budget

The Pentagon wants fewer soldiers, more technology

March 7, 2014: 3:11 PM ET

The Fiscal 2015 defense budget commits to a smaller human footprint and a whole lot of new equipment.

By Clay Dillow

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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.

MORE: Ukraine's next revolution: cleaning up its financial system

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?

  • Future drones: Northrop Grumman (NOC) makes both the Global Hawk and its larger, maritime-optimized cousin, the MQ-4C Triton. The Air Force's unmanned Global Hawks were nearly mothballed last year before Congress stepped in to resuscitate the program. Now the Global Hawk is being tapped to replace the Air Force's 50-year-old U-2 spy plane, ensuring that the drones will be in the Air Force fleet for years to come. The Navy is ordering its own $13 billion fleet of 68 Tritons for persistent maritime surveillance, with the first airframes currently rolling off the production line. Northrop Grumman also makes the X-47B, the technology demonstrator program for the Navy's UCLASS program, putting it in good position to win that business when a contract is awarded in 2015 (competition for UCLASS will also come from Boeing (BA), Lockheed Martin (LMT), and General Atomics, maker of the now-iconic Predator and Reaper drones).
  • Not-so-future drones: While the new budget proposal is kind to some unmanned aerial systems, to others it was rather ambivalent if not altogether cold. Acquisition funds for General Atomics' MQ-1B Predator and MQ-1C Reaper drones were halved from $590 million in fiscal 2014 to $293.1 million in fiscal 2015. Likewise, the Pentagon will spend less on Aerovironment's RQ-11 Raven, AAI Corp.'s RQ-7 Shadow, and Boeing subsidiary Insitu's RQ-21 Blackjack, though the total budget for acquisition of these smaller platforms only fell from $252.5 million to $238.1 million.
  • All in on the F-35: The Pentagon's plan all along has been to phase out the menagerie of small attack aircraft in the department's portfolio and replace them with variants of the F-35 Joint Strike Fighter. For the Navy, this appears to be the moment where it goes all-in on the F-35C, the version that will takeoff and land from aircraft carriers. There's no funding in the fiscal 2015 budget proposal for the Boeing F/A-18, the Navy's current workhorse fighter/bomber, and unless something changes quickly that production line will close. The Navy is still tapping Boeing to build it's P-8 Poseidon sub-hunting aircraft, however, the first of which just entered service last year (the Navy eventually plans to acquire 117 P-8s).
  • A new helicopter fleet for the Air Force: This development was so close to not happening that it's not even in the fiscal 2015 budget. The Air Force has for years tried to modernize its fleet of aging Sikorsky Pave Hawk helicopters but hasn't been able to free up the cash. But at a Pentagon briefing Tuesday Maj. Gen. James Martin confirmed that the air service will find around $430 million in other USAF programs to get the program underway. That will benefit Sikorsky and Lockheed Martin, whose design was selected last year but who never saw the money to start development.
  • JLTV is a go: The ground forces have long-known they've needed to replace the Humvee but the rapid introduction of the Mine Resistant Ambush Protected vehicle in Iraq and Afghanistan nearly derailed the Army and Marine's concerted effort to do so. Now that the Joint Light Tactical Vehicle program has survived intact into the current budget it's unlikely to lose traction now. A final contractor for JLTV production will be announced next year, selected from competing teams at South Bend, Ind.-based AM General, Wisconsin-based Oshkosh Corporation, and Lockheed Martin.
  • Meanwhile, the Ground Combat Vehicle is dead: The end of funding for the Army's Ground Combat Vehicle program means that the competitors for what could've been a $36 billion contract -- General Dynamics and BAE Systems -- will have to walk away.
  • The Navy will keep building ships and subs: This isn't breaking news, but the fiscal 2015 budget reaffirms that nothing will change the Navy's ship-buying behavior even in the current fiscal environment. The U.S. Navy will continue to buy two Arleigh Burke class destroyers and two submarines per year. That's particularly good news for Huntington Ingalls, which has the contract for one destroyer per year, and General Dynamics, which constructs the remaining destroyers as well as Virginia-class submarines.

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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