Overview and Consolidated Results of Operations
$651 millionin research and development costs, a 12% increase over the prior year, demonstrating our commitment to expanding our current product lines across all of our businesses. As a result, we brought new products to market in many of our businesses, including the certification of two new models of Cessna aircraft, the Citation M2 and the Sovereign+ jet. † Acquired six companies, including two flight simulation and aircraft training product companies for the Textron Systemssegment, two companies to augment our Greenlee business in the Industrial segment and two service centers at Cessna for an aggregate cash payment of $196 million. † Made $204 millionin contributions to our pension plans and ended the year with an unfunded pension plan liability of $199 million, compared to $1.3 billionat the end of 2012. † Reduced our debt-to-capital, net of cash ratio to 15% from 24% in the prior year, in part due to the maturity of our convertible senior notes and the settlement of the related call option and warrants. An analysis of our consolidated operating results is set forth below. A more detailed analysis of our segments' operating results is provided in the Segment Analysis section on pages 20 to 28. Revenues (Dollars in millions) 2013 2012 2011 Revenues $ 12,104 $ 12,237 $ 11,275
% change compared with prior period (1)% 9%
$133 million, 1%, in 2013, compared with 2012, as revenue decreases in the Cessna, Finance, and Textron Systemssegments were partially offset by higher revenues in the Bell and Industrial segments. The net revenue decrease included the following factors:
† Lower Cessna revenues of
† Lower Finance revenues of
$83 million, primarily attributable to an unfavorable impact of $46 millionfrom lower average finance receivables and a decrease of $25 millionin revenues related to the resolution of a Timeshare account in 2012. † Lower Textron Systemsrevenues of $72 million, largely due to lower volume of $51 millionin the Marine & Land product line and lower volume of $28 millionin the UAS product line.
$962 million, 9%, in 2012, compared with 2011, as increases in the Bell, Cessna, Industrial and Finance segments were partially offset by a reduction in the Textron Systemssegment. The net revenue increase included the following factors:
Increased Industrialsegment revenues of $115 million, primarily due to higher volume of $171 million, primarily reflecting higher market demand in the Fuel Systems and Functional Components and Golf, Turf Care and Light 18 --------------------------------------------------------------------------------
Transportation Vehicles product lines, partially offset by an unfavorable foreign exchange impact of
† Higher Finance revenues of
† Lower Textron Systems revenues of
Cost of Sales and Selling and Administrative Expense
(Dollars in millions) 2013 2012 2011 Operating expenses
$ 11,257 $ 11,184 $ 10,503Cost of sales 10,131 10,019 9,308 % change compared with prior period 1% 8%
Gross margin as a percentage of Manufacturing revenues 15.4% 16.7%
Selling and administrative expenses 1,126 1,165
$ 1,195% change compared with prior period (3)% (3)% Manufacturing cost of sales and selling and administrative expenses together comprise our operating expenses. Changes in operating expenses are more fully discussed in our Segment Analysis below.
Cost of sales as a percentage of manufacturing revenues was 84.6% in 2013, and 83.3% in both 2012 and 2011.
Consolidated manufacturing cost of sales increased
$112 million, 1%, in 2013, compared with 2012, primarily due to higher sales volume at Bell and the impact from businesses acquired in 2013, partially offset by lower sales at Cessna and Textron Systems. In 2013, gross margin as a percentage of manufacturing revenues decreased 130 basis points primarily due to unfavorable performance at Bell, largely due to manufacturing inefficiencies associated with labor disruptions resulting from negotiations with bargained employees and with the implementation of a new enterprise resource planning system in the first quarter of 2013, as well as lower Citation jet and CitiationAir volume at Cessna. Selling and administrative expenses decreased $39 million, 3%, in 2013 compared with 2012, largely due to a reduction in administrative expenses of $26 millionand lower provision for loan losses of $20 millionat the Finance segment, both primarily associated with the non-captive business. Selling and administrative expense was also impacted by $28 millionin severance costs incurred in 2013 at Cessna, which were largely offset by a $27 millioncharge from an unfavorable arbitration award incurred in 2012 at Cessna. In 2012, consolidated manufacturing cost of sales increased $711 million, 8%, compared with 2011, principally due to higher net sales volume. Cost of sales was reduced by $65 millionin 2012 from foreign exchange fluctuations, primarily in the Industrial segment due to the weakening of the euro. In addition, cost of sales included $37 millionin charges related to our new UAS fee-for-service contracts at Textron Systems, which were offset by the impact of 2011 charges at Textron Systemsof $60 millionrelated to the impairment of intangible assets and severance costs. Selling and administrative expense decreased $30 million, 3%, in 2012, compared with 2011. The decrease was largely driven by lower operating expenses of $56 millionat the Finance segment primarily associated with the exit of the non-captive business, partially offset by a $27 millioncharge at Cessna from an unfavorable arbitration award described more fully in the Segment Analysis below. Interest Expense (Dollars in millions) 2013 2012 2011 Interest expense $ 173 $ 212 $ 246
% change compared with prior period (18)% (14)%
Interest expense on the Consolidated Statement of Operations includes interest for both the Finance and Manufacturing borrowing groups with interest related to intercompany borrowings eliminated. Interest expense for the Finance segment is included within segment profit and includes intercompany interest. Consolidated interest expense decreased
$39 million, 18%, in 2013, compared with 2012, and $34 million, 14%, in 2012 compared with 2011, primarily due to lower average debt outstanding.
Valuation Allowance on Transfer of Golf Mortgage Portfolio to Held for Sale
In the fourth quarter of 2011, we determined that we no longer had the intent to hold the remaining Golf Mortgage portfolio for investment for the foreseeable future, and, accordingly, transferred
$458 millionof the remaining Golf Mortgage finance receivables, net of an $80 millionallowance for loan losses, from the held for investment classification to the held for sale 19 -------------------------------------------------------------------------------- classification. These finance receivables were recorded at fair value at the time of the transfer, resulting in a $186 millioncharge recorded to Valuation allowance on transfer of Golf Mortgage portfolio to held for sale.
Other Losses, net
In 2011, other losses, net included
$55 millionin losses on the early extinguishment of a portion of our convertible notes which was largely offset by a $52 milliongain from the collection on notes receivable in connection with the disposition of the Fluid & Power business in 2008.
Income Tax Expense
Our effective tax rate was 26.1% in 2013, 30.9% in 2012 and 28.1% in 2011, and generally differs from the U.S. federal statutory tax rate of 35% due to certain earnings from our operations in lower-tax jurisdictions throughout the world, as well as research credits. The jurisdictions with favorable tax rates that have the most significant effective tax rate impact in the periods presented include primarily
Canada, Germany, Belgiumand China. We have not provided for U.S. taxes for those earnings because we plan to reinvest all of those earnings indefinitely outside of the U.S. Our effective tax rate will fluctuate based on the mix of earnings from our U.S. and non-U.S. operations. In addition, the American Taxpayer Relief Act of 2012 was enacted on January 2, 2013to retroactively reinstate and extend the Federal Researchand Development Tax Credit from January 1, 2012to December 31, 2013. As a result our income tax provision for 2013 includes a tax benefit that reduced the annual effective tax rate by approximately four percent. We estimate our full year annual effective tax rate in 2014 to be approximately 31.5%. For a full reconciliation of our effective tax rate to the U.S. federal statutory tax rate of 35% see Note 12 to the Consolidated Financial Statements. Segment Analysis We operate in, and report financial information for, the following five business segments: Cessna, Bell, Textron Systems, Industrial and Finance. Segment profit is an important measure used for evaluating performance and for decision-making purposes. Segment profit for the manufacturing segments excludes interest expense and certain corporate expenses. The measurement for the Finance segment includes interest income and expense along with intercompany interest expense. In our discussion of comparative results for the Manufacturing group, changes in revenue and segment profit typically are expressed for our commercial business in terms of volume, pricing, foreign exchange and acquisitions. Additionally, changes in segment profit may be expressed in terms of mix, inflation and cost performance. Volume changes in revenue represent increases/decreases in the number of units delivered or services provided. Pricing represents changes in unit pricing. Foreign exchange is the change resulting from translating foreign-denominated amounts into U.S. dollars at exchange rates that are different from the prior period. Acquisitions refer to the results generated from businesses that were acquired within the previous 12 months. For segment profit, mix represents a change due to the composition of products and/or services sold at different profit margins. Inflation represents higher material, wages, benefits, pension or other costs. Cost performance reflects an increase or decrease in research and development, depreciation, selling and administrative costs, warranty, product liability, quality/scrap, labor efficiency, overhead, product line profitability, start-up, ramp up and cost-reduction initiatives or other manufacturing inputs. Approximately 30% of our 2013 revenues were derived from contracts with the U.S. Government. For our segments that have significant contracts with the U.S. Government, we typically express changes in segment profit related to the government business in terms of volume, changes in program performance or changes in contract mix. Changes in volume that are discussed in net sales typically drive corresponding changes in our segment profit based on the profit rate for a particular contract. Changes in program performance typically relate to profit recognition associated with revisions to total estimated costs at completion that reflect improved or deteriorated operating performance or award fee rates. Changes in contract mix refers to changes in operating margin due to a change in the relative volume of contracts with higher or lower fee rates such that the overall average margin rate for the segment changes. Cessna % Change (Dollars in millions) 2013 2012 2011 2013 2012 Revenues $ 2,784 $ 3,111 $ 2,990(11)% 4% Operating expenses 2,832 3,029 2,930 (7)% 3% Segment (loss) profit (48) 82 60 - 37% Profit margin (2)% 3% 2% Backlog $ 1,018 $ 1,062 $ 1,889(4)% (44)% 20
Cessna Revenues and Operating Expenses
Factors contributing to the 2013 year-over-year revenue change are provided below: 2013 versus (In millions) 2012 Volume
$ (373)Acquisitions 33 Other 13 Total change $ (327)In 2013, Cessna's revenues decreased $327 million, 11%, compared with 2012, primarily due to lower Citation jet volume of $384 millionand lower CitationAirvolume of $114 million, largely related to the wind-down of our fractional share business. These decreases were partially offset by higher aftermarket volume of $65 million, largely due to increased service demand, and higher pre-owned aircraft volume of $53 million. We delivered 139 Citation jets in 2013, compared with 181 jets in 2012. During 2013, the portion of Cessna's revenues derived from aftermarket sales and services increased to 33% of Cessna's revenues, compared with 25% in the corresponding period of 2012, due to higher aftermarket volume and the impact of lower Citation jet revenues. Cessna's operating expenses decreased $197 million, 7%, in 2013, compared with 2012, primarily due to lower sales volume as discussed above. The volume-related decrease in operating expenses was partially offset by $37 millionof operating costs incurred by service centers acquired at the beginning of 2013 and $33 millionof inflation, largely due to higher pension expense of $17 million.
Operating expenses in 2013 were impacted by
Factors contributing to the 2012 year-over-year revenue change are provided below: 2012 versus (In millions) 2011 Volume and mix $ 126 Other (5) Total change $ 121 Cessna delivered 181 Citation jets in 2012, compared with 183 jets in 2011, however revenues increased
$121 million, 4%, in 2012, compared with 2011. The increase in revenues was primarily due to a $68 millionimpact from higher pre-owned aircraft volume and $57 millionof higher Citation jet revenues reflecting a change in mix of new jets sold during the period. During 2012, the portion of Cessna's revenues derived from aftermarket sales and services represented 25% of Cessna's revenues, compared with 24% in the corresponding period of 2011.
Cessna's operating expenses increased by
$93 millionin higher direct material costs, resulting from increased pre-owned aircraft sales volume and a change in the mix of jets sold during the period.
$27 millioncharge recorded in the fourth quarter of 2012 due to an unfavorable award an arbitration panel entered against Cessna as a result of an alleged breach of a supply agreement. These increases were partially offset by $33 millionof cost reductions from improved factory efficiency and $24 millionin lower engineering and development expenses. 21
Cessna Segment (Loss) Profit
Factors contributing to 2013 year-over-year segment (loss) profit change are provided below: 2013 versus (In millions) 2012 Volume $ (99 ) Inflation, net of pricing (21 ) Other (10 ) Total change
$ (130 )Cessna's segment profit decreased $130 millionin 2013, compared with 2012, primarily due to a $99 millionimpact from lower sales volume as described above and $21 millionin inflation, net of pricing, largely due to higher pension expense of $17 million. Segment profit was also impacted by $28 millionin severance costs incurred in 2013, largely offset by a $27 millioncharge from an unfavorable arbitration award incurred in 2012, as described above. Factors contributing to 2012 year-over-year segment profit change are provided below: 2012 versus (In millions) 2011 Volume and mix $ 53 Performance 12 Inflation, net of pricing (43 ) Total change $ 22
In 2012, Cessna's segment profit increased
$33 millionin improved factory efficiency. † $24 millionin lower engineering and development expenses. † $(27) millionunfavorable arbitration award as described above.
Inflation, net of pricing, included a
Cessna's backlog decreased
$44 million, 4%, in 2013 and $827 million, 44%, in 2012. The decrease in backlog in 2012 was mainly attributable to deliveries in excess of new orders and canceled Citation jet orders. Bell % Change (Dollars in millions) 2013 2012 2011 2013 2012 Revenues: V-22 program $ 1,755 $ 1,611 $ 1,3809 % 17 % Other military 959 940 919 2 % 2 % Commercial 1,797 1,723 1,226 4 % 41 % Total revenues 4,511 4,274 3,525 6 % 21 % Operating expenses 3,938 3,635 3,004 8 % 21 % Segment profit 573 639 521 (10 )% 23 % Profit margin 13 % 15 % 15 % Backlog $ 6,450 $ 7,469 $ 7,346(14 )% 2 % Bell's major U.S. Governmentprograms at this time are the V-22 tiltrotor aircraft and the H-1 helicopter platforms, which are both in the production stage and represent a significant portion of Bell's revenues from the U.S. Government. During the second quarter of 2013, we signed the second multi-year V-22 contract for production and delivery of 99 units beginning in late 2014 with options for 23 additional aircraft. 22 --------------------------------------------------------------------------------
Bell Revenues and Operating Expenses
Factors contributing to the 2013 year-over-year revenue change are provided below: 2013 versus (In millions) 2012 Volume $ 193 Other 44 Total change $ 237
Bell's revenues increased
$144 millionincrease in V-22 program volume largely due to higher aircraft deliveries, as we delivered 41 V-22 aircraft in 2013, compared with 39 aircraft in 2012. In addition, military aftermarket volume was higher by $35 million, reflecting increased support of fielded aircraft. † $74 millionincrease in commercial revenues, largely due to higher aircraft volume, as we delivered 213 aircraft in 2013, compared to 188 aircraft in 2012. This increase was partially offset by lower commercial aftermarket revenue of $50 million, largely due to lower volume, which in part, resulted from the conversion to a new enterprise resource planning system in the first quarter of 2013. † $19 millionincrease in other military volume, reflecting higher H-1 deliveries. We delivered 25 H-1 aircraft in 2013, compared with 24 H-1 aircraft in 2012. Bell's operating expenses increased $303 million, 8%, in 2013, respectively, compared with 2012, largely due to higher volume as described above and $68 millionin unfavorable performance, which included $27 millionin lower favorable profit adjustments on its long-term contracts. The unfavorable performance was largely due to manufacturing inefficiencies associated with labor disruptions resulting from negotiations with bargained employees and with the implementation of a new enterprise resource planning system in the first quarter of 2013. On October 13, 2013, Bell reached a new five-year collective bargaining agreement with the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) and UAW Local218 which represents these employees. The impact of these disruptions is expected to continue to depress Bell's margins in 2014 as the costs for inventories manufactured in 2013 are realized as products are delivered. Factors contributing to the 2012 year-over-year revenue change are provided below: 2012 versus (In millions) 2011 Volume $ 728 Other 21 Total change $ 749
Bell's revenues increased
$476 millionincrease in commercial volume, largely related to higher deliveries reflecting our investment in new products and increased focus on commercial markets. Bell delivered 188 commercial aircraft in 2012, compared with 125 aircraft in 2011. † $231 millionincrease in volume related to the V-22 program, primarily reflecting higher deliveries based on schedule requirements and higher revenues related to the support of fielded aircraft. Bell delivered 39 V-22 aircraft in 2012, compared with 34 deliveries in 2011. † $21 millionincrease in other military volume resulting from higher deliveries and services rendered under several programs, partially offset by lower spares and aftermarket volume. Bell delivered 24 H-1 aircraft in 2012, compared with 25 aircraft in 2011.
Bell's operating expenses increased
Bell Segment Profit
Factors contributing to 2013 year-over-year segment profit change are provided below: 2013 versus (In millions) 2012 Performance $ (68 ) Volume and Mix (10 ) Other 12 Total change $ (66 ) Bell's segment profit decreased
$66 million, 10%, in 2013, respectively, compared with 2012, primarily due to unfavorable performance discussed above. Segment profit was also impacted by an unfavorable mix of commercial aircraft deliveries. Factors contributing to 2012 year-over-year segment profit change are provided below: 2012 versus (In millions) 2011 Volume and mix $ 143 Performance (18 ) Other (7 ) Total change $ 118 Bell's segment profit increased $118 million, 23%, in 2012, compared with 2011, primarily due to the impact of higher volume in our commercial aircraft and military businesses as described above. Performance reflects higher net research and development expense in 2012 of $26 milliondue to the ramp-up of new product development and higher selling and administrative expenses largely due to our investment in business system improvement and upgrade activities, which were partially offset by favorable program performance in our military programs, reflecting improved manufacturing efficiencies.
Textron Systems% Change (Dollars in millions) 2013 2012 2011 2013 2012 Revenues $ 1,665 $ 1,737 $ 1,872(4 )% (7 )% Operating expenses 1,518 1,605 1,731 (5 )% (7 )% Segment profit 147 132 141 11 % (6 )% Profit margin 9 % 8 % 8 % Backlog $ 2,803 $ 2,919 $ 1,337(4 )% 118 %
Textron Systems Revenues and Operating Expenses
Factors contributing to the 2013 year-over-year revenue change are provided below: 2013 versus (In millions) 2012 Volume $ (76 ) Other 4 Total change $ (72 ) Revenues at
Textron Systemsdecreased $72 million, 4%, in 2013, compared with 2012, primarily due to lower volume in the Marine & Land product line of $51 millionand in the UAS product line of $28 million. Textron Systems'operating expenses decreased $87 million, 5%, in 2013, compared with 2012, primarily due to improved performance reflecting the favorable impact of lower profit adjustments, including $22 millionin lower UAS fee-for-service program charges, along with cost reduction initiatives across most product lines Operating expenses were also impacted by the lower sales volume described above. 24
-------------------------------------------------------------------------------- Factors contributing to the 2012 year-over-year revenue change are provided below: 2012 versus (In millions) 2011 Volume
$ (141 )Other 6 Total change $ (135 )Revenues at Textron Systemsdecreased $135 million, 7%, in 2012, compared with 2011, primarily due to lower volume in the Marine & Land product line of $76 million, lower volume in the Mission Support and Other product line of $45 millionand lower volume in Weapons and Sensors of $13 million. Textron Systems'operating expenses decreased $126 million, 7%, in 2012, compared with 2011, primarily due to the lower volume. Operating expenses for 2012 included $37 millionin charges discussed below related to the UAS fee-for-service program, which were offset by the impact of charges at Textron Systemsof $60 millionduring 2011, related to the impairment of intangible assets and severance costs.
UAS Fee-For-Service Program
In 2012, we were awarded two indefinite delivery, indefinite quantity (IDIQ) contracts with separate
U.S. Governmentcustomers for UAS fee-for-service activities. In the third quarter of 2012, we experienced start-up issues as we began deployment for the first of these contracts, the MEUAS II program, which required us to augment training procedures, add resources and adjust certain estimated costs. At that time, we took an $18 millioncharge reflecting our estimated loss on the awarded task orders under both contracts based on our deployment experience, which resulted in changes to certain assumptions, and also reflected higher subcontractor, up-front training and program management costs to support the ramp-up. In the fourth quarter of 2012, we experienced propulsion performance issues with our systems, and as a result, we were not able to perform within our previous cost estimates. Based on the issues we have encountered, we increased our estimate of the cost to complete the awarded task orders under both contracts through completion of those orders and recorded a $19 millionunfavorable program profit adjustment in the fourth quarter of 2012. In 2013, we recorded $15 millionof charges for the UAS fee-for service program related to our estimate of costs to fulfill options that were exercised by the customer during the third quarter; these options extended the period of performance on the initial task orders under the contracts for one year. We continued to experience unacceptable quality from our engine supplier for this program and decided in the third quarter to transition the manufacture of the engine to our Lycoming business. We believe this change will allow us to improve performance.
Textron Systems Segment Profit
Factors contributing to 2013 year-over-year segment profit change are provided below: 2013 versus (In millions) 2012 Performance $ 58 Volume and mix (33 ) Other (10 ) Total change $ 15 Segment profit at
Textron Systemsincreased $15 million, 11% in 2013 compared with 2012, largely due to improved performance reflecting the favorable impact of lower profit adjustments, including $22 millionin lower UAS fee-for-service program charges, along with cost reduction initiatives across most product lines. This improved performance was partially offset by the lower volume described above. 25
-------------------------------------------------------------------------------- Factors contributing to 2012 year-over-year segment profit change are provided below: 2012 versus (In millions) 2011 Volume and mix $ (57 ) Impairment charge in 2011 41 Performance 4 Other 3 Total change $ (9 ) Segment profit at
Textron Systemsdecreased $9 million, 6%, in 2012, compared with 2011, reflecting the impact of lower volume described above and deliveries on lower margin contracts during the current period. The favorable performance reflects a charge in 2011 of $19 millionprimarily in severance costs related to workforce reductions, $9 millionin lower amortization expense on intangible assets and $8 millionin lower net research and development costs, partially offset by the $37 millionin charges related to the UAS fee-for-service program described above. Textron Systems Backlog In 2013, Textron Systemsbacklog decreased $116 million, 4%, largely due to deliveries in excess of new orders. In 2012, Textron Systemsbacklog increased $1.6 billion, 118%, largely due to additional orders in the UAS and Marine & Land product lines, including the Canadian TAPV contract for $693 million. Industrial % Change (Dollars in millions) 2013 2012 2011 2013 2012 Revenues: Fuel Systems and Functional Components $ 1,853 $ 1,842 $ 1,8231 % 1% Other Industrial 1,159 1,058 962 10 % 10% Total revenues 3,012 2,900 2,785 4 % 4% Operating expenses 2,770 2,685 2,583 3 % 4% Segment profit 242 215 202 13 % 6% Profit margin 8 % 7 % 7 %
Industrial Revenues and Operating Expenses
Factors contributing to the 2013 year-over-year revenue change are provided below: 2013 versus (In millions) 2012 Volume $ 58 Acquisitions 46 Other 8 Total change $ 112 Industrial segment revenues increased
$112 million, 4%, in 2013, compared with 2012, largely due to higher volume of $58 millionand the impact from newly acquired companies of $46 millionwithin our Powered Tools, Testing and Measurement Equipment product line. Higher volume resulted from a $32 millionincrease in the Other Industrialproduct lines, mostly due to higher market demand in the Golf, Turf Care and Light Transportation Vehicle product line, and a $26 millionincrease in the Fuel Systems and Functional Components line, reflecting higher automotive industry demand in North America. Operating expenses for the Industrial segment increased $85 million, 3%, in 2013, compared with 2012, largely due to higher volume and a $43 millionimpact from newly acquired companies. Operating expenses were also impacted by improved performance of $27 millionassociated with the Fuel Systems and Functional Components product line, which was partially offset by $16 millionof inflation in this product line, reflecting higher compensation and material costs. 26
-------------------------------------------------------------------------------- Factors contributing to the 2012 year-over-year revenue change are provided below: 2012 versus (In millions) 2011 Volume
$ 171Foreign exchange (80 ) Other 24 Total change $ 115Industrial segment revenues increased $115 million, 4%, in 2012, compared with 2011. Higher volume resulted from a $93 millionincrease in the Fuel Systems and Functional Components product line, reflecting higher automotive industry demand in North America, and a $78 millionincrease in the Other Industrialproduct lines, largely related to higher market demand in the Golf, Turf Care and Light Transportation Vehicles product line. The unfavorable foreign exchange impact was mostly related to the weakening of the euro, which primarily impacted the Fuel Systems and Functional Components product line. Operating expenses for the Industrial segment increased $102 million, 4%, in 2012, compared with 2011, largely due to $130 millionin higher direct material costs in support of higher sales volume. In 2012, operating expenses were also impacted by cost inflation of $44 million, primarily due to higher material and overhead costs, partially offset by lower costs due to a favorable foreign exchange impact of $70 millionresulting from the weakening of the euro.
Industrial Segment Profit
Factors contributing to 2013 year-over-year segment profit change are provided below: 2013 versus (In millions) 2012 Performance
$ 39Volume 9 Inflation, net of pricing (22 ) Other 1 Total change $ 27Segment profit for the Industrial segment increased $27 million, 13%, in 2013, compared with 2012, primarily due to improved performance of which $27 millionwas associated with the Fuel Systems and Functional Components product line. The $22 millionunfavorable impact from inflation, net of pricing, was primarily in the Fuel Systems and Functional Components product line, reflecting higher compensation and material costs. Factors contributing to 2012 year-over-year segment profit change are provided below: 2012 versus (In millions) 2011 Volume $ 31Inflation, net of pricing (17 ) Other (1 ) Total change $ 13Segment profit for the Industrial segment increased $13 million, 6%, in 2012, compared with 2011, primarily due to the impact from higher volume as described above, partially offset by cost inflation that exceeded related price increases. 27
Finance (In millions) 2013 2012 2011 Revenues
$ 132 $ 215 $ 103Segment profit (loss) 49 64 (333 ) Finance Revenues Finance segment revenues decreased $83 millionin 2013, compared with 2012, primarily attributable to an unfavorable impact of $46 million, attributable to lower average finance receivables of $834 million. Revenues during 2013 were also lower by $25 milliondue to the resolution of a Timeshare account that returned to accrual status in 2012.
Finance segment revenues increased
$90 millionincrease related to the valuation of Golf Mortgage finance receivables held for sale. In 2012, we had $76 millionin favorable valuation adjustments compared with unfavorable valuation adjustments of $14 millionin 2011.
† These increases were partially offset by a
Finance Segment Profit (Loss)
Finance segment profit decreased
$15 millionin 2013, compared with 2012, primarily resulting from the resolution of a Timeshare account in 2012 as discussed above, as well as an unfavorable impact of $25 millionin net interest margin from lower average finance receivables. These decreases were partially offset by lower administrative expenses of $26 millionand lower provision for loan losses of $20 million, largely related to the downsizing of the non-captive business. Finance segment profit increased $397 millionin 2012, compared with 2011, primarily due to changes in valuation adjustments, lower portfolio losses, net of gains, and the resolution of one significant Timeshare account discussed above, as well as lower administrative expense of $56 million, primarily associated with the exit of the non-captive business. In addition, we recorded a $186 millionvaluation allowance on the transfer of the Golf Mortgage portfolio from held for investment to the held for sale classification during the fourth quarter of 2011. These increases were partially offset by a $27 milliondecrease in net interest margin attributable to lower average finance receivables. Finance Portfolio Quality The following table reflects information about the Finance segment's credit performance related to finance receivables that are classified as held for investment. December 28, December 29, (Dollars in millions) 2013 2012 Finance receivables $ 1,483 $ 1,934Nonaccrual finance receivables 105 143
Ratio of nonaccrual finance receivables to finance receivables
7.08 % 7.39 % 60+ days contractual delinquency $ 80 $ 90 60+ days contractual delinquency as a percentage of finance receivables 5.39 % 4.65 % 28
Liquidity and Capital Resources
Our financings are conducted through two separate borrowing groups. The Manufacturing group consists of
Textronconsolidated with its majority-owned subsidiaries that operate in the Cessna, Bell, Textron Systemsand Industrial segments. The Finance group, which also is the Finance segment, consists of Textron Financial Corporation(TFC) and its consolidated subsidiaries. We designed this framework to enhance our borrowing power by separating the Finance group. Our Manufacturing group operations include the development, production and delivery of tangible goods and services, while our Finance group provides financial services. Due to the fundamental differences between each borrowing group's activities, investors, rating agencies and analysts use different measures to evaluate each group's performance. To support those evaluations, we present balance sheet and cash flow information for each borrowing group within the Consolidated Financial Statements. Key information that is utilized in assessing our liquidity is summarized below: December 28, December 29, (In millions) 2013 2012 Manufacturing group Cash and equivalents $ 1,163 $ 1,378Debt 1,931 2,301 Shareholders' equity 4,384 2,991 Capital (debt plus shareholders' equity) 6,315
Net debt (net of cash and equivalents) to capital 15% 24% Debt to capital 31% 44% Finance group Cash and equivalents $ 48 $ 35 Debt 1,256 1,686 We believe that our calculations of debt to capital and net debt to capital are useful measures as they provide a summary indication of the level of debt financing (i.e., leverage) that is in place to support our capital structure, as well as to provide an indication of the capacity to add further leverage. We believe that we will have sufficient cash to meet our future needs, based on our existing cash balances, the cash we expect to generate from our manufacturing operations and other available funding alternatives, as appropriate. On
October 4, 2013, Textronentered into a senior unsecured revolving credit facility for an aggregate principal amount of $1.0 billion, of which up to $100 millionis available for the issuance of letters of credit. This facility expires in October 2018. At December 28, 2013, there were no amounts borrowed against the facility, and there were $35 millionof letters of credits issued against it. We maintain an effective shelf registration statement filed with the Securities and Exchange Commissionthat allows us to issue an unlimited amount of public debt and other securities. On January 30, 2014, we issued $250 millionin 3.65% notes due 2021 and $350 millionin 4.30% notes due 2024 under this registration statement. We plan to use the net proceeds of the issuance of these notes to finance a portion of the acquisition of all outstanding equity interests in Beech Holdings, LLC, the parent of Beechcraft Corporation, which we have agreed to purchase for approximately $1.4 billionin cash. The transaction is expected to close during the first half of 2014, subject to customary closing conditions, including regulatory approvals. If the transaction is not completed, or the related merger agreement is terminated, on or before December 31, 2014, we will be required to redeem all outstanding 2021 notes at a redemption price equal to 101% of the principal amount thereof, plus accrued and unpaid interest. On January 24, 2014, in order to finance the Beechcraft acquisition, we also entered into a five-year term loan with a syndicate of banks in the principal amount of $500 millionwhich we intend to draw down upon the closing of the transaction. 29
Manufacturing Group Cash Flows
Cash flows from continuing operations for the Manufacturing group as presented in our Consolidated Statement of Cash Flows are summarized below:
(In millions) 2013 2012 2011 Operating activities
$ 658 $ 958 $ 761Investing activities (624 ) (476 ) (423 ) Financing activities (240 ) 29 (360 ) We generated $658 millionin cash from operating activities in 2013 on $914 millionin Manufacturing group segment profit and $470 millionof net income. The $300 milliondecrease in cash flows from operating activities from 2012 was largely due to a $429 millionimpact related to working capital requirements and $64 millionin lower income from continuing operations, which were partially offset by $211 millionin lower contributions to our pension plans in 2013.
most significant change within working capital was a
$230 millionunfavorable impact resulting from net tax payments of $223 millionin 2013, compared to net tax refunds of $7 millionin 2012. In addition, we had $165 millionin cash inflows related to changes in inventory levels, largely at Cessna, which was more than offset by $264 millionof cash outflows from changes in accounts receivable and accounts payable. The change in inventory levels at Cessna was primarily related to lower pre-owned inventory, partially offset by higher inventory in support of new sales. In 2012, we generated $958 millionin cash from operating activities on $1.1 billionin Manufacturing group segment profit and $534 millionof Manufacturing group net income. The 26% increase in cash flows from operating activities from 2011 was largely due to lower cash contributions of $237 millionmade to our pension plans in 2012. Within working capital, we had a $117 millionreduction in cash resulting from an increase in pre-owned inventory in at Cessna primarily due to higher trade-in activities, which was largely offset by a reduction in net taxes paid.
Pension contributions were
Investing cash flows in 2013, 2012 and 2011 primarily included capital expenditures of
In 2013, financing activities primarily consisted of the repayment of
$528 millionof outstanding debt, including the settlement of our convertible notes, which was partially offset by proceeds from a $150 millionvariable-rate term loan agreement. In 2012, we generated cash from financing activities, largely due to the receipt of $490 millionfrom the Finance group in payment of its intergroup borrowing, partially offset by $272 millionin share repurchases and $189 millionin payments on our outstanding debt. In 2011, financing activities primarily consisted of $580 millionin payments related to the purchase and cancellation of convertible notes and $175 millionin intergroup financing for our Finance group, partially offset by $496 millionin proceeds from the issuance of notes. Dividends
Dividend payments to shareholders totaled
In the fourth quarter of 2012, under a 2007 share repurchase authorization, we repurchased 11.1 million shares of our common stock for a total cost of
$272 millionwhich fully utilized our available repurchase authorization. On January 23, 2013, our Board of Directors approved a new authorization program for 25 million shares under which we intend to purchase shares of common stock to offset the impact of dilution from share-based compensation plans beginning in 2014 and for opportunistic capital management purposes. On February 5, 2014, we entered into an accelerated share repurchase agreement (ASR) with a counterparty to repurchase an aggregate of 4.3 million shares of our outstanding common stock from the counterparty for $150 million. The ASR is scheduled to expire in December 2014. Upon final settlement of the ASR, we may receive additional shares or pay additional cash or shares, at our option, based on the daily volume weighted average market price of our common stock over the course of a calculation period, less a discount.
Capital Contributions Paid To and Dividends Received From the
Under a Support Agreement between
30 -------------------------------------------------------------------------------- shareholder's equity of no less than
$200 million. Cash contributions paid to TFC to maintain compliance with the Support Agreement and dividends paid by TFC to Textron Inc.are detailed below: (In millions) 2013 2012
Dividends paid by TFC to Textron
$ 175 $ 345 $ 179Capital contributions paid to TFC under Support Agreement - (240 ) (182 ) During 2013, we also made a $1 millioncapital contribution to TFC to fund the repurchase of a portion of TFC's 6% Fixed-to-Floating Rate Junior Subordinated Notes. Due to the nature of these contributions, we classify these contributions within cash flows used by operating activities for the Manufacturing group in the Consolidated Statements of Cash Flows. Capital contributions to support Finance group growth in the ongoing captive finance business are classified as cash flows from financing activities. The Finance group's net income (loss) is excluded from the Manufacturing group's cash flows, while dividends from the Finance group are included within cash flows from operating activities for the Manufacturing group as they represent a return on investment.
Finance Group Cash Flows
The cash flows from continuing operations for the Finance group are summarized below: (In millions) 2013 2012 2011 Operating activities
$ 66 $ 5 $ 65Investing activities 624 934 1,453 Financing activities (677 ) (918 ) (1,536 ) In 2013 and 2012, the Finance group's cash flows from operating activities were primarily impacted by changes in net taxes received/paid and the impact of earnings. Net tax refunds/(payments) were $49 million, $(43) millionand $65 millionin 2013, 2012 and 2011, respectively. Net tax payments in 2012 included a settlement related to the Internal Revenue Service's challenge of tax deductions claimed in prior years for certain leveraged lease transactions. Cash flows from investing activities primarily included collections on finance receivables and proceeds from sales of finance receivables and other finance assets totaling $853 millionin 2013, $1.3 billionin 2012 and $1.9 billionin 2011, partially offset by financial receivable originations of $271 millionin 2013, $331 millionin 2012 and $471 millionin 2011. Cash used in financing activities included principal payments on long-term debt of $743 million, $426 millionand $756 millionin 2013, 2012 and 2011, respectively. These cash outflows were partially offset by proceeds from long term debt of $298 million, $106 millionand $430 million, respectively. In 2012, the Finance group also made cash payments totaling $493 millionto the Manufacturing group related to intergroup borrowings. In 2011, the Finance group paid $1.4 billionagainst the outstanding balance on its bank line of credit. Consolidated Cash Flows
The consolidated cash flows from continuing operations, after elimination of activity between the borrowing groups, are summarized below:
(In millions) 2013 2012 2011 Operating activities
$ 813 $ 935 $ 1,068Investing activities (264 ) 378 843 Financing activities (742 ) (781 ) (1,951 ) 31
-------------------------------------------------------------------------------- Cash flows from operating activities decreased
$122 millionduring 2013 as compared with 2012, largely due to a $133 millionimpact related to working capital requirements and lower earnings, which were partially offset by a $206 millionimpact of lower contributions to our pension plans in 2013. Significant changes within working capital included a $138 millionunfavorable impact resulting from net taxes paid between the periods as net tax payments were $174 millionand $36 millionin 2013 and 2012, respectively, and $264 millionof cash outflows related to changes in accounts receivable and accounts payable. These cash outflows were partially offset by $198 millionof cash inflows related to changes in inventory levels, largely at Cessna, and a $141 millionimpact from lower captive finance receivables. Cash flows from operating activities decreased during 2012 as compared with 2011, as higher earnings were offset by changes in working capital, which included lower net cash receipts from our captive financing activities of $140 millionand an increase in pre-owned inventory in the Cessna segment largely due to higher trade-in activities, resulting in a cash reduction of $117 million. Our use of cash for working capital requirements was partially offset by $237 millionin lower cash pension contributions made in 2012. Cash flows from investing activities included capital expenditures of $444 million, $480 million, and $423 millionin 2013, 2012 and 2011, respectively. Collections on finance receivables and proceeds from sales of finance receivables and other finance assets totaled $368 millionin 2013, $848 millionin 2012 and $1.4 billionin 2011. Cash flows from investing activities also included $196 millionof cash used in 2013 for acquisitions of four businesses within our Textron Systemsand Industrial segments and two service centers in our Cessna segment. Financing activities primarily consisted of the repayment of outstanding long-term debt of $1.3 billion, $0.6 billionand $1.4 billionin 2013, 2012 and 2011, respectively, partially offset by proceeds from the issuance of long-term debt of $448 million, $106 millionand $926 million, in 2013, 2012 and 2011, respectively. Cash used in financing activities also included $272 millionof share repurchases in 2012 and repayments of $1.4 billionagainst the outstanding balance on our bank credit lines in 2011.
Captive Financing and Other Intercompany Transactions
The Finance group finances retail purchases and leases for new and used aircraft and equipment manufactured by our Manufacturing group, otherwise known as captive financing. In the Consolidated Statements of Cash Flows, cash received from customers or from the sale of receivables is reflected as operating activities when received from third parties. However, in the cash flow information provided for the separate borrowing groups, cash flows related to captive financing activities are reflected based on the operations of each group. For example, when product is sold by our Manufacturing group to a customer and is financed by the Finance group, the origination of the finance receivable is recorded within investing activities as a cash outflow in the Finance group's statement of cash flows. Meanwhile, in the Manufacturing group's statement of cash flows, the cash received from the Finance group on the customer's behalf is recorded within operating cash flows as a cash inflow. Although cash is transferred between the two borrowing groups, there is no cash transaction reported in the consolidated cash flows at the time of the original financing. These captive financing activities, along with all significant intercompany transactions, are reclassified or eliminated from the Consolidated Statements of Cash Flows.
Reclassification and elimination adjustments included in the Consolidated Statement of Cash Flows are summarized below:
(In millions) 2013 2012
Reclassifications from investing activities: Finance receivable originations for Manufacturing group inventory sales
$ (248 ) $ (309 ) $ (284 )Cash received from customers and the sale of receivables 485 405
Other capital contributions made to Finance group - - (60 ) Other 27 (16 )
Total reclassifications from investing activities 264 80
Reclassifications from financing activities: Capital contribution paid by Manufacturing group to Finance group 1 240
Dividends received by Manufacturing group from Finance group (175 ) (345 ) (179 ) Other capital contributions made to Finance group - -
Other (1 ) (3 ) (8 ) Total reclassifications from financing activities (175 ) (108 )
Total reclassifications and adjustments to cash flow from operating activities
$ 89 $ (28 ) $ 24232
The following table summarizes the known contractual obligations, as defined by reporting regulations, of our Manufacturing group as of
Payments Due by Period Less than 1 More Than 5 (In millions) Total Year 1-3 Years 4-5 Years Years Liabilities reflected in balance sheet: Long-term debt
$ 1,936$ 8 $ 765 $ 365 $ 798Interest on borrowings 509 108 183 122 96 Pension benefits for unfunded plans (1) 359 26 48 43 242 Postretirement benefits other than pensions (1) 445 48 85 71 241 Other long-term liabilities (2) 549 123 147 65 214 Liabilities not reflected in balance sheet: Operating leases (3) 342 63 82 49 148 Purchase obligations (4) 3,264 2,492 742 18 12 Total Manufacturing group $ 7,404 $ 2,868 $ 2,052 $ 733 $ 1,751(1) We maintain defined benefit pension plans and postretirement benefit plans other than pensions as discussed in Note 11 to the Consolidated Financial Statements. Included in the above table are discounted estimated benefit payments we expect to make related to unfunded pension and other postretirement benefit plans. Actual benefit payments are dependent on a number of factors, including mortality assumptions, expected retirement age, rate of compensation increases and medical trend rates, which are subject to change in future years. Our policy for funding pension plans is to make contributions annually, consistent with applicable laws and regulations; however, future contributions to our pension plans are not included in the above table. In 2014, we expect to make contributions to our funded pension plans of approximately $33 millionand approximately $19 millionin the Retirement Account Plan. Based on our current assumptions, which may change with changes in market conditions, our current contribution estimates for each of the years from 2015 through 2018 are estimated to be in the range of approximately $75 millionto $130 millionunder the plan provisions in place at this time. (2) Other long-term liabilities included in the table consist primarily of undiscounted amounts in the Consolidated Balance Sheet as of December 28, 2013, representing obligations under deferred compensation arrangements and estimated environmental remediation costs. Payments under deferred compensation arrangements have been estimated based on management's assumptions of expected retirement age, mortality, stock price and rates of return on participant deferrals. The timing of cash flows associated with environmental remediation costs is largely based on historical experience. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and product liability, warranty and litigation reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments.
(3) Operating leases represent undiscounted obligations under noncancelable leases.
(4) Purchase obligations include undiscounted amounts committed under legally enforceable contracts or purchase orders for goods and services with defined terms as to price, quantity and delivery dates. Approximately 40% of the purchase obligations we disclose represent purchase orders issued for goods and services to be delivered under firm contracts with the
U.S. Governmentfor which we have full recourse under customary contract termination clauses. 33 --------------------------------------------------------------------------------
The following table summarizes the known contractual obligations, as defined by reporting regulations, of our Finance group as of
Payments Due by Period Less than 1 More Than 5 (In millions) Total Year 1-3 Years 4-5 Years Years Liabilities reflected in balance sheet: Term debt
$ 783 $ 174 $ 357 $ 133 $ 119Securitized debt (1) 172 49 93 26 4 Subordinated debt 299 - - - 299 Interest on borrowings (2) 260 40 67 24 129 Total Finance group $ 1,514 $ 263 $ 517 $ 183 $ 551(1) Securitized debt payments do not represent contractual obligations of the Finance group, and we do not provide legal recourse to investors who purchase interests in the securitizations beyond the credit enhancement inherent in the retained subordinate interests. (2) Interest payments reflect the current interest rate paid on the related debt. They do not include anticipated changes in market interest rates, which could have an impact on the interest rate according to the terms of the related debt.
Critical Accounting Estimates To prepare our Consolidated Financial Statements to be in conformity with generally accepted accounting principles, we must make complex and subjective judgments in the selection and application of accounting policies. The accounting policies that we believe are most critical to the portrayal of our financial condition and results of operations are listed below. We believe these policies require our most difficult, subjective and complex judgments in estimating the effect of inherent uncertainties. This section should be read in conjunction with Note 1 to the Consolidated Financial Statements, which includes other significant accounting policies.
We make a substantial portion of our sales to government customers pursuant to long-term contracts. These contracts require development and delivery of products over multiple years and may contain fixed-price purchase options for additional products. We account for these long-term contracts under the percentage-of-completion method of accounting. Under this method, we estimate profit as the difference between total estimated revenues and cost of a contract. The percentage-of-completion method of accounting involves the use of various estimating techniques to project costs at completion and, in some cases, includes estimates of recoveries asserted against the customer for changes in specifications. Due to the size, length of time and nature of many of our contracts, the estimation of total contract costs and revenues through completion is complicated and subject to many variables relative to the outcome of future events over a period of several years. We are required to make numerous assumptions and estimates relating to items such as expected engineering requirements, complexity of design and related development costs, product performance, performance of subcontractors, availability and cost of materials, labor productivity and cost, overhead and capital costs, manufacturing efficiencies and the achievement of contract milestones, including product deliveries, technical requirements, or schedule. Our cost estimation process is based on the professional knowledge and experience of engineers and program managers along with finance professionals. We update our projections of costs at least semiannually or when circumstances significantly change. Adjustments to projected costs are recognized in earnings when determinable. Anticipated losses on contracts are recognized in full in the period in which the losses become probable and estimable. Due to the significance of judgment in the estimation process described above, it is likely that materially different revenues and/or cost of sales amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. Our earnings could be reduced by a material amount resulting in a charge to earnings if (a) total estimated contract costs are significantly higher than expected due to changes in customer specifications prior to contract amendment, (b) total estimated contract costs are significantly higher than previously estimated due to cost overruns or inflation, (c) there is a change in engineering efforts required during the development stage of the contract or (d) we are unable to meet contract milestones. 34 -------------------------------------------------------------------------------- At the outset of each contract, we estimate the initial profit booking rate. The initial profit booking rate of each contract considers risks surrounding the ability to achieve the technical requirements (for example, a newly-developed product versus a mature product), schedule (for example, the number and type of milestone events), and costs by contract requirements in the initial estimated costs at completion. Profit booking rates may increase during the performance of the contract if we successfully retire risks surrounding the technical, schedule, and costs aspects of the contract. Likewise, the profit booking rate may decrease if we are not successful in retiring the risks; and, as a result, our estimated costs at completion increase. All of the estimates are subject to change during the performance of the contract and, therefore, may affect the profit booking rate. When adjustments are required, any changes from prior estimates are recognized using the cumulative catch-up method with the impact of the change from inception-to-date recorded in the current period. The following table sets forth the aggregate gross amount of all program profit adjustments that are included within segment profit for the three years ended
December 28, 2013: (In millions) 2013 2012 2011 Gross favorable $ 51 $ 88 $ 83Gross unfavorable (22 ) (73 ) (29 ) Net adjustments $ 29 $ 15 $ 54Goodwill We evaluate the recoverability of goodwill annually in the fourth quarter or more frequently if events or changes in circumstances, such as declines in sales, earnings or cash flows, or material adverse changes in the business climate, indicate that the carrying value of a reporting unit might be impaired. The reporting unit represents the operating segment unless discrete financial information is prepared and reviewed by segment management for businesses one level below that operating segment, in which case such component is the reporting unit. In certain instances, we have aggregated components of an operating segment into a single reporting unit based on similar economic characteristics. We calculate the fair value of each reporting unit, primarily using discounted cash flows. These cash flows incorporate assumptions for short- and long-term revenue growth rates, operating margins and discount rates that represent our best estimates of current and forecasted market conditions, cost structure, anticipated net cost reductions, and the implied rate of return that we believe a market participant would require for an investment in a business having similar risks and business characteristics to the reporting unit being assessed. The revenue growth rates and operating margins used in our discounted cash flow analysis are based on our strategic plans and long-range planning forecasts. The long-term growth rate we use to determine the terminal value of the business is based on our assessment of its minimum expected terminal growth rate, as well as its past historical growth and broader economic considerations such as gross domestic product, inflation and the maturity of the markets we serve. We utilize a weighted-average cost of capital in our impairment analysis that makes assumptions about the capital structure that we believe a market participant would make and include a risk premium based on an assessment of risks related to the projected cash flows of each reporting unit. We believe this approach yields a discount rate that is consistent with an implied rate of return that an independent investor or market participant would require for an investment in a company having similar risks and business characteristics to the reporting unit being assessed. If the reporting unit's estimated fair value exceeds its carrying value, the reporting unit is not impaired, and no further analysis is performed. Otherwise, the amount of the impairment must be determined by comparing the carrying amount of the reporting unit's goodwill to the implied fair value of that goodwill. The implied fair value of goodwill is determined by assigning a fair value to all of the reporting unit's assets and liabilities, including any unrecognized intangible assets, as if the reporting unit had been acquired in a business combination. If the carrying amount of the goodwill exceeds the implied fair value, an impairment loss would be recognized in an amount equal to that excess.
Based on our annual impairment review, the fair value of all of our reporting units exceeded their carrying values, and we do not believe that there is a reasonable possibility that any units might fail the initial step of the impairment test in the foreseeable future.
We maintain various pension and postretirement plans for our employees globally. These plans include significant pension and postretirement benefit obligations, which are calculated based on actuarial valuations. Key assumptions used in determining these obligations and related expenses include expected long-term rates of return on plan assets, discount rates and healthcare cost projections. We also make assumptions regarding employee demographic factors such as retirement patterns, mortality, turnover and rate of compensation increases. We evaluate and update these assumptions annually. 35
-------------------------------------------------------------------------------- To determine the weighted-average expected long-term rate of return on plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on plan assets will increase pension expense. For 2013, the assumed expected long-term rate of return on plan assets used in calculating pension expense was 7.56%, compared with 7.58% in 2012. In 2013 and 2012, the assumed rate of return for our domestic plans, which represent approximately 90% of our total pension assets, was 7.75%. A 50-basis-point decrease in this long-term rate of return in 2013 would have increased pension expense for our domestic plans by approximately
$25 million. The discount rate enables us to state expected future benefit payments as a present value on the measurement date, reflecting the current rate at which the pension liabilities could be effectively settled. This rate should be in line with rates for high-quality fixed income investments available for the period to maturity of the pension benefits, which fluctuate as long-term interest rates change. A lower discount rate increases the present value of the benefit obligations and increases pension expense. In 2013, the weighted-average discount rate used in calculating pension expense was 4.23%, compared with 4.94% in 2012. For our domestic plans, the assumed discount rate was 4.25% in 2013, compared with 5.00% for 2012. A 50-basis-point decrease in this discount rate in 2013 would have increased pension expense for our domestic plans by approximately $31 million. The trend in healthcare costs is difficult to estimate, and it has an important effect on postretirement liabilities. The 2013 medical and prescription drug healthcare cost trend rates represent the weighted-average annual projected rate of increase in the per capita cost of covered benefits. The 2013 medical rate of 7.20% is assumed to decrease to 5.00% by 2021 and then remain at that level. The 2013 prescription drug rate of 7.20% is assumed to decrease to 5.00% by 2021 and then remain at that level. See Note 11 to the Consolidated Financial Statements for the impact of a one-percentage-point change in the cost trend rate. Warranty Liabilities We provide limited warranty and product maintenance programs, including parts and labor, for certain products for periods ranging from one to five years. A significant portion of these liabilities arises from our commercial aircraft businesses. We also may incur costs related to product recalls. We estimate the costs that may be incurred under warranty programs and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect this liability include the number of products sold, historical costs per claim, contractual recoveries from vendors, and historical and anticipated rates of warranty claims, including production and warranty patterns for new models. During our initial aircraft model launches, we typically incur higher warranty-related costs until the production process matures, at which point warranty costs moderate. We assess the adequacy of our recorded warranty and product maintenance liabilities periodically and adjust the amounts as necessary. Adjustments are made to accruals as claim data and actual experience warrant. Should future warranty experience differ materially from our historical experience, we may be required to record additional warranty liabilities, which could have a material adverse effect on our results of operations and cash flows in the period in which these additional liabilities are required. Finance Receivables Finance receivables are generally recorded at the amount of outstanding principal less allowance for losses. We maintain the allowance for losses on finance receivables at a level considered adequate to cover inherent losses in the portfolio based on management's evaluation. For larger balance accounts specifically identified as impaired, including large accounts in homogeneous portfolios, a reserve is established based on comparing the expected future cash flows, discounted at the finance receivable's effective interest rate, or the fair value of the underlying collateral if the finance receivable is collateral dependent, to its carrying amount. The expected future cash flows consider collateral value; financial performance and liquidity of our borrower; existence and financial strength of guarantors; estimated recovery costs, including legal expenses; and costs associated with the repossession and eventual disposal of collateral. When there is a range of potential outcomes, we perform multiple discounted cash flow analyses and weight the potential outcomes based on their relative likelihood of occurrence. The evaluation of our portfolio is inherently subjective, as it requires estimates, including the amount and timing of future cash flows expected to be received on impaired finance receivables and the estimated fair value of the underlying collateral, which may differ from actual results. While our analysis is specific to each individual account, critical factors included in this analysis include industry valuation guides, age and physical condition of the collateral, payment history and existence and financial strength of guarantors. We also establish an allowance for losses to cover probable but specifically unknown losses existing in the portfolio. This allowance is established as a percentage of non-recourse finance receivables, which have not been identified as requiring specific reserves. The percentage is based on a combination of factors, including historical loss experience, current delinquency and default trends, collateral values and both general economic and specific industry trends. 36
Deferred income tax balances reflect the effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and their tax bases, as well as from net operating losses and tax credit carryforwards, and are stated at enacted tax rates in effect for the year taxes are expected to be paid or recovered. Deferred income tax assets represent amounts available to reduce income taxes payable on taxable income in future years. We evaluate the recoverability of these future tax deductions and credits by assessing the adequacy of future expected taxable income from all sources, including the future reversal of existing taxable temporary differences, taxable income in carryback years, available tax planning strategies and estimated future taxable income. The amount of income taxes we pay is subject to ongoing audits by federal, state and foreign tax authorities, which may result in proposed assessments. Our estimate of the potential outcome for any uncertain tax issue is highly judgmental. We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions for which it is more likely than not that a tax benefit will be sustained, we record the largest amount of tax benefit with a greater than 50% likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. Interest and penalties are accrued, where applicable. We recognize net tax-related interest and penalties for continuing operations in income tax expense. If we do not believe that it is more likely than not that a tax benefit will be sustained, no tax benefit is recognized. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities due to settlement of income tax examinations, new regulatory or judicial pronouncements, or other relevant events. As a result, our effective tax rate may fluctuate significantly on a quarterly and annual basis.