It's been five years since the events of Sept. 11, 2001, and the U.S.-led "War On Terror" continues. There are many companies in the business of providing armaments for the national defense. One such company, Ceradyne, Inc. (CRDN) has been winning contracts as a result of the government's strong demand for the firm's ceramic body armor. Higher revenue combined with Ceradyne's relatively efficient manufacturing has allowed for significant profit margin improvement, helping the company to generate superior earnings growth and landing it on the Reuters Select stock screen for Strong Operating Margins.
We started our search by focusing on the 13 companies from the aerospace & defense industry that registered recently on at least one Reuters Select stock screen. (Click here for an Excel sheet comparing all the members of the aerospace & defense industry.)
We focused on measures of management's performance, favoring companies with better results for return on investment [ROI] over both the trailing 12-month [TTM] period and over the last five years. We looked at ROI instead of other measures of effectiveness, such as return on equity [ROE], because ROE simply looks at how much net income is generated for the given shareholder equity, whereas ROI takes into consideration the complete capital structure: ROI is calculated as net income divided by shareholder equity, long-term debt and all other long-term liabilities. This brought our list down to six companies.
Next, we looked for companies that have grown faster than their peers in terms of both revenue and earnings per share [EPS] over the last five years. This brought the list down to just two companies.
Our final step was to focus on the company with the lower valuation. It is tempting to simply compare key metrics, such as price to earnings (P/E) or P/Sales ratios. Of course, an issue that we face is that shares of Armor Holdings, Inc. (AH) have a higher P/E but a lower P/Sales ratio than Ceradyne's shares.
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So, we turned our attention to each stock's valuation based on analyst expectations of future performance, and this is where Ceradyne took the lead.
On average, analysts in a Reuters poll look for Armor to post EPS of $3.82 this year and $5.08 next. Given the current stock price of about $53, AH shares are trading at roughly 13.9 times 2006 earnings and 10.4 2007's expected figure. Also, analysts believe that Armor can grow its EPS at an average annual clip of about 7.8 percent. This yields PEG (forward P/E divided by long-term EPS growth rate) ratios of approximately 1.8 and 1.3, respectively.
By comparison, analysts look for Ceradyne to generate EPS of $4.28 in 2006, followed by $4.25 in 2007. Given its current stock price of roughly $42.50, Ceradyne's shares are trading at 9.9 times this year's earnings and 10 times 2007's consensus estimate. But, analysts look for the company earnings to grow at an average annual pace of more than 18 percent. This gives Ceradyne PEG ratios below 1.00 - low enough to appeal to even the most ardent value hunters.
Although analysts believe that Ceradyne can grow its future EPS at a faster clip than Armor, we found that the consensus for Ceradyne is much slower than the company's own historical pace. Specifically, Ceradyne has a history of posting superior revenue and EPS growth rates. Further, its rate of growth has been accelerating, with the pace in the trailing 12-month [TTM] period faster than the five-year average, and the clip in the most recent quarter [MRQ] faster yet. Given that very fast growth rates are not sustainable over long periods, it is not surprising to see analysts looking for a pace down the road that is only a fraction of the company's recent performance.
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Significant improvement in its already-superior profit margins has allowed for Ceradyne's top-line gains to bolster EPS growth. It has also enabled the company to land on the Strong Operating Margins screen, which looks for companies with better-than-average margins. The screen requires that a company's operating margin eclipse the industry norm over both the TTM and five-year periods. As indicated below, Ceradyne's operating margin easily eclipses the industry average over both time frames.
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Another requirement of the screen is that a company's TTM operating margin must be at least 25 percent wider than its five-year norm. Ceradyne easily clears this hurdle: As indicated above, its improvement is closer to 77 percent.
At the time of publication, Erik Dellith did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.