|Shares Out. (in M):||25||P/E||10.0x||0.0x|
|Market Cap (in $M):||790||P/FCF||13.1x||0.0x|
|Net Debt (in $M):||88||EBIT||116||0|
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
Negative Fundamentals Impacting the Company:
Ceradyne misclassified as a Defense Contractor
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.
*Normalized to reflect future body armor procurement separate from defense budget
**Median industrial P/E of 15-17x