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Executives

Joel Moskowitz – Chairman, CEO and President

David Reed – VP and President of North American Operations

Marc King – VP and President of Ceradyne Armor Systems

Michael Kraft – VP, Nuclear and Semiconductor Business Units

Jerry Pellizzon – CFO and Corporate Secretary

Analysts

Pierre Maccagno – Needham

Josephine Millward – Stanford Group

Gary Liebowitz – Wachovia

Jiwon Lee – Sidoti and Company

Tim Quillin – Stephens Inc.

Michael French – Morgan Joseph

Ben Mackovak – Rivanna Capital

Gifford Combs – Dalton

Brent Reed [ph] – FBR

David Keyser [ph] – Abadi & Company [ph]

Bryce Dille – JMP Securities

Peter Karr [ph]

Ceradyne, Inc. (CRDN) Q3 2008 Earnings Call Transcript October 28, 2008 11:00 AM ET

Operator

Ladies and gentlemen thank you for standing by. Welcome to the Ceradyne third quarter 2008 results conference call. This conference is being recorded today, October 28, 2008 at the request of Ceradyne. All participants are currently in a listen-only mode. Later, we will conduct a question-and-answer session. We request the participants to limit themselves to one question and one follow-up to allow others on the call an opportunity to participate.

Hosting the call today is Joel Moskowitz, Ceradyne’s Chairman and Chief Executive Officer; who is accompanied by David Reed, President of North America operations; Jerry Pellizzon, Chief Financial Officer; Marc King, Vice President of Armor Operations; and Michael Kraft, Vice-President of Nuclear and Semiconductor Business Units.

Before I turn the call over to Mr. Moskowitz, the company has requested that I read the following statement. The matters discussed in this conference call may include forwardlooking statements regarding future events and the future performance of Ceradyne that involve risks and uncertainties that could cause actual results to differ materially. These risks and uncertainties are described in the company’s annual report on Form 10-K for the fiscal year and due December 31, 2007 as filed with the Securities and Exchange Commission.

I will now turn the conference call over to Mr. Moskowitz. Please go ahead sir.

Joel Moskowitz

Thank you, Mindy, and I’m very pleased to have everybody on the line today for the teleconference regarding the reporting of our third quarter and nine-month 2008 financial results.

In addition to the forward-looking statements that Mindy read, I’d also like to remind everyone a recording is being made of this conference call. As our practice has been, before the market opened this morning, we issued a press release outlining our third quarter and nine-month 2008 financial results as well as providing guidance for the balance of 2008 for the entire year, the initial guidance for 2009, as well as some other comments regarding our outlook for your company. Briefly, I’ll review the press release.

We stated that the third quarter, we had sales of $167.7 million, that compared to $191.6 million of sales in the third quarter of last year 2007. Net income for the third quarter 2008 decreased by about $13.3 million or 40.6% to $19.4 million or $0.73 per diluted share. Now, that compared to $32.7 million or $1.16 per fully diluted share last year in the third quarter of ’07.

Now, that net income in the third quarter included the previously announced non-recurring pretax acquisition-related compensation charge of $9.8 million. We had announced that several times as we completed the SemEquip deal and that had to do with pre-closing commitments related to the SemEquip acquisition, which we acquired August of 2008, and that was used to pay certain incentive compensation to certain employees and advisors.

The income number also included a pretax charge of $3 million that came from other than temporary reduction in the value of our investments in auction rate securities. These non-recurring after-tax acquisition-related charges amounted to $6.2 million or approximately $0.24 per fully diluted share, and the after-tax other than temporary reduction in the value of our investments was $1.9 million or $0.07. So, the two charges had a combined negative impact on the third quarter net income of $0.31 per fully diluted share.

Now, the gross margins were 39.7% of net sales in Q3 of ’08, and that compared to 39.6% in the same period last year. The provision for income tax was 36.1% in the Q3 of ’08, and that compared to 39.6% of last year in the same period. The fully diluted average shares outstanding were 26.6 million in Q3, that compared to 28.1 million in the third quarter of 2007. And the lower average shares outstanding in the current quarter was due primarily to the purchase of 1.1 million shares under the company’s stock repurchase program, which we announced in March 4, 2008.

For the nine months, sales were $541.3 million for the period ending September 30, 2008, and that compared to $565.4 million last year in the same period. With net income for the nine months of ’08 being $85.5 million or $3.18 per fully diluted share on 26.9 million, that compared to $109 million or $3.93 per fully diluted share on 27.7 million shares last year for the same nine-month period.

Now, in that $3.18, you also have the same impact that we discussed above, namely, that the net income was reduced with a non-recurring pretax acquisition charge of $9.8 million that related to SemEquip and $3.5 million that related to the other than temporary reduction in the value of our investments in auction rate securities. These amounted to non-recurring after-tax charges of $0.32 per fully diluted share for the first nine months of 2008.

The gross margin for the same nine-month period in ‘08 was 39.5% and that compared to 40.7% with the provision for income taxes of 36.3% in the first nine months of 2008, that compared to 37.1% same period last year.

New bookings for Q3 2008 were $119.4 million and that compared to $163.6 million same period last year. And the nine months – for the total nine months, we booked $476.6 million in 2008 that compared to $395.3 million in the comparable period last year.

The total backlog as of September 30, 2008 was $174.9 million that compares to last year of slightly less $173.1 million.

Now in the press release where, because we’re coming out with our total projections or guidance for ’08 and as well as our initial guidance for ’09, I stated that I thought it might be helpful to our shareholders, if we did give initial guidance for ’09 and as well as discuss some of the areas that your management team continues to focus on. We now have a better visibility for all of ’08, so we've tightened the range a bit to show sales of $695 million to $700 million for all of ’08, and an earnings range of $4 to $4.15 per fully diluted share.

Now, those earnings also include the $0.32 that we discussed in the paragraphs related to the SemEquip acquisition and the expenses related to other than temporary reduction in the value of our investments and auction rate securities. That compares – on September 10, we had provided guidance which these numbers the sales are slightly below the low-end of the guidance and the earnings range adding back to $0.32 would be higher than the lower-end of the guidance that we gave.

And as you may recall, there was some question about XSAPI – how much we could ship in the fourth quarter, if we even had gotten the fourth XSAPI, and we did win that ID/IQ award which we announced, but it came in late enough that actually in Q4 we’ll ship very little of XSAPI. We will ship some of the first article test parts and that’s in the numbers that I just quoted for our guidance for the full year.

Now, in October of 2008, we repeat that we had won the largest contract we ever got at Ceradyne, a five year XSAPI as well as ESAPI plate from the US Army at Aberdeen Proving Grounds for $2.37 billion, which is an indefinite delivery, indefinite quantity generally called ID/IQ five-year contract. And we then received two initial to delivery orders amounting to $73 million which was the first article as well as production.

In this press release, we announced yesterday October 27, the Department of Army issued a 120-day stop work order on the initial delivery order, which was named 0002, that’s $72 million but we were allowed to continue working on the initial first article test order on the ID/IQ contract.

I stated also that we believe that the stop work order is attributable to a protest filed by BAE Systems. We also anticipate that the protest will be resolved in a relatively short period of time. I’m sure in the Q&A that someone will be asking Dave to comment on that.

Although this ID/IQ contract is both for XSAPI and ESAPI, we expect the army will primarily order the XSAPI which would most likely result in total orders under this five- year procurement of less than the full $2.37 billion.

And although we believe that the government may increase its requirements for XSAPI to a Pure Fleet. Pure Fleet is the language that’s used when the government determines that they want every soldier, including National Guard or noncombatants, combatants, full deployment of XSAPI.

Because we cannot project that decision at this time, we’re assuming that our normal flow of XSAPI and ESAPI sustained and non-Pure Fleet XSAPI and Special Forces armor, if we add those numbers up, they come out to about $125 million short of what we shipped in 2008. That is the way we came up with our guidance for 2009. This reduction in shipments will be partially offset by increased sales of our ceramic crucibles, which will double to about $80 million in 2009, and increased sales in other non-defense areas such as our ESK Ceramics subsidiary in Germany.

Now assuming no Pure Fleet increase, which is what we are assuming for the purposes of this initial guidance, our sales for next year would be $640 million to $650 million, with an earnings range of $3.00 to $3.25, and that assumes a tax rate of 36% and fully diluted average shares of $26.5 million.

I went on to point out, because of the capital markets crisis, it is currently evident not only in the United States but worldwide that your company has a very strong balance sheet, particularly we have strong cash, cash equivalents, restricted cash, and short-term investments totaling $215 million. In addition to that, which we usually don't site as cash because it’s classified as a long-term investment are our auction rate securities, which are now in an illiquid status.

The team, most of whom are on the phone right now, except for our operations that are far away, continues to focus on the areas that we have repeatedly discussed. We’re working very hard on acquisitions, particularly defense products, including armor for military vehicles. We have Marc King on the phone. He may give us a little bit of information on that solar energy and – which continues to be a strong suit.

I’d like to mention in solar energy that we have developed a technical improvement to our traditional ceramic crucibles which we have filed a patent for and we expect this to be substantive in the marketplace as it will make a better ingot of silicon and that will release cleanly from the crucible, as well as our ceramics for smelting of aluminum.

It is interesting to know, and for those of you who’ve been following Ceradyne, remember that I’ve been following this since the first day 41 years ago, that we do have a decline in body armor shipments. That’s what we’re projecting for 2009 with our current visibility, assuming no Pure Fleet and it will be about 40% of our shipments.

Now, as we look at it at Ceradyne, we’re moving towards our goal of a diversified company and a lot of that will be based on the sales growth in the future in these non-defense areas. However, even with this decline that we’re projecting next year, even with partially being offset by non-defense, we expect it will continue to generate strong monthly cash flows and that we’re all very excited, actually, about what we see in the marketplace.

We’re planning to expand our solar operations in China, possibly Singapore, for sure Atlanta, Georgia is expanding, and we continue to put in capital expenditures in our non-defense areas in Germany, we are looking for record years out of ESK Ceramics, and a small subsidiary area that they run. But the plans, because of continued increase in the demand for our ceramic silicon carbide products for pump seals and bearings, which is a very important part of ESK’s non-defense programs.

So I think that a more lengthy press release than we normally put out gives you the factual information on Q3, on the balance of ’08, how we see things in ’09, our continued focus in these various areas.

And I’m going to turn this over now as we’ve been doing in recent calls to Jerry Pellizzon, Ceradyne’s Chief Financial Officer, who will give you a little bit of an overview of some of the financial aspects that he wants to highlight. Jerry?

Jerry Pellizzon

Thank you, Joel. A pleasant good morning to everybody wherever you may be. We have a revenue diversification trend that began in Q3 ’07, continued again into this quarter and for the nine months. And it’s interesting to note that the non-armor, non-defense business of Ceradyne had record sales for the year-to-date and record sales for any quarter, and also record earnings contribution. That is driven by our crucible business, not only in China but also in Atlanta, but also other areas of the business, the fluid handling at ESK, our broad metallurgy business at ESK. So we’re seeing some solid growth into that business. The percentage of revenue from our business now is – has declined at 62% from 73% of the revenue compared to the same period in ’07; and so we've really got solid business there.

Non-defense sales year-to-date are $205 million versus $136 million in ’07, so you got a growth rate of 50%. If you net up your contributions of the 2007 acquisitions from the growth rate of 35% and the sales to date are $173 million versus $128 million. So, we’re really pleased about our performance of the non-industrial business and we’re very optimistic about it for the future.

In terms of income from operations, we did declined by $15.1 million before the impact of the charge for the acquisition of the SemEquip, but we did deliver a very healthy 26.2% operating profit margin and our annualized pretax return on capital was 22.3%. So basically, there’s a fact that the selling, general and administrative expenses related to the incremental revenue of our non-defense business are generally higher than those attributable to body armor. So, replacing body armor revenue dollar-for-dollar cannot expect to generate equivalent profit margins but still contribute very, very good incremental profits. So in general, the results of the first nine months of 2008 reflect our strategy of expanding our business through internal growth and strategic acquisitions.

Free cash flow for the nine months ended September 30, 2008 amounted to $91.5 million versus $62.2 million in the comparable period last year. EBITDA was $161 million for the nine months, compared to $188 million during the same period the year before. Our depreciation and amortization is $30 million for the nine months. We were at $18 million last year. Our CapEx was $36 million and compared to $28.3 million last year.

So overall, we’ve seen a healthy growth of our non-industrial, non-defense business. We’re still producing good healthy returns. The balance sheet, as Joel noted, is rock-solid. We continue to produce cash; we’re going to produce cash in 2009 also. So we’re anticipating that we’ll build our cash position. And as we mentioned, we do have a buyback program with about $65 million left on it, so we have ample cash. And in today’s credit constrained era, it's probably one of our most valuable assets that we have on our balance sheet.

Additionally, our DSOs continue to go in the right direction. They’re now a record low 28 days compared to 43 days for the prior year. So I think that the note on the balance sheet is that strong liquidity, strong cash position, and the note on the operating side is that we continue to perform on an excellent basis for manufacturing companies. Joel?

Joel Moskowitz

Thanks a lot, Jerry. I think, Mindy, it would be most productive if we go right into the Q&A period, so we can bring everybody into the act and answer any questions from the people on the line.

Question-and-Answer Session

Operator

(Operator instructions)

Your first question comes from Pierre Maccagno from Needham. Your line is open.

Pierre Maccagno – Needham

Good morning, Joel and Jerry.

Joel Moskowitz

Hi, Pierre.

Jerry Pellizzon

Good morning, Pierre.

Pierre Maccagno – Needham

So, could you give us a little bit of an explanation on the reduced shipments in ’09 versus ’08? Is that because there’s a reduced demand or there’s a change in market share? And also if you could tell us, in terms of the number of sets shipped per month, how much of that is that you expect in ’09 versus ’08?

Joel Moskowitz

Yes, I think that, as I stated, the decrease is almost solely attributable to body armor, even though we just got a $2.3 billion ID/IQ order, the biggest we’ve ever seen. But really, what really counts is delivery orders and we’re looking at it what I hope will be conservatively. But I think the best one to answer that question is the Vice President and President in the North American Operations who lives the armor game, Dave Reed. Dave?

David Reed

Hi, Pierre. Let me give you a little flavor for that. The last time we all spoke, we really were not under contract. We had passed some of the testing that would allow us to go into the contract base. So, as everyone is seeing, we are now officially under contract. We’re one of three companies that will participate over the next five years on the XSAPI Program, so that’s great news for us. We’re very anxious to move ahead with the program. We’ll be submitting first article parts this week. Testing will take place over the next month, month and a half and then we expect that within that same time period, there’ll be some kind of resolution of the protest.

To answer your question directly, it looks like the army itself, initial order is only for about 120,000 sets for the next year, and I think they’re probably going a little slow because they have some nervousness about how the companies will perform on this new product. It’s a very difficult product to make. It’s really the next generation. It has to stop a much more demanding threat in the prior ESAPI product.

And I think maybe once the government gets through that first article testing and has a chance to look at the performance of Ceradyne and maybe our competitors too that they may be a little bit more bullish about rolling the product out, so we’ll certainly be lobbying for that. We know for sure that this is a friendly fire issue right now. It’s certainly the new ammunition that’ll be showing up in the coming years on any battlefield that we’ll see, so for our soldiers not to have the XSAPI will be a bad decision and I don’t think really anybody in the Congress, Senate or the Army wants that to happen. So we’re looking right now at about 8,500 sets a month between Army and Marine and Air Force requirements next year for the XSAPI. And we’re also anticipating that at some point, they’ll move the side plate program into that. And we’re expecting maybe about 11,000 sets of the side plate, and that’s in our forecast also, Pierre.

Pierre Maccagno – Needham

So, when you say 120,000 sets for next year, is that the whole industry or is that you? And also if you can talk about –

David Reed

No, that’s the army’s requirement.

Pierre Maccagno – Needham

Okay. And you get more or less what percentage of that, would you say?

David Reed

On its first delivery order, the 0002, we got about 63%.

Pierre Maccagno – Needham

Okay. And you expect that to continue forward?

David Reed

Well, I certainly hope so.

Pierre Maccagno – Needham

Okay. And my follow-up question is the gross margins, are these dropping or is that changing at all?

David Reed

I’ll let Jerry answer that one.

Pierre Maccagno – Needham

Okay.

Jerry Pellizzon

Well, Pierre, there’s a sales mix issue that – and also we had a competitive bid so the margins are forecasted down for ‘09 versus ’07. We do have opportunities to increase it from our plan, but I think they’re going to be lower than they were in ’08, primarily because of the sales mix issue, the product themselves and how we bid. And if you look at the first quarter, the first quarter of the year we are going to be down in gross margin and we’re expecting that to be the weakest quarter of the four, but we’re very confident about the number. But, the first quarter of 2009 will be our weakest quarter, primarily because of sales mix. Once we get past the contract that we have on the books that will be produced and shipped in the first quarter, then the margins for the next few quarters will I think increase and they will be much better.

Pierre Maccagno – Needham

So, when you talk about the sales mix, what do you mean specifically? I mean, some of the plates have lower margins or lower ASPs or –?

Jerry Pellizzon

Pierre, as you saw in the past couple of months here, we’ve announced some new orders. We in particular got quite a bit of orders placed for foreign military sales of the two generations ago SAPI product. That has to be much more competitively bid. Those margins are quite a bit lower than what we can see on the most advanced products. So that’s primarily going to be shipped in the first quarter of next year and so that drags down the total. The total amount of shipments will probably be a little higher for body armor in Q1, but the gross margins in dollars will about be equal across all the quarters but in percentage it will be a little bit lower in Q1.

Pierre Maccagno – Needham

Thank you very much.

Operator

Your next question comes from Josephine Millward from Stanford Group, your line is open.

Josephine Millward – Stanford Group

Good morning.

Joel Moskowitz

Good morning Josephine.

Josephine Millward – Stanford Group

Joel, can you give us a little more color behind the BAE protest? What is the basis of their protest and why do you think this will be resolved shortly, and also in your guidance, are you assuming shipment of XSAPI in Q1 at all?

David Reed

Hi Josephine, this is Dave. Let me take that answer. The basis of the protest appears to be that BAE is looking at the new laws that regulate the indefinite quantity, indefinitely delivery orders, which say that for each new delivery, you have to come out to the qualified bidders on that contract and ask them to resubmit their schedule for the products and a quote for the product. And so on this order, the army actually placed the first article test and contract on a Friday. And then two days later, two business days later, on Tuesday, they released the first delivery order that is 0002. So BAE didn’t get a large portion from what we can see and so they’re a little upset by that. And so they protested that that second delivery order should have officially been re-bid, that they should have had a chance over that two-day period to give a new quote for that production volume of 120,000 units. We anticipate that this will be resolved quickly because it doesn’t seem to be that complex of an issue. The GAO is going to look at it and either say re-bid it or no we don’t agree with you, the Army did come out a week prior and asked for best and final and this doesn’t qualify.

Josephine Millward – Stanford Group

Okay, that’s helpful. So your guidance assumes shipment of XSAPI starting in January?

David Reed

Yes, it does.

Josephine Millward – Stanford Group

Okay. Also, in your backlog, does that include the $72 million of XSAPI order that you announced in October?

David Reed

Yes.

Josephine Millward – Stanford Group

Can you give us an update on vehicle armoring?

Joel Moskowitz

Yes. I think that I have Marc on the line in Washington, and maybe he can give you an overview of where we stand on some of our programs. Marc?

Marc King

Yes, hi Josephine. Good morning.

Josephine Millward – Stanford Group

Hi, Marc.

Marc King

Overall, we’re pretty optimistic with our efforts to date regarding the use of our successful development of LTAS. We have now delivered to one of our OEMs a complete LTAS kit that’s in full testing for the United States Army for the primary cargo truck used by the Army – medium duty cargo truck used by the Army as part of its B-Kit for armoring that is in an Army test now, and we expect to see some results back in probably about 90 to 120 days on that.

We’re in development with another OEM. I’m sorry I can’t give you these names because of nondisclosure agreements that we have. But for other armor kits deals that were negotiated at the recent Army exhibition in Washington, the folks back in Wixom, Michigan are working on new designs for B-Kits for additional armored trucks that we plan to present as part of army requirements going forward in the not too distant future.

And most importantly, I think probably the latest buzz has to do with a new vehicle that just became a requirement, a result of the joint operational need statement coming from our forces in Afghanistan that is referred to as JUON [ph], which has just recently, I’m sure you’ve read in the open press, that JUON has become a requirement and that requirement is being turned into a request for proposal.

I guess optimistically we look at that knowing that in a previous request for information, we have submitted to the Tank-Automotive Command in Detroit a response to that RFI using the same technology used in our BULL submission earlier. That RFI was singled out by the group at TACOM doing this evaluation. We’ve been told that the information we provided and that all of the requirements of the JUON, we assume it will translate into the RFP and we’re leaning very forward in the foxhole so to speak looking for an opportunity here to provide an RFP back on what we hope will be as many as 2,000 vehicles to support operations in Afghanistan.

Josephine Millward – Stanford Group

Marc, can you help us quantify the three opportunities you listed and clarify what’s included in your ‘09 guidance?

David Reed

Well Josephine, let me jump in there because I just finished reviewing that budget portion. We’ve got $30 million worth of shipments right now in the plan, primarily related to the shipment of B-Kit style armor that Marc spoke about. We have nothing in there for his comments on that BULL light program. That would be additional upside potential next year.

Josephine Millward – Stanford Group

Okay. And the big B-Kit is to the OEF for army cargo trucks, right?

David Reed

That’s correct.

Josephine Millward – Stanford Group

Great, thank you very much.

Joel Moskowitz

Thank you, Josephine.

Operator

Your next question comes from Gary Liebowitz from Wachovia, your line is open.

Gary Liebowitz – Wachovia

Good morning gentlemen.

Joel Moskowitz

Hi, Gary.

Gary Liebowitz – Wachovia

Could you clarify – I thought I heard you say that you still expect first deliveries of XSAPI to be in January? I thought that the original production – delivery due dates were January and February. Now, with this potentially four-month stay, you’re still saying it’s January?

David Reed

Well, the way that rolls out is that we expect the first article to be approved probably end of November or early December. And then, we also expect the protest to be resolved pretty quickly, because as I said earlier, it’s not a difficult issue. It’s either they come out and ask for the re-bid or it’s overruled and the existing contract stand. In either case, they only have two days to ask for a re-bid and not make an award or the original one stands. So there’s not much to happen there. The deliveries on the existing contract call for February deliveries and you can deliver early on that, so we will be looking to make our first deliveries at the end of January right now.

Gary Liebowitz – Wachovia

Okay, I understand. Also, I just want to ask about the body armor, can you talk about some of the trends in the other businesses? It looks like sales out of the Canadian business almost completely dried up in the quarter. What was happening there and what’s happening with the ESK margins?

Joel Moskowitz

I think on Ceradyne Canada, I will let Michael Kraft to comment on that and then we will chime in with ESK.

Michael Kraft

Hi Gary, this is Michael Kraft. The Canada operations are based on a product line as you know that we acquired (inaudible) and historically that’s the product line that you run pretty much three quarters out of the year, and the prior owner had shut down and taken a layoff and really operate the business about three quarters out of the year. So, that’s what we see in Q3, the seasonality of the business and it really doesn’t reflect anything that we see and looking in nuclear from a market slowdown or really any kind of loss in market share. Jerry, do you want to take the ESK?

Jerry Pellizzon

Yes, the ESK, we did have some challenges during the quarter. Part of it is that their shipments overall of armor were down and they just didn’t have enough revenue to absorb all their manufacturing overhead. We continue to face challenges on pricing for the evaporation boats. That’s had a negative contribution – period-over-period year-to-date, there’s about $2 million of gross margin that were off in that business. But the rest of their lines are doing well. Their fluid handling parts were parts that are doing well, but between armor and the reduction in the volume and the evaporation boats, that’s what really contributed to that change.

Joel Moskowitz

Yes, one point on that to those who follow ESK, they’ll see about a 15% bump in sales in ’09, and they’re going to be focusing on their margins. I agree wholeheartedly with Jerry. One, when we see an armor turned down, it means we’re buying less powder from them, which we let them mark up and that goes right to their margins. On the area of the evaporation boats, we have instituted a series of price increases which will be reflected towards the end of this year, end of Q4. And right now, they’re holding and we’re taking a pretty firm position on that. And the CEO and President, Thomas Juengling, has a very clear mandate to be looking at the bottom line.

Remember, this is a pretty interesting company. It’s been around since 1922. It was their research department that came up with this breakthrough methodology on the crucibles working with Bruce Lockhart and his team in Atlanta. They get credit for that, actually, and I think you’re going to see this regarding the armor. I mean, we’ll still be getting powders from them next year. You’re going to see some margin improvement as we go forward.

Gary Liebowitz – Wachovia

Okay. And just one last one back on the body armor, how do you think the – it seems like the Army is looking for a comparable way to do XSAPI as it was for ESAPI but with the extra protection. Where do you stand there? How overweight are you now? And do you think if you get your number down that the market might actually open up a fair amount for you?

David Reed

Well, I think, Gary, that the weight issue is something that everybody needs to understand a little bit better themselves, even the Army in many cases. The new improved Outer Tactical Vest has taken out some coverage issues, particularly on the side plate. They've reduced the weight of the soft side armor by about 3.2 pounds, so a whole suite of X front and back and side at the maximum allowable 10% only adds about 1.7 pounds. So overall, the average guy who doesn’t have either one of these items right now would see about over a pound reduction in the total weight he’s carrying, so I think that there’s some education required there to some of the people that are funding the programs, but we don’t see it as a big issue. We’re somewhere just below the 10% overweight number compared to ESAPI right now, and we think that that product affords great protection. It’s going to look pretty silly if a guy is going to be killed in friendly fire issues going forward because he wasn’t give a plate that would stop what we’re shooting out of our automatic weapons. And I think that overall the army’s going to make the right decision there and it’s definitely being supported by Congress.

Gary Liebowitz – Wachovia

Okay, thank you.

Joel Moskowitz

Thank you, Gary.

Operator

Your next question comes from Jiwon Lee from Sidoti & Company. Your line is open.

Jiwon Lee – Sidoti and Company

Good morning.

Joel Moskowitz

Good morning.

Jiwon Lee – Sidoti and Company

My first question is on the solar cell crucibles. Projecting about $80 million for next year, is this level a little bit below your previous projection? And how should we be thinking about this business growing beyond next year?

Joel Moskowitz

Well, that’s a very good question. This year earlier on I said I thought that our shipments would be $40 million to $50 million and now, it looks like they’re coming in a little more than $40 million, and the $80 million looks pretty firm. I thought it could be more in ’09 earlier last year, and then we were a little concerned because of the shortage of silicon. That shortage of silicon seems to be an issue but our customers are able to use a commodity grade metal specification instead of the normally ultra high purity silicon, and so the 80 million comes out by – it’s their numbers to us. We’re not going by generalities. As far as the future goes, it looks pretty good. It looks about as good as I can imagine.

Every analysis that I’ve seen and more important, what our customers say, is a growth rate of between 35% and 40%, which is about what it’s been growing lately. So if that’s true, then our business should continue to grow at that kind of number if not more if we’re correct, and I know you know a lot about our business, Jiwon. If I’m right and this coating, which we call a pre-coded crucible, is as good as it seems, we will increase market share. Right now, I’m looking – our numbers are growing at about the same rate as the market.

The other thing is the basic technology, it’s called polycrystalline silicon; and although there are competitive methodologies for making solar cells, namely thin film and various types of mirrors that rotate and track or concentrate sunlight, it still looks like the poly is the material of choice because it’s so mature with about 65% of the total solar market. So I think we’re in pretty good shape.

Jiwon Lee – Sidoti & Company

Okay. And back to the body armor, that is my follow-up question, where do we stand or what does the Army tell you about the side plate and your conversion to the X-Type?

David Reed

Well, Jiwon, it makes very little sense to provide some these forward groups with front and back protection that stops their friendly fire issue, the extra [ph] without giving them sides, so the army has said that they will follow the XSAPI program with their side plate program within 30 to 60 days. That’s what in our plan. We’re showing that we’ll be delivering late in Q1, early Q2 an X version of the side plate.

Jiwon Lee – Sidoti & Company

Your market share there is considerably bigger than the chest plates though right now, yes?

David Reed

Yes, that’s always been true. We’ve always held a pretty high position in that.

Jiwon Lee – Sidoti & Company

Okay, that’s all for me. Thank you.

Joel Moskowitz

Thank you, Jiwon.

Operator

Your next question comes from Tim Quillin from Stephens Incorporated. Your line is open.

Tim Quillin – Stephens Inc.

Good morning.

Joel Moskowitz

Good morning.

David Reed

Hi, Tim.

Tim Quillin –Stephens Inc.

In terms of body armor, how should we think about fourth quarter sales relative to third quarter?

David Reed

Right now, it looks we’re going to be down a little bit in the fourth quarter. I think we’re going to be about $80 million.

Tim Quillin – Stephens Inc.

Okay, that’s helpful. Is that the shipments as well of the foreign military sales orders?

David Reed

Just a very little bit of that is going out in December, that’s the start of those orders. Most of that downturn reflects not getting any of the XSAPI out. We had thought originally that we might see some shipments in late November, early December but because of the delay that shifted that product into early next year.

Tim Quillin – Stephens Inc.

Okay. And just a point of clarification, I thought earlier on the call, you said that the $72 million order for XSAPI was included in your backlog but I think it’s excluded. Is that correct?

Joel Moskowitz

That was included.

Tim Quillin – Stephens Inc.

Okay. In your 10-Q, it says specifically that it’s excluded.

David Reed

Well, the difference there, Tim, is that it was an October order and as of September 30, it wasn’t included. As of the current backlog, which I think was a question before, not to create confusion, but I think it’s totally – it’s in the course, but the 9/30, it was not.

Tim Quillin – Stephens Inc.

Right, right. And what would you – so did you mention your current backlog, what is your current backlog?

Joel Moskowitz

The backlog is quoted in my report that I gave paraphrasing the press release is as September 30. So it does not include the $72 million even though when I was to stay outside, I misspoke, because you’re right, that came in after the close of Q3.

Tom Quillin – Stephens Incorporated

Now, that’s a helpful clarification. And then, in terms of operating expense management as revenue declined into 2009, can you bring SG&A cost down or R&D cost down or your selling expenses down, and how does SemEquip factor into your expenses as well as we go into ’09? Thank you.

Jerry Pellizzon

Okay. Why don’t we go to SemEquip and I’ll let Michael answer that?

Michael Kraft

Well, from SemEquip’s standpoint, we have a plan to build this business. We have a plan right now for ‘09 based on some of the softening to reduce those expenses, and we’re just looking at forecasting those ‘09 numbers right now, and certainly, we’re not going to be conservative but we’re certainly going to be smart about bringing those numbers in line as a percentage. I mean, I think that’s the best I can tell you. Overall, I think we’re doing that in all of our business. I don’t know, Jerry, if you want to add anything to that.

Joel Moskowitz

Well, one thing on SemEquip, I want to make it clear. We said that we would – this is a star – effectively a late stage startup. And what Michael said is absolutely so, we are reducing our cost there. But we have in our numbers next year, what we anticipate will be a loss of about $6 million and that’s already built into that number.

Jerry Pellizzon

Just to clarify, that $6 million is pretax? So we’re looking at a $4 million post tax loss in that business?

Joel Moskowitz

So that’s already in the numbers that we put out, Tom.

Jerry Pellizzon

And also, Tom, as to answer your question before about current backlog, it’s now at $220 million as of Monday.

Tom Quillin – Stephens Incorporated

Okay, that’s helpful. Thank you.

Operator

Your next question comes from Michael French from Morgan Joseph. Your line is open.

Michael French – Morgan Joseph

Good morning gentleman.

Joel Moskowitz

Yes. Hi, Michael.

Michael French – Morgan Joseph

I have a question about new investments and expanding operations and establishing new operations. I’m just wondering if you could discuss the plans here and particularly if you could talk about CapEx and the timing and magnitude of any new sales?

Joel Moskowitz

Well yes. What I’ll do is I’ll discuss some of the opportunities we are looking at, and then I’ll let Jerry come in with some of the plans we have for CapEx particularly in 2009. When I mentioned these locations, in China we have began the process, I’m not sure it’s absolutely complete yet, applying additional 13.7 acres in Tianjin, and that’s primarily for the crucibles which as I say we expect to double next year. Most of these shipments will be within the country of China. However, there’s another market that’s growing in China for our ESK products and we’re evaluating whether we want to put additional manufacturing facilities in Tianjin to make these silicon carbide components for industrial applications, so that’s number one.

Number two, I mentioned Singapore. It’s actually a variety of other places, mostly in South East Asia. Again, we’re focused on the few silica ceramics with our new patented or patent applied for pre-coding and we’re doing that because we’re developing a strategy of establishing our crucible supply chain as close as we can to the user. It’s worked out quite successfully now, both in the States where we deliver to people like BP, so we are in Maryland, and in China, where we deliver to the major solar producers, and it looks like Southeast Asia is the next place that our customers are going so we’re doing that.

Now, I also mentioned Germany, and that comes about because of our expansion and particularly in two product lines which includes both building and equipment and capacity that silicone carbide which is about almost 25% of their business now and growing. And we actually are starting to bump into capacity, so we’re expanding there and we’re expanding in the operation as I said. And the other area is boron nitride where we are becoming more aggressive on our marketing for both metallurgical applications and as I mentioned before cosmetics.

Jerry, you want to talk a little bit about some numbers related to –?

Jerry Pellizzon

Sure. The color on the numbers of CapEx next year is about $40 million. We’re having the plan now and ironically our depreciation and amortization is about that number also, so you can look for about $80 million of cash flow next year and those capital expenditures, and of course the bulk of those are dedicated towards the expansion in China in which we anticipate opening that facility early Q4 of 2009 and we’ve had very good results often enough both the facility in China. It’s specifically laid out to produce crucibles so we got high production rates. So you’re looking at about $80 million of cash flow next year and a CapEx of about $40 million.

Michael French – Morgan Joseph

Okay thank you. I have a question and a follow up on the body armor side. Maybe this is for Dave. Where was the number of sets associated with the $72 million order that you just got?

David Reed

Well I’m not really going to go into any of the details because as I said this may be re-bid so we’re just trying to keep that a little bit tight to the best there, Michael.

Michael French – Morgan Joseph

Okay. And you did mention one number, your run rate at 85,000 sets a month. Are you planning that for the full 12 months?

David Reed

All but December – I mean all but January.

Michael French – Morgan Joseph

What’s the number in January?

David Reed

It’s probably five or six, something like that.

Michael French – Morgan Joseph

Okay, thank you and good luck.

Operator

Your next question comes from Ben Mackovak from Rivanna Capital. Your line is open.

Ben Mackovak – Rivanna Capital

Hi, guys. What would 2009 look like with appear freight increase?

Joel Moskowitz

Well, it depends to what level that you accelerate shipment. It could be anywhere worth of another $50 million.

Ben Mackovak – Rivanna Capital

Okay. Once stayed down, it’s fully transition to a more diversified company, however long that may be? What percent it fell do you think will still come from defense?

Joel Moskowitz

Well, in our annual report last year, we talked about a target of a billion dollar company, a 50% defense. The vehicle armor which is still small, you heard we got about $30 million planned which is less than 5% of sales next year. There’s a whole different game. When Marc talked about a few thousand vehicles to the new specifications coming out of Afghanistan, these are hundreds and hundreds of thousands of dollars of vehicle probably. So I mean these numbers are very large. I think that’s what we’re going to see. Will see body armor – the good thing about body armor I know that people discount a lot of this. That’s the ID/I Q contract has been the biggest solidifying base we’ve ever had. We’ve never had visibility like that. It’s true they can order anything they want. That’s always been the case with the ID/IQ and for sure you can count on it being less than the $42.3 billion but it’s five years, and the facts are that the most of the ID/IQs we got, and it’s usually two or three years, I think almost always the government is going over the top. Usually to implementing either what they call a surge or just ordering more than what was on the contract by explaining that it is due dates, so we’re pretty comfortable at a lower level about a steady level of armor for quite a long period of time.

Ben Mackovak – Rivanna Capital

Okay, good, thanks.

Joel Moskowitz

You’re welcome.

Operator

Our next question comes from Gifford Combs from Dalton. Your line is open.

Gifford Combs – Dalton

Hi. I just wanted to ask if you had any thoughts about speeding up your stock buy back program in light of what’s happened to the stock price today.

Joel Moskowitz

Sure. That’s the answer.

Gifford Combs – Dalton

You want to quantify sure?

Joel Moskowitz

We have $65 million. We bought about a million shares, totaling a little more than $30 million. And we have some self-imposed idea of how to do this. I don’t want to quantify it anymore than that but we obviously are very interested in buying stock back.

Gifford Combs – Dalton

Thank you.

Operator

Your next question comes from Brent Reed [ph] from FBR. Your line is open.

Brent Reed – FBR

Good morning. My question has to do with potential side plates for the XSAPI contract. Is there currently an RP associated with those side plates?

Joel Moskowitz

No.

Brent Reed – FBR

Do you see – is this what you were seeing? I believe it was 30 to 60 days after the XSAPI contract that you were looking for?

Joel Moskowitz

Well, we expect the governments to make some moves in that area pretty soon. You know we’ll just have to wait and see what they’re timing is but as I said we don’t see anything in our plan until probably end of Q1 as we do the shipments of that products so that’s about five months away.

Brent Reed – FBR

Okay and just one follow-up to that. As far the side plates are concerned, do you see any potential of this being a potential conversion of the current side plate contract?

Joel Moskowitz

Well, as you know, that’s a multi-year program that does allow engineering changes to take place so it’s possible.

Brent Reed – FBR

Okay, thank you.

Operator

Your next question comes from David Keyser [ph] from Abadi [ph] & Company. Your line is open.

David Keyser – Abadi & Company

Good morning, guys.

Jerry Pellizzon

Good morning, David.

David Keyser – Abadi & Company

I just want you to clarify on the acquisition front. Where are you looking, how big are you looking to go, and how quickly things are different and that sort of thing, if you can clarify that?

Joel Moskowitz

Yes, I think I can comment on that. Right now, we’re so comfortable where we are meaning having all these cash generated continuing Jerry’s numbers that he put out the next year is – he said $80 million in free cash flow. That’s almost $5 million a month generated and that’s assuming we’re putting money into SemEquip which we plan to do right from the beginning. The question on the acquisitions is that – we’re not looking right now at a major acquisition. The fine is more than a $100 million or so. We have several smaller ones that fit right into our mode of acquiring companies that go in to current core businesses. We’re looking at some smaller competitive but we’re moving slow and conservatively right now as we see the debts settling in the financial markets. We think there’s going to be some opportunities that have nothing to do with performance and everything to do with unit price. It’s a good place for us to be to have this type of award chest [ph]. I would say you will not see any short-term acquisitions of substance meaning the next nine years or 120 days but you will probably see something next year.

David Keyser – Abadi & Company

And a follow up on that, so you’re really counting then on the core business that you have in the – the young businesses that you have to grow and then support the more diversified revenue-based more so than making an acquisition to do so?

Joel Moskowitz

That’s absolutely correct.

David Keyser – Abadi & Company

Okay, thank you very much guys.

Joel Moskowitz

Sure.

Operator

Our next question comes from Bryce Dille from JMP Securities. Your line is open

Bryce Dille – JMP Securities

Hi guys. Thank you for taking my call. Just a question on the XSAPI contract. From my understanding, each new award [ph] against the offsetting ID/IQ is going to be competitively bid. Can you talk about the frequency of upcoming bids? Are they going to be annual or semiannual or what type of timeframe?

Joel Moskowitz

Well, we moved to an industry trying to get that added in to the main budget starting in 2010 body armor. It’s been coming out of supplemental money, as you know, for the past six years, seven years. So if that happens, then we would look more at annual awards. Right now, we expect that there will be additional opportunities to bid on marine business and potentially, some air force business; and those would probably be independent reviews. And again, when the army comes out for that, the language of the contract says that they look at the risk, the delivery, the price, and the sustainment [ph] of the industrial base as their four categories for making those decisions on the delivery orders.

Bryce Dille – JMP Securities

And then just a follow-up. Provided they stay competitively bid, will the army continue to accept protests going forward?

David Reed

The army doesn’t have any choice on anything, guys. I mean, any company in that mix can protest, that’s – it’s America, but the GAO then has to rule on that. This is new territory because the law changed last year. I think everybody’s a little frustrated with it. I suspect that the GAO themselves will be putting a little pressure back on Congress to clarify this because right now, as you just said, anybody could protest any one of those and there’s always a delay involved, and none of that’s really good for the sustainment of any of our military industries right now. But as I said, I think these issues typically are cleared up pretty fast on this kind of issue compared to some of the more complicated ones involved around the testing of the product like the last protest. So I don’t see this one taking very long to resolve itself and we’re looking at it, as Joel said, a very good base of business with the army over the next five years with this contract. So on our last talk, we didn’t have a base. We didn’t know what the army was going to do.

Now, they are committing to the initial adoption of XSAPI. As everybody knows in the past, we started with SAPI, then they adopted ESAPI and everybody got ESAPI. Now, they’re starting with the adoption of XSAPI, and we expect that all of our forces will be protected against friendly fire in the future, guys. So it looks like, as Joel said, a lower base but a very good base over the next five years, so I’m pretty excited about that and I’m looking forward to doing a good job for the army.

Joel Moskowitz

Before we take the next question, I wanted to bring in a separate subject that I thought people might ask about but haven’t, and that’s the very large future market for a smelting of aluminum. We’ve brought this up constantly. We’re doing a few million dollars a year. Probably, that would be about the same in ’09.

But recently, we’ve accelerated our efforts and have actually formed an ad hoc test force headed by the President of ESK Ceramics, Thomas Jungling, which includes various senior people in the industry that we’re retaining to help us penetrate and accelerate this market. And I just want to put out some more information so that everybody understands that this is one remainder of the two billion dollar markets that we referred to; one, of course, we’ve already mentioned which is armor for military vehicles, and this is the other one.

When you make aluminum, you produce more carbon dioxide than you do aluminum. Carbon dioxide is a greenhouse gas and the World Bank, where Ceradyne is in communications with, is monitoring the Kyoto Protocol and would state that the target will be 5% less CO2 based on a 1990 base, which is equivalent to about 26% reduction from here. So here you have a whole industry putting out perhaps as much as 100 million tons of carbon dioxide.

The two largest polluters in Canada are aluminum companies, and aluminum is going to be one of the materials that will help our environment, will help our economy because of its light weight, weighing about 30% of the weight of the steel. And Ceradyne believes it has a solution to reduce the cost, reduce the electricity, increase the capacity, and increases the life of the cells as well as to reduce and possibly eliminate pollutants. And we are now working with everyone on this, meaning governments as well as companies; and we’re very excited about it. A question that was asked – I was asked about four questions ago was, “Are we going to tighten our belts on SG&A and that sort of thing?” And Michael Kraft said, “Well, in some areas, of course, we will on some of these newer operations.” I’ll tell you where we won’t. We won’t in the research going into this new exciting program. This could be Ceradyne in five or ten years with the space of armor that we have, and it’s an exciting area. We have a very proprietary product. And before we went down the continued questioning on the body armor, which is appropriate, was even though it’s less, it’s still going to be 40% of our shipments next year. Don’t lose sight of these other programs. That’s the end of my monologue.

Operator

Your next question comes from Gary Liebowitz from Wachovia. Your line is open.

Gary Liebowitz – Wachovia

Thanks again. It sounds like there’s been some downward average selling price pressure on XSAPI because of the multiple re-bids. Can you tell any, on the cost side, how does the cost structure for XSAPI compare to that of ESAPI?

Joel Moskowitz

Dave?

David Reed

You know, Gary, the XSAPI project is very competitive right now. We’re going to see some maybe a potential to re-bid, so we’re going to keep pretty quiet on that. But it’s a new ceramic material, it’s a little less expensive to make than the past ceramic we were making so we feel pretty good about our cost position there. We’re okay.

Gary Liebowitz – Wachovia

Okay, thanks.

Operator

Your next question comes from Peter Karr [ph], a private investor. Your line is open.

Peter Karr

Yes, my original question was about the stock buyback which you touched on and obviously, you’re enthused with that thought process. Are you going to commit any more money in addition to the $65 million to the buyback?

Joel Moskowitz

I can’t answer that just yet. It’s a good question. Let’s see what happens to the price of the stock, and we’re a very pragmatic company. For a long time, we resisted pressure to buyback the stock because we felt that our money could be better utilized in acquisitions or indeed the expansion. I’m still of a mode, thankfully, that if we see opportunities and we can get deals on some of these potential acquisitions and we’re going to just do that. In the stocks in this neighborhood, we can’t help but be a buyer.

Peter Karr

And just a small quick follow-up. The increasing value of the American dollar, how will that affect your company and will have an effect because it’s rapidly gaining against the Canadian dollar?

Joel Moskowitz

Well, regarding Canada, right now it’s insignificant. Our business out of Ceradyne Canada isn’t that big a deal. Eventually, Jerry, we have a very clear program on that. What’s more important to us, of course, is the Euro versus the dollar because we’re having – 25% of our business is being sold in Euros and with the Euro against the dollar, I haven’t looked at it lately, but it’s $1.25 or so. That’s actually in our – it’s helping us.

Peter Karr

Thank you.

Jerry Pellizzon

Yes, I think, Peter, the question is that the downward value of the Europe with a strength of its own is going to help ESK. And to give you an idea on the stock buyback, we have to take that up, obviously, with our board. But here’s a thought, that if we actually queued on ’09, we’ll have $315 million in the bank; and if we pay off the convertible debt, that’ll leave us $200 million. That will be $7.5 of pure cash on all of our stock in $17. It seems like that for – it’s a pretty compelling story.

Joel Moskowitz

I think that wraps it up, Mindy. Hello?

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Ceradyne, Inc. Q3 2008 Earnings Call Transcript
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