UPDATE 4-Kratos boosts surveillance with $225 mln Integral buy

* To boost presence in intelligence, public safety markets

* Kratos sees deal adding to earnings

* Deal comes on the heels of Herley takeover (Adds background on the deal, earlier acquisition, byline)

By Bijoy Anandoth Koyitty and Soyoung Kim

BANGALORE/NEW YORK, May 16 (Reuters) - Kratos Defense & Security Solutions Inc (KTOS.O) is to buy rival Integral Systems Inc ISYS.O for $225 million in cash and stock to expand in the surveillance and intelligence business where defense spending is expected to remain strong.

The deal is the second major acquisition for Kratos this year. It struck a deal to buy microwave technology company Herley Industries for $270 million in February.

Kratos, which provides security and surveillance services to U.S. government agencies, said it would acquire each Integral Systems stock for $5 a share in cash and 0.588 shares of common stock.

Based on Kratos' Friday closing, the offer price values Integral Systems at $12.65 a share, a discount of about 3 percent to the stock's close on Friday.

Kratos shares closed down 4 percent at $12.49 on Monday, reducing the value of the exchange offer. Integral Systems shares fell 6.53 percent to $12.16.

"I don't think this is a discount. The stock does funny things when you announce that you are looking at strategic alternatives," Integral Systems Chief Executive Paul Casner told an investor on a conference call.

In January, Integral Systems said it hired boutique investment bank Stone Key Partners to help it explore strategic alternatives, including a possible sale. The stock had gained 32 percent since a Reuters report on Jan. 7 said the defense company has hired advisers to seek a buyer. [ID:nN07204536]

Maryland-based Integral Systems provides controls for military ground systems and satellites. Its important markets include cyber security, intelligence, communications and unmanned aerial systems. The company had also gone through an unsuccessful auction process to sell itself five years ago.

Kratos joined the bidding for Integral Systems late in the auction process, only after it closed the Herley acquisition on March 31, people familiar with the matter said.

KEEPING A WATCH

Desire to find new growth areas amid looming defense spending cuts has spurred major arms suppliers to pay top dollar to snap up smaller rivals in high-demand technologies such as cyber security and surveillance. [ID:nN20275579]

Defense contractors are also looking to divest non-core businesses to make their organizations leaner and sharpen their focus on faster-growing areas in the face of softening demand.

In a recent example, British aerospace and defense group Cobham (COB.L) said earlier this month that it would look to sell its commercial systems and analytic solutions businesses.

Stone Key has been retained to run an auction for the analytic solutions unit, which provides a range of scientific, systems engineering and network warfare services to the U.S. missile defense and national security markets, people familiar with the matter said.

"Overall, we see little to no growth potential domestically for the large prime defense contractors," Morgan Keegan analyst Brian Ruttenbur said in a note.

"But we remain optimistic about the outlook for certain smaller niche areas such as C4ISR, unmanned systems, and cyber security."

The transaction is expected to add to Kratos' earnings per share, margins and cash flow, excluding transaction-related and financing costs, with expected revenues of $175 million, Kratos said in a statement.

Kratos said Jefferies Group and Key Capital Corporation have provided it firm commitments of up to $145 million in debt financing. Jefferies & Company Inc acted as exclusive financial adviser to Kratos on the deal.

(Reporting by Bijoy Koyitty in Bangalore and Soyoung Kim in New York; Editing by Bernard Orr)