Small defense tech firms big bet for large contractors

By Bhaswati Mukhopadhyay and Dhanya Ann Thoppil

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.