As the world economy continues its rebound, corporate executives are getting
more confident. The result has been an uptick in mergers & acquisitions.
After all, many large companies have huge amounts of cash and are trying to find
ways to boost their top-lines. One sector that looks poised for much more
dealmaking is the aerospace and defense industry. Of course, thanks to strong
defense spending there is a variety of cash-rich operators like General Dynamics
(NYSE: GD ), Lockheed Martin (NYSE: LMT ), Northrop Grumman (NYSE: NOC ) and
Raytheon (NYSE: RTN ). At the same time, the industry is facing some powerful
trends that should lead to increased consolidation. First of all, the major
defense firms are experiencing lower backlogs of orders as well as more project
cancellations. This is likely to persist for five to ten years as the U.S.
defense spending tightens. Keep in mind that the new Secretary of Defense is
likely to be Leon Panetta. He is a well-known budget hawk and was even the
chief of the Office of Management and Budget during the Clinton years, when the
US produced budget surpluses. Next, there will probably be force drawdowns in
Iraq and Afghanistan over the next couple years. The fact is that America is
war-weary. If anything, the killing of Osama bin Laden is likely to be a
factor that will accelerate the process. To fight these trends, it will be
temping for the major defense firms to acquire smaller companies. These should
provide access to growth markets and new technologies. So what are some of the
potential buyout targets? Here's a look a three candidates: AeroVironment
(NASDAQ: AVAV ): Roughly 85% of the company's revenue comes from advanced
unmanned aircraft systems known as drones. As seen in the wars in Libya, Iraq
and Afghanistan, these are becoming a critical part of the U.S. arsenal. No
doubt, the drone business has been a big growth driver AeroVironment, which has
a 40-year history of innovation. From 2004 to 2010, revenue surged from $48
million to $250 million. The operating margins are currently 19% and are
likely to increase over time. AeroVironment also develops charging systems for
electric vehicle batteries. This business has substantial long-term growth
potential as well. However, if AeroVironment does sell to a major defense firm,
the battery business is likely to be unloaded. But in light of its traction
– with Nissan as a customer – it could fetch a premium valuation. Alliant
Techsystems (NYSE: ATK ): The company has two main businesses. One is for
solid rocket propulsion systems. Unfortunately, in light of the budget issues
at NASA, this business is likely to diminish over time. But Alliant's other
business, military ammunition, is a gem. The focus is on affordable offerings,
which have high-end capabilities. It's the kind of thing that is likely to
remain attractive to the Pentagon. Alliant has several ammunition plants. For
example, its Missouri facility has the capacity to produce 1.4 billion rounds of
small-caliber ammunition per year. All in all, Alliant is trading a cheap
valuation, in light of its assets and cash flows. The stock is at only 5.6
times EBITDA. And going forward, the company forecasts that free cash flow
will be between $225 million to $250 million in 2011. FLIR Systems (NASDAQ: FLIR
): Since the late 1970s, the company has been at the cutting-edge of infrared
technologies. Of course, they are crucial for the modern battlefield, such as
with night vision. But FLIR also has a strong footprint in other sectors, such
as law enforcement, homeland security and border patrol. In fact, FLIR has made
a variety of breakthroughs that should lead to large market opportunities.
These include innovations like gas detection, food inspection, predictive
maintenance and building monitoring. FLIR has demonstrated a strong long-term
track record of growth. Over the past ten years, the average annual growth
rate of revenue was 23%. Yes, it's the kind of performance that would
attract any large defense firm. Hilary Kramer is the editor of the GameChangers
and Breakout Stocks Under $5 stock picking newsletters. As of this writing, she
held no position in any of the stocks named here.
