Testing Ceradyne's Armor (CRDN, AH)

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Ceradyne Inc. (CRDN) is a supplier of advanced technical ceramic products and powders. Their products span the areas of aerospace and defense, industrial, alternative energy, medical, automotive and consumer.

If you can think back to your early elementary school days when you made those great clay projects in art class and brought them home to your parents and said, "I made you this... er... change dish!" Well, that is ceramics in its basic form. Ceramics really involves the formation of any inorganic non-metallic material with the use of heat. Traditional uses of ceramics were pottery (like your change dish), bricks, tile, art, etc.

Ceramics are characterized as being hard, porous and brittle. Today, while ceramics are still widely used in art and home decor, the study of advanced technical ceramics seeks to mitigate the weak points of ceramics while enhancing the positive elements. And this is where Ceradyne comes in. Ceradyne makes products from advanced ceramic powders, most notably boron carbide, including personal body armor as well as vehicle armor for the armed forces, industrial components, intermediate products for food packaging, diesel engine components, ceramic orthodontic brackets, and crucibles for melting silicon for making photovalic cells (for solar energy).

Ceradyne is predominantly run by a group of technically focused scientists from Alfred University, one of the top US universities for the study of ceramic science. The company is headquartered in Costa Mesa, CA.

The company has been seeing tremendous growth as of late, primarily from sales of their body and vehicle armor. Ceramic armor is not only harder, but also lighter than traditional armor and the government has been buying a ton of it for the soldiers deployed over in Iraq and Afghanistan.

In addition, the company purchased ESK Ceramics, a German producer of advanced ceramic powders, in August of 2004. This not only increased Ceradyne's sales, but it also made them the only fully vertically integrated ceramics manufacturer.

The most obvious growth driver here is the continued sale of body armor to the US government. But, as you can imagine, while this is the most promising growth driver, it is also one of the biggest risks. Fortunately, there are other forces at play here.

Ceramics tend to be more durable and tougher than metals and other materials generally found in industrial settings. They not only wear less over time (think about the ceramic dishes that archaeologists dig up from thousands of years ago) but they can also resist the effects of highly corrosive substances. The drawback, though, is that ceramic parts also tend to be a lot more expensive. One of Ceradyne's challenges as they try to continue to grow and move forward, is to continue to develop more cost effective ways to produce ceramic solutions so that they are more cost competitive with the traditional materials that they are replacing.

If Ceradyne is able to succeed at bringing down the cost of producing advanced ceramic materials, it could mean wider adoption of ceramic materials and a source of ongoing growth for the company. If they cannot, they very well may fall back to the same flattish growth that they showed prior to the recent armor demand.

Ceradyne current trades at roughly 15x the 2006 consensus EPS estimates. On a PEG basis, this puts them at just over 0.5x, which would plop them squarely into the camp of what I would call a smoking deal. The issue here is whether you can really accept that they company's real 5-year growth rate is 27.5%. Up until the recent increase in demand for armor, Ceradyne did not have a particularly impressive growth trajectory, and the risk is certainly there that they fall back down to the 15% growth rate that they had been trucking along at.

Armor Holdings (AH), probably Ceradyne's prime competitor, trades at just about the same forward P/E multiple, yet are not expected to have growth nearly as robust as Ceradyne's. Not only that, but for your 15x price tag, in Ceradyne you're getting a company that has (according to Yahoo!Finance) a 25% operating margin and a 15% net margin, both roughly double those of Armor Holdings. You'd also pick up a 32% return on equity - and that's better than a kick in the pants.

I would also point out that other defense related companies like Lockheed Martin Corp. (NYSE:LMT) and General Dynamics Corp. (NYSE:GD) are trading at multiples at or above Ceradyne. While these companies are obviously much more established and have a much broader sales base than Ceradyne, they are likewise at risk for sales declines when the war starts winding down, yet they do not have the high-growth breakout potential that Ceradyne has.

My conclusion is that Ceradyne offers a good short to mid term investment opportunity, albeit one that has to be closely monitored. If sales of armor to the US military falls off faster than Ceradyne is able to open up new growth channels it could mean all aboard for the Ceradyne pain train.

In addition, while I always can appreciate a company that is run by people who are well versed and immersed in the product / technology that they are selling, it does concern me a little bit that Ceradyne's management team is light on members with serious business bloodlines. This type of management set-up can be great for when a product catches on and is able to sell itself based on the strength of its value (such as Ceradyne's armor products), but could be tough when trying to make inroads in new territory.

On the other hand, I believe that a lot of the risk of a slowdown of government sales is already built into the price of Ceradyne, otherwise it would be trading much higher. The way I look at it is that even if sales growth falls back to the 15% that they've shown historically, they're trading at 1.0x their growth rate, which is still a bargain to me.

CRDN 1-yr Chart

For full disclosure, I own shares of Lockheed Martin.