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In the Short Run, Sweeter Days for Defense Contractors

As a candidate, George W. Bush portrayed himself as a radical on defense. He pledged to skip a generation of weapons and transform the military into a 21st century fighting force. Now, President Bush's Defense Secretary, Donald H. Rumsfeld, is reviewing the recommendations of 20 separate panels on how to overhaul the Pentagon. The process has weapons-makers and the brass in a near-panic over the fate of their pet programs.

However, the message from some of those close to the review process is: Relax. As much as Bush and Rumsfeld want to shake things up, the betting is that, in the short term, the biggest change can be summed up in two sweet words for defense industry executives and investors--more money.

GOOD NEWS. Bush is scheduled to lay out his Administration's defense plans in broad themes in a May 25 commencement address at the U.S. Naval Academy in Annapolis, Md. But it could be a decade or two before the Pentagon achieves his vision of missile defenses, superfast, long-range bombers, and unmanned aerial vehicles. Right now, Rumsfeld needs to make investments to modernize aircraft, ships, and artillery, which in many instances the Clinton Administration allowed to deteriorate. That's why he may ask for an increase of up to $40 billion in the proposed $325 billion defense budget for 2002. "I see no inclination on the part of the new Administration to kill any major weapons program," says Loren B. Thompson, chief operating officer of the Lexington Institute, a think tank in Arlington, Va. "This looks like pretty good news for the defense industry."

While Bush has raised questions about whether the military needs to spend some $340 billion on three new jet fighters, sources say all three are expected to get a green light. Lockheed Martin Corp.'s (LMT) F-22 Raptor will soon go into production, and Boeing Co.'s (BA) Super Hornet will continue rolling off the assembly line. A decision on which of the two companies will build the Joint Strike Fighter for the Army, Navy, and Marines is expected this fall. Not only will the winner get to make different versions for the three services, but the fighter could also be a big export item.

Rumsfeld's lofty new ideas largely focus on potential conflicts in Asia, where there are few air bases for existing short-range fighters. The beneficiaries include two contractors left on the sidelines during the industry's mega-merger wave: Northrop Grumman Corp. (NOC) and General Dynamics Corp. (GD)

Northrop Grumman dominates the field for unmanned aerial vehicles, which would help limit casualties. And as the maker of the stealthy B2 bomber, it would be a contender if a new bomber is built. GD could benefit if the Navy builds more submarines and converts GD's Trident nuclear subs into conventional subs armed with cruise missiles. Missile defense would give a boost to Boeing, the prime contractor, and big subcontractors such as Lockheed Martin, Raytheon (RTN.A), and TRW (TRW).

In the near term, the biggest changes Rumsfeld may impose will be internal. He may alter how generals and admirals are selected. And Rumsfeld has picked three seasoned corporate executives as secretaries of the Army, Navy, and Air Force in a quest to squeeze more efficiency out of such operations as payroll and health care.

But it's unlikely they will squeeze enough money out to bankroll everything Rumsfeld wants. That means the Pentagon will be asking for a big share of the $350 billion "reserve" left from the budget surplus after the Bush tax cut. With Social Security and Medicare also claiming those funds, Rumsfeld will have to sharpen his skills as a bureaucratic infighter to make sure guns--not geezers--get the cash. Senator John McCain (R-Ariz.) arrived in Washington in 1987 with strong financial backing from the National Rifle Assn. When he ran for President last year, though, he upset the gun lobby by promising to seek criminal background checks for buyers at gun shows. McCain is further alienating the NRA by teaming up with Senator Joseph I. Lieberman (D-Conn.) on a bill to make good on his pledge, which the NRA says will destroy gun shows. McCain is also appearing in gun-safety ads airing in 2,600 movie theaters in 44 states.

Andrew McKelvey, founder of job recruitment Web site, is bankrolling the ads. McKelvey last year started Americans for Gun Safety. It advocates stronger enforcement of gun laws and safer gun design. With Thomas A. Scully moving to run the Health Care Financing Administration, which oversees Medicare and Medicaid, his lucrative post as president of the for-profit hospital group, Federation of American Hospitals, has become much sought-after. The leading candidate to succeed Scully, whose salary and benefits topped $600,000, is Charles N. Kahn III, president of the Health Insurance Assn. of America. The loss of Kahn and his strong Republican connections--he had been the GOP staff director of the House Ways & Means health subcommittee--would mean the HIAA is more likely to merge with the managed-care group, the American Association of Health Plans. Talks between the two fell apart last year when small insurers balked.

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