10-K 1 d10k.htm FORM 10-K FORM 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

 

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

For the fiscal year ended December 31, 2005

OR

 

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

For the transition period from              to             

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

     

IRS Employer

Identification No.

 

2941 Fairview Park Drive, Suite 100,

Falls Church, Virginia


     

22042-4513


Address of principal executive offices       Zip code

Registrant’s telephone number, including area code:

703 876-3000


Securities registered pursuant to Section 12(b) of the Act:

 

                        Title of each class                        


     

Name of exchange on which registered


Common stock, par value $1.00 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  x    No  ¨

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  ¨    No  x

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  x    No  ¨

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 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.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Large Accelerated Filer  x    Accelerated Filer  ¨    Non-Accelerated Filer    ¨  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $20,125,000,000 as of July 3, 2005 (based on the closing price of the shares on the New York Stock Exchange).

200,144,251 shares of the registrant’s common stock were outstanding at January 29, 2006.

DOCUMENTS INCORPORATED BY REFERENCE:

Part III incorporates information from certain portions of the registrant’s definitive proxy statement for the 2006 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year.

 



Table of Contents

INDEX

 

     Page

PART I     
        Item 1. Business    3
        Item 1A. Risk Factors    13
        Item 1B. Unresolved Staff Comments    14
        Item 2. Properties    15
        Item 3. Legal Proceedings    16
        Item 4. Submission of Matters to a Vote of Security Holders    16
PART II     

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

   17
        Item 6. Selected Financial Data    18
        Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations    19
        Item 7A. Quantitative and Qualitative Disclosures About Market Risk    33
        Item 8. Financial Statements and Supplementary Data    34
        Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    62
        Item 9A. Controls and Procedures    62
        Item 9B. Other Information    64
PART III     
        Item 10. Directors and Executive Officers of the Company    64
        Item 11. Executive Compensation    65
        Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    65
        Item 13. Certain Relationships and Related Transactions    65
        Item 14. Principal Accountant Fees and Services    65
PART IV     
        Item 15. Exhibits and Financial Statement Schedules    65

   Signatures

   66

   Schedule II - Valuation and Qualifying Accounts

   67

   Index to Exhibits

   67

 

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(Dollars in millions, unless otherwise noted)

PART I


ITEM 1. BUSINESS

BUSINESS OVERVIEW

General Dynamics is a market leader in information systems and technologies; land and expeditionary combat vehicles and systems, armaments and munitions; shipbuilding and marine systems; and business aviation. Incorporated in Delaware, the company employs approximately 72,200 people and has a presence worldwide.

Formed in 1952 through the combination of Electric Boat Company, Consolidated Vultee (CONVAIR) and other companies, General Dynamics grew internally and through acquisitions until the early 1990s, when it sold all of its divisions except Electric Boat and Land Systems. Beginning in 1995, the company expanded those two core defense businesses by purchasing other shipyards and combat vehicle-related businesses. In 1997, to reach a new, growing market, the company began acquiring companies with expertise in information technology products and services, particularly in the command, control, communications, computing, intelligence, surveillance and reconnaissance (C4ISR) arenas. In 1999, the company purchased Gulfstream Aerospace Corporation, a business-jet aircraft and aviation-support-services company. In the last 10 years, General Dynamics has acquired and successfully integrated 40 businesses, including three in 2005.

General Dynamics focuses on creating shareholder value while delivering the best products and services possible to its military, other government and commercial customers. The company emphasizes excellence in program management and continual improvement in all of its operations. General Dynamics values ethical behavior and promotes a culture of integrity throughout all aspects of its businesses. This culture is evident in how the company deals with shareholders, employees, customers, partners and the communities in which it operates.

General Dynamics has four primary business groups – Information Systems and Technology, Combat Systems, Marine Systems and Aerospace – and a small Resources group.

PRODUCTS AND SERVICES

INFORMATION SYSTEMS AND TECHNOLOGY

The Information Systems and Technology group provides systems integration expertise, hardware and software products and support services in three principal markets.

 

  Tactical and strategic mission systems: The group designs, builds and services complex command, control, communications and computing systems for defense customers worldwide, and is a recognized leader in information assurance products and systems for U.S. national security customers.

 

  Intelligence mission systems: For the U.S. intelligence community, the group provides highly specialized signals and information collection, processing and distribution systems; special-purpose computing; multi-level security; data mining and fusion; special-mission satellites and payloads; and information operations services.

 

  Network infrastructure and information technology services: The group provides world-class design, development, installation and integration of voice, video and data networks, as well as a full spectrum of information technology (IT) support services (such as staff augmentation and skilled mission support) to military and other government agencies and select commercial customers.

Acquisitions and new program wins since 1997 have combined to build capabilities that address each of these markets across a wide range of land, sea, air and space platforms. As a result, the group has a broad customer base that includes the U.S. Army, Marine Corps, Air Force, Navy and Coast Guard; the U.S. national security community; and international customers.

Information Systems and Technology’s total revenues have more than doubled over the past three years, reflecting the increasing use of digital, network-centric C4ISR and information-sharing technologies in the U.S. national security community. The U.S. intelligence community’s drive to improve its information-sharing capabilities increasingly requires additional secure, networked communications systems. The company expects that meeting emerging requirements among homeland defense customers to link local, state and federal communities will create another potential growth area for the group.

 

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Among the key offerings that differentiate the company in these evolving markets are:

 

  technologies that enable on-the-move command, control and communications, which make ground forces more agile and effective, support widely dispersed operations and reduce the size of support infrastructure;

 

  capabilities to link soldiers, sensors and weapons in real time, as well as the ability for commanders to maintain a clear perspective of the battlefield that can be shared at all levels of command;

 

  development of “open architecture” mission systems based on open-source software and commercial-off-the-shelf technology that add advanced capabilities to land, sea and airborne platforms at reduced technical risk and cost;

 

  cost-effective, operationally responsive special-mission satellites, payloads and services;

 

  information assurance technologies, products, systems and services that ensure the security, integrity and confidentiality of digital communications worldwide; and

 

  IT services and network infrastructure, from system architecture and design to build-out, maintenance, operations and upgrades.

Recent examples of the value of these offerings to the company’s customers from among the Information Systems and Technology group’s portfolio of more than 3,000 contracts include the following:

In November, the company successfully demonstrated a new on-the-move voice, video and data communications network known as the Warfighter Information Network-Tactical (WIN-T) for the Army. This demonstration proved, for the first time, that the required technologies and network-management skills exist to support secure, high-speed communication across a dynamic Internet Protocol network of fixed and mobile nodes using ground, airborne and satellite assets. WIN-T is a self-forming, self-healing network, requiring significantly less human involvement than existing systems. The demonstration was a key milestone in the development of WIN-T which, when deployed, will be the principal tactical communications network for the Army.

Information Systems and Technology continued its work on similar network development and deployment programs for international customers as well. The group delivered the first functional brigade set of the new BOWMAN tactical network to the United Kingdom’s Ministry of Defence, which promptly deployed it to support operations in Iraq. In addition, the Royal Dutch Marines awarded the group a contract for a BOWMAN-type system for its ground force, and the Australian Land Forces selected the group for the initial phase of a similar program called the Battlespace Communications System (Land) or “JP 2072.”

In a program designed to provide real-time links among soldiers, sensors and platforms, the Information Systems and Technology group continued its work on the small, lightweight Cluster 5 radios of the Joint Tactical Radio System (JTRS). When deployed in compact configurations ranging from handheld radios to unattended sensors and unmanned aerial vehicles, this technology will enable U.S. forces to communicate more effectively than they can with existing systems.

The company provides systems integration and design agent services for the Navy’s Open Architecture Track Manager (OATM) project, and has taken a leading role in demonstrating the value of an “open architecture” approach to mission systems on several platforms. These include the Navy’s Littoral Combat Ship and the Canadian Defence Forces’ Maritime Helicopter Project. This open architecture approach is designed to facilitate the rapid introduction of emerging technologies to platform-based mission systems at significantly lower cost and risk than is feasible under the legacy approach.

Information Systems and Technology brings its expertise to the homeland security arena as well. For example, it has a contract to provide all site integration, program and construction management for radio access in the New York Statewide Wireless Network (SWN). In addition, Information Systems and Technology is the prime contractor on the Coast Guard’s Rescue 21 communications system, which is designed to provide enhanced command-and-control communications as well as improved search-and-rescue capabilities. The group also provides IT services and other support to homeland security organizations in locations across the country.

In 2005, General Dynamics completed three acquisitions to strengthen the Information Systems and Technology group’s market position. In April, the company acquired privately held MAYA Viz Ltd., a leader in visualization and collaboration technologies that support real-time decision making. In August, General Dynamics purchased Tadpole Computer, Inc., a provider of Unix®-based mobile, secure and battlefield-tested computing platforms for mission-critical military, government and commercial operations. In September, the company acquired Itronix Corporation, further expanding its offerings of wireless, rugged, mobile computing solutions, especially for defense customers. In January 2006, the company acquired privately held FC Business Systems, Inc., which provides a broad spectrum of IT services to a variety of government customers. General Dynamics also has entered into a definitive agreement to acquire Anteon International Corporation, a leading information systems integration company that provides mission, operational and IT enterprise support to the U.S. government. The company expects the Anteon transaction to close in the first half of 2006.

 

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Net sales for the Information Systems and Technology group were 37 percent of the company’s consolidated net sales in 2005, 35 percent in 2004 and 30 percent in 2003. Net sales by major products and services were as follows:

 

Year Ended December 31    2005    2004    2003

Tactical and strategic mission systems

   $ 3,912    $ 2,966    $ 2,221

Intelligence mission systems

     2,110      2,006      1,314

Network infrastructure and IT services

     1,804      1,750      1,313
     $ 7,826    $ 6,722    $ 4,848

COMBAT SYSTEMS

The Combat Systems group is a leading supplier of land and expeditionary combat systems around the world, providing tracked and wheeled armored combat vehicles, armament systems and ammunition to the U.S. military and its allies. The group supplies, supports and enhances existing products and develops new combat systems for the future. Specific Combat Systems product lines include the development, manufacture and support of the following:

 

  a full spectrum of wheeled armored combat vehicles,

 

  tracked main battle tanks and infantry fighting vehicles,

 

  guns and ammunition-handling systems,

 

  ammunition and ordnance,

 

  reactive armor and protection systems,

 

  mobile bridge systems,

 

  chemical and biohazard detection products, and

 

  radomes and other complex composite components for aerospace systems.

Among its key offerings, Combat Systems produces the Army’s Stryker wheeled infantry combat vehicle, a focal point of the Army’s .ongoing transformation. The rapid development and deployment of this program, which progressed from design to fielding in just four years, demonstrates the Combat Systems group’s ability to anticipate and quickly respond to evolving customer needs.

The ability of U.S. Stryker Brigade Combat Teams to cover great distances rapidly and engage in combat operations immediately upon arrival has significantly enhanced the Army’s operational flexibility and tactical agility. In support of Operation Iraqi Freedom, Army personnel drove 310 Stryker vehicles more than six million miles in less than two years with an operational readiness rate above 95 percent. Stryker vehicle configurations include carriers for mortars, engineer squads, infantry squads, command groups and fire support teams; as well as a nuclear, biological and chemical reconnaissance vehicle; an anti-tank guided missile vehicle; a medical evacuation variant; and a Mobile Gun System featuring a 105mm cannon mounted on a low-profile turret integrated into the Stryker chassis.

General Dynamics also produces the United States’ main battle tank, the Abrams, which has been highly effective in both open and urban Iraqi terrain. The M1A2, with its System Enhancement Package (SEP), is the latest, most technologically advanced Abrams configuration. It is a fully digital platform with an enhanced command-and-control system, second-generation thermal sights and improved armor. The SEP configuration integrates new information technologies to improve soldier warfighting capability with enhanced digital features, including color maps and displays, high-density computer memory, increased microprocessing speed and improved communications capabilities.

Combat Systems is completing the development of the Marine Corps’ Expeditionary Fighting Vehicle (EFV). The EFV’s breakthrough design provides excellent cross-country mobility, lethal firepower, high speed on water and land, extensive information and communications networking, and enhanced crew protection and survivability. These attributes are designed to provide the Marine Corps with greater lethality and operational ability. Low-rate initial production is expected to begin in 2007. The company anticipates production of more than 1,000 units for the Marines through 2020, as well as additional vehicles for international sales.

The company’s European business is a recognized combat systems integrator with manufacturing and production sites in Austria, Germany, Spain and Switzerland, and has customers in more than 30 countries. General Dynamics continues to grow this business through the design, manufacture and marketing of light- and medium-weight tracked and wheeled tactical vehicles, amphibious bridge systems, artillery systems, light weapons, ammunition and propellants. Among the group’s successes in 2005 were contracts with several European customers, including agreements to provide Pandur II armored combat vehicles to the Portuguese army and navy, self-propelled howitzers to the Spanish army, Duro III wheeled armored vehicles to the German armed forces, and Eagle IV armored patrol vehicles to the Danish army.

        The Combat Systems group is involved in numerous efforts to bring advanced technologies into the current force and to help the Department of Defense achieve its transformation objectives. The group is a key participant in the development of manned and unmanned ground vehicles and key technologies for Future Combat Systems (FCS), the Army’s largest development program. The Army plans to begin FCS vehicle production in 2010 and expects to integrate several mature FCS technologies into the current force beginning in 2008. In addition, the Marine Corps has selected the group to develop and produce the Expeditionary Fire Support System (EFSS), a

 

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120mm mortar system that can be internally transported by the V22 Osprey. The group also leads the consortium that is developing highly advanced robotic ground vehicles to expand the Army’s capabilities while reducing risk to soldiers.

The Combat Systems group provides solutions to new and emerging threats faced by U.S. forces around the world. For example, the group produces chemical and biological detection systems for the U.S. government, including the Joint Biological Point Detection System (JBPDS), the first deployed near-real-time biological detection capability. In addition, the group has provided solutions to protect against improvised explosive devices (IED) to the Army, Marines and Department of Homeland Security.

Combat Systems is a leader in the field of high-performance armament systems. This includes weapons carried on most U.S. fighter aircraft, such as high-speed Gatling guns and the Hydra-70 (70mm) family of rockets, as well as individual and crew-served weapons, including the M2 heavy machine gun and the MK19 grenade launcher. Combat Systems manufactures precision metal and composite components, and designs and produces shaped-charge warheads and control actuation systems. In addition, Combat Systems is a major manufacturer of large- and medium-caliber ammunition, bomb bodies and propellant. In 2005 the group was selected as a second source for up to 500 million rounds per year of critical small-caliber ammunition, such as 7.62mm and .50-caliber ammunition and the 5.56mm ammunition fired by the M-16 family of weapons. The group also provides demilitarization services for more than 50 types of munitions.

In February 2006, the company entered into a definitive agreement to acquire SNC Technologies, Inc., an ammunition system integrator that supplies small-, medium- and large-caliber ammunition and related products to armed forces and law enforcement agencies in North America and around the world. The company expects the transaction to close in the second quarter of 2006.

Net sales for the Combat Systems group were 24 percent of the company’s consolidated net sales in 2005, 23 percent in 2004 and 24 percent in 2003. Net sales by major products and services were as follows:

 

Year Ended December 31    2005    2004    2003

Medium armored vehicles and related products

   $ 1,610    $ 1,295    $ 1,228

Main battle tanks and related products

     931      819      799

Engineering and development

     864      763      639

Munitions and propellant

     615      525      406

Rockets and missile components

     324      335      278

Armament systems

     129      133      145

Aerospace components and other

     548      537      512
     $ 5,021    $ 4,407    $ 4,007

MARINE SYSTEMS

The Marine Systems group designs, builds and supports submarines and a variety of ships for the Navy and commercial customers. These sophisticated platforms and capabilities include:

 

  the Virginia-class attack submarine,

 

  Trident ballistic-missile submarine conversion (SSGN),

 

  surface warfare ships [DDG-51, DD(X), LCS],

 

  auxiliary and combat-logistics ships (T-AKE),

 

  commercial tankers,

 

  engineering design support and

 

  overhaul, repair and life-cycle support services.

Marine Systems leads the development of the Navy’s new fast-attack Virginia-class submarine and shares construction of these submarines with a teaming partner. In September 2005, the first of the Virginia-class submarines deployed for its initial mission considerably earlier than scheduled, due in large part to innovative production processes pioneered by the group. The Virginia-class submarine is an agile multi-mission platform with stealth, firepower, endurance, and advanced network and communication capabilities. In addition, the group is converting four Trident ballistic-missile submarines to SSGN submarines. The SSGN is a multi-mission submarine optimized for conventional tactical strike and special operations support, important capabilities for potential future engagements around the world. The group delivered the first of the four SSGNs, USS Ohio, to the Navy in December 2005.

The Marine Systems group also is working on a joint Defense Advanced Research Projects Agency (DARPA)/Navy submarine initiative to reduce future submarine costs. As part of this initiative, called Tango Bravo, the group has been tasked with developing and demonstrating three new technologies: an external weapon-launch system, a shaftless propulsion system and ship infrastructure reduction.

            The Marine Systems group is the lead designer and producer of Arleigh Burke-class guided-missile destroyers (DDG-51), one of the world’s most advanced surface combatants. Under the Navy’s plan, the company will augment the 26 company-built destroyers already in the fleet by delivering nine more DDGs through 2010, when the Navy plans to transition to construction of the next-generation destroyer [DD(X)]. The company, the Navy and other industry members are now designing this revolutionary multi-mission destroyer. Following the completion of a multi-year initial design and systems-engineering phase, in September 2005 the company received one of two contracts to perform transition work leading to detailed design and construction of the ship. In November 2005, the Department of Defense authorized the DD(X) program’s entry into the final

 

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development phase prior to ship construction. This crucial milestone also authorized the Navy to pursue an initial production quantity of up to eight ships under a two-lead-ship strategy. The Congress continued its support of the program by fully funding the Navy’s 2006 DD(X) budget requirements. Recognizing the long-term value of two surface-combatant builders to the Navy, the Congress stipulated that the ships be procured at two separate shipyards.

Marine Systems leads one of two industry teams competitively awarded contracts for the design and construction of the Navy’s Littoral Combat Ship (LCS), a key element of the Navy’s plan to address asymmetric maritime threats. As part of the group’s industry team, the Information Systems and Technology group is developing the ship’s core computing infrastructure and electronics. The team’s first high-speed LCS trimaran is now under construction at a teammate’s Alabama facility. Delivery to the Navy is scheduled for October 2007. The multi-mission LCS platform is intended for defense against terrorist swarm boats, mines and submarine threats in coastal areas.

The group’s auxiliary ships support the U.S. military’s forward presence and combat operations by delivering essential military equipment, ammunition, food, fuel, parts and supplies to U.S. forces around the world. In support of the Navy’s global logistics requirements, Marine Systems is leading the innovation of at-sea replenishment through the design and construction of the Lewis and Clark-class (T-AKE) dry cargo/ammunition ship. The first new Navy combat-logistics ship design in almost 20 years, T-AKE is optimized for efficient cargo transfer and is the first modern Navy ship to incorporate proven commercial marine technologies, such as integrated electric-drive propulsion. Integrated electric-drive propulsion is designed to minimize T-AKE operations and maintenance costs over an expected 40-year life. In May, the group launched the first T-AKE, which is scheduled for delivery to the Navy in mid-2006.

The group also designs and manufactures commercial ships, including double-hull oil tankers. The company delivered the third tanker in a four-ship contract to its customer in November, and the fourth tanker is scheduled for completion in 2006.

In addition, the Marine Systems group provides ship and submarine repair and other comprehensive support services to the Navy and commercial customers in a variety of locations throughout the United States and around the globe. Internationally, the group provides key U.S. allies essential program management, planning and design support for submarine and surface-ship construction programs.

Net sales for the Marine Systems group were 22 percent of the company’s consolidated net sales in 2005, 25 percent in 2004 and 26 percent in 2003. Net sales by major products and services were as follows:

 

Year Ended December 31    2005    2004    2003

Nuclear submarines

   $ 2,396    $ 2,432    $ 2,256

Surface combatants

     1,008      1,002      973

Auxiliary and commercial ships

     598      576      638

Repair and other services

     693      716      404
     $ 4,695    $ 4,726    $ 4,271

AEROSPACE

The Aerospace group designs, develops, manufactures and services a comprehensive fleet of advanced business-jet aircraft. Corporations, private individuals and government users alike rely on these aircraft to fulfill a wide range of requirements. The Aerospace group is known for superior aircraft design, safety, quality and reliability; technologically advanced onboard systems; on-time aircraft delivery; and industry-leading product support.

Since acquiring Gulfstream Aerospace Corporation in 1999, General Dynamics has implemented a strategy of continuous, stable investment in the development of new aircraft models and technological innovations to keep Gulfstream aircraft at the leading edge of business aviation. As a result, the group has revamped and expanded its entire aircraft product line to address additional elements of the business-jet market and introduced new technologies that enhance the reputation of Gulfstream aircraft as powerful business tools.

In the past four years, the group’s product line has increased from two to six aircraft, offering more options at various price and performance points to business-jet customers than ever before. Four of the new aircraft – the G350, G450, G500 and G550 – share the same pilot type rating as the GV, resulting in significant cost efficiencies for multiple-aircraft fleet operators from both a training and a maintenance perspective.

Investment in new technologies, such as the Enhanced Vision System (EVS) and air-to-ground communications capabilities, has accelerated, helping to ensure that Gulfstream aircraft distinguish themselves from the competition. In 2005, the Aerospace group leased a 100,000-square-foot building that will be dedicated in 2006 as the Gulfstream Research and Development Center. It will centralize the company’s research and development efforts in advanced avionics and cabin technologies, enhanced vision systems, and sonic-boom suppression. In addition, the group has continued its commitment to customer service, providing award-winning responsive support that helps maintain its outstanding record of aircraft safety, reliability and availability.

 

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With six aircraft models available at varying combinations of range, speed and cabin dimensions, the group competes aggressively and effectively in the mid-size to ultra-long-range market sectors.

LOGO

In 2005, the Aerospace group achieved a number of important milestones that continued to distinguish its products and services from its competition. In cooperation with Israel Aircraft Industries (IAI), the company produced, tested and certified its newest business-jet aircraft, the mid-size, high-speed G150, which replaces the G100. Certified by both the Israel Civil Aviation Authority and the U.S. Federal Aviation Administration (FAA) in November, the G150 offers an entirely new cabin design that can accommodate up to eight passengers. With four passengers onboard, the G150 can fly 2,950 nautical miles nonstop, farther than any other business-jet aircraft in its class.

The company continues to enhance the position of its products outside the United States. In 2005, the European Aviation Safety Agency (EASA) and the Joint Aviation Authorities (JAA) validated the Gulfstream G350 and G500. This enabled the aircraft to be certified and registered by two agencies with extensive European and international membership, broadening the market appeal of each. In the Asia-Pacific region, the company has seen a marked increase in demand for Gulfstream aircraft, driven by corporate globalization and the growing popularity of international air charter services. In the Middle East, historically a strong Gulfstream market, aircraft sales continue to grow.

Because the high altitude capability, range, endurance, reliability and efficiency of Gulfstream aircraft are ideal for meeting a variety of mission requirements, the company remains a leading provider of aircraft for government special-mission applications. In 2005, the company delivered one aircraft to the Japanese Coast Guard for a special search-and-rescue mission; one to the National Center for Atmospheric Research; one to the Israeli Ministry of Defense; and one each to the Army and Navy. A German government agency also ordered a G550 for high-altitude research.

In 2005, the FAA certified the company’s ultra-high-speed broadband multi-link (BBML) system. This advanced technology enables customers to access the Internet at altitudes up to 51,000 feet at connection speeds similar to those typically found in corporate offices. Gulfstream’s BBML service is up to 10 times faster than other widely used in-flight connections. Video conferencing and voice-over-Internet-protocol capabilities are in development and are expected to be offered as options in 2006.

Net sales for the Aerospace group were 16 percent of the company’s consolidated net sales in 2005 and 2004 and 18 percent in 2003. Net sales by major products and services were as follows:

 

Year Ended December 31    2005    2004    2003

New aircraft

   $ 2,730    $ 2,288    $ 2,081

Aircraft services

     484      446      408

Pre-owned aircraft

     219      278      457
     $ 3,433    $ 3,012    $ 2,946

 

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RESOURCES

The Resources group comprises a coal mining business and an aggregates operation that mines sand, stone and gravel for construction use. Net sales were $269 in 2005, $252 in 2004 and $256 in 2003. This represented approximately 1 percent of the company’s consolidated net sales in 2005 and 2004 and 2 percent in 2003.

For additional discussion of the company’s business groups, including significant program wins in 2005, see Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7, of this Annual Report on Form 10-K. For information on the revenues, operating earnings and identifiable assets attributable to each of the company’s business groups, see Note R to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.

COMPETITION

Several factors sustain General Dynamics’ ability to compete successfully in all of its markets. These include the technical excellence, reliability and cost competitiveness of the company’s products and services; its reputation for integrating complex systems and delivering them on schedule; the successful management of the company’s businesses and customer relationships; and a strong company-wide focus on professional ethics.

DEFENSE MARKET

The U.S. government contracts with numerous domestic and foreign companies for defense products and services. General Dynamics competes in this arena against other defense contractors. At times the company has teaming and subcontracting relationships with some of its competitors. Key competitive factors in this market include technological innovation, low-cost production, performance and market knowledge.

The Information Systems and Technology group competes with a host of companies, from large defense companies to smaller niche competitors with specialized technologies. The Combat Systems group competes with both domestic and foreign businesses. The Marine Systems group’s market has only one other primary competitor, Northrop Grumman Corporation, with which it also cooperates on several programs, including the Virginia-class submarine and DD(X) destroyer. The Navy’s LCS program has expanded competition to include another large defense company seeking a role as a prime contractor.

BUSINESS-JET AIRCRAFT MARKET

The business-jet aircraft market is divided into segments based on aircraft range, price and cabin size. Gulfstream has at least one competitor for each of its six products, with proportionately more competitors for the shorter-range aircraft. The key competitive factors include aircraft safety and performance, service quality and timeliness, innovative marketing programs, and price. An important discriminator is technological innovation: business-jet companies that offer next-generation technologies can gain a competitive edge. The company believes that it competes effectively on all these criteria.

CUSTOMERS

In 2005, 67 percent of the company’s net sales were to the U.S. government; 17 percent were to U.S. commercial customers; 11 percent were directly to international defense customers; and the remaining 5 percent were to international commercial customers.

U. S. GOVERNMENT

The company’s primary customer is the U.S. government, particularly the Department of Defense. General Dynamics is also developing increasingly strong ties with additional U.S. customers throughout the national security community, including intelligence, homeland security and first-responder agencies at both the federal and state level. The company derives approximately two-thirds of its revenues from the U.S. government, either as a prime contractor or as a subcontractor, and expects that its business mix will remain in this range for the foreseeable future.

The company’s net sales to the U.S. government were as follows:

 

Year Ended December 31    2005     2004     2003  

Direct

   $ 13,617     $ 12,473     $ 10,405  

Foreign Military Sales *

     587       382       502  

Total U.S. government

   $ 14,204     $ 12,855     $ 10,907  

Percent of total net sales

     67 %     67 %     67 %
* In addition to its direct international sales, the company sells to foreign governments through the Foreign Military Sales (FMS) program. Under the FMS program, the company contracts with and is paid by the U.S. government, and the U.S. government assumes the risk of collection from the foreign government customer.

        The company performs its U.S. government business under both cost-reimbursement and fixed-price contracts. Contracts for research, engineering, prototypes, repair and maintenance are often cost-reimbursement arrangements. Under cost-reimbursement contracts, the customer reimburses the company for allowable costs and, based on the terms of the contract, pays a fixed fee and/or an incentive- or award-based fee. The company’s production contracts are fixed-price in most cases. In these instances, the company agrees to perform a specific scope of work for a fixed amount. In 2005, cost-reimbursement and fixed-price contracts accounted for approximately 46 percent and 54 percent, respectively, of the company’s government business.

 

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Cost-reimbursement and fixed-price contracts each present advantages and disadvantages. Cost-reimbursement contracts generally involve lower risk for the company. They may include fee schedules that prompt the customer to award increased payments when the company satisfies certain performance criteria. However, not all costs are recoverable under these types of contracts. In addition, the government has the right to object to costs, and this could increase the company’s risk. Fixed-price contracts offer the company greater profit potential, if the company can complete the work for less than the contract amount. However, on fixed-price contracts the company generally absorbs cost overruns that might occur.

U. S. COMMERCIAL

The company’s commercial sales were $3,667 in 2005, $3,028 in 2004 and $2,910 in 2003. These sales represented approximately 17 percent of the company’s consolidated net sales in 2005, 16 percent in 2004 and 18 percent in 2003. The majority of these sales are for Gulfstream aircraft, primarily to FORTUNE 500® corporations and large, privately held companies. Customers from a wide range of industries operate the aircraft.

INTERNATIONAL

The company’s direct (non-FMS) sales to defense and commercial customers outside the United States were $3,373 in 2005, $3,236 in 2004 and $2,511 in 2003. These sales represented approximately 16 percent of the company’s consolidated net sales in 2005, 17 percent in 2004 and 15 percent in 2003.

General Dynamics’ overseas subsidiaries conduct most of the company’s direct international defense sales. The company has an operating presence around the world, including subsidiary operations in Australia, Austria, Canada, Germany, Mexico, Spain, Switzerland and the United Kingdom. General Dynamics’ overseas subsidiaries are committed to developing long-term relationships in their respective countries and have distinguished themselves as principal regional suppliers. International commercial sales are primarily exports of business-jet aircraft.

For information regarding sales and assets by geographic region, see Note R to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.

SUPPLIERS

The company depends on suppliers and subcontractors for raw materials and components. These supply networks can experience price fluctuations. Raw materials, particularly steel, have recently experienced cost growth, which can put pressure on pricing. The company has not experienced, and does not foresee, any difficulty in obtaining the materials, components or supplies necessary for its business operations.

RESEARCH AND DEVELOPMENT

The company conducts independent research and development (R&D) activities as part of its normal business operations. Over the past three years, the majority of company-sponsored R&D expenditures was in the defense business. In accordance with government regulations, the company recovers a significant portion of these expenditures through overhead charges to U.S. government contracts. In the commercial sector, the Aerospace group R&D activities support primarily product enhancement and development programs for Gulfstream aircraft. The company also conducts R&D activities under U.S. government contracts to develop products for large development and technology programs.

Research and development expenditures were as follows:

 

Year Ended December 31    2005    2004    2003

Company–sponsored

   $ 344    $ 326    $ 276

Customer–sponsored

     206      194      229
     $ 550    $ 520    $ 505

 

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BACKLOG

The company’s total backlog represents the estimated remaining sales value of work to be performed under firm contracts and includes funded and unfunded portions. For additional discussion of backlog, see Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7, of this Annual Report on Form 10-K.

Summary backlog information for each business group follows:

 

              2005 Total
Backlog Not
Expected to be
Completed in
2006
December 31    2005    2004  
     Funded    Unfunded    Total    Funded    Unfunded    Total  

Information Systems and Technology

   $ 6,960    $ 2,415    $ 9,375    $ 7,071    $ 2,276    $ 9,347   $ 3,897

Combat Systems

     6,954      2,374      9,328      6,398      2,318      8,716     5,083

Marine Systems

     8,419      7,014      15,433      9,899      6,943      16,842     11,053

Aerospace

     5,853      2,210      8,063      4,652      2,192      6,844     4,735

Resources

     165      65      230      200      58      258     120
     $ 28,351    $ 14,078    $ 42,429    $ 28,220    $ 13,787    $ 42,007   $ 24,888

REGULATORY MATTERS

U . S . GOVERNMENT DEFENSE CONTRACTS

U.S. government contracts are subject to procurement laws and regulations. The Federal Acquisition Regulation (FAR) governs the majority of the company’s contracts. The FAR mandates uniform policies and procedures for U.S. government acquisitions and purchased services. Also, there can be agency-specific acquisition regulations that provide implementing language for, or that supplement, the FAR. For example, the Department of Defense implements the FAR through the Defense Federal Acquisition Regulation supplement (DFARs). For all federal government entities, the FAR regulates the phases of any products or services acquisition, including:

 

  acquisition planning,

 

  competition requirements,

 

  contractor qualifications,

 

  protection of source selection and vendor information, and

 

  acquisition procedures.

The FAR also guides government agencies in the management phase of contracts after the award. For example, FAR language regulates the conditions under which the government can terminate a contract. This can occur at the government’s convenience or for default. If a contract is terminated for the convenience of the government, a contractor is entitled to receive payments for its allowable costs. Generally, this includes the proportionate share of fees or earnings for the work already done. If a contract is terminated for default, in most cases the government pays for only the work it has accepted. In addition, the FAR subjects the company to audits and other reviews by the government. These reviews cover issues such as cost, performance, accounting and general business practices relating to its contracts. Such reviews may result in a government adjustment of the company’s contract-related costs and fees. Failure to comply with procurement laws or regulations can also result in civil, criminal or administrative proceedings. These might involve fines, penalties, suspension of payments, or suspension or debarment from government contracting or subcontracting for a period of time.

INTERNATIONAL

The company’s international sales are subject to U.S. and foreign government regulations and procurement policies and practices. They are also subject to regulations relating to import-export control, investments, exchange controls and repatriation of earnings. Other factors can affect international sales, such as currency exchange fluctuations, and political and economic risks.

BUSINESS-JET AIRCRAFT

The Aerospace group is subject to FAA regulation in the United States and other similar aviation regulatory authorities throughout the world. For an aircraft to be manufactured and sold, the model must receive a type certificate from the appropriate aviation authority, and each individual aircraft must receive a certificate of airworthiness. Aviation authorities can require changes to a specific aircraft, or model type, for safety reasons if they believe the plane does not meet their standards. Maintenance facilities must be licensed by aviation authorities as well.

 

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ENVIRONMENTAL

General Dynamics is subject to a variety of federal, state, local and foreign environmental laws and regulations. These cover the discharge, treatment, storage, disposal, investigation and remediation of certain materials, substances and wastes. The company assesses regularly its compliance status and management of environmental matters.

Operating and maintenance costs associated with environmental compliance and management of contaminated sites are a normal, recurring part of the company’s operations. Historically, these costs have not been significant relative to total operating costs or cash flows. Often they are allowable costs under the company’s contracts with the U.S. government. Based on information currently available to the company, and current U.S. government policies relating to allowable costs, the company does not expect continued environmental compliance to have a material impact on its results of operations, financial condition or cash flows.

Under existing U.S. environmental laws, there is a concept known as a Potentially Responsible Party (PRP), a designation determined by the U.S. Environmental Protection Agency or a state environmental agency. If a company is designated a PRP, it is potentially liable to the government or third parties for the full cost of remediating contamination at the relevant site. In cases where the company has been designated a PRP, generally it seeks to mitigate these environmental liabilities by obtaining the relevant insurance vehicles and by pursuing appropriate cost-recovery actions. In the unlikely event that the company is required to fully fund the remediation of a site, the current statutory framework would allow the company to pursue contributions from other PRPs. For additional information relating to the impact of environmental controls, see Note O to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.

INTELLECTUAL PROPERTY

The company is a leader in the development of innovative products, manufacturing technologies and systems-integration practices. In addition to owning a large portfolio of proprietary intellectual property, the company licenses certain intellectual property rights of third parties. The U.S. government has licenses to the company’s patents developed in the performance of government contracts, and it may use or authorize others to use the inventions covered by the company’s patents. Although these intellectual property rights are important to the operation of the company’s business, no existing patent, license or other intellectual property right is of such importance that its loss or termination would, in the opinion of management, have a material impact on the company’s business.

AVAILABLE INFORMATION

The company files several types of reports with the Securities and Exchange Commission (SEC) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. These reports include an annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Free copies of these reports are made available as soon as practicable on the company’s website (http://www.generaldynamics.com) and through the General Dynamics investor relations office at (703) 876-3195.

These reports also can be obtained at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room is available by calling the SEC at (800) SEC-0330. The SEC maintains a website (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.

 

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ITEM 1A. RISK FACTORS

An investment in General Dynamics’ common stock or debt securities is subject to risks and uncertainties. Investors should consider the following factors, in addition to the other information contained or incorporated by reference in this Annual Report on Form 10-K, before deciding to purchase the company’s securities.

Because three of General Dynamics’ four major business groups serve the defense market, the company’s sales are highly concentrated with the U.S. government. The customer relationship with the U.S. government involves certain risks that are unique. In addition to the U.S. government, the company’s defense businesses rapidly have expanded their sales to international customers in recent years, which has exposed the company to a different set of risks. The Aerospace group’s market presents its own risks that are largely tied to U.S. and global economic conditions. Despite the varying nature of the defense, international and business-aviation operations and the markets they serve, each shares some common risks, such as the ongoing development of high-technology products and the price, availability and quality of materials and suppliers.

The company depends on the U.S. government for a significant portion of its sales. In each of the past three years, approximately 67 percent of the company’s net sales were to the U.S. government. U.S. defense spending has historically been cyclical. Defense budgets have received their strongest support when perceived threats to national security raise the level of concern over the country’s safety. As these threats subside, spending on the military tends to decrease. Accordingly, while Department of Defense funding has grown rapidly over the past few years, there is no assurance that this trend will continue. Rising budget deficits, the cost of the Global War on Terrorism and increasing costs for domestic programs continue to put pressure on all areas of discretionary spending, which could ultimately impact the defense budget. Wartime support for defense spending could wane if the country’s troop deployments in support of operations in Iraq and Afghanistan are reduced.

A decrease in U.S. government defense spending or changes in spending allocation could result in one or more of the company’s programs being reduced, delayed or terminated. Reductions in the company’s existing programs, unless offset by other programs and opportunities, could adversely affect its ability to sustain and grow its future sales and earnings.

U.S. government contracts generally are not fully funded at inception and are subject to termination. The company’s U.S. government sales are funded by customer budgets, which operate on an October-to-September fiscal year. In February of each year, the President of the United States presents to the Congress the budget for the upcoming fiscal year. This budget proposes funding levels for every federal agency and is the result of months of policy and program reviews throughout the Executive branch. From February through September of each year, the appropriations and authorization committees of Congress review the President’s budget proposals and establish the funding levels for the upcoming fiscal year in appropriations and authorization legislation. Once these levels are enacted into law, the Executive Office of the President administers the funds to the agencies.

There are two primary risks associated with this process. First, the process may be delayed or disrupted. Changes in congressional schedules, negotiations for program funding levels or unforeseen world events can interrupt the funding for a program or contract. This, in fact, occurred during the 2006 budget process, in which the defense appropriations bill was not approved until three months into the 2006 fiscal year, delaying contract orders that would have been awarded in 2005. Second, funds for multi-year contracts can be changed in subsequent years in the appropriations process.

In addition, the U.S. government has increasingly relied on indefinite delivery, indefinite quantity (IDIQ) contracts and other procurement vehicles that are subject to a competitive bidding and funding process even after the award of the basic contract, adding an additional element of uncertainty to future funding levels. Delays in the funding process or changes in funding can impact the timing of available funds or can lead to changes in program content or termination at the government’s convenience. The loss of anticipated funding or the termination of multiple or large programs could have an adverse effect on the company’s future sales and earnings.

The Aerospace group is subject to changing customer demand or preferences for business aircraft. The Aerospace group’s business-jet market is influenced in part by the capital goods sector and the demand for business-aviation products by U.S. and foreign businesses, the U.S. and other governments, and high-net-worth individuals. The group’s future results depend on a number of factors, some of which are beyond the company’s control. These factors include general economic conditions and price and demand pressures in the market. A severe downturn in these market factors could adversely affect the sales and profitability of the company’s Aerospace group.

The company’s earnings and margins depend on its ability to perform under its contracts. The company’s contracts require management to make various assumptions and projections about the outcome of future events over a period of several years. These projections can include future labor productivity and availability, the nature and complexity of the work to be performed, the cost and availability of materials, the impact of delayed performance, and the timing of product deliveries. If there is a significant change in one or more of these assumptions, circumstances or estimates, or if the company is unable to control the costs incurred in performing under these contracts, the profitability of one or more of these contracts may be adversely affected.

 

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The company’s earnings and margins depend on subcontractor performance and raw material and component availability and pricing. The company relies on subcontractors and other companies to provide raw materials, major components and subsystems for its products or to perform a portion of the services that the company provides to its customers. Occasionally, the company relies on only one or two sources of supply, which, if disrupted, could have an adverse effect on the company’s ability to meet its commitments to customers. The company depends on these subcontractors and vendors to fulfill their contractual obligations in a timely and satisfactory manner in full compliance with customer requirements. If one or more of the company’s subcontractors or suppliers is unable to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed-upon services, the company’s ability to perform its obligations as a prime contractor may be adversely affected.

International sales and operations are subject to greater risks that sometimes are associated with doing business in foreign countries. The company’s international business may pose greater risks than its business in the United States because in some countries there is increased potential for changes in economic, legal and political environments. The company’s international business is also sensitive to changes in a foreign government’s national priorities and budgets. International transactions frequently involve increased financial and legal risks arising from foreign exchange rate variability and differing legal systems and customs in other countries. In addition, some international customers require contractors to agree to offset programs that may require in-country purchases or manufacturing or financial support arrangements as a condition to awarding contracts. The contracts may include penalties in the event the company fails to perform in accordance with the offset requirements. An unfavorable event or trend in any one or more of these factors could adversely affect the company’s sales and earnings associated with its international business.

The company’s future success will depend, in part, on its ability to develop new technologies and maintain a qualified workforce to meet the needs of its customers. Virtually all of the products produced and sold by General Dynamics are highly engineered and require sophisticated manufacturing and system integration techniques and capabilities. Both the commercial and government markets in which the company operates are characterized by rapidly changing technologies. The product and program needs of the company’s government and commercial customers change and evolve regularly. Accordingly, the company’s future performance in part depends on its ability to identify emerging technological trends, develop and manufacture competitive products, and bring those products to market quickly at cost-effective prices. In addition, because of the highly specialized nature of its business, the company must be able to hire and retain the skilled and appropriately qualified personnel necessary to perform the services required by the company’s customers. If the company is unable to develop new products that meet customers’ changing needs or successfully attract and retain qualified personnel, future sales and earnings may be adversely affected.

Developing new technologies entails significant risks and uncertainties that may not be covered by indemnity or insurance. While the company maintains insurance for some business risks, it is not possible to obtain coverage to protect against all operational risks and liabilities. The company generally seeks indemnification where the U.S. government is permitted to extend indemnification under applicable law. In addition, the company generally seeks limitation of potential liability related to the sale and use of its homeland security products and services through qualification by the Department of Homeland Security under the SAFETY Act provisions of the Homeland Security Act of 2002. The company may elect to provide products or services even in instances where it is unable to obtain such indemnification or qualification.

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements that are based on management’s expectations, estimates, projections and assumptions. Words such as “expects,” “anticipates,” “plans,” “believes,” “scheduled,” “estimates” and variations of these words and similar expressions are intended to identify forward-looking statements. These include but are not limited to projections of revenues, earnings, segment performance, cash flows, contract awards, aircraft production, deliveries and backlog stability. Forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict. Therefore, actual future results and trends may differ materially from what is forecast in forward-looking statements due to a variety of factors, including, without limitation, the risk factors discussed in this section.

All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the company or any person acting on the company’s behalf are qualified by the cautionary statements in this section. The company does not undertake any obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

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ITEM 2. PROPERTIES

The company believes its main facilities are adequate for its present needs and, as supplemented by planned improvements and construction, expects them to remain adequate for the foreseeable future. A summary of floor space at the main facilities of the Information Systems and Technology, Combat Systems, Marine Systems and Aerospace business groups as of December 31, 2005, follows*:

 

(Square feet in millions)    Company-
owned
Facilities
   Leased
Facilities
   Government-
owned
Facilities
   Total

Information Systems and Technology:

                   

Scottsdale, AZ (Office/Lab/Factory/Warehouse)

   1.5    —      —      1.5

Northern VA (Office/Lab)

   —      1.1    —      1.1

Pittsfield, MA (Lab)

   —      —      0.9    0.9

Taunton, MA (Office/Factory)

   0.2    0.4    —      0.6

Bloomington, MN (Office)

   —      0.5    —      0.5

Needham, MA (Office/Lab)

   0.5    —      —      0.5

Santa Clara, CA (Office/Factory)

   —      0.4    —      0.4

Catawba, NC (Office)

   0.1    0.2    —      0.3

Gilbert, AZ (Office/Factory)

   0.1    0.2    —      0.3

Kilgore, TX (Office/Plant)

   0.3    —      —      0.3

Ontario, Canada (Office/Plant)

   0.2    0.1    —      0.3

Ypsilanti, MI (Hangar/Office)

   —      0.3    —      0.3

Ann Arbor, MI (Office)

   —      0.2    —      0.2

Calgary, Canada (Office)

   —      0.2    —      0.2

McLeansville, NC (Office)

   —      0.2    —      0.2

Alberta, Canada (Office)

   —      0.1    —      0.1

Annapolis Junction, MD (Warehouse/Office)

   —      0.1    —      0.1

East Sussex, U.K. (Office)

   —      0.1    —      0.1

Florham Park, NJ (Office)

   —      0.1    —      0.1

Lexington Park, MD (Office)

   —      0.1    —      0.1

Richardson, TX (Office/Warehouse)

   —      0.1    —      0.1

San Antonio, TX (Office)

   —      0.1    —      0.1

South Wales, U.K. (Office)

   —      0.1    —      0.1

Tallin, Estonia (Office)

   0.1    —      —      0.1

Combat Systems:

                   

Lima, OH (Plant)

   —      —      1.6    1.6

Camden, AR (Office/Plant)

   0.9    0.5    —      1.4

Marion, VA (Office/Plant)

   0.9    0.1    —      1.0

Murcia, Spain (Plant)

   —      —      1.0    1.0

Trubia, Spain (Plant)

   —      —      1.0    1.0

Palencia, Spain (Plant)

   —      —      0.9    0.9

Granada, Spain (Plant)

   —      —      0.7    0.7

Marion, IL (Office/Plant)

   —      0.7    —      0.7

Vienna, Austria (Office/Plant)

   —      0.7    —      0.7

Ontario, Canada (Office/Plant)

   0.4    0.2    —      0.6

Sterling Heights, MI (Office/Warehouse)

   0.6    —      —      0.6

Garland, TX (Office/Plant)

   0.5    —      —      0.5

Kaiserslautern, Germany (Office/Plant)

   0.5    —      —      0.5

Oviedo, Spain (Plant)

   —      —      0.5    0.5

Saco, ME (Office/Plant)

   0.5    —      —      0.5

St. Marks, FL (Office/Plant)

   0.4    —      —      0.4

Sevilla, Spain (Office/Plant)

   —      —      0.4    0.4

Kreuzlingen, Switzerland (Office/Plant)

   0.3    —      —      0.3

La Coruna, Spain (Plant)

   —      —      0.3    0.3

Red Lion, PA (Office/Plant)

   0.3    —      —      0.3

 

* The Resources group operates two underground coal mines in Illinois and several stone quarries, as well as sand and gravel pits and yards, for its aggregates business in Illinois and Indiana. Coal preparation and rail loading facilities located at each mine are sufficient for its output.

 

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(Square feet in millions)    Company-
owned
Facilities
   Leased
Facilities
   Government-
owned
Facilities
   Total

Combat Systems (continued):

                   

Scranton, PA (Plant)

   —      0.3    —      0.3

Anniston, AL (Plant/Warehouse)

   —      —      0.2    0.2

Burlington, VT (Office/Plant)

   —      0.2    —      0.2

Charlotte, NC (Office/Plant)

   —      0.2    —      0.2

Lincoln, NE (Office/Plant)

   0.2    —      —      0.2

Westminster, MD (Office/Plant)

   —      0.2    —      0.2

Woodbridge, VA (Office)

   —      0.2    —      0.2

Shelby Township, MI (Office/Plant)

   —      0.1    —      0.1

Marine Systems:

                   

Groton, CT (Shipyard)

   2.9    —      —      2.9

Quonset Point, RI (Plant/Warehouse)

   0.3    1.1    —      1.4

Brunswick, ME (Office/Plant/Warehouse)

   1.1    0.2    —      1.3

Bath, ME (Shipyard)

   1.1    —      —      1.1

San Diego, CA (Shipyard)

   0.8    0.2    —      1.0

Mexicali, Mexico (Office/Warehouse)

   —      0.2    —      0.2

Aerospace:

                   

Savannah, GA (Office/Factory)

   1.4    0.2    —      1.6

Dallas, TX (Service/Completion Center)

   0.2    0.1    —      0.3

Long Beach, CA (Service/Completion Center)

   0.3    —      —      0.3

Appleton, WI (Service/Completion Center)

   0.1    0.1    —      0.2

Mexicali, Mexico (Factory)

   —      0.2    —      0.2

Brunswick, GA (Service/Completion Center)

   —      0.1    —      0.1

Las Vegas, NV (Service Center)

   —      0.1    —      0.1

London, England (Service Center)

   —      0.1    —      0.1

Minneapolis, MN (Service Center)

   —      0.1    —      0.1

West Palm Beach, FL (Service Center)

   —      0.1    —      0.1

Westfield, MA (Service Center)

   0.1    —      —      0.1

ITEM 3. LEGAL PROCEEDINGS

For information relating to legal proceedings, see Note O to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the company’s security holders during the fourth quarter of the year ended December 31, 2005.

 

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PART II

 


ITEM 5. MARKET FOR THE COMPANY’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The company’s common stock is listed on the New York Stock Exchange.

The high and low sales prices of the company’s common stock and the cash dividends declared with respect to the company’s common stock for each quarterly period during the two most recent fiscal years are included in the Supplementary Data contained in Part II, Item 8, of this Annual Report on Form 10-K.

As of January 29, 2006, there were approximately 153,000 holders of the company’s common stock.

For information regarding securities authorized for issuance under the company’s equity compensation plans, see Note P to the Consolidated Financial Statements contained in Part II, Item 8, of this Annual Report on Form 10-K.

The following table provides information about the company’s fourth quarter repurchases of equity securities that are registered pursuant to Section 12 of the Exchange Act:

 

Period    Total Number of Shares
Purchased*
   Average Price
Paid per Share
   Total Number of
Shares Purchased as
Part of Publicly
Announced Program
   Maximum Number of
Shares that May Yet
Be Purchased Under
the Program

10/03/05 – 10/30/05

   237,500    $ 115.50    3,690,100    2,309,900

10/31/05 – 11/27/05

   382,500      115.90    4,072,600    1,927,400

11/28/05 – 12/31/05

   750,500      114.41    4,823,100    1,176,900

Total

   1,370,500    $ 115.01    4,823,100    1,176,900
* On February 5, 2003, the company’s board of directors authorized management to repurchase up to 6 million shares. The company has repurchased an aggregate of 4,823,100 shares of common stock in the open market pursuant to this repurchase program. Unless terminated earlier by resolution of the board of directors, the program will expire when an aggregate of 6 million shares has been repurchased.

For additional information relating to the company’s repurchases of its common stock during the past three years, see Financial Condition, Liquidity and Capital Resources–Financing Activities–Share Repurchases contained in Part II, Item 7, of this Annual Report on Form 10-K.

The company did not make any unregistered sales of equity securities in 2005.

 

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ITEM 6. SELECTED FINANCIAL DATA

The following table presents summary selected historical financial data derived from the audited Consolidated Financial Statements and other company information for each of the five years presented. The following information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the audited Consolidated Financial Statements and the Notes thereto.

 

(Dollars and shares in millions, except per share and employee amounts)    2005     2004     2003     2002     2001  

Summary of Operations

                                        

Net sales

   $ 21,244     $ 19,119     $ 16,328     $ 13,658     $ 11,874  

Operating earnings

     2,197       1,944       1,442       1,570       1,467  

Interest expense, net

     (118 )     (148 )     (98 )     (45 )     (56 )

Provision for income taxes, net

     632       583       368       530       475  

Earnings from continuing operations

     1,468       1,205       979       1,042       931  

Discontinued operations, net of tax

     (7 )     22       25       (125 )     12  

Net earnings

     1,461       1,227       1,004       917       943  

Earnings per share:

                                        

Basic:

                                        

Continuing operations

     7.31       6.04       4.95       5.17       4.63  

Discontinued operations

     (0.03 )     0.11       0.13       (0.62 )     0.06  

Net earnings

     7.28       6.15       5.08       4.55       4.69  

Diluted:

                                        

Continuing operations

     7.25       5.98       4.91       5.14       4.59  

Discontinued operations

     (0.03 )     0.11       0.13       (0.62 )     0.06  

Net earnings

     7.22       6.09       5.04       4.52       4.65  

Cash dividends declared per common share

     1.60       1.44       1.28       1.20       1.12  

Sales per employee

     299,400       283,200       276,000       260,100       249,800  

Financial Position

                                        

Cash and equivalents

   $ 2,331     $ 976     $ 861     $ 327     $ 439  

Total assets

     19,591       17,544       16,183       11,731       11,069  

Short- and long-term debt

     3,291       3,297       4,043       1,471       1,978  

Shareholders’ equity

     8,145       7,189       5,921       5,199       4,528  

Book value per share

     40.69       35.76       29.91       25.87       22.56  

Other Information

                                        

Funded backlog

   $ 28,351     $ 28,220     $ 24,827     $ 21,113     $ 19,105  

Total backlog

     42,429       42,007       40,631       28,731       26,538  

Shares outstanding

     200.2       201.0       198.0       201.0       200.7  

Weighted average shares outstanding:

                                        

Basic

     200.8       199.6       197.8       201.4       201.1  

Diluted

     202.4       201.5       199.2       202.9       202.9  

Active employees

     72,200       70,000       65,200       53,200       50,800  

 

Note: Prior year amounts have been reclassified for discontinued operations.

 

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(Dollars in millions, except per share amounts or unless otherwise noted)

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(For an overview of the company’s business groups, including a discussion of products and services provided, see the Business discussion contained in Part I, Item 1, of this Annual Report on Form 10-K.)

MANAGEMENT OVERVIEW

LOGO

General Dynamics is a market leader in mission-critical information systems and technologies; land and expeditionary combat systems, armaments and munitions; shipbuilding and marine systems; and business aviation. The company is comprised of four primary business groups — Information Systems and Technology, Combat Systems, Marine Systems and Aerospace — and a smaller Resources group. General Dynamics’ primary customers are the U.S. military, other government organizations, the armed forces of allied nations, and a diverse base of corporate and individual buyers of business aircraft.The company operates in two primary markets — defense and business aviation. The majority of the company’s revenues derive from contracts with the U.S. military.

The current Administration’s desire to modernize U.S. military forces coupled with the U.S. military’s engagement in the Global War on Terrorism has driven steady Department of Defense funding increases since 2001. For fiscal year 2006, the Congress appropriated $411 billion for the Department of Defense, a 33 percent increase in funding since 2001. This amount includes $147 billion for procurement and research and development (R&D) activities, an increase of 43 percent since 2001. Procurement and R&D budgets, also known as investment accounts, provide the majority of the company’s revenues and, over the past several years, these budget lines have enjoyed sustained increases that demonstrate continued administration and congressional support. For fiscal year 2007, the President has requested that the Congress appropriate $439 billion for the Department of Defense, a 7 percent increase over the 2006 funding. This includes $157 billion for procurement and R&D, an increase of 7 percent over 2006 investment funds. In addition, the President’s 2007-2011 future year defense program (FYDP) anticipates investment funding growing at a nearly 5 percent compound annual growth rate, led by 9 percent compound annual procurement growth.

During this wartime era, defense budgets have evolved to include not only the President’s initial budget submission, but also supplemental funds requested over the course of the fiscal year. For fiscal year 2006, the Congress has been asked to provide at least $118 billion in supplemental funding, which, if approved, will bring total defense funding for fiscal year 2006 to over $525 billion, an approximately 65 percent increase since 2001. Approximately 20 percent, or $25 billion, of the 2006 supplemental funding request is anticipated for additional investment funding.

Looking ahead, the defense budget top line is expected to continue to grow, albeit at a somewhat more moderate rate. Supplemental funding to support ongoing conflicts, in part, is linked to levels of deployed troops and conflict intensity and will likely decrease with a reduction of hostilities. While this introduces some variability into the overall level of future defense spending, based on the recently approved and proposed defense budgets, the company expects the levels of funding available for its programs will likely continue to grow in 2006 and 2007.

The importance of many of the companies programs to the future of the U.S. military was highlighted in the 2005 Department of Defense Quadrennial Defense Review. This strategic document emphasized some core departmental missions, including pursuing the Global War on Terrorism, enhancing homeland defense efforts and encouraging the spread of democratic institutions worldwide. The review highlighted many strategic priorities that are supported by General Dynamics’ products and services, including increasing special operations forces, improving intelligence-gathering capabilities, accelerating the production of littoral combat ships and increasing submarine procurement.

Defense Funding 2001–2007

LOGO

 

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Internationally, many foreign governments remain committed to funding weapons and equipment modernization in the pursuit of interoperability with U.S. and allied forces and flexible capabilities for peacekeeping and regional operations. The company is committed to pursuing international opportunities presented by increased foreign demand for military hardware and information technologies. While revenue opportunities are significant, European and other foreign defense budgets are subject to the same unpredictable issues of contract award timing, defense priorities and overall fiscal spending pressures that exist in the United States. The company continues to focus on the needs of these customers and expects growing international sales, particularly in the Information Systems and Technology and Combat Systems businesses.

In the business-aviation market, the Aerospace group is one of the world’s leading designers and manufacturers of business-jet aircraft and is a leader in the long-range and ultra-long-range, large-cabin business-jet market, as well as in the business-jet-service and product-support market. In 2005, the business-jet market continued to strengthen, reflecting an improved global economy and higher U.S. corporate earnings. To meet growing demand and maximize the company’s opportunities in the business-aviation market, the Aerospace group is increasing annual deliveries at a prudent production rate while focusing on margin improvement and a continual effort to bring new technology and products to market through ongoing R&D efforts. The company expects continued growth in the business-jet market, particularly as the company’s new mid-sized G150 model enters full-rate production in 2006.

General Dynamics’ management is committed to creating shareholder value through ethical business practices, disciplined program management and continuous operational improvements. The company’s solid performance over the past 10 years is measured in its sustained revenue and earnings growth and strong cash flow. General Dynamics’ record as an industry leader in cash flow generation has enabled it to consistently deploy resources to enhance shareholder returns through strategic and tactical acquisitions, payment of dividends and share repurchases.

CONSOLIDATED OVERVIEW

Results of Operations

General Dynamics’ net sales grew to $21.2 billion in 2005, up $2.1 billion, or 11 percent, over 2004. The company’s Information Systems and Technology group contributed over half of the sales increase in 2005, in large part from continued strong demand for the group’s tactical and strategic communications and computing products. The Combat Systems and Aerospace groups also experienced strong sales growth during the year, while sales in the Marine Systems group were consistent with 2004.

Operating earnings increased 13 percent in 2005 to $2.2 billion compared with $1.9 billion in 2004. The growth in earnings resulted from the increased volume in Information Systems and Technology, Combat Systems, and Aerospace. In addition, the Aerospace group’s earnings increased at almost double the rate of sales in 2005 driven by a number of factors resulting from improved demand for the company’s business jets over the past two years. Increased earnings were offset in part by program losses in the Marine Systems group. Overall, the company’s operating margins increased to 10.3 percent in 2005 compared with 10.2 percent in 2004.

Net sales increased 17 percent in 2004 over 2003, reaching $19.1 billion. This sales growth came from increased volume across all of the company’s primary business groups, and acquisitions in the Information Systems and Technology and Combat Systems groups.

In 2004, operating earnings increased at twice the rate of sales growth. Earnings improved from $1.4 billion in 2003 to $1.9 billion in 2004, an increase of 35 percent. Improved performance in each of the company’s major business groups contributed to the growth in earnings. The Aerospace group produced substantially improved earnings on steady volume as a result of significant cost-cutting efforts and process improvements, while Marine Systems experienced fewer losses on its commercial shipbuilding programs compared with 2003. As a result, the company’s operating margins jumped from 8.8 percent in 2003 to 10.2 percent in 2004.

LOGO

 

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The company’s cash flow from operating activities significantly exceeded net earnings in each of the past three years, continuing the company’s consistent record of generating substantial cash from operations. Net cash provided by operating activities was $2.1 billion in 2005 compared with $1.8 billion in 2004 and $1.7 billion in 2003. In addition, the company generated over $300 in cash from the sale of several non-core businesses in 2005. Over the three-year period, the company used its cash to fund acquisitions and capital expenditures, repurchase its common stock, pay dividends and reduce its outstanding debt.

General and administrative (G&A) expenses as a percentage of sales were 6.2 percent in 2005 compared with 6.1 percent in 2004 and 6.6 percent in 2003. G&A was $1.3 billion in 2005, $1.2 billion in 2004 and $1.1 billion in 2003. The company expects 2006 G&A as a percent of sales to approximate the 2005 rate.

In 2005, the company had income from non-operating items of $21 compared with net expense of $8 in 2004 and income of $3 in 2003. The income in 2005 consisted primarily of sales of assets.

Net interest expense was $118 in 2005, a reduction of $30 from 2004. The decrease resulted from interest income generated by the company’s strong cash position during the year. Net interest increased to $148 in 2004 from $98 in 2003 because of a higher average borrowing balance from the company’s issuance of additional debt in 2003 to fund acquisitions.

The company’s effective tax rate was 30.1 percent in 2005, 32.6 percent in 2004 and 27.3 percent in 2003. In 2005, the company favorably resolved its 1999 to 2002 audit with the Internal Revenue Service. This settlement resulted in a $66 non-cash benefit, which reduced the company’s 2005 tax rate by 3.1 percent. The 2003 tax rate benefited from the settlement of the 1996 to 1998 federal audit and the resolution of some outstanding state tax disputes. These events resulted in non-cash benefits in 2003 totaling $68, favorably impacting the company’s tax rate by 5 percent. The company anticipates an effective tax rate of approximately 34 percent in 2006 excluding the effect of potential settlements or other discrete events. For additional discussion of tax matters, see Note E to the Consolidated Financial Statements.

In 2004, General Dynamics reviewed its businesses to identify operations that were not core to the company and could be divested. As a result, the company completed the sale of several small businesses in the second half of 2004 and the first quarter of 2005. The company’s reported net sales for all periods presented exclude the revenues associated with these businesses. Their earnings, however, are included as discontinued operations, net of income taxes, for all periods. The company received approximately $300 in cash, net of taxes, in 2005 from the sale of these businesses. For additional discussion of these divestiture activities, see Note C to the Consolidated Financial Statements.

Backlog

LOGO

General Dynamics’ total backlog increased by $400 during 2005, reaching $42.4 billion at December 31. Funded backlog was $28.4 billion at year end. Significant order activity in each of the company’s business groups led to total new orders of $22.4 billion during the year despite a postponement of some order activity in the fourth quarter due to the delayed 2006 Department of Defense budget process.

The total backlog for the company’s defense businesses was $34.1 billion at the end of 2005, compared with $34.9 billion at year-end 2004. The defense backlog represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog was $22.3 billion at December 31, 2005. This 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. The unfunded backlog for the defense businesses represents firm orders for which funding has not been appropriated. While there is no guarantee that future budgets and appropriations will provide funding for a given program, the company has included in backlog only those programs that it believes are likely to receive funding. The backlog does not include work awarded under indefinite delivery, indefinite quantity (IDIQ) contracts. The total potential value of these contracts, which may be realized over the next 15 years, was approximately $6 billion as of December 31, 2005.

The Aerospace group’s total backlog grew 18 percent in 2005, reaching a record level of $8.1 billion at December 31. The Aerospace funded backlog, an indicator of near-term demand, grew 26 percent to $5.9 billion at year end as a result of continued

strong new aircraft orders in 2005. The funded backlog includes orders for which the company has definitive purchase contracts and deposits from the customer. The Aerospace unfunded backlog of $2.2 billion at December 31, 2005, consists of options to purchase new aircraft and agreements to provide future aircraft maintenance and support services.

The Resources group contributed $230 to the company’s backlog at year-end 2005, including funded backlog of $165.

 

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REVIEW OF OPERATING SEGMENTS

INFORMATION SYSTEMS AND TECHNOLOGY

Results of Operations and Outlook

 

Year Ended December 31    2005     2004     Variance  

Net sales

   $ 7,826     $ 6,722     $ 1,104    16 %

Operating earnings

     865       718       147    20 %

Operating margin

     11.1 %     10.7 %             

The Information Systems and Technology group’s sales and operating earnings increased substantially in 2005 compared with 2004. The group experienced a significant increase in activity in 2005 on its programs that provide secure communications and network systems to U.S. forces around the world. This demand is driven by both the Department of Defense and the U.S. intelligence community’s continuing effort to improve command-and-control and information-sharing capabilities, and the extensive deployment of U.S. forces in the Global War on Terrorism. These programs include:

 

  Intelligence Information, Command-and-Control Equipment and Enhancements (ICE2), which supports critical intelligence and command-and-control systems and networks for U.S. defense and intelligence operations worldwide;

 

  Common Hardware/Software III (CHS-3), which provides continually updated commercial and ruggedized computers, network equipment and software to the U.S. armed forces and other federal agencies worldwide;

 

  Mobile User Objective System (MUOS), which enables on-the-move satellite connectivity for U.S. and allied forces; and

 

  “Cluster 5” of the Joint Tactical Radio System (JTRS), under which the group is developing small, lightweight software-defined radios for use by all branches of the U.S. military.

Information Systems and Technology’s support of international customers’ command-and-control and communications needs also contributed to the significant sales volume in 2005. These programs include most notably the BOWMAN and Combat, Infrastructure and Platform (CIP) programs for the United Kingdom and the Canadian Maritime Helicopter Project (MHP). BOWMAN is a secure digital voice and data communications system for the U.K. armed forces. The related CIP program is the new digital command-and-control system for U.K. ground and joint forces. Under the MHP contract, the company is providing integrated mission systems for 28 state-of-the-art helicopters that are intended to replace Canada’s aging fleet of marine helicopters.

Acquisitions in 2004 and 2005 contributed about 40 percent of the group’s 2005 sales growth. During 2005, the company completed three acquisitions to strengthen its market position – MAYA Viz Ltd., in April; Tadpole Computer, Inc., in August; and Itronix Corporation in September. The company acquired Spectrum Astro, Inc., and TriPoint Global Communications Inc. in the second half of 2004. The operating results of these businesses have been included as of the respective dates of the acquisitions. The increase in sales excluding the effect of acquisitions was 10 percent.

Operating margins in 2005 improved over 2004 due to the timing and mix of contract performance phases and customer deliveries, and the continued integration of acquired businesses.

The company expects single-digit sales growth in the Information Systems and Technology group in 2006 with operating margins similar to the average margins achieved in 2005, though margins may fluctuate from period to period.

 

Year Ended December 31    2004     2003     Variance  

Net sales

   $ 6,722     $ 4,848     $ 1,874    39 %

Operating earnings

     718       533       185    35 %

Operating margin

     10.7 %     11.0 %             

The solid growth in Information Systems and Technology in 2005 followed a significant increase in sales in 2004. The group experienced considerable growth in sales and operating earnings in 2004 due to increased volume across all areas of its business mix, including:

 

  communications products, such as the BOWMAN program for the U.K. armed forces and the Warfighter Information Network-Tactical (WIN-T) program for the U.S. Army;

 

  global mission solutions, such as the ICE2 contract for the U.S. Air Force;

 

  surveillance and reconnaissance systems; and

 

  network infrastructure and wireless systems.

Acquisitions in 2003 and 2004 contributed about half of the sales growth in 2004. The group’s operating margins decreased in 2004 compared with 2003 from a shift in program mix and the impact of lower-margin businesses acquired in 2003.

Backlog

LOGO

 

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The Information Systems and Technology group finished 2005 with a total backlog of $9.4 billion, up slightly from $9.3 billion at the end of 2004. The group maintained this substantial level of backlog despite record sales volume in 2005 due to a significant amount of order activity during the year. The group’s funded backlog was $7 billion at December 31, 2005, approximately 75 percent of the total backlog. Unlike the company’s other defense businesses, the Information Systems and Technology group’s backlog is comprised primarily of a large number of mid-size contracts and programs as well as several large-scale, long-term programs awarded over the past few years. Several significant awards contributed to the backlog in 2005.

The group received an order from the Army to integrate up to 500 Land Warrior soldier ensembles into a Stryker experimental battalion. Land Warrior uses advanced combat technology to enhance individual soldiers’ tactical awareness, lethality and survivability. This award is part of a contract valued at approximately $260. In 2005, the Army merged the Land Warrior and Future Force Warrior programs into one contract managed by General Dynamics to expedite the fielding of this integrated system.

The group’s backlog at December 31, 2005, included approximately $350 for the Army’s Future Combat Systems (FCS) program. The Army realigned the FCS program in 2005 to expedite delivery of newly developed technologies to existing forces. In addition, the company was awarded modifications to several of its contracts under the FCS program. The group received $210 in orders in 2005, including a modification worth $154 to accelerate technology development of the program’s integrated computer system by two years. Combat Systems also performs work on the FCS program.

Information Systems and Technology received a contract worth $170 to design, manufacture and deliver 25 12-meter antennas for an advanced radio telescope array at an international astronomy facility. The antennas are a critical element of a project intended to provide the world’s most sensitive, highest resolution telescope to enable scientists to observe and image galaxies, stars and planets with unprecedented clarity.

The Navy awarded the group a contract with a potential value of approximately $150 through 2009 to provide fire control system production, operational support, field engineering services, training and development for the Navy’s Trident ballistic missile submarines.

The group was awarded a contract worth over $100 to support the development of New York’s Statewide Wireless Network. The network is intended to improve communications and enhance coordination for state and local public safety and public service organizations responding to emergency situations across New York. Information Systems and Technology was selected to provide all site integration activities, including program and construction management and site development for all radio-access site infrastructure.

The Navy awarded the group a contract to provide system integration and design agent services for the Open Architecture Track Manager. The track manager is an improved component within naval combat systems that receives and translates information to create an integrated picture of the locations and paths of aircraft, ships and submarines in the battle space. The contract has a potential value of approximately $100.

In 2005, the group experienced significant demand from international customers for its communications and IT products and services.

The group is a member of the team that was selected in 2005 by the U.K. Ministry of Defence for the first increment of the Defence Information Infrastructure (Future) program. The program calls for consolidation of numerous existing information networks into a single infrastructure and is a key component of the United Kingdom’s future military strategy. The company’s subcontract is worth approximately $220, with options valued at an additional $300.

The group received a contract from the Royal Netherlands Navy worth approximately $115 to supply the New Integrated Marines Communications and Information Systems (NIMCIS). NIMCIS is a two-year program to equip the Royal Netherlands Marine Corps with a BOWMAN-like communications system.

The group leads a team selected by the Commonwealth of Australia to serve as the preferred prime system integrator for the first phase of the Battlespace Communications System (Land) program (JP 2072). JP 2072 is intended to provide the Australian Land Force with a deployable, scalable, secure and integrated battlespace communications system that allows ground forces to exchange information across all combat elements, improving soldiers’ safety and their ability to accomplish their missions. The group’s contract has an initial value of approximately $75, and the total program has a potential value of approximately $600 if all options are exercised.

        The group’s backlog does not include approximately $4.8 billion of potential contract value awarded under IDIQ contracts. IDIQ contracts are used when a customer has not defined the exact timing and quantity of deliveries that will be required at the time the contract is executed. These agreements set forth the majority of the contractual terms, including prices, but are funded as delivery orders are placed. A significant portion of this IDIQ value represents contracts for which the company has been designated as the sole-source supplier over several years to design, develop, produce and integrate complex products and systems for the military or other government agencies. Management believes that the customers intend to fully implement these systems. However, because the value of these arrangements is subject to the customer’s future exercise of an indeterminate quantity of delivery orders, the company recognizes these contracts in backlog only when they are funded. In 2005, funding from customers under these IDIQ contracts contributed approximately $1.8 billion to the group’s backlog.

Information Systems and Technology was awarded several significant IDIQ contracts during 2005, including a modification providing approximately $150 in funding for its Rescue 21 search-and-rescue communications system for the U.S. Coast Guard. The award brings the funded contract value to over $300. This IDIQ contract has a potential value of approximately $750 if all options are exercised.

The Army awarded the group the Total Engineering and Integration Services (TEIS) contract, an IDIQ multiple-award contract to provide information technology engineering and technical support at customer sites worldwide. The TEIS contract has a performance period of one base year and four option years with a ceiling value of approximately $800.

 

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COMBAT SYSTEMS

Results of Operations and Outlook

 

Year Ended December 31    2005     2004     Variance  

Net sales

   $ 5,021     $ 4,407     $ 614    14 %

Operating earnings

     576       522       54    10 %

Operating margin

     11.5 %     11.8 %             

The Combat Systems group produced strong growth in net sales and operating earnings in 2005 compared with 2004. The largest contributor to the increase was the Stryker wheeled combat vehicle program. Volume on this program increased significantly in 2005 as the group continued production of the fourth and fifth brigades and began work on the Mobile Gun System. Demand for add-on armor spurred additional program activity. Other notable volume increases include the M1A2 Abrams tank System Enhancement Package (SEP) program, the Canadian RG-31 mine-protected personnel vehicle contract and the Saudi Arabian National Guard light armored vehicle contract. In the armaments and munitions businesses, demand increased in 2005 for reactive armor, counter-improvised explosive device (IED) systems, and large-, medium- and small-caliber ammunition.

These increases were offset in part by the completion of several international combat vehicle programs in 2004, including the Ulan tracked armored vehicle program and the Australian and New Zealand light armored vehicle programs. Sales were also down in the group’s European business as a result of delays in the timing of customer requirements. Additionally, Combat Systems experienced a temporary decline in volume in 2005 on the Hydra-70 rocket production program, as the group transitioned to a new contract awarded during the year.

Operating margins were down slightly in 2005 compared with 2004 because of a shift in product mix and the timing of deliveries in the group’s European business.

The company expects Combat Systems to produce double-digit sales growth overall in 2006, with particularly strong growth in the group’s European business as the work that was deferred in 2005 is realized. Operating margins in 2006 should be consistent with the full-year 2005 margins.

 

Year Ended December 31    2004     2003     Variance  

Net sales

   $ 4,407     $ 4,007     $ 400    10 %

Operating earnings

     522       443       79    18 %

Operating margin

     11.8 %     11.1 %             

The Combat Systems group’s net sales and operating earnings increased in 2004 compared with 2003 from increased demand for the group’s products in the United States and internationally. Several armored vehicle programs in the group’s European business contributed to the sales and earnings growth, including Leopard tanks, Ulan tracked infantry vehicles and Piranha wheeled combat vehicles. Activity also increased on the group’s contract to develop manned ground vehicles for the Army’s FCS program and in its munitions and armaments businesses. This growth was reduced by a lower volume of M1 Abrams tank upgrades and reduced deliveries on the Stryker program due to the timing of customer requirements. Operating earnings increased at almost double the rate of sales growth in 2004 because of improved performance on several of the group’s programs and a shift in contract mix.

Backlog

LOGO

The Combat Systems group’s backlog increased 7 percent in 2005, reaching $9.3 billion at December 31. Funded backlog increased 9 percent over 2004 to $7 billion at year end. The group’s backlog consists primarily of long-term production contracts with scheduled deliveries through 2013.

The group’s backlog at December 31, 2005, included approximately $1.9 billion for the Army’s FCS program. In 2005, Combat

Systems was awarded a $282 modification to its contract for the engineering development and demonstration of a family of manned ground vehicles. The modification extends the contract through 2012. The group also received a modification valued at approximately $50 under its contract to develop the autonomous navigation system for FCS ground vehicles. Information Systems and Technology is performing additional work on the FCS program.

The Combat Systems group’s backlog at year end also included approximately $1.2 billion for the production of Stryker wheeled combat vehicles. In 2005, the group received orders from the Army valued at approximately $1.5 billion under the Stryker program. These awards included the production of 423 vehicles to equip the fifth Stryker brigade, add-on armor sets and engineering services. Also included in the awards was an order for 99 Stryker vehicles to meet additional Army requirements and a contract for the refurbishment of 265 Stryker infantry combat vehicles returning from duty in Iraq. Under this contract, the company will service, repair and modify the Stryker vehicles, restoring them to pre-combat, like-new condition before their next deployment.

 

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In 2005, the Army also awarded the Combat Systems group two contracts worth approximately $300 to upgrade 124 M1A2 Abrams tanks to the M1A2 SEP configuration. Through this program, the company retrofits M1A2 tanks with improved electronics, command-and-control capabilities and armor enhancements that are designed to improve the tank’s effectiveness.

Combat Systems received a contract valued at approximately $130 for the production of Towed Artillery Digitization (TAD) Digital Fire Control Systems (DFCS) for the M777 howitzer. This system provides sensors, displays, mission computers, power supplies and communication systems that support the M777 155mm howitzer used by the Army and Marines Corps.

In addition, in February 2006, the group received an order worth approximately $130 from the Marine Corps to provide eight-wheeled light armored vehicles (LAV) in various configurations. The contract has a total potential value of over $300 for a total of 130 vehicles to be delivered in 2007 and 2008.

Internationally, in 2005 the group finalized a contract with the Government of Portugal to produce 260 Pandur II armored combat vehicles. The contract is valued at approximately $480, and deliveries are scheduled to begin in 2007 and continue through 2009.

The Combat Systems group has several international, long-term combat vehicle production contracts in backlog as of December 31, 2005. The group’s Leopard program is a long-term battle tank manufacturing contract for the Spanish army under license from a German company. The group’s backlog at the end of 2005 included over $700 for the production of 181 Leopard tanks, with deliveries scheduled through 2009. The group also produces Pizarro Advanced Infantry Fighting Vehicles for the Spanish army. The year-end backlog included $665 for the production of 212 Pizarro vehicles scheduled for delivery through 2012.

In January 2006, Combat Systems received several orders for its combat vehicles from European customers, further demonstrating the appeal of these vehicles in the international market. The group was selected by the Czech Republic to produce 199 eight-wheeled Pandur II armored personnel carriers between 2007 and 2012 for the Czech army. The contract, which is expected to be finalized and added to backlog in the first half of 2006, has an option for 35 additional vehicles and is worth up to $1 billion. The Belgian government selected the group’s Piranha light armored vehicle for its Armored Infantry Vehicle program. The program calls for up to 242 vehicles and related logistics support and is worth approximately $600 if all options are exercised. The group also received an order from the Irish Department of Defence valued at approximately $40 for 15 Piranha vehicles.

The Combat Systems group’s backlog at year end also included approximately $1.4 billion in armament, munitions and composite-structures programs. In 2005, the group received funding of approximately $150 for the production of Hydra-70 (70mm) rockets, motors and warheads. These orders are part of a five-year requirements contract with an estimated value of $900. The group was also awarded an initial order of $170 under a five-year contract to supply 300-500 million rounds per year of small-caliber ammunition to the U.S. armed forces. The contract has a total potential value of approximately $1.2 billion if all options are exercised. Additionally, the group received contract modifications worth approximately $90 for the production of enhanced-capability reactive armor tile sets for Army Bradley Fighting Vehicles.

In February 2006, the group received an IDIQ contract from the Marine Corps with a potential value of approximately $290 to develop, design, integrate, produce and install IED Electronic Countermeasure systems.

MARINE SYSTEMS

Results of Operations and Outlook

 

Year Ended December 31    2005     2004     Variance  

Net sales

   $ 4,695     $ 4,726     $ (31 )   (1 )%

Operating earnings

     249       292       (43 )   (15 )%

Operating margin

     5.3 %     6.2 %              

The Marine Systems group’s net sales remained steady in 2005 compared with 2004. Activity on the Virginia-class submarine and T-AKE combat logistics ship construction programs increased significantly in 2005. Construction is in progress on the second through seventh ships of the Virginia class and the first three of nine T-AKE ships under contract. The volume increase in these programs was offset by the completion of the Seawolf-class submarine program in 2004, decreased activity on the group’s commercial tanker contract, and fewer repair and engineering contracts.

Program losses in 2004 and 2005 adversely affected operating earnings and margins in Marine Systems. The company continued to experience losses on its contract to build four double-hull oil tankers. In 2003 and 2004, the company recorded losses on this contract related to performance problems, schedule delays and subcontractor difficulties. In 2005, additional schedule delays and labor hour growth resulted in a loss of $50 on the program. The second and third ships were delivered in 2005, and the final ship is scheduled for delivery in the third quarter of 2006. Management does not expect any additional charges on the commercial tanker program, though risk will remain until the final ship is delivered.

The group also recorded losses totaling approximately $20 in the first half of 2005 on two submarine maintenance and overhaul contracts. These losses resulted from customer-requested change orders that the group fulfilled prior to securing adequate contractual protection. The company is in negotiations with the customer to recover some of the incurred costs and does not expect to have this type of exposure on future submarine overhaul contracts.

The group has also experienced cost growth on the Navy’s T-AKE program primarily from engineering- and design-related changes imposed by the customer. The company has submitted a formal request for equitable adjustment with the customer seeking more than $500 of additional contract payments for the rework effort and scope growth caused

 

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by these changes. The company is recording revenue at a break-even level based on the assumed recovery of a portion of this claim (see Note F to the Consolidated Financial Statements). The company is in discussions with the Navy to quantify its contractual relief for the unanticipated costs and expects the resolution of this matter to take several quarters. As of December 31, 2005, the first T-AKE was 91 percent complete, the second ship was 51 percent complete, and construction had begun on the third ship. The first ship is scheduled to be delivered in the second quarter of 2006.

The company expects the Marine Systems group’s sales in 2006 to be similar to the 2005 volume with improving margins, assuming no further program losses.

 

Year Ended December 31    2004     2003     Variance  

Net sales

   $ 4,726     $ 4,271     $ 455    11 %

Operating earnings

     292       216       76    35 %

Operating margin

     6.2 %     5.1 %             

In 2004, the group’s net sales increased compared with 2003 from higher volume on the Virginia-class and T-AKE programs and the conversion of Trident ballistic-missile submarines to a conventional-strike configuration (SSGN). Engineering and repair contract activity was also up in 2004. Lower volume on commercial shipbuilding contracts and mature defense production programs partially offset the growth in these programs. Operating earnings and margins improved significantly because of improved results on the group’s commercial shipbuilding programs in 2004 relative to 2003.

Backlog

LOGO

The Marine Systems group’s backlog consists of long-term submarine and ship construction programs, as well as repair and engineering contracts. The group’s total backlog as of December 31, 2005, was $15.4 billion, including $8.4 billion of funded backlog. The 2005 backlog was down 8 percent from the previous year as the group continued its progress on the significant volume of awards received in 2003. The current backlog provides for shipbuilding programs through 2014.

The Virginia-class submarine program is the group’s largest contract in backlog. The lead ship in the class was delivered in 2004, and the company’s backlog included $8.3 billion at December 31, 2005, for the construction of the nine additional submarines under contract. The current Navy plan calls for one submarine to be delivered per year through 2011 and two per year starting in 2012. The company is the prime contractor on this program, and construction is shared equally with its teaming partner. In 2005, the Navy awarded Marine Systems a contract worth over $100 to provide lead-yard services and research-and-development studies for Virginia-class submarines in support of the related construction contract. In January 2006, the Navy awarded the group a contract modification worth $1.3 billion that provides funding for the construction of the eighth Virginia-class submarine and advance procurement for the ninth and tenth ships.

The group’s backlog at year-end 2005 included $2.5 billion for nine Arleigh Burke-class DDG destroyers scheduled for delivery through 2010. In 2005, the Navy awarded the company approximately $560 in funding to construct the final destroyer under contract in the DDG program.

The Navy exercised two options in 2005 worth approximately $590 for the seventh and eighth ships in the T-AKE program, bringing the total contract value to $2.5 billion. The group’s backlog at the end of 2005 included $1.7 billion for the construction of the first eight T-AKE ships. Deliveries of these ships are scheduled through 2008. In January 2006, the Navy exercised an option worth approximately $320 for the ninth T-AKE ship, bringing the total contract value to $2.8 billion.

In 2005, the Navy modified the Marine Systems group’s SSGN contract, adding approximately $320. Under this contract, the company is converting four Trident ballistic-missile submarines to an SSGN configuration, a multi-mission submarine optimized for tactical strike and special operations support. The 2005 awards cover the conversion of the third and fourth ships, the USS Michigan and the USS Georgia, and bring the total value of the contract to $1.3 billion. The conversion of the USS Ohio was completed in 2005.

Marine Systems leads one of two teams selected for the development and construction of the Littoral Combat Ship (LCS), the Navy’s newest class of high-speed surface combatants. LCS ships are designed to operate in coastal areas against terrorist threats, high-speed swarm boats, mines and diesel submarines. In 2005, the Navy exercised an option worth $223 for the detailed design and construction of the LCS. The company’s first LCS is expected to be delivered in 2007.

The group also received a seven-year contract from the Navy in 2005 worth approximately $200 for the maintenance and repair of four LSD-class and four LPD-class ships. These amphibious ships transport Marines and their combat equipment to areas throughout the world, and launch and support landing craft and helicopters during amphibious assault and other military operations.

 

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AEROSPACE

Results of Operations and Outlook

 

Year Ended December 31    2005     2004     Variance  

Net sales

   $ 3,433     $ 3,012     $ 421    14 %

Operating earnings

     495       393       102    26 %

Operating margin

     14.4 %     13.0 %             
Aircraft Deliveries (in units):                        

Green

     89       78               

Completion

     84       77               

The Aerospace group’s net sales increased in 2005 compared with 2004 on a significant jump in new aircraft volume and higher aircraft services activity. The company delivered 11 more green units and seven more completions in 2005 than in 2004, reflecting a strong increase in demand over the past two years. Pre-owned sales declined as the group’s customers increasingly opt to sell their pre-owned aircraft in the market rather than trading them in with the company.

The group’s 2005 operating earnings increased significantly over 2004. A number of factors contributed to this strong earnings growth. Earnings in new aircraft manufacturing improved due to a combination of increased deliveries, a more favorable mix of units delivered and improving pricing. Aircraft services earnings increased from the higher volume and improved cost performance. Pre-owned aircraft earnings were up substantially on three fewer deliveries as market conditions continue to improve.

New aircraft orders in 2005 exceeded 2004’s record level, and new aircraft pricing continued to improve during the year. Gulfstream has raised its planned production for 2006 by more than 25 percent over 2005, and the 2006 production schedule is substantially sold out. The company expects significant sales growth in the Aerospace group in 2006 with margins that approximate those achieved in 2005. The company expects a shift in mix in the group starting in 2006 due to increased production of lower-margin, mid-size aircraft with the introduction of the new G150.

 

Year Ended December 31    2004     2003     Variance  

Net sales

   $ 3,012     $ 2,946     $ 66    2 %

Operating earnings

     393       218       175    80 %

Operating margin

     13.0 %     7.4 %             
Aircraft Deliveries (in units):                        

Green

     78       74               

Completion

     77       74               

Net sales in the Aerospace group grew slightly in 2004 over 2003. Increased new aircraft sales and higher aircraft services activity were offset by lower pre-owned aircraft sales. Operating earnings and margins increased substantially in 2004 because of significant cost reductions, higher earnings on pre-owned aircraft sales and a more favorable mix of aircraft deliveries.

Summary of Aircraft Statistical Information

Sales contracts for new aircraft usually have two major milestones: the manufacture of the “green” aircraft and the aircraft’s completion, which includes exterior painting and installation of customer-selected interiors and optional avionics. The company records revenues when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the fully outfitted aircraft.

The following table summarizes key unit data for the Aerospace group’s orders and backlog:

 

Year Ended December 31    2005     2004     2003  

New orders

   124     96     75  

Options exercised

   —       1     3  

Firm orders

   124     97     78  

Cancellations (a)

   (3 )   (2 )   (12 )

Total orders

   121     95     66  

New options

   —       —       3  

Firm contracts in backlog

   207     175     158  

Options in backlog

   100     100     103  

Total aircraft in backlog

   307     275     261  

Completions in backlog (b)

   42     39     38  

 

(a) Excludes fractional activity, because orders are made under master agreements that the customer draws down over several years. The company received cancellations for seven aircraft in 2003 from fractional fleet customers.
(b) Represents aircraft that have moved from green production to the completion process as of year end. Backlog includes only the value of the completion effort on these aircraft.

New Aircraft Book-to-Bill Ratio 2003-2005*

LOGO

 

* Represents ratio of new aircraft orders to deliveries (in units) during the year. Deliveries include 12 units in 2005, 10 units in 2004 and two units in 2003 to fractional fleet customers.

 

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Backlog

LOGO

The Aerospace group’s backlog exceeded $8 billion at the end of 2005, an increase of 18 percent over 2004. The group’s funded backlog grew 26 percent in 2005 to $5.9 billion at year end, representing almost 75 percent of the total backlog. The group received 124 orders in 2005, 28 percent more than the record number of orders received in 2004, excluding fractional activity. In the fourth quarter of 2005, the Aerospace group achieved a book-to-bill ratio (net orders divided by sales) greater than one for the sixth consecutive quarter.

The group’s backlog includes aircraft deliveries through 2011. A significant portion of the group’s backlog is with NetJets Inc. (NetJets), a unit of Berkshire Hathaway and the leader in the fractional aircraft market. NetJets purchases the aircraft for use in its fractional ownership program. The group’s funded backlog at year end included $1.6 billion with NetJets, representing firm contracts for 91 aircraft, including 15 green aircraft that are scheduled for delivery in 2006. The unfunded backlog included $1.4 billion for 100 aircraft options from NetJets, constituting all of the options in backlog. NetJets also represented 69 percent of the maintenance and support services in unfunded backlog. Deliveries of aircraft to NetJets are scheduled from 2006 through 2011 and represent as little as 4 percent and as much as 11 percent of projected new aircraft sales in those years.

The group’s remaining $4.3 billion of funded backlog at year-end 2005 consisted of contracts with a broad range of customers from a variety of industries and included approximately $470 of contracts with government customers.

Scheduled Deliveries of Aerospace Funded Backlog

LOGO

RESOURCES

The company’s Resources group consists of two businesses: a coal mining company and an aggregates company that supplies the construction industry.

Results of Operations

 

Year Ended December 31    2005    2004    Variance  

Net sales

   $ 269    $ 252    $ 17     7 %

Operating earnings

     12      19      (7 )   (37 )%

The Resources group’s net sales increased in 2005 compared with 2004 due to higher volume in the aggregates business. Operating earnings decreased in 2005 as a result of adjustments to certain contingent liabilities based on newly available information.

 

On March 1, 2006, the company entered into a definitive agreement to sell its aggregates business. The company expects the transaction to close in the first half of 2006.

 

  

  

Year Ended December 31    2004    2003    Variance  

Net sales

   $ 252    $ 256    $ (4 )   (2 )%

Operating earnings

     19      32      (13 )   (41 )%

The group’s net sales in 2004 decreased slightly compared with 2003 as lower volume in the coal business was largely offset by increased activity in the aggregates business. The group’s 2004 operating earnings were lower than 2003 because the earnings in 2003 were favorably impacted by the reduction of surface reclamation obligations in the company’s coal mining operations.

 

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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

In the mid-1990s, General Dynamics embarked on a strategy of disciplined capital deployment, generating strong cash flow to enable a series of acquisitions designed to grow the company beyond its core platform businesses. These acquisitions incorporated new products and technologies and expanded the company’s customer base. Since 1995, the company has acquired 40 businesses at a total cost of almost $14 billion. This has resulted in a larger, more diversified company while preserving a strong balance sheet and sustained financial flexibility.

General Dynamics’ management continues to emphasize the efficient conversion of net earnings into cash. In 2005, net cash provided by operating activities greatly exceeded net earnings for the third consecutive year. The company employed this cash to complete three niche acquisitions, continue its trend of annual dividend increases and repurchase its outstanding shares. The company ended 2005 with a cash balance of $2.3 billion, total debt of $3.3 billion and a debt-to-capital ratio of 28.8 percent.

Free cash flow from operations was $1.8 billion in 2005 compared with $1.5 billion in both 2004 and 2003. Management defines free cash flow from operations as net cash provided by operating activities less capital expenditures. Management believes free cash flow from operations is a useful measure for investors, because it portrays the company’s ability to generate cash from its core businesses for purposes such as repaying maturing debt, funding business acquisitions, repurchasing its common stock and paying dividends. The following table reconciles the free cash flow from operations with net cash provided by operating activities, as classified on the Consolidated Statement of Cash Flows:

 

Year Ended December 31    2005     2004     2003  

Net cash provided by operating activities

   $ 2,056     $ 1,800     $ 1,721  

Capital expenditures

     (279 )     (264 )     (220 )

Free cash flow from operations

   $ 1,777     $ 1,536     $ 1,501  

Cash flows as a percentage of net earnings:

                        

Net cash provided by operating activities

     141 %     147 %     171 %

Free cash flow from operations

     122 %     125 %     150 %

Over the past 10 years, the company has generated free cash flow from operations well in excess of its net earnings during the period. With free cash flow from operations projected to approximate net earnings in 2006, the company expects to continue to generate funds in excess of its short- and long-term liquidity needs. Management believes that the company has adequate funds on hand and sufficient borrowing capacity to execute its financial and operating strategy.

The following is a discussion of the company’s major operating, investing and financing activities for each of the three years in the period ended December 31, 2005, as classified on the Consolidated Statement of Cash Flows.

Operating Activities

Net cash provided by operating activities was $2.1 billion in 2005, $1.8 billion in 2004 and $1.7 billion in 2003. In each year, net earnings was the primary driver of the company’s cash flow. In 2005, the additional cash flow was due to a high level of customer deposits associated with the order activity in the Aerospace group and a significant inflow of customer advances in the fourth quarter in the company’s European business. In 2004, cash from operating activities exceeded net earnings due primarily to the timing of tax payments. In 2003, the increase in cash flow was attributable to substantial reductions in both new and pre-owned aircraft inventory in the Aerospace group and an influx of customer advances near the end of the year.

Termination of A-12 Program. As discussed further in Note O to the Consolidated Financial Statements, litigation on the A-12 program termination has been ongoing since 1991. If, contrary to the company’s expectations, the default termination ultimately is sustained, the company and 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, which was approximately $1.2 billion at December 31, 2005. If this were the outcome, the government contends the company would owe approximately $1.3 billion. The company’s after-tax cash obligation would be approximately $640. The company believes that it has sufficient resources to pay such an obligation, if required, while still retaining ample liquidity.

Investing Activities

Cash used in investing activities was $181 in 2005, $781 in 2004 and $3.2 billion in 2003. The primary uses of cash in investing activities were business acquisitions and capital expenditures. In 2005, these uses of cash were partially offset by proceeds from divestiture activities.

Business Acquisitions. In 2005, the company completed three acquisitions for a total of approximately $275. On April 1, the company acquired MAYA Viz Ltd., of Pittsburgh, Pennsylvania. On August 16, the company acquired Tadpole Computer, Inc., of Cupertino, California. On September 2, the company acquired Itronix Corporation of Spokane, Washington.

In 2004, the company completed three acquisitions at a total cost of approximately $500. On July 9, the company acquired Spectrum Astro, Inc., of Gilbert, Arizona. On September 17, the company acquired TriPoint Global Communications Inc., based in Newton, North Carolina. On November 1, the company acquired Engineering Technology Inc., of Orlando, Florida.

On August 11, 2003, the company completed its acquisition of Veridian Corporation, headquartered in Arlington, Virginia, for approximately $1.5 billion in cash. On March 1, 2003, the company acquired GM Defense of London, Ontario, a business unit of General Motors Corporation, for approximately $1.1 billion in cash. The company completed several other business acquisitions in the Information Systems and Technology, Combat Systems and Aerospace groups during 2003 at a total cost of approximately $470.

The company financed these acquisitions by issuing commercial paper. The company refinanced a substantial portion of its commercial paper during 2003, as discussed in Financing Activities.

 

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In the fourth quarter of 2005, General Dynamics entered into a definitive agreement to acquire Anteon International Corporation for approximately $2.2 billion, including the assumption of debt. The company intends to finance the acquisition with cash on hand and commercial paper and expects the transaction to close in the first half of 2006.

Capital Expenditures. Capital expenditures were $279 in 2005, $264 in 2004 and $220 in 2003. The company expects capital expenditures of approximately $425 in 2006. The anticipated increase over 2005 relates to planned facility improvements at Gulfstream and certain projects that were delayed in 2005. The company had no material commitments for capital expenditures as of December 31, 2005.

Sale of Assets. In 2005, the company completed the sales of several small, non-core businesses. The company received approximately $300 in cash, net of tax payments, from these divestiture activities. In 2004, the company sold two small, non-core businesses.

The company sold its remaining real estate holdings in southern California in 2004. During 2003 and 2004, the company received a total of $40 in cash in connection with these land sales.

Financing Activities

Cash used by financing activities was $520 in 2005 and $904 in 2004 compared with $2 billion of cash generated in 2003. The company’s typical financing activities are issuances and repayments of debt, payment of dividends and repurchases of common stock.

Debt Proceeds, Net. There were no material debt repayments in 2005. In 2004, the company repaid $500 of floating-rate notes that matured in September. In 2003, the company issued $3.1 billion of medium-term fixed-rate debt securities under a Form S-3 Registration Statement filed with the Securities and Exchange Commission. The proceeds of this debt were used to repay a substantial portion of the company’s commercial paper in 2003, which had the effect of fixing interest rates on debt that previously carried variable rates. Net repayments of commercial paper were $182 in 2004 and $529 in 2003. As of December 31, 2004 and 2005, the company had no commercial paper outstanding. The company has $2 billion in bank credit facilities that have not been drawn upon and are used to provide backup liquidity to the commercial paper program. In the second quarter of 2006, $500 of the company’s fixed-rate debt securities is scheduled to mature.

Dividends. On March 1, 2006, the company’s board of directors declared an increased regular quarterly dividend of $0.46 per share – the ninth consecutive annual increase. The board had previously increased the quarterly dividend to $0.40 per share in March 2005, to $0.36 per share in March 2004 and to $0.32 per share in March 2003.

Share Repurchases. During 2005, the company repurchased 3.3 million shares of its outstanding common stock in the open market at an average price of $107 per share. The company did not repurchase any shares during 2004. In 2003, the company repurchased 4.7 million shares at an average price of $64 per share. As of December 31, 2005, the company had approximately 1.2 million remaining shares authorized for repurchase.

ADDITIONAL FINANCIAL INFORMATION

Off-Balance Sheet Arrangements

As of December 31, 2005, other than operating leases, the company had no material off-balance sheet arrangements, such as guarantees; retained or contingent interests in assets transferred to unconsolidated entities; derivative instruments indexed to the company’s stock and classified in shareholders’ equity on the Consolidated Balance Sheet; and variable interests in entities that provide financing, liquidity, market risk or credit risk support to the company or engage in leasing, hedging or research and development services with the company.

Contractual Obligations

The following table presents information about the company’s contractual obligations as of December 31, 2005:

 

              Payment Due by Period
Contractual Obligations    Total Amount Committed        Less Than 1 Year    1-3 Years    3-5 Years    More Than 5 Years

Long-term debt (a)

   $ 4,038        $ 636    $ 914    $ 881    $ 1,607

Capital lease obligations

     8          2      4      2      —  

Operating leases

     808          143      229      152      284

Purchase obligations (b)

     16,078          7,546      4,786      2,147      1,599

Other long-term liabilities (c)

     3,617          1,180      850      378      1,209
     $ 24,549        $ 9,507    $ 6,783    $ 3,560    $ 4,699

 

(a) Includes scheduled interest payments.
(b) Includes amounts committed under legally enforceable agreements for goods and services with defined terms as to quantity, price and timing of delivery. This amount includes $11.5 billion of purchase orders for products and services to be delivered under firm government contracts under which the company has full recourse under normal contract termination clauses. As disclosed in Note Q to the Consolidated Financial Statements, the company expects to make approximately $40 of contributions to its retirement plans in 2006. This amount has been excluded from the above amount.
(c) Represents other long-term liabilities on the company’s Consolidated Balance Sheet, including the current portion of long-term liabilities. The projected timing of cash flows associated with these obligations is based on management’s estimates, which are largely based on historical experience.

 

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Commercial Commitments

The following table presents information about the company’s commercial commitments as of December 31, 2005:

 

              Amount of Commitment Expiration by Period
Commercial Commitments    Total Amount Committed        Less Than 1 Year    1-3 Years    3-5 Years    More Than 5 Years

Letters of credit*

   $ 1,615        $ 991    $ 235    $ 10    $ 379

Trade-in options*

     570          210      360      —        —  
     $ 2,185        $ 1,201    $ 595    $ 10    $ 379
* See Note O to the Consolidated Financial Statements for discussion of letters of credit and aircraft trade-in options.

Application of Critical Accounting Policies

Management’s Discussion and Analysis of the company’s Financial Condition and Results of Operations is based on the company’s Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to long-term contracts and programs, goodwill and other intangible assets, income taxes, pensions and other post-retirement benefits, workers’ compensation, warranty obligations, pre-owned aircraft inventory, and contingencies and litigation. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes the following policies are critical and require the use of significant business judgment in their application:

Revenue Recognition – Government Contracts. The company accounts for sales and earnings under long-term government contracts and programs using the percentage-of-completion method of accounting. The company follows the guidelines of American Institute of Certified Public Accountants (AICPA) Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, except that revisions of estimated profits on contracts are included in earnings under the reallocation method, in accordance with Accounting Principles Board Opinion No. 20, Accounting Changes, rather than the cumulative catch-up method. Under the reallocation method, the impact of revisions in estimates is recognized prospectively over the remaining contract term, while under the cumulative catch-up method such impact would be recognized immediately. If a revised estimate of contract profitability reveals an anticipated loss on the contract, the company recognizes the loss in the period it is identified. Anticipated losses cover all costs allocable to the contracts, including G&A expenses.

The company estimates profit as the difference between total estimated revenue and total estimated cost of a contract and recognizes that profit over the remaining life of the contract based on either input (e.g., costs incurred) or output (e.g., units delivered) measures, as appropriate to the circumstances. The percentage-of-completion method of accounting involves the use of various estimating techniques to project costs at completion, and in some cases includes estimates of recoveries asserted against the customer for changes in specifications. These estimates involve various assumptions and projections relative to the outcome of future events over a period of several years, including future labor productivity and availability, the nature and complexity of the work to be performed, the cost and availability of materials, the impact of delayed performance, the availability and timing of funding from the customer, and the timing of product deliveries. These estimates are based on the company’s best judgment. A significant change in one or more of these estimates could affect the profitability of one or more of the company’s contracts. The company reviews its contract estimates periodically to assess revisions in contract values and estimated costs at completion and reflects changes in estimates in the current and future periods under the reallocation method.

Business Aircraft. The company accounts for contracts for aircraft certified by the FAA in accordance with Statement of Position 81-1. These contracts usually provide for two major milestones: the manufacture of the “green” aircraft (i.e., before exterior painting and installation of customer-selected interiors and optional avionics) and its completion. The company records revenue at two points: when green aircraft are delivered to, and accepted by, the customer and when the customer accepts final delivery of the fully outfitted aircraft.

 

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The company does not recognize revenue at green delivery unless (1) a contract has been executed with the customer and (2) the customer can be expected to satisfy its obligations under the contract, as evidenced by the receipt of deposits from the customer.

Pre-owned Aircraft Inventories. In connection with orders for new aircraft, the company routinely offers customers trade-in options. Under these options, if exercised, the company will accept trade-in aircraft at a predetermined price based on estimated fair value. It is the company’s policy to limit its investment in pre-owned aircraft inventory at any point in time to $200, unless specifically authorized. Once acquired in connection with a sale of new aircraft, the company records pre-owned aircraft at the lower of trade-in value or estimated net realizable value. The company treats any excess of the trade-in price above the net realizable value as a reduction of revenue upon the recording of the new aircraft sales transaction. The company also regularly assesses the carrying value of pre-owned aircraft in inventory and adjusts the carrying value to net realizable value when appropriate. The company determines net realizable value by using both internal and external aircraft valuation information. These valuations involve estimates and assumptions about many factors, including current market conditions, future market conditions, the age and condition of the aircraft and the availability of the aircraft in the market. These estimates are based on the company’s best judgment. Gross margins on sales of pre-owned aircraft can vary from quarter to quarter depending on the mix of aircraft sold and current market conditions.

Commitments and Contingencies. The company is subject to litigation and other legal proceedings arising out of the ordinary course of its business or arising under provisions relating to the protection of the environment. Estimating liabilities and costs associated with these matters requires the use of judgment. The company records a charge against earnings when a liability associated with claims or pending or threatened litigation matters is probable and when the company’s exposure is reasonably estimable. The ultimate resolution of any exposure to the company may change as further facts and circumstances become known.

Deferred Contract Costs. Certain costs incurred in the performance of the company’s government contracts are recorded under GAAP but are not currently allocable to contracts. Such costs include a portion of the company’s estimated workers’ compensation, other insurance-related assessments, post-retirement benefits and environmental expenses. These costs will become allocable to contracts when they are paid. As permitted by AICPA Audit and Accounting Guide, Audits of Federal Government Contractors, the company has elected to defer these costs in contracts in process until they are paid, at which time the costs are charged to contracts and recovered from the government. The company expects to recover these costs through ongoing business, including both existing backlog and probable follow-on contracts. This business base includes numerous contracts for which the company is the sole source or one of two suppliers on long-term defense programs. The company regularly assesses the probability of recovery of these costs under its current and probable follow-on contracts. This assessment requires the company to make assumptions about future contract costs, the extent of cost recovery under the company’s contracts and the amount of future contract activity. These estimates are based on the company’s best judgment. If the backlog in the future does not support the continued deferral of these costs, the profitability of the company’s remaining contracts could be adversely affected.

Retirement Plans. The company’s defined-benefit pension and other post-retirement benefit costs and obligations depend on various assumptions and estimates. The key assumptions relate to discount rates used to estimate future liabilities and long-term rates of return on plan assets. The company determines the discount rate used each year based on the rate of return currently available on high-quality fixed-income investments with a maturity that is consistent with the projected benefit payout period. The company determines the long-term rate of return on assets based on historical returns and the current and expected asset allocation strategy. These estimates are based on the company’s best judgment, including consideration of both current and future market conditions. In the event a change in any of the assumptions is warranted, future pension and post-retirement benefit cost could increase or decrease.

If the assumed long-term rate of return on pension plan assets increased or decreased by 25 basis points, the company’s net pension income associated with its commercial plans would have increased or decreased by approximately $3 in 2005. Likewise, had the interest rate used to discount the company’s projected pension obligation increased or decreased by 25 basis points, the net pension income associated with the commercial plans would have increased or decreased by approximately $1 in 2005. A 25 basis-point increase or decrease in either the rate of return on assets or the interest rate used for benefit obligations for the company’s post-retirement benefit plans would have decreased or increased the 2005 post-retirement benefit cost by approximately $1. The company’s contractual arrangements with the U.S. government provide for the recovery of contributions to the company’s government plans. As permitted by AICPA Audit and Accounting Guide, Audits of Federal Government Contractors, the company has elected to defer recognition of the cumulative earnings in its government plans to provide a better matching of revenues and expenses. As such, the company’s future income is not subject to the consequences of changes in the assumptions associated with these plans.

Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented.

 

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New Accounting Standards

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation [SFAS 123(R)]. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair value. SFAS 123(R) is effective in the first quarter of 2006. Based on available information, the company expects the adoption of SFAS 123(R) to reduce its net earnings by approximately $35 to $40 in 2006.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, and FASB Statement No. 3. SFAS 154 changes the requirements for accounting and reporting a change in accounting principle. The Statement requires a restatement of prior period financial statements upon adoption of a voluntary change in accounting principle rather than recording the cumulative effect of the change in net earnings in the current period. SFAS 154 is effective for the fiscal year ending December 31, 2006. The company does not expect the adoption of SFAS 154 to have a material effect on its results of operations, financial condition or cash flows.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The company is exposed to market risk, primarily related to interest rates and foreign currency exchange rates. Financial instruments subject to interest rate risk include fixed-rate long-term debt obligations, variable-rate commercial paper and short-term investments. As of December 31, 2005, the company had no material short-term investments and no outstanding commercial paper. Fixed-rate debt obligations issued by the company are generally not putable and are not actively traded by the company in the market. Therefore, the company does not believe its exposure to interest rate risk is material for its fixed-rate debt.

The company may enter into interest rate swap agreements to manage its exposure to interest rate fluctuations. At December 31, 2005, no interest rate swap agreements were in effect.

The company also is subject to foreign currency exchange rate risk relating to receipts from customers, payments to suppliers, long-term debt and certain inter-company transactions in foreign currencies. The company principally uses foreign currency forward contracts from time to time to hedge the price risk associated with firmly committed and forecasted foreign-denominated payments, receipts and inter-company transactions related to its ongoing business and operational financing activities. Foreign currency contracts are sensitive to changes in foreign currency exchange rates. At December 31, 2005 and 2004, a 10 percent unfavorable exchange rate movement in the company’s portfolio of foreign currency forward contracts would have resulted in an incremental realized loss of $5 and $14 (pretax), respectively, and an incremental unrealized loss of $26 and $56 (pretax), respectively. This exchange rate sensitivity relates primarily to changes in the U.S. dollar/Canadian dollar exchange rates. Consistent with the use of these contracts to neutralize the effect of exchange rate fluctuations, these realized and unrealized losses would be offset by corresponding gains in the remeasurement of the underlying transactions being hedged. When taken together, these forward contracts and the offsetting underlying commitments do not create material market risk.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Consolidated Statement of Earnings

 

     Year Ended December 31  
(Dollars in millions, except per share amounts)    2005     2004     2003  

Net Sales

   $ 21,244     $ 19,119     $ 16,328  

Operating costs and expenses

     19,047       17,175       14,886  

Operating Earnings

     2,197       1,944       1,442  

Interest expense, net

     (118 )     (148 )     (98 )

Other income (expense), net

     21       (8 )     3  

Earnings from Continuing Operations before Income Taxes

     2,100       1,788       1,347  

Provision for income taxes, net

     632       583       368  

Earnings from Continuing Operations

     1,468       1,205       979  

Discontinued operations, net of tax

     (7 )     22       25  

Net Earnings

   $ 1,461     $ 1,227     $ 1,004  

Earnings per Share

                        

Basic:

                        

Continuing operations

   $ 7.31     $ 6.04     $ 4.95  

Discontinued operations

     (0.03 )     0.11       0.13  

Net earnings

   $ 7.28     $ 6.15     $ 5.08  

Diluted:

                        

Continuing operations

   $ 7.25     $ 5.98     $ 4.91  

Discontinued operations

     (0.03 )     0.11       0.13  

Net earnings

   $ 7.22     $ 6.09     $ 5.04  

The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

 

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Consolidated Balance Sheet

 

     December 31  
(Dollars in millions)    2005     2004  
ASSETS                 

Current Assets:

                

Cash and equivalents

   $ 2,331     $ 976  

Accounts receivable

     2,034       1,450  

Contracts in process

     3,076       2,890  

Inventories

     1,315       1,195  

Assets of discontinued operations

     7       412  

Other current assets

     410       408  

Total Current Assets

     9,173       7,331  

Noncurrent Assets:

                

Property, plant and equipment, net

     2,125       2,153  

Intangible assets, net

     898       948  

Goodwill

     6,687       6,429  

Other assets

     708       683  

Total Noncurrent Assets

     10,418       10,213  
     $ 19,591     $ 17,544  
LIABILITIES AND SHAREHOLDERS’ EQUITY                 

Current Liabilities:

                

Short-term debt and current portion of long-term debt

   $ 510     $ 6  

Accounts payable

     1,710       1,505  

Customer advances in excess of costs incurred

     1,631       1,003  

Liabilities of discontinued operations

     11       101  

Other current liabilities

     3,045       2,763  

Total Current Liabilities

     6,907       5,378  

Noncurrent Liabilities:

                

Long-term debt

     2,781       3,291  

Other liabilities

     1,758       1,686  

Commitments and contingencies (see Note O)

                

Total Noncurrent Liabilities

     4,539       4,977  

Shareholders’ Equity:

                

Common stock, including surplus

     1,127       998  

Retained earnings

     8,285       7,146  

Treasury stock

     (1,493 )     (1,206 )

Accumulated other comprehensive income

     226       251  

Total Shareholders’ Equity

     8,145       7,189  
     $ 19,591     $ 17,544  

The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

 

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Consolidated Statement of Cash Flows

 

     Year Ended Dceember 31  
(Dollars in millions)    2005     2004     2003  

Cash Flows from Operating Activities*:

                        

Net earnings

   $ 1,461     $ 1,227     $ 1,004  

Adjustments to reconcile net earnings to net cash provided by operating activities–

                        

Depreciation, depletion and amortization of property, plant and equipment

     241       229       204  

Amortization of intangible assets

     101       93       66  

Deferred income tax provision

     144       276       137  

(Increase) decrease in assets, net of effects of business acquisitions–

                        

Accounts receivable

     (555 )     (67 )     61  

Contracts in process

     (196 )     (281 )     (452 )

Inventories

     (120 )     (54 )     189  

Increase (decrease) in liabilities, net of effects of business acquisitions–

                        

Accounts payable

     190       166       49  

Customer advances in excess of costs incurred

     614       212       275  

Customer deposits

     340       179       (10 )

Other current liabilities

     34       (269 )     108  

Other liabilities

     (173 )     66       (80 )

Other, net

     (15 )     (4 )     144  

Net Cash Provided by Operating Activities from Continuing Operations

     2,066       1,773       1,695  

Net Cash (Used) Provided by Discontinued Operations – Operating Activities

     (10 )     27       26  

Net Cash Provided by Operating Activities

     2,056       1,800       1,721  

Cash Flows from Investing Activities:

                        

Proceeds from sale of assets, net

     361       24       34  

Capital expenditures

     (279 )     (264 )     (220 )

Business acquisitions, net of cash acquired

     (277 )     (543 )     (3,044 )

Purchases of available–for–sale securities

     (10 )     (46 )     (30 )

Sales/maturities of available–for–sale securities

     18       37       31  

Other, net

     6       11       1  

Net Cash Used by Investing Activities

     (181 )     (781 )     (3,228 )

Cash Flows from Financing Activities:

                        

Purchases of common stock

     (348 )     —         (300 )

Dividends paid

     (314 )     (278 )     (249 )

Proceeds from option exercises

     148       169       65  

Proceeds from issuance of fixed–rate notes, net

     —         —         3,094  

Repayment of floating–rate notes

     —         (500 )     —    

Net repayments of commercial paper

     —         (182 )     (529 )

Net repayments of other debt

     (6 )     (65 )     (40 )

Other, net

     —         (48 )     —    

Net Cash (Used) Provided by Financing Activities

     (520 )     (904 )     2,041  

Net Increase in Cash and Equivalents

     1,355       115       534  

Cash and Equivalents at Beginning of Year

     976       861       327  

Cash and Equivalents at End of Year

   $ 2,331     $ 976     $ 861  

 

* Revised to reconcile from net earnings.

The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

 

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Consolidated Statement of Shareholders’ Equity

 

(Dollars in millions)

   Common Stock   

Retained
Earnings

   

Treasury
Stock

    Accumulated Other
Comprehensive
Income
   

Total

Shareholders’
Equity

   

Comprehensive
Income

 
   Par    Surplus           

Balance, December 31, 2002

   $ 241    $ 516    $ 5,455     $ (1,016 )   $ 3     $ 5,199          

Net earnings

     —        —        1,004       —         —         1,004     $ 1,004  

Cash dividends declared

     —        —        (253 )     —         —         (253 )     —    

Shares issued under compensation plans

     —        69      —         37       —         106       —    

Tax benefit of exercised stock options

     —        12      —         —         —         12       —    

Shares purchased

     —        —        —         (300 )     —         (300 )     —    

Net loss on cash flow hedge

     —        —        —         —         (14 )     (14 )     (14 )

Unrealized gains on securities

     —        —        —         —         3       3       3  

Foreign currency translation adjustments

     —        —        —         —         164       164       164  

Balance, December 31, 2003

     241      597      6,206       (1,279 )     156       5,921     $ 1,157  

Net earnings

     —        —        1,227       —         —         1,227     $ 1,227  

Cash dividends declared

     —        —        (287 )     —         —         (287 )     —    

Shares issued under compensation plans

     —        116      —         73       —         189       —    

Tax benefit of exercised stock options

     —        44      —         —         —         44       —    

Net gain on cash flow hedges

     —        —        —         —         25       25       25  

Foreign currency translation adjustments

     —        —        —         —         70       70       70  

Balance, December 31, 2004

     241      757      7,146       (1,206 )     251       7,189     $ 1,322  

Net earnings

     —        —        1,461       —         —         1,461     $ 1,461  

Cash dividends declared

     —        —        (322 )     —         —         (322 )     —    

Shares issued under compensation plans

     —        101      —         71       —         172       —    

Tax benefit of exercised stock options

     —        28      —         —         —         28       —    

Shares purchased

     —        —        —         (358 )     —         (358 )     —    

Net loss on cash flow hedges

     —        —        —         —         (6 )     (6 )     (6 )

Foreign currency translation adjustments

     —        —        —         —         (18 )     (18 )     (18 )

Additional pension liability

     —        —        —         —         (1 )     (1 )     (1 )

Balance, December 31, 2005

   $ 241    $ 886    $ 8,285     $ (1,493 )   $ 226     $ 8,145     $ 1,436  

The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

 

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(Dollars in millions, except per share amounts or unless otherwise noted)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization. General Dynamics’ businesses are organized into four groups: Information Systems and Technology, which produces mission-critical information systems and technologies; Combat Systems, which designs and manufactures land and expeditionary combat vehicles, armaments and munitions; Marine Systems, which designs and constructs surface ships and submarines; and Aerospace, which produces Gulfstream aircraft and provides aircraft service operations. The company also owns a coal mining operation and an aggregates operation. The company’s primary customers are the U.S. military, other government organizations, the armed forces of allied nations and a diverse base of corporate and individual buyers of business aircraft.

Basis of Consolidation and Classification. The Consolidated Financial Statements include the accounts of General Dynamics Corporation and its wholly owned and majority-owned subsidiaries. The company eliminates all inter-company balances and transactions in the consolidated statements.

In 2004 and 2005, General Dynamics sold certain non-core businesses, as discussed in Note C. The financial statements for all prior periods have been restated to reflect the results of operations of these businesses in discontinued operations.

Consistent with defense industry practice, the company classifies assets and liabilities related to long-term production contracts as current, even though some of these amounts are not expected to be realized within one year. In addition, some prior-year amounts have been reclassified among financial statement accounts to conform to the current-year presentation.

Use of Estimates. U.S. generally accepted accounting principles (GAAP) require management to make a number of estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Management bases its estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances. Actual results could differ from these estimates.

Revenue Recognition. General Dynamics accounts for sales and earnings under long-term government contracts and programs using the percentage-of-completion method of accounting in accordance with AICPA Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The company estimates the profit on a contract as the difference between the total estimated revenue and the total estimated costs of a contract and recognizes that profit over the contract term. The company determines progress toward completion based on either input measures, such as costs incurred, or output measures, such as units delivered, depending on the nature of the contract. The company applies earnings rates to all contract costs, including general and administrative (G&A) expenses, to determine sales and operating earnings.

The company reviews earnings rates periodically to assess revisions in contract values and estimated costs at completion. The company applies the effect of any changes in earnings rates resulting from these assessments prospectively. The company charges any anticipated losses on contracts and programs to earnings as soon as they are identified. Anticipated losses cover all costs allocable to the contracts, including G&A expenses on government contracts. The company recognizes revenue arising from a claims process either as income or as an offset against a potential loss only when the amount of the claim can be estimated reliably and its realization is probable.

The company accounts for contracts for aircraft certified by the U.S. Federal Aviation Administration in accordance with Statement of Position 81-1. These contracts usually provide for two major milestones: the manufacture of the “green” aircraft and its completion. Completion includes exterior painting and installation of customer-selected interiors and optional avionics. The company records revenue at two points: when green aircraft are delivered to, and accepted by, the customer and when the customer accepts final delivery of the fully outfitted aircraft. The company recognizes sales of all other aircraft products and services when the product is delivered or the service is performed.

General and Administrative Expenses. G&A expenses were $1.3 billion in 2005, $1.2 billion in 2004 and $1.1 billion in 2003. These expenses are included in operating costs and expenses on the Consolidated Statement of Earnings.

Interest Expense, Net. Net interest expense consisted of the following:

 

Year Ended December 31    2005     2004     2003  

Interest expense

   $ 154     $ 157     $ 108  

Interest income

     (36 )     (9 )     (10 )

Interest expense, net

   $ 118     $ 148     $ 98  

Interest payments

   $ 142     $ 149     $ 79  

 

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Cash and Equivalents and Investments in Debt and Equity Securities. General Dynamics classifies its securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The company considers securities with a maturity of three months or less to be cash equivalents. The company adjusts all investments in debt and equity securities to fair value. For trading securities, the adjustments are recognized in the Consolidated Statement of Earnings. Adjustments for available-for-sale securities are recognized as a component of accumulated other comprehensive income in the Consolidated Balance Sheet. The company had available-for-sale investments of $57 at December 31, 2005, and $61 at December 31, 2004. The company had no trading securities at the end of either period.

The contractual arrangements with some of the company’s international customers require the company to maintain certain advance payments made by these customers and apply them only to the company’s activities associated with these contracts. These advances totaled approximately $260 as of December 31, 2005, and represent approximately six months of operating cash requirements under the related contracts.

Accounts Receivable and Contracts in Process. Accounts receivable are amounts billed and currently due from customers. Contracts in process represent recoverable costs incurred and, where applicable, accrued profit related to long-term government contracts for which the customer has not yet been billed (unbilled receivables).

Inventories. Inventories are stated at the lower of cost or net realizable value. Cost for work-in-process inventories, which consist of aircraft components, is based on the estimated average unit cost of the number of units in a production lot, or specific identification. Cost for raw materials inventories is based on the first-in, first-out method, or specific identification. The company records 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, determined at the time of trade and based on estimated fair value.

Property, Plant and Equipment, Net. Property, plant and equipment are carried at historical cost, net of accumulated depreciation, depletion and amortization. The company depreciates most of its assets using the straight-line method and the remainder using accelerated methods. Buildings and improvements are depreciated over periods up to 50 years. Machinery and equipment are depreciated over periods up to 28 years. The company computes depletion of mineral reserves using the units-of-production method.

Impairment of Long-Lived Assets. The company reviews long-lived assets, including intangible assets subject to amortization, for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Impairment losses, where identified, are determined as the excess of the carrying value over the estimated fair value of the long-lived asset. The company assesses the recoverability of the carrying value of assets held for use based on a review of projected undiscounted cash flows. If an asset is held for sale, the company reviews its estimated fair value less cost to sell.

The company reviews goodwill and indefinite-lived intangible assets for impairment annually by applying a fair-value-based test. The company completed the required annual impairment test during the fourth quarter of 2005 and did not identify any impairment.

Environmental Liabilities. The company accrues environmental costs when it is probable that a liability has been incurred and the amount can be reasonably estimated. To the extent the U.S. government has agreed to pay the ongoing maintenance and monitoring costs at sites currently used to conduct the company’s government contracting business, General Dynamics treats these costs as contract costs and recognizes the costs as paid.

Fair Value of Financial Instruments. The company’s financial instruments include cash and equivalents, accounts receivable, accounts payable, short- and long-term debt, and derivative financial instruments. The company estimates the fair value of these financial instruments as follows:

 

  Cash and equivalents, accounts receivable and accounts payable: fair value approximates carrying value due to the short-term nature of these instruments.

 

  Short- and long-term debt: fair value is based on quoted market prices.

 

  Derivative financial instruments: fair value is based on valuation models that use observable market quotes.

The differences between the estimated fair value and carrying value of General Dynamics’ financial instruments were not material as of December 31, 2005 and 2004.

Stock-Based Compensation. The company accounts for its incentive compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The company calculates compensation expense for stock options as the excess, if any, of the quoted market price of the company’s stock at the measurement date over the exercise price. The company records stock awards at fair value at the date of the award. See Note P for a description of the company’s equity compensation plans.

 

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If compensation expense for stock options had been determined based on the fair value at the grant dates for awards under the company’s equity compensation plans, General Dynamics’ net earnings and net earnings per share would have been reduced to the pro forma amounts indicated as follows:

 

Year Ended December 31    2005    2004    2003

Net earnings, as reported

   $ 1,461    $ 1,227    $ 1,004

Add: Stock-based compensation expense included in reported net earnings, net of tax*

     25      33      14

Deduct: Total fair-value-based compensation expense, net of tax

     60      61      42

Pro forma

   $ 1,426    $ 1,199    $ 976

Net earnings per share–basic:

                    

As reported

   $ 7.28    $ 6.15    $ 5.08

Pro forma

   $ 7.10    $ 6.01    $ 4.93

Net earnings per share–diluted:

                    

As reported

   $ 7.22    $ 6.09    $ 5.04

Pro forma

   $ 7.04    $ 5.95    $ 4.90
                      

Weighted average fair value of options granted

   $ 23.26    $ 17.58    $ 10.95

 

* Represents restricted stock grants under the company’s Equity Compensation Plan and 1997 Incentive Compensation Plan.

The company recognizes stock-based compensation cost ratably over the vesting period of the awards. The company estimates the fair value of options on the date of grant using the Black-Scholes option pricing model with the following assumptions for 2005, 2004 and 2003, respectively:

 

  expected dividend yields of 1.50 percent, 1.55 percent and 2.17 percent;

 

  expected volatility of 25.9 percent, 30.7 percent and 31.9 percent;

 

  risk-free interest rates of 3.62 percent, 2.28 percent and 1.73 percent; and

 

  expected lives of 45 to 51 months in 2005 and 27 to 51 months in 2004 and 2003.

Translation of Foreign Currencies. The functional currencies for General Dynamics’ international operations are the respective local currencies. The company translates foreign currency balance sheets at the end-of-period exchange rates and earnings statements at the average exchange rates for each period. The resulting foreign currency translation adjustments are a component of accumulated other comprehensive income, which is included in shareholders’ equity on the Consolidated Balance Sheet.

B. ACQUISITIONS, INTANGIBLE ASSETS AND GOODWILL

In 2005, General Dynamics acquired the following businesses for a total cost of approximately $275, which was paid in cash:

Information Systems and Technology

 

  Itronix Corporation (Itronix) of Spokane, Washington, on September 2. Itronix provides wireless, rugged mobile computing solutions as well as wireless integration and support services for military, public safety and select commercial markets.

 

  Tadpole Computer, Inc. (Tadpole), of Cupertino, California, on August 16. Tadpole provides mobile, secure and battlefield-tested computing platforms for mission-critical military, government and commercial operations.

 

  MAYA Viz Ltd. (MAYA Viz) of Pittsburgh, Pennsylvania, on April 1. MAYA Viz provides enhanced visualization and collaboration technologies that support real-time decision-making.

In 2004, General Dynamics acquired the following businesses for a total cost of approximately $500, which was paid in cash:

Information Systems and Technology

 

  TriPoint Global Communications Inc. (TriPoint) of Newton, North Carolina, on September 17. TriPoint provides ground-based satellite and wireless communication equipment and integration services for voice, video and data applications.

 

  Spectrum Astro, Inc. (Spectrum Astro), of Gilbert, Arizona, on July 9. Spectrum Astro manufactures and integrates space systems, satellites and ground-support equipment.

Combat Systems

 

  Engineering Technology Inc. (ETI) of Orlando, Florida, on November 1. ETI engineers, designs and constructs special-purpose munitions and mechanical, electromechanical, electronic and electro-optic devices.

In 2003, General Dynamics acquired the following businesses for a total cost of approximately $3 billion, which was paid in cash:

Information Systems and Technology

 

  Digital System Resources, Inc. (DSR), of Fairfax, Virginia, on September 10. DSR provides surveillance and combat systems for submarines and surface ships.

 

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  Veridian Corporation (Veridian) of Arlington, Virginia, on August 11. Veridian provides the U.S. Department of Defense, the U.S. Department of Homeland Security and the intelligence community with network security and enterprise protection; intelligence, surveillance and reconnaissance systems development and integration; decision support; information systems development and integration; chemical, biological and nuclear detection capabilities; network and enterprise management services; and large-scale systems engineering.

 

  Creative Technology Incorporated (CTI) of Herndon, Virginia, on March 31. CTI supports the intelligence community and the Department of Defense by delivering systems and network engineering, integration, software development, and operations and technical consulting.

Combat Systems

 

  Steyr Daimler Puch Spezialfahrzeug Aktiengesellschaft & Company KG (Steyr) of Vienna, Austria, on October 2. Steyr develops and manufactures armored combat vehicles, including the Pandur family of wheeled combat vehicles and the Ulan tracked infantry fighting vehicle.

 

  Intercontinental Manufacturing Company (IMCO) of Garland, Texas, a division of Datron, Inc., on September 4. IMCO develops and manufactures aircraft bomb bodies for the U.S. armed services.

 

  General Motors Defense (GM Defense) of London, Ontario, a business unit of General Motors Corporation, on March 1. GM Defense manufactures wheeled armored vehicles and turrets.

Aerospace

 

  BBA Aviation’s aircraft maintenance service business (BBA Aviation) at London Luton Airport in the United Kingdom on April 3. BBA Aviation, the first Gulfstream-owned aircraft service center operated outside the United States, provides aircraft service and maintenance for Gulfstream and other aircraft.

The operating results of these businesses have been included with General Dynamics’ results as of the respective closing dates of the acquisitions. The purchase prices of these businesses have been allocated to the estimated fair value of net tangible and intangible assets acquired, with any excess recorded as goodwill. Some of the estimates related to the Itronix and Tadpole acquisitions are still preliminary at December 31, 2005. The company is awaiting the completion of the identification and valuation of intangible assets acquired. The company expects these analyses to be completed during the first half of 2006.

Intangible assets consisted of the following:

 

December 31    2005
     Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount

Contract and program intangible assets

   $ 996    $ (277 )   $ 719

Other intangible assets

     341      (162 )     179

Total intangible assets

   $ 1,337    $ (439 )   $ 898

 

December 31    2004
     Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount

Contract and program intangible assets

   $ 987    $ (207 )   $ 780

Other intangible assets

     298      (130 )     168

Total intangible assets

   $ 1,285    $ (337 )   $ 948

The company amortizes contract and program intangible assets on a straight-line basis over five to 40 years. Other intangible assets consist primarily of aircraft product design, customer lists, software and licenses and are amortized over three to 21 years.

Amortization expense was $101 in 2005, $93 in 2004 and $66 in 2003. The company expects to record annual amortization expense over the next five years as follows:

 

2006

   $ 99

2007

   $ 94

2008

   $ 89

2009

   $ 89

2010

   $ 84

 

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The changes in the carrying amount of goodwill by business group for the year ended December 31, 2005, were as follows:

 

     December 31, 2004    Acquisitions (a)    Other (b)     December 31, 2005

Information Systems and Technology

   $ 3,905    $ 245    $ 1     $ 4,151

Combat Systems

     1,982      23      (13 )     1,992

Marine Systems

     193      —        —         193

Aerospace

     348      2      —         350

Resources

     1      —        —         1

Total goodwill

   $ 6,429    $ 270    $ (12 )   $ 6,687
(a) Includes adjustments to preliminary assignment of fair value to net assets acquired.
(b) Consists of adjustments for foreign currency translation.

C. DISCONTINUED OPERATIONS

In 2004, General Dynamics reviewed its businesses to identify operations that were not core to the company and could be divested. As a result, the company completed the sale of two businesses in 2004 and recognized an after-tax loss of $2. In the Information Systems and Technology group, the company sold its business specializing in the development of software products and customized solutions for the automotive and airline industries. In the Combat Systems group, the company sold its business specializing in the design and manufacture of electrical equipment for specialty vehicles.

Also in 2004, the company entered into definitive agreements to sell two additional businesses. The company entered into agreements to sell its aeronautical research and development business in the Information Systems and Technology group and its propulsion systems business in the Combat Systems group. These transactions closed in the first quarter of 2005. In addition to the 2004 activity, the company sold two more businesses in the first quarter of 2005. These included the facilities research and development business and the airborne electronics systems business in the Information Systems and Technology group. The company recognized an after-tax loss of $8 from the sale of these businesses in discontinued operations in 2005. The company received combined proceeds from these transactions of approximately $300 in 2005.

The financial statements for all periods have been restated to present the results of operations of these businesses in discontinued operations.

The summary of operating results from discontinued operations follows:

 

Year Ended December 31    2005     2004     2003  

Net sales

   $ 46     $ 435     $ 296  

Operating expenses

     46       408       271  

Operating earnings

     —         27       25  

Gain on disposal

     32       4       10  

Earnings before taxes

     32       31       35  

Tax provision

     (39 )     (9 )     (10 )

(Loss) earnings from discontinued operations

   $ (7 )   $ 22     $ 25  

Assets and liabilities of discontinued operations consisted of the following:

 

December 31    2005    2004

Accounts receivable

   $ —      $ 35

Contracts in process

     —        72

Property, plant and equipment, net

     —        40

Intangible assets, net

     —        74

Goodwill

     —        148

Other assets

     7      43

Assets of discontinued operations

   $ 7    $ 412

Accounts payable

     —        16

Other liabilities

     11      85

Liabilities of discontinued operations

   $ 11    $ 101

 

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D. EARNINGS PER SHARE

General Dynamics computes basic earnings per share using net earnings for the respective period and the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporates the incremental shares issuable upon the assumed exercise of stock options and the issuance of contingently issuable shares.

Basic and diluted weighted average shares outstanding were as follows (in thousands):

 

Year Ended December 31    2005    2004    2003

Basic weighted average shares outstanding

   200,819    199,563    197,790

Assumed exercise of stock options*

   1,555    1,702    1,237

Contingently issuable shares

   50    202    125

Diluted weighted average shares outstanding

   202,424    201,467    199,152
* Excludes the following outstanding options to purchase shares of common stock because the options’ exercise price was greater than the average market price for the shares: year ended December 31, 2005 – 666; year ended December 31, 2004 – 541; year ended December 31, 2003 – 3,337.

E. INCOME TAXES

The following is a summary of the net provision for income taxes for continuing operations:

 

Year Ended December 31    2005     2004     2003  

Current:

                        

U.S. federal

   $ 467     $ 235     $ 240  

State*

     5       (5 )     1  

International

     82       73       58  

Total current

     554       303       299  

Deferred:

                        

U.S. federal

     117       256       129  

State*

     3       5       3  

International

     24       15       5  

Total deferred

     144       276       137  

Tax adjustments

     (66 )     4       (68 )

Provision for income taxes, net

   $ 632     $ 583     $ 368  
* The provision for state and local income taxes that is allocable to U.S. government contracts is included in operating costs and expenses on the Consolidated Statement of Earnings and, therefore, not included in the provision above.

Income tax payments were $529 in 2005, $302 in 2004 and $268 in 2003.

The reconciliation from the statutory federal income tax rate to the company’s effective income tax rate follows:

 

Year Ended December 31    2005     2004     2003  

Statutory federal income tax rate

   35.0 %   35.0 %   35.0 %

Tax settlements

   (3.1 )   —       (5.0 )

State tax on commercial operations, net of federal benefits

   0.3     —       0.2  

Impact of international operations

   (0.4 )   (1.6 )   (1.0 )

Qualified export sales exemption

   (0.4 )   (0.8 )   (0.7 )

Domestic production deduction

   (0.4 )   —       —    

Domestic tax credits

   (0.2 )   (0.2 )   (0.9 )

Other, net

   (0.7 )   0.2     (0.3 )

Effective income tax rate

   30.1 %   32.6 %   27.3 %

The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities consisted of the following:

 

December 31    2005     2004  

Post-retirement and post-employment liabilities

   $ 131     $ 119  

A-12 termination

     91       91  

Tax loss and credit carryforwards

     69       111  

Other

     485       454  

Deferred assets

   $ 776     $ 775  

Intangible assets

     511       366  

Property basis differences

     171       170  

Commercial pension asset

     169       155  

Capital Construction Fund

     167       159  

Long-term contract accounting methods

     141       141  

Lease income

     33       36  

Other

     160       180  

Deferred liabilities

   $ 1,352     $ 1,207  

Net deferred tax liability

   $ (576 )   $ (432 )

The current portion of the net deferred tax liability was an asset of $172 at December 31, 2005, and $217 at December 31, 2004, and is included in other current assets on the Consolidated Balance Sheet. As of December 31, 2005, General Dynamics had U.S. and foreign operating loss carryforwards of $120, the majority of which begin to expire in 2016. The company had research and development and foreign investment tax credit carryforwards of $38 that begin to expire in 2011. The company provided a valuation allowance totaling $115 as of December 31, 2005, and $81 as of December 31, 2004, on some of its deferred tax assets, the recovery of which is uncertain.

 

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Earnings from continuing operations before income taxes includes foreign income of $317 in 2005, $288 in 2004 and $195 in 2003. The company intends to reinvest indefinitely the undistributed earnings of some of its non-U.S. subsidiaries. As of December 31, 2005, the company had approximately $400 of earnings from international subsidiaries that had not been remitted to the United States. Distribution of these earnings to the United States would result in a tax liability of $28.

The Capital Construction Fund (CCF) is a program, established by the U.S. government and administered by the Maritime Administration, that affects the timing of a portion of the company’s tax payments. The program supports the acquisition, construction, reconstruction or operation of U.S. flag merchant marine vessels. It allows companies to defer federal and state income taxes on earnings derived from eligible programs as long as the funds are deposited and used for qualified activities. Unqualified withdrawals are subject to taxation plus interest. The CCF is collateralized by qualified assets as defined by the Maritime Administration. At December 31, 2005, General Dynamics had assigned approximately $404 in U.S. government accounts receivable to the CCF.

On November 27, 2001, General Dynamics filed a refund suit in the U.S. Court of Federal Claims, titled General Dynamics v. United States, for the years 1991 to 1993. The company added the years 1994 to 1998 to this suit on June 23, 2004. The suit seeks recovery of refund claims that were disallowed by the Internal Revenue Service (IRS) at the administrative level. On December 30, 2005, the court issued its opinion regarding one of the issues in the case. The court held that the company could not treat the A-12 contract as complete for federal income tax purposes in 1991, the year the contract was terminated. (See Note O for more information regarding the A-12 contract.) The company is considering whether to appeal this decision. In the event that the court’s opinion becomes final and the company prevails on the other issues in the case, the refund would be approximately $35, including after-tax interest. The company expects any appeals process to take several years to resolve and has recognized no income from this matter.

In 2005, General Dynamics and the IRS reached agreement on the examination of the company’s income tax returns for 1999 through 2002. With the completion of this audit cycle, the IRS has examined all of the company’s consolidated federal income tax returns through 2002. As a result of the resolution of the 1999-2002 audit, the company reassessed its tax contingencies during the first quarter and recognized a non-cash benefit of $66, or $0.33 per share.

In 2003, the company and the IRS reached agreement on the examination of the company’s income tax returns for 1996 to 1998. Based on the results of those examinations, the company reduced its liabilities for tax contingencies, recognizing a non-cash benefit of $49, or $0.25 per share. The company settled various other outstanding state tax disputes during the year, resulting in a net non-cash benefit of $19, or $0.09 per share.

The IRS has begun its examination of General Dynamics’ 2003 and 2004 income tax returns, which the company expects to be completed in 2007. The company has recorded liabilities for tax contingencies for open years. The company does not expect the resolution of tax matters for these years to have a material impact on its results of operations, financial condition or cash flows.

F. CONTRACTS IN PROCESS

Contracts in process represent recoverable costs and, where applicable, accrued profit related to government contracts and consisted of the following:

 

December 31    2005    2004

Contract costs and estimated profits

   $ 24,371    $ 21,165

Other contract costs

     815      814
       25,186      21,979

Less advances and progress payments

     22,110      19,089

Total contracts in process

   $ 3,076    $ 2,890

Contract costs consist primarily of production costs and related overhead and G&A expenses. Contract costs also include contract recoveries for matters such as contract changes, negotiated settlements and claims for unanticipated contract costs, which totaled $264 as of December 31, 2005, and $37 as of December 31, 2004. The claims recognized as of December 31, 2005, include primarily the company’s estimate of the minimum probable recovery it is entitled to in connection with a request for equitable adjustment related to its T-AKE combat logistics ship contract. The company is seeking a contract price adjustment for engineering- and design-related changes imposed by the customer. The company records revenue associated with these matters only when recovery can be estimated reliably and realization is probable.

        Other contract costs represent amounts recorded under GAAP that are not currently allocable to contracts, such as a portion of the company’s estimated workers’ compensation, other insurance-related assessments, post-retirement benefits and environmental expenses. These costs will become allocable to contracts when they are paid. The company expects to recover these costs through ongoing business, including existing backlog and probable follow-on contracts. This business base includes numerous contracts for which the company is the sole source or is one of two suppliers on long-term defense programs. However, if the backlog in the future does not support the continued deferral of these costs, the profitability of the company’s remaining contracts could be adversely affected. The company expects to bill substantially all of its year-end 2005 contracts-in-process balance, with the exception of these other contract costs, during 2006.

 

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G. INVENTORIES

Inventories represent primarily commercial aircraft components and consisted of the following:

 

December 31    2005    2004

Work in process

   $ 701    $ 648

Raw materials

     505      392

Pre-owned aircraft

     71      119

Other*

     38      36

Total inventories

   $ 1,315    $ 1,195
* Consists primarily of coal and aggregates.

H. PROPERTY, PLANT AND EQUIPMENT, NET

The major classes of property, plant and equipment were as follows:

 

December 31    2005     2004  

Machinery and equipment

   $ 2,583     $ 2,475  

Buildings and improvements

     1,303       1,311  

Land and improvements

     216       225  

Construction in process

     137       78  

Mineral reserves

     75       78  
       4,314 *     4,167 *

Less accumulated depreciation, depletion and amortization

     2,189       2,014  

Property, plant and equipment, net

   $ 2,125     $ 2,153  
* The U.S. government provides certain of the company’s plant facilities; the company does not include these facilities above.

I. DEBT

Debt consisted of the following:

 

December 31    Interest Rate     2005    2004

Fixed-rate notes

                   

Notes due in May 2006

   2.125 %   $ 500    $ 499

Notes due in May 2008

   3.000 %     499      499

Notes due in August 2010

   4.500 %     698      698

Notes due in May 2013

   4.250 %     999      999

Notes due in August 2015

   5.375 %     400      400

Senior notes due in 2008

   6.320 %     150      150

Term debt due in 2008

   7.500 %     30      35

Other

   Various       15      17

Total debt

           3,291      3,297

Less current portion

           510      6

Long-term debt

         $ 2,781    $ 3,291

As of December 31, 2005, General Dynamics had outstanding $3.1 billion aggregate principal amount of fixed-rate notes. The sale of the fixed-rate notes was registered under the Securities Act of 1933, as amended (the Securities Act). The notes are fully and unconditionally guaranteed by several of the company’s 100-percent-owned subsidiaries. The company has the option to redeem the notes prior to their maturity in whole or in part at 100 percent of the principal plus any accrued but unpaid interest and any applicable make-whole amounts. See Note T for condensed consolidating financial statements.

The senior notes are privately placed U.S. dollar-denominated notes issued by one of the company’s Canadian subsidiaries. Interest is payable semiannually at an annual rate of 6.32 percent until maturity in September 2008. The subsidiary has a currency swap that fixes both the interest payments and principal at maturity of these notes. As of December 31, 2005, the fair value of this currency swap was a $44 liability, which offset the effect of changes in the currency exchange rate on the related debt. The senior notes are backed by a parent company guarantee.

The company assumed the term debt in connection with the acquisition of Primex Technologies, Inc., in 2001. Annual sinking fund payments of $5 are required in December 2006 and 2007, with the remaining $20 payable in December 2008. Interest is payable in June and December at a rate of 7.5 percent annually.

As of December 31, 2005, other debt consisted primarily of two capital lease arrangements totaling $8.

        As of December 31, 2005 and 2004, the company had no commercial paper outstanding but maintains the ability to access the market. The company has $2 billion in bank credit facilities that provide backup liquidity to its commercial paper program. These credit facilities consist of a $1 billion 364-day facility expiring in December 2006 and a $1 billion multiyear facility expiring in July 2009. The company’s commercial paper issuances and the bank credit facilities are guaranteed by several of the company’s 100-percent-owned subsidiaries. Additionally, a number of the company’s international subsidiaries have available local bank credit facilities of approximately $575.

The company’s financing arrangements contain a number of customary covenants and restrictions. The company was in compliance with all material covenants as of December 31, 2005.

 

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J. OTHER CURRENT LIABILITIES

Other current liabilities consisted of the following:

 

December 31    2005    2004

Customer deposits on commercial contracts

   $ 877    $ 653

Workers’ compensation

     416      432

Retirement benefits

     408      357

Salaries and wages

     392      365

Other*

     952      956

Total other current liabilities

   $ 3,045    $ 2,763
* Consists primarily of contract-related costs assumed in business acquisitions, dividends payable, environmental remediation reserves, warranty reserves and insurance-related costs.

K. OTHER LIABILITIES

Other liabilities consisted of the following:

 

December 31    2005    2004

Deferred U.S. federal income taxes

   $ 756    $ 640

Retirement benefits

     307      342

Customer deposits on commercial contracts

     216      100

Other *

     479      604

Total other liabilities

   $ 1,758    $ 1,686
* Consists primarily of liabilities for tax contingencies for open years, warranty reserves, workers’ compensation and accrued costs of disposed businesses.

L. SHAREHOLDERS’ EQUITY

Authorized Stock. General Dynamics’ authorized capital stock consists of 500 million shares of $1 per share par value common stock and 50 million shares of $1 per share par value preferred stock. The preferred stock is issuable in series, with the rights, preferences and limitations of each series to be determined by the board of directors.

Dividends per Share. Dividends declared per share were $1.60 in 2005, $1.44 in 2004 and $1.28 in 2003.

Shares Issued and Outstanding. The company had 240,940,317 shares of common stock issued as of December 31, 2005 and 2004. The company had 200,181,527 shares of common stock outstanding as of December 31, 2005, and 201,033,153 shares of common stock outstanding as of December 31, 2004. No shares of the company’s preferred stock were outstanding as of either date. The only changes in the company’s shares outstanding during 2005 resulted from shares issued under its equity compensation plans (see Note P for further discussion) and share repurchases in the open market. In 2005, the company repurchased 3.3 million shares at an average price of $107 per share.

Accumulated Other Comprehensive Income. Accumulated other comprehensive income as of December 31, 2005, consists primarily of $211 of foreign currency translation adjustment, net of $84 of deferred taxes.

M. FINANCE OPERATION

General Dynamics leases three liquefied natural gas tankers to an unrelated company. The leases are classified as direct financing leases and extend through 2009. The components of the company’s net investment in the leases receivable are included in other current assets and other assets on the Consolidated Balance Sheet and consisted of the following:

 

December 31    2005     2004  

Aggregate future minimum lease payments

   $ 87     $ 108  

Unguaranteed residual value

     38       38  

Unearned interest income

     (29 )     (39 )

Net investment in leases receivable

   $ 96     $ 107  

The company is scheduled to receive annual minimum lease payments of $21 from 2006 through 2008 and $24 in 2009.

N. FOREIGN EXCHANGE RISK MANAGEMENT

General Dynamics is subject to foreign currency exchange rate risk relating to receipts from customers, payments to suppliers, foreign currency debt and inter-company transactions in foreign currencies.

        As a matter of policy, the company does not engage in interest rate or currency speculation. The company periodically enters into derivative financial instruments, principally foreign currency forward purchase and sale contracts, typically with terms of less than three years. These instruments are designed to hedge the company’s exposure to changes in exchange rates related to both known and anticipated inter-company and third-party sale and purchase commitments made in non-functional currencies. The company also has a currency swap designated as a cash flow hedge that fixes its foreign currency variability on both the principal and interest components of U.S. dollar-denominated debt held by one of the company’s Canadian subsidiaries, as discussed in Note I. There were no derivative financial instruments designated as fair value or net investment hedges during the years ended December 31, 2005 and 2004.

The company recognizes all derivative financial instruments on the Consolidated Balance Sheet at fair value. Changes in fair value of derivative financial instruments are recorded in the Consolidated Statement of Earnings or in accumulated other comprehensive income depending on whether the derivative is designated and qualifies for hedge accounting, the type of hedge transaction represented and the effectiveness of the hedge.

For derivative financial instruments not designated as cash flow hedges, the company marks these forward contracts to market value each period and records the gain or loss in the Consolidated Statement of Earnings. The gains and losses on these instruments offset losses and gains on the assets, liabilities and other transactions being hedged.

 

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Gains and losses related to forward exchange contracts that qualify as cash flow hedges and the currency swap discussed above are deferred in accumulated other comprehensive income until the underlying transaction occurs. The gains and losses reported in accumulated other comprehensive income will be reclassified to earnings upon completion of the underlying transaction being hedged.

As of December 31, 2005, the fair value of the currency swap was a $44 liability, which offset the effect of changes in the currency exchange rate on the related debt. The fair value of outstanding forward exchange contracts was not material. Net gains and losses recognized in earnings in 2005 were not material. The company expects the amount of gains and losses in accumulated other comprehensive income that will be reclassified to earnings in 2006 will not be material.

O. COMMITMENTS AND CONTINGENCIES

Litigation

Termination of A-12 Program. In January 1991, the U.S. Navy terminated the company’s A-12 aircraft contract for default. The A-12 contract was a fixed-price incentive contract for the full-scale development and initial production of the Navy’s carrier-based Advanced Tactical Aircraft. Both the company and McDonnell Douglas, now owned by The Boeing Company, (the contractors) were parties to the contract with the Navy. 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. As a consequence of the termination for default, the Navy demanded that the contractors repay $1.4 billion in unliquidated progress payments. The Navy agreed to defer collection of that amount pending a decision by the U.S. Court of Federal Claims (the trial court) on the contractors’ challenge to the termination for default, or a negotiated settlement.

On December 19, 1995, the trial court issued an order converting the termination for default to a termination for convenience. On March 31, 1998, a final judgment was entered in favor of the contractors for $1.2 billion plus interest.

On July 1, 1999, the U.S. Court of Appeals for the Federal Circuit (the appeals court) remanded the case to the trial court for determination of whether the government’s default termination was justified. On August 31, 2001, following the trial on remand, the trial court upheld the default termination of the A-12 contract. In its opinion, the trial court rejected all of the government’s arguments to sustain the default termination except for the government’s schedule arguments, as to which the trial court held that the schedule the government unilaterally imposed was reasonable and enforceable, and that the government had not waived that schedule. On the sole ground that the contractors were not going to deliver the first aircraft on the date provided in the unilateral schedule, the trial court upheld the default termination and entered judgment for the government.

On January 9, 2003, the company’s appeal was argued before a three-judge panel of the appeals court. On March 17, 2003, the appeals court vacated the trial court’s judgment and remanded the case to the trial court for further proceedings. The appeals court found that the trial court had misapplied the controlling legal standard in concluding that the termination for default could be sustained solely on the basis of the contractors’ inability to complete the first flight of the first test aircraft by December 1991. Rather, the appeals court held that in order to uphold a termination for default the trial court would have to determine that there was no reasonable likelihood that the contractors could perform the entire contract effort within the time remaining for performance. The company does not believe the evidence supports such a determination. Pursuant to the direction of the appeals court, the trial court held further proceedings on June 29 and 30, 2004. The matter is pending before the trial court for decision.

If, contrary to the company’s expectations, the default termination is ultimately sustained, the contractors could collectively be required to repay the government as much as $1.4 billion for progress payments received for the A-12 contract, plus interest, which was approximately $1.2 billion at December 31, 2005. This would result in a liability for the company of approximately $1.3 billion pretax. The company’s after-tax charge would be approximately $700, to be taken as a charge against discontinued operations. The company believes it has sufficient resources to satisfy its obligation if required.

Final Analysis. In May 2003, Final Analysis Communication Services, Inc. (FACS), a Maryland corporation, served the company with a complaint it filed in the U.S. District Court for the District of Maryland. On October 14, 2004, FACS filed a second amended complaint alleging that the company breached contracts among the company, FACS and FACS’ then-corporate parent, Final Analysis, Inc. (FAI), a Maryland corporation. FAI is currently a debtor in the Bankruptcy Court for the District of Maryland. The second amended complaint alleged monetary damages in excess of $500, plus punitive damages. The company denied liability to FACS and asserted counterclaims.

On September 6, 2005, the jury rendered a verdict against the company in the amount of $138 and a verdict in its favor in the amount of $8 on the company’s counterclaims. The judge did not enter judgment on the jury’s verdict, but rather asked for post-trial motions and briefs from both parties. These motions and briefs have been filed, and oral argument before the judge has been set for April 10, 2006. General Dynamics believes the jury’s verdict is not supported by the evidence presented and is legally flawed. The company believes that the ultimate outcome of this matter will not have a material impact on its results of operations, financial condition or cash flows.

 

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Other. Various claims and other legal proceedings incidental to the normal course of business are pending or threatened against the company. While it cannot predict the outcome of these matters, the company believes any potential liabilities in these proceedings, individually or in the aggregate, will not have a material impact on its results of operations, financial condition or cash flows.

Environmental

General Dynamics is subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. The company is directly or indirectly involved in environmental investigation or remediation at some of its current and former facilities, and at third-party sites not owned by the company but where it has been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, the company expects that a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable costs and, therefore, reimbursed by the U.S. government.

As required, the company provides financial assurance for certain sites undergoing or subject to investigation or remediation. Where applicable, the company seeks insurance recovery for costs related to environmental liability. The company does not record insurance recoveries before collection is considered probable. Based on all known facts and analyses, as well as current U.S. government policies relating to allowable costs, the company does not believe that its liability at any individual site, or in the aggregate, arising from such environmental conditions, will be material to its results of operations, financial condition or cash flows. Nor does the company believe that the range of reasonably possible additional loss beyond what has been recorded would be material to its results of operations, financial condition or cash flows.

Minimum Lease Payments

Total rental expense under operating leases was $179 in 2005, $172 in 2004 and $116 in 2003. Operating leases are primarily for facilities and equipment. Future minimum lease payments due during the next five years are as follows:

 

2006

   $ 143

2007

     123

2008

     106

2009

     84

2010

     68

2011 and thereafter

     284

Total minimum lease payments

   $ 808

Other

In the ordinary course of business, General Dynamics has entered into letters of credit and other similar arrangements with financial institutions and insurance carriers totaling approximately $1.6 billion at December 31, 2005. The company, from time to time in the ordinary course of business, guarantees the payment or performance obligations of its subsidiaries arising under certain contracts. The company is aware of no event of default that would require it to satisfy these guarantees.

As a government contractor, the company is occasionally subject to U.S. government investigations relating to its operations, including claims for fines, penalties, and compensatory and treble damages. The company believes, based on current available information, that the outcome of such ongoing government disputes and investigations will not have a material impact on its results of operations, financial condition or cash flows.

On June 5, 2001, General Dynamics acquired substantially all of the assets of Galaxy Aerospace Company LP. Pursuant to the purchase agreement, the selling parties have the contractual right to receive additional payments, up to a maximum of approximately $300 through December 31, 2006, contingent on the achievement of specific revenue targets. Based on current planned aircraft production rates, the company does not anticipate having to make any future payments under this agreement.

As of December 31, 2005, in connection with orders for 33 Gulfstream aircraft in firm contract backlog, the company had offered customers trade-in options, which may or may not be exercised by the customers. If these options are exercised, the company will accept trade-in aircraft (both Gulfstream and competitor aircraft) at a predetermined minimum trade-in price as partial consideration in the new aircraft transaction. Any excess of the trade-in price above the fair market value is treated as a reduction of revenue upon recording of the new aircraft sales transaction. These option commitments last through 2008 and totaled $570 as of December 31, 2005, versus $301 at December 31, 2004. Beyond these commitments, additional aircraft trade-ins are likely to be accepted in connection with future orders for new aircraft.

        Approximately one-fourth of the company’s employees are covered by more than 55 collective bargaining agreements with various unions. A number of these agreements expire within any given year. Historically, the company has been successful at renegotiating successor agreements without any material disruption of operating activities. The company expects to complete the renegotiation of 14 collective bargaining agreements in 2006, covering approximately 5,000 employees. The company does not expect that the renegotiations will, either individually or in the aggregate, have a material impact on its results of operations, financial condition or cash flows.

 

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The company provides product warranties to its customers associated with certain product sales, particularly business-jet aircraft. The company records estimated warranty costs in the period in which the related products are delivered. The warranty liability recorded at each balance sheet date is based on the estimated number of months of warranty coverage remaining for products delivered and the average historical monthly warranty payments, and is included in other current liabilities and other liabilities on the Consolidated Balance Sheet.

The changes in the carrying amount of warranty liabilities for the years ended December 31, 2005, 2004 and 2003 were as follows:

 

Year Ended December 31    2005     2004     2003  

Beginning balance

   $ 199     $ 181     $ 106  

Warranty expense

     33       53       73  

Payments

     (42 )     (37 )     (51 )

Adjustments*

     12       2       53  

Ending balance

   $ 202     $ 199     $ 181  

 

* Includes warranty liabilities assumed in connection with acquisitions.

P. EQUITY COMPENSATION PLANS

The company has various equity compensation plans for employees as well as non-employee members of the board of directors, including:

 

  the General Dynamics Corporation Equity Compensation Plan (Equity Compensation Plan),

 

  the General Dynamics United Kingdom Share Save Plan (U.K. Plan),

 

  the General Dynamics Corporation 1997 Incentive Compensation Plan (Incentive Compensation Plan),

 

  the General Dynamics Corporation Non-employee Directors’ 1999 Stock Plan (Directors’ Stock Plan) and

 

  various equity compensation plans assumed with the acquisition of Gulfstream Aerospace Corporation in 1999 (Gulfstream Plans).

The purpose of the Equity Compensation Plan is to provide the company with an effective means of attracting, retaining and motivating officers, key employees and non-employee directors, and to provide them with incentives to enhance the growth and profitability of the company. Under the Equity Compensation Plan, awards may be granted to officers, employees or non-employee directors in common stock, options to purchase common stock, restricted shares of common stock, participation units or any combination of these.

Stock options may be granted either as incentive stock options, intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended (the Code), or as options not qualified under the Code. All options are issued with an exercise price at or above 100 percent of the fair market value of the common stock on the date of grant. Awards of stock options generally vest over two years, with 50 percent of the options vesting on the first anniversary of the date of grant and the remaining 50 percent vesting on the second anniversary of the date of grant. Stock options awarded under the Equity Compensation Plan may not have a term of more than five years.

Awards of restricted stock represent common stock that may not be sold, transferred, pledged, assigned or otherwise conveyed to another party except upon the passage of time, or upon satisfaction of performance goals or other conditions. However, during the period of restriction, the recipient of restricted shares is entitled to vote the restricted shares and to retain cash dividends paid thereon. Awards of restricted stock generally vest 100 percent after four years.

Participation units are obligations of the company that have a value derived from or related to the value of the company’s common stock. These include stock appreciation rights, phantom stock units, and restricted stock units and are payable in cash, common stock or any combination thereof.

The Equity Compensation Plan replaced, on a prospective basis, the Incentive Compensation Plan and the Directors’ Stock Plan (the prior plans) effective May 5, 2004. No new grant of awards will be made under the prior plans. Any awards previously granted under the prior plans will remain outstanding and will, among other things, continue to vest and become exercisable in accordance with their original terms and conditions.

Under the U.K. Plan, company employees located in the United Kingdom may invest designated amounts in a savings account to be used to purchase a specified number of shares of common stock, based on option grants that the employee may receive, at an exercise price of not less than 80 percent of the fair market value of the common stock. The options may be exercised three, five or seven years after the date of grant.

Options granted under the Gulfstream Plans prior to the company’s acquisition of Gulfstream were subject to different vesting

periods based on the terms of the plans. At the time of the acquisition, substantially all of the outstanding Gulfstream options became fully vested. No additional awards or grants may be made under the Gulfstream Plans.

There were 1,215,595 shares of restricted stock outstanding at December 31, 2005. Information with respect to restricted stock awards follows:

 

Year Ended December 31    2005    2004    2003

Number of shares awarded

     434,454      238,618      435,199

Weighted average grant price

   $ 104.54    $ 91.59    $ 59.89

 

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At December 31, 2005, in addition to the shares reserved for issuance on the exercise of options outstanding, 15,077,014 shares have been authorized for options and restricted stock that may be granted in the future. Information with respect to stock options follows:

 

     Shares Under Option     Weighted-
Average
Exercise
Prices
   Shares Exercisable    Weighted-
Average
Exercise
Prices

Outstanding at December 31, 2002

   7,662,525     $ 67.64    4,119,791    $ 52.87

Granted

   3,591,482       57.17            

Exercised

   (1,475,604 )     50.49            

Canceled

   (109,784 )     66.14            

Outstanding at December 31, 2003

   9,668,619       66.35    4,679,212      66.17

Granted

   2,546,666       91.30            

Exercised

   (3,175,943 )     57.00            

Canceled

   (354,396 )     71.13            

Outstanding at December 31, 2004

   8,684,946       76.89    4,159,564      75.43

Granted

   2,698,561       105.20            

Exercised

   (2,204,058 )     70.10            

Canceled

   (163,335 )     90.87            

Outstanding at December 31, 2005

   9,016,114     $ 86.77    4,856,752    $ 76.29

Information with respect to stock options outstanding and exercisable at December 31, 2005, follows:

 

     Options Outstanding        Options Exercisable
Range of Exercise Prices    Number Outstanding at
12/31/05
   Weighted-
Average
Remaining
Contractual
Life
   Weighted-
Average
Exercise
Price
       Number Exercisable at
12/31/05
   Weighted-
Average
Exercise
Price

$43.00-57.38

   1,970,111    2.19    $ 56.73        1,835,148    $ 56.72

$60.94-74.94

   602,695    0.32      70.82        579,023      70.81

$76.28-91.34

   2,293,680    3.04      90.66        1,049,334      90.03

$93.90-104.48

   1,525,781    1.26      94.09        1,393,247      94.00

$105.03-115.57

   2,623,847    4.17      105.34        —        —  
     9,016,114    2.70    $ 86.77        4,856,752    $ 76.29

 

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Q. RETIREMENT PLANS

The company provides defined-benefit pension and other post-retirement benefits to eligible employees. The following is a reconciliation of the benefit obligations, plan/trust assets and funded status of the company’s plans:

 

     Pension Benefits          Other Post-retirement Benefits  
     2005     2004          2005     2004  

Change in Benefit Obligation

                                     

Benefit obligation at beginning of year

   $ (6,892 )   $ (6,558 )        $ (1,173 )   $ (1,200 )

Service cost

     (236 )     (220 )          (16 )     (15 )

Interest cost

     (399 )     (398 )          (68 )     (72 )

Amendments

     (29 )     239            (18 )     (11 )

Actuarial (loss)/gain

     (277 )     (252 )          (9 )     37  

Foreign currency exchange rate changes

     10       (17 )          —         —    

Settlement/curtailment/other

     27       (6 )          —         3  

Benefits paid

     333       320            87       85  

Benefit obligation at end of year

   $ (7,463 )   $ (6,892 )        $ (1,197 )   $ (1,173 )

Change in Plan/Trust Assets

                                     

Fair value of assets at beginning of year

   $ 6,776     $ 6,378          $ 366     $ 344  

Actual return on plan/trust assets

     403       664            30       37  

Employer contributions

     11       31            24       40  

Settlement/curtailment/other

     (30 )     5            —         —    

Foreign currency exchange rate changes

     (12 )     18            —         —    

Benefits paid

     (333 )     (320 )          (45 )     (55 )

Fair value of assets at end of year

   $ 6,815     $ 6,776          $ 375     $ 366  

Funded Status Reconciliation

                                     

Funded status

   $ (648 )   $ (116 )        $ (822 )   $ (807 )

Unrecognized net actuarial loss

     1,006       606            237       240  

Unrecognized prior service cost

     (79 )     (111 )          (4 )     (21 )

Unrecognized transition obligation

     —         —              2