Every once in a while, it's good to look at an investment from the top down.
As you know, most of us Fools -- and this one in particular -- advocate a "bottom-up" investing approach. We don't try to predict trends or guess the coming direction of macroeconomic winds. We look for good companies selling for a discount to what we believe they're worth, and we buy accordingly. But in the case of the ceramic armor plate business, a sector split among companies like Ceradyne
Last week, TheNew York Times reported the existence of a secret Pentagon report concluding that more extensive body-armor plating would have saved many Marine lives. (For those who just tuned in, the more standard hard armor system includes a front and back ceramic plate. Ancillary plates to protect shoulders, thighs, or the sides of the torso are only beginning to be deployed.)
Since then, this story has snowballed, with many other media sources picking up the news. There are now calls in the halls of government for hearings, more armor budgeting . the whole nine yards. This morning, I awoke to a National Public Radio story complete with impressive-sounding legislative promises for more money to protect the troops. And yes, there's another story in The New York Times.
No big surprise
Ever since hearing, a couple of conference calls ago, that Ceradyne had begun to sell small numbers of ancillary armor plates for sides and shoulders, I figured it would only be a matter of time before the cry went out for more of this lifesaving technology. It follows the curve of body-armor adoption that we saw as the Iraq conflict continued and hard armor plates went from being the exception to the rule. Simply put, the cutting-edge armor tends to start with Special Forces and Marines before adoption moves to the "big army," as Ceradyne managers have called it.
This armor eventually achieves such broad adoption because it really works, and soldiers and family members know it. Therefore, it's pretty tough for anyone in military or policy-making roles to argue that only special ops or "front line" units deserve the best protection -- especially in a situation like Iraq, where the "front line" is wherever the enemy wants it to be. That's why I believe we'll see accelerated adoption of these ancillary plates; I think we're already at the leading edge of the curve.
As an investment, I have long preferred Ceradyne to Armor Holdings, mostly for its narrower focus. (Ceradyne, let's note, was my recommendation for our Stocks 2005 product, and it turned in a mere 38% for the year. The 2006 version is available here.)
While Ceradyne makes many products, including engine parts and industrial wear components, they're all based on its advanced ceramic know-how. Concentrating on these processes has helped the firm generate record revenues and boost profits, despite coping with new plants and acquisitions.
Don't get me wrong, Armor Holdings has done some big business lately, but it operates in so many different arenas that I have trouble keeping track of it all. In its breadth, if not its technology, it's more like a mini General Dynamics
For its smaller size, Ceradyne remains one of the largest producers of these hard armor plates. Just as important to me, it's also the largest producer of the boron carbide needed to make the plates. As I've noted before, this means that Ceradyne stands to profit from plate business that goes to its competitors -- and due to undercapacity and military contracting norms, that will always be the case.
Ceradyne looking forward
How much of this new plate business is Ceradyne getting right now, if any? That's hard to say. In the July 2005 conference call, David Reed, president of North American operations, noted, "We have been producing other components, side plates, and shoulder plates for some of our elite forces, and it looks like there is an opportunity now to move some of that product into the regular forces,"
In the fall conference call, the one where Ceradyne smacked it out of the park and upped guidance for 2005 and 2006 alike, Reed discussed side plates in a bit more detail. Specifically, he noted that even this increased guidance did not assume much business from ancillary plates. Of the guidance, he said, "There's a little bit of side plates in there. We're not all that clear yet on the level of funding . There's not a big portion of that in the current guidance we've given you because of that uncertainty."
I've been trying to piece together whether or not any of Ceradyne's recent orders have been for this extra armor, but it's not an easy task. As of the fall call, the Army had reportedly earmarked a total of $200 million for the extra armor, but Ceradyne's share of that isn't clear -- thus Reed's remarks above. Furthermore, the government has told all its providers to keep even basic armor contract details secret, according to a memo acquired by the Times, so it's not clear just how much we will learn.
On Dec. 27, Ceradyne announced another armor order from the Marines, who are known to have begun buying the ancillary pieces, but the last order didn't specify exactly which types of plates were being ordered. Still, a remark in the release, attributed to Ceradyne CEO Joel Moskowitz, suggests to me that the order was not for the same old plates. He said, "The increased capacity being brought on stream in Lexington, Kentucky, is anticipated to allow the company to not only meet its U.S. Army ESAPI requirements but also various other military ceramic armor systems, such as this one."
Foolish bottom line
A few months ago, I thought I was playing it safe when I shed a third of my Ceradyne position at what were then some new highs. The stock has only continued to climb upward. All I saved myself from was the agony of a few thousand bucks.
Ceradyne recently raised a big pile of cash with a follow-on stock offering, and sold some convertible debt at 2.875%. The proceeds will be used to extinguish loans that were carrying much higher interest rates. The debt has a conversion price of nearly $59 a share, which represents, for me, the bottom range of my current inkling of fair value.
And of course, with the company growing as quickly as it is, with wildcard government contracts, "fair value" will be a pretty ambiguous beast. I'll be watching Ceradyne closely for more clues about this latest call for armor may flow to the bottom line. Until then, I'm convinced my safest move is to hold what I've got -- and consider getting more.
Seth's Ceradyne pick for Stocks 2005 returned almost 40% in a year, but for this year's edition, he thinks he found an even cheaper stock. Take a look at it, plus 11 others from the Fool's market-beating stock pickers like Bill Mann and Fool co-founder David Gardner inStocks 2006.
For related Foolishness:
- Early last month, Ceradyne put the market's knickers in a twist.
- What's up with Ceradyne's wild ride?
- Still, we don't know all of what Ceradyne is up to.
- See Ceradyne's latest quarter, by the numbers.
Seth Jayson is working on not pulling the flowers to water the weeds. At the time of publication, he had shares of Ceradyne but no position in any other firm mentioned here. View his stock holdings and Fool profile here. Fool rules are here.