As the economic crisis squeezes U.S. government budgets and priorities shift beyond defense, the world's top defense contractors will likely turn to acquisitions to ensure they can keep growing.

They won't be looking for blockbuster deals but takeovers for less than $1 billion in niche areas that have been identified by governments as high priorities.

In the United States, defense companies are placing bets on technologies that will be in demand as President Barack Obama channels more funds to counter cyber threats and to increase military intelligence and equipment to better fight insurgents in places like Afghanistan.

We don't see opportunistic M&A, but very disciplined acquisitions buying into programs that are deemed to be the winners, said Paul Weisbrich, senior managing director with McGladrey Capital Markets LLC in Costa Mesa, California.

For instance, he pointed to Boeing Co's 2008 acquisition of Insitu, a U.S. drone maker, for about $400 million as an example of potential deals to come.

We don't see a lot of mega-acquisitions, the multibillion-dollar deals, Weisbrich added. The $100 million to billion-dollar area will be the bulk of the activity.

Last week, General Dynamics Corp announced an agreement to buy Axsys Technologies Inc for $643 million, or $54 a share. Axsys provides high-end optics for manned and unmanned military vehicles and satellites.

Axsys, which had put itself up for sale earlier this year, attracted significant interest from other leading contractors, said David Baxt, head of aerospace and defense investment banking at Jefferies & Co, which advised Axsys on the deal.

The U.S. defense budget request for fiscal 2010 year that begins on October 1 seeks to increase base spending by 4 percent, down from the 7.5 percent rise for the prior year's budget, and is capping production of Lockheed Martin Corp's F-22 fighter jet.

The U.S. budget, which must be approved by Congress, still dwarfs any other military budget -- the next biggest is the United Kingdom.

But there are major concerns that growth will wane in subsequent years as the Obama administration struggles with a massive budget deficit caused by the economic crisis and bailouts of banks and other companies.

Each of the big contractors has got a little bit of a hole in their business right now because everyone had gotten so platform-heavy in the Bush years, Baxt said in reference to major weapons systems such as warplanes, big ships and armored vehicles.

I don't think we're going into a crazy (mergers) boom but M&A in general is back in a way that we haven't seen over the last 18 months, Baxt said, adding that he is working on other deals.

Foreign firms like BAE Systems PLC are also expected to push for more U.S. business. Investment firm Goldman Sachs said in a June 5 research note that United Kingdom-based BAE will need to make acquisitions to offset earnings headwinds.

AEROSPACE LOOKING BETTER

Should company valuations continue to move up from March lows, that could give companies leeway to pay more for takeover targets by using their stock as currency.

But not all observers are expecting higher valuations to

materialize, especially for pure-play military contractors.

The U.S. Standard & Poor's Aerospace and Defense index

<.GSPAERO> ended a five-year string of gains in 2008, when it fell 37 percent. This year, the index is up about 8 percent, compared with a 4 percent rise in the S&P 500 Index <.SPX>.

Equity research firms Goldman Sachs and Macquarie Research both became more cautious on defense stocks in recent weeks, citing effects of expected spending cuts in Europe and the United States.

The firms raised ratings on companies such as Boeing, Airbus parent EADS and Goodrich Corp that serve the commercial aerospace industry more, but downgraded the defense-focused Northrop Grumman Corp , BAE Systems and Finmeccanica of Italy.

The commercial side of the industry is a 'buy' whereas the defense side is almost a 'sell', said Paul Nisbet, an analyst with JSA Research in Sarasota, Florida. He said the U.S. budget request for the fiscal 2011 year, which will have a greater Obama imprint, is sure to include more meaningful weapons cuts.

For this year and next, the majority of the firms will be modestly upward, both on the topline and bottom line, Nisbet said. But come 2011, I think you're going to see the defense side of the industry losing ground both in revenue and earnings, with further declines possible beyond then.

Reflecting this sentiment, commercial aerospace stocks have outperformed defense this year. For example, Boeing has gained 21 percent, while Goodrich has shot up 44 percent.

On the defense side, industry leader Lockheed Martin has gained 2.1 percent so far this year, and Northrop Grumman is up 6 percent. BAE, which is traded in London, has fallen 13 percent.

Some analysts reject the bearish call on defense, saying there will still be plenty of money to be made in the United States for companies that can aid troops fighting insurgencies and make government networks safer, even if weapons spending is curtailed.

The misunderstanding on the Street is that there's going to be this big fall-off in defense and (the United States) is getting out of Iraq 100 percent, and that's just not the case, said Brian Ruttenbur, an analyst with Morgan Keegan in Nashville, Tennessee.

(Reporting by Karen Jacobs, editing by Dave Zimmerman)

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