Ceradyne, Inc.
A Look at CRDN

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By yttire
March 22, 2005

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CRDN has been going down for a while, and it could represent a compelling buy. If its future growth in earnings is strong, it would be a convincing buy, and if they are weak then it would be a hold or a sell.

CRDN has a P/E of 22, which is close to the S&P P/E, yet its sales went up by 65% from 2002 to 2003 and another 100% from 2003 to 2004. If these sales were indicative of its future, it would be a screaming buy. Obviously, many people think at this point in time this is not indicative of its future.

CRDN was a "Stocks 2005" pick at a share price of $48 and is selling at this moment for $25 and change. The investment thesis is that they produce high tensile ceramics which would be in demand to protect troops and which could be in strong demand for domestic applications, which require great strength. It's low in 2004 was $14 and in 2003 around $3.5

- Aside. I purchased "Stocks 2005" with the express purpose of buying those which fell out of favor if the fundamentals seemed strong. To keep me in the game I bought a small position in each stock. This same strategy in 2004 would have yielded spectacular results- buying on the losers. Now, here we have the sought after goal- a "Stocks 2005" pick which has plummeted and it may represent a doubling of your money. I did it before with such stocks- but it completely and utterly depends on the fundamentals analysis. If the fundamentals have eroded then there is nothing here, just a whiff of a goal and losses. So here we are, and it will be interesting to see if I can get anyone to also look at the fundamentals.

PouliFool, if you had the time of posting the numbers you put into the DCF calculator I'd appreciate it and we could talk about CRDN's potential from th DCF point of view.

So to start, I am going to look at the 10-K filed 2005-03-06 (the annual report). Note the stock price has been falling since December, well before the release of this report. In fact at the release date it was around $26.

I am going to excerpt bits and comment on them.

We develop, manufacture and market advanced technical ceramic products, ceramics powders and components for defense, industrial, automotive/diesel and commercial applications. Our competitive advantage results from our expertise in ceramic material science as well as our vertically integrated approach of designing much of our key equipment and controlling the manufacturing process from raw material powders to finished product.

- Aside. I find violence against humans a repulsive and brutish obsession of our species. I believe that political force can be used without mutilation or death and this should be our national goal. Body armor is a part of that vision, so although I detest violence it can be used in a positive way.

The principal factor contributing to our recent growth in sales is increased demand by the U.S. military for ceramic body armor that protects soldiers. Ceramic armor contracts generally are awarded in an open competitive bidding process. Our future level of sales of ceramic body armor will depend on our ability to successfully compete for this business. Our sales also increased in 2004 because we purchased ESK Ceramics on August 23, 2004 and their operations have been consolidated with ours since September 1, 2004.

They go on to point out that their technical ceramics have a higher melting point than alloy steal and weigh about a third as much. It has a hardness about 4 times that of steel, and can have variable conductivity. They talk about some market opportunities such as chemical processing containers, pump seals, and high temperature lubricants. They note aluminum and steel foundries would be a prime target of their wares. Also photovoltaic development requires crucibles with high heat tolerances. So there is certainly a potential market here.

They mention their competitors: Armor Holdings, ArmorWorks, Cercom, CoorsTek, Kyocera's Industrial Ceramics Group, Saint Gobain, UK Abrasives, Sintec, GE Advanced Ceramics, Ceramtec, Denka, HC Starck, Hitachi, Morgan, Spectra-Mat and Vesuvius. Quite a bit of competition. They note: When competing with high strength steel alloys and plastic products, we may not be able to compete effectively when price is a primary consideration, because our products are typically more expensive.

They note they have a backlog of orders: As of December 31, 2004, we had backlog of approximately $199.9 million and $4,400 of unexercised options for orders. As of December 31, 2003, we had backlog of approximately $103.1million and $1.1 million of unexercised options for orders. However, I do not see when these orders are tallied in the books. This looks extremely important for it will influence outside perception of cash flow. Something that needs to be known.

They talk about how important defense spending is and then note in bold: A critical raw material used to make ceramic body armor is in limited supply. A delay or inability to obtain sufficient quantities of this material could limit the amount of body armor we can manufacture and therefore result in reduced revenue, profits and cash flows. They name "Spectra Shield" and "Dyneema" as in limited supply and predict that their ability to fulfill contracts depends on this flow. Definite risk here on fulfillment of contracts.

They have just acquired ESK and note they may experience difficulty merging, and that their debt load has risen substantially because of this which puts them at risk of default.

Due to demand for their products, they have made significant capital investments to meet 2005 demand. If this demand does not exist, they will still be paying for these capital investments.

One of their primary domestic sales is for orthodontics for which they have an exclusive deal with 3M until 2007. If 3M does not market effectively growth in this section will be diminished. (past 2007 though this represents opportunity)

Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance.

Net sales of 2004 over 2003 are 100% higher ($215 million for sale over $100 million). They noted earlier $199 million in contracts already for 2005, but I can not tell when these have been (or will be) booked as sales. This seems critical.. they mention it here. Sales Recognition. Sales are recorded when all of the following have occurred: an agreement of sale exists, product delivery and acceptance has occurred or services have been rendered, and collection is reasonably assured.

This appears to be a critical passage: . We expect our shipments of ceramic body armor to be higher in fiscal year 2005 than in 2004. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2006 from levels we expect to achieve in 2005.

Thus this may be at the core of the decline of the stock.


2006 sales - Aside. This stock is a small cap and has a market cap of 621 million, so is going to be volatile regardless of the fundamentals.

The accounts receivable seem a bit high at $48 million and they note they have large doubtful accounts (which look like they were written off ) in 2003 and 2004. Inability to collect on accounts is not great.

So where does this leave us?

It appears they should have sales above $200 million for already booked contracts for 2005. So they should show some growth, but it is lumpy sales and the domestic divisions should pull through with some growth but not a ton. Beyond this, it is a gamble on future contracts. The overall share decline appears to represent this possibility. There is a real possibility of declining revenue in 2006 and beyond, and a real possibility of it going up.

Therefore, this seems to be somewhat speculative in nature and is not recommended for a large purchase at this time, unless you are feeling lucky. However, continuing to hold to see how the cards play out seems reasonable both on a short-term basis and longer-term basis.

When I looked at JCOM a while back (and made a ton of money) it was clear that the future was bright- in this case it is not certain it is risk prone. (And seems high risk considering the managements own concern with 2006 sales, but this may be pessimism on management's part, if you read the start of the 10K they are an extremely paranoid bunch.) My guess is the CFO feels over his head in this company. The whole thing sounds a little out of control, which would be great if they had a n assurance of upwards growth, but without it will lead to "inefficiencies" as they put it. (lots of sweat and tears). Still, this could be a great stock to own.

If CRDN does get a lot of new contracts, I have doubt they will be able to even fulfill them considering all the hedging text in the 10K. They would be able to fulfill some of them, but come on they have $200 million in backlog from last year (their entire revenue for last year) how much more capacity can they come up with? However, if they do get these potential contracts, it will assure 2006 revenues..

A lot of their business comes down to their perception in the market place, and since there are few large buyers this introduces additional uncertainties in their marketing schemes.

It is unknown to me how the expected fulfillment of contracts will be rewarded in the market. That is, as they book revenue for these known sales it will show up in EPS on the quarterly statements, and depending on how they book these it could materially affect the stock price. If you were familiar with how the market rewards such revenue, you could certainly do well. The stock may rebound sharply as this revenue is booked- I can't tell you but someone with more experience may be able to. This would be worth a consideration.

This stock also appeared on a screen I ran looking for solid companies which were performing badly. These have historically returned outstanding returns. So this certainly may warrant further exploration and a consideration of investment dollars, but for my taste it is a bit risky, although if the wind gets behind it I may change my tune.

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