Analysis: Defense firms privately skeptical on budget outlook

An aerial view of the Pentagon building in Washington, June 15, 2005.

WASHINGTON (Reuters) - The Pentagon's new austerity diet assumes growth of 1 percent in the defense budget to keep money flowing into new weapons and upgrades, but industry executives are privately preparing for real cuts and the cancellation of more weapons programs.

Across the sector, companies like Lockheed Martin Corp (LMT.N), Northrop Grumman Corp (NOC.N) and Boeing Co (BA.N) are laying off workers, consolidating divisions and actively pursuing acquisitions to fill the coming revenue gap.

While arms makers are still pursuing the few big-ticket weapons programs that will begin in coming years, many executives say they realize their focus will increasingly shift to upgrading existing ships, planes and ground vehicles.

Executives attending the annual conference of the Air Force Association's largest booster group this week said they hoped Defense Secretary Robert Gates and his acquisition chief, Ashton Carter, succeed in cutting overhead costs enough to maintain growth in investment accounts. Still, they added they were already making contingency plans.

"We know that's the party line ... but there certainly are going to be fewer dollars available moving forward," said one senior industry executive who asked not to be named, noting that rising personnel and health costs would clearly leave fewer dollars for research, development and procurement.

A changing political climate, mounting concern about the U.S. deficit, and the prospect of angry Tea Party-backed candidates moving into Congress were a further wild card in the mix this year, said the executive.

"The budget for procurement does not look that healthy," agreed Neil Kacena, vice president for advanced development programs at Lockheed Martin Aeronautics.

For instance, Lockheed is hoping that a new composite airplane that is much lighter and cheaper to operate could give it an edge in the competition for a new Air Force bomber, the only new aircraft development program on the horizon for now.

Virginia-based defense consultant Jim McAleese said the best-case scenario called for a flat defense budget, but it was "not unrealistic" to begin thinking about a decline.

ARMY ALREADY PLANNING FOR DECLINE IN BUDGET

Loren Thompson, chief operating officer of the Virginia-based Lexington Institute, said Army officials were already running scenarios that assumed a decline of 10 to 20 percent in the Army budget midway through the next decade.

He said Gates' assurances about stable defense spending were based on flawed fiscal assumptions, especially given the current projected national deficit of $1.4 trillion.

Coupled with high turnover in top Pentagon jobs, lawmakers' determination to safeguard jobs, and the department's own bureaucracy, that meant Pentagon planners might soon need to go back to the "drawing boards," Thompson said.

Top military officials, usually careful to stick to Gates' playbook, have already begun expressing their own concerns about a possible decline in spending.

Air Force Chief of Staff General Norton Schwartz said austerity would be a continuing theme in coming years. "Defense budgets will continue to level or even decline, even as demands and expectations of our military increase," he said.

The recent downward revision of the second quarter U.S. gross domestic product underscored the uncertainty about the strength of the U.S. recovery, he said.

Admiral Mike Mullen, chairman of the Joint Chiefs of Staff, also chimed in, warning in a video interview with the Financial Times that dramatic action was needed to avert the "drastic" defense cuts seen in Britain and Germany.

"If we do not figure out how to manage ourselves inside this growing challenge, then I do worry that it won't be too long before those kinds of cuts will be part of our future as well, and that would be very dangerous," Mullen said.

Carter said it was crucial for industry to support the efficiency drive, or their worst fears would come true: canceled programs, "uncertainty and turbulence in the budget, market uncertainty, difficulty for industry, erosion in the confidence of the taxpayer... foregone military capabilities."

"That's the whole point," Carter told Reuters after he addressed the Air Force event.

SOME PROGRAMS LIKELY TO BE AXED REGARDLESS

Terminations of existing programs can generate big savings, but are often tough to execute, given congressional concerns about job losses, as Gates has learned from repeated, unsuccessful efforts to kill a second F-35 fighter engine.

But a close reading of Carter's efficiency directives points to cancellation of several developmental programs, which don't yet have huge workforces, analysts say.

High on that list are the Marine Corps Expeditionary Fighting Vehicle, being built by General Dynamics Corp (GD.N) and a new Northrop sensor for tracking targets on the ground, while two big Army vehicle programs could be delayed for some time.

Integrated air and ground missile defenses are also flagged for "redundancy" reviews, which could point to trouble for the U.S.-European MEADS missile program being developed by Lockheed Martin, Europe's EADS (EAD.PA), Britain's BAE Systems (BAES.L) and Italy's Finmeccanica (SIFI.MI), McAleese said.

(Reporting by Andrea Shalal-Esa, editing by Dave Zimmerman)