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20 Oct 05. Jonathan Karp of the Wall Street Journal As the defense industry kicks off what is expected to be a strong earnings season, the mood is hardly celebratory. The reason: Defense contractors are staring down the barrel of what could be one of the toughest Pentagon budget cycles in years.

Defense-industry executives and investors are bracing for a potential body blow as President Bush mulls deep Pentagon-budget cuts to both rein in the federal deficit and offset massive bills from Iraq and the Gulf Coast hurricanes. That has taken some of the glee out of coming earnings reports, such as the one filed yesterday by General Dynamics Corp., which reported a boost in third-quarter profit of 16%.

Down the road, the picture looks gloomier. Pentagon officials say the administration is aiming to trim between $10 billion and $15 billion a year in planned defense spending from fiscal 2007 to 2012, slowing the overall rate of Pentagon-spending growth. Given the continuing military operations in Iraq, the Pentagon is scouring weapons programs for possible cuts instead of taking reductions from current-force needs. Major cuts could be averted by a combination of political pressure from Congress — always eager to protect local jobs — and the fact that a war is being waged. That is what happened last year, when a plan for $30 billion in Pentagon cuts through 2011 was seen as a knee-jerk budget exercise and was partially rolled back by Congress.

Though it is too early to know which military services or defense companies will be most affected by potential cuts, Washington pundits finger warships and fighter jets as most vulnerable. Northrop Grumman Corp., which recently cut its 2005 profit outlook because of hurricane damage to its Gulf shipyards, could get hit again if its next-generation Navy destroyer DDX is put on the chopping block. Lockheed Martin Corp.’s F-35 Joint Strike Fighter, the biggest Pentagon weapons program, and Boeing Co.’s $125 billion Future Combat Systems ground-forces modernization program are also under scrutiny. Lockheed, the country’s biggest military contractor by sales, saw its stock rise 20% in the first five months of this year. But the share price has slipped back 4% since the end of May as concerns about a budget crunch grew. If the 2007 budget doesn’t cut spending on the Joint Strike Fighter as much as investors currently fear, Lockheed could rebound. In 4 p.m. composite trading yesterday on the New York Stock Exchange, Lockheed’s shares were up $1.82, or 3%, at $62.71, giving the company a market value of about $27 billion. General Dynamics’ stock has risen nearly 19% this year, and could emerge least wounded from the budget process because it has higher exposure to the Army, which is expected to be more insulated from cuts than the traditionally better-funded Air Force and Navy. In 4 p.m. composite Big Board trading yesterday, General Dynamics’s shares were up $1.14, or 1%, at $121.06. The company’s market capitalization is about $24 billion.

“Despite what the budget numbers turn out to be, [defense companies] will generate earnings growth above the S&P 500’s average in the latter half of this year and into next,” says Tim Bei, an aerospace and defense analyst at Baltimore fund manager T. Rowe Price. In addition to being focused on expanding profit margins, he said, defense companies also will benefit into 2007 from supplemental budget funding for the Iraq war, which includes billions of dollars in procurement funds. T. Rowe Price currently owns shares of Lockheed, General Dynamics and Raytheon Co.

Byron Callan, who analyzes defense companies for Prudential Equity Group in New York, said in a report that “defense stocks that have been under pressure recently could see their prices appreciate through the first half of 2006 as investor sentiment shifts toward a more favorable outlook than may now be perceived.” Prudential currently has “overweight” ratings for

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