(FORTUNE Magazine) – INTERPRETING PRESIDENTIAL DEFENSE BUDGETS IS AN exercise in political analysis as much as financial accounting. And Lehman Brothers aerospace and defense analyst Joseph F. Campbell Jr., 59, has been balancing the two skill sets for more than 30 years. After working as a national security analyst in the Carter and Reagan administrations, Campbell came to Wall Street in the early 1980s. The two-time FORTUNE All-Star likes to refer to things like trucks and canteens simply as "green stuff they sell to the Army." That's typical of his flair for cutting through accounting arcana to get to real-dollar implications for the companies he covers. With the military mired in Iraq and Congress weighing President Bush's new $419 billion defense budget, Campbell offered FORTUNE's Oliver Ryan his insights on the impact of "supplemental" spending, why it's better to bet on the Army than the Navy right now, and which stocks should benefit no matter where the money flows.

What do you make of the President's budget?

I've been doing this a long time, and it's an unusual budget. The budget plans go from 2006 to 2011, and they say they took $50 billion out of the Navy and Air Force and noncombat army, and then added $30 billion back--mostly allocating it to what they call "modularity," which is restructuring our Army so that it is bigger and more flexible. They want the Army to be able to be deployed and rotated in bite-sized chunks rather than in divisions. Almost all of the new money is in procurement. This means buying tanks, ships, plane, and so on. But keep in mind the main budget is not to be confused with the 2005 "supplemental."

Just where is all that supplemental money going?

The war in Iraq has been funded with these supplementals and will probably continue to be. Mostly what we've paid for in the war is bullets and soldiers' combat pay and all the gasoline they're burning up over there, the transportation of people, etc. It's expensive, and it's been running on the order of $65 billion a year. This time in the supplemental, when you add up everything, we're going to spend $100 billion. Where's the new money going? Well, it's going to procurement--something like $17 billion in 2005 alone. The problem is that the Army is configured as an expeditionary force for these wars, whether it's Bosnia, Iraq I, or Iraq II. We haven't had a "Well, how would you like to hang out there for a decade?" kind of war for a while. So the Army is restructuring.

Is the Army getting more than the other services?

It's been a long time since the Army has gained share on the Navy and the Air Force, but this year it will. We haven't had this happen since Vietnam, and it's a big change. I think Congress is going to add 30,000 to 34,000 people, and they're going to get another 20,000 to 24,000 troops by taking people who are noncombat domestic personnel and making them fighters. So you'll see ten more brigades, and five of these are heavy. Which means they have armor.

So a lot more money is going to be spent on military hardware?

Yes. We were thinking that the budgets would grow 5% a year, which indeed was the growth from '04 to '05 to '06. So Bush's previous $140 billion "hardware" budget might have turned out to be $147 billion. But we find this little Christmas present in the form of modularity, which accounts for the extra $17 billion in the supplemental. So this thing is going to end up being about $164 billion compared with $140 billion, so something like a 17% increase. Who gets it? It's clear that if you are mostly an Army contractor, you might benefit. And if you mostly make ships, you certainly won't. Beyond that the government has refused to give any details.

Given all that, which defense stocks do you like?

My view for some time has been that the defense budget would be characterized by turbulence in the biggest weapons programs. Nearly every big new weapons system slips, and nearly every old system is retained longer than you thought it would be. And nearly every one of them will be upgraded with the componentry that was meant for the new platform which ended up not getting funded. So our pick is a company like L-3 Communications (LLL, $74), which makes equipment that goes everywhere--that serves the Army, Navy, Air Force, Lockheed, Raytheon, Boeing, Northrop, and so on. There's no ship at L-3 to be canceled. There's no aircraft carrier to be retired. There's no F-22 to be done in.

With a trailing P/E of 22, L-3 is not exactly cheap, is it?

You have to look forward. We have L-3 pricing at an 18 P/E on '05 earnings and a 15 P/E on '06 based on numbers that we have fairly good confidence in.

Does that mean L-3 gets a lift from the bigger defense budget?

Our view on L-3 is independent of the most recent news. It's a perception that says there are two ways to invest in defense stocks: Either pick the guys that stay out of the news and have superior growth rates, or buy the big names that make up the bulk of the budget. On the other hand, we do have a new scenario at hand: If we don't get to go home from Iraq, then the Army has to change. So our thought process hasn't altered, and our L-3 recommendation is still in place--actually, it's probably strengthened by all the turmoil. But when we see the final numbers, we will likely make some new judgments about other companies.

Can you give us a preview of who benefits most from the budget?

In the context of the redistribution of money from the Air Force and the Navy to the Army, it makes sense to ask yourself, Who are the Army's biggest contractors? And I suppose the purest plays are probably things like United Defense Industries (UDI, $51), which makes seven out of the eight track- and wheeled-vehicles in use by the Army. That stock has been on a tear. Another way to approach this is to say you might as well just buy the world's largest defense company, which is Lockheed Martin (LMT, $59).

Finally, what's the latest on Secretary Rumsfeld's much heralded transformation of the military?

The battle of transformation was sort of preempted by the war, and now what's happened is that modularity has given the Secretary an opportunity to take a lot of these weapons systems on. Secretary Rumsfeld is taking a swing at programs that he didn't like but never had the political clout to take away, and it's still not clear that he does. But the bottom line is, there's no such thing as lean manufacturing and low-cost defense. What you get from defense contractors is a plant in every congressional district. ■