Cold War, Hot Stocks

The Pentagon's spending plans were no secret on Wall Street. Share prices of top U.S. defense contractors began soaring months ago, in anticipation of the Pentagon's Quadrennial Defense Review, which was released last week. The early buzz was clear indication that Defense Secretary Donald Rumsfeld's efforts to modernize the American military had stalled. And indeed, the new spending map leaves intact the sky-high budgets for heavy weapons with roots in the cold war--including Lockheed Martin's F-22 fighter jet, Northrop Grumman's DD(X) destroyer and Raytheon's electronic communications systems. "Institutional investors have been following the QDR tea leaves for some time," says John Kutler, president of Quarterdeck Investment Partners, an investment bank that specializes in aerospace and defense. "They concluded that there won't be [the] programmatic cuts on the hardware side that some worried about."

Since he came to office five years ago, Rumsfeld has criticized many of the weapons on the military's wish list--multibillion-dollar fighter jets, warships, submarines and transport vehicles--as relics that suck resources away from the weaponry needed to create a lighter, smaller and more efficient military. The new QDR, an exhaustive study of threats to U.S. national security and how best to meet them, suggests the brass is digging in against a lame-duck secretary. No major weapons programs are earmarked for cancellation, according to analysts, and the issue of ballooning defense expenditures at a time of record budget deficits is deferred. That point was confirmed in the Bush budget announced last week, which gave the Pentagon a higher-than-expected 7 percent increase for weapons procurement and research. The stock-market result: over the last three months, Lockheed is up by 19 percent, Northrop by 15 percent and Raytheon by 14 percent. "The politics surrounding defense procurement is as difficult as ever," says Doug Berenson, a defense-industry specialist at DFI International, a Washington consulting firm. "The coalition of interests around these programs are so strong that even the secretary of Defense can't control them."

Deliberations over the QDR began months ago with Rumsfeld and his inner circle at the heart of the process, says Frank Cevasco, president of Cevasco International, a consulting firm that specializes in defense. Over time, however, the chain of command flattened, with Rumsfeld's representatives working with equal numbers of officers from the military departments. As a result, responsibility for much of the report's key recommendations, including provisions for cost cuts, was refracted throughout the Defense Department rather than concentrated inside Rumsfeld's office. ''Rumsfeld found himself obliged to share control of the QDR process," Cevasco says. ''The changes collectively amounted to a large sum of money, and I expect some of the cuts may be reversed by Congress at the encouragement of the military departments."

Not only have most legacy programs survived, but weapons that support Rumsfeld's ''transformation" vision are being downsized. The Army's Future Combat System, a $130 billion transport and battle-management system, is being trimmed. Despite the successes scored in Afghanistan and Iraq by unmanned weaponry like the Predator drone, an aerial robot that can surveil as well as destroy targets, the Navy and Air Force are scaling back their Joint Unmanned Combat Air System due to technology constraints. "One of the shocking things about the document is that there is nothing new," says Daniel Goure, vice president of the nonpartisan Lexington Institute. "There's nothing here that would allow a shift of mission equipment away from tanks, subs, and surface ships."

With his focus trained on Iraq, analysts say, Rumsfeld is not in position to resist Pentagon procurement demands. In October, he reversed his 2004 decision to cancel Lockheed Martin's C-130J transport aircraft. In December Rumsfeld recommended extending through 2012 the production run of the F-22, which analysts say he had threatened to cut off. This keeps alive the Air Force's bid to both increaseF-22 orders and keep the plane in production indefinitely. "The Air Force is hopeful that once Rumsfeld has left town, it can then convince Congress to keep building the F-22," says Berenson. ''Their strategy is clearly to fight another day." And no doubt Wall Street will still be watching.