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Executives

Joel Moskowitz - Chairman and CEO

Jerry Pellizzon - CFO

David Reed - President of North American Operations

Michael Kraft - President of Nuclear and Semiconductor Products

Analysts

Pierre Maccagno - Needham & Company

Al Kaschalk - Wedbush Morgan

Josephine Millward - Stanford Group

Gary Liebowitz - Wachovia

Jason Simon - JMP Securities

Michael French - Morgan Joseph

Ferat Ongoren - Citigroup

Ceradyne Inc. (CRDN) Q4 2007 Earnings Call February 26, 2008 11:00 AM ET

Operator

Welcome to the Ceradyne 2007 Fourth Quarter and Full Year Results Conference Call. (Operator Instructions)

Hosting Ceradyne's call today is Mr. Joel Moskowitz, the Company's Chairman and Chief Executive Officer. Accompanying Mr. Moskowitz are Jerry Pellizzon, Chief Financial Officer, and David Reed, President of North American Operations.

I would now like to turn the conference over to Mr. Moskowitz. Please go ahead, sir.

Joel Moskowitz

Good morning, everyone, and welcome to our Q4 and full year '07 teleconference. We are very pleased to be here. Driving to work here in sunny California was a beautiful day. The sun is out. It's a prettier day than our stock prices right now. But maybe we can shed some of that sunlight on our company.

Additionally, here is Michael Kraft, the President of Nuclear and Semiconductor Products.

Before I begin my remarks I would like to make the following preliminary comments. The matters discussed in this conference call may include forward-looking 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-ended December 31, 2007, as filed with the Securities and Exchange Commission.

I'd also like to advise you and repeat the information that Dennis just provided that we are making a recording of this conference call.

Earlier today, before the stock market opened, Ceradyne issued a press release regarding reporting our fourth quarter and 12 month 2007 financial results. I'd like to review that with you, and as we have done in the past we will be pleased to go in to a question-and-answer mode after I review the press release.

In the fourth quarter of 2007, our sales increased to $191.4 million, which compares to $178.7 million in the Q4 of '06.

The net income was down 6.7%, about $2.5 million to $35.2 million or a $1.28 per diluted share that compared to $37.7 million, or a $1.38 per diluted share last year in the fourth quarter.

Fully diluted average shares outstanding for the fourth quarter were 27.6 million, which compared to 27.4 million in the same period in 2006.

Our gross profit margins were 39.6% of net sales in Q4 '07, that compared to 40.7% in 2006 Q4. And our provision for income taxes was up a bit 33.7% in the fourth quarter of '07, which compared to 33.3% in the fourth quarter of '06.

For the 12 months, our sales for the year ending December 31 '07 reached a record of $756.8 million, which was up from $662.9 million in the same period last year.

Net income for the year ended December 31, 2007 increased to a record $144.3 million or $5.20 per diluted share on 27.7 million shares, compared to last year at $128.4 million or $4.69 per fully-diluted-share on 27.4 million shares for the year ended December 31, '06.

New bookings for the fourth quarter '07 were $258 million, which compares to $313.5 million for the same period last year. And for the 12 months ending December 31, '07 new bookings were $651.3 million, which compares to $730.1 million in '06. And the ending backlog was $238.9 million as of December 31, '07, which compares to last year at December 31, '06 of $344.3 million.

And additionally, as we usually do at the end of the release, we have the balance sheet and income statements. And of course we've filed our 10-K.

In the press release, which was a little more lengthy than our usual, we went on to state that we were pleased in the fourth quarter financial performance. It allowed us to meet our guidance which we had made early in '07 of $720 million to $740 million and in sales in the range of $5.20 to $5.40 per fully-diluted-share. It was also consistent with our October 30, 2007 comment that we would meet our 2007 guidance with sales at the upper range and our earnings at the lower range.

I repeated in this press release our guidance on October 30th for 2008. I think it might be helpful to read it again as some of you may not actually have this release.

In the past, we have issued forward full-year guidance in the prior year once we felt we had reasonable visibility. Remember, this is what we said on October 30th. Due to the potential magnitude of the BULL combat vehicle, as well as the five-year XSAPI/ESAPI proposal, neither of which has been awarded, we are providing the following guidance with an unusually wide range. The lower range reflects all of our current business units, as well as body armor, which was reduced somewhat from the current shipping level, even though multi-year XSAPI/ESAPI orders will not be issued until early 2008. But it does not include any production of the BULL combat vehicle. The higher end of the range includes the lower end plus production of the BULL combat vehicle in the second half of 2008.

During our October 30, 2007 conference call, we stated that our initial 2008 guidance was sales in the range of $780 million to $1.067 billion and earnings in the range of $5.60 to $6.65 per fully-diluted-share.

Our press release goes on to state that we now believe, based on recent discussions and events, that the above 2008 guidance should be modified for the following reasons.

Early this month, that is February, and to remind the listeners, on October 30th, we had anticipated that we would be bidding the XSAPI/ESAPI early in December, and that was subsequently extended for the fifth time to early February. However, early this month Ceradyne did submit its proposal for a five-year supply of both ESAPI (Enhanced Small Arms Protective Inserts) and XSAPI. The total of the anticipated award is estimated at $1.2 billion as an ID/IQ (Indefinite Delivery/Indefinite Quantity) contract. We believe that this contract will be awarded to multiple bidders in a similar manner as the prior and current SAPI and ESAPI contracts.

Because of our past performance and manufacturing capacity in our Lexington, Kentucky, and Costa Mesa, California facilities, we anticipate a favorable win percentage of delivery orders, primarily XSAPI. However, due to the multiple delays and extensions the government has granted, we believe that shipments against this anticipated order will not begin until the fourth quarter of 2008.

Based on the delivery schedule under our current ESAPI contract, there will be a four-month gap between completion of this contract and the expected commencement of the XSAPI shipments. Relying on non-binding discussions with the government, we do not believe that there will be extensions of the current order as there were in Q3 and Q4 2007.

Our intention with the Army's concurrence is to stretch out the current ESAPI contract through Q3 2008, with the anticipation that a new contract for XSAPI will be in place by the Q4 2008. Although we anticipate additional ESAPI sustainment orders, as well as other body armor orders, the net result will be a reduction in 2008's body armor shipments of approximately $80 million from the amount that was included in our initial 2008 guidance.

To rationalize our armor-related costs, we are reducing our workforce by approximately 234 employees, and reducing certain other body armor variable costs. Over 50% of these reductions will be temporary workers, and the balance will be mostly hourly workers hired in the past 12 months. We have also informed the Army that we can return to our former level of production, if required, within 60 days.

Due to projected offsetting 2008 increases in solar ceramic crucibles and other non-defense business, the net estimated reduction in our initial 2008 revenue guidance is $65 million.

After the award of the $18.1 million prototype BULL contract (MRAP II) to Ceradyne and its partners, Oshkosh Truck, and Ideal Innovations on December 19, 2007 we and our partners were able to obtain substantially better pricing on materials and subcomponents which we have passed on to the government, making us much more competitive, but resulting in lower potential revenue from this program. This reduction in revenue was also reflected in the revised 2008 guidance which follows.

Due to the potential magnitude of the BULL combat vehicle program, as well as the five-year XSAPI/ESAPI proposal, neither of which has been awarded, we are providing the following revised guidance with an unusually wide range. The lower range reflects all of our current business units, even though multi-year XSAPI/ESAPI orders will not be issued before Q3 2008, but does not include any production orders for the BULL combat vehicle. The higher-end of the range includes the lower-end, plus production of the BULL combat vehicle in the second half of 2008.

Based on the foregoing factors, our revised 2008 guidance is a sales range of $715 million to $836 million, with an earnings range of $4.55 to $5.05 per fully-diluted-shares.

I went on to comment that we continue to pursue our growth strategy of internal expansion of our manufacturing capacity as well as selected strategic acquisitions. Our strong position of cash and marketable securities at year-end should enable us to act quickly as opportunities present themselves. Our goal continues to be revenues in excess of $1 billion by 2010, evenly distributed between defense and non-defense markets, with an international and product diversification focus. A few selected recent activities follow.

Solar Energy Ceramic Crucibles: We have selected an approximately 12-acre site near our current plant in Tianjin, China, and plan to construct 200,000 square feet of additional manufacturing capacity to meet the increasing demand for ceramic crucibles to produce polycrystalline photovoltaic silicon for solar panels. Our plan is to have this factory running towards the end of 2008.

Additionally, we are expanding our ceramic crucible manufacturing capacity at our factories near Atlanta, Georgia. We believe our shipments of these solar-related products will increase from $11 million in 2007, to an estimated $50 million, to $60 million this year in 2008, and to well over $100 million in 2009. Our 2007 acquisition of our raw material supplier Minco will provide us a reliable source of high purity raw materials to support this expansion.

Next comment was on ESK Ceramics, in Kempten, Germany. During the first half of 2008, we will complete about $20 million of the capital expenditures for the expansion of manufacturing capacity at our ESK Ceramics subsidiary in Kempten, Germany. The products are principally boron nitride powders for cosmetic applications as well as powders and components for metallurgy and thermal management.

The second product expansion is primarily silicon carbide industrial seal and bearing components. The total additional capacity for these growth markets is $25 million per year.

The next item was the BULL Combat Vehicle. Team BULL, which is Ceradyne, Inc., Oshkosh Truck, and Ideal Innovations, shipped its first BULL, also called them MRAP II, vehicles earlier this month and plans to complete the six prototypes on time. We believe the testing is progressing smoothly, with excellent performances.

We anticipate a production decision by the government early in the second quarter of 2008. Ultimately, the production decision will rely, not only on our performance, but also on the government's perception of the need in the field for this advanced state-of-the-art combat vehicle and our BULL product-offering compared to the competitive environment.

Acquisitions: The 2007 acquisitions of Ceradyne Boron Products, formerly EaglePicher Boron, and Minco have been successfully integrated into Ceradyne's other operations and are performing at or above our expectations.

We continue to explore strategic acquisition opportunities in both defense-related and industrial applications, and we expect additional acquisitions to be made this year.

The balance of the release involved the announcement of this conference call as well as description of Ceradyne and additional Safe Harbor language.

Also included, as I mentioned earlier, was the income statement for the quarter and the year, as well as the balance sheet as of year-end.

Before we go into Q&A, I will turn it over Jerry Pellizzon, our Chief Financial Officer who may want to make some comments on the balance sheet items, income statements, and our cash flow as it looks for the rest of the year. Jerry?

Jerry Pellizzon

Thank you, Joel, and good morning, everyone. Free cash flow, as we redefine as net income plus depreciation; amortization less capital expenditures; and including the impact of working capital during the quarter-ended December 31, 2007 was $50,848,000, compared to $11,800,000 in '06.

Year-to-date, we produced a $111 million of free cash flow versus $103 million the year before, and it's interesting to note that we're projecting that we will match that free cash flow in 2008, despite reduced earnings.

Our EBITDA for the quarter was $63 million, compared to the same number in '06. Year-to-date; we produced $257 million of EBITDA compared to $217 million in the year before.

Depreciation amounted to $26.7 million in '07 compared to $18 million in '08. Our CapEx for the year was $42 million and in '06 it was $36 million, and we're planning about $49 million of CapEx in 2008.

Our DSOs for the year-end were 39 days day sales upstanding versus 66 in the year prior to that. Joe?

Joel Moskowitz

Thanks Jerry. I think that the most efficient way to proceed since I'm sure there is a lot of interest in not only what we're doing, but our projections for the rest of the year and some other exciting things that are happening. The best way is just to go into Q-&-A mode. Dennis?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question will come from the line of Pierre Maccagno with Needham.

Pierre Maccagno - Needham & Company

Hi, Joel and Jerry.

Joel Moskowitz

Good morning Pierre.

Pierre Maccagno - Needham & Company

So regarding the BULL, if could you explain why your decision to pass along the savings to the government which translates into lower revenues and so based on that, what is the build in the ASPs that you're assuming and your margins remained the same?

Joel Moskowitz

Yeah, I'll let Dave fill that question. The question Dave was, why do we pass on the savings directly to the government that we got, when we got all these revised bids on the BULL that supplies materials and subcomponents?

David Reed

Here we felt that in the first round when we bid the program, there was a lot of uncertainty in the actual pricing of that material. As you know much of that material is on the DX rated contracts. So on the original bids we were not able to secure conformations that we could get the lowest possible pricing and as we moved into the second phase of the program, we found out that those programs would be the DX rated that we would be able to get that favorable pricing. And because of that we pass that savings on to make our program the most competitive, it could be against the rival and MRAP II vehicles were playing against.

Pierre Maccagno - Needham & Company

So you are now more competitive than anybody else you would say?

David Reed

I think we're extremely competitive, I don't know all those numbers, it's impossible to know that right now here. But I think the vehicle we've offered to the government is an outstanding performing vehicle and I think the price is not one that will make them hesitate to purchase the vehicle.

Pierre Maccagno - Needham & Company

So the ASP now, I guess the last time you said it was about $0.5 million per vehicle, and so what are you assuming now, half of that, more or less?

Joel Moskowitz

We didn't say that, last time I think someone on the phone had suggested the MRAP I were about $0.5 million, but we're right in the process peer of working on this ever changing landscape. I would be very uncomfortable in throwing out actual price units. I think that's sufficient to say that I support Dave in what he said. We passed these numbers along. It didn't really affect the margins all that much and they put us right we think in the driver seat subject to the different conditions that we've outlined in our press release.

Pierre Maccagno - Needham & Company

Would your margins be the same versus what you had before, your assumption as before?

Joel Moskowitz

They'll be a little bit less but not much.

Pierre Maccagno - Needham & Company

Okay. And the number of vehicles?

Joel Moskowitz

Well, we don't know. We've gotten some input but it's not worth even speculating about it. In our numbers that you see, we've estimated in '08 we could ship about 300 vehicles. That's where that number comes from the Delta from no BULL to BULL.

Pierre Maccagno - Needham & Company

So that hasn't changed basically in your assumptions?

Joel Moskowitz

Well, we are. We registered a bit because it looks like instead of March, this could easily be a June or so decision making.

Pierre Maccagno - Needham & Company

Okay. And then regarding the body armor, the reason for the push back or that the government is taking so long, do you have any idea?

David Reed

Well, the last time we spoke Pierre, we were supposed to have submitted the bids on December 8th; they pushed that back to February 8th. All of the bids have been submitted by us and the competition and now the government has just begun testing those inserts.

So with that push back, they moved their award dates back considerably mainly because they have many variants that have come in from us and from the various other competitors. And they're going to have to shoot that entire product to do the final valuation and ranking of all of those inserts, both hard armor and flexible armor. So they have given themselves some cushion. We're hopeful that they will move through that quickly. We've lobbied extensively with the government and with the army to make sure that they keep that evaluation going as fast as possible.

Pierre Maccagno - Needham & Company

But your sense of their commitment to transition to XSAPI seems to be the same growth?

David Reed

As far as I can tell, yes, the army has said that they have seen the threat; I think most people know that that threat is already a friendly fire issue. The US Army uses that new threat in some of our automatic weapons. So it's definitely in the field by us. So there's a friendly fire issue. And also we believe that there are some incidences in the field now that we have seen that are used by the opposition. So I believe based on our conversations with the government that they have every intention to move to a higher level of protection for the soldiers in the theater.

Pierre Maccagno - Needham & Company

Then lastly this four months gap, there's going to be the three months of the third quarter going on to the first month of the fourth quarter, is that right? And then what gross margins would you be expecting in, I mean, to grow to in the third quarter?

David Reed

Well, our original ESAPI contract ran out at the end of May and we have stretched that out with the army now, so that it will run through the end of September. We expect that they will make awards in August or early September for deliver in October. As you heard in the press release, we have made some reductions across the Board and personnel and we expect that our margins will hold up pretty well with that. That can't be exactly the same because you're not spreading the fixed cost over the same amount of product but overall we won't be too much different for you.

Pierre Maccagno - Needham & Company

So this gap in four months would be what September, October, November, December?

David Reed

No, the gap would have been, if we had not stretched our schedule at the end of May we would've completed all of our ESAPI production and then in June, July, August and September we would not have had any ESAPI to produce and deliver to the army. And so we've spread out our existing order over instead of five months this year, nine months this year, so that we have a level run of production in our hot pressing and body armor assembly areas.

Pierre Maccagno - Needham & Company

Oh, I see, okay, I understand. Okay. Thank you very much.

Joel Moskowitz

Thank you, Pierre.

Operator

Your next question will come from the line of Al Kaschalk with Wedbush Morgan.

Al Kaschalk - Wedbush Morgan

Good morning, guys.

Joel Moskowitz

Hi, Al.

Al Kaschalk - Wedbush Morgan

Just a follow-up on the body armor production. Does that mean you may take one of the lines down, or is it just really like you said reducing the output from each of the line by keeping them all running somewhat efficiently I guess?

David Reed

Well, we still have very strong business on our side plate programs with the army and most of those products are made in Costa Mesa. So the Cost Mesa hot pressed facility will be running pretty close to full capacity throughout that time period and most of the reduction is in our chest protector business which is done primarily in our Lexington, Kentucky facility.

Also there we will not be shutting down any line but will be slowed down by about a third on all three of those lines. We don't want to ramp down anything because then you will have equipment that's not being utilized day-in and day-out and recovering that to full capacity is a little more difficult than when you cycle it every day, every week.

Al Kaschalk - Wedbush Morgan

Right. In addition then to the testing, what are the data points or maybe said differently, what is the information flow that the company can expect and therefore we should as to either the ramp up or the awarding of this, because it's possible that through stretching in the south four additional months that in 2009 we may have further cut in the level?

David Reed

I am not sure I understand that comment a further cut in the level out.

Al Kaschalk - Wedbush Morgan

Well, in terms of production rates and then how much you're going to be producing, I mean I guess you need another contract right at some point in second half of this year?

David Reed

Yeah, as I said earlier the government has indicated that they expect to make awards in the August to September time period, so they have given themselves many, many months to test these inserts. I don't anticipate they will need anymore time, that's probably the longest review period the army has ever had for a program of this magnitude.

So they should be able to get through that cycle and it's possible they could even complete it sooner than that. It just depends on how the testing goes at the lab, but we expect that those awards will be made and they've indicated deliveries to start in October of this year.

Al Kaschalk - Wedbush Morgan

All right. Just a little maintenance on the guidance for '08, Jerry. Do you have any charges in there or included in there for some of these cost reduction programs or efforts in terms of employees or are those going to be called out separately in the guidance?

Jerry Pellizzon

No, we reflect what we anticipate will happen. There are some cost savings programs that we put through in '08 versus '07. We had a logistics savings program on our freight that was credited towards '08 and recognized in the guidance. So we have our programs in there. We have all our costs of severance, etcetera, etcetera. So I think everything as much as possible is according to GAAP and fully loaded.

Al Kaschalk - Wedbush Morgan

And then Joel, maybe just a bigger picture question in terms of the direction here on the BULL. If I look at the revised guidance, it looks like it's down basically $0.55 to a $1.05. But I think I heard you indicate that there it still remains on the high end of the range, a little bit of the BULL end there. So what's giving you confidence either the June or some time in '08 the company could receive a production order or why wouldn't you just take out the BULL guidance and let us (inaudible)?

Joel Moskowitz

What we have is no BULL guidance on the low end of the range, there is not one vehicle in there.

Al Kaschalk - Wedbush Morgan

All right.

Joel Moskowitz

And on the high end of that range as I said there's about 300 vehicles laid in '08.

Jerry Pellizzon

So Al, the difference between $5.05 and $4.55.

Al Kaschalk - Wedbush Morgan

Yes.

Jerry Pellizzon

That $0.50 there is the impact of the Bull itself all alone.

Al Kaschalk - Wedbush Morgan

Okay, all right. Little bit more constructive then on the new businesses or the new opportunities excluding solar discussion. What's going to help or drive the top line or perhaps where you're focusing some of your growth dollars in?

Joel Moskowitz

Sure. I'm glad you asked that question because obviously we are sticking to our netting so to speak on the movement to non-defense as well as some defense areas. The solar even though you wanted not to talk about it, I do want to mention that every time we get additional projections from our Atlanta operations, they are going up. And the actual number we have in our plan which is now moving up was $53 million. And when I asked the other day how much of that is booked or committed based on specific customers, it was 48. So in other words, we have something like 9% somewhat.

So we're pretty optimistic on solar because the polycrystalline materials are really one of the processes which are here and now and fairly mature and a lot of expansion. We're looking at 35% growth a year and as I said recently to our own staff, the sun isn't going out any time soon and so that we have a very long viewpoint. In the other areas that I talked about before, I have mentioned ESK because we are out of capacity now on the cosmetic boron nitride. We're expanding that and I mentioned the seals of which we put out. We've got some of the largest orders for ESK, they ever got from their two largest customers in Europe for the seals silicon carbide.

And for some of the more future where in the past I said there are really two product lines that could end up bringing a $1 billion worth of revenues to Ceradyne, one is the combat vehicles and I think where we are, I think we discussed that earlier and the other is a major revision to the methodology of smelting aluminum that would use our advanced non-oxide materials made in Germany, that's progressing out. I know that it is, as recently for example in January we've got 12 on order for 12 tons of aluminum related ceramics.

I don't know any other products that they ordered by the ton, except maybe the boron nitride for cosmetics and that's small quantities. Now we are involved with almost every major aluminum company in the world. There were meetings, extensive meetings in Europe as recently as this month in France and Germany and I continue to believe that is one of the future opportunities of Ceradyne. We are investigating and planning. You'll see no impact in '08, well a little bit, I just told you, we got 12 tones.

But I think in '09 you'll begin to see product moving for what is called a drain cathode and then there will be other products at the end of '09 and into 2010. We're seriously considering expanding our operations away from Germany, perhaps in the manufacturing of titanium diboride and all the other areas that we are working on an alternative energy continued to increase, albeit at smaller absolute dollars than the defense products but with good margins and very long upside.

One of the areas that you and I have talked about that I want to reiterate is what they call unconventional oil which means the high viscosity oil trap and the oil sands and tar shales in Canada and Colorado where I've said repeatedly a decision would be made about that next year. We still believe that and we are going to play a very important role in that. So the company continues to move in the same areas that are discussed. One thing that we discussed internally so you'll have a little bit of flavor from management is a reduction of $80 million in defense two years ago would have been much more serious.

We take it very serious and we are moving very quickly. As of this morning, we began the reductions in force that will be completed in the next 44 hours. And well it should all be taken in the context of the total company that the non-defense area, the non-body armor area has grown and will continue to grow and we're going to be very focused on that. We're looking at some acquisitions in '08 that I am comfortable and discussing, they are still in various stages of discussions, two of them are non-defense and one is in the defense area.

Al Kaschalk - Wedbush Morgan

Based on the rough numbers, it looks like with an $80 million reduction that you finally broke the need to 60% barrier on the sales line, so the trend is continuing to go more favorable to diversified?

Joel Moskowitz

I haven't actually calculated that number, but the trend is getting to, Jerry you said it was.

Jerry Pellizzon

62%.

Joel Moskowitz

Okay. So it will continue to move that way. I can't name another product, it's going to go from $11 million to $50 million to a $100 million in the solar sales that we're very comfortable on. We know how to make this. I've repeated it, I'd say it again I believe we have the best quality in the world because we've a secret in obtaining the purities because we use our aerospace and missile technology as it relates to radomes to make these high purity fused silica ceramic crucibles to melt silicon and because you get very low or no impurities into the silicon, you get what's a very high efficiency in converting sunlight to electricity.

Al Kaschalk - Wedbush Morgan

Thanks. And one final thing again Jerry thanks for filing the K along with your earnings release. I know that's a lot of effort. I appreciate it.

Jerry Pellizzon

You're welcome.

Joel Moskowitz

Yeah. We may let him go to sleep sometime in the next week or two, Al.

Operator

Our next question will come from the line of Josephine Millward with Stanford Group.

Josephine Millward - Stanford Group

Hi, good morning.

Joel Moskowitz

Hi, Josephine.

Jerry Pellizzon

Good morning, Josephine.

Josephine Millward - Stanford Group

Good morning. In your guidance reduction for this four month ESAPI delivery gap, are you assuming 19,000 sets per month or is it 20,000 to 23,000 sets that you're currently shipping?

David Reed

Josephine, what we were referring to was the order from the army was for 19,000 sets and we spread those five months of 19,000 over the nine-month time period. We do have other ESAPI orders. We continue to produce some of the replacement ESAPI products for the Defense Supply Center Philadelphia. We also have some orders from the Marines that continue.

So we do have other products that we're making there on the lines, plus we have a continued body armor insert business from the special Ops guys.

Josephine Millward - Stanford Group

Right.

David Reed

And they are still putting a handle on what they're going to order for the year. So there is a little potential there to fill in some of this shortfall.

Jerry Pellizzon

Josephine, what we have in terms of the non-army ESAPI, the other ESAPI that Dave alluded to. I'll just quantify it; it's about $50 million of business this year.

Josephine Millward - Stanford Group

Okay.

Jerry Pellizzon

That doesn't include the side plate, the ESPI plates.

Josephine Millward - Stanford Group

Okay. So non-army ESAPI business is about $50 million for the year?

Jerry Pellizzon

The non-army that's right.

Josephine Millward - Stanford Group

In your $80 million reduction, are you including additional sustainment orders? It's my understanding that the army is skewing the process of evaluating how much sustainment they need for ESAPI post-May. So have you included any thing and if you can talk about your assumptions?

David Reed

That is in the number that Jerry just stated. We do have sustainment. So far the army has looked at that getting sustainment through DSCP, not on their own.

Josephine Millward - Stanford Group

Right. So how much sustainment have you included in the $80 million reduction because it looks like you are taking out four months for 19,000 sets, I don't see any replacement in there?

David Reed

Well, the DSCP that we can get, we've already gotten one order roughly equal to a month where we got about 15,000 sets of DSCP and it looks like we'll probably get maybe up to 30 million total from them.

Josephine Millward - Stanford Group

Okay. But so you haven't included any of that?

David Reed

No, that is in the number.

Joel Moskowitz

Remember I just said, this is Joel, the $80 million is the reduction from our prior guidance.

Josephine Millward - Stanford Group

Right.

Joel Moskowitz

So there was some DSCP orders in that, you are correct in that. We do know Philadelphia is discussing increasing some of their requirements, but we don't feel comfortable enough to put it in right now. We're going to work redouble our efforts of course to get them to increase it but I think it's reasonable because the 80 becomes 65 when we added some other non-defense things in there.

Josephine Millward - Stanford Group

Okay. I understand.

Joel Moskowitz

But there was some statement in the original October 30 guidance.

Josephine Millward - Stanford Group

Could you tell me how much sustainment you included in your guidance? I am just trying to; it seems to me that you might be a little conservative.

Joel Moskowitz

Yeah, we might be, and I think the best thing to do unless you guys have the numbers in front of you is why don't you call Jerry offline.

Josephine Millward - Stanford Group

Okay.

Joel Moskowitz

And he'll have to dig out all the back up to the last guidance.

Josephine Millward - Stanford Group

Okay. No problem. My next question is related to MRAP. Other than passing on cost savings to the government, it looks like you have also lowered your assumption in terms of number of units you can produce. I believe on the last call, you talked about maybe 500 to 600 units. Did something happen to change your outlook in terms of the maximum number you can produce? Or is it just indications from the government that they may not make a decision until later on this year?

David Reed

I think the only thing that's going on there just being is that when we made the original forecast, we had thought the program might start a little earlier than we now think it will. As Joel said, we expect them to make an order some time early in the second quarter, that's when they would look to place an order and with the ramp up schedule we have given them that probably pushes us a couple of months out from what we thought we were going to do before and that gives us less vehicles that are producible in 2008 versus the original guidance that we had Josephine.

Josephine Millward - Stanford Group

Okay. So at this point if you were to receive an order say at the end of March, you think the maximum number of vehicles that you can produce is about 300 units?

David Reed

Yeah, a bit over 300 units and most of that has to do with just getting into the DX rated queue to get the types of materials streaming into the battery that we would need to ramp up.

Josephine Millward - Stanford Group

Okay. And can you give us an update on LTAS in light of your recent order from Oshkosh?

David Reed

Yeah, we feel really good about LTAS Josephine. We have gotten a letter from the army telling us that our system is accepted by them for a threshold LTAS. We've now started to share that information with all of our customers that resulted in an initial order from Oshkosh as we announced to make a prototype cap for them and we really think that that positions us, we may be the only other option they have other than aluminum metal to build out these vehicles that the army and marines are going to be looking for over the next five years.

I think you've seen some of those recent announcements that they’ve asked for numbers by early this summer from both the army and the marines to add into their palm so that they can figure out how many exact vehicles they require "A" kit, "B" kit strategy on and we think we can offer all of those OEMs up to a 35% to 40% freight savings over the existing solutions they had to work with. So I think we've got a step up on most of our competitors there and we're really anxious to move ahead on those programs that they come through later this year and into '09.

Josephine Millward - Stanford Group

Are you still expecting about $10 million to $20 million from LTAS this year from OEMs? Or can you give us an estimate of what your expectations are for '08 and possibly '09? I don’t know if you've got any results from, you talked about doing a study with a Washington consultant on LTAS potential; I don't know if you have an update for us on that?

David Reed

We don't have any high numbers in there for LTAS this year. We expect that activity will start in '09. We expect to complete several reiterations of prototypes throughout the year that will probably be less than $5 million in total business when it's all said and done. But the upside for the fleet, the army is talking about up to 40,000 vehicles over the next five years and their own internal estimate is that's about $2 billion worth of add-on armor in the "A" and "B" Kit. So it's a very large market that we're playing in and we believe we have some exceptional products to help them reduce the load on there drive trains.

Josephine Millward - Stanford Group

Okay. So you said that army's estimate...

Joel Moskowitz

And Josephine, this is Joel. You'd ask about the study that we've commissioned.

Josephine Millward - Stanford Group

Right.

Joel Moskowitz

We don't have the results on that yet. There is a big meeting here in California. I think March 9th Dave?

David Reed

Yes.

Joel Moskowitz

And the Washington Group that's doing the study will present their initial findings.

Josephine Millward - Stanford Group

Okay. So, going back to what you were saying the army's estimate of LTAS is up to $2 billion over the five years, did I hear you right?

David Reed

Yes, that's their estimate of up to 40,000 vehicles required by the army alone. And they are estimating the costs could be between $25,000 to $50,000 per vehicle for these "A" kit, "B" kit add-ons.

Josephine Millward - Stanford Group

The question for you on the order from Oshkosh, is there a reason why it was just a "B" Kit because I thought the OEMs are integrating the "A" kit and the "B" kit was optional? And when do you expect to have, I guess what's the next step with Oshkosh, will you make more prototypes, or are you expecting some sort of production order in the near future?

David Reed

That order is actually for the HEMTT, the A3 that's the all composite version. So it is a "B" kit, they are interested to outfit this first one and then drive the vehicle around, see what impact if any it has on the composite cab and then I am sure there'll be some design issues that we will have to deal with later in the year. And so it will be a typical prototype and development effort for them and then now have that option to offer to the government.

Josephine Millward - Stanford Group

Okay. But what about the "A" kit, are they evaluating "A" kits as well?

David Reed

We have given them some solutions on "A" kit, the "A" kit portion is typically not the driver in the dollars, it's typically just some installed firewall in your feet area of the vehicle and may be a couple segments in the pillars and so it's not a big driver for the total dollar value, the "B" kit is what attaches on to the outside of the vehicle and provides all of the coverage side front, back, top. So that's where the real dollars are and that's what we are focusing on.

Operator

Your next question will come from the line of Gary Liebowitz with Wachovia.

Gary Liebowitz - Wachovia

Good morning, gentlemen.

Joel Moskowitz

Good morning, Gary.

Gary Liebowitz - Wachovia

Jerry and Joel, I am just trying to get my hands around the guidance, if I look at the low end of the EPS and the revenue ranges for 2008, by my math it suggested about 28% pre-tax margin for the full year, that's what you did in the second half of '07. But it seems like going into '08 you have the major headwind of your most profitable business being somewhat down, what is working to offset that?

Joel Moskowitz

We've had some cost savings in various programs, but really it's the expansion of the crucible business that's helping that out and we are also implementing cost saving programs here in Costa Mesa and (inaudible) armor programs to drive that margin up, even though we believe in the back half of the year it's little to slightly lower, but the headwind is, general improvement in our industrial business and also included in that is the Solar Energy business, photovoltaic cells, the crucibles that we anticipate will have higher margins in '08 as opposed to '07.

To give you some color on that, Gary, we are expanding our facilities in China for the production of crucibles. We are building, we are in the process now, we are organizing the development and building of a 200,000 square foot facility in near Tianjin to provide additional production capacity to meet the further growing demand in that business.

Gary Liebowitz - Wachovia

Okay. And also can you talk about what happened in the Canadian subsidiary in the quarter, it looks like the loss was somewhat worsened. I know you have been thinking that would be break-even by year end, but it just seems like the ramp up there is not going as planned.

Joel Moskowitz

Yeah, I think that's a correct observation. It was a small operation. We expected it to do better as we came to the year end and the business and the shipment levels just have not materialized. Also the projections are quite strong in '09. We have a significant facility there and we have two new development areas, one is a product called BORTEC and the other of course is implementing the enriched boron from our Eagle Picher operation. But we are concerned about it, the key thing in looking at it is it small and we can control that operation. That's under Michael Kraft. Michael, do you want to have any input on that?

Michael Kraft

Well, yeah, just a little bit to add to that Joel. We had a change in material that we used to produce the heats and so we've had a little bit of a delay in that change. Everything else is going according to plan. We're going to have record this year in the shipment of our BORAL product line which is the first product line and primary material that we ship out of that factory, as well as I am scheduled to put our new rolling mill up in (inaudible) and that's planned for Q2. So everything is being built out and we look for a really strong year in '09.

Joel Moskowitz

The rolling mill that Michael just talked about, that's the state-of-the-art that will probably be one of the few of only, the only one in that area, the world of that magnitude and they saw a lot of interest and that really expands our capabilities. But we will watch it, we've gone to -- I personally have visited with our major customer in Paris and nukes are in and they are going to create a lot of waste products and we got to make sure that we're there. The product coming out of legal picture is probably the best in the world. It's on the pricey side, so we have to look to areas where they are worried about physical size, but your observation is correct we're go to be watching that very carefully.

Gary Liebowitz - Wachovia

But also Jerry on capital spending, I guess you had some issues with permitting an ESK in the prior quarter, sounds like those have been resolved?

Jerry Pellizzon

No, I don't recall that. Right now, we're making an acquisition of some property contiguous to that plant. For the year we're going to spend about $49 million, $50 million in CapEx. That includes our expansion at the ESK and our expansion in China. As I've mentioned before that we're very, very excited about. But everything is on par now. I don't recall any permit issues right now.

Joel Moskowitz

What we're referring to is (inaudible) 22-acre site we have there, 530,000 square feet of manufacturing. They were looking to sell some buildings as well as some undeveloped land and we wanted to buy it, so that we wouldn't be landlocked. And I think that's what you're referring to. We had to get the okay of some of the surrounding neighbors and that sort of thing. That's all on stream, in fact the deal may be done, I'm really not sure of that.

David Reed

But Joel, we're going to fund that probably within two weeks.

Joel Moskowitz

Okay. So you can consider it effectively done. But even when we buy that additional property there is nothing immediate that will change.

Operator

Your next question will come from the line of Jason Simon with JMP Securities.

Jason Simon - JMP Securities

Good morning guys.

Joel Moskowitz

Good morning, Jason.

Jason Simon - JMP Securities

The question would be about the MRAP II program and what you believe the potential size of the upcoming order would be not for yourselves but for the total order for the market?

David Reed

We've heard up to maybe 3,000 vehicles, but again as Joel said earlier Jason we don't really know, that's currently in review by both the army and the marines for how many of the MRAP I are going to settle in on and what if anything they're going to do with the MRAP II.

Like I said earlier, we believe it's the superior vehicle, it's on the best available chassis it's got a great drive. We had great reviews for our category two BULL, that was out at the Winter Rodeo in Reno. And we had over 200 soldiers ride through that vehicle out on a tough course and they all said it's the best riding MRAP they've ever sat in. So we felt pretty good about that.

Jason Simon - JMP Securities

Good. And I guess how many vehicles or companies have been down selected for the upcoming program?

Joel Moskowitz

Well, right now I'll answer that. As you know they have given two orders to BAE and to team BULL of which we are part of and those are the two that we're focused on. However, the government has also said that anyone who had an MRAP I could be a competitor, could compete if they had a solution and the solution would be under their engineering changed plan, ECP where they might be able to take it for additional armor on.

So it's a little bit cloudy, the competitor field. We look at it; we're competing against everyone even though BAE has got to be considered the leading competitor. I also agree with Dave Reed, I am surely not an expert on the vehicles and we don't have written reports still in the bidding and negotiating stage. But I can tell you that I am very enthused about it, included in this were 200 soldiers that went through the vehicle that was brigadier, general who also gave it a lot of praise.

The reason we have the comment in our press release is that the final decision will probably be based on the real perception of the need both in Iraq and Afghanistan, as well as where we stand competitively. I think it is more than a reasonable expectation if they buy an MRAP II that we have a good shot of getting a fair share of that, if not all of it.

I based that on some of the comments David has made, as far as I know we are the only ones with independent suspension which means high off road capabilities in places like Afghanistan, to be on road is just to be off road.

David Reed

Hey Jason that 10 manned vehicle that we demoed for everybody that they rode around in.

Jason Simon - JMP Securities

Yes.

David Reed

That's the vehicle that the government blew up with the massive underbelly blast. We put it back on the road for less than $70,000 with repair works. So I don't think anybody else in the field could ever make our comment about their MRAP like that.

Jason Simon - JMP Securities

So obviously the quality performance really compares (inaudible) against MRAP I. Dave, is there a situation where they would look at the MRAP II as not being cost competitive to the MRAP I, is that they won't even take that into consideration?

David Reed

I don't think so. I think we are right in there. I really do, I think that's the price we have got out there depending which MRAP I, you want to look at put us within the competitive field. So I think we are in good shape.

Jason Simon - JMP Securities

Okay. And I guess just back on the XSAPI program, the five year ID/IQ calls for $250 million run rate a year, that's kind of where you are, I think of the 19,000 set run rate I guess for the ESAPI program. What should we assume that in 2009 you're be going to be getting back to those types of numbers, the 19,000 set per month number?

David Reed

Can't make that call yet. We don't know exactly what kind of a roll-out the government's going to pursue over that five year period. If they run at a high rate like they have been, they could fill up that whole thing in three years. So we think that it may be at a slightly lower level than that in total between all the competitors. So we'll just have to keep an eye on that and then update you a little bit later in the year on that Jason.

Jason Simon - JMP Securities

Thanks very much guys.

Joel Moskowitz

Okay, Jason. We're going to take two more calls, Dennis.

Operator

Thank you. Your next question will come from the line of Michael French with Morgan Joseph.

Michael French - Morgan Joseph

Good morning Joel, Dave and Jerry.

Joel Moskowitz

Hi, Michael.

Michael French - Morgan Joseph

The first question is potential use of cash, what do you have to say about purchasing stocks and particularly at these levels Ceradyne has resources that it could be in?

Joel Moskowitz

Well I've said on the last call that we would consider it and that's where we stand. We will seriously consider purchasing stock and the real criteria is going to be these acquisitions that we're looking at and of course the price of the stock which is now lower than it was when we talked about this on October 30th. We're considering it, we can do it, you're right we have the resources to do it and we might do it. We would be probably hesitating if we felt that within the next few months we might need that cash to do an acquisition, we certainly won't borrow to buy stock back.

Michael French - Morgan Joseph

Okay. And other question on the guidance and following up from the last question about the XSAPI run rate, so what is the guidance assumed in terms of historic that you have three, four months of XSAPI production in the October, November, December?

Joel Moskowitz

Yeah, the guidance assumes that we're going to be running for those three months at about, I think we put in 12,000 sets, 11,000 to 12,000 sets.

Michael French - Morgan Joseph

That's correct. And finally on the LTAS, should we start thinking about seeing news from other OEMs like Oshkosh, any time soon or do you think they're waiting to see how this works out for Oshkosh before we see commitments from some of other vendors?

Joel Moskowitz

Well, I think there's plenty of opportunity there for us. As I said earlier, there's going to be somewhere between 30,000 or 40,000 vehicles requiring this level for greater armor in the next five years. So we're a little bit closer to Oshkosh obviously because of some of the BULL activity and because of some of our earlier work on giving them some cab prototype.

So that's the first area we're going to work with. But we'll continue to work with all the other guys. We've presented the same solution to AM General. As you know, they are buying products from us now for the existing HUMVEEs. They may be in place on some of their work to substitute this material in order to save them a little bit away.

Michael French - Morgan Joseph

You're right. What kind of a response are you getting?

Joel Moskowitz

They liked the weight savings; they think it's a great. But until we got their certification letter it was all meaningless because they weren't allowed to use it. The army said on LTAS, you got to have a letter from us that says this is an acceptable armor and up until four weeks ago we didn't have there letter. We got the letter now.

Operator

And this morning's final question will come from the line of Ferat Ongoren with Citigroup.

Ferat Ongoren - Citigroup

Hi, a quick one for Jerry. Jerry, if you go back and look at the 10-K, you mentioned the auction rate north of $38 million, how should we think about those?

Jerry Pellizzon

Well, we have a portfolio including the auction rates of $225 million at the end of the year. We took the permanent impairment on part of that portfolio. We have brought some issues with the investment firm that was managing those securities with us and the fact that they didn't follow our investment policy. So it's something that we are pursuing and there was only $41 million originally of a $220 million portfolio and unfortunately it is what it is and the credit markets are in a state of disarray as you are well aware.

Ferat Ongoren - Citigroup

Sure. Are you comfortable with the rest of the portfolio?

Jerry Pellizzon

For us, that's difficult to say, there are developments every day that can swing that. Our portfolio was structured by MBIA and to the extent that they can get additional financing and shore up their balance sheet and keep their ability to rate on an AAA basis then I think we're going to come out of this fine and I think the market in my opinion will eventually come back. But it is a state of disarray; they never had failed auctions in 20 years and suddenly they are failing all over the place including municipal.

So it only $40 million, I think it's rather in the scope of our balance sheet, it's rather immaterial. We've held a $150 million to $220 million of cash on our balance sheet throughout '07 and we're producing about $10 million of cash flow per month and we anticipate that without the impact of acquisitions that we're probably going to have about $330 million of cash in our balance sheet from the end of 2008.

Ferat Ongoren - Citigroup

That was a second question. I mean I would have thought that you may have given the working capital liquidation that is going to happen next year, given the [lower deliver] rate, the working capital would have been bigger plus than what the guidance implies. Is there some R&D capitalization or other types of capitalization going on relating to MRAP program?

Jerry Pellizzon

No, I think on a working capital front, I think we just as we usually do, we are pretty conservative. I think there is upside to that number, but we have to manage our inventories to slightly lower level of business. We are building up some inventories. We will be for the BULL pending that order and we will be developing facilities for the BULL to further that program and create capacity, but I think we are just being conservative with that right now

Ferat Ongoren - Citigroup

Okay. And then along the final question for Joel. Joel, you are talking about the potential opportunities in commercial, but if I'd said the bigger pieces of the commercial business, now the largest business you have is ESK, pre-tax profit was down more than 20%, cam roller business facing headwinds. Genaware is losing more money. I mean are you getting to the point where you have 10, 15 of these projects and just getting very difficult to manage them?

Joel Moskowitz

I think that your observations have merit. The cam followers have been an issue for it's actually getting better on cam followers and Dave has, we have brought in this Vice President Ken Morris who has restructured our advanced ceramic operations here on the West Coast and I actually feel more comfortable about some of these plans.

The Canadian operation as we discussed earlier is doing less than what we thought it would do. We are a quarter or two behind in getting this $2.5 million rolling mill there and the jury is out on that in the short run but it's really a small part of the total business. As far as ESK, their margins in some of their product areas are actually increasing such as their surface engineering and some of the areas are quite competitive and we are taking a hard look at that. I think that the changes we have made, remember we've made some significant management changes.

The ESK has a new CEO for the first time ever since Ceradyne brought it. Thomas Juengling who is really one of our bright stars, we spent the last two years in the States. I spoke with him as recently as yesterday and he is quite on top of everything there, including the opportunity to expand. I think that we're going to have to have a little patience and watch the profit margins go up over there.

They should because they are going to have additional volume. They also remember we will have some reductions because they supply us the boron carbide for the armor and Thomas is moving right on top of that. As of next week they will have reduced their force related to that primarily through some temps that they had there. So we have made changes in the management. We brought in Ken out here. We put Thomas Juengling back there and all of these are in a positive mode. The kind of looking at it as you have mentioned, I think that you are looking at it the right way. We would like to see those margins go up as the volume goes up and we're going to work real hard on that and you'll just have to see if we perform.

Ferat Ongoren - Citigroup

Okay, thank you.

Joel Moskowitz

Okay. Dennis, that should be it.

Operator

Okay. Gentlemen, do have any closing comments?

Joel Moskowitz

Yeah, I do. I appreciate most of the people who have asked questions were analysts who have been following the company and have a very in depth knowledge of a lot of Ceradyne activities, particularly as they relate to armor. And one of the analysts, I think it was Al who brought up the fact that we keep increasing our percentage of non-defense business. And remember as important as defense is and I've said there were $2 billion opportunities. And that is combat vehicles and aluminum. We are going to work on both very hard. We have a lot of money in the bank and it gives us the strength to do the negotiations on some of these deals.

We will shortly announce our new Vice President, a new position for Vice President of Business Development to help us put these things together and hopefully bring another smart person to the top as an officer of the corporation to help me with observation, well are we just getting a little too thin. I think we will be okay with the changes that we are currently doing.

So I think that I know people have reacted negatively to the announcement. The company always tries to put out information as soon as we feel that we reasonably can rely on it. It's a moving target sometimes. I remember the question on October 30th of whether we thought there would be a delay in the next ESAPI/XSAPI after four delays and we didn't think there would be, having qualified if I say, well you never know with the government.

And then within days, they extended that to February 7th which we did meet and now it's in the process. But that really has caused us to look more hard at these projections, and this is what we think is a realistic guidance. I also think that market still doesn't really value the company completely as it should in that we are doing what we said we would do as far as these other areas and we are very excited about them and we have the means to pursue it and we have the technology and we have the capacity. So as always, the numbers will be out and we are going to work very hard on maybe making these guidance numbers look conservative but it was the prudent thing to do at this time.

And with that, I'll talk to you in about three months. That's it, Dennis.

Operator

Thank you, gentlemen. Ladies and gentlemen, this does conclude today's Ceradyne 2007 fourth quarter and full year results conference call. You may now disconnect.

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Source: Ceradyne Inc. Q4 2007 Earnings Call Transcript

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