Company Overview:

Ceradyne is best known as the manufacturer of the ceramic SAPI (Small Arms Protective Inserts) body armor plates.  In 2004, before Ceradyne won the Department of Defense SAPI contract, it had revenues of $100 million.  By 2007, ceramic body armor represented 71% of the company’s $750 million in revenue.  Today, body armor sales represents 33% of the company’s current $570 million in revenue; the remainder of the revenue comes from sales of ceramic products and powders to the industrial, automotive, and commercial sectors.

The key to Ceradyne’s diversification has come from the energy sector.  Before 2006, Ceradyne had no exposure to this market.  But, as profitability from body armor increased, management proactively invested in new segments to enlarge the company’s footprint.  Through a handful of acquisitions, Ceradyne was not only able to expand into the solar, oil & gas, and nuclear power industries, but it’s now vertically integrated, producing the key ingredients (ceramic powders) used in manufacturing of ceramic products.  Today, approximately 30% of its revenue is derived from the energy sector.

Ceradayne is a significant manufacturer of ceramic crucibles used in the production of photovoltaic solar cells.  Photovoltaic solar cells are created by depositing polycrystalline silicon sand into a crucible (large tub) and heating it to temperatures in excess of 2500 degrees Fahrenheit, at which point, the sand liquefies and is then cooled into a solid.  It is vital that the crucibles be able to withstand these extreme temperatures while maintaining its integrity.  Any contamination of the molten silicon from the crucible and the resulting photovoltaic solar cells will become useless.  

In addition to the solar industry, Ceradyne is one of the key producers (over 70% market share) of Boron carbide.  Boron carbide is used to create the Boron 10 isotope, which is a key ingredient in neutron absorbing or reflecting material used in the construction and operation of nuclear power plants.  Boron 10 is also well known for its use in safe storage of spent nuclear fuel rods. Over the past three years, Ceradyne’s revenues from production of the Boron 10 isotope have increased as nuclear energy, outside the United States, is having a renaissance. Lithuania gets 79% of its electricity from Nuclear power, France 75%, Belgium 52%, Switzerland 40%, South Korea 35% and the US is at the low end with 20%.  In the next decade, China is expected to build 200 nuclear power plants, Japan 14 and Russia 11. These numbers do not include the fifty power plants already under construction in sixteen different countries. 

Ceradyne also manufactures ceramic drill bits and stacked thrust bearings used for down-hole drilling in the oil and gas sector.  These bits and bearings cost a bit more then their conventional counterparts, but unlike steel or other alloys, ceramic products have a higher tolerance to both corrosion and erosion, and therefore do not need to be replaced as often.  These same properties led to the recently developed ceramic sand filter (Petroceram) currently in use by both oil and natural gas drillers. The filter prevents sand and dirt from mixing with either the oil or gas as it is pumped to the surface.  The importance of ceramic equipment to the oil and gas sector is that since they do not need to be replaced as often, they will reduce the number of “down” days needed to replace drilling equipment.  With drilling rig rates starting around $30,000 per day, one can see how quickly the ceramic equipment can pay for itself.

Positive Fundamentals Impacting the Company:

Body Armor / ECH

• Ceradyne recently won the Department of Defense contract to produce 50% (300,000 body armor plates) of the E-SAPI sustainment contract.  E-SAPI is the second generation of ceramic body armor replacing the initial SAPI.  The contract runs for one year starting in February of 2012 and will generate $127 million in revenue.  The contract also specifies that hot pressed boron carbide be used in the production of the E-SAPI body armor.  Ceradyne is the key supplier of boron carbide and has already been contacted for quotes by the remaining competitors of the E-SAPI contract.  So, it is quite possible that Ceradyne could end up supplying 100% of the ceramic material and manufacturing 50% of the body armor plates for the upcoming E-SAPI sustainment contract.  In addition, Ceradyne has also begun manufacturing X-SAPI, the third generation of body armor, for the military.

• The ECH (Enhanced Combat Helmet – a ceramic, seamless, military helmet) is expected to go into production by the second quarter of 2012.  Initial production is expected to generate $12 million for Ceradyne with the full production expected in 2013, yielding $170 million.  Ceradyne is currently the only company to have met the Department of Defense’s specifications and testing requirements.

• The 2012 Defense Authorization Act requires, starting in 2013, that a separate budget be presented directly to the President for “Organizational clothing and individual equipment.”  “Organizational clothing and individual equipment” would cover both body armor and the upcoming ECH, ensuring that all military personnel will be properly outfitted to serve in the field.  The separate budget also eliminates the uncertainty surrounding defense budget cuts and the current reliance on supplemental funding used to procure body armor.

Balance Sheet

• Ceradnye has a fortified balance sheet with $260 million (32% of its market capitalization) in cash and approximately $90 million in debt.  The board announced at the end of August that it had approved a share repurchase program of up to $100 million (12.5% of its shares at current prices).  Ceradyne’s management has done a very good job of allocating capital.  In 2005, the company issued 2 million shares at $43.50/share and used the proceeds for acquisitions.  Between 2008 and 2009, management repurchased 2 million shares (7% of its stock) at approximately $21.50/share.  Even if management does not repurchase a meaningful amount of shares at the current level, the program will provide downside protection if the market or the stock were to take another swoon.

Operational Leverage

• Ceradyne has two distinct methods of applying their form of operational leverage.  With large fixed operating costs, the company’s margins are highly correlated to their production levels.  Management has done a good job of resizing and moving their manufacturing facilities to make them more efficient, as well as taking advantage of tax savings.  In addition, one of the reasons Ceradyne carries a large cash balance is to have ready cash available for acquisitions.  In the past, management has proven itself to be very skillful at acquiring small to medium “bolt on” companies.  Most of these acquisitions would not have made financial sense had it not been for Ceradyne’s ability to harness the intellectual property and combine it with their accretive knowledge of ceramics production and manufacturing.  Diaphorm, an acquisition made in 2009, is just such an example.  Purchased for $9.5 million (plus contingent consideration of another $10 million if revenue targets were to be met), Diaphorm was manufacturing polymer based ballistic helmets for law enforcement, security, and paramilitary markets.  Ceradyne was able to acquire Diaphorm’s designs and intellectual property and combine it with its own knowledge of ceramic manufacturing and military connections.  The result is a seamless, ceramic military helmet that is scheduled for production starting in 2012 achieving full production in 2013, which is expected to generate over $170 million in revenue.

Negative Fundamentals Impacting the Company:

Short-term Headwinds

• In March of 2011, a typhoon caused a nuclear melt-down at the Fukushima Nuclear Power Plant in Japan.  Germany immediately took all of its nuclear power plants off-line and announced it would disband its nuclear power program.  China reacted by announcing that it was reassessing its future nuclear program.  It is unlikely that China will dramatically change its national position on nuclear power.  Germany has already begun investigating alternative forms of energy, including increasing exposure to solar energy over the long-run.

• Government austerity measures, primarily in Europe, have lead to cut backs in solar power subsidies.  Without these subsidies, solar power becomes more costly to produce.  This has led to overproduction and five to nine gigawatts of excess capacity that needs to be worked through.  In the short-run the result has been less solar cell demand, price reductions and industry consolidation.  However, in the long-run, lower solar panel costs combined with higher overall energy costs will continue to make solar power more affordable and close the gap leading to power grid parity. 

• Culmination of the campaigns in both Iraq and Afghanistan has created uncertainty surrounding future body armor requirements.  However, with the introduction of the 2012 Defense Authorization Act, the budget for body armor funding has become more reliable.

Ceradyne misclassified as a Defense Contractor

• Ceradyne continues to be classified as a defense contractor, even though body armor only accounts for roughly 1/3 of its revenue.  The company currently trades at 10x its expected $3.20 EPS which is commensurate to the 9-10x earnings multiples of other defense contractors (LLL, RTN, GD, LMT).  The remaining 2/3 of its revenue comes from sales of ceramic powders and products to the industrial, automotive and commercial sectors carry an aggregate multiple of 15-17x earnings, which is not being taken into consideration.

Industry Competition:

There are a number of companies that compete with Ceradyne.  In defense, its main rivals are:  Armor Works, BAE Systems, and The Protective Group.  In solar (crucibles), the competitors are:  Vesuvius, Sinoma and SPM.  And in the industrial segment, competition comes from:  CoorsTek, Denka, Momentive, Hitachi, and Kyocera.  In spite of this competition, Ceradyne is still able to maintain a significant market share in body armor, boron carbide, ceramic crucibles, orthodontic brackets, oil & gas drilling products, precision investment casting, and the soon to be produced ECH (Enhanced Combat Helmet).  The key to Ceradyne’s success comes from the company’s accretive knowledge attained over the years of manufacturing and the niche markets in which it operates.  These two attributes help provide a durable moat protecting it from outside competition.  Creating ceramic products is very similar to baking a cake:  the process is very important, but success comes from the ingredients and their proportions to one another.  Ceradyne is a vertically integrated company, creating both the raw material and the end product.  In the case of its crucibles which are produced in the United States and in China, Ceradyne mixes the raw material in the US and then ships the combined “mix” to its facility in China.  By shipping only the combined blend and not the recipe, Ceradyne protects its intellectual property from easily being replicated.

For a company to enter or expand into any of Ceradyne’s markets would require a large upfront capital expenditure and years of production to get a return on their investment, assuming the company can capture market share.  Ceradyne’s jumbo crucible, for an example, sells for approximately $800 dollars.  In relation, the amount of polycrystalline silicon sand that the crucible holds currently goes for about $35,000 dollars.  For a solar manufacture, the cost of the crucible is not meaningful enough to risk contaminating $35,000 dollars of polycrystalline silicon and future sales by searching for the lowest cost crucible; satisfied customers become very sticky.  Companies currently competing with Ceradyne have realized that since they service a niche market, investing more capital will not necessarily translate into increased market share.  This is why Ceradyne is able to spend, on average, only 6% of its revenues annually on capital expenditure and still maintain its market share.  With over 45 years of accretive knowledge working with ceramics, Ceradyne’s cumulated experience benefits its current and future product lines. 

What is Ceradyne worth?

Ceradyne currently is trading at 10x 2011 earnings estimates of $3.20/share and a 7.5x multiple if you remove the cash and add back the debt.  One might justify the low P/E, as it is equal to the P/E of other defense contractors.  There are two issues with valuing Ceradyne as a defense contractor:  First, defense contractors are trading at a discount mostly because of the uncertainty surrounding the upcoming budget cuts.  Ceradyne will not be significantly impacted by budget cuts because of the 2012 Defense Authorization Act.  The second reason not to value Ceradyne like a defense contractor is because Ceradyne only generates 1/3 of its revenue from defense spending.  Therefore, it should receive a higher multiple proportionate with the diversity of its revenue stream.  A straight line valuation (1/3*12 P/E^* + 2/3*16 P/E^**) generates a 14.6 P/E multiple.  14.6 multiple*$3.20 EPS yields a stock price of $46.72/share.  Taking into consideration the niche markets Ceradyne serves, its market share, its sustainable margins, and operating leverage, one could feel comfortable using a 16x P/E multiple which equates to a stock price of $51.20/share.

Ceradyne stock is also cheap on an EV/EBITDA basis, as it trades at a 4.1x multiple.  Using an 8x multiple appropriate for an established company in its industry, Ceradyne’s stock price would be trading at $48.50/share.  Currently, somewhere around $50/share is probably a good intrinsic value for the company.  Recently, Joel Moskowitz, Ceradyne’s CEO has been speaking about the potential for the company to double its revenue to $1 billion by 2015 (he lays out the road map in the 2010 annual report).  If that were to happen, the intrinsic value of the company of course would be higher.

Key Takeaways:

• Ceradyne maintains a number one or two position in the niche markets that it serves.  It would be very difficult for new or existing competitors to try to gain market share:
• Ceradyne is the low cost producer – the company is vertically integrated producing both the ceramic powders and manufacturing the final products
• Creating advanced technical ceramics requires years of accretive knowledge and experience not only in the production process but also in the ability to change the mix of the ceramic powders.  Ceradyne has over 45 years of experience in ceramic manufacturing.
• Customers are very sticky - they are focused on quality and dependability and not necessarily the lowest cost.

• Current overcapacity and reduction of European subsidies in solar industry will have a negative short-term impact on Ceradyne’s revenue.  Long-term, higher energy prices combined with lower solar production cost and more efficient solar panels will help close the gap making solar energy more affordable.

• The ESAPI contract is a sustainment contract – military is stockpiling to make sure there is enough ESAPI inventory.  Production of XSAPI in progress and could run for another 5-6 years before hitting sustainment.  Most likely, by that time, the next generation of SAPI will already be in production.

• A crucible can only be used once and is actually broken apart to get to the hardened photovoltaic solar cell.  Similarly, a ceramic body armor insert is made to crack when impacted by a bullet or projectile, spreading the force of the impact around the soldier and not into the soldier.  This is the reason for Department of Defense’s sustainment contract, to make sure that replacement inserts are available.

^*Normalized to reflect future body armor procurement separate from defense budget

^**Median industrial P/E of 15-17x

• Higher energy price will continue to close the gap between energy generated from solar and fossil fuels leading to better economics for solar energy.

• Working through solar panel excess inventory.

• Market revaluation of Ceradyne P/E multiple to reflect the revenue breakdown, as well as the niche markets it serves.

• Expanding Ceradyne’s footprint through acquisition and continued operation leverage leading to increased revenues.