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ROCKWELL COLLINS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW AND OUTLOOK We have a diversified and balanced business, serving both commercial and government markets. On December 23, 2013, we completed our acquisition of ARINC Incorporated (ARINC) for approximately $1.4 billion. The acquisition of ARINC was funded through a combination of new long-term debt issuances and commercial paper borrowings. In connection with this acquisition, a new Information Management Services business segment was formed. This new segment combines ARINC with the Company's flight services business, which had previously been included in the Commercial Systems segment. The integration of the ARINC business is well underway and is progressing as planned. The acquisition of ARINC is expected to expand our position as a leading provider of information management services. Total revenues increased 7 percent during the first six months of 2014 as inorganic sales from the ARINC acquisition and higher revenues in Commercial Systems were partially offset by a 2 percent reduction within the Government Systems business. During the first half of our fiscal year, we maintained total segment operating margins at 20 percent of sales. During this same period, diluted earnings per share from continuing operations decreased 3 percent to $2.03, driven by higher income taxes resulting from differences in availability of the Federal Research and Development Tax Credit, which expired on December 31, 2013. In December 2013, Congress passed and the President signed into law the Murray-Ryan Bipartisan Budget Act (BBA) of 2013, raising government discretionary spending limits for fiscal years 2014 and 2015. The overall impact of the BBA on our current year results is expected to be favorable and was previously incorporated into our sales estimates for Government Systems. More recently, the President released the fiscal year 2015 Department of Defense Budget, which reflects top-line growth in government spending for fiscal year 2016 and beyond. While the President's budget is higher than sequestration and provides some visibility into future year program spending, uncertainty surrounding defense spending could have a material adverse effect on our Company and the defense industry in general. We remain confident that our product offerings are well positioned to meet the needs of our government customers in this uncertain environment and we continue to enhance our international strategies and make proactive adjustments to our cost structure as necessary. Our Commercial Systems business continues to benefit from strong market conditions in air transport with original equipment manufacturers (OEMs) increasing their production rates and building robust order backlogs as new aircraft enter into service. Production rates at the light end of the business jet market continue to be depressed. The market share gains we have achieved over the past several years, however, are expected to position us for growth as the market recovers. The following table is a complete summary of our fiscal year 2014 guidance, which has been updated from amounts previously provided on January 21, 2014: • total sales in the range of $4.95 billion to $5.05 billion • diluted earnings per share from continuing operations in the range of $4.40 to $4.55 (from $4.35 to $4.55) (1) • cash provided by operating activities in the range of $600 million to $700 million • capital expenditures of about $160 million • total research and development investment of about $950 million (2) (1) Earnings per share guidance was updated to reflect lower than previously estimated intangible asset amortization expense for ARINC. (2) Total research and development (R&D) investment is comprised of company and customer-funded R&D expenditures and the net increase in pre-production engineering costs capitalized within Inventory. RESULTS OF OPERATIONS The following management discussion and analysis is based on reported financial results for the three and six months ended March 31, 2014 and 2013 and should be read in conjunction with our condensed consolidated financial statements and notes thereto in Item 1 of Part I of this quarterly report. As discussed in Note 4 of the Notes to Condensed Consolidated Financial Statements, we intend to divest ARINC's Aerospace Systems Engineering and Support division and therefore, this business has been accounted for as a discontinued operation for all periods presented. Unless otherwise noted, disclosures pertain to our continuing operations. Three Months Ended March 31, 2014 and 2013 Sales Three Months Ended March 31 (in millions) 2014 2013 Total sales $ 1,272 $ 1,131 Percent increase 12 % Total sales increased $141 million, or 12 percent. ARINC, which was acquired on December 23, 2013, contributed $137 million of the overall revenue growth. Non-acquisition organic revenues increased $4 million from the prior year, driven by a combined $15 million increase within the Commercial Systems and Information Management Services businesses, partially offset by an $11 million reduction in Government Systems sales. Refer to the Government Systems, Commercial Systems, and Information Management Services Financial Results sections below for a detailed discussion of sales in the second fiscal quarter of 2014 compared to the same period last year. Cost of Sales Three Months Ended March 31 (in millions) 2014 2013 Total cost of sales $ 894 $ 804 Percent of total sales 70.3 % 71.1 % Cost of sales consists of all costs incurred to design, manufacture and deliver our products and services and includes R&D, raw material, labor, facility, product warranty, depreciation, amortization and other related expenses. Total cost of sales increased $90 million, or 11 percent, primarily due to the following: • $102 million of inorganic cost of sales from the ARINC acquisition • partially offset by $12 million of other net decreases to cost of sales, including lower employee incentive compensation costs, a reduction in company-funded R&D expense within Commercial Systems, and benefits from cost savings initiatives 29-------------------------------------------------------------------------------- Research and Development (R&D) expense is included as a component of cost of sales and is summarized as follows: Three Months Ended March 31 (in millions) 2014 2013 Customer-funded: Government Systems $ 92 $ 101 Commercial Systems 27 25 Total customer-funded 119 126 Company-funded: Government Systems 19 19 Commercial Systems 48 52 Total company-funded 67 71Total research and development expense (1) $ 186 $ 197 Percent of total sales 14.6 % 17.4 % (1) The Company is currently evaluating ARINC's research and development expenditures in connection with our ongoing integration and purchase price accounting activities. As a result, Research and Development expenses related to the newly formed Information Management Services segment have been excluded from the table above. We make significant investments in research and development to provide our customers with the latest technological advancements. Total R&D expense is comprised of both company-funded and customer-funded R&D expenditures. In addition to the R&D expenditures shown in the table above, we capitalize in inventory the cost of certain pre-production engineering effort incurred during the development phase of programs when the customer has provided us a long-term supply arrangement and a contractual guarantee for reimbursement. Pre-production engineering costs are then amortized over their useful lives. This amortization cost is included within customer-funded R&D expense and totaled $8 million and $7 million for the three months ended March 31, 2014 and 2013, respectively. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further discussion of our incremental investments in pre-production engineering effort. Customer-funded R&D expenditures are incurred pursuant to contractual arrangements and are typically accounted for as contract costs within cost of sales with the reimbursement accounted for as a sale in accordance with the percentage-of-completion method of accounting. Company-funded R&D expenditures relate to the development of new products and the improvement of existing products and are expensed as incurred. Company-funded R&D expense consists primarily of payroll-related expenses of employees engaged in R&D activities, engineering-related product materials and equipment and subcontracting costs. Total R&D expense for the three months ended March 31, 2014 decreased $11 million from the same period last year. The customer-funded portion of R&D expense decreased $7 million as a number of programs in Government Systems that were in development have completed or are now transitioning to production. The $4 million decrease in company-funded R&D was principally within Commercial Systems and was driven by a reduction in R&D efforts associated with various next generation business jet avionics development programs. In addition to the R&D expenses above, our investments in pre-production engineering programs capitalized within inventory had a net increase of $46 million during the three months ended March 31, 2014, primarily driven by effort on the Boeing 737 MAX platform and Bombardier CSeries and Global 7000/8000 programs. For the three months ended March 31, 2013, our investments in pre-production engineering had a net increase of $40 million. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further discussion of our incremental investments in pre-production engineering effort. 30 -------------------------------------------------------------------------------- Selling, General and Administrative Expenses Three Months Ended March 31 (in millions) 2014 2013 Selling, general and administrative expenses $ 150 $ 126 Percent of total sales 11.8 % 11.1 % Selling, general and administrative (SG&A) expenses consist primarily of labor, facility and other expenses related to employees not directly engaged in manufacturing or R&D activities. These activities include marketing and business development, finance, legal, information technology and other administrative and management functions. Total SG&A expenses for the three months ended March 31, 2014 increased $24 million, driven primarily by $19 million of SG&A from the recently acquired ARINC business. Interest Expense Three Months Ended March 31 (in millions) 2014 2013 Interest Expense $ 16 $ 8 Percent increase 100 % Interest expense for the three months ended March 31, 2014 increased by $8 million from the same period last year, primarily driven by incremental interest on the long-term debt and commercial paper we issued to fund the ARINC acquisition. See Note 10 of the Notes to the Condensed Consolidated Financial Statements for more detail regarding outstanding debt. Net Income and Diluted Earnings Per Share Three Months Ended March 31 (in millions, except per share amounts) 2014 2013 Income from continuing operations, net of taxes $ 147 $ 161 Percent of sales 11.6 % 14.2 % Income from discontinued operations, net of taxes 1 - Net income $ 148 $ 161 Percent of sales 11.6 % 14.2 % Diluted earnings per share from continuing operations $ 1.07 $ 1.17 Diluted earnings per share from discontinued operations 0.01 - Diluted earnings per share $ 1.08 $ 1.17 Income from continuing operations, net of taxes for the three months ended March 31, 2014 was $147 million, a $14 million decrease from the $161 million reported for the three months ended March 31, 2013. Diluted earnings per share from continuing operations decreased 9 percent, or $0.10, during the three months ended March 31, 2014. Income from continuing operations, net of taxes and earnings per share for the second quarter of fiscal year 2014 benefited from higher operating earnings in Commercial Systems, driven by higher sales to air transport customers, and the additional earnings from our recently completed ARINC acquisition in our newly formed Information Management Services segment. 31 -------------------------------------------------------------------------------- These benefits, however, were more than offset by higher income taxes, higher interest expense, and lower operating earnings within Government Systems that resulted from their decreased sales volume. The higher income tax expense was primarily attributable to the absence of a $31 million income tax benefit that was included in the prior year results related to the retroactive reinstatement of the Federal Research and Development Tax Credit, which once again expired on December 31, 2013. Government Systems Financial Results Government Systems Sales The following table presents Government Systems sales by product category: Three Months Ended March 31 (in millions) 2014 2013 Avionics $ 333 $ 324 Communication products 132 152 Surface solutions 56 57 Navigation products 46 45 Total $ 567 $ 578 Percent (decrease) (2 )% Avionics sales increased $9 million, or 3 percent, primarily due to the following: • a $19 million increase from the combined impact of higher hardware deliveries and installations on the E-6B aircraft upgrade program and other international aircraft platforms • partially offset by $10 million in other net decreases to revenue, including lower development revenues on the KC-46 and KC-10 programs Communication products sales decreased $20 million, or 13 percent, primarily driven by a $16 million reduction in satellite communication sales as fewer terminals were delivered and service revenues declined as troop deployments wind down in the Middle East. Government Systems Segment Operating Earnings Three Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 109 $ 112 Percent of sales 19.2 % 19.4 % The $3 million decrease in Government Systems operating earnings was primarily caused by the $11 million reduction in sales volume discussed in the Government Systems sales section above. The decrease in Government Systems operating earnings as a percent of sales was primarily driven by the unfavorable margin impact from the lower sales volume. 32 -------------------------------------------------------------------------------- Commercial Systems Financial Results Commercial Systems Sales The following table presents Commercial Systems sales by product category and type of product or service: Three Months Ended March 31 (in millions) 2014 2013 Air transport aviation electronics: Original equipment $ 171 $ 154 Aftermarket 124 116 Wide-body in-flight entertainment 18 18 Total air transport aviation electronics 313 288 Business and regional aviation electronics: Original equipment 146 158 Aftermarket 97 96 Total business and regional aviation electronics 243 254 Total $ 556 $ 542 Percent increase 3 % In connection with the acquisition of ARINC, a new Information Management Services business segment was formed that combines ARINC with the Company's existing flight services business, which had previously been included in the Commercial Systems segment. Prior period sales and earnings for the Commercial Systems segment have been revised to exclude results of the flight services business. Total air transport aviation electronics sales increased $25 million, or 9 percent, primarily due to the following: • OEM sales increased $17 million, or 11 percent primarily due to increased product deliveries from higher aircraft production rates for the Boeing 787 aircraft • aftermarket sales increased $8 million, or 7 percent, driven primarily by higher regulatory airspace mandates and increased service and support activities Total business and regional aviation electronics sales decreased $11 million, or 4 percent, primarily due to the following: • OEM sales decreased $12 million, or 8 percent, driven by a reduction in sales at the light-end of the business jet market • aftermarket sales increased $1 million, or 1 percent, as a result of higher service and support activities 33-------------------------------------------------------------------------------- Commercial Systems Segment Operating Earnings Three Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 127 $ 116 Percent of sales 22.8 % 21.4 % Commercial Systems operating earnings increased $11 million, or 9 percent, primarily due to incremental earnings from the higher sales volume and a $7 million benefit from the combined impact of lower company-funded R&D expense and savings realized from cost reduction initiatives. The increase in Commercial Systems operating earnings as a percent of sales was primarily due to the benefits from lower company-funded R&D expense and cost savings initiatives. Information Management Services Financial Results Information Management Services Sales On December 23, 2013, we acquired ARINC. In connection with this acquisition, a new Information Management Services business segment was formed. This new segment combines ARINC with our existing flight services business. Sales and earnings of the existing flight services business were previously included in the Commercial Systems segment. This business has been reclassified into the Information Management Services segment and prior period results of Commercial Systems have been restated. Prior period results of the Information Management Services segment do not include any sales or earnings from the ARINC acquisition, but do include a full three months of sales and earnings from the reclassified flight services business. Sales and earnings for the three months ended March 31, 2014 include a full three months of activity from the flight services business and the ARINC acquisition. Our Information Management Services business enables mission-critical data and voice communications throughout the world to customers including the U.S. Federal Aviation Administration (FAA), commercial airlines, business aircraft operators, airport and critical infrastructure operators and major passenger and freight railroads. These communications are enabled by ARINC's high-performance, high-quality and high-assurance proprietary radio and terrestrial networks, enhancing customer efficiency, safety and connectivity. Our information management services include: • voice and data communication services, such as GLOBALink voice and data services, which enable satellite, VHF and HF transmissions between the cockpit, the FAA and airline operation centers ensuring safety and efficiency for commercial airlines. These communications are enabled through ARINC's legacy ACARS® analog system and through the FAA's next generation VDLM2 digital technology • pre-flight and in-flight planning services and communications, such as ARINC Direct and ASCEND®, which provide business aircraft operators with cockpit and cabin voice and data communication capabilities, around the clock flight planning and support, flight tracking, weather information and ground services • airport communications and information systems designed to ease congestion and improve airport efficiency via airline agent and passenger-facing check-in, baggage, boarding and access control solutions • train dispatching and information systems including solutions to support positive train control as mandated by the 2008 Railroad Safety Improvement Act • mission critical security systems including intrusion detection, access control, video and credential management and vehicle identification for nuclear power plants and defense-related facilities 34-------------------------------------------------------------------------------- The following table presents Information Management Services sales: Three Months Ended March 31 (in millions) 2014 2013 Sales $ 149 $ 11 Total Information Management Services sales increased $138 million, primarily due to the acquisition of ARINC, which contributed $137 million of revenue to the second quarter of fiscal year 2014. Note 3 of the Notes to Condensed Consolidated Financial Statements presents supplemental pro-forma financial data as if the acquisition of ARINC had been completed as of the beginning of our prior year, or on October 1, 2012. The pro-forma data included in Note 3 combines the Company's consolidated results with the stand-alone results of ARINC for the pre-acquisition periods. The pro-forma data excludes the results of ASES, which we intend to divest. The supplemental pro-forma data is not necessarily indicative of results that actually would have occurred had the acquisition truly been consummated on October 1, 2012. On a pro-forma basis, sales for the newly formed Information Management Services segment would be $149 million and $132 million for the three months ended March 31, 2014 and 2013, respectively. The $17 million, or 13 percent, increase in the pro-forma sales was primarily due to growth in the flight planning and voice and data communication services provided by ARINC's commercial and business aviation divisions. Refer to Note 3 of the Notes to Condensed Consolidated Financial Statements for further pro-forma disclosures. Information Management Services Segment Operating Earnings Three Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 18 $ 1 Percent of sales 12.1 % 9.1 % Information Management Services operating earnings increased $17 million, primarily due to the acquisition of ARINC. Operating earnings includes depreciation and amortization expense of $12 million and $1 million for the three months ended March 31, 2014 and 2013, respectively. General Corporate, Net General corporate expenses that are not allocated to our business segments are included in General corporate, net. These costs are included within Cost of sales, SG&A and Other Income, net on the Condensed Consolidated Statement of Operations. General corporate, net is summarized as follows: Three Months Ended March 31 (in millions) 2014 2013 General corporate, net $ 16 $ 17 35-------------------------------------------------------------------------------- Six Months Ended March 31, 2014 and 2013 Sales Six Months Ended March 31 (in millions) 2014 2013 Total sales $ 2,343 $ 2,193 Percent increase 7 % Total sales increased $150 million, or 7 percent. ARINC, which was acquired on December 23, 2013, contributed $143 million, or 7 percent, to the overall revenue growth. Non-acquisition organic revenues increased $7 million from the prior year, driven by a combined $32 million increase within the Commercial Systems and Information Management Services businesses, partially offset by a $25 million reduction in Government Systems sales. Refer to the Government Systems, Commercial Systems, and Information Management Services Financial Results sections below for a detailed discussion of sales. Cost of Sales Six Months Ended March 31 (in millions) 2014 2013 Total cost of sales $ 1,650 $ 1,554 Percent of total sales 70.4 % 70.9 % Cost of sales consists of all costs incurred to design, manufacture and deliver our products and services and includes R&D, raw material, labor, facility, product warranty, depreciation, amortization and other related expenses. Total cost of sales increased $96 million, or 6 percent, primarily due to the following: • $106 million of inorganic cost of sales from the ARINC acquisition • partially offset by a $10 million reduction in company-funded R&D expense, as explained below Research and Development (R&D) expense is included as a component of cost of sales and is summarized as follows: Six Months Ended March 31 (in millions) 2014 2013 Customer-funded: Government Systems $ 181 $ 199 Commercial Systems 49 47 Total customer-funded 230 246 Company-funded: Government Systems 35 36 Commercial Systems 97 106 Total company-funded 132 142Total research and development expense (1) $ 362 $ 388 Percent of total sales 15.5 % 17.7 % (1) The Company is currently evaluating ARINC's research and development expenditures in connection with our ongoing integration and purchase price accounting activities. As a result, Research and Development expenses related to the newly formed Information Management Services segment have been excluded from the table above. 36 -------------------------------------------------------------------------------- We make significant investments in research and development to provide our customers with the latest technological advancements. Total R&D expense is comprised of both company-funded and customer-funded R&D expenditures. In addition to the R&D expenditures shown in the table above, we capitalize in inventory the cost of certain pre-production engineering effort incurred during the development phase of programs when the customer has provided us a long-term supply arrangement and a contractual guarantee for reimbursement. Pre-production engineering costs are then amortized over their useful lives. This amortization cost is included within customer-funded R&D expense and totaled $14 million and $12 million for the six months ended March 31, 2014 and 2013, respectively. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further discussion of our incremental investments in pre-production engineering effort. Customer-funded R&D expenditures are incurred pursuant to contractual arrangements and are typically accounted for as contract costs within cost of sales with the reimbursement accounted for as a sale in accordance with the percentage-of-completion method of accounting. Company-funded R&D expenditures relate to the development of new products and the improvement of existing products and are expensed as incurred. Company-funded R&D expense consists primarily of payroll-related expenses of employees engaged in R&D activities, engineering-related product materials and equipment and subcontracting costs. Total R&D expense for the six months ended March 31, 2014 decreased $26 million from the same period last year. The customer-funded portion of R&D expense decreased $16 million as a number of programs that were in development have completed or are now transitioning to production in Government Systems. The $10 million decrease in company-funded R&D was principally within Commercial Systems and was driven by a reduction in R&D efforts associated with various next generation business jet avionics development programs. In addition to the R&D expenses above, our investments in pre-production engineering programs capitalized within inventory had a net increase of $89 million during the six months ended March 31, 2014, primarily driven by effort on the Boeing 737 MAX platform and Bombardier CSeries and Global 7000/8000 programs. For the six months ended March 31, 2013, our investments in pre-production engineering had a net increase of $76 million. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further discussion of our incremental investments in pre-production engineering effort. Selling, General and Administrative Expenses Six Months Ended March 31 (in millions) 2014 2013 Selling, general and administrative expenses $ 286 $ 250 Percent of total sales 12.2 % 11.4 % Selling, general and administrative (SG&A) expenses consist primarily of labor, facility and other expenses related to employees not directly engaged in manufacturing or R&D activities. These activities include marketing and business development, finance, legal, information technology and other administrative and management functions. Total SG&A expenses for the six months ended March 31, 2014 increased $36 million, primarily due to: • $20 million of SG&A costs from the recently acquired ARINC business • $13 million of transaction costs for legal, accounting and advisory fees resulting from the ARINC acquisition • $3 million of other net increases, including higher bid and proposal activities 37-------------------------------------------------------------------------------- Interest Expense Six Months Ended March 31 (in millions) 2014 2013 Interest Expense $ 28 $ 14 Percent increase 100 % Interest expense increased by $14 million during the six months ended March 31, 2014 compared to the same period in 2013, primarily due to incremental interest on the new long-term debt and commercial paper we issued to fund the ARINC acquisition. See Note 10 of the Notes to the Condensed Consolidated Financial Statements for more detail regarding outstanding debt. Net Income and Diluted Earnings Per Share Six Months Ended March 31 (in millions, except per share amounts) 2014 2013 Income from continuing operations, net of taxes $ 278 $ 293 Percent of sales 11.9 % 13.4 % Income from discontinued operations, net of taxes 1 - Net income $ 279 $ 293 Percent of sales 11.9 % 13.4 % Diluted earnings per share from continuing operations $ 2.03 $ 2.10 Diluted earnings per share from discontinued operations 0.01 - Diluted earnings per share $ 2.04 $ 2.10 Income from continuing operations, net of taxes for the six months ended March 31, 2014 was $278 million, down 5 percent, or $15 million, from the $293 million in income from continuing operations, net of taxes reported for March 31, 2013. Diluted earnings per share from continuing operations decreased 3 percent to $2.03 for the six months ended March 31, 2014 compared to $2.10 for the six months ended March 31, 2013. The rate of decrease in diluted earnings per share from continuing operations was less than the rate of decrease in income from continuing operations, net of taxes as a result of the favorable impacts from our share repurchase program. Income from continuing operations, net of taxes and earnings per share in the first half of fiscal year 2014 benefited from higher operating earnings in Commercial Systems and Information Management Services, and from the gain realized on the divestiture of Kaiser Optical Systems, Inc. (KOSI). These benefits, however, were more than offset by higher income taxes, higher interest cost, transaction costs incurred in connection with the ARINC acquisition, and lower operating earnings within Government Systems that resulted from the decreased sales volume. 38 -------------------------------------------------------------------------------- Government Systems Financial Results Government Systems Sales The following table presents Government Systems sales by product category: Six Months Ended March 31 (in millions) 2014 2013 Avionics $ 650 $ 639 Communication products 250 285 Surface solutions 114 107 Navigation products 85 93 Total $ 1,099 $ 1,124 Percent (decrease) (2 )% Avionics sales increased $11 million, or 2 percent, primarily due to the following: • a $31 million increase from the combined impact of higher hardware deliveries and installations on the E-6B aircraft upgrade program and other international aircraft platforms • partially offset by $20 million in other net decreases to revenue, including lower development revenues on the KC-46 and KC-10 programs Communication products sales decreased $35 million, or 12 percent, primarily driven by a $37 million reduction in satellite communication sales as fewer terminals were delivered and service revenues declined as troop deployments wind down in the Middle East. Surface solutions sales increased $7 million, or 7 percent, primarily due to the following: • $18 million increase attributable to higher international sales of Firestorm targeting systems • partially offset by other net decreases to revenue of $11 million, including a reduction of effort on the Common Range Integrated Instrumentation Systems development program Navigation products sales decreased $8 million, or 9 percent, primarily due to fewer deliveries of our GPS-based products. Government Systems Segment Operating Earnings Six Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 210 $ 219 Percent of sales 19.1 % 19.5 % The $9 million decrease in Government Systems operating earnings was primarily due to the $25 million reduction in sales volume discussed in the Government Systems sales section above. The decrease in Government Systems operating earnings as a percent of sales was primarily driven by the unfavorable margin impact from the lower sales volume. 39 -------------------------------------------------------------------------------- Commercial Systems Financial Results Commercial Systems Sales The following table presents Commercial Systems sales by product category and type of product or service: Six Months Ended March 31 (in millions) 2014 2013 Air transport aviation electronics: Original equipment $ 328 $ 294 Aftermarket 252 228 Wide-body in-flight entertainment 37 45 Total air transport aviation electronics 617 567 Business and regional aviation electronics: Original equipment 275 300 Aftermarket 185 181 Total business and regional aviation electronics 460 481 Total $ 1,077 $ 1,048 Percent increase 3 % In connection with the acquisition of ARINC, a new Information Management Services business segment was formed that combines ARINC with the Company's existing flight services business, which had previously been included in the Commercial Systems segment. Prior period sales and earnings for the Commercial Systems segment have been revised to exclude results of the flight services business. Total air transport aviation electronics sales increased $50 million, or 9 percent, primarily due to the following: • OEM sales increased $34 million, or 12 percent primarily due to increased product deliveries from higher aircraft production rates for the Boeing 787 aircraft • aftermarket sales increased $24 million, or 11 percent, primarily driven by higher revenue from regulatory airspace mandates, increased service and support activities, and a large delivery of spare parts for 787 aircraft • wide-body IFE sales decreased $8 million, or 18 percent, resulting from the absence of a $7 million last-time buy order for spare parts that was delivered to an airline customer last year Total business and regional aviation electronics sales decreased $21 million, or 4 percent, primarily due to the following: • OEM sales decreased $25 million, or 8 percent, driven by a reduction in sales at the light-end of the business jet market • aftermarket sales increased $4 million, or 2 percent, as a result of higher service and support activities Commercial Systems Segment Operating Earnings Six Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 238 $ 221 Percent of sales 22.1 % 21.1 % 40-------------------------------------------------------------------------------- Commercial Systems operating earnings increased $17 million, or 8 percent, primarily due to incremental earnings from the higher sales volume and a $9 million benefit resulting from a reduction in company-funded R&D expenses. The incremental earnings from the higher sales volume were tempered as the sales growth primarily related to newer products, which typically feature less favorable initial margins. Therefore, the increase in Commercial Systems operating earnings as a percent of sales was primarily due to the benefits from lower company-funded R&D expense. Information Management Services Financial Results Information Management Services Sales On December 23, 2013, we acquired ARINC. In connection with this acquisition, a new Information Management Services business segment was formed. This new segment combines ARINC with our existing flight services business. Sales and earnings of the existing flight services business were previously included in the Commercial Systems segment. This business has been reclassified into the Information Management Services segment and prior period results of Commercial Systems have been restated. Prior period results of the Information Management Services segment do not include any sales or earnings from the ARINC acquisition, but do include a full six months of sales and earnings from the reclassified flight services business. Sales and earnings for the six months ended March 31, 2014 include a full six months of activity from the flight services business and also include financial results for the ARINC acquisition for periods subsequent to the acquisition date. The following table presents Information Management Services sales: Six Months Ended March 31 (in millions) 2014 2013 Sales $ 167 $ 21 Total Information Management Services sales increased $146 million, primarily due to the acquisition of ARINC, which contributed $143 million of revenue to the first six months of 2014. Note 3 of the Notes to Condensed Consolidated Financial Statements presents supplemental pro-forma financial data as if the acquisition of ARINC had been completed as of the beginning of our prior year, or on October 1, 2012. The pro-forma data included in Note 3 combines the Company's consolidated results with the stand-alone results of ARINC for the pre-acquisition periods. The pro-forma data excludes the results of ASES, which we intend to divest. The supplemental pro-forma data is not necessarily indicative of results that actually would have occurred had the acquisition truly been consummated on October 1, 2012. On a pro-forma basis, sales for the newly formed Information Management Services segment would be $273 million for both the six months ended March 31, 2014 and 2013. An increase in pro-forma revenue within ARINC's commercial and business aviation divisions was offset by the combined impact of a reduction to revenue from the completion of effort on projects in ARINC's airport business and lower sales resulting from changes in the estimated profit margins expected to be realized on certain long-term contracts within the rail division. Refer to Note 3 of the Notes to Condensed Consolidated Financial Statements for further pro-forma disclosures. Information Management Services Segment Operating Earnings Six Months Ended March 31 (in millions) 2014 2013 Segment operating earnings $ 20 $ 2 Percent of sales 12.0 % 9.5 % 41-------------------------------------------------------------------------------- Information Management Services operating earnings increased $18 million, primarily due to to the acquisition of ARINC. Operating earnings includes depreciation and amortization expense of $13 million and $2 million for the six months ended March 31, 2014 and 2013, respectively. General Corporate, Net General corporate expenses that are not allocated to our business segments are included in General corporate, net. These costs are included within Cost of sales, SG&A and Other Income, net on the Condensed Consolidated Statement of Operations. General corporate, net is summarized as follows: Six Months Ended March 31 (in millions) 2014 2013 General corporate, net $ 31 $ 30 Retirement Plans Net benefit expense for pension benefits and other retirement benefits are as follows: Three Months Ended Six Months Ended March 31 March 31 (in millions) 2014 2013 2014 2013 Pension benefits $ 1 $ 2 $ 4 $ 4 Other retirement benefits 3 3 5 7 Net benefit expense $ 4 $ 5 $ 9 $ 11 Pension Benefits In 2003, we amended our U.S. qualified and non-qualified pension plans covering all salary and hourly employees not covered by collective bargaining agreements to discontinue benefit accruals for salary increases and services rendered after September 30, 2006. Additionally, the ARINC defined benefit pension plan that we assumed in connection with the December 2013 acquisition is also largely frozen to new participants who are not covered by collective bargaining agreements. As discussed in Note 11 of the Notes to Condensed Consolidated Financial Statements, the ARINC pension plan was approximately 99 percent funded at the acquisition date. For 2014, we anticipate $10 million of expense from the Rockwell Collins defined benefit pension plans. We expect this amount to be partially offset by $5 million of income from the acquired ARINC pension plans. Total defined benefit pension expense for 2014 is therefore expected to be $5 million, compared to $7 million of pension expense in 2013. Our objective with respect to the funding of our pension plans is to provide adequate assets for the payment of future benefits. Pursuant to this objective, we will fund our pension plans as required by governmental regulations and may consider discretionary contributions as conditions warrant. We believe our strong financial position continues to provide us the opportunity to make contributions to our pension fund without inhibiting our ability to pursue strategic investments. During the six months ended March 31, 2014, we made contributions to our U.S. qualified pension plan of $55 million. We do not expect to make any additional contributions to our U. S. qualified pension plan during 2014 nor do we expect to make any contributions to our ARINC pension plan during 2014. Contributions to our non-U.S. plans and U.S. non-qualified plan are anticipated to total $14 million in 2014. For the six months ended March 31, 2014 we made contributions to our non-U.S. plans and U.S. non-qualified pension plan of $8 million. Other Retirement Benefits We expect other retirement benefits expense of approximately $9 million for 2014. This compares to 2013 expense of $15 million. 42 -------------------------------------------------------------------------------- Income Taxes At the end of each interim reporting period we make an estimate of the annual effective income tax rate. Tax items included in the annual effective income tax rate are pro-rated for the full year and tax items discrete to a specific quarter are included in the effective income tax rate for that quarter. The estimate used in providing for income taxes on a year-to-date basis may change in subsequent interim periods. The difference between our effective income tax rate and the statutory income tax rate is primarily the result of the tax benefits derived from the Federal Research and Development Tax Credit (Federal R&D Tax Credit), which provides a tax benefit on certain incremental R&D expenditures and the Domestic Manufacturing Deduction, which provides a tax benefit on U.S. based manufacturing. During the three months ended March 31, 2014 and 2013, the effective income tax rate from continuing operations was 31.3 percent and 18.3 percent, respectively. The higher effective income tax rate from continuing operations for the three months ended March 31, 2014, was primarily due to the differences in availability of the Federal R&D Tax Credit, partially offset by a favorable adjustment recorded in the current period that related to the resolution of the IRS audit for taxable years ended September 30, 2010 and 2011. During the six months ended March 31, 2014 and 2013, the effective income tax rate from continuing operations was 29.4 percent and 23.9 percent, respectively. The higher effective income tax rate for the six months ended March 31, 2014, was primarily due to the differences in the availability of the Federal R&D Tax Credit as well as the absence of a tax benefit that was recognized last year for net operating loss carryovers in the United Kingdom. These unfavorable impacts were partially offset by favorable adjustments recorded in the current period due to the resolution of the IRS audit for taxable years ended September 30, 2010 and 2011 and the recognition of a tax benefit related to the Extraterritorial Income Exclusion claimed in prior years. For fiscal year 2014, our effective income tax rate is projected to be about 30 percent and assumes that the Federal R&D Tax Credit is not extended beyond December 31, 2013. The acquisition of ARINC does not have a material impact on our effective income tax rate for the year. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Summary Our ability to generate significant cash flow from operating activities coupled with our expected ability to access the credit markets enables us to execute our growth strategies and return value to our shareowners. The timing of our cash inflows is historically heavily weighted towards the second half of our fiscal year, particularly our fourth quarter. We expect this trend to continue in the future. Operating Activities Six Months Ended March 31 (in millions) 2014 2013 Cash provided by operating activities $ 63 $ 179 43 -------------------------------------------------------------------------------- The $116 million reduction in cash provided by operating activities during the six months ended March 31, 2014 compared to the same period last year was primarily due to the following: • payments for production inventory and other operating costs increased by $173 million to $2,013 million during the first half of 2014, compared to $1,840 million during the first half of 2013. The increased payments for operating costs primarily resulted from the higher sales volume associated with our recently completed acquisition of ARINC. In addition, the operating cost payments for 2014 include approximately $13 million of payments that relate to ARINC transaction closing costs • payments for employee incentive pay increased $60 million. Incentive pay is expensed in the year it is incurred and is paid in the first fiscal quarter of the following year. During the six months ended March 31, 2014, $114 million was paid for employee incentive pay costs expensed during fiscal year 2013. This compares to $54 million paid during the six months ended March 31, 2013 for employee incentive pay costs expensed during fiscal year 2012 • cash payments for income taxes increased $69 million to $114 million during the first six months of 2014 compared to $45 million paid during the same period last year. The increase in cash used for income tax payments is primarily due to differences in the availability of the Federal R&D Tax Credit and the timing of tax deductions, including lower contributions to our pension plan in fiscal year 2014 as compared to fiscal 2013 • the above items were partially offset by higher cash receipts from customers which increased by $140 million to $2,380 million during the first half of 2014, compared to $2,240 million during the first half of 2013. The increase was primarily attributable to higher sales volume from our acquisition of ARINC • in addition, payments to our pension plan were lower by $54 million as we made contributions of $63 million during the six months ended March 31, 2014 as compared to $117 million during the same period in the prior year Investing Activities Six Months Ended March 31 (in millions) 2014 2013 Cash used for investing activities $ (1,462 ) $ (62 ) The $1.4 billion increase in cash used for investing activities during the six months ended March 31, 2014 compared to the same period last year was primarily due to the following: • in December 2013, we acquired ARINC for $1.415 billion. We had no business acquisitions during the same period of the prior year • partially offset by the proceeds from the divestiture of our KOSI business in November 2013. We had no business divestitures during the same period of the prior year Financing Activities Six Months Ended March 31 (in millions) 2014 2013 Cash provided by (used for) financing activities $ 1,414 $ (113 ) 44 -------------------------------------------------------------------------------- The $1.527 billion increase in cash provided by financing activities during the six months ended March 31, 2014 compared to the same period last year was primarily due to the following: • we received net proceeds of $1.089 billion from the issuance of long-term debt in December 2013. A portion of these proceeds were used to finance the acquisition of ARINC and the remainder was used to repay $200 million of long-term debt that matured in December 2013 • net proceeds from short-term commercial paper borrowing increased by $246 million. During the first six months of 2014, net proceeds from short-term commercial paper borrowings were $631 million, compared to net proceeds of $385 million during the same period last year. The increase in short-term commercial paper borrowings was driven by our financing of the ARINC acquisition • cash repurchases of common stock decreased $376 million to $61 million during the six months ended March 31, 2014, compared to $437 million repurchased during the same period last year The Company expects share count to remain fairly stable during 2014 and expects some level of share repurchases to occur in order to offset the dilution from employee stock benefits. Financial Condition and Liquidity We maintain a capital structure that enables us sufficient access to credit markets. When combined with our ability to generate strong levels of cash flow from our operations, this capital structure provides the strength and flexibility necessary to pursue strategic growth opportunities and to return value to our shareowners. A comparison of key elements of our financial condition as of March 31, 2014 and September 30, 2013 are as follows: (in millions) March 31, 2014 September 30, 2013 Cash and cash equivalents $ 410 $ 391 Short-term debt(1) (866 ) (436 ) Long-term debt, net (1,658 ) (563 ) Net debt (2) $ (2,114 ) $ (608 ) Total equity $ 1,852 $ 1,623 Debt to total capitalization (3) 58 % 38 % Net debt to total capitalization (4) 53 % 27 % (1) Short-term debt at March 31, 2014 is comprised of short-term commercial paper borrowings. Short-term debt at September 30, 2013 includes $235 million of short-term commercial paper borrowings, $200 million of unsecured debt that matured on December 1, 2013 (the 2013 Notes) and a $1 million fair value swap adjustment related to the 2013 Notes (2) Calculated as total of short-term and long-term debt, net (Total debt), less cash and cash equivalents (3) Calculated as Total debt divided by the sum of Total debt plus Total equity (4) Calculated as Net debt divided by the sum of Net debt plus Total equity We primarily fund our contractual obligations, capital expenditures, small to medium sized acquisitions, dividends and share repurchases from cash generated from operating activities. On December 23, 2013, we acquired ARINC for $1.415 billion. This acquisition was funded through a combination of new long-term debt which we issued on December 16, 2013 and commercial paper borrowings. The net proceeds from the long-term debt issuance totaled $1.089 billion, of which approximately $900 million was used for the ARINC acquisition and a portion was used to effectively refinance the 2013 Notes, which had matured on December 1, 2013 (the 2013 Notes principal was initially paid at maturity using commercial paper). The balance of the ARINC purchase price was funded with commercial paper issuances which we intend to pay down over the next few years using our operating cash flow. While the incremental debt resulting from the acquisition of ARINC increased our leverage, we expect to maintain our investment grade credit ratings and have continued access to the credit markets. As of March 31, 2014, approximately 90 percent of our cash and cash equivalents resides at non-U.S. locations and may not be readily accessible for use in the U.S. due to potential adverse income tax implications and other statutory limitations. Due to the 45 -------------------------------------------------------------------------------- fluctuations of cash flows, we supplement our internally-generated cash flow from time to time by issuing short-term commercial paper. Under our commercial paper program, we may sell up to $1.2 billion face amount of unsecured short-term promissory notes in the commercial paper market. The commercial paper notes have maturities of not more than 364 days from the date of issuance. At March 31, 2014, short-term commercial paper borrowings outstanding were $866 million with a weighted-average interest rate and maturity period of 0.34 percent and 37 days, respectively. At September 30, 2013, short term commercial paper borrowings outstanding were $235 million. The maximum amount of short-term commercial paper borrowings outstanding during the six months ended March 31, 2014 was $975 million. In the event our access to the commercial paper markets is impaired, we have access to a five-year $1 billion unsecured revolving credit facility and a 364-day $200 million unsecured revolving credit facility, each of which was entered into on December 23, 2013. These revolving credit facilities are in place principally to support our commercial paper program. The credit facilities include one financial covenant that requires us to maintain a consolidated debt to total capitalization ratio of not greater than 60 percent. The ratio excludes the accumulated other comprehensive loss equity impact related to defined benefit retirement plans. Our debt to total capitalization ratio at March 31, 2014 based on this financial covenant was 45 percent. We had no borrowings at September 30, 2013 under our revolving credit facilities. In addition, alternative sources of liquidity could include funds available from the issuance of equity securities, debt securities and potential asset securitization strategies. To date, we have not raised capital through the issuance of equity securities, nor do we have any current plans to do so, as we prefer to use debt financing to lower our overall cost of capital and increase our return on shareowners' equity. Credit ratings are a significant factor in determining our ability to access short-term and long-term financing as well as the cost of such financing. Our strong credit ratings have enabled continued access to both short and long-term credit markets. If our credit ratings were to be adjusted downward by the rating agencies, the implications of such actions could include impairment or elimination of our access to credit markets and an increase in the cost of borrowing. The following is a summary of our credit ratings as of March 31, 2014: Credit Rating Agency Short-Term Rating Long-Term Rating Outlook Fitch Ratings F1 A Negative Moody's Investors Service P-2 A3 Stable Standard & Poor's A-2 A- Stable When the Company announced its intent to acquire ARINC and fund the purchase price through the incurrence of additional debt, each of the above rating agencies placed our credit ratings under review for possible downgrade. In October 2013, Fitch affirmed our current short-term and long-term ratings, but revised our outlook to Negative from Stable. In December 2013, Standard & Poor's lowered the Company's short-term and long-term ratings by one notch to A-2 and to A-, respectively. Also in December 2013, Moody's lowered the Company's short-term and long-term ratings by one notch to P-2 and A3, respectively. We do not expect any of the changes to our credit ratings or outlook to materially impact our ability to access credit markets or significantly increase our cost of borrowing. We were in compliance with all debt covenants at March 31, 2014 and September 30, 2013. ENVIRONMENTAL For information related to environmental claims, remediation efforts and related matters, see Note 19 of the Notes to Condensed Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES Preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America requires management of Rockwell Collins to make estimates, judgments and assumptions that affect our financial condition and results of operations that are reported in the accompanying condensed consolidated financial statements as well as the related disclosure of assets and liabilities contingent upon future events. The critical accounting policies used in preparation of our financial statements are described in Management's Discussion and Analysis in our Annual Report on Form 10-K for the year ended September 30, 2013. Actual results in these areas could differ from management's estimates. 46 -------------------------------------------------------------------------------- CAUTIONARY STATEMENT This quarterly report contains statements, including certain projections and business trends, that are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to the financial condition of our customers, including bankruptcies; the health of the global economy, including potential deterioration in economic and financial market conditions; adjustments to the commercial OEM production rates and the aftermarket; the impacts of natural disasters, including operational disruption, potential supply shortages and other economic impacts; cybersecurity threats, including the potential misappropriation of assets or other sensitive information, corruption of data or operational disruption; delays related to the award of domestic and international contracts; delays in customer programs; unanticipated impacts of sequestration and other provisions of the Budget Control Act of 2011 as modified by the Bipartisan Budget Act of 2013; the discontinuance of support for military transformation and modernization programs; potential adverse impact of oil prices on the commercial aerospace industry; the impact of terrorist events on the commercial aerospace industry; declining defense budgets resulting from budget deficits in the U.S. and abroad; changes in domestic and foreign government spending, budgetary, procurement and trade policies adverse to our businesses; market acceptance of our new and existing technologies, products and services; reliability of and customer satisfaction with our products and services; potential unavailability of our mission-critical data and voice communication networks; favorable outcomes on or potential cancellation or restructuring of contracts, orders or program priorities by our customers; recruitment and retention of qualified personnel; regulatory restrictions on air travel due to environmental concerns; effective negotiation of collective bargaining agreements by us and our customers; performance of our customers and subcontractors; risks inherent in development and fixed-price contracts, particularly the risk of cost overruns; risk of significant reduction to air travel or aircraft capacity beyond our forecasts; our ability to execute to our internal performance plans such as our productivity and quality improvements and cost reduction initiatives; achievement of ARINC integration and synergy plans as well as our other acquisition and related integration plans; continuing to maintain our planned effective tax rates; our ability to develop contract compliant systems and products on schedule and within anticipated cost estimates; risk of fines and penalties related to noncompliance with laws and regulations including export control and environmental regulations; risk of asset impairments; our ability to win new business and convert those orders to sales within the fiscal year in accordance with our annual operating plan; and the uncertainties of the outcome of lawsuits, claims and legal proceedings, as well as other risks and uncertainties, including but not limited to those detailed herein and from time to time in our Securities and Exchange Commission filings. These forward-looking statements are made only as of the date hereof. |