General Dynamics (NYSE: GD) entered into a definitive agreement to acquire Axsys Technologies, Inc. (NASDAQ: AXYS) in a deal that is at a high premium if you consider the recent rally.  But this merger price is a rather low premium to recent trading, and it is a very unexciting premium if you compare the price to yesterday’s $50.00 close.  The $54.00 per share offer comes to roughly $643 million for a ‘whopping’ 8% premium, and the transaction has  been approved by the boards of directors of both companies.  We have several reasons to believe that this merger may need to command a higher price premium despite what the companies have agreed to.

First and foremost, Axsys has been speculated as a takeover stock for quite some time.  This stock slid from November 2007 highs and Summer 2007 highs north of $70.00 all the way down to under $30 with the early 2009  market tank.  Many speculators were washed out on the way down as share prices cratered.  But there was merger speculation money invested in Axsys.

Then in March after the market meltdown, the company engaged Jefferies to evaluate a possible sale and that sent shares instantly north of $40.00.  It has made a steady trickle-up since then to close at $50.00 yesterday.  An 8% premium is just unexciting.

The transaction is expected to be earnings-neutral in 2009 for General Dynamics and is expected to be accretive to General Dynamics’ earnings after this year.  If this is not even dilutive at all to 2009 earnings, we could argue that another bidder might be able to absorb more of a hit for 2009.  This is far from a ballsy buyout price, even if you consider that the climate of super-premium deals is not out there.

The transaction is subject to normal regulatory approvals as well as approval by Axsys Technologies’ shareholders, and the companies said this transaction is expected to close during the third quarter of the year.  We will not be surprised lawsuits by holders or on behalf of holders are filed demanding a higher price.  It traded at almost $80.00 last year, and as noted it has been a possible takeover speculation name for quite some time.

The options speculation that has been in this stock is also showing a significant mood of disappointment.  Usually you see higher options prices in out-of-the-money Call Options into a merger announcement.  Going out two months shows that the August $55.00 Calls has a price of $0.25.  That is out of the money, and this $0.25 price looks like it is actually DOWN $2.60 from this week’s spike-up prices.  In short, speculators got this one wrong on the price and right on the transaction.  The open interest for June-09 was 6,201 for the $50 Calls and that price looks only up $0.50 at $3.10 today.  The August $50 and $55 Calls had open interest of 1,636 and 1.189 contracts respectively, and the prices on both of those are down today.  In short, the bet in the speculative calls options got the  price very wrong.

Axsys Technologies is a global leader in the design and manufacture of high-performance electro-optical and infrared sensors and systems and multi-axis stabilized cameras.  By the sound of it, it is just what you think it is.  Surveillance and security, plus the offensive applications needed for military use.  Clients are the U.S. military and homeland security agencies, military and agency systems support integrators, law enforcement, and commercial customers in high-performance markets for aerial and perimeter surveillance applications. Axsys Technologies became a solid player in optical solutions for surveillance, reconnaissance and targeting applications.  This would be a solid product addition for any of the key defense and homeland security giants.

As of March 28, 2009 , the company had a backlog of $162.1 million and anticipates 2009 sales of $280 million.  Analysts are actually ahead of the company with Thomson Reuters consensus estimates of $284.9 million for 2009 and $318.3 million for 2010.  There has been at least some history of significantly beating earnings expectations in some quarters.

We will have this one under an expedited full review for our Special Situations Newsletter, and a decision will be made on that review in the next few days.

General Dynamics employs 92,900 workers globally, while Axsys has close to 1,000 workers.  With the size of General Dynamics and with a solid position in aviation, combat systems, armaments, munitions, shipbuilding, marine systems, information systems, technology, and more, we think that Axsys will be a rather easy operation to integrate for General Dynamics.  It would also be easy for another large competitor to integrate, and what is obvious as a heart attack is that a larger defense player and homeland security player would be able to instantly turn on significantly higher orders.

The other issue we have with the premium here is that the investor climate has changed significantly since the March lows and since the company put itself up for sale.  CEO’s are growing more confident than they have been for months and months.  This total buyout premium also does not look like that much more of a significant percentage gain from after the “post-exploring the the sale” announcement when you compare this to peers.  It is a premium and outperformance, just not an exciting amount.  Not really at all.

By our count, there are more than 10 other companies which could be or could have been buyers of Axsys, and that number would be higher if some of the more diversified and conglomerated companies had not seen their common stock get so battered before the March to present rally.

There are many hurdles that could be in place to another merger deal despite our opinion.  What those are will not be known until the proxy materials are reviewed.  But that could be tools already under management’s control, a break-up fee, and other tools.  We have inquiries into other special situation analysts in an effort to get more color here.

Our ending takeaway here is that this merger could command a higher premium from another large defense and homeland operator.  How much higher, that remains the question.

Jon C. Ogg
June 4, 2009

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