Ceradyne: Excellent diversified addition to any long-term portfolio
When comparing revenues from the second quarter of 2011 and the second quarter of 2012, sales declined by 10% from $145.4 million to $130.6 million. On the same note, net income plunged from $19.1 million to $6.8 million, a 64% descent. As a result, margins were negatively impacted upon several fronts, with profit margins falling from 13.1% to 5.2% while gross margins declined from 36.4% to 28%. Cash and short-term investments declined slightly to $268 million, while inventories increased to $130 million. As a whole however, the firm remains liquid, with a current ratio at 3.57, and with the removal of inventory from this equation, renders an acid test of approximately 2.69. When compared against Q1 of 2012 however, sales and net income recovered considerably. Ceradyne is currently trading at a 35.9% discount from book value of $29.22.
In terms of management, Ceradyne is led by leadership that is upfront with their investors as demonstrated via their neutral if not outright negative outlook. Three primary factors were attributed to this dismal quarter:
1. Weakness in the European economy.
2. Decline in defensive sales and lower unit selling cost.
3. Buildup of solar inventories and lower unit selling cost.
The following is a breakdown of sales by sector for the second quarter of 2012:
As mentioned in the aforementioned article, and demonstrated in the diagram, Ceradyne’s business model is largely dependent upon sales of ceramic body armor, among other defensive applications, to the U.S. military. Between 2002 and 2008, body armor sales spiked from $26.2 million to $385 million, an annualized growth of 56.5%. With the gradual withdrawal from Iraq and Afghanistan came a paralleled decline in demand from the U.S. military, which ultimately rendered the relatively weak recent quarters. Management forecast armor revenues to be less then that of 2011, and flat over the next few years in a range of $50 to $150 million yearly. Negative conditions seemingly plague this division, as in first quarter 2012, a $6.9 million body armor order from the military was stopped due to quality control. Ceradyne has submitted a corrective action plan, but it is subject to approval. On a similar note, their highly touted Enhanced Combat Helmet has been delayed due to “technical issues.” As such, there may be underlying defects in their armor division that may impact future quarters.
In terms of energy applications and sales, this division boasted of the highest margins a year ago. However, divisional sales declined 38.3% due to “reduction of government subsidies for the installation of solar panels and a buildup of inventories of solar cells and solar wafers in end market distribution channels.” In particular, Ceradyne’s CEO noted that their Chinese counterparts are in possession of excess solar capacity and inventory, which in conjunction with weak European demand, yielded a net division loss of $0.14 per share. Looking forward, however, Ceradyne plans to remain in the solar crucible business due to what they perceive as continued demand in the near future. They anticipate that China will “work off those inventories,” but are considering reducing costs via additional automation, process improvement, and the sale of one of their two major facilities.
So what is the final word on CRDN? Ceradyne’s management revised annual guidance downwards, with revenues in a range of $475 to $485 million, and EPS of approximately $1. Year-to-date, Ceradyne’s share value has declined by nearly 20%. Seemingly hopeless, one must recall that Ceradyne remains optimistic regarding their “Ceradyne $1 Billion,” that is, to reach revenues of $1 billion by 2016. With the drawdown in the Middle East conflict, Ceradyne has diversified their company across several different sectors. As such, it is of this analyst’s opinion that much of their future growth, lest a new conflict should occur, will originate from all sectors except for defense.
Ceradyne produces the isotope Boron 10 which absorbs neutrons at a rate five times greater then non-isotopic materials. China in particular plans on establishing 200 reactors over a 25-year period, while the U.S. Department of Energy plans on establishing small nuclear reactors (SNRS) as their next generation of nuclear energy. The China market by itself, should Ceradyne develop a relationship with them, represents at least $1 billion in market value according to Ceradyne’s estimates. As such, if nuclear energy is the future, with the proper safeguards in place, Ceradyne is well positioned to present a product that is integral to the success of nuclear reactors.
For the near future, however, Ceradyne’s management is more optimistic regarding their PetroCeram and Chemtrix products. Their PetroCeram products are oriented towards the filtration of oil as it is pumped through sand. Most competing sand filtration products are made of stainless steel. However, due to ceramic being intrinsically lighter and more durable then metal, Ceradyne believes that this is their competitive advantage in this billion-dollar market. Second, Ceradyne acquired a 30% interest in Chemtrix, which allows them to diversify their chemistry flow reactors. Essentially, in flow chemistry, pumps move liquids into a tube in which they connect to other tubes with different liquids. If they are chemically reactive, a reaction will occur. As such, the utility of this reactor speaks for itself as it yields a myriad of potential pharmaceutical and industrial usages. Initially, Ceradyne had only offered the ceramic portion of the system for sale, but with their deal option to buy Chemtrix in the next year, they will be able to sell the entire reactor.
The final word on Ceradyne is that for the short-term future, Ceradyne is still a “defense” company, and as such, short term prospects are dim. However, from the eyes of a value investor, seemingly, Ceradyne is repositioning itself to be a conglomerate industrial and energy leader. As such, Ceradyne is an excellent diversified addition to any long-term portfolio.
Recent Guru Changes:
Guru Joel Greenblatt owes 62,117 shares of Ceradyne as of first quarter 2012.
Guru Ken Fisher eliminated his position of 385,125 shares of Ceradyne as of second quarter 2012.