Defense industry to see smaller mergers.

• Author: Insinna, Valerie
• Position: FINANCIAL OUTLOOK

* Given the failed merger between BAE Systems and EADS, it's likely there will be few "mega-mergers" of large defense contractors in the coming years, an investment banking firm report said.

Instead, the largest prime contractors will try to diversify their businesses by picking up small or mid-size companies that do commercial non-defense work or specialize in high-priority defense needs, according to a January report from Mesirow Financial Investment Banking Group in Chicago.

"What we're going to see more of particularly from the larger transactions ... are companies looking for diversification outside of defense or, within defense, areas that are still high-growth areas," said Andrew Carolus, managing director for the firm.

Such areas include intelligence, surveillance and reconnaissance technologies, unmanned aerial vehicles and cybersecu-rity, he said.

Despite a shrinking defense budget, the report predicts "healthy" merger and acquisition activity across the defense industry in 2013, with a possibility of more deals once long-term budgets are approved.

"Most of these [defense] companies are sitting on record amounts of cash," Carolus said. "They've all generated healthy cash flow over the last several years with the U.S. spending upwards of three quarters of a trillion dollars."

With less money and fewer contracting opportunities...