Defense/Aerospace Industries

[DewDiligence]

Small Defense Firms Are M&A Targets

[Among the target companies mentioned here, the only one I follow is CUB.]

http://www.reuters.com/article/idCNSGE60C0IX20100201

›By Bijoy Koyitty and Bhaswati Mukhopadhyay

BANGALORE, Feb 1 (Reuters) - Smaller U.S. defense firms are back on the acquisition radar, helped by a renewed interest in surveillance and intelligence -- two key areas that have been attracting federal interest lately.

The sector is expected to see more deals in the near term than it has in the past three years, as large players, grappling with cutbacks in major defense programs, look to sustain growth by buying smaller rivals in niche areas.

"The industry has consolidated considerably in the last 10 to 15 years and it will continue to do so. Most acquisition targets probably will be in the area of smaller firms," said Tian Qiu, an analyst at Templeton Global Equities Group.

The renewed chatter follows a move by Argon ST <STST.O> to put itself on the block recently -- almost a year after Axys Technologies put itself up for sale, triggering the first round of deal talk. Argon makes sensors for intelligence, surveillance and reconnaissance systems.

"There is a shift in strategy as the government moves away from fighting a large war. Now the requirement is for mission critical technologies and these smaller firms are filling that gap," Broadpoint Amtech analyst Peter Arment said.

Possible targets include X-ray detection system maker American Science and Engineering Inc <ASEI.O>, communications firms Comtech Telecommunications <CMTL.O> and Applied Signal Technology <APSG.O>, and biometric identification systems firm Cogent Systems <COGT.O>, according to analysts.

The rising importance of unmanned war systems puts drone maker AeroVironment Inc <AVAV.O> in focus, while defense training firm Cubic Corp <CUB> is a potential target given the infusion of more U.S. troops in Afghanistan.

The possible acquirers include Lockheed Martin Corp <LMT.N>, Boeing Co <BA.N>, Northrop Grumman <NOC.N>, General Dynamics <GD.N>, Goodrich Corp <GR.N>, BAE Systems Plc <BAES.L>, EADS <EAD.PA> and Science Applications International <SAI.N>.

According to a recent Reuters Insider report, Boeing could be the frontrunner for Argon ST, given the logic of synergies with the planemaker's 2008 purchase of Digital Receiver Technology, which develops wireless surveillance products for government customers.

Science Applications International is best poised to make a sizable acquisition with $1 billion on balance sheet, and the possible targets could be American Science & Engineering and Cogent Systems, the report said.

AVERTING ANOTHER 9/11

Companies with a focus on homeland security and cyber security have a clear edge in the M&A market, with the U.S. government prioritizing these segments in the wake of the recent security threats.

Homeland security was pushed to the top of Obama's 2010 agenda after a passenger tried to blow up a Detroit-bound flight with a bomb concealed in his underwear on Christmas Day.

"Homeland security is very similar to defense -- you have government as customer," said Philip Finnegan, director, corporate analysis at research firm Teal Group.

"It has the potential to grow even if defense comes under pressure."

L-3 Communications Holdings <LLL.N> has said it plans to buy assets in the intelligence surveillance business this year. Goodrich is interested in areas such as precision-guided weapons, intelligence surveillance and helicopter components.

REASONABLE VALUATIONS

Valuations are becoming cheaper as sellers tend to be more reasonable on their expectations now, analysts said. "We have seen that most of the defense group in general was out of favor last year, the multiples have compressed," Broadpoint Amtech's Arment said.

Deal valuations in the sector now range from 7 to 11 times forward EBITDA (earnings before interest, taxes, depreciation and amortization), depending on the company.

Companies that have proprietary technologies, are in high-growth areas or have access to customers in the intelligence arena stand on the upper range of the multiples.

For example, Argon ST and American Science & Engineering trade at 11 times forward EBITDA.

Shares of most of these small defense companies, which crashed during slowdown, are beginning to stabilize now. On an average, they have gained 13 percent of their value in the last three months.

Executives at the Reuters Aerospace and Defense Summit in Washington in December said lower valuations will drive mergers in the aerospace and defense sector this year with larger companies spending up to $1 billion each.

"The small to mid-cap defense companies, specifically those with an emphasis on technology, will offer investors the highest probability of upside under the DoD's new philosophy," analyst Michael Ciarmoli of Boenning & Scattergood wrote in a January note.‹