Defense deals to grow, but more niche than mega

By Karen Jacobs

ATLANTA (Reuters) - As the economic crisis squeezes U.S. government budgets and priorities shift beyond defense, the world's top defense contractors will likely turn to acquisitions to ensure they can keep growing.

They won't be looking for blockbuster deals but takeovers for less than $1 billion in niche areas that have been identified by governments as high priorities.

In the United States, defense companies are placing bets on technologies that will be in demand as President Barack Obama channels more funds to counter cyber threats and to increase military intelligence and equipment to better fight insurgents in places like Afghanistan.

"We don't see opportunistic M&A, but very disciplined acquisitions buying into programs that are deemed to be the winners," said Paul Weisbrich, senior managing director with McGladrey Capital Markets LLC in Costa Mesa, California.

For instance, he pointed to Boeing Co's 2008 acquisition of Insitu, a U.S. drone maker, for about $400 million as an example of potential deals to come.

"We don't see a lot of mega-acquisitions, the multibillion-dollar deals," Weisbrich added. "The $100 million to billion-dollar area will be the bulk of the activity."

Last week, General Dynamics Corp announced an agreement to buy Axsys Technologies Inc for $643 million, or $54 a share. Axsys provides high-end optics for manned and unmanned military vehicles and satellites.

Axsys, which had put itself up for sale earlier this year, attracted "significant interest" from other leading contractors, said David Baxt, head of aerospace and defense investment banking at Jefferies & Co, which advised Axsys on the deal.

The U.S. defense budget request for fiscal 2010 year that begins on October 1 seeks to increase base spending by 4 percent, down from the 7.5 percent rise for the prior year's budget, and is capping production of Lockheed Martin Corp's F-22 fighter jet.

The U.S. budget, which must be approved by Congress, still dwarfs any other military budget -- the next biggest is the United Kingdom.

But there are major concerns that growth will wane in subsequent years as the Obama administration struggles with a massive budget deficit caused by the economic crisis and bailouts of banks and other companies.

Each of the big contractors has "got a little bit of a hole in their business right now because everyone had gotten so platform-heavy in the Bush years," Baxt said in reference to major weapons systems such as warplanes, big ships and armored vehicles.

"I don't think we're going into a crazy (mergers) boom but M&A in general is back in a way that we haven't seen over the last 18 months," Baxt said, adding that he is working on other deals.

Foreign firms like BAE Systems PLC are also expected to push for more U.S. business. Investment firm Goldman Sachs said in a June 5 research note that United Kingdom-based BAE will need to make acquisitions to offset earnings headwinds.

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