An Intelligent Deal For Raytheon

By Stephen D. Simpson, CFA | December 23, 2010 AAA

The unpredictable and highly political nature of defense and intelligence spending make it difficult for small, publicly traded defense companies to really thrive. It is not all that surprising, then, that there has been a wave of M&A in the space - not only due to the increasing significance of electronic warfare and the need for bigger companies to add technology, but also the increasing uncertainty of spending in the face of higher deficits and debts.

With all that in mind, then, it is not surprising to see Monday's announcement that
Raytheon (NYSE:RTN) reached a deal to acquire Applied Signal (Nasdaq:APSG). (For background reading, check out the Mergers & Acquisitions Tutorial.)

IN PICTURES: 5 Tips To Reading The Balance Sheet

The Scoop on the Deal
What is a surprise is that Applied Signal's management essentially put itself on the block back in October of this year. This is surprising because the company's management had not been very warm to the idea of a sale for many years. With that change in attitude though, things moved quickly.

Raytheon, one of the largest defense companies in the world, announced that it would acquire Applied Signal for $490 million in an all-cash deal that values Applied Signal at $38 per share. That is not only a 9% premium to the stock's closing price on Friday, but also a 90% premium to where the stock traded before management publicly discussed the possibility of a sale.

All in all, this is an eminently fair deal for Applied Signal shareholders. Relative to deals like Boeing (NYSE:BA), which bought Argon ST; Northrop Grumman (NYSE:NOC), which bought Essex; and FLIR (Nasdaq:FLR), which acquired iCX Tech; if APSG goes out at more than 15 times its trailing EBITDA, it's a fair price.

The Changing Landscape
This is not a bad deal for a very small company with a tough operating environment. Although Applied Signal certainly had a clean balance sheet and good technology, the general expectation is that the government is going to have to cut back on military spending in the face of huge deficits and rising debt. While it is entirely possible that those cuts might disproportionately hit the big-ticket hardware businesses of major contractors like General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), Boeing and Raytheon, it is nevertheless hard to see how Applied Signal could avoid running into lean times.

To that end, it will be interesting to know how many suitors Applied Signal entertained before closing this deal. As one of the few available pure-plays in intelligence, surveillance, reconnaissance and cyber-solutions, it would stand to reason that any of those large players (as well, perhaps, as companies like L-3 Communications (NYSE:LLL) or Harris (NYSE:HRS) would have been interested.

For Raytheon, though, this is a solid deal. Intelligence and information systems is about 13% of the company's revenue and while this deal won't radically change that (adding about $200 million in revenue to base of nearly $25 billion), it gives the company technologies that can be further developed, integrated and embedded into existing platforms and development projects.

Anybody Else?
With this deal, there is a sizable gap in smaller defense stocks, particularly those with specialties in the signal intelligence market. Nevertheless, there are still some names left to consider. Although they are not necessarily clear comparables to Applied Signal, small/mid-cap investors could look at names like CACI Intl (Nasdaq:CACI), AeroVironment (Nasdaq:AVAV), Elbit Systems (Nasdaq: ESLT) and ManTech (Nasdaq:MANT) as starting points for further due diligence. All of these stocks trade at discounts to Applied Signal's take-out valuation, but it is up to investors to do their own due diligence and decide whether those discounts are appropriate or represent bargains-in-the-making. (For more, see Where The M&A Action Is, And What's Next.)

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