Shares of ceramics specialist Ceradyne (NASDAQ:CRDN) got dynamited this morning, as investors reacted with outrage and despair to an earnings report that underwhelmed on both performance and prospects. Let's address those two separately.

Beating sales expectations, but missing on earnings, neither Ceradyne's fourth-quarter performance nor its full-year results quite explain the shellacking the shares took this morning. For the quarter, sales grew 7% to $191.4 million. Perversely, profits dropped 7% to $1.28 per diluted share as gross margins shed 110 basis points.

But you can't blame investors for being disappointed -- these Q4 results marked a real slowdown for Ceradyne. Over the course of 2007, sales grew twice as fast as they did in Q4, and profits lagged sales growth at 11%. Moreover, free cash flow generated over the course of the year grew even more slowly than GAAP profits, rising just 8% year over year to $111 million.

So the year's results weren't great, and the quarter's news was undeniably bad. But does any of this explain why Ceradyne's shares currently trade for a miserly seven times earnings? In my opinion, no. Investors may be disappointed with the 2007 news, but the only way to explain the stock's 7 P/E is to conclude that people expect 2008 will be even worse. Sadly, Ceradyne confirmed that fear this morning.

Declining backlog levels mean that Ceradyne can probably expect less business in the future than it's had in the past. In fact, management does expect less business. Citing delays in the government's award of a $1.2 billion bundle of body armor contracts, management cut guidance for the current year. The company now expects fiscal 2008 sales to range between $715 million and $836 million, while profits should range from $4.55 to $5.05 per share. At the low end, that makes for perhaps a 6% decline in revenue, but as much as a 12% slide in profits.

Dawn? Or just plain dark?
You know, people say it's always darkest before the dawn -- and right now, things are looking pitch black for Ceradyne. But there are glimmers of hope on the horizon. For one thing, the firm still generates 29% operating margins, and it's working hard to replace business lost to sagging body armor orders. The company may win additional military orders of the heavily armored BULL MRAP that it's building in cooperation with Oshkosh (NYSE:OSK). Oshkosh has also given Ceradyne a small contract to provide a prototype light vehicle armor system. And there's always a chance that one of the other bidders in the military's "Jolt" Humvee replacement program will want to use Ceradyne's light ceramic armor systems in its bid. (So keep an eye out for such news from heavy hitters like General Dynamics (NYSE:GD) or Lockheed Martin (NYSE:LMT).)

Meanwhile, management continues to grow the civilian side of its business. Ceradyne is expanding capacity to produce ceramic crucibles used in cooking up polycrystalline photovoltaic silicon for solar panels, and also industrial components made from silicon carbide.

Small consolation after a rough earnings release, to be sure, but hope's in vogue this year, right?

For more details on developments over the past few months, read: