Ceradyne, Inc. (CRDN)

Ceradyne has grown nicely over the past decade. It remains a popular pick (current CAPS 5-star). I plan on keeping my eye on it over the next year, as I have some optimism that the business is in good shape to out-perform longer-term if management can execute very well in this environment, and also as a potential acquisition target. I am pessimistic short-term, though, and think the current price reflects over-optimism.

CRDN remains primarily a defense play. I expect continued decent sales on its body armor products, with upside from vehicle armor opportunities. But I think present expectations for the base sales are too high. Not only do I think that overall near-term demand will be below current publicly-expressed views (by mgmt and analysts), I also think larger players are increasing pricing and market share pressures on the business as they recalibrate views of the opportunity which were, IMHO, too pessimistic for the past few years but are more in line with the nearer- and mid-term opportunities. CRDN already estimated that Q4 body armor sales would be down sequentially to Q3 (old news). Additionally, CRDN hasn’t been shy about issuing press releases on contract wins, even small ones, and even blanket POs without any assured revenue – but the company has been pretty silent since “stealthily” resetting expectations at the Stephens presentation. The declining defense business volumes also affect CRDN’s ESK subsidiary which suffered from excess capacity through Q3 and will almost certainly do so for the next few quarters based on mgmt’s own forecasts.

Many have commented on CRDN’s efforts to diversify the business away from defense into other areas, primarily industrial applications (including advances associated with aluminum smelting techniques) and solar panel manufacturing equipment. The first product play generating enthusiasm here is CRDN’s crucibles, used in manufacturing solar panels. The crucibles business appears very attractive, with robust expected sales growth and attractive margins. However, the forecasts have been coming down and I don’t think the realistic growth is sufficient enough to outweigh the impact on the stock from defense sales lost. Initially forecast by mgmt as a $50M - $60M business this year, and well over $100M in 2009; it subsequently was forecast to hit $40M - $50M, and in the Q3 call we learned that it looked to come in a little bit over $40M. Hitting $40M on the year means a fourth quarter of $10.7M, which would be three sequential quarters of $11.2M, $10.7M, and $10.7M from crucibles – essentially flat for 3 quarters in a row and hardly the growth powerhouse I think some have expected and continue to expect. I’ll hold my powder on the reduced $80M 2009 forecast shared in the Q3 call, as I’m not convinced in the present environment visibility is good enough to make this forecast in light of previous misfires and the current economic environment. As an additional data point on the crucibles business CRDN forecast as recently as Feb 2008 a 200% increase in manufacturing floor space in China opening toward the end of 2008 to accommodate increasing crucible demand; by October 2008 the target opening date of the increased space was pushed out to Q4 2009 – this is not the behavior one expects from a cash-rich business riding a dramatically growing market demand for crucibles. Presumably near- and mid-term demand is not significant enough to exhaust capacity at the present facility nor to invest cash sitting on the balance sheet into manufacturing capacity which is presumably high-return given the stated growth expectations for the market. I’ve also seen reference to concerns about pricing pressures in target market China (mostly Morgan Joseph analyst comments – but I expect such pressures in a market growing as fast as CRDN projects). On the aluminum smelting opportunity – this is very, very early stage with miles to go – mgmt estimated revenues would be a few million in 2009 – roughly the same as in 2008.

Another area of its non-defense business is in semiconductor (primarily memory) equipment, led through its 2006 acquisition of SemEquip. Near-term prospects for suppliers to memory manufacturers is dismal (the customers are bleeding), and in the Q3 call mgmt acknowledged that despite a plan to build the business, there was a need to reduce expenses given the environment. It will be a very delicate balancing act to effectively manage that business for near-term efficiency without sacrificing the positioning to capitalize on a future upturn. I certainly can't see this area of non-defense business replacing decling defense sales any time soon.

Mid- and longer-term the general bucket of non-defense business offers up lower margins – SG&A is and will remain higher, and while the non-defense businesses may offer opportunity for incremental growth, “replacing body armor revenue dollar-for-dollar cannot expect to generate equivalent profit margins.” The business may be rightly trading margin for market diversification, but CRDN’s stock price is, IMHO, predicated on its historically higher-margin business growing at a good clip.

On the upside, CRDN has good free cash-flow, has a strong balance sheet with limited debt and a good chunk of liquid cash, and a decent backlog. I like its body armor business (though concerned about competitive pressures and a softening demand), and think its non-defense businesses offer interesting opportunities though they’re subject to near-term conditions deserving pessimism.

So, as I started with – I’m interested in CRDN longer-term and will keep my eye on the business. In the near-term, I think there are several factors that point to the very real possibility that Q4 disappoints, and that Q1 and Q2 may be tougher than the market currently anticipates. With volume and margin pressure hitting in both Q4 and Q1, I expectantly await the earnings announcement in late Feb and expect the stock to take a hit near-term. If that happens, I might be a buyer mid- or late-year; but I can’t see backing this before greater visibility on the business over then next 6 months.