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Ultra Electronics Holdings plc Buys Division Of Kratos Defense & Security Solutions, Inc For $265 Million

Ultra Electronics Holdings (LSE: ULE), a mid-cap defence and aerospace company, announced today that it has agreed to acquire the Electronics Products Division (“EPD”) of Kratos Defense & Security Solutions for up to $265 million. The acquisition would strengthen the company’s presence in the electronic warfare market, which is fast-growing despite recent defence spending cuts.

Electronic warfare and emergent technologies

EPD uses microwave and radio frequency technology for use in electronic warfare, radar and communication, missile and flight simulation applications. The business already supplies its proprietary technology to the Trident II D5 missile, F-16 Fighting Falcon, Eurofighter and the AMRAAM missile programmes. EPD had EBITDA (earnings before interest, tax, depreciation and amortisation) of $22 million and pre-tax profits of $11 million in 2014; which makes the acquisition seem on the more expensive side.

However, this reflects the growth prospects of the business. Ultra expects to benefit from substantial cost savings of around $8 million annually following the merger, and hopes to gain market share by increasing its technical capability and expanding its product range.

Although the outlook for the defence sector remains pessimistic with reduced defence spending, investments in emergent technologies are likely to remain prioritised. Ultra expects the electronic warfare market in the US will grow by 3% annually in the medium term. The company is also targeting other emergent technologies, including cryptosecurity, sonar-based submarine detection, mine detection and surveillance systems. Ultra made five acquisitions in 2014, costing a total of £107.5 million, which is more than four times what it had spent in 2013.

The market reacted positively to news of the acquisition

Ultra’s success in integrating acquisitions in the past gives us confidence that it can do the same with EPD. Its focus on bolt-on acquisitions, which have been smaller in scale and operate within similar markets, has made it easier to realise cost synergies and integrate them within the company. Acquisitions in the past have allowed the company to diversify away from the defence, allowing it to grow its exposure to cyber security, commercial aerospace, transport and energy markets.

Acquisitions is not the only growth strategy for the company, as it commits about 5% of its revenues on research and development. However, reduced traditional defence spending and the termination of its Oman Airport IT contract will still cause a short term disruption to its earnings growth trajectory. In the longer run, growth in commercial aerospace, security and prioritised defence markets should help the company to overcome these short term difficulties.

Reflecting the market’s confidence of the move, shares in Ultra rose by 2.6% to 1,880p by early afternoon. Ultra has a forward dividend yield of 2.5%. Its shares are currently trading at a forward P/E ratio of 15.5, which is slightly more expensive than its defence peers. But, Ultra’s greater focus on priority defence markets means that its premium valuation is well deserved.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.