Pentagon budget shows modest growth, weapons reforms

WASHINGTON Sun Jan 24, 2010 2:27pm EST

WASHINGTON (Reuters) - Emerging details about the fiscal 2011 defense budget confirm what U.S. defense executives have been expecting: Defense Secretary Robert Gates is delivering on his promise to secure modest, but steady growth while continuing to kill unneeded and troubled arms programs.

Personnel and health care costs will drive the Pentagon's fiscal 2011 budget request to a record $708 billion, but budget documents obtained by Reuters indicate the days of sharply rising weapons budgets and ample new program starts are over.

At the same time, mounting public concern about federal spending and the sharply widening budget deficit are likely to curb the ability of lawmakers to pump money back into programs targeted for termination as they have in the past.

"It's largely what we were expecting," one senior defense industry executive said, noting that weapons makers have been trying to position themselves in markets that are still expected to see growth in coming years -- unmanned systems, cybersecurity and weapons that can help troops now.

Draft budget documents show Gates is seeking to end seven weapons programs in fiscal 2011, including two that lawmakers rescued from the eight-item kill list last year -- Boeing Co's C-17 transport plane and a second engine for Lockheed Martin Corp's F-35 fighter jet.

But many of the new terminations, including a new Navy cruiser and a program to replace the Navy's EP-3 surveillance plane, were largely expected, and don't carry nearly the punch of the dramatic swath of cuts that Gates announced last April.

The budget still includes significant funding for a range of aircraft, ships, missiles, ammunition and ground vehicles like the mine-resistant trucks being sped to Afghanistan.

And some programs, like the Expeditionary Fighting Vehicle, an amphibious vehicle being developed for the Marine Corps by General Dynamics Corp that has experienced problems in the past, have apparently escaped the axe, at least for now.

EASING OFF THE ACCELERATOR

Rob Stallard of Macquarie Securities said he's sticking to his underweight rating on the defense sector in general, noting that tightening budget pressures could lead to further cuts and delays in weapons programs in coming years.

"We're still in this period of easing off the accelerator," Stallard told Reuters, adding that further, more subtle actions such as slower growth in programs and cuts in procurement amounts were likely to permeate the sector in coming years.

Moreover, an overall economy recovery could make other sectors more attractive to investors than defense and undercut congressional arguments aimed at propping specific arms programs as employment recovers in other sectors, he said.

Congress does control the Pentagon's purse strings, so Gates may well face more battles with lawmakers unless the White House issues the kind of unequivocal veto threat that helped him finally end Lockheed's F-22 fighter program.

Appropriators seized upon the Obama administration's vaguer veto threat about the second F-35 engine, for instance, as a "loophole through which one could drive a Mack truck," said one congressional aide, who was not authorized to speak publicly.

General Electric Co and Britain's Rolls-Royce Group rallied their supporters in Congress last year, and could well prevail again this year, given that the alternate F-35 engine is nearing the end of its development.

On the other hand, Boeing may have a tougher time securing so-called "plus up" funding for its C-17 transport plane, which the Pentagon has been trying to halt for years.

The company has already begun to prepare for the eventual end of that production line, mounting aggressive efforts to capture a few more orders overseas, said Stallard.

Last week's upset victory by a Republican in the Senate race for Massachusetts underscored growing concern about federal spending, which could further fuel pressure on defense spending, Daniel Goure of the Virginia-based Lexington Institute wrote in a blog entry on the group's website.

Still, the overall mood among defense contractors is far less unsettled than last year, especially after Gates met top executives earlier this month and assured them he would like to see "steady, consistent growth in defense budgets."

"That's the best for us. It's best for them, so that there's predictability and one can plan going forward," Pentagon spokesman Geoff Morrell said, describing Gates' comments at the meeting. "The booms and busts that we've experienced over the decades help neither of us frankly."

Marion Blakey, president and CEO, of the Aerospace Industries Association, said the industry trade group knew Gates would continue to put his imprint on the defense budget, but felt reassured about the general trend.

"We're optimistic that the fiscal 2011 defense budget, including procurement, is going to be consistent with the level of recent years. The nation has obligations across the globe that we simply can't shirk from," she said.

The big defense contractors have such diverse portfolios that they are not terribly vulnerable to changes in any one specific program, but some of the proposals in the 2011 budget contains nuggets of good news for individual companies.

Analysts said the budget, due to be released on February 1 along with a more policy-setting Quadrennial Defense Review, would generally benefit Boeing, General Dynamics, and smaller companies like ammunition maker Alliant Techsystems.

They said there were no outright losers, but some companies clearly face headwinds, including Northrop Grumman Corp, which was hoping for more ship orders, and Lockheed, whose F-35 will get fewer early production orders.

Raytheon Co, the 6th largest contractor, remained well-positioned given that some of its equipment is on nearly every major U.S. weapons program, said Loren Thompson, of the Lexington Institute.

(Reporting by Andrea Shalal-Esa; Editing by Diane Craft)