By Clay Dillow
FORTUNE -- Defense Secretary Chuck Hagel went before Congress this week to explain to legislators exactly how the Pentagon plans to cut personnel, update equipment to reduce long-term costs, and create a leaner, more streamlined operating structure that will function even with fewer dollars coming in the door. If that sounds more like the bullet points for a Chapter 11 proceeding than the rollout of a national security strategy, it's no coincidence. While the Department of Defense is far from bankrupt (the proposed budget includes $495.6 billion in base spending, and that doesn't account for additional contingency funds), the fallout from shrinking federal budgets and the specter of sequestration has led to major restructuring at the Pentagon. The U.S. military is downsizing, and for defense contractors that could be a very good thing.
The proposed budget -- which would reduce troop levels in the Army to levels not seen since the run-up to World War II -- clearly prioritizes technology and machinery over manpower while also showing a preference for the acquisition of new systems over the updating and refurbishing of old ones. Why? The Pentagon suffers from many of the same problems currently plaguing American industry -- high health care costs, a range of costly benefits, pension obligations ballooning at an unsustainable rate -- and Hagel's new budget reflects that reality. Machines augment the force with a high up-front cost that doesn't pile onto the long-term problem of compensation, pension, or health care costs -- costs department officials say they are determined to curb.
For the Pentagon, all this suggests a difficult transition period. But for the companies that supply the force-multiplying technologies that will keep America's fighting force up to military spec, the future looks promising even if Congress and the Pentagon continue to tighten the budgetary belt.
So what's happening in the budget? Spending in fiscal 2015 will remain essentially flat -- the base budget actually calls for $420 million less than last year's budget -- meaning the department could either continue to grow on the personnel side or the equipment side, but not both. Officials have clearly decided to focus on growing its technology and equipment portfolio at the expense of the military's human footprint even as new challenges like the volatile situation in Ukraine threaten to shake-up the Pentagon's geopolitical priorities.
Under the new budget, the Air Force would retire its aging fleet of Cold War-era U-2 spy planes and A-10 Thunderbolt II close air support aircraft in favor of newer systems like the Northrop Grumman Global Hawk unmanned reconnaissance drone and the F-35 joint strike fighter. It will also protect three future aircraft -- its next-generation long-range strike bomber, the F-35, and the Boeing-built KC-46A aerial refueling tanker -- all while reducing the number of airmen in its active-duty, reserve, and guard units from a total of 503,000 to something just north of 480,000.
The U.S. Navy will maintain its 11 carrier strike groups, but half of its cruiser fleet will transition to a reduced operating capacity and the aircraft carrier USS George Washington could be mothballed by any steep future cuts. The seaborne service will also buy 20 fewer Littoral Combat Ships -- a shallow-water combat vessel designed as a future workhorse for the Navy but whose development has been plagued with problems -- paring the total purchase to 32 from 52. However, it will continue its purchase of two submarines and two destroyers per year, and yet-to-be-built platforms like the Navy's Unmanned Carrier-Launched Airborne Surveillance and Strike jet (or UCLASS, a future unmanned fighter jet slated to enter service around 2020) and the replacement for its current fleet of Ohio class ballistic missile submarines remain budget priorities.
As for the ground forces, the Army will reduce its troop levels from 520,000 to as low as 440,000 while the Marine Corps will trim its standing troop presence from 190,000 to 182,000, with more cuts possible if further sequestration cuts -- delayed for now -- take another chunk out of the budget in the future. The Army also canceled its new Ground Combat Vehicle program and retired its fleet of Kiowa helicopters, but managed to protect several next-generation acquisition programs, including the Joint Light Tactical Vehicle program, a ground vehicle that will replace the Humvee for both the Army and Marines. The Army is settling for upgrades to its fleet of UH-60 Black Hawk and AH-64 Apache helicopters for now, but it still plans to develop an all-new helicopter in the near future.
How does all this affect the defense sector?
Of course, all this is happening against the backdrop of a military "pivot" to Asia, the winding down of the war in Afghanistan, the ongoing Syrian crisis, and a situation in Eastern Europe that places old military rivals on opposite sides of a brewing conflict -- any one of which could cause a reshuffling of the Pentagon's already-fluid priorities. (Just today, China announced it will ratchet up its own 2014 military spending by 12.2%.) But for now, the U.S. Department of Defense is focused on cutting personnel costs while improving its technology portfolio. For the foreseeable future that means fewer humans, more machinery, and what looks to be a very busy defense sector.
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The Republican senator talks about how he'd fix government waste, what to do about government employees, and how Americans know how stupid Congress is.
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