10-Q 1 gd-2013033110q.htm 10-Q GD-2013.03.31 10Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2013
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-3671

GENERAL DYNAMICS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
 
13-1673581
State or other jurisdiction of incorporation or organization
 
I.R.S. employer identification no.
 
 
 
2941 Fairview Park Drive, Suite 100
Falls Church, Virginia
 
22042-4513
Address of principal executive offices
 
Zip code
(703) 876-3000
Registrant’s telephone number, including area code
    
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 and (2) has been subject to such filing requirements for the past 90 days. Yes ü No ___
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 Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ü No ___
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.
Large Accelerated Filer ü Accelerated Filer __ Non-Accelerated Filer __ 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 ü
353,186,716 shares of the registrant’s common stock, $1 par value per share, were outstanding on March 31, 2013.

1


INDEX


2


PART I – FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)

 
Three Months Ended
(Dollars in millions, except per-share amounts)
April 1, 2012
 
March 31, 2013
Revenues:
 
 
 
Products
$
4,718

 
$
4,459

Services
2,861

 
2,945

 
7,579

 
7,404

Operating costs and expenses:
 
 
 
Products
3,764

 
3,529

Services
2,420

 
2,521

General and administrative (G&A)
535

 
507

 
6,719

 
6,557

Operating earnings
860

 
847

Interest, net
(39
)
 
(23
)
Earnings before income taxes
821

 
824

Provision for income taxes, net
257

 
253

Net earnings
$
564

 
$
571

 
 
 
 
Earnings per share
 
 
 
  Basic
$
1.58

 
$
1.62

  Diluted
$
1.57

 
$
1.62

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.


3


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

 
Three Months Ended
(Dollars in millions)
April 1, 2012
 
March 31, 2013
Net earnings
$
564

 
$
571

Net gain (loss) on cash flow hedges
14

 
(12
)
Unrealized gains on securities
5

 
4

Foreign currency translation adjustments
169

 
(178
)
Change in retirement plans' funded status
57

 
100

Other comprehensive income (loss) before tax
245

 
(86
)
Provision for income tax, net
45

 
33

Other comprehensive income (loss), net of tax
200

 
(119
)
Comprehensive income
$
764

 
$
452

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.

 
 
 
 

4


CONSOLIDATED BALANCE SHEETS

 
 
 
(Unaudited)
(Dollars in millions)
December 31, 2012
 
March 31, 2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and equivalents
$
3,296

 
$
3,745

Accounts receivable
4,204

 
4,261

Contracts in process
4,964

 
5,073

Inventories
2,776

 
2,863

Other current assets
504

 
408

Total current assets
15,744

 
16,350

Noncurrent assets:
 
 
 
Property, plant and equipment, net
3,403

 
3,374

Intangible assets, net
1,383

 
1,310

Goodwill
12,048

 
11,934

Other assets
1,731

 
1,641

Total noncurrent assets
18,565

 
18,259

Total assets
$
34,309

 
$
34,609

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
2,469

 
$
2,503

Customer advances and deposits
6,042

 
5,958

Other current liabilities
3,109

 
3,308

Total current liabilities
11,620

 
11,769

Noncurrent liabilities:
 
 
 
Long-term debt
3,908

 
3,909

Other liabilities
7,391

 
7,349

Commitments and contingencies (See Note L)


 


Total noncurrent liabilities
11,299

 
11,258

Shareholders' equity:
 
 
 
Common stock
482

 
482

Surplus
1,988

 
1,961

Retained earnings
17,860

 
18,234

Treasury stock
(6,165
)
 
(6,201
)
Accumulated other comprehensive loss
(2,775
)
 
(2,894
)
Total shareholders' equity
11,390

 
11,582

Total liabilities and shareholders' equity
$
34,309

 
$
34,609

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.


5


CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 
Three Months Ended
(Dollars in millions)
April 1, 2012
 
March 31, 2013
Cash flows from operating activities:
 
 
 
Net earnings
$
564

 
$
571

Adjustments to reconcile net earnings to net cash provided by operating activities –
 
 
 
Depreciation of property, plant and equipment
97

 
95

Amortization of intangible assets
57

 
47

Stock-based compensation expense
35

 
31

Excess tax benefit from stock-based compensation
(21
)
 
(12
)
Deferred income tax provision
3

 
11

(Increase) decrease in assets, net of effects of business acquisitions –
 
 
 
Accounts receivable
(233
)
 
(57
)
Contracts in process
162

 
(98
)
Inventories
(114
)
 
(95
)
Increase (decrease) in liabilities, net of effects of business acquisitions –
 
 
 
Accounts payable
(387
)
 
34

Customer advances and deposits
205

 
(94
)
Income taxes payable
188

 
217

Other current liabilities
(269
)
 
(176
)
Other, net
127

 
30

Net cash provided by operating activities
414

 
504

Cash flows from investing activities:
 
 
 
Capital expenditures
(90
)
 
(75
)
Purchases of available-for-sale securities
(65
)
 
(29
)
Purchases of held-to-maturity securities
(126
)
 

Other, net
17

 
28

Net cash used by investing activities
(264
)
 
(76
)
Cash flows from financing activities:
 
 
 
Proceeds from option exercises
78

 
12

Dividends paid
(169
)
 

Purchases of common stock
(76
)
 

Other, net
1

 
12

Net cash (used) provided by financing activities
(166
)
 
24

Net cash used by discontinued operations
(1
)
 
(3
)
Net (decrease) increase in cash and equivalents
(17
)
 
449

Cash and equivalents at beginning of period
2,649

 
3,296

Cash and equivalents at end of period
$
2,632

 
$
3,745

Supplemental cash flow information:
 
 
 
Cash payments for:
 
 
 
Income taxes
$
82

 
$
26

Interest
$
57

 
$
19

The accompanying Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.

6


NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share amounts or unless otherwise noted)
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Consolidation and Classification. The unaudited Consolidated Financial Statements include the accounts of General Dynamics Corporation and our wholly owned and majority-owned subsidiaries. We eliminate all inter-company balances and transactions in the unaudited Consolidated Financial Statements.
Consistent with defense industry practice, we classify assets and liabilities related to long-term production contracts as current, even though some of these amounts may not be realized within one year.
Interim Financial Statements. The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. These rules and regulations permit some of the information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) to be condensed or omitted.
Our fiscal quarters are 13 weeks in length. Because our fiscal year ends on December 31, the number of days in our first and fourth quarters varies slightly from year to year. Operating results for the three-month period ended March 31, 2013, are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.
The unaudited Consolidated Financial Statements contain all adjustments that are of a normal recurring nature necessary for a fair presentation of our results of operations and financial condition for the three-month periods ended April 1, 2012, and March 31, 2013.
These unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012.
Revenue Recognition. We account for revenues and earnings using the percentage-of-completion method. Under this method, contract costs and revenues are recognized as the work progresses, either as the products are produced or as services are rendered. We estimate the profit on a contract as the difference between the total estimated revenue and costs to complete a contract and recognize that profit over the life of the contract. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize the loss in the quarter it is identified.
We review and update our contract estimates regularly. We recognize changes in estimated profit on contracts under the reallocation method. Under the reallocation method, the impact of a revision in estimate is recognized prospectively over the remaining contract term. The net increase in our operating earnings (and on a diluted per-share basis) from the favorable impact of revisions in contract estimates totaled $68 ($0.13) and $108 ($0.20) for the three-months periods ended April 1, 2012, and March 31, 2013, respectively. In the first quarter of 2013, no revisions on any one contract were material to our unaudited Consolidated Financial Statements.
Subsequent Events. We have evaluated material events and transactions that have occurred after the balance sheet date and concluded that no subsequent events have occurred that require adjustment to or disclosure in this Form 10-Q.

7



B. ACQUISITIONS, INTANGIBLE ASSETS AND GOODWILL
We did not acquire any businesses in the first quarter of 2013. In 2012, we acquired seven businesses for an aggregate of $444, funded by cash on hand, including one in the first quarter of 2012.

The changes in the carrying amount of goodwill by reporting unit for the three months ended
March 31, 2013, were as follows:

 
Aerospace
 
Combat Systems
 
Marine Systems
 
Information Systems and Technology
 
Total Goodwill
December 31, 2012 (a)
$
2,697

 
$
2,961

 
$
290

 
$
6,100

 
$
12,048

Acquisitions (b)

 
2

 

 
(2
)
 

Other (c)
(66
)
 
(36
)
 

 
(12
)
 
(114
)
March 31, 2013
$
2,631

 
$
2,927

 
$
290

 
$
6,086

 
$
11,934

(a)
Goodwill on December 31, 2012, in the Information Systems and Technology reporting unit is net of $1,994 of accumulated impairment losses.
(b)Includes adjustments during the purchase price allocation period.
(c)Consists primarily of adjustments for foreign currency translation.
Intangible assets consisted of the following:

 
Gross Carrying Amount
Accumulated Amortization
Net Carrying Amount
 
Gross Carrying Amount
Accumulated Amortization
Net Carrying Amount
 
December 31, 2012
 
March 31, 2013
Contract and program intangible assets*
$
2,066

$
(1,165
)
$
901

 
$
2,068

$
(1,206
)
$
862

Trade names and trademarks
494

(87
)
407

 
486

(93
)
393

Technology and software
180

(108
)
72

 
160

(109
)
51

Other intangible assets
175

(172
)
3

 
176

(172
)
4

Total intangible assets
$
2,915

$
(1,532
)
$
1,383

 
$
2,890

$
(1,580
)
$
1,310

* Consists of acquired backlog and probable follow-on work and related customer relationships.
Amortization expense was $57 and $47 for the three-month periods ended April 1, 2012, and March 31, 2013, respectively. We expect to record amortization expense of $165 in 2013.


C. EARNINGS PER SHARE
Earnings per Share. We compute basic earnings per share (EPS) using net earnings for the period and the weighted average number of common shares outstanding during the period. Diluted EPS generally incorporates the additional shares issuable upon the assumed exercise of stock options and the release of restricted shares and restricted stock units (RSUs). Basic and diluted weighted average shares outstanding were as follows (in thousands):


8


Three Months Ended
April 1, 2012
March 31, 2013
Basic weighted average shares outstanding
356,987

351,873

Dilutive effect of stock options and restricted stock/RSUs*
2,373

1,644

Diluted weighted average shares outstanding
359,360

353,517

* Excludes the following outstanding options to purchase shares of common stock and nonvested restricted stock because the effect of including these options and restricted shares would be antidilutive: 2012 - 23.859 and 2013 - 24.707.

D. FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:
Level 1 – quoted prices in active markets for identical assets or liabilities;
Level 2 – inputs, other than quoted prices, observable by a marketplace participant either directly or indirectly; and
Level 3 – unobservable inputs significant to the fair value measurement.
We did not have any significant non-financial assets or liabilities measured at fair value on December 31, 2012, or March 31, 2013, except for long-lived assets that were impaired in 2012, including goodwill in our Information Systems and Technology business group.
Our financial instruments include cash and equivalents, marketable securities and other investments; accounts receivable and accounts payable; short- and long-term debt; and derivative financial instruments. The carrying values of cash and equivalents, accounts receivable and payable, and short-term debt on the Consolidated Balance Sheets approximate their fair value. The following tables present the fair values of our other financial assets and liabilities on December 31, 2012, and March 31, 2013, and the basis for determining their fair values:

 
Carrying
Value
 
Fair
Value
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
(a)
Financial assets (liabilities) (b)
December 31, 2012
Other investments
150

 
150

 
96

 
54

Derivatives
22

 
22

 

 
22

Long-term debt,
     including current portion
(3,909
)
 
(3,966
)
 

 
(3,966
)
 
 
 
 
 
 
 
 
 
March 31, 2013
Other investments
152

 
152

 
98

 
54

Derivatives
3

 
3

 

 
3

Long-term debt,
     including current portion
(3,910
)
 
(3,915
)
 

 
(3,915
)
(a)Determined under a market approach using valuation models that incorporate observable inputs such as interest rates, bond yields and quoted prices for similar assets and liabilities.
(b)We had no Level 3 financial instruments on December 31, 2012, or March 31, 2013.

9



E. CONTRACTS IN PROCESS
Contracts in process represent recoverable costs and, where applicable, accrued profit related to long-term contracts that have been inventoried until the customer is billed, and consisted of the following:
 
December 31, 2012
 
March 31, 2013
Contract costs and estimated profits
$
8,162

 
$
8,584

Other contract costs
1,089

 
1,140

 
9,251

 
9,724

Advances and progress payments
(4,287
)
 
(4,651
)
Total contracts in process
$
4,964

 
$
5,073

Contract costs consist primarily of labor, material, overhead and G&A expenses. Contract costs also may include estimated contract recoveries for matters such as contract changes and claims for unanticipated contract costs. We record revenue associated with these matters only when the amount of recovery can be estimated reliably and realization is probable. Assumed recoveries for claims included in contracts in process were not material on December 31, 2012, or March 31, 2013.
Other contract costs represent amounts that are not currently allocable to government contracts, such as a portion of our estimated workers’ compensation obligations, other insurance-related assessments, pension and other post-retirement benefits and environmental expenses. These costs will become allocable to contracts generally after they are paid. We expect to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. If the backlog in the future does not support the continued deferral of these costs, the profitability of our remaining contracts could be adversely affected.

F. INVENTORIES
Our inventories represent primarily business-jet components and are stated at the lower of cost or net realizable value. Work-in-process represents largely labor, material and overhead costs associated with aircraft in the manufacturing process and is based primarily on the estimated average unit cost of the units in a production lot. Raw materials are valued primarily on the first-in, first-out method. We record pre-owned aircraft acquired in connection with the sale of new aircraft at the lower of the trade-in value or the estimated net realizable value. Inventories consisted of the following:
 
December 31, 2012
 
March 31, 2013
Work in process
$
1,518

 
$
1,620

Raw materials
1,109

 
1,117

Finished goods
69

 
60

Pre-owned aircraft
80

 
66

Total inventories
$
2,776

 
$
2,863


10



G. DEBT
Debt consisted of the following:
 
 
December 31, 2012
 
March 31, 2013
Fixed-rate notes due:
Interest Rate
 
 
 
January 2015
1.375%
$
500

 
$
500

July 2016
2.250%
500

 
500

November 2017
1.000%
895

 
895

July 2021
3.875%
499

 
499

November 2022
2.250%
990

 
990

November 2042
3.600%
498

 
498

Other
Various
27

 
28

Total debt
 
3,909

 
3,910

Less current portion
 
1

 
1

Long-term debt
 
$
3,908

 
$
3,909

Our fixed-rate notes are fully and unconditionally guaranteed by several of our 100-percent-owned subsidiaries (see Note O for condensed consolidating financial statements). We have the option to redeem the notes prior to their maturity in whole or part for the principal plus any accrued but unpaid interest and applicable make-whole amounts.
On March 31, 2013, we had no commercial paper outstanding, but we maintain the ability to access the market. We have $2 billion in bank credit facilities that provide backup liquidity to our commercial paper program. These credit facilities include a $1 billion multi-year facility expiring in July 2013 and a $1 billion multi-year facility expiring in July 2016. These facilities are required by rating agencies to support our commercial paper issuances. We plan to renew or replace, in whole or in part, these credit facilities prior to their expiration at similar levels. Our commercial paper issuances and the bank credit facilities are guaranteed by several of our 100-percent-owned subsidiaries.
Our financing arrangements contain a number of customary covenants and restrictions. We were in compliance with all material covenants on March 31, 2013.

11



H. OTHER LIABILITIES
A summary of significant other liabilities by balance sheet caption follows:

 
December 31, 2012
 
March 31, 2013
Salaries and wages
$
835

 
$
661

Workers' compensation
578

 
561

Retirement benefits
318

 
325

Deferred income taxes
173

 
121

Other (a)
1,205

 
1,640

Total other current liabilities
$
3,109

 
$
3,308

 
 
 
 
Retirement benefits
$
5,671

 
$
5,642

Customer deposits on commercial contracts 
849

 
839

Deferred income taxes
144

 
132

Other (b)
727

 
736

Total other liabilities
$
7,391

 
$
7,349

(a)Consists primarily of dividends payable, taxes payable, environmental remediation reserves, warranty reserves, liabilities of discontinued operations and insurance-related costs.
(b)Consists primarily of liabilities for warranty reserves and workers' compensation.
 
The increase in the March 31, 2013, other current liabilities amount is primarily due to $198 of dividends payable. We did not have any dividends payable on December 31, 2012, because we accelerated our first quarter 2013 dividend payment to December 2012.

I. INCOME TAXES
Deferred Tax Assets. Our net deferred tax asset was included on the Consolidated Balance Sheets in other assets and liabilities as follows:

 
December 31, 2012
 
March 31, 2013
Current deferred tax asset
$
44

 
$
29

Current deferred tax liability
(173
)
 
(121
)
Noncurrent deferred tax asset
1,251

 
1,138

Noncurrent deferred tax liability
(144
)
 
(132
)
Net deferred tax asset
$
978

 
$
914

Tax Uncertainties. For all periods open to examination by tax authorities, we periodically assess our liabilities and contingencies based on the latest available information. Where we believe there is more than a 50 percent chance that our tax position will not be sustained, we record our best estimate of the resulting tax liability, including interest, in the Consolidated Financial Statements. We include any interest or penalties incurred in connection with income taxes as part of income tax expense.
During the first quarter of 2013, we reached agreement with the Internal Revenue Service (IRS) on the examination of our federal income tax return for 2011. The resolution of this audit had no material impact on our results of operations, financial condition, cash flows or effective tax rate. With the completion of this audit, the IRS has examined our consolidated federal income tax returns through 2011.

12


We participate in the IRS’s Compliance Assurance Process, a real-time audit of our consolidated corporate federal income tax return. We have recorded liabilities for tax uncertainties for the years that remain open to review. We do not expect the resolution of tax matters for open years to have a material impact on our results of operations, financial condition, cash flows or effective tax rate.
Based on all known facts and circumstances and current tax law, we believe the total amount of unrecognized tax benefits on March 31, 2013, is not material to our results of operations, financial condition or cash flows, and if recognized, would not have a material impact on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly vary over the next 12 months, producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.

J. SHAREHOLDERS' EQUITY
Dividends per Share. Dividends declared per share were $0.51 and $0.56 for the three-month periods ended April 1, 2012, and March 31, 2013. Cash dividends paid were $169 for the three-month period ended April 1, 2012. We did not pay any dividends in the first three months of 2013 because we accelerated our first quarter 2013 dividend payment to December 2012.
Other Comprehensive Income (Loss). The tax effect for each component of other comprehensive income (OCI) consisted of the following:
 
Gross Amount
Benefit (Provision) for Income Tax
Net Amount
 
Gross Amount
Benefit (Provision) for Income Tax
Net Amount
Three Months Ended
April 1, 2012
 
March 31, 2013
Gain (loss) on cash flow hedges
$
14

$
(7
)
$
7

 
$
(12
)
$
4

$
(8
)
Unrealized gains on securities
5

(1
)
4

 
4

(2
)
2

Foreign currency translation adjustments
169

(17
)
152

 
(178
)
2

(176
)
Change in retirement plans' funded status
57

(20
)
37

 
100

(37
)
63

Other comprehensive income (loss)
$
245

$
(45
)
$
200

 
$
(86
)
$
(33
)
$
(119
)
The changes, net of tax, in each component of accumulated other comprehensive loss (AOCI) consisted of the following:
 
Gains (Losses) on Cash Flow Hedges
Unrealized Gains on Securities
Foreign Currency Translation Adjustments
Changes in Retirement Plans’ Funded Status
AOCI
Balance, December 31, 2012
$
6

$
7

$
1,092

$
(3,880
)
$
(2,775
)
OCI before reclassifications
(3
)
2

(176
)
(2
)
(179
)
Amounts reclassified from AOCI
(5
)


65

60

Other comprehensive loss
(8
)
2

(176
)
63

(119
)
Balance, March 31, 2013
$
(2
)
$
9

$
916

$
(3,817
)
$
(2,894
)


13


Significant amounts reclassified out of each component of AOCI consisted of the following:

Three Months Ended March 31, 2013
Amount Reclassified from AOCI
Consolidated Statement of Earnings Line Item
Losses on cash flow hedges of foreign exchange contracts
$
(8
)
Operating costs and expenses
 
3

Tax benefit
 
(5
)
 
Changes in retirement plans' funded status
 
 
Recognized net actuarial loss
112

*
Amortization of prior service credit
(13
)
*
 
(34
)
Tax expense
 
65

 
Total reclassifications, net of tax
$
60

 
* These AOCI components are included in our net periodic pension and other post-retirement benefit cost. See Note M for additional details.

K. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
We are exposed to market risk, primarily from foreign currency exchange rates, interest rates, commodity prices and investments. We may use derivative financial instruments to hedge some of these risks as described below. We do not use derivatives for trading or speculative purposes.
Foreign Currency Risk. Our foreign currency exchange rate risk relates to receipts from customers, payments to suppliers and inter-company transactions denominated in foreign currencies. To the extent possible, we include terms in our contracts that are designed to protect us from this risk. Otherwise, we enter into derivative financial instruments, principally foreign currency forward purchase and sale contracts, designed to offset and minimize our risk. The one year average maturity of these instruments matches the duration of the activities that are at risk.
Interest Rate Risk. Our financial instruments subject to interest rate risk include fixed-rate long-term debt obligations and variable-rate commercial paper. However, the risk associated with these instruments is not material.
Commodity Price Risk. We are subject to risk of rising labor and commodity prices, primarily on long-term fixed-price contracts. To the extent possible, we include terms in our contracts that are designed to protect us from this risk. Some of the protective terms included in our contracts are considered derivatives but are not accounted for separately because they are clearly and closely related to the host contract. We have not entered into any material commodity hedging contracts but may do so as circumstances warrant. We do not believe that changes in labor or commodity prices will have a material impact on our results of operations or cash flows.
Investment Risk. Our investment policy allows for purchases of fixed-income securities with an investment-grade rating and a maximum maturity of up to five years. On March 31, 2013, we held $3.7 billion in cash and equivalents, but held no marketable securities.
Hedging Activities. We had $2.5 billion in notional forward exchange contracts outstanding on December 31, 2012, and $2.4 billion on March 31, 2013. We recognize derivative financial instruments on the Consolidated Balance Sheets at fair value (see Note D).
We record changes in the fair value of derivative financial instruments in operating costs and expenses in the Consolidated Statements of Earnings or in OCI within the Consolidated Statements of Comprehensive Income depending on whether the derivative is designated and qualifies for hedge

14


accounting. Gains and losses related to derivatives that qualify as cash flow hedges are deferred in OCI until the underlying transaction is reflected in earnings. We adjust derivative financial instruments not designated as cash flow hedges to market value each period and record the gain or loss in the Consolidated Statements of Earnings. The gains and losses on these instruments generally offset losses and gains on the assets, liabilities and other transactions being hedged. Gains and losses resulting from hedge ineffectiveness are recognized in the Consolidated Statements of Earnings for all derivative financial instruments, regardless of designation.
Net gains and losses recognized in earnings and OCI, including gains and losses related to hedge ineffectiveness, were not material to our results of operations for the three-month periods ended April 1, 2012, and March 31, 2013. We do not expect the amount of gains and losses in OCI that will be reclassified to earnings during the next 12 months to be material.
We had no material derivative financial instruments designated as fair value or net investment hedges on December 31, 2012, or March 31, 2013.
Foreign Currency Financial Statement Translation. We translate foreign-currency balance sheets from our international businesses' functional currency (generally the respective local currency) to U.S. dollars at the end-of-period exchange rates, and statements of earnings at the average exchange rates for each period. The resulting foreign currency translation adjustments are a component of OCI.
We do not hedge the fluctuation in reported revenues and earnings resulting from the translation of these international operations' results into U.S. dollars. The impact of translating our international operations’ revenues and earnings into U.S. dollars was not material to our results of operations for the three-month periods ended April 1, 2012, or March 31, 2013. In addition, the effect of changes in foreign exchange rates on non-U.S. cash balances was not material in the first three months of either 2012 or 2013.

L. COMMITMENTS AND CONTINGENCIES
Litigation
Termination of A-12 Program. The A-12 aircraft contract was a fixed-price incentive contract for the full-scale development and initial production of the carrier-based Advanced Tactical Aircraft with the U.S. Navy and a team composed of contractors General Dynamics and McDonnell Douglas (now a subsidiary of The Boeing Company). In January 1991, the U.S. Navy terminated the contract for default and demanded the contractors repay $1.4 billion in unliquidated progress payments. Following the termination, the Navy agreed to defer the collection of that amount pending a negotiated settlement or other resolution. Both contractors had full responsibility to the Navy for performance under the contract, and both are jointly and severally liable for potential liabilities arising from the termination.
Over 20 years of litigation, the trial court (the U.S. Court of Federal Claims), appeals court (the Court of Appeals for the Federal Circuit) and the U.S. Supreme Court have issued various rulings, some in favor of the government and others in favor of the contractors.
On May 3, 2007, the trial court issued a decision upholding the government’s determination of default. This decision was affirmed by a three-judge panel of the appeals court on June 2, 2009, and on November 24, 2009, the court of appeals denied the contractors’ petitions for rehearing. On September 28, 2010, the U.S. Supreme Court granted the contractors’ petitions for review as to whether the government could maintain its default claim against the contractors while invoking the state-secrets privilege to deny the contractors a defense to that claim.
On May 23, 2011, the U.S. Supreme Court vacated the judgment of the court of appeals, stating that the contractors had a plausible superior knowledge defense that had been stripped from them as a

15


consequence of the government’s assertion of the state-secrets privilege. In particular, the U.S. Supreme Court held that, in that circumstance, neither party can obtain judicial relief.
In addition, the U.S. Supreme Court remanded the case to the court of appeals for further proceedings on whether the government has an obligation to share its superior knowledge with respect to highly classified information, whether the government has such an obligation when the agreement specifies information that must be shared (as was the case with respect to the A-12 contract), and whether these questions can safely be litigated by the courts without endangering state secrets. On July 7, 2011, the appeals court remanded these issues to the trial court for further proceedings consistent with the U.S. Supreme Court’s opinion. These issues remain to be resolved on remand.
We believe that the lower courts will ultimately rule in the contractors’ favor on the remaining issues in the case. We expect this would leave all parties where they stood prior to the contracting officer’s declaration of default, meaning that no money would be due from one party to another. Additionally, even if the lower courts were to ultimately sustain the government’s default claim, we continue to believe that there are significant legal obstacles to the government’s ability to collect any amount from the contractors given that no court has ever awarded a money judgment to the government. For these reasons, we have not recorded an accrual for this matter.
If, contrary to our expectations, the government prevails on its default claim and its recovery theories, the contractors could collectively be required to repay the government, on a joint and several basis, as much as $1.4 billion for progress payments received for the A-12 contract plus interest. Interest was approximately $1.6 billion on March 31, 2013. This would result in a liability to us of half of the total (based upon The Boeing Company satisfying McDonnell Douglas’ obligations under the contract), or approximately $1.5 billion pretax. Our after-tax charge would be approximately $835, or $2.36 per share, which would be recorded in discontinued operations. Our after-tax cash cost would be approximately $740. We believe we have sufficient resources to satisfy our obligation if required.
Other. Various claims and other legal proceedings incidental to the normal course of business are pending or threatened against us. These matters relate to such issues as government investigations and claims, the protection of the environment, asbestos-related claims and employee-related matters. The nature of litigation is such that we cannot predict the outcome of these matters. However, based on information currently available, we believe any potential liabilities in these proceedings, individually or in the aggregate, will not have a material impact on our results of operations, financial condition or cash flows.
Environmental
We are subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. We are directly or indirectly involved in environmental investigations or remediation at some of our current and former facilities and third-party sites that we do not own but where we have been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, we expect that a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable contract costs and, therefore, recoverable under U.S. government contracts.
As required, we provide financial assurance for certain sites undergoing or subject to investigation or remediation. We accrue environmental costs when it is probable that a liability has been incurred and the amount can be reasonably estimated. Where applicable, we seek insurance recovery for costs related to environmental liabilities. We do not record insurance recoveries before collection is considered probable. Based on all known facts and analyses, we do not believe that our liability at any individual site, or in the aggregate, arising from such environmental conditions, will be material to our results of operations, financial

16


condition or cash flows. We also do not believe that the range of reasonably possible additional loss beyond what has been recorded would be material to our results of operations, financial condition or cash flows.
Other
Portugal Program. In 2012, the Portuguese Ministry of National Defense notified our Combat Systems group's European Land Systems business that it was terminating the contract to provide 260 Pandur vehicles based on an alleged breach of contract. Subsequently, the customer drew $75 from bank guarantees for the contract. We have asserted that we are not in breach of the contract and that the termination of the contract was invalid, and we are currently in arbitration with the customer. Given the uncertainty of receiving further payments, we reserved the receivables and contracts in process balances and accrued an estimate of the remaining costs related to the close-out of the contract, totaling $258 in 2012. As of March 31, 2013, approximately $195 of bank guarantees relating to the program and its related offset requirements remained outstanding. The bank guarantees could be drawn upon by the customer through 2014 and, therefore, have a possible impact on our future operating results and cash flows. 
Restructuring Costs. In 2012, the company recorded a $98 restructuring charge for plans being carried out to eliminate excess capacity and align our Combat Systems group's European Land Systems business with expected demand given the European fiscal condition. The charge primarily represented our estimate of severance costs as determined based on local laws. Following discussions with labor representatives, management offered an enhanced severance benefit through April 2013 to employees that voluntarily terminated. Based on the acceptance rate, management estimates that an additional $15 of severance costs will be required to be recognized in the second quarter of 2013.
Letters of Credit and Guarantees. In the ordinary course of business, we have issued letters of credit, performance or surety bonds, bank guarantees and other similar arrangements with financial institutions and insurance carriers totaling approximately $1.9 billion on March 31, 2013. In addition, from time to time in the ordinary course of business, we contractually guarantee the payment or performance obligations of our subsidiaries arising under certain contracts.
Government Contracts. As a government contractor, we are subject to U.S. government audits and investigations relating to our operations, including claims for fines, penalties, and compensatory and treble damages. We believe the outcome of such ongoing government disputes and investigations will not have a material impact on our results of operations, financial condition or cash flows.
In the performance of our contracts, we routinely request contract modifications that require additional funding from the customer. Most often, these requests are due to customer-directed changes in scope of work. While we are entitled to recovery of these costs under our contracts, the administrative process with our customer may be protracted. Based upon the circumstances, we periodically file claims or requests for equitable adjustment (REAs). In some cases, these requests are disputed by our customer. We believe our outstanding modifications and other claims will be resolved without material impact to our results of operations, financial condition or cash flows.
Aircraft Trade-ins. In connection with orders for new aircraft in funded contract backlog, our Aerospace group has outstanding options with some customers to trade in aircraft as partial consideration in their new-aircraft transaction. These trade-in commitments are structured to establish the fair market value of the trade-in aircraft at a date generally 120 or fewer days preceding delivery of the new aircraft to the customer. At that time, the customer is required to either exercise the option or allow its expiration. Any excess of the pre-established trade-in price above the fair market value at the time the new aircraft is delivered is treated as a reduction of revenue in the new-aircraft sales transaction.
Product Warranties. We provide warranties to our customers associated with certain product sales. We record estimated warranty costs in the period in which the related products are delivered. The warranty

17


liability recorded at each balance sheet date is generally based on the number of months of warranty coverage remaining for products delivered and the average historical monthly warranty payments. Warranty obligations incurred in connection with long-term production contracts are accounted for within the contract estimates at completion. Our other warranty obligations, primarily for business-jet aircraft, are included in other current and noncurrent liabilities on the Consolidated Balance Sheets.
The changes in the carrying amount of warranty liabilities for the three-month periods ended April 1, 2012, and March 31, 2013, were as follows:

Three Months Ended
April 1, 2012
 
March 31, 2013
Beginning balance
$
293

 
$
319

Warranty expense
19

 
24

Payments
(15
)
 
(16
)
Adjustments*
(5
)
 
(2
)
Ending balance
$
292

 
$
325

* Includes reclassifications.

M. RETIREMENT PLANS
We provide defined-contribution benefits, as well as defined-benefit pension and other post-retirement benefits, to eligible employees.
Net periodic cost associated with our defined-benefit pension and other post-retirement benefit plans for the three-month periods ended April 1, 2012, and March 31, 2013, consisted of the following:

 
Pension Benefits
Other Post-retirement Benefits
Three Months Ended
April 1, 2012
 
March 31, 2013
April 1, 2012
 
March 31, 2013
Service cost
$
71

 
$
80

$
3

 
$
4

Interest cost
131

 
124

14

 
13

Expected return on plan assets
(147
)
 
(148
)
(7
)
 
(7
)
Recognized net actuarial loss
66

 
106

2

 
6

Amortization of prior service (credit) cost
(11
)
 
(15
)
2

 
2

Net periodic cost
$
110

 
$
147

$
14

 
$
18

 
 
 
 
 
 
 
Our contractual arrangements with the U.S. government provide for the recovery of contributions to our pension and other post-retirement benefit plans covering employees working in our defense business groups. For non-funded plans, our government contracts allow us to recover claims paid. Following payment, these recoverable amounts are allocated to contracts and billed to the customer in accordance with the Cost Accounting Standards (CAS) and specific contractual terms. For some of these plans, the cumulative pension and post-retirement benefit cost exceeds the amount currently allocable to contracts. To the extent recovery of the cost is considered probable based on our backlog and probable follow-on contracts, we defer the excess in contracts in process on the Consolidated Balance Sheets until the cost is allocable to contracts. See Note E for discussion of our deferred contract costs. For other plans, the amount allocated to contracts and included in revenues has exceeded the plans’ cumulative benefit cost. We have deferred recognition of these excess earnings to provide a better matching of revenues and expenses. These deferrals have been classified against the plan assets on the Consolidated Balance Sheets.

18


In late 2011, changes were made to the CAS to harmonize the regulations with the Pension Protection Act of 2006. As a result, pension costs allocable to our contracts are expected to increase beginning in 2014 when the impact of the CAS regulations begins to take effect. For certain contracts awarded prior to February 27, 2012, we are entitled to recovery of these additional pension costs from our customers. We submitted REAs of approximately $165 for these contracts in 2012.

N. BUSINESS GROUP INFORMATION
We operate in four business groups: Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. We organize our business groups in accordance with the nature of products and services offered. These business groups derive their revenues from business aviation; combat vehicles, weapons systems and munitions; military and commercial shipbuilding and services; and communications and information technology, respectively. We measure each group’s profit based on operating earnings. As a result, we do not allocate net interest, other income and expense items, and income taxes to our business groups.
Summary financial information for each of our business groups follows:

 
Revenues
Operating Earnings
Three Months Ended
April 1, 2012
March 31, 2013
April 1, 2012
March 31, 2013
Aerospace
$
1,623

$
1,778

$
271

$
310

Combat Systems
1,911

1,553

203

215

Marine Systems
1,605

1,626

185

159

Information Systems and Technology
2,440

2,447

218

185

Corporate*


(17
)
(22
)
 
$
7,579

$
7,404

$
860

$
847

*Corporate operating results primarily consists of stock option expense.

 
 
 
 
 



19


O. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
The fixed-rate notes described in Note G are fully and unconditionally guaranteed on an unsecured, joint and several basis by certain of our 100-percent-owned subsidiaries (the guarantors). The following condensed consolidating financial statements illustrate the composition of the parent, the guarantors on a combined basis (each guarantor together with its majority owned subsidiaries) and all other subsidiaries on a combined basis.

CONDENSED CONSOLIDATING STATEMENTS OF EARNINGS (UNAUDITED)
Three Months Ended April 1, 2012
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
Revenues
$

$
6,297

$
1,282

$

$
7,579

Cost of sales
(5
)
5,084

1,105


6,184

G&A
22

412

101


535

Operating earnings
(17
)
801

76


860

Interest, net
(40
)
1



(39
)
Other, net





Earnings before income taxes
(57
)
802

76


821

Provision for income taxes
(18
)
238

37


257

Equity in net earnings of subsidiaries
603



(603
)

Net earnings
$
564

$
564

$
39

$
(603
)
$
564

Comprehensive income
$
764

$
561

$
201

$
(762
)
$
764

Three Months Ended March 31, 2013
 
 
 
 
 
Revenues
$

$
6,388

$
1,016

$

$
7,404

Cost of sales
3

5,224

823


6,050

G&A
20

406

81


507

Operating earnings
(23
)
758

112


847

Interest, net
(23
)
(1
)
1


(23
)
Earnings before income taxes
(46
)
757

113


824

Provision for income taxes
(9
)
230

32


253

Equity in net earnings of subsidiaries
608



(608
)

Net earnings
$
571

$
527

$
81

$
(608
)
$
571

Comprehensive income
$
452

$
548

$
(122
)
$
(426
)
$
452



20


O. CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2012
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
ASSETS
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and equivalents
$
2,248

$

$
1,048

$

$
3,296

Accounts receivable

1,254

2,950


4,204

Contracts in process
439

3,199

1,326


4,964

Inventories
 
 
 
 
 
Work in process

1,507

11


1,518

Raw materials

1,020

89


1,109

Finished goods

32

37


69

Pre-owned aircraft

80



80

Other current assets
45

249

210


504

Total current assets
2,732

7,341

5,671


15,744

Noncurrent assets:
 
 
 
 
 
Property, plant and equipment
155

5,556

1,292


7,003

Accumulated depreciation of PP&E
(56
)
(2,850
)
(694
)

(3,600
)
Intangible assets

1,693

1,222


2,915

Accumulated amortization of intangible assets

(1,068
)
(464
)

(1,532
)
Goodwill

7,661

4,387


12,048

Other assets
700

738

328

(35
)
1,731

Investment in subsidiaries
33,324



(33,324
)

Total noncurrent assets
34,123

11,730

6,071

(33,359
)
18,565

Total assets
$
36,855

$
19,071

$
11,742

$
(33,359
)
$
34,309

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Customer advances and deposits
$

$
3,052

$
2,990

$

$
6,042

Other current liabilities
394

3,743

1,441


5,578

Total current liabilities
394

6,795

4,431


11,620

Noncurrent liabilities:
 
 
 
 
 
Long-term debt
3,881

27



3,908

Other liabilities
4,121

2,704

566


7,391

Total noncurrent liabilities
8,002

2,731

566


11,299

Intercompany
17,069

(17,388
)
319



Shareholders' equity:
 
 
 
 
 
Common stock
482

6

44

(50
)
482

Other shareholders' equity
10,908

26,927

6,382

(33,309
)
10,908

Total shareholders' equity
11,390

26,933

6,426

(33,359
)
11,390

Total liabilities and shareholders' equity
$
36,855

$
19,071

$
11,742

$
(33,359
)
$
34,309



21


O. CONDENSED CONSOLIDATING BALANCE SHEET (UNAUDITED)
March 31, 2013
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
ASSETS
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and equivalents
$
2,758

$

$
987

$

$
3,745

Accounts receivable

1,516

2,745


4,261

Contracts in process
498

3,189

1,386


5,073

Inventories
 
 
 
 
 
Work in process

1,608

12


1,620

Raw materials

1,030

87


1,117

Finished goods

20

40


60

Pre-owned aircraft

66



66

Other current assets
30

198

180


408

Total current assets
3,286

7,627

5,437


16,350

Noncurrent assets:
 
 
 
 
 
Property, plant and equipment
155

5,605

1,302


7,062

Accumulated depreciation of PP&E
(58
)
(2,902
)
(728
)

(3,688
)
Intangible assets

1,684

1,206


2,890

Accumulated amortization of intangible assets

(1,098
)
(482
)

(1,580
)
Goodwill

7,659

4,275


11,934

Other assets
441

742

311

147

1,641

Investment in subsidiaries
34,141



(34,141
)

Total noncurrent assets
34,679

11,690

5,884

(33,994
)
18,259

Total assets
$
37,965

$
19,317

$
11,321

$
(33,994
)
$
34,609

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Customer advances and deposits
$

$
3,069

$
2,889

$

$
5,958

Other current liabilities
795

3,760

1,256


5,811

Total current liabilities
795

6,829

4,145


11,769

Noncurrent liabilities:
 
 
 
 
 
Long-term debt
3,882

26

1


3,909

Other liabilities
4,100

2,669

580


7,349

Total noncurrent liabilities
7,982

2,695

581


11,258

Intercompany
17,606

(17,912
)
306



Shareholders' equity:
 
 
 
 
 
Common stock
482

6

44

(50
)
482

Other shareholders' equity
11,100

27,699

6,245

(33,944
)
11,100

Total shareholders' equity
11,582

27,705

6,289

(33,994
)
11,582

Total liabilities and shareholders' equity
$
37,965

$
19,317

$
11,321

$
(33,994
)
$
34,609



22


O. CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended April 1, 2012
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
Net cash provided by operating activities
$
(72
)
$
607

$
(121
)
$

$
414

Cash flows from investing activities:
 
 
 
 
 
Purchases of held-to-maturity securities
(126
)



(126
)
Capital expenditures

(75
)
(15
)

(90
)
Purchases of available-for-sale securities
(45
)
(20
)


(65
)
Other, net
23

20

(26
)

17

Net cash used by investing activities
(148
)
(75
)
(41
)

(264
)
Cash flows from financing activities:
 
 
 
 
 
Dividends paid
(169
)



(169
)
Proceeds from option exercises
78




78

Purchases of common stock
(76
)



(76
)
Other, net
21

(20
)


1

Net cash used by financing activities
(146
)
(20
)


(166
)
Net cash used by discontinued operations


(1
)

(1
)
Cash sweep/funding by parent
636

(512
)
(124
)


Net decrease in cash and equivalents
270


(287
)

(17
)
Cash and equivalents at beginning of period
1,530


1,119


2,649

Cash and equivalents at end of period
$
1,800

$

$
832

$

$
2,632

Three Months Ended March 31, 2013
 
 
 
 
 
Net cash provided by operating activities
$
(63
)
$
595

$
(28
)
$

$
504

Net cash used by investing activities

(67
)
(9
)

(76
)
Net cash used by financing activities
24




24

Net cash used by discontinued operations
(3
)



(3
)
Cash sweep/funding by parent
552

(528
)
(24
)


Net increase in cash and equivalents
510


(61
)

449

Cash and equivalents at beginning of period
2,248


1,048


3,296

Cash and equivalents at end of period
$
2,758

$

$
987

$

$
3,745



23


(Dollars in millions, except per-share amounts or unless otherwise noted)
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

BUSINESS OVERVIEW

General Dynamics is an aerospace and defense company that offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding; and communications and information technology. We operate through four business groups: Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. Our primary customers are the U.S. government, including the Department of Defense (DoD), intelligence community and other U.S. government customers; international governments; and a wide range of corporate and individual customers for business jets. We operate in two primary markets, defense and business aviation, with the majority of our revenues from contracts with the U.S. government. The following discussion should be read in conjunction with our 2012 Annual Report on Form 10-K and with the unaudited Consolidated Financial Statements included in this Form 10-Q.

DEFENSE BUSINESS ENVIRONMENT

Over the past several years, the level of U.S. defense spending has been negatively impacted by the country's fiscal shortfall. The Budget Control Act of 2011 (BCA) mandated a $487 billion, or approximately 8 percent, reduction to previously-planned defense funding over the next decade. In addition, the BCA included a sequester mechanism that imposed additional defense cuts of $500 billion, or approximately 9 percent, over nine years starting in fiscal year (FY) 2013 if the Congress did not identify a means to reduce the U.S. deficit by $1.2 trillion. Because these means were not identified, the sequester mechanism took effect on March 1, 2013.

Although much of the U.S. government is operating under a continuing resolution (CR), the FY 2013 defense budget of $528 billion was passed late in March 2013, providing funding for the Department of Defense's (DoD) current priorities and allowing new program starts and multi-year contracts. While the FY 2013 defense budget incorporates the reductions mandated by the BCA, it does not include the $43 billion of cuts required by the sequester mechanism. The DoD is determining how to implement these reductions. In addition, early in the second quarter of 2013, the President's FY 2014 budget request was published, which complies with the $527 billion amount mandated by the BCA, but like the FY 2013 budget does not include the $55 billion of FY 2014 cuts imposed by the sequester.

These budget uncertainties continue to negatively impact the flow of contract awards. However, despite these uncertainties, our outlook for the U.S. defense business is buoyed by the relevance of our programs to the military's funding priorities, the diversity of our products and customers within the budget and our proven track record of successful contract execution.

Our 2013 financial outlook for each of our defense business groups assumed that the U.S. government would operate under a CR in FY 2013 and that there would be no significant reductions to the proposed defense budget. The outlook for our defense groups incorporates the FY 2013 budget and reflects our current understanding of how customers will implement the sequester. We will continue to monitor and assess the sequester's impact on our business.


24


RESULTS OF OPERATIONS
INTRODUCTION
An understanding of our accounting practices is important to an evaluation of our operating results. We recognize the majority of our revenues using the percentage-of-completion method of accounting. The following paragraphs explain how this method is applied in recognizing revenues and operating costs in our Aerospace and defense business groups.
In the Aerospace group, contracts for new aircraft have two major phases: the manufacture of the “green” aircraft and the aircraft’s outfitting, which includes exterior painting and installation of customer-selected interiors. We record revenues on these contracts at the completion of these two phases: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the outfitted aircraft. Revenues in the Aerospace group’s other original equipment manufacturers (OEMs) completions and services businesses are recognized as work progresses or upon delivery of services. Changes in revenues result from the number and mix of new aircraft deliveries (green and outfitted), progress on aircraft completions and the level of aircraft service activity during the period.
The majority of the Aerospace group’s operating costs relates to new aircraft production for firm orders and consists of labor, material and overhead costs. The costs are accumulated in production lots and recognized as operating costs at green aircraft delivery based on the estimated average unit cost in a production lot. While changes in the estimated average unit cost for a production lot impact the level of operating costs, the amount of operating costs reported in a given period is based largely on the number and type of aircraft delivered. Operating costs in the Aerospace group’s completions and services businesses are generally recognized as incurred.
For new aircraft, operating earnings and margins are a function of the prices of our aircraft, our operational efficiency in manufacturing and outfitting the aircraft and the mix of aircraft deliveries between the higher-margin large-cabin and lower-margin mid-cabin aircraft. Additional factors affecting the group’s earnings and margins include the volume, mix and profitability of completions and services work performed, the market for pre-owned aircraft and the level of general and administrative (G&A) and research and development (R&D) costs incurred by the group.
In the defense groups, revenue on long-term government contracts is recognized as work progresses, either as products are produced or services are rendered. As a result, changes in revenues are discussed generally in terms of volume, typically measured by the level of activity on individual contracts or programs. Year-over-year variances attributed to volume are due to changes in production or service levels and delivery schedules.
Operating costs for the defense groups consist of labor, material, subcontractor and overhead costs and are generally recognized as incurred. Variances in costs recognized from period to period primarily reflect increases and decreases in production or activity levels on individual contracts and, therefore, result largely from the same factors that drive variances in revenues.
Operating earnings and margins in the defense groups are driven by changes in volume, performance or contract mix. Performance refers to changes in profitability based on revisions to estimates at completion on individual contracts. These revisions result from increases or decreases to the estimated value of the contract, the estimated costs to complete or both. Therefore, changes in costs incurred in the period do not necessarily impact profitability. It is only when total estimated costs at completion change that profitability may be impacted. Contract mix refers to changes in the volume of higher- vs. lower-margin work. Higher or lower margins can be inherent in the contract type (e.g., fixed-price/cost-reimbursable) or type of work (e.g., development/production).

25


CONSOLIDATED OVERVIEW

Three Months Ended
April 1, 2012
 
March 31,
2013
 
Variance
Revenues
$
7,579

 
$
7,404

 
$
(175
)
 
(2.3
)%
Operating costs and expenses
6,719

 
6,557

 
(162
)
 
(2.4
)%
Operating earnings
860

 
847

 
(13)

 
(1.5
)%
Operating margins
11.3
%
 
11.4
%
 
 
 
 
Our revenues and operating costs were down in the first quarter of 2013 compared with the prior-year period driven primarily by the lower volume in the Combat Systems group on the domestic Stryker, Abrams and Mine-Resistant, Ambush-Protected (MRAP) vehicle programs and lower axle sales. This decrease was partially offset by outfitted deliveries of the G650 aircraft and green deliveries of the G280 aircraft in the Aerospace group. Operating margins were up slightly in the first quarter of 2013.
PRODUCT REVENUES AND OPERATING COSTS

Three Months Ended
April 1, 2012
 
March 31,
2013
 
Variance
Revenues
$
4,718

 
$
4,459

 
$
(259
)
 
(5.5
)%
Operating costs
3,764

 
3,529

 
(235
)
 
(6.2
)%

Product revenues were lower in the first quarter of 2013 compared with the prior-year period. The decrease consisted of the following:

Aircraft manufacturing and outfitting
$
185

Military vehicle production
(259
)
Weapons systems production
(83
)
Ship construction
(74
)
Other, net
(28
)
Total decrease
$
(259
)
In the first quarter of 2013, aircraft manufacturing and outfitting revenues increased due to outfitted deliveries of the G650 aircraft and green deliveries of the G280 aircraft. U.S. and European military vehicle production decreased on several programs, including the U.S. Stryker, Abrams and MRAP programs and several international Duro and Eagle wheeled vehicle programs. Weapons systems revenues decreased primarily due to lower axle sales. The completion of the T-AKE combat-logistics ship program in late 2012 resulted in the decrease in ship construction revenues.
Product operating costs were lower in the first quarter of 2013 compared with the prior-year period. The decrease consisted of the following:


26


Primary changes due to volume:
 
  Aircraft manufacturing and outfitting
$
166

  Military vehicle production
(242
)
  Weapons systems production
(59
)
  Ship construction
(38
)
 
(173
)
Other changes, net
(62
)
Total decrease
$
(235
)

The decrease in product operating costs was primarily due to lower volume. No other changes were material.
SERVICE REVENUES AND OPERATING COSTS

Three Months Ended
April 1, 2012
 
March 31,
2013
 
Variance
Revenues
$
2,861

 
$
2,945

 
$
84

 
2.9
%
Operating costs
2,420

 
2,521

 
101

 
4.2
%

Service revenues were higher in the first quarter of 2013 compared with the prior-year period. The increase consisted of the following:

Ship engineering and repair
$
95

Other, net
(11
)
Total increase
$
84

In the first quarter of 2013, the increase in ship engineering and repair revenues was driven by submarine overhaul and repair work.
Service operating costs increased in the first quarter of 2013 compared with the prior-year period. The increase consisted of the following:

Ship engineering and repair volume
$
93

Other changes, net
8

Total increase
$
101

The increase in service operating costs was primarily due to higher volume. No other changes were material.

27


OTHER INFORMATION
G&A Expenses
As a percentage of revenues, G&A expenses were 6.8 percent in the first quarter of 2013, compared with 7.1 percent in the prior-year period. We expect G&A expenses in 2013 to be approximately 6.5 percent of revenues.
Interest, Net
Net interest expense in the first three months of 2013 was $23 compared with $39 in the same period in 2012. The decrease in interest expense results from our debt refinancing completed in December 2012 that significantly lowered the weighted-average interest rate on our outstanding debt from 3.9 percent to 2.2 percent. We expect full-year 2013 net interest expense to be approximately $90.
Effective Tax Rate
Our effective tax rate for the first three months of 2013 was 30.7 percent compared with 31.3 percent in the same period in 2012. In the first quarter of 2013, Congress retroactively extended the R&D tax credit for 2012, which favorably impacted our first-quarter effective tax rate. We anticipate a full-year 2013 effective tax rate of approximately 32 percent.

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

Three Months Ended
April 1, 2012
 
March 31,
2013
 
Variance
Revenues
$
1,623

 
$
1,778

 
$
155

 
9.6
%
Operating earnings
271

 
310

 
39

 
14.4
%
Operating margin
16.7
%
 
17.4
%
 
 
 
 
 
 
 
 
 
 
 
 
Gulfstream aircraft deliveries (in units):
 
 
 
 
 
 
 
Green
28
 
30
 
2

 
7.1
%
Outfitted
19
 
29
 
10

 
52.6
%
Operating Results
The Aerospace group’s revenues increased in the first quarter of 2013 compared with the prior-year period. The increase consisted of the following:


28


Aircraft manufacturing, outfitting and completions
$
154

Aircraft services
(40
)
Pre-owned aircraft
41

Total increase
$
155

Aircraft manufacturing, outfitting and completions revenues include the manufacture and outfitting of Gulfstream business-jet aircraft as well as completions of aircraft produced by other OEMs. Aircraft manufacturing, outfitting and completions revenues increased in 2013 primarily due to outfitted deliveries of the G650 aircraft and green deliveries of the G280 aircraft. Outfitted deliveries of the G650 aircraft began in the fourth quarter of 2012 while green deliveries of the G280 aircraft began in the second quarter of 2012. Aircraft services revenues were lower in 2013 largely due to the sale of three European-based facilities in Jet Aviation's maintenance business in the fourth quarter of 2012 and lower services revenues across the group. Pre-owned aircraft sales increased in the first quarter of 2013 due to the sale of two aircraft as compared to no pre-owned aircraft sales in the first quarter of 2012, somewhat compressing margins of the group.
The group's operating earnings increased in the first quarter of 2013 compared with 2012. The increase consisted of the following:

Aircraft manufacturing, outfitting and completions
$
38

Aircraft services
(2
)
Pre-owned aircraft

G&A/other expenses
3

Total increase
$
39

Aircraft manufacturing, outfitting and completions earnings increased in the first quarter of 2013 compared with the prior-year period primarily due to the increase in G650 outfitted deliveries discussed above.
Outlook
We expect an increase of approximately 16 percent in the group’s full-year revenues in 2013 compared with 2012, primarily due to increased production of Gulfstream aircraft, and operating margins in the mid-15 percent range.
COMBAT SYSTEMS

Three Months Ended
April 1, 2012
 
March 31, 2013
 
Variance
Revenues
$
1,911

 
$
1,553

 
$
(358
)
 
(18.7
)%
Operating earnings
203

 
215

 
12

 
5.9
 %
Operating margins
10.6
%
 
13.8
%
 
 
 
 
Operating Results
The Combat Systems group’s revenues decreased in the first quarter of 2013 compared with the prior-year period. The decrease consisted of the following:


29


U.S. military vehicles
$
(247
)
Weapon systems and munitions
(74
)
European military vehicles
(37
)
Total decrease
$
(358
)
In the first three months of 2013, revenues were down in the group’s U.S. military vehicles business due to lower volume on the domestic Stryker, Abrams and MRAP vehicle programs. Revenues were down in the first quarter of 2013 in the weapons systems and munitions business primarily due to lower axle sales and slower contract execution. In the group’s European military vehicle business, revenues were down due to final vehicle deliveries in 2012 under several Duro and Eagle wheeled vehicle contracts.
The Combat Systems group’s operating margins increased 320 basis points in the first quarter of 2013. Operating results in the first quarter of 2012 include the negative impact of $67 of out-of-period adjustments in our European military vehicles business.
Outlook
We expect the Combat Systems group’s full-year revenues in 2013 to be down 8 percent from 2012 with operating margins in the mid- to high-13 percent range. This outlook includes the anticipated impact of $15 of restructuring-related charges in our European military vehicles business in the second quarter of 2013. For further discussion of the restructuring costs, see Note L to the unaudited Consolidated Financial Statements.
MARINE SYSTEMS

Three Months Ended
April 1, 2012
 
March 31, 2013
 
Variance
Revenues
$
1,605

 
$
1,626

 
$
21

 
1.3
 %
Operating earnings
185

 
159

 
(26
)
 
(14.1
)%
Operating margins
11.5
%
 
9.8
%
 
 
 
 
Operating Results
Revenues increased in the Marine Systems group in the first quarter of 2013 compared with the prior-year period. The increase consisted of the following:

Navy ship construction
$
(88
)
Navy ship engineering, repair and other services
95

Commercial ship construction
14

Total increase
$
21

The group’s U.S. Navy ship-construction programs currently include Virginia-class submarines, DDG-1000 and DDG-51 destroyers, and Mobile Landing Platform (MLP) auxiliary support ships. The decrease in 2013 revenues is almost entirely due to the completion of the T-AKE combat-logistics ship program in late 2012. Revenues were higher on engineering and repair programs for the Navy in the first three months of 2013 driven by submarine overhaul and repair work, including restoration efforts on USS Miami. Design work for two liquefied natural gas (LNG)-powered containerships that will begin construction in 2014 resulted in commercial ship construction revenues in the first quarter of 2013.

30


With the completion of the mature T-AKE program in 2012, the Marine Systems group's operating earnings decreased in the first quarter of 2013 at a higher rate than revenues, resulting in a 170-basis point decrease in operating margin compared with the prior-year period.
Outlook
We expect the Marine Systems group’s 2013 full-year revenues to remain near 2012 levels. Operating margins are expected to be in the mid- to high-9 percent range in 2013.
INFORMATION SYSTEMS AND TECHNOLOGY

Three Months Ended
April 1, 2012
 
March 31, 2013
 
Variance
Revenues
$
2,440

 
$
2,447

 
$
7

 
0.3
 %
Operating earnings
218

 
185

 
(33
)
 
(15.1
)%
Operating margins
8.9
%
 
7.6
%
 
 
 
 
Operating Results
The Information Systems and Technology group’s revenues increased in the first quarter of 2013 compared with the prior-year period. The increase consisted of the following:
 
Mobile communication systems
$
(11
)
Information technology (IT) solutions and mission support services
38

Intelligence, surveillance and reconnaissance (ISR) systems
(20
)
Total increase
$
7

While revenues were down slightly in our mobile communication and ISR systems businesses, revenues increased in our IT services business driven primarily by higher volume on the New Campus East (NCE) and St. Elizabeths campus IT infrastructure support and modernization programs.
Operating earnings and margins decreased in the first quarter of 2013 compared with the prior-year period due to growth in lower-margin IT services.
Outlook
We expect 2013 full-year revenues in the Information Systems and Technology group to be down approximately 5 percent from 2012 with operating margins in the low-8 percent range. Operating margins are expected to improve in the second half of 2013 as revenues for higher-margin encryption products in our mobile communication systems business increase.
CORPORATE
Corporate results consist primarily of compensation expense for stock options. Corporate operating costs totaled $22 in the first quarter of 2013 compared with $17 in the first quarter of 2012. We expect 2013 full-year Corporate operating costs of approximately $90.

BACKLOG AND ESTIMATED POTENTIAL CONTRACT VALUE
Our total backlog, including funded and unfunded portions, was $48.5 billion on March 31, 2013, compared with $51.3 billion at year-end 2012. Our backlog does not include work awarded on unfunded indefinite

31


delivery, indefinite quantity (IDIQ) contracts or unexercised options associated with existing firm contracts, which we refer to collectively as estimated potential contract value. On March 31, 2013, estimated potential contract value was $25.2 billion, compared with $26.9 billion at the end of 2012.
The following table details the backlog and the estimated potential contract value of each business group at the end of the fourth quarter of 2012 and first quarter of 2013:
 
Funded
 
Unfunded
 
Total Backlog
 
Estimated Potential Contract Value
 
Total Estimated Contract Value
 
December 31, 2012
Aerospace
$
15,458

 
$
209

 
$
15,667

 
$

 
$
15,667

Combat Systems
7,442

 
1,298

 
8,740

 
2,794

 
11,534

Marine Systems
13,495

 
3,606

 
17,101

 
3,047

 
20,148

Information Systems and Technology
8,130

 
1,643

 
9,773

 
21,009

 
30,782

Total
$
44,525

 
$
6,756

 
$
51,281

 
$
26,850

 
$
78,131

 
 
 
 
 
 
 
 
 
 
 
March 31, 2013
Aerospace
$
15,029

 
$
197

 
$
15,226

 
$

 
$
15,226

Combat Systems
6,677

 
1,180

 
7,857

 
3,038

 
10,895

Marine Systems
12,551

 
3,108

 
15,659

 
2,324

 
17,983

Information Systems and Technology
8,158

 
1,551

 
9,709

 
19,811

 
29,520

Total
$
42,415

 
$
6,036

 
$
48,451

 
$
25,173

 
$
73,624


AEROSPACE
Aerospace funded backlog represents aircraft orders for which we have definitive purchase contracts and deposits from customers. Unfunded backlog consists of agreements to provide future aircraft maintenance and support services.
The group ended the first quarter of 2013 with $15.2 billion of backlog, down from $15.7 billion at year-end 2012 as we deliver on our G650 backlog. Orders were up modestly from the prior-year period and from the fourth quarter of 2012 and included demand for products across our portfolio.
While 2012 orders were largely from North American customers, approximately 70 percent of the group’s orders in the first three months of 2013 were from international customers, with strong demand from the Asia-Pacific region. International customers represented over 60 percent of the group’s backlog at the end of the first quarter.

DEFENSE GROUPS
The total backlog for our defense groups represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are similarly approved and funded by their governments. While there is no guarantee that future budgets and appropriations will provide funding for a given program, we have included in total backlog only firm contracts at the amounts we believe are likely to receive funding.
Total backlog in our defense groups was $33.2 billion on March 31, 2013, down 7 percent from year-end. The decrease was primarily on our long-term construction programs in the Combat Systems and

32


Marine Systems groups. With the passage of a FY 2013 defense budget in the first quarter, we expect the flow of contract awards to improve in the remainder of the year. Nonetheless, our defense groups each received notable contract awards in the quarter.
Combat Systems awards included the following:
$55 from the U.S. Army for the production of Hydra-70 rockets.
Marine Systems awards included the following:
An IDIQ contract from the U.S. Navy to perform submarine safety and maintenance work. The program has a maximum potential value of $215 over five years.
Information Systems and Technology awards included the following:
$160 for commercial wireless network systems and support.
$160 for combat and seaframe control systems on two Navy Littoral Combat Ships (LCS).
$105 for the National Geospatial-Intelligence Agency's NCE infrastructure support and modernization program.
$85 from the U.S. Department of Education to assist in the implementation and operation of the Federal Student Aid Information Center.
$75 to provide advanced communication services to the Canadian Army.
$75 from the Army under the Warfighter Information Network-Tactical (WIN-T) program for Increment 2 equipment production and training.
$70 from the Army for ruggedized computing equipment under the Common Hardware Systems-4 (CHS-4) program.
$60 from the U.S. Air Force for networking and computing products and support under the Network-Centric Solutions (NETCENTS) program.
$60 for the United Kingdom's Bowman communications system for long-term support and enhancement activities for the program.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
We ended the first quarter of 2013 with a cash balance of $3.7 billion, up from $3.3 billion at the end of 2012. Our net debt, defined as debt less cash and equivalents and marketable securities, was $165 at the end of the first quarter of 2013, down $448 from the end of 2012. The following is a discussion of our major operating, investing and financing activities, as classified on the Consolidated Statement of Cash Flows, in the first three months of 2012 and 2013.
OPERATING ACTIVITIES
We generated cash from operating activities of $504 in the first three months of 2013 compared with $414 in the same period in 2012. The primary driver of cash flows in both periods was net earnings offset in part

33


by growth in operating working capital (OWC). The increase in OWC in the first three months of 2013 is largely due to timing of contract payments and, consistent with historical experience, is expected to largely reverse by the end of the year.
As discussed further in Note L to the unaudited Consolidated Financial Statements, litigation on the A-12 program termination has been ongoing since 1991. If, contrary to our expectations, the default termination ultimately is sustained and the government prevails on its recovery theories, we, along with The Boeing Company, could collectively be required to repay the U.S. government as much as $1.4 billion for progress payments received for the A-12 contract plus interest. Interest was approximately $1.6 billion on March 31, 2013. If this were the outcome, we would owe half of the total, or approximately $1.5 billion pretax. Our after-tax cash obligation would be approximately $740. We believe we have sufficient resources, including access to capital markets, to pay su