BANGALORE - As the United States draws down troops in Afghanistan and Iraq and cuts back on defense spending, its reliance on technology will only rise, benefiting a clutch of companies specializing in intelligence gathering, surveillance and reconnaissance.
The U.S. military will need more equipment like infrared sensors, jammers and unmanned aerial vehicle (UAV) systems to counter threats to its troops, with the Obama administration planning to cut troops in Afghanistan by a third by 2012, and exit from Iraq by the end of this year.
"(The United States) will have to continue to keep an eye on what is occurring in these countries. So, we will invest in intelligence gathering equipment to complement the decrease in actual forces on ground," Lazard Capital Markets analyst Michael Lewis said.
Defense technology companies such as signal intelligence systems maker Mercury Computer Systems , night-vision systems specialist FLIR Systems and unmanned aerial vehicle (UAV) maker AeroVironment are expected to benefit from this shift in defense spending priorities.
"What you are going to see is the need for more of the advanced or next-generation capabilities that enable force protection, increased situational awareness and survivability capabilities," analyst Michael Ciarmoli of KeyBanc Capital Markets said.
Despite the cuts to U.S. defense spending, Ciarmoli sees a "healthy" expansion of funding, probably in the high single digits, for the high-margin intelligence and surveillance, and defense electronics businesses.
In April, President Barack Obama asked the defense department to come up with $400 billion in spending cuts spread over 12 years. The war in Afghanistan alone costs the United States more than $110 billion a year.
"Certainly, having high troop level presence is very expensive ... So, if you draw down and ultimately have a stand-off technology approach ... you will have a net gain in terms of lower costs," Gleacher & Co analyst Peter Arment said.
Other companies expected to benefit from the shift include Kratos Defense & Security Solutions Inc and Comtech Telecommunications Corp .
The way the United States has fought the war in Libya, with focus on providing technology to allies in the battle field, is also a pointer to the change in the future model for military engagement overseas.
"Assuming it conducts future missions in this fashion, we believe next-generation capabilities will continue to be procured in a rapid manner, which also augurs well for select defense contractors," analyst Ciarmoli said.
One piece of equipment that is expected to see a jump in funding is electronic jammers used to counter the improvised explosive devices (IEDs) that have maimed and killed many troops in Afghanistan and Iraq.
IEDs are difficult to counter with conventional bomb detection systems, and industrial major ITT Corp last August won a $455 million contract to develop the jammers, known as joint counter radio-controlled improvised explosive device electronic warfare (JCREW).
Mercury Computer Systems is a sub-contractor for providing signal processing technology for the latest version of JCREW.
"Key to the signal processing technology in JCREW is to defeat an adversary signal that detonates a bomb ... We have certainly seen improvements in Mercury's business as a result of its positioning in the market," Lazard Capital's Lewis said.
Another red-hot opportunity is onboard signal processing for aircraft, including unmanned aerial vehicles, or drones, that the U.S. forces increasingly rely on in conflict zones.
Mercury Computer and a large number of private companies compete with larger rivals like Curtiss Wright Corp in this market.
"Aircraft, manned or unmanned, want to have these systems to take less power, they want it to be lighter. So, companies that can provide this are in good space right now to continue to see contract flowing," Lewis said.
The new opportunities are also expected to sustain the current M&A momentum in the sector.
The last one year saw defense giants like Boeing Co , Safran and Raytheon Co snapping up smaller rivals for their technologies.
FLIR Systems bought ICx Technologies in a $274 million deal last August to expand into the market for sensing technologies. In May, Kratos agreed to buy rival Integral Systems for $225 million to expand in the surveillance and intelligence business.
"Most of the deals by the large defense companies will be billion dollars and under," Gleacher & Company's Arment said.