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ROCKWELL COLLINS : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

07/22/2014 | 01:07pm US/Eastern

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.

We continue to execute our strategy to reshape our Government Systems portfolio to align with the changing dynamics of the defense environment. During 2014, we entered into an agreement to sell our satellite communication systems business formerly known as Datapath, Inc. (Datapath), which designs, manufactures and services ground-based satellite communication systems primarily for military customers. The sale is subject to customary closing conditions and is expected to close in the fourth quarter of fiscal 2014. Earlier this year, Government Systems sold its Kaiser Optical Systems, Inc. (KOSI) subsidiary for $23 million. The decision to sell these businesses is part of an overall strategy to reshape the Government Systems segment to align with the changing dynamics of the defense environment and focus on opportunities in addressed markets for the Company's core products and solutions. We have updated our guidance to reflect the pending divestiture of Datapath. We now expect revenues from the continuing operations of Government Systems to decrease by low-single digits from 2013 to 2014 (we previously expected sales to decrease by mid-single digits).

Total revenues increased 10 percent during the first nine months of 2014 as inorganic sales from the ARINC acquisition and higher revenues in Commercial Systems were partially offset by a 1 percent reduction within the Government Systems business. During this same period, diluted earnings per share from continuing operations decreased 1 percent to $3.25, 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. We continue to expect the overall impact of the BBA on our current year results to be favorable. This has been 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 summary of our company's fiscal year 2014 financial guidance for continuing operations. The fiscal year 2014 outlook has been updated due to the pending sale of Datapath and to narrow the ranges from the previous financial guidance:

•      total sales in the range of $4.90 billion to $4.95 billion (from $4.95
       billion to $5.05 billion)



•      diluted earnings per share in the range of $4.45 to $4.55 (from $4.40 to
       $4.55) (1)



•      cash provided by operating activities of about $650 million (from $600
       million to $700 million)


• capital expenditures of about $160 million (2)

• total research and development investment of about $950 million (3)





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(1) Earnings per share guidance was updated to reflect lower than previously estimated intangible asset amortization expense and integration costs for ARINC.

(2) Includes internally developed software and other costs associated with the expansion and construction of ARINC's network-related assets.

(3) 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 nine months ended June 30, 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 entered into an agreement to divest the Satellite Communication Systems business, which was formerly included within the Government Systems segment. We also previously announced our intent to divest ARINC's Aerospace Systems Engineering and Support division. These businesses have been accounted for as discontinued operations for all periods presented. Certain prior period amounts relating to the Government Systems segment have been reclassified to conform to the current year presentation. Unless otherwise noted, disclosures pertain to our continuing operations.

Three Months Ended June 30, 2014 and 2013

Sales
                      Three Months Ended
                           June 30
(in millions)          2014          2013
Total sales        $    1,264$ 1,132
Percent increase           12 %


Total sales increased $132 million, or 12 percent. ARINC, which was acquired on December 23, 2013, contributed $134 million of the overall revenue growth. Organic revenues decreased $2 million from the prior year, driven by a $34 million reduction within Government Systems that was mostly offset by a $32 million increase within Commercial Systems. Refer to the Government Systems, Commercial Systems and Information Management Services Financial Results sections below for a detailed discussion of sales in the third quarter of 2014 compared to the same period last year.

Cost of Sales

                            Three Months Ended
                                  June 30
(in millions)               2014           2013
Total cost of sales      $    877$    769
Percent of total sales       69.4 %         67.9 %


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.


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Total cost of sales increased $108 million, or 14 percent, primarily due to the following:

$93 million of cost of sales from the ARINC business acquired this year



•      partially offset by a $20 million reduction to cost of sales from the
       lower sales volume in Government Systems



•      the remaining net increase of $35 million was primarily due to the
       combined impact of higher sales volumes within Commercial Systems and an
       increase in employee benefit related costs


Research and Development (R&D) expense is included as a component of cost of sales and is summarized as follows:

                                            Three Months Ended
                                                  June 30
(in millions)                               2014           2013
Customer-funded:
Government Systems                       $     85$     97
Commercial Systems                             37             25
Information Management Services (1)             3              -
Total customer-funded                         125            122

Company-funded:

Government Systems                             18             17
Commercial Systems                             43             49
Information Management Services (1)             1              -
Total company-funded                           62             66

Total research and development expense $ 187$ 188 Percent of total sales

                       14.8 %         16.6 %



(1)Research and development expenses for the Information Management Services segment, including the ARINC acquisition, do not include costs of internally developed software and other costs associated with the expansion and construction of network-related assets. These costs are capitalized as Property on the Condensed Consolidated Statement of Financial Position. 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 $10 million and $6 million for the three months ended June 30, 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 June 30, 2014 decreased $1 million from the same period last year. This decrease was attributable to a $4 million reduction in company-funded R&D, principally within Commercial Systems and driven by a reduction in R&D efforts associated with various next generation business jet avionics development programs. An increase in customer-funded R&D expenses within Commercial Systems driven by various international programs was offset by a reduction in Government Systems as a number of programs that were in development have completed or are now transitioning to production.


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In addition to the R&D expenses above, our investments in pre-production engineering programs capitalized within inventory had a net increase of $43 million during the three months ended June 30, 2014, primarily driven by effort on the Boeing 737 MAX, Airbus A350 and Bombardier programs. For the three months ended June 30, 2013, our investments in pre-production engineering had a net increase of $37 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


                                                  Three Months Ended
                                                        June 30
(in millions)                                     2014           2013

Selling, general and administrative expenses $ 148$ 130 Percent of total sales

                             11.7 %         11.5 %



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 June 30, 2014 increased $18 million, driven primarily by $21 million of SG&A from the recently acquired ARINC business, partially offset by reductions from other cost savings initiatives.


Interest Expense

                      Three Months Ended
                            June 30
(in millions)           2014           2013
Interest Expense   $       15$   7
Percent increase        114.3 %


Interest expense for the three months ended June 30, 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
                                                                           June 30
(in millions, except per share amounts)                                2014          2013
Income from continuing operations, net of taxes                    $     163$  161
Percent of sales                                                        12.9 %       14.2 %

Income (loss) from discontinued operations, net of taxes                  (5 )          3
Net income                                                         $     158$  164
Percent of sales                                                        12.5 %       14.5 %

Diluted earnings per share from continuing operations              $    1.19$ 1.18
Diluted earnings (loss) per share from discontinued operations         (0.04 )       0.02
Diluted earnings per share                                         $    1.15$ 1.20



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Income from continuing operations, net of taxes for the three months ended June 30, 2014 was $163 million, a $2 million increase from the $161 million reported for the three months ended June 30, 2013. Diluted earnings per share from continuing operations increased $0.01, or 1 percent, during the three months ended June 30, 2014.

Income from continuing operations, net of taxes and earnings per share for the third quarter of fiscal year 2014 benefited from the additional earnings from our recently completed ARINC acquisition in our newly formed Information Management Services segment and lower income tax expense. These benefits, however, were mostly offset by higher interest expense, higher employee benefit related costs and lower operating earnings within Government Systems that resulted from lower sales volume. Government Systems Financial Results

Government Systems Sales

Prior period results of the Communication products category in Government Systems have been revised to exclude Datapath, which is now reported as a discontinued operation, as discussed in Note 4 of the Notes to Condensed Consolidated Financial Statements. The following table presents Government Systems sales by product category:

                            Three Months Ended
                                 June 30
(in millions)                2014          2013
Avionics                 $    317$  341
Communication products        107            120
Surface solutions              68             62
Navigation products            43             46
Total                    $    535$  569
Percent (decrease)             (6 )%


Avionics sales decreased $24 million, or 7 percent, primarily due to the following:

•      A $16 million reduction from the timing of program schedule requirements
       for hardware deliveries and installations on the E-6B aircraft upgrade
       program



•      A $24 million decrease from the combined impact of lower development
       revenues on the KC-46 and KC-10 programs and the completion of various
       rotary wing upgrade programs



•      partially offset by $16 million in other net increases to revenue,
       including higher hardware deliveries for F-15 aircraft and the Joint
       Helmet Mounted Cueing Systems program


Communication products sales decreased $13 million, or 11 percent, primarily driven by lower deliveries of the Joint Tactical Radio System Manpack radios.

Surface solutions sales increased $6 million, or 10 percent, primarily due to higher international Firestorm targeting system revenues.

Navigation products sales decreased $3 million, or 7 percent, primarily due to a reduction in development revenues on a GPS modernization program.



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Government Systems Segment Operating Earnings


                                Three Months Ended
                                      June 30
(in millions)                   2014           2013

Segment operating earnings $ 112$ 125 Percent of sales

                 20.9 %         22.0 %



The $13 million decrease in Government Systems operating earnings was primarily caused by the combined impact of the $34 million reduction in sales volume discussed in the Government Systems sales section above, the absence of certain favorable program adjustments that occurred in the prior year and higher employee benefit related costs, partially offset by a more favorable product mix of higher margin hardware revenues and cost saving initiatives.

The decrease in Government Systems operating earnings as a percent of sales was primarily driven by the unfavorable margin impact from the absence of certain favorable program adjustments that occurred in the prior year and higher employee benefit related costs.

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
                                                            June 30
(in millions)                                          2014           2013
Air transport aviation electronics:
Original equipment                                 $     181$     151
Aftermarket                                              127             127
Wide-body in-flight entertainment                         17              19
Total air transport aviation electronics                 325             297
Business and regional aviation electronics:
Original equipment                                       157             158
Aftermarket                                              101              96
Total business and regional aviation electronics         258             254
Total                                              $     583$     551
Percent increase                                           6 %


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 $28 million, or 9 percent, primarily due to the following:

•      OEM sales increased $30 million, or 20 percent primarily due to increased
       product deliveries from higher aircraft production rates for the Boeing
       787 aircraft and higher customer funded development program sales



•      aftermarket sales were flat as higher spares revenue for Boeing 787 and
       747-8 aircraft were offset by a reduction in retrofits and other sparing
       activity




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Total business and regional aviation electronics sales increased $4 million, or 2 percent, primarily due to the following:

•      OEM sales decreased $1 million, or 1 percent, as a reduction in sales at
       the light-end of the business jet market was mostly offset by higher
       customer funded development program revenues



•      aftermarket sales increased $5 million, or 5 percent, primarily due to
       higher service and support activities


Commercial Systems Segment Operating Earnings


                                Three Months Ended
                                      June 30
(in millions)                   2014           2013

Segment operating earnings $ 130$ 131 Percent of sales

                 22.3 %         23.8 %



Commercial Systems operating earnings decreased $1 million, or 1 percent and were adversely impacted by higher employee benefit related costs. While operating earnings benefited from a $6 million reduction in company funded research and development expenses, the incremental earnings from the higher sales volume were tempered as the sales growth primarily related to lower margin revenues from new products and customer-funded development programs.

The decrease in Commercial Systems operating earnings as a percent of sales was primarily driven by the unfavorable mix of lower margin sales volumes.

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 June 30, 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 our 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



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•      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


The following table presents Information Management Services sales:

                      Three Months Ended
                            June 30
(in millions)            2014             2013
Sales           $       146$  12

Total Information Management Services sales increased $134 million, due to the acquisition of ARINC, which contributed $134 million of revenue to the third 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 our 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 $146 million and $142 million for the three months ended June 30, 2014 and 2013, respectively. The $4 million, or 3 percent, increase in the pro-forma sales was primarily due to double-digit growth in the flight planning and voice and data communication services provided by ARINC's commercial and business aviation divisions, partially offset by a reduction to revenue from the completion of effort on certain projects in ARINC'sairport business and the wind-down of a government program that the company exited. 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
                                      June 30
(in millions)                    2014           2013
Segment operating earnings   $      21$   1
Percent of sales                  14.4 %         8.3 %


Information Management Services operating earnings increased $20 million, primarily due to the acquisition of ARINC.

Operating earnings includes depreciation and amortization expense of $11 million and $1 million for the three months ended June 30, 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
                                     June 30
(in millions)                     2014             2013
General corporate, net   $       14$  14




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Nine Months Ended June 30, 2014 and 2013

Sales
                      Nine Months Ended
                           June 30
(in millions)          2014         2013
Total sales        $    3,577$ 3,255
Percent increase           10 %



Total sales increased $322 million, or 10 percent. ARINC, which was acquired on December 23, 2013, contributed $277 million, or 9 percent, to the overall revenue growth. Non-acquisition organic revenues increased $45 million from the prior year, driven by a combined $64 million increase within the Commercial Systems and Information Management Services businesses, partially offset by a $19 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

                            Nine Months Ended
                                 June 30
(in millions)               2014         2013
Total cost of sales      $   2,495$ 2,258
Percent of total sales        69.8 %      69.4 %


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 $237 million, or 10 percent, primarily due to the following:

$199 million of cost of sales from the ARINC business acquired this year



•      partially offset by a $20 million reduction resulting from the combined
       impact of lower sales volume in Government Systems and lower
       company-funded R&D expense within Commercial Systems, as explained below



•      the remaining net increase of $58 million was primarily attributable to
       the higher sales volume in Commercial Systems






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Research and Development (R&D) expense is included as a component of cost of sales and is summarized as follows:

                                            Nine Months Ended
                                                 June 30
(in millions)                               2014          2013
Customer-funded:
Government Systems                       $    266$  296
Commercial Systems                             86           72
Information Management Services (1)             5            -
Total customer-funded                         357          368

Company-funded:

Government Systems                             53           51
Commercial Systems                            140          155
Information Management Services (1)             1            -
Total company-funded                          194          206

Total research and development expense $ 551$ 574 Percent of total sales

                       15.4 %       17.6 %



(1) Research and development expenses for the Information Management Services segment, including the ARINC acquisition, do not include costs of internally developed software and other costs associated with the expansion and construction of network-related assets. These costs are capitalized as Property on the Condensed Consolidated Statement of Financial Position. 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 $24 million and $18 million for the nine months ended June 30, 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 nine months ended June 30, 2014 decreased $23 million from the same period last year. The customer-funded portion of R&D expense decreased $11 million as the combined impact of the inclusion of ARINC's R&D expense with an increase in customer-funded R&D expenses within Commercial Systems associated with various international programs was more than offset by a reduction in Government Systems resulting from a number of programs that were in development that have completed or are now transitioning to production. The $12 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 $132 million during the nine months ended June 30, 2014, primarily driven by effort on the Boeing 737 MAX, Airbus A350 and Bombardier programs. For the nine months ended June 30, 2013, our investments in pre-production engineering had a net increase of $113 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.



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Selling, General and Administrative Expenses


                                                  Nine Months Ended
                                                       June 30
(in millions)                                     2014          2013

Selling, general and administrative expenses $ 430$ 374 Percent of total sales

                             12.0 %       11.5 %



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 nine months ended June 30, 2014 increased $56 million, primarily due to:

$41 million of SG&A costs from the recently acquired ARINC business

$13 million in transaction costs for legal, accounting and advisory fees
       resulting from the ARINC acquisition




Interest Expense

                      Nine Months Ended
                           June 30
(in millions)          2014           2013
Interest Expense   $      43$  21
Percent increase       104.8 %


Interest expense increased by $22 million during the nine months ended June 30, 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


                                                                      Nine Months Ended
                                                                           June 30
(in millions, except per share amounts)                                2014         2013
Income from continuing operations, net of taxes                    $     445$  455
Percent of sales                                                        12.4 %      14.0 %

Income (loss) from discontinued operations, net of taxes                  (8 )         2
Net income                                                         $     437$  457
Percent of sales                                                        12.2 %      14.0 %

Diluted earnings per share from continuing operations              $    3.25$ 3.29

Diluted earnings (loss) per share from discontinued operations (0.06 ) 0.01 Diluted earnings per share

                                         $    3.19$ 3.30

Income from continuing operations, net of taxes for the nine months ended June 30, 2014 was $445 million, down 2 percent, or $10 million, from the $455 million in income from continuing operations, net of taxes reported for June 30, 2013. Diluted


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earnings per share from continuing operations decreased 1 percent to $3.25 for the nine months ended June 30, 2014 compared to $3.29 for the nine months ended June 30, 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 nine months 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. Government Systems Financial Results

Government Systems Sales

Prior period results of the Communication products category in Government Systems have been revised to exclude Datapath, which is now reported as a discontinued operation, as discussed in Note 4 of the Notes to Condensed Consolidated Financial Statements. The following table presents Government Systems sales by product category:

                            Nine Months Ended
                                 June 30
(in millions)                2014         2013
Avionics                 $     967$   980
Communication products         327          335
Surface solutions              182          169
Navigation products            128          139
Total                    $   1,604$ 1,623
Percent (decrease)              (1 )%


Avionics sales decreased $13 million, or 1 percent, primarily due to the following:

•      a $32 million decrease from lower development revenues on the KC-46 and
       KC-10 programs



•      partially offset by $19 million in other net increases to revenue,
       including higher hardware deliveries for F-15 aircraft and the Joint
       Helmet Mounted Cueing Systems program


Communication products sales decreased $8 million, or 2 percent, primarily driven by fewer deliveries of international Talon radios.

Surface solutions sales increased $13 million, or 8 percent, as a $14 million reduction in effort on the Common Range Integrated Instrumentation Systems development program was more than offset by other net increases to revenue of $27 million, including higher international Firestorm targeting systems revenues.

Navigation products sales decreased $11 million, or 8 percent, primarily due to a reduction in development revenues on a GPS modernization program.

Government Systems Segment Operating Earnings

                                Nine Months Ended
                                     June 30
(in millions)                   2014          2013
Segment operating earnings   $    328$  345
Percent of sales                 20.4 %       21.3 %



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The $17 million decrease in Government Systems operating earnings was primarily caused by the combined impact of the $19 million reduction in sales volume discussed in the Government Systems sales section above and the absence of certain favorable program adjustments that occurred in the prior year.

The decrease in Government Systems operating earnings as a percent of sales was primarily driven by the unfavorable margin impact from the absence of certain favorable program adjustments that occurred in the prior year.

Commercial Systems Financial Results

Commercial Systems Sales


The following table presents Commercial Systems sales by product category and
type of product or service:

                                                      Nine Months Ended
                                                           June 30
(in millions)                                          2014         2013
Air transport aviation electronics:
Original equipment                                 $      509$   445
Aftermarket                                               379         355
Wide-body in-flight entertainment                          54          64
Total air transport aviation electronics                  942         864
Business and regional aviation electronics:
Original equipment                                        432         458
Aftermarket                                               286         277
Total business and regional aviation electronics          718         735
Total                                              $    1,660$ 1,599
Percent increase                                            4 %


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 $78 million, or 9 percent, due to the following:

•      OEM sales increased $64 million, or 14 percent primarily due to increased
       product deliveries from higher aircraft production rates for the Boeing
       787 and 737 aircraft



•      aftermarket sales increased $24 million, or 7 percent, driven by higher
       revenue from regulatory airspace mandates, increased service and support
       activities, and higher spares revenue for Boeing 787 aircraft



•      wide-body IFE sales decreased $10 million, or 16 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 $17 million, or 2 percent, primarily due to the following:

•      OEM sales decreased $26 million, or 6 percent, as a reduction in sales at
       the light-end of the business jet market was partially offset by higher
       customer funded development program revenues



•      aftermarket sales increased $9 million, or 3 percent, as a result of
       higher service and support activities





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Commercial Systems Segment Operating Earnings


                                Nine Months Ended
                                     June 30
(in millions)                   2014          2013

Segment operating earnings $ 368$ 352 Percent of sales

                 22.2 %       22.0 %



Commercial Systems operating earnings increased $16 million, or 5 percent, primarily due to a $15 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 lower margin revenues from new products and customer-funded development programs.

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 nine months of sales and earnings from the reclassified flight services business. Sales and earnings for the nine months ended June 30, 2014 include a full nine 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:

                      Nine Months Ended
                           June 30
(in millions)           2014             2013
Sales           $       313$  33

Total Information Management Services sales increased $280 million, primarily due to the acquisition of ARINC, which contributed $277 million of revenue to the first nine 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 $419 million and $415 million for the nine months ended June 30, 2014 and 2013, respectively. The $4 million, or 1 percent, increase in the pro-forma revenue was primarily due to growth in ARINC's commercial and business aviation divisions, partially offset by the combined impact of a reduction to revenue from the completion of effort on projects in ARINC'sairport business, lower sales resulting from changes in the estimated profit margins expected to be realized on certain long-term contracts within the rail business and the wind-down of a government program that the company exited. Refer to Note 3 of the Notes to Condensed Consolidated Financial Statements for further pro-forma disclosures.


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Information Management Services Segment Operating Earnings

                                Nine Months Ended
                                     June 30
(in millions)                    2014           2013
Segment operating earnings   $      41$  3
Percent of sales                  13.1 %        9.1 %


Information Management Services operating earnings increased $38 million, primarily due to the acquisition of ARINC.

Operating earnings includes depreciation and amortization expense of $24 million and $3 million for the nine months ended June 30, 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:

                               Nine Months Ended
                                    June 30
(in millions)                    2014            2013
General corporate, net   $      45$  44




Retirement Plans

Net benefit expense for pension benefits and other retirement benefits are as
follows:

                                   Three Months Ended                Nine Months Ended
                                        June 30                           June 30
(in millions)                        2014              2013            2014            2013
Pension benefits            $       1$   2$       5$   6
Other retirement benefits           2                     4            7                 11
Net benefit expense         $       3$   6$      12$  17

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.



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During the nine months ended June 30, 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 nine months ended June 30, 2014 we made contributions to our non-U.S. plans and U.S. non-qualified pension plan of $11 million.

Other Retirement Benefits We expect other retirement benefits expense of approximately $9 million for 2014. This compares to 2013 expense of $15 million.

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.


During the three months ended June 30, 2014 and 2013, the effective income tax
rate from continuing operations was 28.8 percent and 30.0 percent, respectively.
The lower current year effective income tax rate from continuing operations was
primarily due to favorable adjustments related to the resolution of certain tax
matters from prior years offset by the differences in availability of the
Federal R&D Tax Credit.
During the nine months ended June 30, 2014 and 2013, the effective income tax
rate from continuing operations was 29.3 percent and 26.1 percent, respectively.
The higher current year effective income tax rate was primarily due to the
differences in the availability of the Federal R&D Tax Credit partially offset
by favorable adjustments recorded in the current period due to the resolution of
certain tax matters from prior years.
For fiscal year 2014, our effective income tax rate is projected to be about
30.0 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

                                             Nine Months Ended
                                                  June 30
(in millions)                                  2014           2013
Cash provided by operating activities   $     237$ 309




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The $72 million reduction in cash provided by operating activities during the nine months ended June 30, 2014 compared to the same period last year was primarily due to the following:

•      payments for production inventory and other operating costs increased by
       $287 million to $2,996 million during the nine months ended June 30, 2014,
       compared to $2,709 million during the same period in the prior year. 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



•      cash payments for income taxes increased $94 million to $166 million
       during the first nine months of 2014 compared to $72 million during the
       same period last year. The increase is primarily due to the timing of tax
       deductions including a lower contribution to our pension plan during the
       first nine months of 2014 as compared to the prior year, differences in
       availability of the federal R&D Tax Credit as the tax credit expired on
       December 31, 2013, and the payment of an IRS audit settlement in the
       current year



•      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 nine months ended June 30, 2014,
       $114 million was paid for employee incentive pay costs expensed during
       fiscal year 2013. This compares to $54 million paid during the nine months
       ended June 30, 2013 for employee incentive pay costs expensed during
       fiscal year 2012



•      the above items were partially offset by higher cash receipts from
       customers which increased by $325 million to $3,594 million during the
       nine months ended June 30, 2014 compared to $3,269 million during the same
       period in the prior year. 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 $66 million during the nine months ended June 30,
       2014 as compared to $120 million during the same period in the prior year




Investing Activities

                                          Nine Months Ended
                                               June 30
(in millions)                              2014         2013

Cash (used for) investing activities $ (1,497 )$ (85 )

The $1.4 billion increase in cash used for investing activities during the nine months ended June 30, 2014 compared to the same period last year was primarily due to the following:

•      in December 2013, we acquired ARINC for $1.405 billion. We had no business
       acquisitions during the same period of the prior year



•      cash payments for property additions increased $30 million to $115 million
       for the nine months ended June 30, 2014, compared to $85 million in the
       same period last year



•      partially offset by $24 million in 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

                                                       Nine Months Ended
                                                            June 30
(in millions)                                           2014           2013

Cash provided by (used for) financing activities $ 1,316$ (203 )





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The $1.519 billion increase in cash provided by financing activities during the nine months ended June 30, 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 refinance $200
       million of long-term debt that matured in December 2013



•      net proceeds from short-term commercial paper borrowing increased by $220
       million. During the first nine months of 2014, net proceeds from
       short-term commercial paper borrowings were $620 million, compared to net
       proceeds of $400 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 $413 million to $111 million
       during the nine months ended June 30, 2014, compared to $524 million
       repurchased during the same period last year


The Company expects share count to remain fairly stable over the balance of 2014.

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 June 30, 2014 and September 30, 2013 are as follows:

(in millions)                         June 30, 2014     September 30, 2013
Cash and cash equivalents            $         450     $             391
Short-term debt(1)                            (855 )                (436 )
Long-term debt, net                         (1,663 )                (563 )
Net debt (2)                         $      (2,068 )   $            (608 )
Total equity                         $       1,953     $           1,623
Debt to total capitalization (3)                56 %                  38 %
Net debt to total capitalization (4)            51 %                  27 %



(1)    Short-term debt at June 30, 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 $1.405 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 June 30, 2014, approximately 92 percent of our cash and cash equivalents resides at non-U.S. locations and may not be readily accessible for use in the U.S. due to potential adverse income tax implications and other statutory limitations. Due to the fluctuations of cash flows, we supplement our internally-generated cash flow from time to time by issuing short-term


                                       47

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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 June 30, 2014, short-term commercial paper borrowings outstanding were $855 million with a weighted-average interest rate and maturity period of 0.34 percent and 41 days days, respectively. For the nine months ended June 30, 2014 and 2013, gross borrowings under our commercial paper program with a maturity period greater than 90 days were $265 million and $0, respectively. For the nine months ended June 30, 2014 and 2013, gross payments under our commercial paper program with a maturity period greater than 90 days were $90 million and $0, respectively. These borrowings and payments were included within short-term commercial paper borrowings, net on the Condensed Consolidated Statement of Cash Flows for the nine months ended June 30, 2014 and 2013, 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 nine months ended June 30, 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 June 30, 2014 based on this financial covenant was 44 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 June 30, 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 June 30, 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.



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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.

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.

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