Defense stocks dodged a bullet this week when the Pentagon said it plans for its budget to grow modestly through 2014 before leveling off in 2015, but political and fiscal concerns in Congress could slow the sector further during that period and beyond.

Defense stocks extended a relief rally into a second day after Defense Secretary Robert Gates announced a budget containing cost-cutting and program cancellations that were not as severe as some had expected.

Defense stocks were modestly higher on Friday, with the Standard & Poor's Aerospace and Defense index up 0.5 percent in late afternoon trading. The index had closed 0.9 percent higher on Thursday.

Gates said the Defense Department would cut $78 billion in spending over five years to help pare the growing U.S. budget deficit. He outlined plans for U.S. defense spending to grow modestly through 2014, then level off in 2015 and 2016.

Anil Daka, a Morningstar analyst, said the plans from Gates suggested that defense contractors would face slower revenue growth and perhaps flat-to-lower operating margins in coming years.

There's not a great possibility for earnings growth, Daka said. Still, he added that Gates' speech helped remove this uncertainty about how bad the defense budgets are going to be and that's why I think you've seen those stocks rally.

Among key contractors, industry leader Lockheed Martin was up 0.7 percent on Friday while Northrop Grumman Corp gained 0.8 percent and L-3 Communications Holdings shot up 4.5 percent.

General Dynamics Corp shares were up 1.0 percent despite the announced cancellation of the company's Expeditionary Fighting Vehicle marine craft program.

The bottom line: No real surprises, Morgan Stanley analyst Heidi Wood said in a client note.

GATES PLAN 'OPTIMISTIC'

Still, Wood said the plan unveiled by Gates looked optimistic and there was a high potential for further downward pressure in fiscal year 2013 and beyond.

Fears that U.S. fiscal pressures will slow budget growth have been an overhang on defense shares for nearly two years, after the sector enjoyed steady increases following the September 11, 2001, attacks as U.S. defense spending ramped up.

Joseph Nadol, an aerospace and defense analyst with JP Morgan, said in a note on Friday that while company valuations have already fallen, we are not yet ready to call a bottom.

For now, most companies had not yet posted significant earnings misses, and low expectations could lead to trading rallies on less than negative news, Nadol said.

Mounting margin pressures and the overall climate would continue to spur increased mergers and acquisitions activity, later in 2011 and 2012, he said.

Defense company executives generally welcomed the Pentagon's budget forecast, saying they were continuing to work on lowering costs and improving performance.

Linda Hudson, chief executive of the U.S. unit of Britain's BAE Systems, said the company had initiated a restructuring last year to cut costs, improve efficiency and increase the speed with which products are brought to market.

BAE is nearing a decision on the sale of its platform solutions business, with three bidders due to submit best and final offers this week.

Rob Stallard of RBC Capital Markets said the overriding theme for the sector was a continued tightening in the defense budget and further pressure on defense contractors.

With a clear agenda in place, the next step will be getting congressional approval and carrying out these changes effectively, Stallard said in a note, adding, Given the potential for further, more substantial cuts in the future, we see limited upside from here.

(Reporting by Karen Jacobs in Atlanta and Andrea Shalal-Esa in Washington; Editing by Gary Hill)

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