More mergers seen in U.S. defense space

NEW YORK (Reuters) - Italian defense manufacturer Finmeccanica SpA's (SIFI.MI) recent $4 billion acquisition of U.S. defense company DRS Technologies Inc DRS.N was a big one, but it is not the last one.

More European defense manufacturers looking to gain a presence in the U.S. defense market -- the world's largest -- will likely be targeting U.S. defense suppliers.

Increasing acquisition activity is also expected within the domestic defense sector as suppliers consolidate to become one- stop shops for manufacturers such as Boeing Co (BA.N), Lockheed Martin Corp (LMT.N) and Northrop Grumman Corp (NOC.N).

U.S. defense spending -- pegged at more than $500 billion for 2009, excluding more than $100 billion for the cost of war -- is not expected to decrease in the next few years, regardless of who wins the presidential elections this year.

The pace of spending could rise or fall, but the overall budget is not expected to shrink.

"Four key factors underlie this assessment," said Matthew Smith, a defense economics analyst at Jane's Information Group.

"The cost of the military is rising, the political will to reduce spending is nonexistent, the security environment remains challenging and, despite current economic concern, the U.S. can afford it."

With the strength of the euro, this is an opportune time for European companies to make acquisitions in the United States and try to get a piece of the massive U.S. defense budget.

"It's certainly a good time for European companies to get access to U.S. defense programs and the U.S. defense budget," said Rick Phillips, managing director of aerospace and defense at CIT Investment Banking Services.

"Not only is the euro high now, but when the dollar strengthens against the euro, the dollar earnings will be higher when reported in euros.

"So even if dollar earnings are flat, the apparent multiple paid (calculated in euros) will decrease when the dollar strengthens."

LIKELY SUITORS

In a disclosure that points to the pent-up demand, DRS said it received a higher offer from an unnamed foreign bidder and an expression of interest by a U.S. defense company before finalizing a deal with Finmeccanica.

A French daily said on Wednesday that French defense electronics group Thales SA (TCFP.PA) is considering a counter- bid for DRS. If Thales does not bid for or acquire DRS, it is one of the companies expected to make acquisitions in the U.S. market in the near future.

Another potential suitor is Airbus parent EADS NV (EAD.PA), which was expected to counter-bid for DRS, but said Finmeccanica's offer was "too high," even though it had highlighted possible synergies from a DRS takeover and said the company was on EADS' target list.

Analysts say Finmeccanica's move has raised the prospect of EADS being strategically sidelined in the lucrative U.S. defense market, leading many to expect the Franco-German company to target another U.S. company soon.

In fact, EADS has said publicly it already has a target list of companies.

Some tier-two defense suppliers include Dallas-based Vought Aircraft Industries, which is 90 percent owned by private equity firm Carlyle Group CYL.UL and Primus International, owned by private equity firm Oak Hill Capital Partners, and Moog Inc (MOGa.N).

Deal valuations in the supplier sector would range from 8 to 14 times EBITDA (earnings before interest, taxes, depreciation and amortization) depending on the company.

"Higher multiple companies generally have key proprietary technologies, are in high-growth areas such as UAVs (unmanned air vehicles), or have access to key customers in the intelligence arena," Phillips said.

DOMESTIC CONSOLIDATION

"You can also expect to see a lot of acquisitions and a few joint ventures taking place among the U.S. defense suppliers," said Bill Alderman, president of Alderman & Co, a consulting firm specializing in aerospace and defense.

Some analysts and bankers believe the U.S. company interested in DRS was probably L-3 Communications Holdings Inc (LLL.N), which itself is the subject of speculation right now, with rumors swirling about that Raytheon Co (RTN.N) is interested.

"I think there will be strong M&A activity in the defense supply chain, driven by the evolving requirements of the Department of Defense," Alderman said, referring to a growing need for the maintenance and overhaul of aircraft fleets.

"The defense supply chain provider to the DOD wants to be able to say: 'I can do all of this for you at this price and I guarantee performance.' That would need strong joint venture agreements or acquisitions."

(Additional reporting by Andrea Shalal-Esa in Washington; Editing by Andre Grenon)