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Which defense firms will get lift from budget?

ATLANTA (Reuters) - Will expected increases in U.S. defense spending lift all contractors over the next year?

On Monday, U.S. President Barack Obama asked Congress to approve $708 billion in defense spending for fiscal 2011, including a 3.4 percent rise in the Pentagon’s base budget plus billions more to fund U.S. military operations in Iraq, Afghanistan and Pakistan.

Defense stocks, which have been clouded by concerns that growth in U.S. spending will slow in coming years, headed lower on Wednesday after two straight days of gains. The Standard & Poor's Aerospace & Defense Index .GSPAERO was off a modest 0.2 percent in afternoon trading.

Analysts say niche companies will benefit more than others as the Obama administration seeks to fight new enemy threats while traditional weapons programs face more scrutiny.

BUY SPECIALTY

Small companies that provide next-generation systems and upgrades for unmanned systems and products that gather or monitor intelligence are poised for success, said Michael Ciarmoli, an aerospace and defense analyst with Boenning & Scattergood.

“That portion of the budget seems to be insulated,” Ciarmoli said. “Seemingly, these companies are in the sweet spot.”

His top picks for 2010 include Comtech Telecommunications CMTL.O, a provider of mission-critical tracking networks, satellite company Orbital Sciences ORB.N and FLIR Systems FLIR.O, which makes cameras used in unmanned spy planes.

Patrick McCarthy, an analyst with FBR Capital Markets, said the latest budget request provided upside for so-called "Army plays," prime contractors such as missile maker Raytheon Co RTN.N and L-3 Communications LLL.N, which provides products that detect explosives.

“With this budget, the Obama administration and (Department of Defense) are clearly recognizing that defense spending needs to stay high,” Murphy said.

SLOWER GROWTH FOR SOME BIG PLAYERS

Companies in FBR's coverage space that fared the worst because of the budget were industry leader Lockheed Martin Corp LMT.N and AeroVironment AVAV.O, the firm said.

Peter Arment, an analyst with Broadpoint AmTech, said growth would slow for some big contractors because of a flat outlook for weapons-modernization spending.

Broadpoint AmTech maintained a "buy" on Raytheon, but said it was still on the sidelines for General Dynamics GD.N and Lockheed, which faces pressure over its F-35 Joint Strike Fighter, the world's largest military aircraft program.

This week, U.S. Defense Secretary Robert Gates said that he would dock Lockheed $614 million in performance fees because the F-35 program’s performance had not met expectations over the past two years. Gates also replaced the Pentagon’s manager in charge of the program.

“Lockheed is highly respected and we certainly think its valuation is very cheap,” Arment said. But, he added, “The JSF has slipped in terms of timing and we’re not seeing the earnings progression that we’d like to see.”

Reporting by Karen Jacobs; editing by Robert MacMillan

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