BANGALORE (Reuters) - Ashton Carter, the Pentagon’s chief weapons buyer, wrote to staff in late June outlining his department’s determination to cut costs and shift more than $1 billion in savings to modernize troops and technology.

Within 48 hours, Boeing Co BA.N, one of the Pentagon's biggest contractors, announced its acquisition of signal technology firm Argon ST, swiftly followed by its purchase of cyber-software maker Narus.

As the United States strengthens its focus on national security, Boeing's peers Lockheed Martin Corp LMT.N, Northrop Grumman NOC.N, General Dynamics GD.N, Goodrich Corp GR.N and BAE Systems Plc BAES.L, will also be eyeing a bigger slice of the surveillance and intelligence market.

All of which is sending valuations sky-high for the mid-tier defense contractors that provide the niche surveillance and intelligence technologies.

Boeing's deal for Argon ST, and FLIR Systems' FLIR.O buy of Argon's rival ICx Technologies ICXT.O saw valuations inflate to about 14 times forward EBITDA, well above the broader sector average of 8-9 times.

As deals gain momentum and valuations rise, one name doing the rounds as a potential next target is Applied Signal Technology APSG.O, whose products are used by U.S. defense and homeland security agencies to intercept cellphone, microwave and military communication signals.

Others likely to attract interest include Mercury Computer Systems MRCY.O, ComTech Telecommunications CMTL.O, Integral System Inc ISYS.O, which helps the military control ground systems and satellites, and drone maker AeroVironment Inc AVAV.O, analysts said.

“These smaller companies come up with 80 percent of the solutions at a fraction of a price,” said David Rowlett, an analyst at T. Rowe Price Group, which manages $391 billion.

“They compete on nimbleness and innovation and can move quicker than the big guys.”

L-1 Identity Systems ID.N, a maker of finger and iris recognition devices, said last week it was close to announcing a deal, which analysts peg at around $1 billion.

“Eventually some other areas would also get consolidated, but for the next 12-18 months, it will be the niche growth areas attracting deals,” said Brian Ruttenbur of Morgan, Keegan & Co.

SIGNALS MIXED

The acquisitions of Argon ST and ICx saw defense valuations break the double-digit barrier for the first time in three years, but the broader sector won’t see similar increases just yet.

“The high numbers will be specific to the industry that is in high demand,” Michael Lewis of BB&T Capital Markets said.

“Highly coveted businesses like intelligence, very niche offerings like censors, unmanned systems, cyber security - those are the areas that will see a high M&A premium,” he said.

Analysts expect Applied Signal to have a valuation similar to that of Argon ST, in a takeover scenario.

“If there’s a company out there that wants to make a strong bid for a property like Applied Signal, it will have to bid very, very high,” Lewis said.

Applied Signal shares currently trade at 7.2 times forward EBITDA, a 39 percent premium to its peers, according to Thomson Reuters StarMine data.

The company, which has a market value of $256 million, strengthened its cyber security offerings through the acquisition in April of privately held Seismic LLC.

Shares of L-1 Identity, valued at $819 million, currently trade at 12.7 times forward EBITDA, a 118 percent premium to its peers. The company put itself up for sale in March.

Valuations for the larger firms are weighed by budgetary concerns and the U.S. military’s aim to reduce its presence in Iraq and Afghanistan.

“We’re looking for about 3 percent growth going forward in the defense budget, which is about half what we’ve seen over the last 10 years,” said Ruttenbur.

A prolonged softness in spending could bring a reality check to the current high valuations.

“If you give a couple more years, a lot of reality would set in on some of the defense names ... acquisitions would be a bit easier as sellers would be in a much more desperate situation,” said T. Rowe Price’s Rowlett.

“History shows that going for wild, large and highly-priced acquisitions is not a good move.”