DEALTALK-Signal, security firms next targets in defense M&A

* Pentagon cost-cutting to speed up niche M&A

* APSG, Mercury Computer to attract interest

* Record valuations for niche technology firms

By Bijoy Anandoth Koyitty

BANGALORE, Aug 27 (BestGrowthStock) – Ashton Carter, the Pentagon’s
chief weapons buyer, wrote to staff in late June outlining his
department’s determination to cut costs and shift more than $1
billion in savings to modernize troops and technology.

Within 48 hours, Boeing Co (BA.N: ), one of the Pentagon’s
biggest contractors, announced its acquisition of signal
technology firm Argon ST, swiftly followed by its purchase of
cyber-software maker Narus.

As the United States strengthens its focus on national
security, Boeing’s peers Lockheed Martin Corp (LMT.N: ), Northrop
Grumman (NOC.N: ), General Dynamics (GD.N: ), Goodrich Corp (GR.N: )
and BAE Systems Plc (BAES.L: ), will also be eyeing a bigger
slice of the surveillance and intelligence market.

All of which is sending valuations sky-high for the
mid-tier defense contractors that provide the niche
surveillance and intelligence technologies.

Boeing’s deal for Argon ST, and FLIR Systems’ (FLIR.O: ) buy
of Argon’s rival ICx Technologies (ICXT.O: ) saw valuations
inflate to about 14 times forward EBITDA, well above the
broader sector average of 8-9 times.

As deals gain momentum and valuations rise, one name doing
the rounds as a potential next target is Applied Signal
Technology (APSG.O: ), whose products are used by U.S. defense
and homeland security agencies to intercept cellphone,
microwave and military communication signals.

Others likely to attract interest include Mercury Computer
Systems (MRCY.O: ), ComTech Telecommunications (CMTL.O: ), Integral
System Inc (ISYS.O: ), which helps the military control ground
systems and satellites, and drone maker AeroVironment Inc
(AVAV.O: ), analysts said.

“These smaller companies come up with 80 percent of the
solutions at a fraction of a price,” said David Rowlett, an
analyst at T. Rowe Price Group, which manages $391 billion.

“They compete on nimbleness and innovation and can move
quicker than the big guys.”

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StarMine valuations: http://r.reuters.com/puv67n

For a Factbox, click: [ID:nSGE67Q0IQ]

For a graphic: http://link.reuters.com/quj77n

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L-1 Identity Systems (ID.N: ), a maker of finger and iris
recognition devices, said last week it was close to announcing
a deal, which analysts peg at around $1 billion.

“Eventually some other areas would also get consolidated,
but for the next 12-18 months, it will be the niche growth
areas attracting deals,” said Brian Ruttenbur of Morgan, Keegan
& Co.

SIGNALS MIXED

The acquisitions of Argon ST and ICx saw defense valuations
break the double-digit barrier for the first time in three
years, but the broader sector won’t see similar increases just
yet.

“The high numbers will be specific to the industry that is
in high demand,” Michael Lewis of BB&T Capital Markets said.

“Highly coveted businesses like intelligence, very niche
offerings like censors, unmanned systems, cyber security –
those are the areas that will see a high M&A premium,” he said.

Analysts expect Applied Signal to have a valuation similar
to that of Argon ST, in a takeover scenario.

“If there’s a company out there that wants to make a strong
bid for a property like Applied Signal, it will have to bid
very, very high,” Lewis said.

Applied Signal shares currently trade at 7.2 times forward
EBITDA, a 39 percent premium to its peers, according to Thomson
Reuters StarMine data.

The company, which has a market value of $256 million,
strengthened its cyber security offerings through the
acquisition in April of privately held Seismic LLC.

Shares of L-1 Identity, valued at $819 million, currently
trade at 12.7 times forward EBITDA, a 118 percent premium to
its peers. The company put itself up for sale in March.

Valuations for the larger firms are weighed by budgetary
concerns and the U.S. military’s aim to reduce its presence in
Iraq and Afghanistan.

“We’re looking for about 3 percent growth going forward in
the defense budget, which is about half what we’ve seen over
the last 10 years,” said Ruttenbur.

A prolonged softness in spending could bring a reality
check to the current high valuations.

“If you give a couple more years, a lot of reality would
set in on some of the defense names … acquisitions would be a
bit easier as sellers would be in a much more desperate
situation,” said T. Rowe Price’s Rowlett.

“History shows that going for wild, large and highly-priced
acquisitions is not a good move.”
(Reporting by Bijoy Koyitty in Bangalore, additional reporting
by Megha Mandavia; Editing by Ian Geoghegan)

DEALTALK-Signal, security firms next targets in defense M&A