(For an overview of our business groups, including a discussion of products and services provided, see the Business discussion contained in Part I, Item 1, of this Annual Report on Form 10-K.)

MANAGEMENT OVERVIEW

General Dynamics offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding design and construction; and information systems, technologies and services. We operate through four business groups - Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. Our primary customers are the U.S. military, other U.S. government organizations, the armed forces of other nations, and a diverse base of corporate, government and individual buyers of business aircraft. We operate in two primary markets: defense and business aviation. The majority of our revenues derive from contracts with the U.S. military.

[[Image Removed: LOGO]]

The nation's engagement in the global war on terror, coupled with the need to modernize U.S. military forces, has driven steady Department of Defense funding increases since 2001. In particular, procurement and research and development (R&D) budgets, also known as investment accounts, provide the majority of our revenues. Defense Department total, or top-line, funding has increased at a compound annual growth rate of 6.9 percent from fiscal 2001 through 2009, while procurement and R&D spending has grown nearly 7.3 percent annually during that period. For fiscal year 2009, the Congress appropriated $516 billion for the Department of Defense, including approximately $182 billion for procurement and R&D. Budget expenditures generally lag congressional funding, and we expect that expenditures applied toward programs over the next few years will be consistent with defense funding appropriated in recent years. Our future growth potential in the U.S. defense market is driven by the size of the defense budget, the allocation of that budget to investment accounts, the diversity of our exposure to different programs and customers within the budget, and our successful execution of the contracts we are awarded.

During this period of war, defense budgets have included the President's budget submission, as well as supplemental funds requested over the course of the fiscal year to meet the emergent needs of the warfighter. For fiscal year 2008, the Congress appropriated $183 billion in emergency spending, including approximately $68 billion, or 37 percent, for investment accounts. For fiscal year 2009, the Congress has appropriated $66 billion in supplemental funding, primarily for battlefield operational requirements. The Defense Department has indicated that it will request at least another $70 billion of supplemental funding in 2009 to include funds for procuring additional weaponry. If this second supplemental is approved, defense funding for fiscal year 2009 will total approximately $652 billion, a 110 percent increase since 2001.

Looking ahead, we expect defense core budget top-line growth to moderate. In the near-term, top-line funding should remain at or near current well-funded levels, led by the need to continue to support ongoing war operations. While the landscape will continue to evolve in conjunction with the new administration's defense strategy as well as dynamic macroeconomic and geopolitical conditions, we expect near-term defense funding levels to be driven primarily by the following:

• continued support for the warfighter from the administration and the Congress in the face of threats posed by an uncertain global security environment;

• the number of troops deployed in Afghanistan and Iraq, coupled with the increase in the overall size of the U.S. military;

• the need to reset and replenish equipment and supplies damaged and consumed during the war;

• the need to maintain thousands of jobs that support the health of our nation's military infrastructure; and

• the need to modernize that infrastructure to address the evolving requirements of modern-day warfare.

Future supplemental funding levels will likely decrease in tandem with the administration's current plan to reduce troop levels in

Iraq, offset somewhat by an increased footprint in Afghanistan. As this supplemental spending decreases, some of the supplemental funding that had previously been used to finance core procurement programs will likely shift back to the base budget.

Beyond our U.S. defense market, governments around the world continue to fund weapons and equipment modernization programs, leading to significant defense export opportunities. We are committed to pursuing international opportunities presented by international demand for military hardware and information technologies. While the revenue upside can be significant, European and other international defense budgets are subject to unpredictable issues of contract award timing, defense priorities and overall fiscal spending pressures. As we broaden the customer base for our defense products around the world, we expect growing international sales.

The business-aviation market remained strong for much of 2008. While mid-size order activity moderated from past years, Gulfstream enjoyed continued strong order activity for its long-range and ultra-long-range business-jet offerings, including its new G650 product. Market conditions changed significantly, however, in the fourth quarter of 2008 as credit and financial markets seized in reaction to deteriorating global economic conditions. This severe dislocation caused new aircraft order activity to slow.

This sudden financial turmoil affected some of Gulfstream's customers who either sought deferral or defaulted on their aircraft orders.

These perturbations in the group's backlog had no impact to financial performance in 2008 due largely to the willingness of customers in the backlog to move up to earlier availabilities. If the market continues to erode, additional defaults and deferrals may occur. However, we believe the diversity and duration of the business-jet order book positions the Aerospace group to bridge the current market turmoil. Aircraft-service revenues, which grew 8 percent in 2008, provide the group diversified exposure to after-market sales fueled by recent growth in the global installed business-jet fleet. We believe continued investment in new aircraft products will drive long-term growth, particularly when the Aerospace group begins delivering its newest aircraft offerings, the G250 in 2011 and the G650 in 2012.

We are committed to creating shareholder value through ethical business practices, disciplined program management and continuous operational improvements. Our solid performance is measured in our sustained revenue and earnings growth and strong cash flow. General Dynamics' record as an industry leader in cash flow generation has provided our management the flexibility to execute our operational strategy, and enabled us to consistently deploy resources to further enhance shareholder returns through strategic and tactical acquisitions, payment of dividends and share repurchases.

CONSOLIDATED OVERVIEW

The following discussion of our results of operations is based on operating performance at the business group level. The disclosures focus on the material financial measures our management uses to evaluate the performance of each of our four business groups, including sales, operating earnings and margins, cash flow, and orders and backlog. For the defense business groups, the discussion of results of operations is based on specific contracts and programs that drive the group's results rather than types of products and services, which often comprise multiple contracts with different customers. For the Aerospace group, the results are analyzed with respect to specific lines of products and services, consistent with how the group is managed.

In the defense business groups, the majority of the sales are generated by long-term government contracts. As discussed further in the Application of Critical Accounting Policies section, we account for sales under these contracts using the percentage-of-completion method of accounting. Under this method, revenue is recognized as work progresses, either as products are produced and delivered or as services are rendered, as applicable. As a result, changes in sales are generally discussed in terms of volume. Volume indicates increases or decreases in sales due to changes in production or construction activity levels, changes in delivery schedules or levels of services on individual contracts.

In the Aerospace group, we recognize revenue using the percentage-of-completion method. Sales contracts for new aircraft have two major phases: the manufacture of the "green" aircraft and the aircraft's completion, which includes exterior painting and installation of customer-selected interiors and optional avionics. We record revenues on these contracts at two milestones: when green aircraft are delivered to and accepted by the customer, and when the customer accepts final delivery of the aircraft. Revenues in the Aerospace group's Jet Aviation aircraft outfitting business are recognized as work progresses, similar to our defense businesses. Aircraft services revenues are recognized upon delivery of services. Changes in sales in this group result from the number of new aircraft deliveries (both green and completion), the progress toward completion of aircraft outfitting activities, the level of service activity during the period and the number of pre-owned aircraft sold.

Operating earnings and margins in the defense business groups are generally discussed in terms of changes in sales volume, performance, or the mix of contracts (e.g., fixed-price/cost-reimbursable) and the phases of work within those contracts (e.g., development/production). Performance refers to changes in contract earnings rates during the term of the contract based on revisions to estimates of profit at completion on individual contracts. These revisions result from increases or decreases to the estimated value of the contract and/or the estimated costs required to complete the contract. The following discussion of results provides additional disclosure to the extent that a material or unusual event causes a change in the profitability of a contract.

Operating earnings and margins in the Aerospace group are generally a function of the prices we are able to charge for our various aircraft models, the operational efficiency of the group in the manufacture and completion of the aircraft, and the mix of aircraft deliveries among the higher-margin large-cabin and lower-margin mid-size aircraft. Additional factors affecting the group's earnings and margins include the volume and profitability of services work performed, the number and type of pre-owned aircraft sold, and the level of general and administrative costs incurred by the group, which include selling expenses and research and development costs.

[[Image Removed: LOGO]]

20 General Dynamics 2008 Annual Report

Results of Operations

            Year Ended December 31     2008         2007              Variance
            Net sales                $ 29,300     $ 27,240         $ 2,060    7.6 %
            Operating earnings          3,653        3,113             540   17.3 %
            Operating margin             12.5 %       11.4 %

In 2008, we achieved solid growth in sales and a significant increase in operating earnings compared with 2007. This strong performance during the year resulted in our highest operating margin in eight years backed by continued strong cash flows from operations. We received a record level of orders in 2008, ending the year with the highest backlog in our history.

Each of our four business groups produced increases in sales in 2008 over the prior year. Sales growth in the Aerospace and Marine Systems groups was particularly strong in 2008 as a result of continued increases in business-jet aircraft deliveries and increased activity on U.S. Navy and commercial shipbuilding programs. In the Combat Systems group, strong demand for U.S. military vehicles and related support services drove the increase in sales. Higher activity in tactical and strategic mission systems contributed the majority of the sales growth in the Information Systems and Technology group.

Our operating earnings increased at more than double the rate of sales growth in 2008, and three of our four business groups reported earnings in excess of $1 billion. Growth in operating earnings exceeded the sales growth in all of our business groups due to strong program execution and a continued focus on operating performance. Overall, our operating margins increased 110 basis points to 12.5 percent in 2008, the fifth consecutive year of margin expansion.

            Year Ended December 31     2007         2006              Variance
            Net sales                $ 27,240     $ 24,063         $ 3,177   13.2 %
            Operating earnings          3,113        2,625             488   18.6 %
            Operating margin             11.4 %       10.9 %

We produced significant sales growth in 2007 on the strength of rising sales in each of our business groups. In particular, the Combat Systems and Aerospace groups generated substantial sales growth in 2007 on U.S. military vehicle sales and increased business-jet deliveries. Sales in the Information Systems and Technology group increased primarily as a result of the acquisition of Anteon International Corporation in mid-2006. Sales were up slightly in the Marine Systems group compared with 2006. Our operating earnings grew at a higher rate than sales in 2007, as three of our four business groups achieved significant operating leverage. The Aerospace group's earnings and margins reflected the strength of improved pricing and ongoing productivity improvements. Operating earnings and margins were up in Combat Systems and Marine Systems due to improved operational execution across a variety of programs. Our overall operating margins improved 50 basis points in 2007 to 11.4 percent.

Cash Flow

Cash flows from operations in 2008 exceeded net earnings for the tenth consecutive year. Net cash provided by operating activities was $3.1 billion in 2008, $2.9 billion in 2007 and $2.1 billion in 2006. In addition, we generated over $300 in cash in 2006 from the sale of several non-core businesses. Over the three-year period, we used our cash to fund acquisitions and capital expenditures, repurchase our common stock, pay dividends and repay maturing debt. Our net debt - debt less cash and equivalents and marketable securities - was $2.3 billion at the end of 2008 compared with a net surplus of $268 at the end of 2007. Our net debt increased by $2.5 billion during the year after $3.2 billion spent on acquisitions, over $1.5 billion of share repurchases, $533 of dividends paid, $490 of capital expenditures and more than $470 of company-sponsored research and development during the year.

Other Financial Information

General and administrative (G&A) expenses as a percentage of sales declined to 5.9 percent in 2008 from 6 percent in 2007 and 6.2 percent in 2006, reflecting our continued emphasis on operating leverage. G&A was $1.7 billion in 2008, $1.6 billion in 2007 and $1.5 billion in 2006. We expect 2009 G&A as a percent of sales to approximate the 2008 rate.

Net interest expense was $66 in 2008 compared with $70 in 2007 and $101 in 2006. Interest income generated by our strong cash position has increased during each of the past three years while scheduled repayments of our long-term debt have steadily reduced interest expense. We expect net interest expense to increase to approximately $140 to $150 in 2009 due to the issuance of additional debt in 2008.

Our effective tax rate was 31.2 percent in 2008, 31.7 percent in 2007 and 32.3 percent in 2006. In 2008, our taxes were reduced by a refund associated with the settlement of outstanding litigation. This resulted in a $35, or approximately $0.09 per-share, benefit that reduced our 2008 tax rate by 100 basis points. Our effective tax rate in 2007 was impacted favorably by the resolution of our 2003 to 2004 federal income tax audit with the Internal Revenue Service. This settlement resulted in a benefit of $18, or approximately $0.04 per share, which reduced our effective tax rate by 60 basis points. We anticipate an effective tax rate of approximately 31.5 to 32 percent in 2009. For additional discussion of tax matters, see Note E to the Consolidated Financial Statements.

Discontinued Operations

In 2008, we entered into an agreement to sell our Spanish nitrocellulose operation and recognized a pretax loss of $11 in discontinued operations. We expect the sale to close in the first quarter of 2009.

In 2007, we completed the sale of our coal mining operation and received proceeds of approximately $25. We had previously recognized a pretax loss of $57 in discontinued operations in 2006 in anticipation of the sale.

In 2006, we completed the sale of our aggregates operation. We received approximately $315 in cash from the sale of this business and recognized a pretax gain of $199 in discontinued operations.

Our reported net sales exclude the revenues associated with these divested businesses. We have included their operating results, along with the gains and losses from the transactions discussed above, as discontinued operations, net of income taxes. For additional discussion of our divestiture activities and the results of discontinued operations, see Note C to the Consolidated Financial Statements.

Backlog and Estimated Potential Contact Value

[[Image Removed: LOGO]]

Our total backlog increased almost 60 percent in 2008 to $74.1 billion at the end of the year. Funded backlog was $51.7 billion at year end, up 39 percent over 2007. We received $57 billion of new orders in 2008, the highest level in our history. Order activity was significant across each of our business groups, resulting in backlog growth in each group in 2008.

The total backlog for our defense businesses increased 49 percent in 2008 to $51.6 billion, compared with $34.6 billion at the end of 2007. The defense backlog represents the estimated remaining sales value of work to be performed under firm contracts. The funded portion of this backlog was $29.9 billion at the end of 2008, up 17 percent over 2007. This includes items that have been authorized and appropriated by the Congress and funded by the customer, as well as commitments by international customers that are similarly approved and funded by their governments. The unfunded backlog for the defense businesses represents firm orders that do not meet these criteria. While there is no guarantee that future budgets and appropriations will provide funding for a given program, we have included in the backlog only firm contracts we believe are likely to receive funding.

The Aerospace group's total backlog reached a record level of $22.5 billion at year-end 2008 compared with $12.3 billion at the end of 2007, an increase of more than 83 percent. The group's funded backlog increased almost 90 percent during the year to $21.9 billion at the end of 2008. The funded backlog represents orders for which we have definitive purchase contracts and deposits from the customer. The Aerospace unfunded backlog of $618 at the end of 2008 consists of agreements to provide future aircraft maintenance and support services.

Our backlog does not include work awarded under unfunded indefinite delivery, indefinite quantity (IDIQ) contracts, unexercised options associated with existing firm contracts or options to purchase new aircraft, which we refer to collectively as estimated potential contract value.

IDIQ contracts are used when the customer has not defined the exact timing and quantity of deliveries that will be required at the time the contract is executed. These agreements, which set forth the majority of the contractual terms, including prices, are funded as delivery orders are placed. A significant portion of our IDIQ value represents contracts for which we have been designated as the sole-source supplier to design, develop, produce and integrate complex products and systems over several years for the military or other government agencies. Management believes the customers intend to fully implement these systems. The estimated potential contract value also includes our estimate of the value we will receive under multiple-award IDIQ contracts in which we are one of several companies competing for task orders under the contract. Because the value of these arrangements is subject to the customer's future exercise of an indeterminate quantity of delivery orders, we recognize these contracts in backlog only when they are funded.

Contract options in our defense businesses represent agreements to perform additional work beyond the products and services associated with firm contracts, if the customer exercises the option. These options are negotiated in conjunction with a firm contract and provide the terms under which the customer may elect to procure additional units or services at a future date. Contract options in the Aerospace group represent options to purchase new aircraft, including long-term option agreements with fleet customers. We recognize options in backlog when the customer exercises the option and establishes a firm order.

As of December 31, 2008, the estimated potential value associated with these IDIQ contracts and contract options was approximately $16.8 billion, up from $14.5 billion at the end of 2007. We expect to realize this value over the next 10 to 15 years. This represents management's estimate of the potential value we will receive. The actual amount of funding received in the future may be higher or lower.

REVIEW OF OPERATING SEGMENTS

AEROSPACE

Results of Operations and Outlook



          Year Ended December 31             2008        2007             Variance
          Net sales                         $ 5,512     $ 4,828         $ 684   14.2 %
          Operating earnings                  1,021         810           211   26.0 %
          Operating margin                     18.5 %      16.8 %

          Aircraft deliveries (in units):
          Green                                 156         138            18   13.0 %
          Completion                            152         138            14   10.1 %

22 General Dynamics 2008 Annual Report

The Aerospace group generated significant sales growth in 2008, attributable primarily to increased aircraft deliveries compared with 2007. The group increased aircraft production rates for the fifth consecutive year in 2008 in response to a steadily growing aircraft backlog. As a result, new aircraft sales increased 12 percent in 2008. Sequential years of higher new aircraft deliveries have expanded the group's worldwide installed base of business-jet aircraft. As a result, demand in the group's aircraft services business grew in 2008, with volume up 8 percent compared to 2007. Our November 2008 acquisition of Jet Aviation, a business-jet outfitting and aviation-services company, also contributed to the group's sales growth. Approximately one-quarter of the group's increase in sales in 2008 came from the addition of Jet Aviation. Pre-owned aircraft sales were $18 in 2008, down from $78 in 2007. The group had four pre-owned aircraft available for sale on December 31, 2008.

The Aerospace group's operating earnings increased at a significantly higher rate than sales in 2008. The following factors impacted the group's growth in operating earnings during the year:

           Increased aircraft deliveries                         $ 146
           Pricing, delivery mix and productivity improvements     105
           Increased aircraft services                              11
           Pre-owned aircraft activity                             (25 )
           General and administrative expenses                     (26 )
           Total increase in operating earnings                  $ 211

Operating earnings and margins on the group's 2008 aircraft deliveries were up compared with the units delivered in 2007, the result of improved pricing on aircraft orders over the past several years. The group also continued to generate productivity improvements in the aircraft assembly and outfitting processes, which further improved earnings in 2008. In late 2008, the number of pre-owned aircraft transactions was significantly curtailed in response to the deterioration of the global economic environment. As a result, the group wrote down the carrying value of the four pre-owned aircraft available for sale at year end. The group's earnings growth was also tempered by increased selling expenses from strong order activity and higher product-development costs associated with the introduction of two new aircraft models in 2008. The net effect of these factors was a 170 basis-point increase in operating margins in 2008, following two years of 120 basis-point improvement.

The significant deterioration in the economic environment in late 2008 weakened the global demand for business jets, particularly in the mid-size aircraft segment. As a consequence of these conditions and the relatively short duration of the group's mid-size backlog, we plan to significantly reduce mid-size aircraft production in 2009. Given the substantial level and duration of the large-cabin aircraft backlog, we expect to increase production of these models in 2009. However, we assess aircraft production requirements quarterly and will modify the group's production and delivery schedule as necessary based on the state of our backlog and market conditions. We also expect more pre-owned activity in 2009 than we experienced in 2008 or 2007. Of the contracts for 2009 aircraft deliveries, approximately 10 include aircraft trade-in options, which the customers may elect to exercise.

Including the effect of a full year of results of Jet Aviation, we expect the Aerospace group's 2009 sales to increase between 20 and 25 percent over 2008. We expect the group's operating margins to be 200 to 220 basis points lower than those achieved in 2008 due primarily to the increase in aircraft-services volume associated with the Jet Aviation acquisition.

          Year Ended December 31             2007        2006             Variance
          Net sales                         $ 4,828     $ 4,116         $ 712   17.3 %
          Operating earnings                    810         644           166   25.8 %
          Operating margin                     16.8 %      15.6 %

          Aircraft deliveries (in units):
          Green                                 138         113            25   22.1 %
          Completion                            138         104            34   32.7 %

The Aerospace group's sales and operating earnings increased significantly in 2007 over 2006. To meet growing global demand, the group increased aircraft production in 2007 resulting in new-aircraft sales growth of 22 percent compared with the prior year. Aircraft-services volume also increased 20 percent over 2006. Sales of pre-owned aircraft decreased to $78 in 2007 from $217 in 2006 as favorable market conditions led more customers to sell their own aircraft rather than trade them in.

. . .