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Last week’s flurry of deals among second-tier defense contractors is a harbinger of a round of consolidation to come. Armed with strong currency stemming from the renewed emphasis on defense spending that followed Sept. 11, a number of smallish government contractors are on the prowl for acquisitions, according to industry consultants and investment bankers. A decade of consolidation among the industry’s largest players has created a group of defense titans such as Boeing Co., Lockheed Martin Corp. and Northrop Grumman Corp. that command market capitalizations in excess of $12 billion. Beneath them stand some smaller companies that are now left to cobble together niches and build businesses strong enough to compete with those larger firms. “The mid- to late 1990s was all about consolidation of the prime contractors,” said Jon Kutler, founder and CEO of defense-focused investment bank Quarterdeck Investment Partners LLC. “That, for the most part, has happened, but it was only the tip of the iceberg. There is still a huge amount of overcapacity and fragmentation among the secondary contractors.” By all indications, the consolidation game is already afoot. Last week alone United Defense Industries Inc. swallowed United States Marine Repair Inc. for $150 million, EDO Corp. struck a deal for Condor Systems Inc. for $112.3 million, and DRS Technologies Inc. agreed to buy Eaton Corp.’s Navy Control unit for $92.2 million in cash. Analysts say those three deals encapsulate many of the trends driving industry consolidation. For United Defense and EDO, the transactions allowed small contractors to broaden their product portfolio and revenue base. For the larger Eaton, selling its control division was a way to exit a business no longer seen as part of its future. “We have a number of large companies using the recession as an excuse to exit noncore businesses and a number of small companies eager to broaden their base,” said another industry banker who asked not to be identified. “That is a great mix for getting deals done.” William J. Frost, a vice president at EDO, confirmed his company’s interest in doing more deals. “EDO has indicated its desire to make some strategic acquisitions, and we continue to pursue possible opportunities,” he said. The company has been in buying mode since 2000, he added, when it purchased Long Island, N.Y.-based AIL Technologies Inc. for $86.8 million. That deal doubled the size of EDO overnight. A year later, EDO added Dynamic Systems Inc. of Virginia. Industry experts said they expect dealmaking among this second tier to heat up even more this summer and to remain strong well into 2003. Steve Grundman, director of aerospace and defense consulting at Charles River Associates in Boston, said he is looking for midsize defense information technology providers and commercial aviation specialists in particular to bulk up. The Pentagon’s growing emphasis on network security and electronic eavesdropping gives small IT companies ample motivation to expand, Grundman said. “Defense electronics and IT companies are seen as well-positioned to ride the wave of new defense and homeland security spending,” he said. “Buyers are motivated because they have a strong currency and they believe there will be ample opportunity to deploy any capacity they can acquire.” The IT market is divided between subsidiaries of the first-tier players, including Northrop’s Logicom unit, and a large number of small-cap players. Grundman said he does not expect the large firms to buy any of the smaller vendors, but companies such as DRS Technologies and EDO will likely remain opportunistic, he said. Other probable buyers include highly acquisitive L3 Communications Holdings Inc. of New York, and Veritas Capital-backed Integrated Defense Technologies Inc. of Huntsville, Ala. Technology services companies such as Arlington, Va.-based CACI International Corp., recently public Fairfax, Va.-based Anteon International Corp., and San Diego-based Titan Corp., could also do deals. But commercial aerospace vendors could provide the industry with some of its largest deals in the coming months, analysts said. With airlines buying fewer planes, companies such as Charlotte, N.C.-based Goodrich Corp. and United Technologies Corp. of Hartford, Conn., could look to defense acquisitions for new sources of revenue. “Many of the second-tier are looking at Boeing, which, all things considered, has weathered this downdraft successfully,” Grundman said. “I would think some of the other aerospace companies might be interested in mimicking Boeing’s diversification strategy.” Even before Sept. 11 there was evidence of this trend, he noted. Goodrich, for example, bought Raytheon Co.’s optical systems unit last fall. Goodrich’s CEO Dave Burner told a Salomon Smith Barney Inc. conference earlier this year that he hopes to expand the company by 5 percent annually through deals. Copyright (c)2002 TDD, LLC. All rights reserved.

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