Defense for Your Portfolio

Despite appearances to the contrary, Fool contributor Seth Jayson isn't down on all stocks that are having a good run. Nor is he down on "defense" stocks. Like other Fools, he just gets extra cautious when everyone is jumping into the pool at the same time. He gets a little defensive this week and takes a look at a pair of armor specialists that have looked invincible over the past year.

The opening salvo
If there's anything I enjoy more than pointing out the obvious and making wisecracks, it's reading the irate and childish rants that come my way after I do so. Following the recent write-up I did on Mace Security International (NASDAQ:MACE), I was subjected to a vehement but amusing stream of obscenities from some shareholders.

In addition to the usual howls of "your [sic] probaly [sic] short," there was a widely held belief in some kind of Fool-wide conspiracy. It was summed up nicely by Stockrokkit99 (not his real name) who wrote, "Yous [sic] fools always bashing defense stocks!"

Both of the charges are, of course, nonsense. Not only is there no Fool-wide policy on any company or industry, but as writers, our positions in securities are revealed in nice big letters at the bottom of every piece we type. You can read about it in our top-of-the-line disclosure policy.

Still, it gets tiresome to play Mr. Snickerpuss all the time. So, over the next couple of weeks, I'll take a look at a few "defense industries" that have something to offer besides message-board hype.

Fancy pottery
Ceradyne (NASDAQ:CRDN) is tough to sum up in a sentence, but I'll try: The firm makes high-tech, non-oxide ceramic products.

These materials have names that you'll definitely not remember from high school science -- unless you wore really thick glasses -- like aluminum nitride, silicon nitride, and boron carbide. Sounds exotic, but the stuff is used in a broad array of products that we encounter every day, from engines to orthodontic braces with partner 3M (NYSE:MMM).

These days, Ceradyne is best known for its laminate, ceramic armor plating. It's not just for personal vests, though it can be incorporated into those systems. Historically, the main seller has been a plate used to fortify helicopter cockpits against ground fire and to offer lighter alternatives to steel plate for land-based vehicles.

The military conflicts in Afghanistan and Iraq have required more of these products, helping to supercharge Ceradyne's revenues and earnings over the past few years. Just take a look at the recent performance.

Toss in growing net margins of more than 12% -- 13.6% in the latest quarter -- plus a healthy, 20% return on equity, and you're looking at a firm that already seems to be firing on all cylinders.

Ceradyne suffers a bit from its new reputation as a body armor company. For instance, when peer DHB Industries (AMEX:DHB) recently won a big army contract, Ceradyne's stock was spanked, even though the deal was for a product that Ceradyne doesn't offer. This misconception is important for potential shareholders, as it only adds to the volatility that has already been visited on the stock by day traders.

What I like best about Ceradyne is the way it is positioning itself for a future when sales of body armor will slacken. (Make no mistake; that is a big risk.) To this end, the company is working on a new ceramic armored helmet, along with producing missile nose cones for Patriot, Aegis, and Arrow systems. It's also moving operations to cheaper locations in the U.S. and looking outside itself for smart assets.

In May, it purchased a small and profitable ceramics molding company, whose products and technology give Ceradyne a foothold in the medical field. Last week, it acquired ESK, one of its key suppliers, in a move that will not only double its annual revenue but also give it further inroads in foreign and industrial markets, where manufacturers and engine makers uses its cam rollers and ultra-strong bearings.

I'm normally not a fan of wildly diverse companies, but Ceradyne's wide-ranging product line and recent acquisitions all come back to its expertise in high-tech ceramics. And management inspires confidence. In addition to plotting a careful path forward, Chair, CEO and President Joel P. Moskowitz is relatively frugal with his own paycheck. (Last year, he took home a fourth of what his counterpart did, while giving shareholders twice the earnings.) As a fast-growing leader that's planning for growth tomorrow, there are a lot of reasons to like this company, despite its rich valuation.

Well-vested
If you hadn't heard about DHB Industries (AMEX:DHB) through Stocks 2004 or the Hidden Gems watchlist, you probably heard the shareholders cheering last month after an enormous government contract put in an order for body armor worth $240 million. For a little perspective, consider that the total for that request comes to more than 2003's entire revenue stream.

DHB is a holding company whose subsidiaries make body armor known as bulletproof vests. And nobody makes as many of them as this firm. I'm not just talking about the unit volume, which has seen massive increases since its Interceptor system became the protective jacket of choice for the U.S. military. DHB produces a vast array of protective products for use by armed forces, as well as police, SWAT, prison guards, and marine security forces -- the notion of a bulletproof and watertight garment is one that really turns my head.

Huge contracts for the U.S. military have jump-started revenues over the past few years. Interceptor's stellar reputation -- boosted by plenty of press coverage during the Iraq war -- is one reason. Another is the modular nature of the system, which makes it easy, and likely, for the government to request add-ons, like the supplementary arm and shoulder protectors that comprise that giant order mentioned above. Look at what DHB's newfound popularity has meant for the top line.

* Q204 earnings per share and year-over-year percentage changes are estimates.

If you're paying close attention, you'll notice that DHB has had a bit of trouble converting those sales into earnings. How does a company take a banner year with a 77% increase in revenues and turn it into a 6% drop in earnings per share? Well, as Rich Smith noted a few months ago, the tax man cameth, and he wanted $11 million last year, compared with a $3.7 credit the year before. But a 1% decline in gross margin didn't help.

Still last year, the firm reduced SG&A (as a percentage of sales) by two full points. If DHB can keep a handle on its production costs, it should be able to capitalize on those big, recent contracts. And a better than 30% return on equity demonstrates that management does a very good job reinvesting in the company.

But DHB carries a few risk factors that investors should consider. First is the founder and chair, David H. Brooks. A little more than a decade ago, he settled insider-trading charges and was barred from working in that field. And, as noted in the recent 10-K, DHB's auditors resigned last fall at the same time that it cited deficiencies in internal controls and the reporting of related transactions with Brooks' wife, Terry. Currently, DHB rents a facility controlled by her and purchases $30 million in raw materials from another company owned by her.

Another risk is the end of U.S. military intervention overseas. DHB's other product lines provide some cushion against this eventuality, but there's much more competition for vests in the police market. And although DHB is trying hard to break into foreign markets, last year, sales outside the U.S. accounted for only 1% of revenues.

Where does that leave investors? DHB has already breached the 3-year target price range suggested by Tom Gardner when he picked the company for Stocks 2004. But with almost half a billion bucks in the backlog, no end in site in Iraq or Afghanistan, and the probability of more big government contracts on the horizon, DHB should have plenty of room left to run.

Zipping it up
Keep in mind that neither of these companies is very free with the free cash flow, which is something most Fools like to see, at least somewhere out on the horizon. Both of these companies have potential to keep growing, but carry significant risks. As they might put it, the best defense is to protect yourself. Keep your positions small, and don't chase these shares. Volatility can be your friend if you wait for it to hand you a bargain price for a piece of a company you admire.

Check out the following for answers to Foolish questions:

• What's this whole return on equity thing about?
• And while I'm asking, can you refresh me on free cash flow?
• I know you'd like me to sign up for Hidden Gems, but can't you show me how to look for them myself?

Fool contributor Seth Jayson owns shares of Ceradyne, but has no position in any other company mentioned. View his Fool profile here.