Small defense tech firms big bet for large contractors

United States Navy F/A-18C fighter jets from the strike fighter squadron VFA-192 Golden Dragons are parked on the deck of the USS Kitty Hawk aircraft carrier in Hong Kong April 28, 2008.

BANGALORE (Reuters) - When small U.S. defense subcontractor Axsys Technologies AXYS.O put itself up for sale this month, it sparked talk of another round of consolidation in the defense technology market.

Shifting priorities in defense spending toward intelligence and surveillance, and away from big-ticket weapons programs, have resulted in cash-rich defense contractors such as Lockheed Martin Corp (LMT.N), Boeing Co (BA.N) and Northrop Grumman Corp (NOC.N) scouting for smaller players with niche technologies.

"It is an opportunity to pick up key capabilities -- in terms of technologies that you don't have, access to customers that you don't have," Philip Finnegan, corporate analysis director at defense research firm Teal Group, said.

Industry experts said companies such as American Science and Engineering Inc (ASEI.O), which makes X-ray detection systems, and Comtech Telecommunications Corp (CMTL.O), known for its communications products, are attractive targets.

Other well-placed companies are Argon ST STST.O and Applied Signal Technology Inc APSG.O, the only listed firms that sell signal intelligence gear.

Mid-sized companies that large defense contractors had previously found attractive have largely been acquired.

Last year Italian aerospace and defense group Finmeccanica (SIFI.MI) bought U.S. defense communications company DRS Technologies for $4 billion to boost its presence in the United States.

In 2007, Britain's BAE Systems Plc (BAES.L) acquired body armor and truck maker Armor Holdings for $4.1 billion.

"Therefore, we think there will be a step down in market capitalization, and several companies...that have the same attributes as Axsys could draw attention," Levenson said.

It's still early days in Axsys' search for potential buyers, but analysts believe the company's unique technology -- cameras used in missile tracking systems and unmanned drones -- makes it a compelling target for larger defense firms.

"Consolidation could happen. There will be some smaller defense companies that may look at the opportunity at this point to become part of larger entities, especially with the funding changes that are probably expected over the next couple of years in the industry," Needham & Co analyst James Ricchiuti told Reuters recently.

FLIR Systems Inc (FLIR.O) is another key mid-sized defense company with a unique technology -- it makes heat-sensitive goggles. However, analysts ruled out FLIR being a possible target because its commercial thermography business has not been doing very well, and the company has said it is not for sale.

VALUATION COMPELLING

Even though shares of most of these smaller companies have risen in the past year, driven by demand for their unique products, analysts said valuations were still attractive.

Argon ST and Applied Signal have gained 17 percent and 73 percent, respectively, in the past year. In comparison, the Dow Jones U.S. aerospace and defense index .DJUSAE lost 47 percent of its value during the same period.

Historically these companies had enterprise value that was 10 to 13 times their forward EBITDA. Now, most of them are trading in the mid-to-high single digits, Stifel's Levenson noted.

Argon ST has an enterprise value which is 8.6 times its forward EBITDA, Applied Signal has a multiple of 8.7 and American Science a multiple of 6.8.

The smaller contractors could even persuade the interested buyer to pay a higher premium than might have been a case in the past, Levenson said.

Comtech and Axsys have become attractive targets in the wake of a big slide in their share prices in the past year.

Axsys put itself up for sale after pressure on its stock had led to "an increasing number of overtures from interested strategic buyers."

KEY TO BIG CONTRACTS

The acquisitions could give the defense behemoths control over intellectual properties of the smaller companies and help them win big contracts, Stifel's Levenson said.

In December, Boeing acquired Maryland-based Digital Receiver Technology Inc, which develops wireless surveillance products for government customers. Boeing said the deal would help it expand its presence in the intelligence market.

BAE Systems, which generates over half its sales from the United States, said in February it was seeking further acquisition targets for its security business.

Earlier this month, Europe's EADS (EAD.PA) said it was still looking for modest acquisitions in the United States to increase its presence in the U.S. defense market.

The acquisitions may also give prime contractors access to the customers of smaller contractors, increasing the possibility of cross-selling, Teal Group's Finnegan said.

Some of the smaller companies also have the advantage of being the sole supplier of products related to a particular technology.

However, some analysts said the Axsys deal talk is very specific to that company and not reflective of a sector trend.

"There is consolidation, but it is not any more aggressive than usual," analyst Michael French of Morgan Joseph & Co Inc said.

(Editing by Saumyadeb Chakrabarty and Anil D'Silva)