Document


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

FORM 10-Q

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

For the quarterly period ended July 3, 2016
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-3671

GENERAL DYNAMICS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
 
13-1673581
State or other jurisdiction of incorporation or organization
 
I.R.S. employer identification no.
 
 
 
2941 Fairview Park Drive, Suite 100
Falls Church, Virginia
 
22042-4513
Address of principal executive offices
 
Zip code
(703) 876-3000
Registrant’s telephone number, including area code
    
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes ü No ___
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ü No ___
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer ü Accelerated Filer __ Non-Accelerated Filer __ Smaller Reporting Company ___
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No ü
305,278,868 shares of the registrant’s common stock, $1 par value per share, were outstanding on July 3, 2016.

1


INDEX

 
 
 
PART I -
PAGE
Item 1 -
 
 
 
 
 
 
 
 

Item 2 -
Item 3 -
Item 4 -
 
PART II -
Item 1 -
Item 1A -
Item 2 -
Item 6 -
 
            

2


PART I – FINANCIAL INFORMATION

ITEM 1. UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)

 
Three Months Ended
(Dollars in millions, except per-share amounts)
July 3, 2016
 
July 5, 2015
Revenue:
 
 
 
Products
$
4,848

 
$
5,138

Services
2,817

 
2,744

 
7,665

 
7,882

Operating costs and expenses:
 
 
 
Products
3,747

 
4,031

Services
2,362

 
2,303

General and administrative (G&A)
486

 
467

 
6,595

 
6,801

Operating earnings
1,070

 
1,081

Interest, net
(23
)
 
(20
)
Other, net
1

 
—

Earnings before income tax
1,048

 
1,061

Provision for income tax, net
290

 
309

Net earnings
$
758

 
$
752

 
 
 
 
Earnings per share
 
 
 
Basic
$
2.49

 
$
2.31

Diluted
$
2.44

 
$
2.27

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


3


CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)

 
Six Months Ended
(Dollars in millions, except per-share amounts)
July 3, 2016
 
July 5, 2015
Revenue:
 
 
 
Products
$
9,712

 
$
10,070

Services
5,677

 
5,596

 
15,389

 
15,666

Operating costs and expenses:
 
 
 
Products
7,530

 
7,850

Services
4,790

 
4,738

G&A
946

 
970

 
13,266

 
13,558

Operating earnings
2,123

 
2,108

Interest, net
(45
)
 
(41
)
Other, net
11

 
3

Earnings from continuing operations before income tax
2,089

 
2,070

Provision for income tax, net
601

 
602

Earnings from continuing operations
1,488

 
1,468

Discontinued operations
(13
)
 
—

Net earnings
$
1,475

 
$
1,468

 
 
 
 
Earnings per share
 
 
 
Basic:
 
 
 
Continuing operations
$
4.86

 
$
4.48

Discontinued operations
(0.04
)
 
—

Net earnings
$
4.82

 
$
4.48

Diluted:
 
 
 
Continuing operations
$
4.77

 
$
4.41

Discontinued operations
(0.04
)
 
—

Net earnings
$
4.73

 
$
4.41

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


4


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

 
Three Months Ended
 
Six Months Ended
(Dollars in millions)
July 3, 2016
 
July 5, 2015
 
July 3, 2016
July 5, 2015
Net earnings
$
758

 
$
752

 
$
1,475

$
1,468

(Losses) gains on cash flow hedges
(24
)
 
(1
)
 
158

(384
)
Unrealized gains (losses) on securities
5

 
(2
)
 
(4
)
—

Foreign currency translation adjustments
(56
)
 
69

 
125

(35
)
Change in retirement plans' funded status
66

 
91

 
126

188

Other comprehensive (loss) income, pretax
(9
)
 
157

 
405

(231
)
Provision (benefit) for income tax, net
15

 
33

 
84

(71
)
Other comprehensive (loss) income, net of tax
(24
)
 
124

 
321

(160
)
Comprehensive income
$
734

 
$
876

 
$
1,796

$
1,308

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


5


CONSOLIDATED BALANCE SHEETS

 
(Unaudited)
 
 
(Dollars in millions)
July 3, 2016
 
December 31, 2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and equivalents
$
1,899

 
$
2,785

Accounts receivable
3,539

 
3,446

Contracts in process
4,996

 
4,357

Inventories
3,520

 
3,366

Other current assets
432

 
617

Total current assets
14,386

 
14,571

Noncurrent assets:
 
 
 
Property, plant and equipment, net
3,440

 
3,466

Intangible assets, net
733

 
763

Goodwill
11,572

 
11,443

Other assets
1,638

 
1,754

Total noncurrent assets
17,383

 
17,426

Total assets
$
31,769

 
$
31,997

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
Current liabilities:
 
 
 
Short-term debt and current portion of long-term debt
$
537

 
$
501

Accounts payable
2,128

 
1,964

Customer advances and deposits
5,365

 
5,674

Other current liabilities
4,105

 
4,306

Total current liabilities
12,135

 
12,445

Noncurrent liabilities:
 
 
 
Long-term debt
2,899

 
2,898

Other liabilities
5,740

 
5,916

Commitments and contingencies (See Note L)


 


Total noncurrent liabilities
8,639

 
8,814

Shareholders' equity:
 
 
 
Common stock
482

 
482

Surplus
2,756

 
2,730

Retained earnings
24,213

 
23,204

Treasury stock
(13,491
)
 
(12,392
)
Accumulated other comprehensive loss
(2,965
)
 
(3,286
)
Total shareholders' equity
10,995

 
10,738

Total liabilities and shareholders' equity
$
31,769

 
$
31,997

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


6


CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 
Six Months Ended
(Dollars in millions)
July 3, 2016
 
July 5, 2015
Cash flows from operating activities - continuing operations:
 
 
 
Net earnings
$
1,475

 
$
1,468

Adjustments to reconcile net earnings to net cash provided by operating activities:
 
 
 
Depreciation of property, plant and equipment
182

 
184

Amortization of intangible assets
50

 
59

Equity-based compensation expense
51

 
71

Deferred income tax provision
62

 
21

Discontinued operations
13

 
—

(Increase) decrease in assets, net of effects of business acquisitions:
 
 
 
Accounts receivable
(83
)
 
455

Contracts in process
(619
)
 
330

Inventories
(150
)
 
(149
)
Increase (decrease) in liabilities, net of effects of business acquisitions:
 
 
 
Accounts payable
157

 
222

Customer advances and deposits
(423
)
 
(1,252
)
Other, net
158

 
24

Net cash provided by operating activities
873

 
1,433

Cash flows from investing activities:
 
 
 
Capital expenditures
(134
)
 
(190
)
Maturities of held-to-maturity securities
—

 
500

Proceeds from sales of assets
4

 
259

Other, net
(55
)
 
(18
)
Net cash (used) provided by investing activities
(185
)
 
551

Cash flows from financing activities:
 
 
 
Purchases of common stock
(1,189
)
 
(1,565
)
Dividends paid
(447
)
 
(432
)
Proceeds from stock option exercises
92

 
198

Repayment of fixed-rate notes
—

 
(500
)
Other, net
4

 
(25
)
Net cash used by financing activities
(1,540
)
 
(2,324
)
Net cash used by discontinued operations
(34
)
 
(16
)
Net decrease in cash and equivalents
(886
)
 
(356
)
Cash and equivalents at beginning of period
2,785

 
4,388

Cash and equivalents at end of period
$
1,899

 
$
4,032

Supplemental cash flow information:
 
 
 
Cash payments for:
 
 
 
Income taxes
$
460

 
$
530

Interest
$
42

 
$
45

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


7


CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (UNAUDITED)

 
Common Stock
 
Retained
 
Treasury
 
Accumulated
Other 
Comprehensive
 
Total
Shareholders’    
(Dollars in millions)
Par
 
Surplus
 
Earnings
 
Stock
 
Loss
 
Equity
December 31, 2015
$
482

 
$
2,730

 
$
23,204

 
$
(12,392
)
 
$
(3,286
)
 
$
10,738

Net earnings
—

 
—

 
1,475

 
—

 
—

 
1,475

Cash dividends declared
—

 
—

 
(466
)
 
—

 
—

 
(466
)
Equity-based awards
—

 
26

 
—

 
90

 
—

 
116

Shares purchased
—

 
—

 
—

 
(1,189
)
 
—

 
(1,189
)
Other comprehensive income
—

 
—

 
—

 
—

 
321

 
321

July 3, 2016
$
482

 
$
2,756

 
$
24,213

 
$
(13,491
)
 
$
(2,965
)
 
$
10,995

 
 
 
 
 
 
 
 
 
 
 


December 31, 2014
$
482

 
$
2,548

 
$
21,127

 
$
(9,396
)
 
$
(2,932
)
 
$
11,829

Net earnings
—

 
—

 
1,468

 
—

 
—

 
1,468

Cash dividends declared
—

 
—

 
(452
)
 
—

 
—

 
(452
)
Equity-based awards
—

 
109

 
—

 
175

 
—

 
284

Shares purchased
—

 
—

 
—

 
(1,693
)
 
—

 
(1,693
)
Other comprehensive loss
—

 
—

 
—

 
—

 
(160
)
 
(160
)
July 5, 2015
$
482

 
$
2,657

 
$
22,143

 
$
(10,914
)
 
$
(3,092
)
 
$
11,276

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


8


NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share amounts or unless otherwise noted)
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Consolidation and Classification. The unaudited Consolidated Financial Statements include the accounts of General Dynamics Corporation and our wholly owned and majority-owned subsidiaries. We eliminate all inter-company balances and transactions in the unaudited Consolidated Financial Statements. Some prior-year amounts have been reclassified among financial statement accounts to conform to the current-year presentation.
Consistent with defense industry practice, we classify assets and liabilities related to long-term contracts as current, even though some of these amounts may not be realized within one year.
Interim Financial Statements. The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. These rules and regulations permit some of the information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) to be condensed or omitted.
Our fiscal quarters are 13 weeks in length. Because our fiscal year ends on December 31, the number of days in our first and fourth quarters varies slightly from year to year. Operating results for the three- and six-month periods ended July 3, 2016, are not necessarily indicative of the results that may be expected for the year ending December 31, 2016.
The unaudited Consolidated Financial Statements contain all adjustments that are of a normal recurring nature necessary for a fair presentation of our results of operations and financial condition for the three- and six-month periods ended July 3, 2016, and July 5, 2015.
These unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.
Revenue Recognition. We account for revenue and earnings using the percentage-of-completion method. Under this method, contract costs and revenues are recognized as the work progresses, either as the products are produced or as services are rendered. We estimate the profit on a contract as the difference between the total estimated revenue and expected costs to complete a contract and recognize that profit over the life of the contract. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize the loss in the quarter it is identified.
We review and update our contract-related estimates regularly. We recognize adjustments in estimated profit on contracts under the reallocation method. Under the reallocation method, the impact of an adjustment in estimate is recognized prospectively over the remaining contract term. The net impact of adjustments in contract estimates on our operating earnings (and on a diluted per-share basis) totaled favorable changes of $83 ($0.17) and $187 ($0.39) for the three- and six-month periods ended July 3, 2016, and $45 ($0.09) and $108 ($0.21) for the three- and six-month periods ended July 5, 2015, respectively. No adjustment on any one contract was material to our unaudited Consolidated Financial Statements in the second quarter and first six months of 2016 or 2015.

9


In the second quarter of 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 prescribes a single, common revenue standard that replaces most existing revenue recognition guidance in GAAP. The standard outlines a five-step model whereby revenue is recognized as performance obligations within a contract are satisfied. The standard also requires new, expanded disclosures regarding revenue recognition. Several ASUs have been issued since the issuance of ASU 2014-09. These ASUs, which modify certain sections of ASU 2014-09, are intended to promote a more consistent interpretation and application of the principles outlined in the standard. Once a final technical corrections and improvements update is issued by the FASB in 2016, the standard is expected to be final.
ASU 2014-09 is effective in the first quarter of 2018 for public companies. However, entities can elect to adopt one year earlier in the first quarter of 2017. The standard permits the use of either the retrospective or cumulative-effect transition method.
We are utilizing a bottom-up approach to analyze the standard’s impact on our contract portfolio, comparing our historical accounting policies and practices and identifying potential differences from applying the requirements of the new standard to our contracts. While this assessment continues, we have not yet completed our determination of the impacts of the standards or the effect of these impacts on our Consolidated Financial Statements. Consequently, we have not yet selected a transition date or method. We expect this determination will near completion in the second half of 2016. Because the new standard will impact our business processes, systems and controls, we have developed a comprehensive change management project plan to guide the implementation.
The required adoption of the ASU will preclude our use of the reallocation method of recognizing adjustments in estimated profit on contracts discussed above. As changes in estimated profit will be recognized in the period they are identified (cumulative catch-up method), rather than prospectively over the remaining contract term, we expect the impact of adjustments of contract estimates may be larger and potentially more variable from period to period. Anticipated losses on contracts will continue to be recognized in the quarter they are identified.
Accounting Standards Updates. In the second quarter of 2016, we adopted ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 impacted several aspects of the accounting for share-based payment transactions. The ASU requires that excess tax benefits and tax deficiencies (the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes) be recognized as income tax expense or benefit in the Consolidated Statement of Earnings. Previously, these amounts were recognized directly to shareholders' equity. On the Consolidated Statement of Cash Flows, the excess tax benefit from equity-based compensation is classified as an operating activity. Additionally, cash paid when directly withholding shares for tax withholding purposes is classified as a financing activity.
As a result of adoption, we recognized a tax benefit in the second quarter of approximately $30 related to the first six months of 2016. The impact in the second half of 2016 will depend on the level of stock option exercise activity, but is expected to be less than the first half of 2016, which benefitted from the first-quarter release of restricted stock. As this area of the ASU permits only prospective adoption, there was no impact on our 2015 Consolidated Financial Statements.
On the Consolidated Statement of Cash Flows, the adoption of the ASU resulted in a $60 increase in net cash provided by operating activities and a corresponding $60 increase in net cash used by financing activities for the six months ended July 3, 2016. The areas of the ASU that relate to the Consolidated Statement of Cash Flows were adopted retrospectively. We have restated our prior-period Consolidated

10


Statements of Cash Flows accordingly, resulting in an $85 increase in net cash provided by operating activities and a corresponding $85 increase in net cash used by financing activities for the six months ended July 5, 2015, and a $108 increase in net cash provided by operating activities and a corresponding $108 increase in net cash used by financing activities for the year ended December 31, 2015. The other aspects of the ASU did not have a material impact on our results of operations, financial condition or cash flows.
There are several new accounting standards that have been issued by the FASB, but are not yet effective. New accounting standards issued prior to 2016 are included in our Annual Report on Form 10-K for the year ended December 31, 2015. In 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 requires the recognition of lease rights and obligations as assets and liabilities on the balance sheet. Previously, lessees were not required to recognize on the balance sheet assets and liabilities arising from operating leases. The ASU also requires disclosure of key information about leasing arrangements. ASU 2016-02 is effective on January 1, 2019, using the modified retrospective method of adoption, with early adoption permitted. We have not yet determined the effect of the ASU on our Consolidated Financial Statements nor have we selected a transition date.
Other ASUs issued by the FASB in 2016 but not yet effective are not expected to have a material effect on our Consolidated Financial Statements.

B. ACQUISITIONS AND DIVESTITURES, GOODWILL, AND INTANGIBLE ASSETS
Acquisitions and Divestitures
In 2016, we acquired an aircraft management and charter services provider in our Aerospace group and a manufacturer of unmanned underwater vehicles (UUVs) in our Information Systems and Technology group. These amounts are included in other investing activities in the unaudited Consolidated Statement of Cash Flows. We did not acquire any businesses in 2015.
The operating results of these acquisitions have been included with our reported results since the respective closing dates. The purchase prices of the acquisitions have been allocated to the estimated fair value of net tangible and intangible assets acquired, with any excess purchase price recorded as goodwill.
In 2015, we completed the sale of our axle business in the Combat Systems group and a commercial cyber security business in our Information Systems and Technology group. In the first quarter of 2016, we recognized a final adjustment to the loss on the sale of the axle business of $13 in discontinued operations.
Goodwill
The changes in the carrying amount of goodwill by reporting unit for the six months ended July 3, 2016, were as follows:
 
Aerospace
 
Combat Systems
 
Information Systems and Technology
 
Marine Systems
 
Total
Goodwill
December 31, 2015 (a)
$
2,542

 
$
2,591

 
$
6,021

 
$
289

 
$
11,443

Acquisitions (b)
19

 
—

 
5

 
—

 
24

Other (c)
44

 
56

 
5

 
—

 
105

July 3, 2016
$
2,605

 
$
2,647

 
$
6,031

 
$
289

 
$
11,572

(a)Goodwill on December 31, 2015, in the Information Systems and Technology reporting unit is net of $2 billion of accumulated impairment losses.
(b)Includes adjustments during the purchase price allocation period.
(c)Consists primarily of adjustments for foreign currency translation.

11


Intangible Assets
Intangible assets consisted of the following:
 
Gross Carrying Amount (a)
Accumulated Amortization
Net Carrying Amount
 
Gross Carrying Amount (a)
Accumulated Amortization
Net Carrying Amount
 
July 3, 2016
 
December 31, 2015
Contract and program intangible assets (b)
$
1,636

$
(1,255
)
$
381

 
$
1,626

$
(1,214
)
$
412

Trade names and trademarks
466

(136
)
330

 
455

(127
)
328

Technology and software
120

(98
)
22

 
119

(96
)
23

Other intangible assets
154

(154
)
—

 
154

(154
)
—

Total intangible assets
$
2,376

$
(1,643
)
$
733

 
$
2,354

$
(1,591
)
$
763

(a)
Change in gross carrying amounts consists primarily of adjustments for foreign currency translation and acquired intangible assets.
(b)
Consists of acquired backlog and probable follow-on work and associated customer relationships.
Amortization expense was $23 and $50 for the three- and six-month periods ended July 3, 2016, and $29 and $59 for the three- and six-month periods ended July 5, 2015.

C. EARNINGS PER SHARE
We compute basic earnings per share (EPS) using net earnings for the period and the weighted average number of common shares outstanding during the period. Basic weighted average shares outstanding have decreased throughout 2016 and 2015 due to share repurchases. See Note J for additional details of our share repurchases. Diluted EPS incorporates the additional shares issuable upon the assumed exercise of stock options and the release of restricted stock and restricted stock units (RSUs). The dilutive effect of stock options and restricted stock/RSUs increased because of the adoption of ASU 2016-09 during the second quarter of 2016. See Note A for additional detail of our adoption of this accounting standard.
Basic and diluted weighted average shares outstanding were as follows (in thousands):
 
Three Months Ended
Six Months Ended
 
July 3, 2016
July 5, 2015
July 3, 2016
July 5, 2015
Basic weighted average shares outstanding
304,470

326,153

306,199

327,653

Dilutive effect of stock options and restricted stock/RSUs*
5,738

5,273

5,610

5,396

Diluted weighted average shares outstanding
310,208

331,426

311,809

333,049

* Excludes outstanding options to purchase shares of common stock because these options had exercise prices in excess of the average market price of our common stock during the period and therefore the effect of including these options would be antidilutive. These options totaled 4,664 and 3,792 for the three- and six-month periods ended July 3, 2016, and 2,091 and 1,387 for the three- and six-month periods ended July 5, 2015, respectively.

D. FAIR VALUE
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:

12


•
Level 1 – quoted prices in active markets for identical assets or liabilities;
•
Level 2 – inputs, other than quoted prices, observable by a marketplace participant either directly or indirectly; and
•
Level 3 – unobservable inputs significant to the fair value measurement.
We did not have any significant non-financial assets or liabilities measured at fair value on July 3, 2016, or December 31, 2015.
Our financial instruments include cash and equivalents, marketable securities and other investments; accounts receivable and payable; short- and long-term debt; and derivative financial instruments. The carrying values of cash and equivalents, accounts receivable and payable and short-term debt on the Consolidated Balance Sheet approximate their fair value. The following tables present the fair values of our other financial assets and liabilities on July 3, 2016, and December 31, 2015, and the basis for determining their fair values:
 
Carrying
Value
 
Fair
Value
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant Other Observable Inputs
(Level 2) (b)
Financial Assets (Liabilities) (a)
July 3, 2016
Available-for-sale securities
$
185

 
$
185

 
$
101

 
$
84

Derivatives
(506
)
 
(506
)
 
—

 
(506
)
Long-term debt, including current portion
(3,460
)
 
(3,578
)
 
—

 
(3,578
)
 
 
 
 
 
 
 
 
 
December 31, 2015
Available-for-sale securities
186

 
186

 
124

 
62

Derivatives
(673
)
 
(673
)
 
—

 
(673
)
Long-term debt, including current portion
(3,425
)
 
(3,381
)
 
—

 
(3,381
)
(a)We had no Level 3 financial instruments on July 3, 2016, or December 31, 2015.
(b)Determined under a market approach using valuation models that incorporate observable inputs such as interest rates, bond yields and quoted prices for similar assets and liabilities.

E. INCOME TAXES
Net Deferred Tax Asset. Our net deferred tax asset was included on the Consolidated Balance Sheet in other assets and liabilities as follows:
 
July 3, 2016
 
December 31, 2015
Current deferred tax asset
$
9

 
$
3

Current deferred tax liability
(826
)
 
(829
)
Noncurrent deferred tax asset
1,135

 
1,272

Noncurrent deferred tax liability
(86
)
 
(75
)
Net deferred tax asset
$
232

 
$
371

Tax Uncertainties. For all periods open to examination by tax authorities, we periodically assess our liabilities and contingencies based on the latest available information. Where we believe there is more than a 50 percent chance that our tax position will not be sustained, we record our best estimate of the resulting tax liability, including interest, in the Consolidated Financial Statements. We include any interest or penalties

13


incurred in connection with income taxes as part of income tax expense. The total amount of these tax liabilities on July 3, 2016, is not material to our results of operations, financial condition or cash flow.
We participate in the Internal Revenue Service (IRS) Compliance Assurance Process (CAP), a real-time audit of our consolidated federal corporate income tax return. The IRS has examined our consolidated federal income tax returns through 2014. We do not expect the resolution of tax matters for open years to have a material impact on our results of operations, financial condition, cash flows or effective tax rate.
Based on all known facts and circumstances and current tax law, we believe the total amount of any unrecognized tax benefits on July 3, 2016, is not material to our results of operations, financial condition or cash flows, and if recognized, would not have a material impact on our effective tax rate. In addition, there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly vary over the next 12 months, producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.

F. CONTRACTS IN PROCESS
Contracts in process represent recoverable costs and, where applicable, accrued profit related to long-term contracts less associated advances and progress payments. These amounts have been inventoried until the customer is billed, generally in accordance with the agreed-upon billing terms or upon shipment of products or rendering of services. Contracts in process consisted of the following:
 
July 3, 2016
 
December 31, 2015
Contract costs and estimated profits
$
25,649

 
$
20,742

Other contract costs
868

 
965

 
26,517

 
21,707

Advances and progress payments
(21,521
)
 
(17,350
)
Total contracts in process
$
4,996

 
$
4,357

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

G. INVENTORIES
Our inventories represent primarily business-jet components and are stated at the lower of cost or net realizable value. Work in process represents largely labor, material and overhead costs associated with aircraft in the manufacturing process and is based primarily on the estimated average unit cost of the units in a production lot. Raw materials are valued primarily on the first-in, first-out method. We record pre-

14


owned aircraft acquired in connection with the sale of new aircraft at the lower of the trade-in value or the estimated net realizable value.
Inventories consisted of the following:
 
July 3, 2016
 
December 31, 2015
Work in process
$
2,079

 
$
1,889

Raw materials
1,335

 
1,376

Finished goods
26

 
28

Pre-owned aircraft
80

 
73

Total inventories
$
3,520

 
$
3,366


H. DEBT
Debt consisted of the following:
 
 
July 3, 2016
 
December 31, 2015
Fixed-rate notes due:
Interest rate
 
 
 
July 2016
2.250%
$
500

 
$
500

November 2017
1.000%
900

 
900

July 2021
3.875%
500

 
500

November 2022
2.250%
1,000

 
1,000

November 2042
3.600%
500

 
500

Other
Various
60

 
25

Total debt - principal
 
3,460

 
3,425

Less unamortized debt issuance costs and discounts
 
24

 
26

Total debt
 
3,436

 
3,399

Less current portion
 
537

 
501

Long-term debt
 
$
2,899

 
$
2,898

Our fixed-rate notes are fully and unconditionally guaranteed by several of our 100-percent-owned subsidiaries. See Note O for condensed consolidating financial statements. We have the option to redeem the notes prior to their maturity in whole or part for the principal plus any accrued but unpaid interest and applicable make-whole amounts.
On July 3, 2016, we had no commercial paper outstanding, but we maintain the ability to access the commercial paper market in the future. We have $2 billion in committed bank credit facilities for general corporate purposes and working capital needs. These credit facilities include a $1 billion multi-year facility expiring in July 2018 and a $1 billion multi-year facility expiring in November 2020. These facilities are required by rating agencies to support our commercial paper issuances. We may renew or replace, in whole or part, these credit facilities at or prior to their expiration dates. Our bank credit facilities are guaranteed by several of our 100-percent-owned subsidiaries. We also have an effective shelf registration on file with the SEC that allows us to access the debt markets.
Subsequent to the end of the second quarter of 2016, we repaid $500 of fixed-rate notes on their maturity date with cash on hand.

15


Our financing arrangements contain a number of customary covenants and restrictions. We were in compliance with all covenants on July 3, 2016.

I. OTHER LIABILITIES
A summary of significant other liabilities by balance sheet caption follows:
 
July 3, 2016
 
December 31, 2015
Deferred income taxes
$
826

 
$
829

Salaries and wages
649

 
648

Fair value of cash flow hedges
545

 
780

Workers' compensation
387

 
369

Retirement benefits
299

 
304

Other (a)
1,399

 
1,376

Total other current liabilities
$
4,105

 
$
4,306

 
 
 
 
Retirement benefits
$
4,149

 
$
4,251

Customer deposits on commercial contracts 
394

 
506

Deferred income taxes
86

 
75

Other (b)
1,111

 
1,084

Total other liabilities
$
5,740

 
$
5,916

(a)Consists primarily of dividends payable, taxes payable, environmental remediation reserves, warranty reserves, deferred revenue and supplier contributions in the Aerospace group, liabilities of discontinued operations, and insurance-related costs.
(b)Consists primarily of liabilities for warranty reserves and workers' compensation and liabilities of discontinued operations.

J. SHAREHOLDERS' EQUITY
Share Repurchases. Our board of directors authorizes management’s repurchase of shares of common stock on the open market from time to time. On March 2, 2016, the board of directors authorized management to repurchase up to 10 million additional shares. In the first six months of 2016, we repurchased 8.9 million of our outstanding shares for $1.2 billion. On July 3, 2016, 10.7 million shares remained authorized by our board of directors for repurchase, approximately 4 percent of our total shares outstanding. We repurchased 12.1 million shares for $1.7 billion in the first six months of 2015.
Dividends per Share. Dividends declared per share were $0.76 and $1.52 for the three- and six-month periods ended July 3, 2016, and $0.69 and $1.38 for the three- and six-month periods ended July 5, 2015, respectively. Cash dividends paid were $232 and $447 for the three- and six-month periods ended July 3, 2016, and $226 and $432 for the three- and six-month periods ended July 5, 2015, respectively.

16


Accumulated Other Comprehensive Loss. The changes, pretax and net of tax, in each component of accumulated other comprehensive loss (AOCL) consisted of the following:
 
Losses on Cash Flow Hedges
Unrealized Gains on Securities
Foreign Currency Translation Adjustments
Changes in Retirement Plans’ Funded Status
AOCL
December 31, 2015
$
(487
)
$
20

$
178

$
(2,997
)
$
(3,286
)
Other comprehensive income, pretax
158

(4
)
125

126

405

Provision for income tax, net
37

(2
)
3

46

84

Other comprehensive income, net of tax
121

(2
)
122

80

321

July 3, 2016
$
(366
)
$
18

$
300

$
(2,917
)
$
(2,965
)
December 31, 2014
$
(173
)
$
22

$
541

$
(3,322
)
$
(2,932
)
Other comprehensive loss, pretax
(384
)
—

(35
)
188

(231
)
Benefit for income tax, net
(135
)
1

(3
)
66

(71
)
Other comprehensive loss, net of tax
(249
)
(1
)
(32
)
122

(160
)
July 5, 2015
$
(422
)
$
21

$
509

$
(3,200
)
$
(3,092
)
Amounts reclassified out of AOCL related primarily to changes in retirement plans' funded status and consisted of pretax recognized net actuarial losses of $166 and $222 for the six-month periods ended July 3, 2016, and July 5, 2015, respectively. This was offset partially by pretax amortization of prior service credit of $37 and $36 for the six-month periods ended July 3, 2016, and July 5, 2015, respectively. These AOCL components are included in our net periodic pension and other post-retirement benefit cost. See Note M for additional details.

K. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
We are exposed to market risk, primarily from foreign currency exchange rates, interest rates, commodity prices and investments. We may use derivative financial instruments to hedge some of these risks as described below. We had $7.4 billion in notional forward exchange contracts outstanding on July 3, 2016, and $7.2 billion on December 31, 2015. We do not use derivatives for trading or speculative purposes. We recognize derivative financial instruments on the Consolidated Balance Sheet at fair value. See Note D for additional details.
Foreign Currency Risk and Hedging Activities. Our foreign currency exchange rate risk relates to receipts from customers, payments to suppliers and inter-company transactions denominated in foreign currencies. To the extent possible, we include terms in our contracts that are designed to protect us from this risk. Otherwise, we enter into derivative financial instruments, principally foreign currency forward purchase and sale contracts, designed to offset and minimize our risk. The three-year average maturity of these instruments generally matches the duration of the activities that are at risk.
We record changes in the fair value of derivative financial instruments in operating costs and expenses in the Consolidated Statement of Earnings or in other comprehensive loss (OCL) within the Consolidated Statement of Comprehensive Income depending on whether the derivative is designated and qualifies for hedge accounting. Gains and losses related to derivatives that qualify as cash flow hedges are deferred in OCL until the underlying transaction is reflected in earnings. We adjust derivative financial instruments not designated as cash flow hedges to market value each period and record the gain or loss in the Consolidated

17


Statement of Earnings. The gains and losses on these instruments generally offset losses and gains on the assets, liabilities and other transactions being hedged. Gains and losses resulting from hedge ineffectiveness are recognized in the Consolidated Statement of Earnings for all derivative financial instruments, regardless of designation.
Net gains and losses recognized in earnings, including gains and losses related to hedge ineffectiveness, were not material to our results of operations for the three- and six-month periods ended July 3, 2016, and July 5, 2015. Net gains and losses reclassified to earnings from OCL were not material to our results of operations for the three- and six-month periods ended July 3, 2016, and July 5, 2015, and we do not expect the amount of these gains and losses that will be reclassified to earnings during the next 12 months to be material.
We had no material derivative financial instruments designated as fair value or net investment hedges on July 3, 2016, or December 31, 2015.
Interest Rate Risk. Our financial instruments subject to interest rate risk include fixed-rate long-term debt obligations and variable-rate commercial paper. However, the risk associated with these instruments is not material.
Commodity Price Risk. We are subject to rising labor and commodity price risk, primarily on long-term fixed-price contracts. To the extent possible, we include terms in our contracts that are designed to protect us from these risks. Some of the protective terms included in our contracts are considered derivatives but are not accounted for separately because they are clearly and closely related to the host contract. We have not entered into any material commodity hedging contracts but may do so as circumstances warrant. We do not believe that changes in labor or commodity prices will have a material impact on our results of operations or cash flows.
Investment Risk. Our investment policy allows for purchases of fixed-income securities with an investment-grade rating and a maximum maturity of up to five years. On July 3, 2016, we held $1.9 billion in cash and equivalents, but held no marketable securities.
Foreign Currency Financial Statement Translation. We translate foreign currency balance sheets from our international businesses' functional currency (generally the respective local currency) to U.S. dollars at end-of-period exchange rates, and statements of earnings at average exchange rates for each period. The resulting foreign currency translation adjustments are a component of OCL.
We do not hedge the fluctuation in reported revenue and earnings resulting from the translation of these international operations' results into U.S. dollars. The negative impact of translating our non-U.S. operations’ revenue into U.S. dollars of approximately $25 and $105 was not material to our results of operations for the three- and six-month periods ended July 3, 2016. In addition, the effect of changes in foreign exchange rates on non-U.S. cash balances was not material in the first six months of 2016.

L. COMMITMENTS AND CONTINGENCIES
Litigation
In 2015, Electric Boat Corporation, a subsidiary of General Dynamics Corporation, received a Civil Investigative Demand from the U.S. Department of Justice regarding an investigation of potential False Claims Act violations relating to alleged failures of Electric Boat’s quality system with respect to allegedly non-conforming parts purchased from a supplier. In 2016, Electric Boat was made aware that it is a defendant in a lawsuit related to this matter filed under seal in U.S. district court. In May 2016, the Suspending and

18


Debarring Official for the U.S. Department of the Navy issued a Show Cause Letter to Electric Boat requesting that Electric Boat respond to the official’s concerns regarding Electric Boat’s oversight and management with respect to its quality assurance systems for subcontractors and suppliers. Electric Boat responded to the Show Cause Letter and has been engaged in discussions with the official. Given the current status of these matters, we are unable to express a view regarding the ultimate outcome or, if the outcome is adverse, to estimate an amount or range of reasonably possible loss. Depending on the outcome of these matters, there could be a material impact on our results of operations, financial condition and cash flows.
Additionally, various other claims and legal proceedings incidental to the normal course of business are pending or threatened against us. These other matters relate to such issues as government investigations and claims, the protection of the environment, asbestos-related claims and employee-related matters. The nature of litigation is such that we cannot predict the outcome of these other matters. However, based on information currently available, we believe any potential liabilities in these other proceedings, individually or in the aggregate, will not have a material impact on our results of operations, financial condition or cash flows.
Environmental
We are subject to and affected by a variety of federal, state, local and foreign environmental laws and regulations. We are directly or indirectly involved in environmental investigations or remediation at some of our current and former facilities and third-party sites that we do not own but where we have been designated a Potentially Responsible Party (PRP) by the U.S. Environmental Protection Agency or a state environmental agency. Based on historical experience, we expect a significant percentage of the total remediation and compliance costs associated with these facilities will continue to be allowable contract costs and, therefore, recoverable under U.S. government contracts.
As required, we provide financial assurance for certain sites undergoing or subject to investigation or remediation. We accrue environmental costs when it is probable that a liability has been incurred and the amount can be reasonably estimated. Where applicable, we seek insurance recovery for costs related to environmental liabilities. We do not record insurance recoveries before collection is considered probable. Based on all known facts and analyses, we do not believe that our liability at any individual site, or in the aggregate, arising from such environmental conditions, will be material to our results of operations, financial condition or cash flows. We also do not believe that the range of reasonably possible additional loss beyond what has been recorded would be material to our results of operations, financial condition or cash flows.
Other
Government Contracts. As a government contractor, we are subject to U.S. government audits and investigations relating to our operations, including claims for fines, penalties, and compensatory and treble damages. We believe the outcome of such ongoing government audits and investigations will not have a material impact on our results of operations, financial condition or cash flows.
In the performance of our contracts, we routinely request contract modifications that require additional funding from the customer. Most often, these requests are due to customer-directed changes in the scope of work. While we are entitled to recovery of these costs under our contracts, the administrative process with our customer may be protracted. Based on the circumstances, we periodically file requests for equitable adjustment (REAs) that are sometimes converted into claims. In some cases, these requests are disputed by our customer. We believe our outstanding modifications, REAs and claims will be resolved without material impact to our results of operations, financial condition or cash flows.
Letters of Credit and Guarantees. In the ordinary course of business, we have entered into letters of credit, bank guarantees, surety bonds and other similar arrangements with financial institutions and insurance carriers totaling approximately $1 billion on July 3, 2016. In addition, from time to time and in the ordinary

19


course of business, we contractually guarantee the payment or performance obligations of our subsidiaries arising under certain contracts.
Aircraft Trade-ins. In connection with orders for new aircraft in funded contract backlog, our Aerospace group has outstanding options with some customers to trade in aircraft as partial consideration in their new-aircraft transaction. These trade-in commitments are structured to establish the fair market value of the trade-in aircraft at a date generally 45 or fewer days preceding delivery of the new aircraft to the customer. At that time, the customer is required to either exercise the option or allow its expiration. Any excess of the pre-established trade-in price above the fair market value at the time the new outfitted aircraft is delivered is treated as a reduction of revenue in the new-aircraft sales transaction.
Product Warranties. We provide warranties to our customers associated with certain product sales. We record estimated warranty costs in the period in which the related products are delivered. The warranty liability recorded at each balance sheet date is based generally on the number of months of warranty coverage remaining for the products delivered and the average historical monthly warranty payments. Warranty obligations incurred in connection with long-term production contracts are accounted for within the contract estimates at completion. Our other warranty obligations, primarily for business-jet aircraft, are included in other current and noncurrent liabilities on the Consolidated Balance Sheet.
The changes in the carrying amount of warranty liabilities for the six-month periods ended July 3, 2016, and July 5, 2015, were as follows:
Six Months Ended
July 3, 2016
 
July 5, 2015
Beginning balance
$
465

 
$
428

Warranty expense
55

 
68

Payments
(42
)
 
(58
)
Adjustments
(1
)
 
—

Ending balance
$
477

 
$
438


M. RETIREMENT PLANS
We provide defined-contribution benefits to eligible employees, as well as some defined-benefit pension and other post-retirement benefits.
Net periodic defined-benefit pension and other post-retirement benefit cost for the three- and six-month periods ended July 3, 2016, and July 5, 2015, consisted of the following:
 
Pension Benefits
Other Post-retirement Benefits
Three Months Ended
July 3, 2016
 
July 5, 2015
July 3, 2016
 
July 5, 2015
Service cost
$
44

 
$
57

$
2

 
$
3

Interest cost
114

 
133

9

 
11

Expected return on plan assets
(178
)
 
(174
)
(8
)
 
(8
)
Recognized net actuarial loss (gain)
84

 
109

(1
)
 
1

Amortization of prior service credit
(17
)
 
(17
)
(1
)
 
(1
)
Net periodic benefit cost
$
47

 
$
108

$
1

 
$
6


20


 
Pension Benefits
Other Post-retirement Benefits
Six Months Ended
July 3, 2016
 
July 5, 2015
July 3, 2016
 
July 5, 2015
Service cost
$
88

 
$
114

$
5

 
$
6

Interest cost
228

 
266

17

 
22

Expected return on plan assets
(356
)
 
(348
)
(16
)
 
(16
)
Recognized net actuarial loss (gain)
168

 
219

(2
)
 
3

Amortization of prior service credit
(34
)
 
(34
)
(3
)
 
(2
)
Net periodic benefit cost
$
94

 
$
217

$
1

 
$
13

Beginning in 2016, we refined the method used to determine the service and interest cost components of our net periodic benefit cost. Previously, the cost was determined using a single weighted-average discount rate derived from a yield curve developed from a portfolio of high-quality fixed-income investments with maturities consistent with the projected benefit payout period. Under the refined method, known as the spot rate approach, we use individual spot rates along the yield curve that correspond with the timing of each benefit payment. We believe this change provides a more precise measurement of service and interest costs by improving the correlation between projected cash outflows and corresponding spot rates on the yield curve. Compared to the previous method the spot rate approach decreased the service and interest components of our benefit costs slightly in 2016. We accounted for this change prospectively as a change in accounting estimate.
Our contractual arrangements with the U.S. government provide for the recovery of contributions to our pension and other post-retirement benefit plans covering employees working in our defense business groups. For non-funded plans, our government contracts allow us to recover claims paid. Following payment, these recoverable amounts are allocated to contracts and billed to the customer in accordance with the Cost Accounting Standards (CAS) and specific contractual terms. For some of these plans, the cumulative pension and post-retirement benefit cost exceeds the amount currently allocable to contracts. To the extent recovery of the cost is considered probable based on our backlog and probable follow-on contracts, we defer the excess in contracts in process on the Consolidated Balance Sheet until the cost is allocable to contracts. See Note F for discussion of our deferred contract costs. For other plans, the amount allocated to contracts and included in revenue has exceeded the plans’ cumulative benefit cost. We have deferred recognition of these excess earnings to provide a better matching of revenue and expenses. These deferrals have been classified against the plan assets on the Consolidated Balance Sheet.

N. BUSINESS GROUP INFORMATION
We operate in four business groups: Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. We organize our business groups in accordance with the nature of products and services offered. We measure each group’s profitability based on operating earnings. As a result, we do not allocate net interest, other income and expense items, and income taxes to our business groups.

21


Summary financial information for each of our business groups follows:
 
Revenue
Operating Earnings
Three Months Ended
July 3, 2016
July 5, 2015
July 3, 2016
July 5, 2015
Aerospace
$
2,134

$
2,258

$
434

$
439

Combat Systems
1,315

1,408

219

226

Information Systems and Technology
2,229

2,215

244

237

Marine Systems
1,987

2,001

181

187

Corporate*
—

—

(8
)
(8
)
Total
$
7,665

$
7,882

$
1,070

$
1,081

Six Months Ended
July 3, 2016
July 5, 2015
July 3, 2016
July 5, 2015
Aerospace
$
4,121

$
4,366

$
845

$
870

Combat Systems
2,588

2,771

436

430

Information Systems and Technology
4,562

4,585

492

454

Marine Systems
4,118

3,944

373

375

Corporate*
—

—

(23
)
(21
)
Total
$
15,389

$
15,666

$
2,123

$
2,108

* Corporate operating results consist primarily of stock option expense.



22


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

CONDENSED CONSOLIDATING STATEMENTS OF EARNINGS (UNAUDITED)

Three Months Ended July 3, 2016
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
Revenue
$
—

$
6,693

$
972

$
—

$
7,665

Cost of sales
(2
)
5,360

751

—

6,109

G&A
9

403

74

—

486

Operating earnings
(7
)
930

147

—

1,070

Interest, net
(23
)
—

—

—

(23
)
Other, net
1

—

—

—

1

Earnings before income tax
(29
)
930

147

—

1,048

Provision for income tax, net
(39
)
300

29

—

290

Equity in net earnings of subsidiaries
748

—

—

(748
)
—

Net earnings
$
758

$
630

$
118

$
(748
)
$
758

Comprehensive income
$
734

$
624

$
70

$
(694
)
$
734

Three Months Ended July 5, 2015
 
 
 
 
 
Revenue
$
—

$
6,883

$
999

$
—

$
7,882

Cost of sales
(4
)
5,574

764

—

6,334

G&A
12

381

74

—

467

Operating earnings
(8
)
928

161

—

1,081

Interest, net
(20
)
(2
)
2

—

(20
)
Earnings before income tax
(28
)
926

163

—

1,061

Provision for income tax, net
(16
)
298

27

—

309

Equity in net earnings of subsidiaries
764

—

—

(764
)
—

Net earnings
$
752

$
628

$
136

$
(764
)
$
752

Comprehensive income
$
876

$
631

$
198

$
(829
)
$
876



23


CONDENSED CONSOLIDATING STATEMENTS OF EARNINGS (UNAUDITED)
Six Months Ended July 3, 2016
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
Revenue
$
—

$
13,509

$
1,880

$
—

$
15,389

Cost of sales
2

10,870

1,448

—

12,320

G&A
20

781

145

—

946

Operating earnings
(22
)
1,858

287

—

2,123

Interest, net
(46
)
—

1

—

(45
)
Other, net
10

1

—

—

11

Earnings before income tax
(58
)
1,859

288

—

2,089

Provision for income tax, net
(51
)
597

55

—

601

Discontinued operations
(13
)
—

—

—

(13
)
Equity in net earnings of subsidiaries
1,495

—

—

(1,495
)
—

Net earnings
$
1,475

$
1,262

$
233

$
(1,495
)
$
1,475

Comprehensive income
$
1,796

$
1,257

$
499

$
(1,756
)
$
1,796

Six Months Ended July 5, 2015
 
 
 
 
 
Revenue
$
—

$
13,651

$
2,015

$
—

$
15,666

Cost of sales
(3
)
11,036

1,555

—

12,588

G&A
24

797

149

—

970

Operating earnings
(21
)
1,818

311

—

2,108

Interest, net
(43
)
(1
)
3

—

(41
)
Other, net
1

2

—

—

3

Earnings before income tax
(63
)
1,819

314

—

2,070

Provision for income tax, net
(41
)
588

55

—

602

Equity in net earnings of subsidiaries
1,490

—

—

(1,490
)
—

Net earnings
$
1,468

$
1,231

$
259

$
(1,490
)
$
1,468

Comprehensive income
$
1,308

$
1,237

$
(26
)
$
(1,211
)
$
1,308




24


CONDENSED CONSOLIDATING BALANCE SHEET (UNAUDITED)

July 3, 2016
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
ASSETS
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and equivalents
$
1,011

$
—

$
888

$
—

$
1,899

Accounts receivable
—

1,248

2,291

—

3,539

Contracts in process
409

3,109

1,478

—

4,996

Inventories
 
 
 
 
 
Work in process
—

2,066

13

—

2,079

Raw materials
—

1,298

37

—

1,335

Finished goods
—

21

5

—

26

Pre-owned aircraft
—

80

—

—

80

Other current assets
44

196

192

—

432

Total current assets
1,464

8,018

4,904

—

14,386

Noncurrent assets:
 
 
 
 
 
Property, plant and equipment (PP&E)
193

6,420

1,158

—

7,771

Accumulated depreciation of PP&E
(63
)
(3,546
)
(722
)
—

(4,331
)
Intangible assets
—

1,447

929

—

2,376

Accumulated amortization of intangible assets
—

(1,159
)
(484
)
—

(1,643
)
Goodwill
—

8,046

3,526

—

11,572

Other assets
1,236

239

163

—

1,638

Investment in subsidiaries
41,865

—

—

(41,865
)
—

Total noncurrent assets
43,231

11,447

4,570

(41,865
)
17,383

Total assets
$
44,695

$
19,465

$
9,474

$
(41,865
)
$
31,769

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Short-term debt
$
500

$
1

$
36

$
—

$
537

Customer advances and deposits
—

2,748

2,617

—

5,365

Other current liabilities
1,377

3,468

1,388

—

6,233

Total current liabilities
1,877

6,217

4,041

—

12,135

Noncurrent liabilities:
 
 
 
 
 
Long-term debt
2,876

23

—

—

2,899

Other liabilities
3,276

1,952

512

—

5,740

Total noncurrent liabilities
6,152

1,975

512

—

8,639

Intercompany
25,671

(24,364
)
(1,307
)
—

—

Shareholders' equity:
 
 
 
 
 
Common stock
482

6

2,354

(2,360
)
482

Other shareholders' equity
10,513

35,631

3,874

(39,505
)
10,513

Total shareholders' equity
10,995

35,637

6,228

(41,865
)
10,995

Total liabilities and shareholders' equity
$
44,695

$
19,465

$
9,474

$
(41,865
)
$
31,769



25


CONDENSED CONSOLIDATING BALANCE SHEET

December 31, 2015
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
ASSETS
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and equivalents
$
1,732

$
—

$
1,053

$
—

$
2,785

Accounts receivable
—

1,181

2,265

—

3,446

Contracts in process
514

2,795

1,048

—

4,357

Inventories
 
 
 
 
 
Work in process
—

1,882

7

—

1,889

Raw materials
—

1,344

32

—

1,376

Finished goods
—

23

5

—

28

Pre-owned aircraft
—

73

—

—

73

Other current assets
140

213

264

—

617

Total current assets
2,386

7,511

4,674

—

14,571

Noncurrent assets:
 
 
 
 
 
PP&E
189

6,386

1,101

—

7,676

Accumulated depreciation of PP&E
(59
)
(3,462
)
(689
)
—

(4,210
)
Intangible assets
—

1,445

909

—

2,354

Accumulated amortization of intangible assets
—

(1,122
)
(469
)
—

(1,591
)
Goodwill
—

8,040

3,403

—

11,443

Other assets
1,379

207

168

—

1,754

Investment in subsidiaries
40,062

—

—

(40,062
)
—

Total noncurrent assets
41,571

11,494

4,423

(40,062
)
17,426

Total assets
$
43,957

$
19,005

$
9,097

$
(40,062
)
$
31,997

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Short-term debt
$
500

$
1

$
—

$
—

$
501

Customer advances and deposits
—

3,038

2,636

—

5,674

Other current liabilities
1,331

3,309

1,630

—

6,270

Total current liabilities
1,831

6,348

4,266

—

12,445

Noncurrent liabilities:
 
 
 
 
 
Long-term debt
2,874

24

—

—

2,898

Other liabilities
3,417

2,021

478

—

5,916

Total noncurrent liabilities
6,291

2,045

478

—

8,814

Intercompany
25,097

(23,816
)
(1,281
)
—

—

Shareholders' equity:
 
 
 
 
 
Common stock
482

6

2,354

(2,360
)
482

Other shareholders' equity
10,256

34,422

3,280

(37,702
)
10,256

Total shareholders' equity
10,738

34,428

5,634

(40,062
)
10,738

Total liabilities and shareholders' equity
$
43,957

$
19,005

$
9,097

$
(40,062
)
$
31,997



26


CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (UNAUDITED)

Six Months Ended July 3, 2016
Parent
Guarantors
on a
Combined
Basis
Other
Subsidiaries
on a
Combined
Basis
Consolidating
Adjustments
Total
Consolidated
Net cash provided by operating activities*
$
280

$
399

$
194

$
—

$
873

Cash flows from investing activities:
 
 
 
 
 
Capital expenditures
(3
)
(111
)
(20
)
—

(134
)
Other, net
1

(15
)
(37
)
—

(51
)
Net cash used by investing activities
(2
)
(126
)
(57
)
—

(185
)
Cash flows from financing activities:
 
 
 
 
 
Purchases of common stock
(1,189
)
—

—

—

(1,189
)
Dividends paid
(447
)
—

—

—

(447
)
Proceeds from stock option exercises
92

—

—

—

92

Other, net
(31
)
(1
)
36

—

4

Net cash used by financing activities
(1,575
)
(1
)
36

—

(1,540
)
Net cash used by discontinued operations
(34
)
—

—

—

(34
)
Cash sweep/funding by parent
610

(272
)
(338
)
—

—

Net decrease in cash and equivalents
(721
)
—

(165
)
—

(886
)
Cash and equivalents at beginning of period
1,732

—

1,053

—

2,785

Cash and equivalents at end of period
$
1,011

$
—

$
888

$
—

$
1,899

Six Months Ended July 5, 2015
 
 
 
 
 
Net cash provided by operating activities*
$
103

$
1,133

$
197

$
—

$
1,433

Cash flows from investing activities:
 
 
 
 
 
Maturities of held-to-maturity securities
500

—

—

—

500

Proceeds from sales of assets
162

97

—

—

259

Capital expenditures
(2
)
(180
)
(8
)
—

(190
)
Other, net
2

(20
)
—

—

(18
)
Net cash provided by investing activities
662

(103
)
(8
)
—

551

Cash flows from financing activities:
 
 
 
 

Purchases of common stock
(1,565
)
—

—

—

(1,565
)
Repayment of fixed-rate notes
(500
)
—

—

—

(500
)
Dividends paid
(432
)
—

—

—

(432
)
Proceeds from stock option exercises
198

—

—

—

198

Other, net
(28
)
3

—

—

(25
)
Net cash used by financing activities
(2,327
)
3

—

—

(2,324
)
Net cash used by discontinued operations
(16
)
—

—

—

(16
)
Cash sweep/funding by parent
1,338

(1,033
)
(305
)
—

—

Net increase in cash and equivalents
(240
)
—

(116
)
—

(356
)
Cash and equivalents at beginning of period
2,536

—

1,852

—

4,388

Cash and equivalents at end of period
$
2,296

$
—

$
1,736

$
—

$
4,032

* Continuing operations only.

27


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

BUSINESS OVERVIEW
General Dynamics is a global aerospace and defense company that offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; C4ISR (command, control, communications, computers, intelligence, surveillance and reconnaissance) solutions and information technology (IT) services; and shipbuilding. We operate through four business groups: Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. Our primary customer is the U.S. government, including the Department of Defense, the intelligence community and other U.S. government customers. We also have significant business with non-U.S. governments and a diverse base of corporate and individual buyers of business-jet aircraft. The following discussion should be read in conjunction with our 2015 Annual Report on Form 10-K and with the unaudited Consolidated Financial Statements included in this Form 10-Q.

RESULTS OF OPERATIONS
INTRODUCTION
An understanding of our accounting practices is important to evaluate our financial statements and operating results. We recognize the majority of our revenue using the percentage-of-completion method of accounting. The following paragraphs explain how this method is applied in recognizing revenue and operating costs in our business groups.
In the Aerospace group, contracts for new aircraft have two major phases: the manufacture of the “green” aircraft and the aircraft’s outfitting, which includes exterior painting and installation of customer-selected interiors. We record revenue on these contracts at the completion of these two phases: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the outfitted aircraft. We do 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 significant deposits from the customer and other factors. Revenue associated with the group’s completions of other original equipment manufacturers' (OEMs) aircraft and the group's services businesses are recognized as work progresses or upon delivery of services. Fluctuations in revenue from period to period result from the number and mix of new aircraft deliveries (green and outfitted), progress on aircraft completions and the level of aircraft service activity during the period.
The majority of the Aerospace group’s operating costs relates to new aircraft production on firm orders and consists of labor, material, subcontractor and overhead costs. The costs are accumulated in production lots, recorded in inventory and recognized as operating costs at green aircraft delivery based on the estimated average unit cost in a production lot. While changes in the estimated average unit cost for a production lot impact the level of operating costs, the amount of operating costs reported in a given period is based largely on the number and type of aircraft delivered. Operating costs in the Aerospace group’s completions and services businesses are recognized generally as incurred.
For new aircraft, operating earnings and margin are a function of the prices of our aircraft, our operational efficiency in manufacturing and outfitting the aircraft and the mix of higher-margin large-cabin and lower-

28


margin mid-cabin aircraft deliveries. Additional factors affecting the group’s earnings and margin include the volume, mix and profitability of completions and services work performed, the volume of and market for pre-owned aircraft and the level of general and administrative (G&A) and net research and development (R&D) costs incurred by the group.
In the three defense groups, revenue on long-term government contracts is recognized as work progresses, as either products are produced or services are rendered. As a result, variations in revenue are discussed generally in terms of volume, typically measured by the level of activity on individual contracts or programs. Year-over-year variances attributed to volume are due to changes in production or service levels and delivery schedules.
Operating costs for the defense groups consist of labor, material, subcontractor, overhead and G&A costs and are recognized generally as incurred. Variances in costs recognized from period to period reflect primarily increases and decreases in production or activity levels on individual contracts and, therefore, result largely from the same factors that drive variances in revenue.
Operating earnings and margin in the defense groups are driven by changes in volume, performance or contract mix. Performance refers to changes in profitability based on adjustments to estimates at completion on individual contracts. These adjustments result from increases or decreases to the estimated value of the contract, the estimated costs to complete or both. Therefore, changes in costs incurred in the period compared with prior periods do not necessarily impact profitability. It is only when total estimated costs at completion on a given contract change without a corresponding change in the contract value that the profitability of that contract may be impacted. Contract mix refers to changes in the volume of higher- vs. lower-margin work. Additionally, higher or lower margins can be inherent in the contract type (e.g., fixed-price/cost-reimbursable) or type of work (e.g., development/production).
CONSOLIDATED OVERVIEW
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
7,665

 
$
7,882

 
$
(217
)
 
(2.8
)%
Operating costs and expenses
6,595

 
6,801

 
(206
)
 
(3.0
)%
Operating earnings
1,070

 
1,081

 
(11
)
 
(1.0
)%
Operating margin
14.0
%
 
13.7
%
 
 
 
 
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
15,389

 
$
15,666

 
$
(277
)
 
(1.8
)%
Operating costs and expenses
13,266

 
13,558

 
(292
)
 
(2.2
)%
Operating earnings
2,123

 
2,108

 
15

 
0.7
 %
Operating margin
13.8
%
 
13.5
%
 
 
 
 
Our consolidated results for the second quarter of 2016 reflected superb operating performance, with operating earnings over $1 billion for the seventh consecutive quarter and record-high operating margins of 14 percent and 13.8 percent in the second quarter and first six months of 2016, respectively.
Revenue was lower in the second quarter and first six months of 2016 driven primarily by decreased volume in our Aerospace and Combat Systems groups. These decreases were offset partially by higher U.S. Navy ship construction and engineering work in our Marine Systems group.
For both periods, operating costs and expenses decreased at a greater rate than revenue, continuing a trend of operating margin growth compared with the prior-year periods. After excluding the effect of a $23

29


non-recurring gain on the sale of a business in the second quarter of 2015, operating margins increased 60 basis points and 50 basis points in the second quarter and first six months of 2016, respectively. This margin expansion was due to improved performance and continued cost reduction efforts in the Aerospace, Combat Systems, and Information Systems and Technology groups.

REVIEW OF BUSINESS GROUPS
Following is a discussion of operating results and outlook for each of our business groups. For the Aerospace group, results are analyzed for specific types of products and services, consistent with how the group is managed. For the defense groups, the discussion is based on the lines of products and services each group offers with a supplemental discussion of specific contracts and programs when significant to the group's results. Additional information regarding our business groups can be found in Note N to the unaudited Consolidated Financial Statements in Item 1.
AEROSPACE
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
2,134

 
$
2,258

 
$
(124
)
 
(5.5
)%
Operating earnings
434

 
439

 
(5
)
 
(1.1
)%
Operating margin
20.3
%
 
19.4
%
 
 
 
 
 
 
 
 
 
 
 
 
Gulfstream aircraft deliveries (in units):
 
 
 
 
 
 
 
Green
31

 
36
 
(5
)
 
(13.9
)%
Outfitted
34

 
41
 
(7
)
 
(17.1
)%
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
4,121

 
$
4,366

 
$
(245
)
 
(5.6
)%
Operating earnings
845

 
870

 
(25
)
 
(2.9
)%
Operating margin
20.5
%
 
19.9
%
 
 
 
 
 
 
 
 
 
 
 
 
Gulfstream aircraft deliveries (in units):
 
 
 
 
 
 
 
Green
62

 
70
 
(8
)
 
(11.4
)%
Outfitted
61

 
73
 
(12
)
 
(16.4
)%
Operating Results
The change in the Aerospace group's revenue in the second quarter and first six months of 2016 consisted of the following:
 
Second Quarter
 
Six Months
Aircraft manufacturing, outfitting and completions
$
(135
)
 
$
(255
)
Aircraft services
37

 
41

Pre-owned aircraft
(26
)
 
(31
)
Total decrease
$
(124
)
 
$
(245
)
Aircraft manufacturing, outfitting and completions revenue decreased in the second quarter and first six months of 2016 due primarily to fewer planned deliveries of G550 and G450 large-cabin aircraft, offset partially by additional deliveries of the ultra-large-cabin G650 aircraft. Aircraft services revenue increased in 2016, driven by higher demand for maintenance and customization work. While we sold the same number

30


of pre-owned aircraft in the second quarter and first six months of 2016 compared to the prior-year periods, the type of aircraft sold in 2016 resulted in lower pre-owned aircraft revenue.
The change in the group's operating earnings in the second quarter and first six months of 2016 consisted of the following:
 
Second Quarter
 
Six Months
Aircraft manufacturing, outfitting and completions
$
(5
)
 
$
(60
)
Aircraft services
19

 
38

Pre-owned aircraft
(4
)
 
(6
)
G&A/other expenses
(15
)
 
3

Total decrease
$
(5
)
 
$
(25
)
Operating margin in the Aerospace group increased 90 basis points in the second quarter and 60 basis points in the first six months of 2016 compared with the prior-year periods, driven primarily by cost savings initiatives and improved operating performance.
Aircraft manufacturing, outfitting and completions earnings were down in the second quarter and first six months of 2016 due to fewer aircraft deliveries and the absence of a supplier settlement received in the first quarter of 2015, offset partially by favorable cost performance. The group’s aircraft services operating earnings have been particularly strong in 2016 due to a favorable mix of work and improved labor efficiencies. In the second quarter of 2016, the group's operating earnings were impacted by slightly higher R&D expenses (included in G&A/other expenses above) associated with ongoing product development efforts.
Outlook
We expect the group's full-year 2016 revenue to be between $8.5 and $8.6 billion with operating margin slightly above 20 percent, resulting in a modest increase in operating earnings from 2015 to 2016.
COMBAT SYSTEMS
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
1,315

 
$
1,408

 
$
(93
)
 
(6.6
)%
Operating earnings
219

 
226

 
(7
)
 
(3.1
)%
Operating margin
16.7
%
 
16.1
%
 
 
 
 
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
2,588

 
$
2,771

 
$
(183
)
 
(6.6
)%
Operating earnings
436

 
430

 
6

 
1.4
 %
Operating margin
16.8
%
 
15.5
%
 
 
 
 
Operating Results
The change in the Combat Systems group's revenue in the second quarter and first six months of 2016 consisted of the following:

31


 
Second Quarter
 
Six Months
International military vehicles
$
(38
)
 
$
(126
)
Weapon systems and munitions
(50
)
 
(50
)
U.S. military vehicles
(5
)
 
(7
)
Total decrease
$
(93
)
 
$
(183
)
Mix shift on our international military vehicle programs drove lower revenue in the second quarter and first six months of 2016 as we transition from engineering to production on major combat-vehicle contracts for customers in the Middle East and Europe and timing of work on the group's contract to upgrade and modernize LAV III combat vehicles for the Canadian Army. Weapon systems and munitions revenues decreased in 2016 due primarily to delays on several products, including Hydra-70 rockets and ammunition for U.S. allies.
Translation of our international businesses' revenue into U.S. dollars in 2016 was affected negatively by foreign currency exchange rate fluctuations, primarily due to the strengthening of the U.S. dollar against the Canadian dollar, continuing a trend we have been experiencing since last year. Had foreign currency exchange rates in the second quarter and first six months of 2016 held constant from the same periods in 2015, revenue in the Combat Systems group in the second quarter and first six months of 2016 would have decreased 5.4 percent and 3.9 percent, respectively, compared with the prior-year periods.
The Combat Systems group's operating margin increased 60 basis points in the second quarter and 130 basis points in the first six months of 2016, driven by a favorable contract mix and improved operating performance across each of our businesses.
Outlook
We expect the Combat Systems group’s full-year revenue to increase slightly in 2016 despite the foreign exchange headwind discussed above. Given the strong operating performance in the first half of 2016, full-year operating margin is expected to expand to approximately 16 percent.
INFORMATION SYSTEMS AND TECHNOLOGY
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
2,229

 
$
2,215

 
$
14

 
0.6
 %
Operating earnings
244

 
237

 
7

 
3.0
 %
Operating margin
10.9
%
 
10.7
%
 
 
 
 
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
4,562

 
$
4,585

 
$
(23
)
 
(0.5
)%
Operating earnings
492

 
454

 
38

 
8.4
 %
Operating margin
10.8
%
 
9.9
%
 
 
 
 
Operating Results
The Information Systems and Technology group's revenue has been essentially steady compared with the second quarter and first six months of 2015. The change in each period consisted of the following:

32


 
Second Quarter
 
Six Months
C4ISR solutions
$
4

 
$
41

IT services
10

 
(64
)
Total increase (decrease)
$
14

 
$
(23
)
C4ISR solutions revenue increased in the second quarter and first six months of 2016 due primarily to higher volume on the Warfighter Information Network-Tactical (WIN-T) mobile communications network program. While revenue increased slightly in the second quarter of 2016 in our IT services business, revenue decreased in the first six months of 2016 driven by lower volume on our health solutions programs, including less contact-center services work for the Centers for Medicare & Medicaid Services.
Operating earnings in the second quarter of 2015 included a gain of $23 on the sale of a commercial cyber security product business. Excluding the impact of this gain on the prior-year periods, the group's operating margin increased 120 basis points and 140 basis points in the second quarter and first six months of 2016, respectively, driven primarily by strong program performance and favorable program mix across our product portfolio. The group continues to realize synergies following the 2015 consolidation of two of our businesses.
Outlook
We expect full-year 2016 revenue in the Information Systems and Technology group to be up slightly from 2015. Full-year operating margin is expected to expand to the mid- to high-10 percent range.
MARINE SYSTEMS
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
1,987

 
$
2,001

 
$
(14
)
 
(0.7
)%
Operating earnings
181

 
187

 
(6
)
 
(3.2
)%
Operating margin
9.1
%
 
9.3
%
 
 
 
 
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
4,118

 
$
3,944

 
$
174

 
4.4
 %
Operating earnings
373

 
375

 
(2
)
 
(0.5
)%
Operating margin
9.1
%
 
9.5
%
 
 
 
 
Operating Results
The change in the Marine Systems group’s revenue in the second quarter and first six months of 2016 consisted of the following:
 
Second Quarter
 
Six Months
U.S. Navy ship construction
$
18

 
$
170

U.S. Navy ship engineering, repair and other services
12

 
66

Commercial ship construction
(44
)
 
(62
)
Total (decrease) increase
$
(14
)
 
$
174

The increase in U.S. Navy ship construction revenue in the second quarter and first six months of 2016 was due to higher volume on Block IV of the Virginia-class submarine program. Revenue from U.S. Navy ship engineering, repair and other services increased in 2016 due primarily to development work on the

33


Ohio-class submarine replacement program. Jones Act commercial ship construction revenue decreased following the delivery of three ships in the first six months of 2016. We have five ships scheduled for delivery through 2017.
Operating margin decreased 20 basis points in the second quarter and 40 basis points in the first six months of 2016 due to contract mix, reflecting a shift in workload from a mature prior-year Expeditionary Mobile Base (ESB) ship that was replaced by commercial ship work.
Outlook
We expect the Marine Systems group’s full-year 2016 revenue to be somewhat higher compared with 2015. We expect the group's operating margin to be in the low-9 percent range.
CORPORATE
Corporate results consist primarily of compensation expense for stock options. Corporate costs totaled $8 in the second quarter of 2016 and 2015, and $23 in the first six months of 2016 compared with $21 in the 2015 period. We expect full-year 2016 Corporate operating costs of approximately $40.

OTHER INFORMATION
PRODUCT REVENUE AND OPERATING COSTS
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
4,848

 
$
5,138

 
$
(290
)
 
(5.6
)%
Operating costs
3,747

 
4,031

 
(284
)
 
(7.0
)%
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
9,712

 
$
10,070

 
$
(358
)
 
(3.6
)%
Operating costs
7,530

 
7,850

 
(320
)
 
(4.1
)%
The change in product revenue in the second quarter and first six months of 2016 consisted of the following:
 
Second Quarter
 
Six Months
Aircraft manufacturing, outfitting and completions
$
(130
)
 
$
(254
)
Military vehicle products
(74
)
 
(216
)
Ship construction
(28
)
 
95

Other, net
(58
)
 
17

Total decrease
$
(290
)
 
$
(358
)
Product revenue decreased in the second quarter and first six months of 2016 due primarily to fewer large-cabin aircraft deliveries and the transition from engineering to production on major combat-vehicle contracts for customers in the Middle East and Europe. These decreases were offset partially in the first six months of 2016 by an increase in ship construction revenue due primarily to higher volume on Block IV of the Virginia-class submarine program.
Product operating costs decreased in the second quarter and first six months of 2016 consistent with the lower volume on the programs described above.

34


SERVICE REVENUE AND OPERATING COSTS
Three Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
2,817

 
$
2,744

 
$
73

 
2.7
%
Operating costs
2,362

 
2,303

 
59

 
2.6
%
Six Months Ended
July 3, 2016
 
July 5, 2015
 
Variance
Revenue
$
5,677

 
$
5,596

 
$
81

 
1.4
%
Operating costs
4,790

 
4,738

 
52

 
1.1
%
The increase in service revenue in the second quarter and first six months of 2016 consisted of the following:
 
Second Quarter
 
Six Months
Military vehicle services
$
31

 
$
82

Ship engineering, repair and other services
14

 
79

Aircraft services
32

 
41

IT services
(21
)
 
(140
)
Other, net
17

 
19

Total increase
$
73

 
$
81

Service revenue increased in the second quarter and first six months of 2016 despite a decrease in IT services revenue due primarily to lower volume on our health solutions programs. The increase in service revenue was driven by higher volume of support services for our major military vehicle production programs and increased development work on the Ohio-class submarine replacement program. Aircraft services revenue increased due to higher demand for maintenance and customization work.
Service operating costs increased in the second quarter and first six months of 2016 consistent with the higher volume on the programs described above.
OTHER FINANCIAL INFORMATION
G&A Expenses
As a percentage of revenue, G&A expenses were 6.1 percent and 6.2 percent in the first six months of 2016 and 2015, respectively. We expect full-year G&A expenses in 2016 to be generally consistent with 2015.
Interest, Net
Net interest expense was $45 in the first six months of 2016 compared with $41 in the same period in 2015. We expect full-year 2016 net interest expense to be approximately $95.
Provision for Income Tax, Net
Our effective tax rate was 28.8 percent in the first six months of 2016 compared with 29.1 percent in the prior-year period. The effective tax rate in 2016 has been favorably impacted by the adoption of Accounting Standards Update (ASU) 2016-09. For further discussion of the adoption of ASU 2016-09, see Note A to the unaudited Consolidated Financial Statements in Part I, Item 1. The effective tax rate in 2015 included the impact of favorable contract close-outs. For 2016, we anticipate the full-year effective tax rate to be approximately 29 percent.

35


Discontinued Operations, Net of Tax
In the first quarter of 2016, we recognized a final adjustment of $13 to the loss on the sale of our axle business in the Combat Systems group. The business was sold in 2015.

BACKLOG AND ESTIMATED POTENTIAL CONTRACT VALUE
Our total backlog, including funded and unfunded portions, was $63.2 billion at the end of the second quarter of 2016, down 2.3 percent from $64.7 billion on April 3, 2016. Our total estimated contract value, which combines total backlog with estimated potential contract value, was $89.1 billion on July 3, 2016, essentially unchanged from the prior quarter.
Estimated potential contract value includes work awarded on unfunded indefinite delivery, indefinite quantity (IDIQ) contracts or unexercised options associated with existing firm contracts. Contract options in our defense business represent agreements to perform additional work under existing contracts at the election of the customer. The actual amount of funding received in the future may be higher or lower than our estimate of potential contract value. We recognize options in backlog when the customer exercises the option and establishes a firm order. In the Aerospace group, estimated potential contract value represents primarily options to purchase new aircraft and long-term agreements with fleet customers.
The following table details the backlog and the estimated potential contract value of each business group at the end of the second and first quarters of 2016:
 
Funded
 
Unfunded
 
Total Backlog
 
Estimated Potential Contract Value
 
Total Estimated Contract Value
 
July 3, 2016
Aerospace
$
11,629

 
$
126

 
$
11,755

 
$
2,221

 
$
13,976

Combat Systems
18,032

 
478

 
18,510

 
4,812

 
23,322

Information Systems and Technology
7,508

 
2,292

 
9,800

 
14,560

 
24,360

Marine Systems
15,908

 
7,260

 
23,168

 
4,237

 
27,405

Total
$
53,077

 
$
10,156

 
$
63,233

 
$
25,830

 
$
89,063

 
 
 
 
 
 
 
 
 
 
 
April 3, 2016
Aerospace
$
12,465

 
$
147

 
$
12,612

 
$
2,368

 
$
14,980

Combat Systems
18,260

 
565

 
18,825

 
4,959

 
23,784

Information Systems and Technology
7,442

 
1,991

 
9,433

 
15,146

 
24,579

Marine Systems
16,547

 
7,317

 
23,864

 
1,999

 
25,863

Total
$
54,714

 
$
10,020

 
$
64,734

 
$
24,472

 
$
89,206


AEROSPACE
Aerospace funded backlog represents aircraft and custom completion orders for which we have definitive purchase contracts and deposits from customers. Unfunded backlog consists of agreements to provide future aircraft maintenance and support services.

36


The group ended the second quarter of 2016 with backlog of $11.8 billion compared with $12.6 billion on April 3, 2016. Demand in the Aerospace group continues to be healthy and we received orders for Gulfstream aircraft across our product portfolio in the second quarter of 2016.

DEFENSE GROUPS
The total backlog in our three defense groups represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are similarly approved and funded by their governments. We have included in total backlog firm contracts at the amounts that we believe we are likely to receive funding, but there is no guarantee that future budgets and appropriations will provide the funding necessary for a given program.
Total backlog in our defense groups was $51.5 billion on July 3, 2016, down slightly from $52.1 billion on April 3, 2016. The book-to-bill ratio (orders divided by revenue) in our Information Systems and Technology group exceeded one-to-one in the second quarter of 2016, continuing a trend of book-to-bill in the group equal to or greater than one-to-one in eight of the last 10 quarters. Backlog decreased slightly in Combat Systems and Marine Systems as these groups perform on major multi-year contracts. Estimated potential contract value was $23.6 billion on July 3, 2016, up over 6 percent compared with $22.1 billion on April 3, 2016. Each of our defense groups received notable contract awards during the second quarter of 2016.
Combat Systems awards included the following:
•
$250 from the U.S. Army for the production of Stryker vehicles with an integrated 30-millimeter gun system.
Information Systems and Technology awards included the following:
•
$630 from the Centers for Medicare & Medicaid Services for contact-center services.
•
$215 from the U.S. Department of State to provide supply chain management services.
•
$135 from the Army for ruggedized computing equipment under the Common Hardware Systems-4 (CHS-4) program.
•
$90 from the Army's Information Technology Agency to operate and maintain network infrastructure.
Marine Systems awards included the following:
•
$640 from the U.S. Navy to design and construct the lead ship in the next generation of fleet oilers, the John Lewis class (TAO-205). Options for five additional ships are included in our estimated potential contract value.
•
$165 from the Navy for lead yard and design services for the Virginia-class submarine program.
•
$105 from the Navy to procure long-lead-time material and engineering support for the fifth ESB ship.
•
$55 from the Navy for design work on the Ohio-class submarine replacement program.


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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
We ended the second quarter of 2016 with a cash balance of $1.9 billion, down $886 from the end of 2015. Our net debt position, defined as cash and equivalents and marketable securities less debt, was $1.5 billion at the end of the second quarter of 2016 compared with $614 at the end of 2015. The following is a discussion of our major operating, investing and financing activities, as classified on the unaudited Consolidated Statements of Cash Flows, in the first six months of 2016 and 2015.
OPERATING ACTIVITIES
We generated cash from operating activities of $873 in the first six months of 2016 compared with $1.4 billion in the same period in 2015. The primary driver of cash flows in both periods was net earnings. As expected, cash flows in the first six months of 2016 were negatively affected by the utilization of significant customer deposits related to a large contract for a Middle Eastern customer in our Combat Systems group and growth in operating working capital in our Aerospace group from the build-up of inventory related to the new G500 and G600 aircraft programs.
INVESTING ACTIVITIES
Cash used by investing activities was $185 in the first six months of 2016 compared with cash provided by investing activities of $551 in the same period in 2015. The primary use of cash for investing activities in both periods was capital expenditures. We expect capital expenditures of approximately 2 percent of revenue in 2016. Other investing activities included cash paid for business acquisitions, maturities of marketable securities and proceeds from asset sales. Cash provided by investing activities in 2015 included proceeds from divestitures and $500 of proceeds from maturing marketable securities.
FINANCING ACTIVITIES
Cash used for financing activities was $1.5 billion in the first six months of 2016 compared with $2.3 billion in the same period in 2015. Our financing activities include repurchases of common stock, payment of dividends and debt repayments. Net cash from financing activities also include proceeds received from stock option exercises.
In the first six months of 2016, we repurchased approximately 8.9 million of our outstanding shares for $1.2 billion. On March 2, 2016, the board of directors authorized management to repurchase up to 10 million additional shares of common stock on the open market. On July 3, 2016, 10.7 million shares remained authorized by our board of directors for repurchase, approximately 4 percent of our total shares outstanding. We repurchased 12.1 million shares for a total of $1.7 billion in the first six months of 2015.
On March 2, 2016, our board of directors declared an increased quarterly dividend of $0.76 per share, the 19th consecutive annual increase. The board had previously increased the quarterly dividend to $0.69 per share in March 2015. Cash dividends paid were $447 in the first six months of 2016 compared with $432 in the same period in 2015.
In the first six months of 2015, we repaid $500 of fixed-rate notes on their scheduled maturity date with the proceeds from the maturing marketable securities discussed in Investing Activities.
In July 2016, subsequent to the end of the quarter, we repaid $500 of fixed-rate notes on their maturity date with cash on hand. See Note H to the unaudited Consolidated Financial Statements in Part I, Item 1 for additional information regarding our debt obligations, including scheduled debt maturities and interest rates.

38


We had no commercial paper outstanding on July 3, 2016. We have $2 billion in bank credit facilities that remain available, including a $1 billion facility expiring in July 2018 and a $1 billion facility expiring in November 2020. These facilities are for general corporate purposes and working capital needs and are required by rating agencies to support our commercial paper issuances. We also have an effective shelf registration on file with the Securities and Exchange Commission that allows us to access the debt markets.
NON-GAAP FINANCIAL MEASURES – FREE CASH FLOW
We define free cash flow from operations as net cash provided by operating activities less capital expenditures. We believe free cash flow from operations is a useful measure for investors because it portrays our ability to generate cash from our businesses for purposes such as repaying maturing debt, funding business acquisitions, repurchasing our common stock and paying dividends. We use free cash flow from operations to assess the quality of our earnings and as a performance measure in evaluating management. The following table reconciles the free cash flow from operations with net cash provided by operating activities, as classified on the unaudited Consolidated Statements of Cash Flows:
Six Months Ended
July 3, 2016
 
July 5, 2015
Net cash provided by operating activities
$
873

 
$
1,433

Capital expenditures
(134
)
 
(190
)
Free cash flow from operations
$
739

 
$
1,243

Cash flows as a percentage of earnings from continuing operations:
 
 
 
Net cash provided by operating activities
59
%
 
98
%
Free cash flow from operations
50
%
 
85
%
We expect to continue to generate funds in excess of our short- and long-term liquidity needs. We believe we have adequate funds on hand and sufficient borrowing capacity to execute our financial and operating strategy.

ADDITIONAL FINANCIAL INFORMATION
ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES
For a discussion of environmental matters and other contingencies, see Note L to the unaudited Consolidated Financial Statements in Part I, Item 1. We do not expect our aggregate liability with respect to these matters to have a material impact on our results of operations, financial condition or cash flows.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our unaudited Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of financial statements in accordance with GAAP requires that we 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 revenue and expenses during the period.
Accounting for long-term contracts and programs involves the use of various techniques to estimate total contract revenue and costs. Contract estimates are based on various assumptions to project the outcome of future events that often span several years. We review our performance monthly and update our contract estimates regularly. We recognize adjustments in estimated profit on contracts under the reallocation

39


method. Under the reallocation method, the impact of an adjustment in estimate is recognized prospectively over the remaining contract term. The net impact of adjustments in contract estimates on our operating earnings (and on a diluted per-share basis) totaled favorable changes of $83 ($0.17) and $187 ($0.39) for the three- and six-month periods ended July 3, 2016, and $45 ($0.09) and $108 ($0.21) for the three- and six-month periods ended July 5, 2015, respectively. No adjustment on any one contract was material to our unaudited Consolidated Financial Statements in the second quarter and first six months of 2016 or 2015.
In the second quarter of 2014, the Financial Accounting Standards Board (FASB) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 prescribes a single, common revenue standard that replaces most existing revenue recognition guidance in GAAP. The standard outlines a five-step model whereby revenue is recognized as performance obligations within a contract are satisfied. The standard also requires new, expanded disclosures regarding revenue recognition. Several ASUs have been issued since the issuance of ASU 2014-09. These ASUs, which modify certain sections of ASU 2014-09, are intended to promote a more consistent interpretation and application of the principles outlined in the standard. Once a final technical corrections and improvements update is issued by the FASB in 2016, the standard is expected to be final.
ASU 2014-09 is effective in the first quarter of 2018 for public companies. However, entities can elect to adopt one year earlier in the first quarter of 2017. The standard permits the use of either the retrospective or cumulative-effect transition method.
We are utilizing a bottom-up approach to analyze the standard’s impact on our contract portfolio, comparing our historical accounting policies and practices and identifying potential differences from applying the requirements of the new standard to our contracts. While this assessment continues, we have not yet completed our determination of the impacts of the standards or the effect of these impacts on our Consolidated Financial Statements. Consequently, we have not yet selected a transition date or method. We expect this determination will near completion in the second half of 2016. Because the new standard will impact our business processes, systems and controls, we have developed a comprehensive change management project plan to guide the implementation.
The required adoption of the ASU will preclude our use of the reallocation method of recognizing adjustments in estimated profit on contracts discussed above. As changes in estimated profit will be recognized in the period they are identified (cumulative catch-up method), rather than prospectively over the remaining contract term, we expect the impact of adjustments of contract estimates may be larger and potentially more variable from period to period. Anticipated losses on contracts will continue to be recognized in the quarter they are identified.
Other significant estimates include those related to goodwill and intangible assets, income taxes, pension and other post-retirement benefits, workers’ compensation, warranty obligations, and litigation and other contingencies. We employ judgment in making our estimates, but they are based on historical experience, currently available information and various other assumptions that we believe 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.
We believe our judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. For a full discussion of our critical accounting policies, see our Annual Report on Form 10-K for the year ended December 31, 2015. For a discussion of new accounting standards that have been issued by the FASB but are not yet effective, see Note A to the unaudited Consolidated Financial Statements in Part I, Item 1.

40



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes with respect to this item from the disclosure included in our Annual Report on Form 10-K for the year ended December 31, 2015.

ITEM 4. CONTROLS AND PROCEDURES
Our management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, on July 3, 2016, our disclosure controls and procedures were effective.
There were no changes in our internal control over financial reporting that occurred during the quarter ended July 3, 2016, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
The certifications of the company’s Chief Executive Officer and Chief Financial Officer required under Section 302 of the Sarbanes-Oxley Act have been filed as Exhibits 31.1 and 31.2 to this report.

FORWARD-LOOKING STATEMENTS
This quarterly report on Form 10-Q contains forward-looking statements that are based on management’s expectations, estimates, projections and assumptions. Words such as “expects,” “anticipates,” “plans,” “believes,” “scheduled,” “outlook,” “estimates,” “should” and variations of these words and similar expressions are intended to identify forward-looking statements. Examples include projections of revenue, earnings, operating margin, segment performance, cash flows, contract awards, aircraft production, deliveries and backlog. In making these statements we rely on assumptions and analyses based on our experience and perception of historical trends, current conditions and expected future developments as well as other factors we consider appropriate under the circumstances. We believe our estimates and judgments are reasonable based on information available to us at the time. 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 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 Item 1A of our Annual Report on Form 10-K. These factors include:
•
general U.S. and international political and economic conditions;
•
decreases in U.S. government defense spending or changing priorities within the defense budget;
•
termination or restructuring of government contracts due to unilateral government action;
•
differences in anticipated and actual program performance, including the ability to perform under long-term fixed-price contracts within estimated costs, and performance issues with key suppliers and subcontractors;
•
expected recovery on contract claims and requests for equitable adjustment;
•
changing customer demand or preferences for business aircraft, including the effects of economic conditions on the business-aircraft market;

41


•
potential for changing prices for energy and raw materials; and
•
the status or outcome of legal and/or regulatory proceedings.
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 General Dynamics or any person acting on our behalf are qualified by the cautionary statements in this section. We do 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. These factors may be revised or supplemented in subsequent reports on SEC Forms 10-Q and 8-K.

PART II - OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS
For information relating to legal proceedings, see Note L to the unaudited Consolidated Financial Statements in Part I, Item 1.

ITEM 1A. RISK FACTORS
There have been no material changes with respect to this item from the disclosure included in our Annual Report on Form 10-K for the year ended December 31, 2015.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table provides information about our second-quarter repurchases of equity securities that are registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended:     
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*
Pursuant to Share Buyback Program
 
 
 
 
4/4/16-5/1/16
 
202,826

 
$
131.42

 
202,826

 
11,565,331

5/2/16-5/29/16
 
350,000

 
$
143.28

 
350,000

 
11,215,331

5/30/16-7/3/16
 
525,000

 
$
140.31

 
525,000

 
10,690,331

Total
 
1,077,826

 
$
139.60

 
 
 
 
* On March 2, 2016, the board of directors authorized management to repurchase 10 million additional shares of common stock.
We did not make any unregistered sales of equity in the second quarter.


42


ITEM 6. EXHIBITS
31.1
Certification by CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2
Certification by CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
32.1
Certification by CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
32.2
Certification by CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
101
Interactive Data File*


* Filed or furnished herewith.

43


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 
GENERAL DYNAMICS CORPORATION

 
by
 
 
Kimberly A. Kuryea
 
 
Vice President and Controller
 
 
(Authorized Officer and Chief Accounting Officer)
Dated: July 27, 2016
 
 
   

44