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By Ben Kolada

Constraints in federal defense spending are causing traditional defense contractors to look outside their core for growth. The latest move is Raytheon’s (NYSE:RTN) pickup of cyber security firm Applied Signal Technology (APSG). The $490 million acquisition, announced today, wraps up a two-month process from when Applied Signal announced that it would seek ’strategic alternatives’ to increase shareholder value.

Raytheon’s $38-per-share offer for Applied Signal represents a 37% premium over Applied Signal’s closing share price the day before it announced it was looking to boost its share price. We suspect the high valuation was partly the result of a competitive bidding process that included Raytheon competitors L-3 Communications (NYSE:LLL) and Cobham (CBMHY.PK).

However, this isn’t the first competitive process we’ve seen for a defense-focused IT service provider. The Applied Signal transaction comes just half a year after its larger rival, Argon ST (Pending:STST), was scooped up by Boeing (NYSE:BA). We understand the Argon property was the focus of an even more hotly contested process, with Boeing eventually paying a premium of 41% above Argon’s share price the day before the deal was announced.

The rise in defense IT valuations is the result of traditional defense contractors looking for growth channels as the federal spigot tightens. After a dozen years of consistent growth in federal defense spending, the Office of Management and Budget projects defense expenditures will decrease by an aggregate of 5% from 2010-2015.

Meanwhile, spending on IT defense is expected to rise. As a result, firms like Argon and Applied Signal have received healthy valuations, but they are not alone. Since late October, when Applied Signal announced it was looking at strategic alternatives to increase shareholder value, including selling itself, acquisition speculation has spilled over to Mercury Computer Systems (NASDAQ:MRCY), a maker of hardware and software systems for the defense industry. Since Applied’s announcement, shares of Mercury Computer have risen 40%.

Disclosure: No positions

Source: M&A Spotlight: Defense Goes on Offense