The two-year agreement, which is likely to pass the Senate this week, is expected to reassure contractors on government spending and unleash pent-up demand for deals, according to analysts. The House of Representatives approved the budget plan last week.
The budget deal would halve the $52 billion in automatic spending cuts facing the Pentagon in fiscal 2014 and would lower mandatory reductions in projected spending in 2015.
"It gives our customers in the U.S. government further certainty for their budget decisions," Marillyn Hewson, chief executive of Lockheed Martin Corp (LMT.N), said in an interview with Reuters.
"It does give us more certainty and helps us in our planning process," she said, noting that the company is always looking for acquisitions to tap new markets or round out existing business areas.
Defense M&A activity ground to a near halt in recent years amid uncertainty about future U.S. military spending that has kept sellers on edge and buyers more apt to invest in share buybacks and dividend payouts than acquisitions. Boeing on Monday announced a $10 billion buyback and increased its dividend 50 percent, part of a broader share-buying spree by large U.S. companies.
Now, however, the industry is poised to hit a three-year high in both the number and value of deals next year as shrinking defense budgets and a surge in commercial aircraft orders prompt consolidation in supply chains for both sectors, said Tom Captain, head of aerospace and defense at consulting firm Deloitte.
"2014 should be a banner year for aerospace and defense M&A activity," Captain said in an interview. "There will be a great number of smaller deals, no blockbusters, but deal value should also be up."
Others are more cautious in their outlook.
Scott Thompson, head of U.S. aerospace and defense for PricewaterhouseCoopers, said the budget deal showed the political will to compromise. But he said the longer-term outlook remained uncertain, and that the U.S. Defense Department still needed to map out its fiscal 2015 budget.
"The next step ... is for (the Pentagon) to submit its 2015 budget. That will provide some specifics on spending priorities. At that point, I think the M&A market will start to improve," he said. He noted that there had been no major defense deals since the Budget Control Act of August 2011, which first put the "sequestration" reductions in place.
FAVORABLE CONDITIONS
The expected rebound reflects more than just the clearing of U.S. government uncertainty. Buyers have accumulated cash, grown more confident about the outlook of possible takeover targets and still need to increase capacity and capability. Sellers, for their part, have seen valuations rise with the stock market.
A recent Deloitte report noted that public aerospace and defense companies had a total of $86 billion of cash on hand at the end of the second quarter of 2013, an increase of 8 percent from a year earlier. Interest rates also remained low, it noted.
Deloitte expects global aerospace and defense industry revenue to increase 5 percent next year. Its forecast shows that a 1.5 percent to 2 percent decline in defense industry sales will be offset by a 9 percent to 11 percent increase by commercial aerospace.
Most experts aren't expecting mergers among the biggest defense contractors - including Lockheed Martin Corp (LMT.N), Boeing Co (BA.N), Raytheon Co (RTN.N) and Northrop Grumman Corp (NOC.N) - although they don't completely rule out such a deal, especially if U.S. lawmakers don't reach an agreement on a longer-term budget deal.
The bulk of the expected M&A activity is likely to be focused on companies with revenue of $100 million to $300 million, said Jeffrey Houle, co-chair of global law firm DLA Piper's defense and government services practice. He declined to name any specific buyers or sellers.
David Melcher, chief executive officer of defense contractor Exelis Inc (XLS.N), agreed that the budget deal would make companies more likely to act on possible M&A deals, noting that there was a limit to how many shares companies like his would want to repurchase.
Exelis, which makes night-vision goggles and other advanced defense equipment, last week announced the spinoff of its lower-margin government services business.
"There's been cash building up on balance sheets, for sure," Melcher said in an interview. "Companies will want to invest in the capabilities they think are going to be needed for the next upturn in defense, which will inevitably come."
BUYING CAPABILITIES
Weapons makers are increasingly looking at acquisitions and foreign orders to offset declining orders from U.S. and European governments, which are tightening their belts after over a decade of war in Iraq and Afghanistan.
Houle said many large defense firms were looking for acquisitions in the cybersecurity, intelligence and healthcare-information-technology fields as ways to increase revenue as orders in core business areas taper off.
Demand for defense deals is likely to keep growing, he added, since the budget deal would only take the worst of the U.S. defense budget cuts off the table for two years, and U.S. military spending is likely to remain under pressure in the long term.
"Even with the new budget deal, the large prime contractors are going to find it more difficult to grow organically" in the long run, Houle said.
He said many firms had been exploring possible acquisitions over the past year, hiring firms to carry out months of due diligence work but then holding off on completing deals because of the lingering uncertainty that has hung over the market.
Captain said deal activity will increase as sellers become more realistic about how much their companies are worth, and rising stock markets provide them with some additional upside after several years of constrained prices.
"The (valuation) gap has closed - companies are now being valued by the stock market what the buyers think they're worth," Captain said.
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