(FORTUNE Magazine) – YEAR AFTER soaring year, American arms makers have ridden Ronald Reagan's military buildup to record sales and earnings. Along the way they have amassed vast hoards of cash, paid off billions of dollars in debt, and routinely posted double-digit growth rates. But with storms blowing up in Congress over the deficit and a welter of procurement scandals, the political wind has shifted. Though the flush times will continue for a while, thanks to an estimated $146 billion in backlogged orders, the defense budget in all probability will grow only marginally for the rest of the decade. By the 1990s some of the industry's biggest players will be scrambling to find growth. Says Oliver C. Boileau, 58, president of embattled General Dynamics: ''We'll all be competing for a smaller relative market, and some of us will be hurt.'' The change was sudden. Back in February the Administration requested a 10.2% increase (to $313.7 billion) in military spending for fiscal 1986 -- about the percentage it got last year. Sometime this summer, Congress will approve -- at most -- a mere 3.6% rise to offset inflation. Procurement patterns in the Pentagon have changed abruptly too. In the past the defense industry has thrived on complex, multibillion-dollar weapons systems like the B-1 bomber and MX missile. But accelerating technological change has pushed unit costs for these weapons inexorably higher over the years, forcing the government to pour more and more money into fewer and fewer programs. Norman R. Augustine, a senior vice president of Martin Marietta and former under secretary of the Army, reckons that the price of a state-of-the-art fighter plane quadruples every decade. Whimsically projecting that trend, Augustine suggests that the price of one tactical aircraft would equal the gross national product early in the 22nd century. Even without reaching that level of absurdity, prices are high enough right now to discourage the Pentagon from laying on a lot of big new weapons programs. Says one Pentagon official: ''We'll cut back on procurement quantities and feed everything through the system at a slower rate.'' So where can the industry find happiness after the buildup? ''In missiles, space, and electronics,'' says Lockheed President Lawrence O. Kitchen, 62. ''That's where the growth is, and that's where we're committing our resources.'' The Pentagon is pouring money into such areas as satellite communications and navigation, and missiles of various types. Another good business will be refitting older planes and weapons systems with new electronic gizmos. The Electronics Industry Association predicts that the overall procurement budget will grow 2.3% annually over the next ten years, while the portion spent on electronics will grow 3.7%. By 1994, according to the association's estimates, electronics will account for 20% of the defense budget, vs. about 18% today. The trouble is, the strategy is so obvious that everyone is pursuing it. And not everyone can win big. One bright hope for new growth is Reagan's Strategic Defense Initiative (SDI), popularly called Star Wars. Now in its infancy, the program will probably double over the next five years, from an estimated $2.7 billion in fiscal 1986. Its magnitude in the 1990s is anybody's guess. Some people are rhapsodic. ''The throw-off from Star Wars will affect our entire industrial base -- in miniaturization, detection, antennas, communications, display technologies,'' says Bernard Schwartz, chairman of Loral Corp., a leading defense electronics contractor. ''As far as I'm concerned, the American century is just beginning.'' Others aren't so sure. ''We really won't know where Star Wars is going for some years,'' says Russ Murray, a staffer of the House Armed Services Committee. ''If a Democratic Administration takes over in 1988, all this talk you hear about making nuclear weapons obsolete will vanish.'' In any case, corporate growth in the high-tech future will be slower and harder to sustain than it is today. Profit margins on sophisticated gadgets, especially during research and development, are much smaller than margins on big production contracts. Lockheed, for example, clears an estimated 11% to 12% of revenues on its mature C-5B production line, but only about 6% on space projects for NASA and the Pentagon. As profitable old contracts reach maturity, the big aerospace contractors will thus have to land twice the dollar value in new advanced-technology programs just to maintain earnings. Competition will be fierce, and the edge will go to companies that have a head start. Says David J. Smith, a defense industry analyst for Sanford C. Bernstein & Co.: ''If you haven't been in space, it will cost an arm and a leg to get into it.'' Slower growth in military spending will hit most of the big aerospace contractors, but some have less to fear than others. Boeing's government business (the Awacs, the MX, and the top-secret stealth bomber, among other things) will grow slowly over the next few years, and some programs, such as the air-launched cruise missile, will end completely. But the Seattle-based giant is poised for takeoff in its huge commercial aircraft business. Last year commercial planes accounted for just over half the company's total sales of $10.6 billion and only 3% of earnings. (The low earnings figure reflects heavy development and testing costs for the new 737-300 series, a more fuel- efficient version of Boeing's earlier short-haul airliner, that went into production in late 1984.) Smith predicts that by 1989, when the expected < airline buying spree will be two or three years old, commercial jets will account for 77% of Boeing's projected sales of $30 billion annually and around the same percentage of earnings, which are expected to exceed $4 billion. McDonnell Douglas will also ride the crest of the commercial airliner wave for the next few years. McDonnell has a niche (about 20%) in a market dominated by Boeing, but projected sales of its MD-80 series of airliners should return the company's transport aircraft division to robust health after several years in the red. Meanwhile, sales of combat aircraft -- 55.3% of corporate sales, 84.6% of earnings -- should continue strong. McDonnell makes the F-15 for the Air Force, and the F-18 carrier-based fighter and the AV-8B Harrier jump jet for the Navy. All three planes should be flying well into the next decade. So should the products of Hughes Helicopters, which McDonnell bought last year. Hughes makes the Army's main attack chopper, the AH-64 Apache, and is bidding on the LHX, an advanced helicopter scheduled to go into production in the early 1990s. PROSPECTS for Rockwell International are nowhere near as bright. Rockwell, too, has strong commercial businesses (electronics, car and truck parts, printing presses). And its defense business is booming, thanks to the B-1B strategic bomber, for which it is the major contractor. Rockwell's sales last year were $9.3 billion, 25% of which came from the B-1. The program, which calls for delivery of 100 planes, will continue lustily until early 1988 -- and then stop. Says Paul H. Nisbet, an analyst with Prudential-Bache Securities: ''If there are no more than 100 B-1s, Rockwell will face a few years of declining earnings and declining growth after the B-1 -- unless they can make a major acquisition.'' Rockwell made one last February, picking up Allen-Bradley for $1.6 billion. Among other products, Allen-Bradley makes factory automation equipment, and Rockwell hopes to double the new subsidiary's $1-billion annual sales over the next five years. Says Chairman Robert Anderson, 64: ''We may be unique among large defense contractors in that our business has always been balanced about 50-50 -- give or take 10% -- between defense and commercial business. Our concept is to maintain a balance so we won't be hostage to any major defense program.'' To limit the damage after the B-1, Rockwell is moving on several fronts. It has just signed a contract with the Air Force for the Navstar satellite navigation system, has a joint venture with Fiat to produce truck axles in Europe, and is bidding on the design of the space station for NASA. Anderson is even trying to persuade the Air Force to buy more copies of the B-1, which has come in ahead of schedule and under budget. Still, there could well be more acquisitions. ''We're not planning to branch out into fast food or appliances,'' Anderson says. ''We tried that and we're not too good at it. But we're always looking to expand our core business. We're looking right now.'' For the other big aerospace contractors, defense is the core business. Their prospects are tied directly to the life spans of their current contracts and their ability to land new ones. Martin Marietta is perhaps least affected by slower spending. The company recently landed a $444.2-million contract to assemble and test the Midgetman missile and to build its fourth stage. Moreover, all ten of its other major government contracts (including the external fuel tank for the space shuttle, the Lantirn fighter navigation system, the Pershing II missile) are relatively new and should provide strong sales and profits through the 1990s. Similarly, the F-18 and the stealth bomber should keep Northrop humming well into the next decade. And the company could make a bundle on the F-20 Tigershark fighter (FORTUNE, June 24). The plane has yet to attract buyers, but its development costs have been written off and it has a growing corps of fans in Congress. The other ''pure play'' contractors -- General Dynamics, Lockheed, and Grumman -- provide a study in contrasting approaches to finding growth in the 1990s. Long-term planning is on hold at General Dynamics while top management grapples with allegations of fraud, stock manipulation, and bribery. The company is under investigation by the Pentagon, several congressional committees, the Justice Department, and the Securities and Exchange Commission. Company officers deny any criminal wrongdoing, but the growing scandal precipitated the retirement of Chairman David S. Lewis, 67, who will step down by year's end. His successor will be Stanley C. Pace, 63, who was recruited from TRW in June. His first priority: a detailed review and overhaul of General Dynamics' cost-accounting and contract charging practices. Strategy will have to wait. The standstill came just as General Dynamics was charting a course into the 1990s. Over the past five years its sales have risen 115% (to $7.8 billion in 1984) and net earnings have jumped 113% (to $382 million). That kind of growth will be impossible to sustain without major changes. The company's three main weapons programs -- the F-16 fighter, the M-1 battle tank, and nuclear submarines -- will continue into the 1990s, but the rate of production will remain essentially flat. Only the company's missile programs are assured of strong growth into the next decade. THE OBVIOUS REMEDY is to seek new business, and General Dynamics is trying. It has upgraded the avionics on the F-16 and mounted a more powerful cannon on the M-1. After spending $300 million to modernize production facilities of its Electric Boat division, it is bidding for the design contract on the SSN-21, the next generation of Navy attack submarines. It responded to Northrop's F-20 challenge by offering a stripped-down version of the F-16 at the bargain- basement price of $13 million a copy, compared with the $19.4-million price tag for the standard model. Among the other projects it hopes to land: an advanced tactical fighter and new missiles. Still, General Dynamics might not be able to grow without acquisitions. The legal salvos exploded over the company before it could make some fundamental decisions about acquisition strategy: Will it diversify, or buy within the defense industry? Will it be a holding company or a hands-on manager? Boileau confirms that General Dynamics is at least window-shopping. ''We want to study the possibility of growing this company through acquisitions,'' he says, ''though that does not mean we're going to walk away from the defense business. Our first challenge is to keep the defense business and grow within its marketplace -- with whatever growth rate it has.'' Says Christopher Demisch, a security analyst with First Boston, ''They have plenty of money; they can afford to think big.'' Lockheed, by contrast, is less interested in buying companies than in modernizing to reinforce its strengths in space and missile systems. The company is two years into a huge long-term investment program, pouring $900 million annually into R&D and updated production facilities. The plan has two aims: to move away from producing big expensive systems that bet the company on a single project, and to move into producing the sophisticated electronics inside those systems. ''The big-ticket items don't come around that often,'' Kitchen says, ''but they stay around and keep being modernized. Everything now flying will go through a major updating sometime.'' Adds Vincent N. Marafino, the company's chief financial officer: ''The key question is, are we positioned in the areas where the defense budget will grow? We think we are.'' Like General Dynamics, Lockheed has grown rapidly during the Reagan buildup, and it has a number of big contracts that are reaching maturity. Sales totaled $8.1 billion in 1984, more than double the level five years earlier, and earnings were $344 million. It's been a long road back. Throughout the 1970s, the company seemed to stagger from disaster to disaster. The decade started with revelations of cost overruns and wing defects in the C-5A. In 1971 Lockheed needed a federal loan guarantee to stave off receivership. Then came a series of overseas bribery scandals and, finally, seemingly endless losses on the wide-body L-1011 airliner. The company took a $400-million write-off on the L-1011 in 1981 and got out of commercial aviation. Today Lockheed concentrates on defense. Among its major programs are some holdovers from the old days: a C-5A wing modification program, scheduled to end next year; production of 50 C-5B transports for the Air Force, with final delivery due in early 1989; and the venerable C-130, which is still being built at a rate of 36 units a year but is threatened by McDonnell Douglas's new C-17. Lockheed's contracts in advanced technology include the Trident II fleet ballistic missile, a satellite communications system called Milstar, space shuttle support for NASA, and -- in the opinion of most analysts -- the top-secret, radar-evading stealth fighter. Kitchen blandly denies the plane's existence, but security analyst David Smith of Sanford C. Bernstein & Co. reckons that it is already in limited production and brought in $850 million last year. LIKE ITS COMPETITORS, Grumman (1984 sales: $2.6 billion) sees its future in advanced technology, but with a difference. ''We're solidly in the tactical side of things, rather than the strategic,'' says Joseph G. Gavin Jr., 64, chairman of the executive committee. Grumman's main business is producing aircraft for the Navy: the F-14 fighter, the A-6 attack plane, and the E-2C and EA-6B electronic surveillance planes. Last summer the company got a new Navy contract to build 500 F-14 and A-6 aircraft with advanced engines and avionics. The company hopes to install the new engines and electronics in the existing planes. To cut costs, the company recently reshuffled its organization chart, scrapping its old system of wholly owned subsidiaries in favor of seven operating divisions. The move should help bolster an eclectic list of non-Navy projects. Consider the experimental X-29, the world's first supersonic aircraft with forward-swept wings. Grumman built the contraption, which had a successful maiden flight last year, under a $93-million contract from the Defense Advanced Research Projects Agency. The company also seems to be everybody's favorite subcontractor. It has signed on to build the tail assembly for the JVX, a vertical takeoff transport being developed by all three services. And it is the prospective subcontractor on three different bids -- from Rockwell, TRW, and GE -- for various chunks of NASA's proposed manned space station. As the industry jockeys for position in the 1990s, it is keeping a weather eye on the drive for procurement reform in Washington. The system will almost certainly be changed to eliminate outrageously priced spare parts and questionable expense claims. Beyond that, it is difficult to tell where -- if anywhere -- the reform movement is headed. One bill before the House would slow down the revolving employment door between the Pentagon and private industry by requiring a two-year pause between jobs. Another bill would open 70% of all procurement contracts to competitive bidding. (The current figure is under 45%.) Lockheed's Kitchen, for one, welcomes the presidential commission on procurement reform being formed under the leadership of David Packard, a former deputy secretary of defense and co-founder of Hewlett-Packard. The commission, Kitchen believes, will approach reform in a comprehensive way rather than with legislative ''Band-Aids.'' Above all, Kitchen yearns for less hostility in the reform debate. ''We're not stupid and we're not crooks,'' he declares. ''We'll play by the rules. Just tell us what they are and make sure everybody understands them.'' Cynics believe that the Packard Commission will do its work well, recommend sensible reforms -- and disappear without a trace. What follows, however, will not be business as usual. Growth in the 1980s was a snap; growth in the 1990s will be a struggle. All the industry's top managers look ahead with fire in their eyes. As General Dynamics' Oliver Boileau puts it: ''If we have to grow in a falling market, then we'll take work away from our competitors.''