForce public safety vehicle systems

above items were partially offset by $48 million of increased development revenues for the Common Range Integrated Instrumentation System program

Navigation products sales decreased $11 million, or 3 percent, primarily due to lower sales of GPS-based products.

Government Systems Segment Operating Earnings
 
(in millions)
 
2012
 
2011
 
2010
Segment operating earnings
 
$
568

 
$
592

 
$
606

Percent of sales
 
21.9
%
 
21.0
%
 
21.2
%


27



Government Systems Operating Earnings for 2012 compared to 2011

Government Systems operating earnings were $568 million, or 21.9 percent of sales, for 2012 compared to operating earnings of $592 million, or 21.0 percent of sales, for 2011. The $24 million decrease in Government Systems operating earnings was primarily due to the following:

$222 million reduction in sales discussed in the Government Systems sales section above resulted in a $137 million decrease to costs and a reduction to earnings of $85 million. The variable gross margin of 38 percent reflects the absence of higher margin hardware sales for Navigation products that occurred last year

partially offset by a $34 million benefit to operating earnings resulting from lower company-funded R&D expense, as explained in the Cost of Sales section above

remaining variance of $27 million was primarily attributable to a benefit from lower employee headcount and incentive compensation costs, partially offset by higher warranty expense and an increase in employee medical and retirement benefit costs, as explained in the Cost of Sales section above

The increase in Government Systems operating earnings as a percent of sales was driven by the decline in company-funded R&D expense and lower employee incentive compensation costs, partially offset by the adverse impact of lower sales.

Government Systems Operating Earnings for 2011 compared to 2010

Government Systems operating earnings were $592 million, or 21.0 percent of sales, for 2011 compared to operating earnings of $606 million, or 21.2 percent of sales, for 2010. The $14 million decrease in Government Systems operating earnings was primarily due to the following:

$18 million reduction attributable to an increase in selling, general and administrative expenses driven by higher employee incentive compensation costs and merit pay increases as discussed in the SG&A section above

$48 million reduction in sales volume discussed in the Government Systems Sales section above resulted in a $31 million reduction to costs and lower operating earnings of $17 million, at a variable gross margin of 35 percent

above items were partially offset by a $21 million net benefit to operating earnings resulting from the combined impact of lower pension costs, as discussed in the Retirement Plans section below, and a $7 million reduction in warranty expenses primarily attributable to a favorable adjustment recorded in 2011 to reduce warranty reserves

Government Systems operating earnings as a percent of sales were relatively flat from 2010 to 2011.


Commercial Systems

Overview and Outlook

Our Commercial Systems business supplies aviation electronics systems, products and services to customers located throughout the world. The customer base is comprised of OEMs of commercial air transport, business and regional aircraft, commercial airlines and business aircraft operators. The near and long-term performance of our Commercial Systems business is impacted by general worldwide economic health, commercial airline flight hours, corporate profits and the financial condition of airlines worldwide.
We expect Commercial Systems sales to increase by about 7 percent in 2013 compared to 2012, primarily due to the following:

sales to aircraft OEMs are expected to increase by high single digits across both the air transport and business and regional markets. Sales to air transport aircraft OEMs should benefit from anticipated production rate increases for the Boeing 787 aircraft and other legacy Boeing and Airbus aircraft. Business and regional jet OEM sales should also improve as the result of modest production rate increases across most OEM customers

aftermarket sales for 2013 are expected to increase by low double-digits. The sales increase is expected to be driven by initial revenue from airspace mandates, business jet cockpit upgrades and higher service and support revenue across both market segments

28




partially offset by an expected decrease of approximately 15 percent in sales of wide-body in-flight entertainment (IFE) products and services due to our decision in 2005 to cease investing in this product area. Wide-body IFE relates to sales of twin-aisle IFE products and systems to customers in the air transport market and also includes related revenue from wide-body service and support activities

We expect the majority of the anticipated sales growth for Commercial Systems to occur in the second half of fiscal year 2013. This is primarily driven by year over year comparability issues with the timing of spares revenues on Boeing 787 aircraft, the lack of Hawker Beechcraft jet deliveries in 2013 and a concentration of anticipated mandate and retrofit activity towards the latter part of our fiscal 2013.

We project Commercial Systems 2013 operating margins will expand by approximately 200 basis points above the 20.6 percent reported in 2012, driven primarily by the anticipated revenue increase.
Risks to the Commercial Systems business include:
turbulence in global economic and financial markets could have a significant impact on demand for air travel, airline demand for new aircraft and the availability of financing for new aircraft

occurrence of an unexpected geopolitical event, including terrorism or a pandemic, that could have a significant impact on demand for air travel and airline demand for new aircraft

potential negative impact that fuel prices could have on the profitability of airline and other aircraft operator customers

our ability to develop products and execute on programs pursuant to contractual requirements

development and market segment acceptance of our products and systems

potential adverse impact from delays or reductions in OEM aircraft production, including delays in the entry into service date for new aircraft

For additional disclosure on Commercial Systems segment results see Note 24 of the Notes to Consolidated Financial Statements in Item 8 below.

Commercial Systems Sales
 
The following table presents Commercial Systems sales by product category and type of product or service:
 
(in millions)
 
2012
 
2011
 
2010
Air transport aviation electronics:
 
 
 
 
 
 
Original equipment
 
$
574

 
$
499

 
$
439

Aftermarket
 
474

 
431

 
380

Wide-body in-flight entertainment
 
91

 
119

 
145

Total air transport aviation electronics
 
1,139

 
1,049

 
964

Business and regional aviation electronics:
 
 
 
 

 
 

Original equipment
 
582

 
557

 
466

Aftermarket
 
414

 
387

 
340

Total business and regional aviation electronics
 
996

 
944

 
806

Total
 
$
2,135

 
$
1,993

 
$
1,770

Percent increase
 
7
%
 
13
%
 
 



29



Commercial Systems Sales for 2012 compared to 2011

Total air transport aviation electronics sales increased $90 million, or 9 percent, primarily due to the following:

air transport OEM sales increased $75 million, or 15 percent, driven primarily by higher sales to Boeing and Airbus as they increased aircraft production rates across various platforms, including the Boeing 787 and 737 aircraft and the Airbus A320

air transport aftermarket sales increased $43 million, or 10 percent. The increase was driven by higher spares revenues of $19 million, primarily for new Boeing 787 and 747-8 aircraft, and a $22 million increase in retrofit and service and support activities

Wide-body IFE sales decreased $28 million, or 24 percent, due to the Company's strategic decision announced in 2005 to cease investment in this product area

Total business and regional aviation electronics sales increased $52 million, or 6 percent, primarily due to the following:

business and regional OEM sales increased $25 million, or 4 percent, primarily related to a $62 million increase in product deliveries for Bombardier Global, Cessna Citation and Gulfstream aircraft. This was partially offset by net reductions of $37 million, including a $27 million reduction in sales to Hawker Beechcraft who filed for Chapter 11 bankruptcy protection in May 2012, and lower sales to regional jet aircraft manufacturers as production rates declined for certain aircraft

business and regional aftermarket sales increased $27 million, or 7 percent, driven by the combined impact of higher retrofit and service and support activities. Retrofit sales increased as customers upgraded aircraft systems in order to gain operational efficiencies, improve performance and modernize the cabin

Commercial Systems Sales for 2011 compared to 2010

Total air transport aviation electronics sales increased $85 million, or 9 percent, primarily due to the following:

air transport OEM sales increased $60 million, or 14 percent, primarily from higher product deliveries to Boeing across multiple platforms, including Boeing 787 aircraft, and increased development effort on avionics packages for the new Commercial Aircraft Corporation of China, Ltd. (COMAC) C919 narrowbody aircraft

air transport aftermarket sales increased $51 million, or 13 percent, primarily related to a $27 million increase in service and support sales and higher aftermarket hardware revenues of $24 million, driven by initial deliveries of spares for Boeing 747-8 aircraft and higher spare part sales to various airline customers as they restocked their inventories

Wide-body IFE sales decreased $26 million, or 18 percent, due to the Company's strategic decision announced in 2005 to cease investment in this product area

Total business and regional aviation electronics sales increased $138 million, or 17 percent, primarily due to the following:

business and regional OEM sales increased $91 million, or 20 percent, primarily due to $64 million of higher sales to Bombardier for Bombardier Global and Challenger 300 aircraft and $14 million of higher avionics sales to Cessna resulting from our new position on the CJ-4 aircraft

business and regional aftermarket sales increased $47 million, or 14 percent. Service and support revenues accounted for $17 million of the increase, driven by improved aircraft utilization. Higher spare parts revenues and increased sales of equipment for simulators primarily contributed an additional $18 million. The remaining increase of $12 million was primarily related to incremental sales from Air Routing and CTA acquisitions


30



Commercial Systems Segment Operating Earnings
 
(in millions)
 
2012
 
2011
 
2010
Segment operating earnings
 
$
440

 
$
381

 
$
287

Percent of sales
 
20.6
%
 
19.1
%
 
16.2
%

Commercial Systems Operating Earnings for 2012 compared to 2011

Commercial Systems operating earnings increased $59 million, or 15 percent, primarily due to the following:

incremental earnings from higher sales volume totaled $61 million, at a variable gross margin of 43 percent, which reflects the impact of lower margins on our Boeing 787 program revenues

partially offset by a $10 million reduction to operating earnings due to the absence of favorable adjustments recorded in the prior year to reduce certain customer incentive reserves

remaining variance of $8 million is primarily comprised of a net benefit from lower employee incentive compensation costs, partially offset by a $5 million bad debt charge recorded in the third quarter of fiscal year 2012 and higher warranty, employee medical and retirement benefit costs, as explained in the Cost of Sales section above

The increase in Commercial Systems operating earnings as a percent of sales was primarily due to the incremental earnings from higher sales volume.

Commercial Systems Operating Earnings for 2011 compared to 2010

Commercial Systems operating earnings increased $94 million, or 33 percent, primarily due to the following:

$223 million sales increase discussed in the Commercial Systems sales section above resulted in a $109 million increase in costs and incremental operating earnings of $114 million, at a variable gross margin of 51 percent

$18 million benefit to operating earnings related to a change in estimate recorded in 2011 to reduce the provision for certain customer incentives

above items were partially offset by a $29 million reduction to operating earnings attributable to an increase in selling, general and administrative expenses as discussed in the SG&A section above

additional $9 million reduction to operating earnings resulted from higher company-funded R&D expense, as explained in the Cost of Sales section above

The increase in Commercial Systems operating earnings as a percent of sales was primarily due to the incremental earnings from higher sales and the favorable impact of the adjustment to customer incentive reserves, partially offset by higher SG&A and company-funded R&D expenses.

General Corporate, Net
 
General corporate expenses that are not allocated to our business segments are included in General corporate, net. These costs are included within Cost of sales, SG&A and Other Income, net on the Consolidated Statement of Operations. General corporate, net is summarized as follows:
(in millions)
 
2012
 
2011
 
2010
General corporate, net
 
$
42

 
$
48

 
$
54


General corporate, net expense decreased $6 million during 2012 as compared to 2011 primarily due to a reduction in employee incentive compensation costs, as discussed in the SG&A section above.


31



General corporate, net expense decreased $6 million during 2011 as compared to 2010 primarily due to a $13 million decrease in defined benefit pension expense that is described in the Retirement Plans section below, partially offset by a $7 million increase in certain SG&A costs, including employee incentive compensation, as discussed in the SG&A section above.


Retirement Plans

Net benefit expense (income) for pension benefits and other retirement benefits are as follows:
 
(in millions)
2012
 
2011
 
2010
Pension benefits
$
(13
)
 
$
(16
)
 
$
26

Other retirement benefits
18

 
10

 
5

Net benefit expense (income)
$
5

 
$
(6
)
 
$
31


Pension Benefits

In 2003, we amended our U.S. qualified and non-qualified pension plans covering all salary and hourly employees not covered by collective bargaining agreements to discontinue benefit accruals for salary increases and services rendered after September 30, 2006. Concurrently, we replaced this benefit by supplementing our existing defined contribution savings plan to include an additional Company contribution effective October 1, 2006. The supplemental contribution to our existing defined contribution savings plan was $41 million, $39 million and $34 million for 2012, 2011 and 2010, respectively.

Defined benefit pension expense (income) for the years ended September 30, 2012, 2011 and 2010 was $(13) million, $(16) million and $26 million, respectively. Pension costs did not change significantly in 2012 compared to 2011. The lower pension expense in 2011 compared to 2010 was primarily due to the change in amortization period of actuarial gains and losses. In 2010, we amortized actuarial gains and losses over the average remaining service period of active participants, or about 11 years. Beginning in 2011, the amortization of such amounts changed to over the expected future life expectancy of inactive participants, or about 28 years. This change in amortization period was attributable to the fact that almost all of the plan's participants are now considered inactive due to the discontinuance of benefit accruals for most employees, as described above.

During 2012, the funded status of our pension plans went from a deficit of $1,407 million at September 30, 2011 to a deficit of $1,466 million at September 30, 2012. This was primarily due to the adverse impact of a decrease in the discount rate used to measure our U.S. pension obligations from 4.43 percent at September 30, 2011 to 3.56 percent at September 30, 2012, partially offset by an increase in plan assets driven by improved market returns in 2012. During 2011, the funded status of our pension plans went from a deficit of $1,185 million at September 30, 2010 to a deficit of $1,407 million at September 30, 2011, primarily due to a decrease in the discount rate used to measure our U.S. pension obligations from 4.85 percent at September 30, 2010 to 4.43 percent at September 30, 2011. In addition, the funded status was adversely impacted by a reduction in plan assets during 2011.

We expect defined benefit pension expense of $7 million in 2013, compared to $13 million of pension income in 2012. The expected $20 million increase in pension costs from 2012 to 2013 is primarily due to a decrease in our expected long-term return on plan assets assumption, from 8.75 percent in 2012 to 8.25 percent in 2013. The higher anticipated pension cost for 2013 is also adversely impacted by an increase in the amortization of net actuarial losses, which are the result of declining discount rates over the past few years.

Our objective with respect to the funding of our pension plans is to provide adequate assets for the payment of future benefits. Pursuant to this objective, we will fund our pension plans as required by governmental regulations and may consider discretionary contributions as conditions warrant. We believe our strong financial position continues to provide us the opportunity to make contributions to our pension fund without inhibiting our ability to pursue strategic investments.

In October 2012, subsequent to our 2012 year end, we made a $55 million contribution to our U.S. qualified pension plan. We plan to contribute an additional $55 million in 2013 for a total $110 million contribution, which we anticipate will fully satisfy the minimum statutory funding requirements for 2013. Any additional future contributions necessary to satisfy the minimum statutory funding requirements are dependent upon actual plan asset returns and interest rates. We may elect to make additional discretionary contributions during 2013 to further improve the funded status of this plan. Contributions to our non-U.S. plans and our U.S. non-qualified plan are expected to total $14 million in 2013.


32



Other Retirement Benefits

We have historically provided retiree medical and life insurance benefits to substantially all of our employees. We have undertaken two major actions over the past several years with respect to these benefits that have lowered both the current and future costs of providing these benefits:

in July of 2002, the pre-65 and post-65 retiree medical plans were amended to discontinue benefits for employees hired after September 30, 2006 and establish a fixed Company contribution. Additional premium contributions will be required from participants for all costs in excess of this fixed contribution amount. This amendment eliminated the risk to us related to health care cost escalations for retiree medical benefits going forward as additional contributions will be required from retirees for all costs in excess of our fixed contribution amount

as a result of the Medicare Prescription Drug, Improvement and Modernization Act of 2003, we amended our retiree medical plans on June 30, 2004 to discontinue post-65 prescription drug coverage effective January 1, 2008. Post-65 retirees have the option of receiving these benefits through Medicare. We believe the Medicare prescription drug benefit is generally better than the benefit that was provided by our discontinued post-65 drug plan

Other retirement benefits expense for the years ended September 30, 2012, 2011 and 2010 was $18 million, $10 million and $5 million, respectively. We expect other retirement benefits expense of approximately $15 million in 2013.

FINANCIAL CONDITION AND LIQUIDITY

Cash Flow Summary

Our ability to generate significant cash flow from operating activities coupled with our expected ability to access the credit markets enables us to execute our growth strategies and return value to our shareowners. The timing of our cash inflows is historically heavily weighted towards the second half of our fiscal year, particularly to our fourth quarter. We expect this trend to continue in the future.

During 2012, we exercised the flexibility of our balance sheet and issued $250 million of 3.10 percent fixed rate unsecured debt. We used the proceeds from this debt, supplemented by available cash on hand, to make significant cash expenditures aimed at future growth and enhanced shareowner value, as shown below:

$714 million of cash payments for share repurchases

$138 million of capital expenditures

$157 million of dividend payments

In addition, we also made $126 million of pension plan contributions.

Operating Activities
 
(in millions)
 
2012
 
2011
 
2010
Cash provided by operating activities
 
$
534

 
$
657

 
$
711


The $123 million decrease in cash provided by operating activities in 2012 compared to 2011 was primarily due to the following:

cash receipts from customers decreased by $114 million to $4,685 million in 2012 compared to $4,799 million in 2011, primarily due to the lower sales volume in 2012 as discussed in the Results of Operations section above and lower collections of receivables from customers, partially offset by higher progress payments received in advance of revenue recognition

payments for income taxes increased $112 million to $208 million in 2012 compared to $96 million in 2011 due to the differences in the timing of cash tax payments resulting from the retroactive extension of the Federal R&D tax credit

33



that benefited the prior year and the expiration of the Federal R&D tax credit that increased cash payments in the current year

payments for employee incentive pay increased $62 million. Incentive pay is expensed in the year it is incurred and paid in the first fiscal quarter of the following year. During 2012, $133 million was paid for employee incentive pay costs incurred during 2011 as compared to $71 million paid in 2011 for employee incentive pay costs incurred during 2010

above items were partially offset by a decrease in payments for inventory and other operating costs of $206 million to $3,672 million in 2012 compared to $3,878 million in 2011. The decrease was primarily due to lower costs associated with the lower sales volume in 2012 discussed in the Results of Operations section above

The $54 million decrease in cash provided by operating activities in 2011 compared to 2010 was primarily due to the following:

payments for inventory and other operating costs increased $237 million to $3,878 million in 2011 compared to $3,641 million in 2010. The increase was primarily due to increased costs associated with the higher sales volume in 2011 discussed in the Results of Operations section above and an increase in inventory, primarily driven by:

    higher pre-production engineering costs resulting from increased effort on programs such as the Airbus A350, various Bombardier platforms in the business jet market, and several international rotary and fixed-wing programs within Government Systems

    additional increases to inventory resulting from the adverse impact of delayed funding authorizations from the U.S. Government, an increase to accommodate a transitional period of relocating certain production effort to other existing facilities and higher purchases of component parts to mitigate supply chain risks after the earthquake and tsunami in Japan

payments for employee incentive pay increased $71 million. Incentive pay is expensed in the year it is incurred and paid in the first fiscal quarter of the following year. During 2011, $71 million was paid for employee incentive pay costs incurred during 2010. No incentive pay costs were incurred for the full year 2009; accordingly, there was no 2010 payment for incentive pay

above items were partially offset by an increase in cash receipts from customers of $212 million to $4,799 million in 2011 compared to $4,587 million in 2010, primarily due to the higher sales volume in 2011 as discussed in the Results of Operations section above and higher collections of receivables from customers, including higher progress payments received in advance of revenue recognition

payments for income taxes decreased $29 million to $96 million in 2011 compared to $125 million in 2010 primarily due to the timing of cash tax payments related to the retroactive extension of the Federal R&D Tax credit

In 2013 cash provided by operating activities is expected to be in the range of $500 million to $600 million. The projected range of cash provided by operating activities accommodates a $110 million expected contribution to our U.S. qualified defined benefit pension plan and a projected $210 million net increase in pre-production engineering costs. We expect a majority of the projected 2013 operating cash flow to be generated in the second half of our fiscal year.

Investing Activities
 
(in millions)
 
2012
 
2011
 
2010
Cash used for investing activities
 
$
(129
)
 
$
(92
)
 
$
(232
)

The $37 million increase in cash used for investing activities in 2012 compared to 2011 was primarily due to the following:

cash proceeds received from the dispositions of property and businesses decreased by $44 million. The majority of this decrease is due to the absence of the Rollmet divestiture which occurred in 2011

the absence of proceeds of $20 million in 2011 from the sale of a short-term investment at a non-U.S. subsidiary

34




partially offset by:

lower payments for the acquisition of businesses of $17 million. In 2012, there were no business acquisitions as compared to $17 million in payments in 2011 for the acquisitions of Blue Ridge Simulation, Inc. and Computing Technologies for Aviation, Inc.

a $14 million decrease in capital expenditures

The $140 million reduction in cash used for investing activities in 2011 compared to 2010 was primarily due to the following:

in 2011 we received $44 million in proceeds from the divestiture of the Rollmet business and $14 million in proceeds from the disposition of property compared to $1 million received from the disposition of property in 2010

in 2011 we acquired Blue Ridge Simulation, Inc. and Computing Technologies for Aviation, Inc. for $17 million compared to the 2010 acquisition of Air Routing for $91 million

we received $20 million from the sale of a short-term investment at a non-U.S. subsidiary in 2011 which was purchased for $21 million in 2010

above items were partially offset by a $43 million increase in property additions

Financing Activities

(in millions)
 
2012
 
2011
 
2010
Cash used for financing activities
 
$
(594
)
 
$
(471
)
 
$
(279
)

The $123 million increase in cash used for financing activities in 2012 compared to 2011 was primarily due to the following:

cash repurchases of common stock increased $386 million to $714 million in 2012 from $328 million in 2011

partially offset by:

net proceeds of $247 million from the issuance of long-term debt in November of 2011

absence of a $24 million repayment of short-term debt at a non-U.S. subsidiary that occurred during 2011

The $192 million increase in cash used for financing activities in 2011 compared to 2010 was primarily due to the following:

cash repurchases of common stock increased $145 million to $328 million in 2011 from $183 million in 2010

repayment of short-term borrowings increased by $24 million in 2011 as short-term debt of $24 million outstanding at the end of 2010 was repaid during 2011

cash proceeds from stock option exercises decreased $16 million to $22 million in 2011 from $38 million in 2010

Share Repurchase Program

Cash flow from operations and the issuance of $250 million of 3.10 percent fixed rate debt in 2012 provided funds for repurchasing our common stock under our share repurchase program as follows:

(in millions, except per share amounts)
 
2012
 
2011
 
2010
Amount of share repurchases
 
$
723

 
$
322

 
$
182

Number of shares repurchased
 
13.3

 
5.5

 
3.2

Weighted average price per share
 
$
54.41

 
$
58.50

 
$
57.50


35




Approximately $16 million and $0 of the 2012 and 2011 share repurchases reflected in the table above are included within accounts payable at September 30, 2012 and 2011, respectively, and are reflected as a non-cash transaction in our Consolidated Statement of Cash Flows.

Dividends

We declared and paid cash dividends of $157 million, $148 million and $151 million in 2012, 2011 and 2010, respectively. Based on our current dividend policy, we will pay quarterly cash dividends which, on an annual basis, will equal $1.20 per share. We expect to fund dividends using cash generated from operations. The declaration and payment of future dividends is at the sole discretion of the Board of Directors.

Financial Condition and Liquidity

We have historically maintained a capital structure characterized by conservative levels of debt outstanding that enables us sufficient access to credit markets. When combined with our ability to generate strong levels of cash flow from our operations, this capital structure provides the strength and flexibility necessary to pursue strategic growth opportunities and to return value to our shareowners. A comparison of key elements of our financial condition as of September 30, 2012 and 2011 are as follows:
 
 
September 30
(in millions)
2012
 
2011
Cash and cash equivalents
$
335

 
$
530

Long-term debt, net
(779
)
 
(528
)
Net debt (1)
$
(444
)
 
$
2

Total equity
$
1,264

 
$
1,528

Debt to total capitalization (2)
38
%
 
26
 %
Net debt to total capitalization (3)
26
%
 
 %

(1)
Calculated as total of long-term debt, net (Total debt), less cash and cash equivalents
(2)
Calculated as Total debt divided by the sum of Total debt plus Total equity
(3)
Calculated as Net debt divided by the sum of Net debt plus Total equity

We primarily fund our contractual obligations, capital expenditures, small to medium sized acquisitions, dividends and share repurchases from cash generated from operating activities. As of September 30, 2012, approximately 75 percent of our cash and cash equivalents resides at non-U.S. locations and may not be readily accessible for use in the U.S. due to potential adverse income tax implications and other statutory limitations. Due to the fluctuations of cash flows, we supplement our internally generated cash flow from time to time by issuing short-term commercial paper. Under our commercial paper program, we may sell up to $850 million face amount of unsecured short-term promissory notes in the commercial paper market. The commercial paper notes have maturities of not more than 364 days from the date of issuance. At September 30, 2012 and September 30, 2011, there were no short-term commercial paper borrowings outstanding. The maximum amount of short-term borrowings outstanding during 2012 was $330 million and the maximum amount outstanding during 2011 was $345 million.

In the event our access to the commercial paper markets is impaired, we have access to an $850 million Revolving Credit Facility through a network of banks that matures in 2016, with options to further extend the term for up to two one-year periods and/or increase the aggregate principal amount up to $1.2 billion. These options are subject to the approval of the lenders. Our only financial covenant under the Revolving Credit Facility requires that we maintain a consolidated debt to total capitalization ratio of not greater than 60 percent, excluding the accumulated other comprehensive loss equity impact related to defined benefit retirement plans. Our debt to total capitalization ratio at September 30, 2012 based on this financial covenant was 21 percent. We had no borrowings at September 30, 2012 under our Revolving Credit Facility.


36



In addition, alternative sources of liquidity could include funds available from the issuance of equity securities, debt securities and potential asset securitization strategies. To date, we have not raised capital through the issuance of equity securities as we prefer to use debt financing to lower our overall cost of capital and increase our return on shareowners' equity.

Credit ratings are a significant factor in determining our ability to access short-term and long-term financing as well as the cost of such financing in terms of interest rates. Our strong credit ratings have enabled continued access to both short and long-term credit markets. If our credit ratings were to be adjusted downward by the rating agencies, the implications of such actions could include impairment or elimination of our access to credit markets and an increase in the cost of borrowing. The following is a summary of our credit ratings as of September 30, 2012:
 
Credit Rating Agency
 
Short-Term Rating
 
Long-Term Rating
 
Outlook
Fitch Ratings
 
F1
 
A
 
Stable
Moody’s Investors Service
 
P-1
 
A1
 
Negative
Standard & Poor’s
 
A-1
 
A
 
Stable

We were in compliance with all debt covenants at September 30, 2012 and September 30, 2011.

Off-balance Sheet Arrangements

As of September 30, 2012, other than operating leases, we had no material off-balance sheet arrangements, including guarantees, retained or contingent interests in assets transferred to unconsolidated entities, derivative instruments indexed to our stock and classified in shareowners' equity on our Consolidated Statement of Financial Position or variable interests in entities that provide financing, liquidity, market risk or credit risk support to our Company.

Contractual Obligations
The following table summarizes certain of our contractual obligations as of September 30, 2012, as well as when these obligations are expected to be satisfied.
 
 
 
 
 
 
 
 
 
 
 
 
 
Payments Due by Period
(in millions)
 
Total
 
Less than
1 Year
 
1 - 3
Years
 
4 - 5
Years
 
Thereafter
Long-term debt
 
$
750

 
$

 
$
200

 
$

 
$
550

Interest on long-term debt
 
199

 
33

 
52

 
48

 
66

Non-cancelable operating leases
 
249

 
64

 
103

 
49

 
33

Purchase obligations:
 
 
 
 
 
 
 
 
 
 
Purchase orders
 
991

 
811

 
150

 
5

 
25

Purchase contracts
 
100

 
50

 
30

 
10

 
10

Total
 
$
2,289

 
$
958

 
$
535

 
$
112

 
$
684


Interest payments under long-term debt obligations exclude the potential effects of the related interest rate swap contracts. See Note 10 of the Notes to Consolidated Financial Statements in Item 8 below.

We lease certain office and manufacturing facilities as well as certain machinery and equipment under various lease contracts with terms that meet the accounting definition of operating leases. Our commitments under these operating leases, in the form of non-cancelable future lease payments, are not reflected as a liability on our Consolidated Statement of Financial Position.

Purchase obligations include purchase orders and purchase contracts. Purchase orders are executed in the normal course of business and may or may not be cancelable. Purchase contracts include agreements with suppliers under which there is a commitment to buy a minimum amount of products or pay a specified amount regardless of actual need. Generally, items represented in purchase obligations are not reflected as liabilities on our Consolidated Statement of Financial Position.

The table excludes obligations with respect to pension and other post-retirement benefit plans (see Note 11 of the Notes to Consolidated Financial Statements in Item 8 below). We plan to contribute $110 million to our U.S. qualified pension plan in 2013, which will fully satisfy the minimum statutory funding requirements for 2013. In October 2012, subsequent to fiscal year

37



end, $55 million of this amount was contributed to the plan. For years beyond 2013, the actual amounts required to be contributed to our U.S. qualified pension plan are dependent upon, among other things, interest rates and underlying asset returns. With the exception of certain bargaining unit plans, payments due under other post-retirement benefit plans are funded as the expenses are incurred.

In addition, the table excludes liabilities for unrecognized tax benefits, which totaled $42 million at September 30, 2012, as we cannot reasonably estimate the ultimate timing of cash settlements to the respective taxing authorities (see Note 16 of the Notes to Consolidated Financial Statements in Item 8 below).

The following table reflects certain of our commercial commitments as of September 30, 2012:

 
 
Amount of Commitment Expiration by Period
(in millions)
 
Total
Amount
Committed
 
Less than
1 Year
 
1 - 3
Years
 
4 - 5
Years
 
Thereafter
Letters of credit*
 
$
71

 
$
57

 
$
13

 
$
1

 
$


* See Note 19 of the Notes to Consolidated Financial Statements in Item 8 below for a discussion of letters of credit.
In addition to the obligations disclosed above, we occasionally enter into offset agreements, required by certain customers in some non-U.S. countries, as a condition to obtaining contract awards for our products and services. These agreements, which generally extend over several years, are customary in our industry and are designed to enhance the social and economic environment of the country in which our customers operate. These commitments may be satisfied through activities that do not require us to use cash, including transfer of technology, providing manufacturing and other consulting support to in-country projects, strategic alliances and transactions conducted by third parties (e.g., our vendors). These agreements may also be satisfied through our use of cash for activities such as placement of direct work or vendor orders for supplies and/or services, building or leasing facilities for in-country operations, in-country employment of a non-U.S. country's citizens and other forms of assistance in the applicable country. The offset rules and regulations, as well as the underlying contracts, may differ from one country to another.

We typically do not commit to offset agreements until contract awards for our products or services are definitive. Should we be unable to meet the offset obligations we may be subject to contractual penalties, and our chances of receiving additional business from the applicable customers could be reduced or, in certain cases, eliminated. We historically have not been required to pay material penalties related to offset obligations and are currently in compliance with our offset commitments.

At September 30, 2012, we had outstanding offset obligations totaling approximately $237 million that extend through 2021. The amounts ultimately applied against our offset requirements are based on negotiations with the customer and the cost to fulfill the obligation is typically only a fraction of the original obligation above.

RECENTLY ISSUED ACCOUNTING STANDARDS

For information related to recently issued accounting standards, see Note 2 of the Notes to Consolidated Financial Statements in Item 8 below.

ENVIRONMENTAL

For information related to environmental claims, remediation efforts and related matters, see Note 21 of the Notes to Consolidated Financial Statements in Item 8 below.

CRITICAL ACCOUNTING POLICIES

The preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America requires us to make estimates, judgments and assumptions that affect our financial condition and results of operations that are reported in the accompanying consolidated financial statements as well as the related disclosure of assets and liabilities contingent upon future events.


38



Understanding the critical accounting policies discussed below and related risks is important in evaluating our financial condition and results of operations. We believe the following accounting policies used in the preparation of the consolidated financial statements are critical to our financial condition and results of operations as they involve a significant use of management judgment on matters that are inherently uncertain. If actual results differ significantly from management's estimates, there could be a material effect on our financial condition, results of operations and cash flows. Management regularly discusses the identification and development of these critical accounting policies with the Audit Committee of the Board of Directors.

Accounting for Long-Term Contracts

A substantial portion of our sales to government customers and certain of our sales to commercial customers are made pursuant to long-term contracts requiring development and delivery of products over several years and often contain fixed-price purchase options for additional products. Certain of these contracts are accounted for under the percentage-of-completion method of accounting. Sales and earnings under the percentage-of-completion method are recorded either as products are shipped under the units-of-delivery method (for production effort), or based on the ratio of actual costs incurred to total estimated costs expected to be incurred related to the contract under the cost-to-cost method (for development effort). Approximately 20 percent of our sales are accounted for under the percentage-of-completion method of accounting.

The percentage-of-completion method of accounting requires management to estimate the profit margin for each individual contract and to apply that profit margin on a uniform basis as sales are recorded under the contract. The estimation of profit margins requires management to make projections of the total sales to be generated and the total costs that will be incurred under a contract. These projections require management to make numerous assumptions and estimates relating to items such as the complexity of design and related development costs, performance of subcontractors, availability and cost of materials, labor productivity and cost, overhead and capital costs and manufacturing efficiency. These contracts often include purchase options for additional quantities and customer change orders for additional or revised product functionality. Sales and costs related to profitable purchase options are included in our estimates only when the options are exercised while sales and costs related to unprofitable purchase options are included in our estimates when exercise is determined to be probable. Sales related to change orders are included in profit estimates only if they can be reliably estimated and collectability is reasonably assured. Purchase options and change orders are accounted for either as an integral part of the original contract or separately depending upon the nature and value of the item. Anticipated losses on contracts are recognized in full in the period in which losses become probable and estimable.

Estimates of profit margins for contracts are typically reviewed by management on a quarterly basis. Assuming the initial estimates of sales and costs under a contract are accurate, the percentage-of-completion method results in the profit margin being recorded evenly as revenue is recognized under the contract. Changes in these underlying estimates due to revisions in sales and cost estimates, the combining of contracts or the exercise of contract options may result in profit margins being recognized unevenly over a contract as such changes are accounted for on a cumulative basis in the period estimates are revised. Cumulative catch-up adjustments resulting from changes in estimates did not have a material effect on our results of operations during the years ended September 30, 2012, 2011 or 2010.

Program Investments

We defer certain pre-production engineering costs in Inventories, net and record up-front sales incentives in Intangible Assets (collectively referred to as Program Investments). These Program Investments are amortized over their estimated useful lives, up to a maximum of 15 years. Estimated useful lives are limited to the amount of time we are virtually assured to earn revenues through a contractually enforceable right included in long-term supply arrangements with our customers. This provides the best matching of expense over the related period of benefit. The following provides an overview of the Program Investments:

 
 
September 30
(in millions)
 
2012
 
2011
Pre-production engineering costs
 
$
569

 
$
446

Up-front sales incentives
 
186

 
173

Total Program Investments
 
$
755

 
$
619


We defer the cost of certain pre-production engineering costs incurred during the development phase of a program in connection with long-term supply arrangements that contain contractual guarantees for reimbursement from customers. These customer guarantees generally take the form of a minimum order quantity with quantified reimbursement amounts if the

39



minimum order quantity is not taken by the customer. These costs are deferred in Inventories, net to the extent of the contractual guarantees and are amortized over their estimated useful lives using a units-of-delivery method, up to 15 years. This amortization expense is included as a component of cost of sales. Amortization is based on our expectation of delivery rates on a program-by-program basis and begins when we start recognizing revenue as we deliver equipment for the program. The estimated useful life is limited to the amount of time we are virtually assured to earn revenues through a contractually enforceable right included in long-term supply arrangements with our customers. Pre-production engineering costs in excess of the contractual guarantee, and costs incurred pursuant to supply arrangements that do not contain customer guarantees for reimbursement, are expensed as incurred.

We also provide up-front sales incentives prior to delivering products or performing services to certain commercial customers in connection with sales contracts. Up-front sales incentives are recorded as a customer relationship intangible asset and are amortized using a units-of-delivery method over the period we have received a contractually enforceable right related to the incentives, up to 15 years. Amortization is based on our expectation of delivery rates on a program-by-program basis. Amortization begins when we start recognizing revenue as we deliver equipment for the program. Up-front sales incentives consisting of cash payments or customer account credits are amortized as a reduction of sales, whereas incentives consisting of free products are amortized as cost of sales.

Risks inherent in recovering the value of our Program Investments include, but are not limited to, the following:

changes in market conditions may affect product sales under a program. In particular, the commercial aerospace market has been historically cyclical and subject to downturns during periods of weak economic conditions, which could be prompted or exacerbated by political or other domestic or international events

bankruptcy or other significant financial difficulties of our customers

our ability to produce products could be impacted by the performance of subcontractors, the availability of specialized materials and other production risks

As of September 30, 2012, Intangible assets include $14 million of up-front sales incentives related to Hawker Beechcraft, Inc., who declared bankruptcy in 2012. We currently estimate this balance to be recoverable. We evaluate the carrying amount of Program Investments for recovery at least annually or when potential indicators of impairment exist, such as a change in the estimated number of products to be delivered under a program. No impairment charges related to Program Investments were recorded in 2012, 2011 or 2010. While we believe our Program Investments are recoverable over time, the cancellation of a program by a customer would represent the most significant impairment factor related to Program Investments. Due to the long-term nature of the procurement cycle and the significant investment required to bring a program to market in the aerospace and defense industry, we believe the likelihood of a customer abruptly canceling a program is remote. We also evaluate our amortization of Program Investments quarterly based on our expectation of delivery rates on a program-by-program basis. The impact of changes in expected delivery rates on the Program Investments' amortization is adjusted as needed on a prospective basis. There were no significant changes in the rate of Program Investment amortization and no significant cumulative adjustments recorded in 2012, 2011 and 2010.

Amortization expense for pre-production engineering costs and up-front sales incentives for 2012, 2011 and 2010 was as follows:
(in millions)
2012

 
2011

 
2010

Amortization of pre-production engineering
$
18

 
$
15

 
$
15

Amortization of up-front sales incentives
9

 
6

 
4

Total amortization of Program Investments
$
27

 
$
21

 
$
19



40



As disclosed in Note 6 of the Notes to Consolidated Financial Statements, the weighted average amortization period for pre-production engineering costs is approximately ten years. As disclosed in Note 8 of the Notes to Consolidated Financial Statements, the weighted average amortization period for up-front sales incentives is approximately nine years. Anticipated amortization expense for Program Investments for fiscal years 2013 and beyond is summarized below:
(in millions)
2013
 
2014
 
2015
 
2016
 
2017
 
Thereafter
Anticipated amortization expense for pre-production engineering costs
$
26

 
$
42

 
$
59

 
$
70

 
$
77

 
$
295

Anticipated amortization expense for up-front sales incentives
8

 
14

 
20

 
26

 
22

 
96

Total anticipated amortization for Program Investments
$
34

 
$
56

 
$
79

 
$
96

 
$
99

 
$
391


Pre-production engineering costs comprise 43 percent of our total Inventory balance at September 30, 2012, compared to 37 percent in the prior year. Pre-production engineering costs increased $123 million from September 30, 2011 to September 30, 2012. The majority of this increase was attributable to a $104 million increase within Commercial Systems, driven by increased spending on programs with Bombardier and Airbus. The remaining increase of $19 million was within Government Systems. Additionally, up-front sales incentives to Commercial Systems customers increased $13 million from September 30, 2011 to September 30, 2012. Growth in our Program Investments continues to be driven by the expanded market share our Company successfully captured over the past several years. Commercial Systems has secured positions on several key platforms in the air transport market, including the Boeing 787, Boeing 747-8 and Airbus A350. In the business and regional jet market, our Pro Line Fusion avionics system has been selected by customers around the globe, including Bombardier, Embraer and Gulfstream. Our customers have provided us a contractual guarantee for reimbursement on several of these programs; as such, our capitalized pre-production engineering costs have increased for these programs as the Company continues development efforts. Our Government Systems business has also contributed to the growth in pre-production engineering costs, as we ramp up efforts on several international rotary and fixed-wing programs that we recently won.

We expect the long-term supply arrangements resulting from these recent program wins to deliver significant revenues and profits to us over the next several years, continuing over the life of the aircraft platforms (which can range from ten to twenty years); as such, we believe our Program Investments are recoverable.

We expect the balance of our capitalized Program Investment costs will continue to increase over the next several years. Looking forward to 2013, we expect pre-production engineering costs to increase approximately $210 million, primarily within Commercial Systems. We primarily fund our Program Investments with cash generated from operating activities. Our 2013 guidance for cash provided by operating activities accommodates the anticipated increase in pre-production engineering costs.

Income Taxes

At the end of each quarterly reporting period, we estimate an effective income tax rate that is expected to be applicable for the full fiscal year. The estimate of our effective income tax rate involves significant judgments resulting from uncertainties in the application of complex tax regulations across many jurisdictions, implementation of tax planning strategies and estimates as to the jurisdictions where income is expected to be earned. These estimates may be further complicated by new laws, new interpretations of existing laws and rulings by taxing authorities. Due to the subjectivity and complex nature of these underlying issues, our actual effective income tax rate and related tax liabilities may differ from our initial estimates. Differences between our estimated and actual effective income tax rates and related liabilities are recorded in the period they become known or as our estimates are revised based on additional information. The resulting adjustment to our income tax expense could have a material effect on our results of operations in the period the adjustment is recorded. A one percentage point change in our effective income tax rate would change our annual income from continuing operations by approximately $9 million.

Deferred tax assets and liabilities are recorded for tax carryforwards and the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. The future realization of our deferred tax assets ultimately depends on our ability to generate sufficient taxable income of the appropriate character (for example, ordinary income or capital gains) within the carryback and carryforward periods available under the tax law and, to a lesser extent, our ability to execute successful tax planning strategies. Management believes it is more likely than not that the current and long-term deferred tax assets will be realized through the reduction of future taxable income, except for deferred tax assets which have been fully reserved and primarily relate to foreign net operating losses. A change in the ability of our

41



operations to continue to generate future taxable income, or our ability to implement desired tax planning strategies, could affect our ability to realize the future tax deductions underlying our net deferred tax assets, and require us to provide a valuation allowance against our net deferred tax assets. The recognition of a valuation allowance would result in a reduction to net income and if significant, could have a material impact on our effective tax rate, results of operations and financial position in any given period.

As part of the determination of our tax liability, management exercises considerable judgment in evaluating tax positions taken by us in determining the income tax provision and establishes reserves for tax contingencies in accordance with the Income Taxes topic of the FASB Accounting Standards Codification. See Note 16 of the Notes to Consolidated Financial Statements in Item 8 below for further detail regarding unrecognized tax benefits, deferred taxes and the factors considered in evaluating deferred tax asset realization.

Goodwill

As of September 30, 2012, we had $780 million of goodwill related to various business acquisitions. We perform impairment tests on goodwill on an annual basis during the second quarter of each fiscal year, or on an interim basis if events or circumstances indicate that it is more likely than not that impairment has occurred.

Goodwill is potentially impaired if the carrying value of the reporting unit that contains the goodwill exceeds its estimated fair value. The fair values of our reporting units are determined using a combination of an income approach, which estimates fair value based upon future discounted cash flows, and a market approach, which estimates fair value using market multiples, ratios and valuations of a set of comparable public companies within our industry.

The valuation methodology and underlying financial information that is used to estimate the fair value of our reporting units requires significant judgments to be made by management. These judgments include, but are not limited to, the long-term projections of future financial performance and the selection of appropriate discount rates used to present value future cash flows. Our five-year strategic operating plan serves as the basis for these valuations and represents our best estimate of future business conditions in our industry as well as our ability to compete. Discount rates are determined based upon the weighted average cost of capital for a set of comparable companies adjusted for risks associated with our different operations. Our goodwill impairment tests that were performed in the second quarter of 2012, 2011 and 2010 yielded no impairments. In addition, based upon the results of our 2012 impairment testing, none of our reporting units were at risk of their carrying value of net assets exceeding their respective fair value. If there were a significant downturn in our business, we could incur a goodwill impairment.

Warranty

Accrued liabilities are recorded on our Consolidated Statement of Financial Position to reflect our contractual obligations relating to warranty commitments to our customers. We provide warranty coverage of various lengths and terms to our customers depending on standard offerings and negotiated contractual agreements. We record an estimate for warranty expense at the time of sale based on historical warranty return rates and repair costs. We believe our primary source of warranty risk relates to extended warranty terms.

As shown in Note 19 of the Notes to Consolidated Financial Statements in Item 8 below, the carrying amount of accrued product warranty costs has declined $91 million from a balance of $217 million at September 30, 2009, to a balance of $126 million at September 30, 2012. This trend is driven by a variety of factors.

Approximately $40 million of the decline from 2009 to 2012 is attributable to the Commercial Systems business. A primary source of warranty risk for Commercial Systems in the past related to sales of wide-body in-flight entertainment products and systems. As discussed in the Commercial Systems Results of Operations section above, sales related to Wide-body IFE have declined significantly over the past several years due to the Company's previously announced decision to cease investing in this product area. As sales volumes related to Wide-body IFE continue to decline and warranty periods on these legacy products expire, our warranty reserve balance has also been reduced. Product reliability improvements have also favorably impacted incurred warranty costs within Commercial Systems, contributing to a lower warranty reserve.

The remaining decrease in our accrued warranty balance from 2009 to 2012 is primarily attributable to certain favorable adjustments recorded by Government Systems in 2012, 2011 and 2010 to reduce warranty reserves for changes in estimate, as shown in Note 19 of the Notes to Consolidated Financial Statements in Item 8 below. These reductions were driven by the completion of certain Government Systems programs that no longer require a warranty and a favorable impact from lower than anticipated repair costs across various product areas.

42




Should future warranty experience differ materially from our historical experience, we may be required to record additional warranty liabilities which could have a material adverse effect on our results of operations and cash flows in the period in which these additional liabilities are required.

Pension Benefits

We historically provided retirement benefits to most of our employees in the form of defined benefit pension plans. Accounting standards require the cost of providing these pension plans be measured on an actuarial basis. These accounting standards will generally reduce, but not eliminate, the volatility of pension expense as actuarial gains and losses resulting from both normal year-to-year changes in valuation assumptions and the differences from actual experience are deferred and amortized. The application of these accounting standards requires management to make numerous assumptions and judgments that can significantly affect these measurements. Critical assumptions made by management in performing these actuarial valuations include the selection of discount rates and expectations on the future rate of return on pension plan assets.

Discount rates are used to determine the present value of our pension obligations and also affect the amount of pension expense recorded in any given period. We estimate this discount rate based on the rates of return of high quality, fixed-income investments with maturity dates that reflect the expected time horizon that benefits will be paid (see Note 11 of the Notes to Consolidated Financial Statements in Item 8 below). Changes in the discount rate could have a material effect on our reported pension obligations and would also impact the related pension expense.

The expected rate of return is our estimate of the long-term earnings rate on our pension plan assets and is based upon both historical long-term actual and expected future investment returns considering the current investment mix of plan assets. Differences between the actual and expected rate of return on plan assets can impact our expense for pension benefits. In 2013, we are reducing our expected rate of return on plan assets by 50 basis points, down to 8.25 percent from the 8.75 percent used in 2012. This reduction in our expected rate of return assumption will serve to increase pension costs in 2013.

Holding all other factors constant, the estimated impact on 2012 pension income and pension benefit obligation for our U.S. plans caused by hypothetical changes to key assumptions is as follows:
 
 
 
 
 
(in millions)
 
Change in Assumption
Assumption
 
25 Basis Point Increase
 
25 Basis Point Decrease
Pension obligation discount rate
 
$105 pension projected benefit obligation decrease
 
$108 pension projected benefit obligation increase
Expected long-term rate of return on plan assets
 
$6 additional pension income
 
$6 decrease to pension income

As disclosed in Note 11 of the Notes to the Consolidated Financial Statements in Item 8 below, beginning in 2011, actuarial gains and losses (including those resulting from a change in the pension obligation discount rate) are amortized over the expected future life expectancy of inactive participants, or about 28 years. In 2010, actuarial gains and losses were amortized over the average remaining service period of active participants, or about 11 years. This change in pension amortization period was the primary factor impacting the $42 million decrease in pension expense from 2010 to 2011. This change in amortization period also resulted in our pension expense (income) being less sensitive to changes in the discount rate assumption. An increase or decrease of 25 basis points in the pension obligation discount rate would impact 2012 pension income by less than $2 million.

Inventory Valuation Reserves

Inventory valuation reserves are recorded in order to report inventories at the lower of cost or market value on our Consolidated Statement of Financial Position. The determination of inventory valuation reserves requires management to make estimates and judgments on the future salability of inventories. Valuation reserves for excess, obsolete and slow-moving inventory are estimated by comparing the inventory levels of individual parts to both future sales forecasts or production requirements and historical usage rates in order to identify inventory that is unlikely to be sold above cost. Other factors that management considers in determining these reserves include overall market conditions and other inventory management initiatives. Management can generally react to reduce the likelihood of severe excess and slow-moving inventory issues by changing purchasing behavior, although abrupt changes in market conditions can limit our ability to react quickly.


43



Management believes its primary source of risk for excess and obsolete inventory is derived from life-time buy inventory. Life-time buy inventory consists of inventory that is typically no longer being produced by our vendors but for which we purchase multiple years of supply in order to meet production and service requirements over the life span of a product. Total life-time buy inventory on hand at September 30, 2012 was $100 million.

Excluding pre-production engineering costs and progress payments, we had $851 million of gross inventory on hand at September 30, 2012 with $86 million of inventory valuation reserves. Although management believes these reserves are adequate, any abrupt changes in market conditions may require us to record additional inventory valuation reserves which could have a material adverse effect on our results of operations in the period in which these additional reserves are required. Pre-production engineering costs are discussed in the "Program Investments" section of our Critical Accounting Policies above.

Item 7A.
Quantitative and Qualitative Disclosures about Market Risk.

Interest Rate Risk

In addition to using cash provided by normal operating activities, we utilize a combination of short-term and long-term debt to finance operations. Our operating results and cash flows are exposed to changes in interest rates that could adversely affect the amount of interest expense incurred and paid on debt obligations in any given period. In addition, changes in interest rates can affect the fair value of our debt obligations. Such changes in fair value are only relevant to the extent these debt obligations are settled prior to maturity. We manage our exposure to interest rate risk by maintaining an appropriate mix of fixed and variable rate debt and when considered necessary, we may employ financial instruments in the form of interest rate swaps to help meet this objective.

At September 30, 2012, we had $200 million of 4.75 percent fixed rate long-term debt obligations outstanding with a carrying value of $200 million and a fair value of $210 million. In November 2003 we converted $100 million of this fixed rate debt to floating rate debt bearing interest at six-month LIBOR less .075 percent by executing “receive fixed, pay variable” interest rate swap contracts. At September 30, 2012, we also had $300 million of 5.25 percent fixed rate long-term debt obligations outstanding with a carrying value of $299 million and a fair value of $363 million. In January 2010 we converted $150 million of this fixed rate debt to floating rate debt based on six-month LIBOR plus 1.235 percent. Finally, at September 30, 2012, we had $250 million of 3.10 percent fixed rate unsecured long-term debt with a carrying value of $249 million and a fair value of $264 million.

A hypothetical 10 percent increase or decrease in average market interest rates would have decreased or increased the fair value of our long-term fixed rate debt, exclusive of the effects of the interest rate swap contracts, by $7 million. The fair value of the $250 million notional value of interest rate swap contracts was a $31 million net asset at September 30, 2012. A hypothetical 10 percent increase or decrease in average market interest rates would decrease or increase the fair value of our interest rate swap contracts by $1 million. Our results of operations are affected by changes in market interest rates related to variable rate debt. Inclusive of the effect of the interest rate swaps, a hypothetical 10 percent increase or decrease in average market interest rates would not have a material effect on our operations or cash flows. For more information related to outstanding debt obligations and derivative financial instruments, see Notes 10, 17 and 18 in the Notes to Consolidated Financial Statements in Item 8 below.

Foreign Currency Risk

We transact business in various foreign currencies which subjects our cash flows and earnings to exposure related to changes to foreign currency exchange rates. We attempt to manage this exposure through operational strategies and the use of foreign currency forward exchange contracts (foreign currency contracts). All foreign currency contracts are executed with banks we believe to be creditworthy and are denominated in currencies of major industrial countries. The majority of our non-functional currency firm and anticipated receivables and payables are hedged using foreign currency contracts. It is our policy not to manage exposure to net investments in non-U.S. subsidiaries or enter into derivative financial instruments for speculative purposes. Notional amounts of outstanding foreign currency forward exchange contracts were $393 million and $502 million at September 30, 2012 and September 30, 2011, respectively. Notional amounts are stated in U.S. dollar equivalents at spot exchange rates at the respective dates. Principal currencies that are hedged include the European euro, British pound sterling and Japanese yen. The duration of foreign currency contracts is generally five years or less. The net fair value of these foreign currency contracts was a net asset of $2 million and $1 million at September 30, 2012 and September 30, 2011, respectively. A 10 percent increase or decrease in the value of the U.S. dollar against all currencies would decrease or increase the fair value of our foreign currency contracts at September 30, 2012 by $8 million. For more information related to outstanding currency forward exchange contracts, see Notes 17 and 18 in the Notes to Consolidated Financial Statements in Item 8 below.

44




Item 8.
Financial Statements and Supplementary Data.

MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS

We, the management team of Rockwell Collins, are responsible for the preparation, integrity and objectivity of the financial statements and other financial information we have presented in this report. The financial statements were prepared in accordance with accounting principles generally accepted in the United States of America, applying our estimates and judgments.

Deloitte & Touche LLP, our independent registered public accounting firm, is retained to audit our financial statements. Their accompanying report is based on audits conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), which include the consideration of our internal controls to determine the nature, timing and extent of audit tests to be applied.

Our Board of Directors exercises its responsibility for these financial statements through its Audit Committee, which consists entirely of independent, non-management Board members. The Audit Committee meets regularly with management, the independent registered public accounting firm and with the Company's General Auditor, both privately and with management present, to review accounting, auditing, internal control and financial reporting matters.

/s/ CLAYTON M. JONES
 
/s/ PATRICK E. ALLEN
Clayton M. Jones
Chairman &
Chief Executive Officer
 

Patrick E. Allen
Senior Vice President &
Chief Financial Officer

45



MANAGEMENT'S REPORT ON
INTERNAL CONTROL OVER FINANCIAL REPORTING

Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Rockwell Collins' internal control over financial reporting is a process designed, under the supervision of the Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Our internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Rockwell Collins; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, and that our receipts and expenditures are being made only in accordance with authorizations of Rockwell Collins' management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of Rockwell Collins' internal control over financial reporting as of September 30, 2012. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on this assessment, management determined that Rockwell Collins maintained effective internal control over financial reporting as of September 30, 2012.

Rockwell Collins' internal control over financial reporting as of September 30, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included within the Controls and Procedures section in Item 9A of this Form 10-K.

/s/ CLAYTON M. JONES
 
/s/ PATRICK E. ALLEN
Clayton M. Jones
Chairman &
Chief Executive Officer
 

Patrick E. Allen
Senior Vice President &
Chief Financial Officer

46




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareowners of
Rockwell Collins, Inc.

We have audited the accompanying consolidated statements of financial position of Rockwell Collins, Inc. and subsidiaries (the "Company") as of September 28, 2012 and September 30, 2011, and the related consolidated statements of operations, cash flows, equity and comprehensive income for each of the three years in the period ended September 28, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of September 28, 2012 and September 30, 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 28, 2012, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of September 28, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 13, 2012 expressed an unqualified opinion on the Company's internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Chicago, Illinois
November 13, 2012



47



ROCKWELL COLLINS, INC.

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(in millions, except per share amounts)
 
September 30
 
2012
 
2011
ASSETS
 
 
 
Current Assets:
 
 
 
Cash and cash equivalents
$
335

 
$
530