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UPDATE 2-Rockwell Collins profit drops on weak government sales

* Earnings of $1.32 a share before items beat estimate of $1.12

* Company says selected for commercial program

* Shares up 3.3 percent

Oct 26 (Reuters) - Rockwell Collins Inc reported higher-than-expected quarterly earnings on Friday and said its commercial business would expand over the next year, while defense operations face U.S. budget challenges.

The supplier of avionics and other electronic systems for planes said during a conference call that it had been chosen to supply a new commercial program to a customer it could not yet disclose, and its shares rose more than 3 percent.

With the possibility of mandatory cuts to U.S. defense spending, Rockwell Collins said it was cutting headcount, merging facilities and looking to bring commercial technologies to military customers.

``We are preparing for all scenarios and taking actions early,'' Chief Executive Officer Clay Jones said during a Friday conference call.

Earnings fell in the fourth quarter ended on Sept. 30 as weaker government sales overshadowed stronger commercial aerospace demand. Net income was $152 million, or $1.06 a share, down 13 percent from $175 million, or $1.13 a share, a year earlier.

Excluding restructuring and asset impairment charges, the profit was $1.32 a share. Analysts on average had expected $1.12, according to Thomson Reuters I/B/E/S.

Sales fell 2 percent to $1.27 billion. Commercial system sales rose 9 percent, aided by higher production at plane makers Boeing Co and Airbus, but government system sales declined 10 percent.

Companies with defense exposure are bracing for sustained pressure on military budgets. U.S. debt ceiling negotiations in 2011 resulted in an agreement that could trigger $500 billion in additional defense budget cuts due to start taking effect in January if Congress does not act to avert them.

Rockwell Collins has reduced its business in some defense segments as the United States moved to curb spending. Business aviation has been a challenge for Rockwell this year as Hawker Beechcraft, a major customer, filed for Chapter 11 bankruptcy protection in May.

The company stood by a prior forecast calling for a profit of $4.30 to $4.50 a share from continuing operations for the fiscal year that ends in September. For fiscal 2012, earnings came to $4.15.

Shares of Rockwell Collins were up 3.3 percent at $55.06 in morning trading.

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