Ceradyne Updated 5-29-09

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Armor for Your Portfolio? A report on Ceradyne, Inc. (CRDN: $22.38): 3/4/2009 (Updated: 5/28/09) Introduction: (Sources: Yahoo! Finance, company filings, and my calculations)

Ceradyne (CRDN) is a developer and manufacturer of ceramic products and powders for use in defense, industrial, automotive and commercial applications. However, over the past few years the company has benefited significantly from the war efforts in Iraq and Afghanistan. Specifically, CRDN has become one of the major suppliers of lightweight ceramic armor for soldiers and as a result has increased its revenue from about $45M in 2001 to $690M in 2008. While the company does have new applications that it hopes to supply ceramic products and powders for, the profitability of CRDN for the foreseeable future is going to be tied to military orders for lightweight armor. As a result of uncertainty regarding President Obama’s plans regarding American troop presence in Iraq and Afghanistan and concerns over defense budget cuts, the stock has been crushed (along with the entire market) over the past 6 months. Down from a 52 week high of $50.51, the stock now trades above $22, up from $16 when this report was first issued. At the current price the stock trades at less than 8x trailing earnings but up from about 4x after the recent run and poor Q1 2009 results. Taking into account the low end of the company’s 2009 guidance, a number that management said would be most likely for 2009, the stock is trading at about 14x forward earnings. The market was obviously anticipating a reduction of orders for armor as troop levels diminish. With Q1 2009 sales down 47.1% year on year and net income down 97% year on year, some bearishness certainly seems warranted. However, despite the very disappointing results and the uncertain nature of future armor orders the stock has bounced close to 60% from its 52 week low and really does not look very cheap any longer. Accordingly, the following includes an updated discussion of the prospects for the lightweight armor space, a review of other opportunities CRDN may have to diversify its customer base, and an analysis that tries to triangulate a reasonable intrinsic value for the shares. Lightweight Armor Market: (Sources: Company fillings, Capital IQ, Seeking Alpha, and my calculations) There is a mountain of evidence that indicates that CRDN is dependent on the US military’s demand for new and innovative body armor in order to grow revenues and earnings. In 2008 shipments of ESAPI (enhanced small arms protective inserts) armor to the US military made up 28.4% of total revenue, down from 40.3% in 2007. Also, in 2008 50.2% of total armor shipments went to the US military, down from 57% in 2007. The issue with this dependency is twofold: (1) going forward there may be fewer troops deployed in dangerous areas that require such sophisticated body armor and (2) many troops already have the ESAPI armor and do not necessarily need new armor. Therefore, the real opportunity for CRDN is to convince the military that soldiers will increasingly need the next generation body armor called XSAPI. The rationale is relatively simple: both enemies and friends are increasingly using machine guns and sniper rifles to fight battles and wars. Therefore, in order to limit friendly-fire and enemy-fire casualties, soldiers need to be protected with next generation body armor.

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The reason to believe that countries all over the world will continue to demand the company’s armor products is that they offer multiple benefits relative to other types of armor. The ESAPI armor is capable of protecting against threats as great as 12.7mm armor piercing machine gun bullets. Plus, in comparison to steel armor, the ceramic armor weighs about 40% less so a soldier is much more mobile and does not get fatigued as quickly. While the international opportunity is nowhere near as large as that of the US military, countries that have troops deployed in volatile areas will need the same protection and this should subsequently lead to at least some demand for CRDN’s products. The company is even creating similar ceramic armor that can be placed on vehicles without adding a meaningful amount of weight. While this application has yet to be widely embraced by the military, CRDN’s management is cautiously optimistic that there will be some opportunities for it in the future. In fact, on the Q1 conference call the management team indicated that CRDN expects to provide armor for current Humvees and believes that it will eventually supply the next generation Expanded Capacity Verhicle-2 (ECV-2) with armor, possibly in Q3 or Q4 of this year. However, the 2009 guidance does not include any provision for sideplate orders. Revenue Breakdown ($US Millions) US Foreign Total

2008 $496.2 184.0 $680.2

% Total 72.95% 27.05% 100%

2007 $62 0.6 136 .2 $75 6.8

% Total

2006

% Total $5

82.00%

56.8

84.00% 10

18.00%

6.1

16.00% $6

100%

62.9

In March, President Obama outlined his immediate and long-term plans for Iraq and Afghanistan. Roughly two-thirds of the 142,000 US troops in Iraq will be withdrawn by the end of 2010. Then, the remaining troops will be taken out of the country by the end of 2011. Some of these troops will be sent home but others will likely be re-deployed to other areas in the region or to Afghanistan. Specifically, the President has said that he intends to keep at least 30,000 troops in Afghanistan. Despite this reduction the management team at CRDN expects there to be demand for at least 120,000 XSAPI units. Based on their previous market share, the CEO said on the Q4 conference call that he hopes to fill 60-70% of those orders. In October 2008 CRDN received a five year Indefinite Delivery/Indefinite Quantity (IDIQ) contract for XSAPI and ESAPI armor. The company does not believe the full $2.3B maximum face value will ever be reached because the military will only order the XSAPI or the ESAPI, but not both. According to company filings the value of this contract is not likely to exceed $1.1B. Over the 5 years this implies about $220M per year in armor orders from the US. While delivery orders have been delayed, CRDN finally received a $77M order in April and has already begun shipping the new armor. However, there is still a good deal of uncertainty regarding the timing of orders from this contract. On the Q1 2009 conference call the management team indicated that CRDN is ready, willing and able to start shipping the XSAPI at any point but the US government is the one delaying the process. In the meantime, the company has downscaled operations and cut employees in the armor division to help save costs. Management has no concerns about ramping up production if and when the orders are received. However, with the significant capacity the company has added over the past few years, a process that included substantial increases in fixed costs, lumpy or sporadic orders going forward could lead to margin contraction as a result of de-leveraging. The body armor is not only the company’s major source of revenue (66% in 2008, 77.6% in 2007 and 79.8% in 2006), but is also one of its higher margin products. As the table below illustrates, the Advanced Ceramic Operations division has consistently been its most profitable. EBT Margins Advanced Ceramic Operations (ACO)

Q1 2009

2008

2007

2006

7.54%

33.10%

36.21%

33.49%

ESK Ceramics

-18.60%

2.76%

8.33%

11.68%

Semicon Associates

11.14%

16.28%

14.19%

17.43%

Thermo Materials

22.22%

29.55%

7.19%

5.87%

Ceradyne Canada

-256.33%

-1.35%

-77.66%

-28.27%

Boron

-29.22%

-81.58%

9.36%

N/A

0.53%

-5.37%

1.48%

3.87%

Corporate

100%

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Total

1.15%

24.21%

29.93%

29.35%

The results from Q1 show that any reduction in body armor orders causes a negative margin mix shift as other, less profitable divisions make up a larger share of revenues. The company anticipates that XSAPI margins will be on par (possibly slight less due to competitive pricing) with margins for the SAPI and ESAPI when production eventually get ramped up. On the most recent call, CRDN indicated that armor margins in 2H 2009 should be much higher than they were in Q1 2009. In addition, as the table below shows, while the percentage of the backlog tied to body armor has shrunken in the past few years, armor still makes up the majority of the backlog. Q1 2009

Dec-08

Dec-07

Amount ($US millions)

Backlog

$177.2

$126.4

$238.9

Dec-06 $344.3

Ceramic Armor % Of Backlog

53.50%

51.80%

75.10%

82.90%

In addition to the previously mentioned reasons that demand for the armor may fall, CRDN is facing a potential problem for 2010 orders. While the company is optimistic that orders for XSAPI will increase as 2009 progresses, management is concerned that the US military will ask for different specifications on the armor for the 2010 orders. Specifically, there have been concerns about the total weight of the armor and CRDN is anticipating that the US military will demand that a few pounds be taken off before it is willing to order for 2010. On the Q4 conference call, the CEO indicated that he expects it to be tough to do but that CRDN has seen some progress based on its significant R&D spending in this area. On the Q1 call the tone had changed regrinding this concern. The management team said that the focus going forward would be to offer the US government a number of armor choices, with the weight varying based on the level of desired protection and mobility. In other words CRDN believes it can serve government’s needs if it offers a variety of body armors that are appropriate for different battle circumstances. However, it has to be mentioned that despite having an ID/IQ contract in place, CRDN could be at a real disadvantage if one of the competitor’s were able to offer a lighter product with similar protection as the heavier CRDN armor. Other Revenue and Growth Opportunities: (Sources: company filings and Seeking Alpha)

1. Nuclear Energy: CRDN’s Boron Products operation produces a boron isotope that is used in the containment of nuclear waste and in radiation control. With many people calling for the US to increase its nuclear capacity (despite the objections of President Obama), the ability to offer products that enhance the safety of the nuclear power generation process puts CRDN in a position to potentially benefit from the building of new reactors. Unfortunately, the Boron Products group has continued to be unprofitable over the last few years. Better economies of scale as a result of increased orders would likely be necessary to turn this group’s performance around. On the Q1 conference call the CEO admitted that this is a small business that will never affect the results in a meaningful way. However, he did indicate that the company has created a boron isotope that absorbs neutrons better than any on the market, a fact that could lead to more order as more nuclear facilities are built around the world.

2. Solar Energy: According to company filings, CRDN has developed a receptacle that will help make solar cell production more cost effective. In order to create solar cells, silicon most be melted in a crucible (or vessel) that can contain molten silicon and prevent unwanted chemicals from contaminating the process. CRDN has already begun selling these crucibles to photovoltaic cell manufacturers and revenue from crucibles increased by $25M from 2007 to 2008. The current problem with solar energy in terms of its practicality is based on the high cost of the entire process. However, with the focus on green energies across the world there could be a significant opportunity for CRDN to participate in making this a viable alternative. The company has already completed a 98,000 square foot facility to manufacture these crucibles in China and is in the process of building another 200,000 square foot facility. CRDN spent a good portion of the Q1 2009 conference call discussing the solar and crucible businesses. The CEO indicated that there has been a lot of negativity regarding the solar industry and as a result the price of silicon and modules are down. However, he went on to say that this does not affect CRDN because it sells

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directly to the manufacturers and offers ceramic coating that allows for the highest purity wafers. The company is being careful not to ramp up production ahead of demand and is letting customers dictate the need to increase production at the new plant.

3. Other Applications: CRDN lists numerous other applications of its ceramic products in areas such as oil drilling, diesel engines, orthodontic brackets, and extracting oil from oil sands. Some of these are potential applications and others are already being used. The goal is to educate current and potential customers about the benefits of ceramic products relative to the current materials being used. The problem the company has had does not appear to have to do with the quality or the functionality of the products. According to the management team, many of the products perform better than the current industry standard products. However, ceramic products are more expensive than those made of other materials such as steel and plastic and that cost has precluded many customers from switching. Accordingly, the company continues to attempt to lower its costs so that it can offer better pricing to customers. The company has the duel burden of trying to be the lowest cost ceramics producer and getting costs low enough to compete with manufacturers who use other materials. Right now many of the current products are limited to high-end applications in which cost is not the only concern, a fact that shrinks the universe of potentially interested commercial and industrial clients substantially. End Markets

Q1 2009

2008

2007

2006

Defense

52.3%

61.8%

74.0%

76.2%

Industrial

39.1%

30.6%

20.1%

17.0%

Auto/Diesel

5.5%

5.8%

4.2%

5.2%

Commercial

3.1%

1.8%

1.7%

1.6%

Total

100%

100%

100%

100%

Valuation: (Sources: Company fillings, Capital IQ, Seeking Alpha, and my calculations) The preceding discussion has highlighted a number of legitimate concerns that have undoubtedly helped push the share price of CRDN down. However, potential investors must consider the possibility that the current sentiment may be too bearish. The following uses multiple valuation analyses to show just how cheap shares of CRDN have become relative to the past. Due to the difficulty in forecasting revenues and costs I believe a DCF analysis is not useful in this case. Multiples: 1. Unlevered Free Cash Flow

FCF

2006

2007

2008

LTM/Current

$87.5

$81.2

$92.1

$71.4

Price/FCF 15.25x 12.31x 4.80x 8.53x *2006-08 figures are based on year end share prices the current figure is based on the current share price *FCF figures are taken from Capital IQ *Management guidance for FCF may not be comparable

The above table shows that in comparison to the FCF multiples that CRDN has traded at over the past few years, the current multiple has contracted significantly. However, it is important to note that management guided for 2009 FCF to be only about $32-$42 million, a range that is inline with the drop in EPS it expects. Specifically, management guided for EPS to drop to between $1.60 and $2.00, a decline of 60% on the low end. This coincides with a drop of 72% in FCF from 2008 on the low end of the guidance. Assuming FCF drops to $32M, the stock would be trading at about 19x FCF, a multiple that does not look that cheap except when you take into consideration that the low end FCF guidance may represent a trough number. (Management indicated that in Q1 2009 FCF was $10.5M despite the low levels of revenue and earnings.) However, investors must try to handicap the possibility that 2009 will not be a trough year but more of a run-rate year as the majority of CRDN’s profits come from military spending that may now be shrinking for reasons other than the global recession.

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2. PE, EV/EBITDA, EV/Sales TEV/LTM Total Revenue

Avg Multiple

2005

3.46x

2006

3.09x

2007

2.31x

2008

1.18x

Current

0.76x

4 Year Average

2.51x

TEV/LTM EBITDA 2005

14.25x

2006

11.11x

2007

7.15x

2008

3.67x

Current

2.69x

4 Year Average

9.05x

2005

24.99x

2006

20.63x

2007

12.58x

2008

7.24x

P/LTM EPS

Current

7.84x

4 Year Average

16.36x

The above figures illustrate the dramatic decline in multiples over the last few years. Assuming that management is correct in assuming that 2009 will be a much weaker year than 2008 in terms of revenue and earnings, it is also important to look at the multiples implied by management EPS and revenue guidance. 2009 Guidance (April 28, 2009)

Implied

EPS*

P/E Low End

$1.60

14.25x

High End

$2

11.40x

Low End

$465

High End

$500

Revenue

TEV/Revenue

FCF

1.04x 0.96x Price/FCF

Low End

$32

19.02x

High End $42 14.49x *Management affirmed the February guidance in Q1 2009 but said that the EPS number should be closer to the low end

Even given this reduced guidance CRDN is trading at a significant discount to prior multiples. The question investors have to ask themselves is what multiple (or desired return) is he or she willing to pay for a company whose earnings are dependent on sustained US troop levels in battle situations and increased purchasing of new equipment. The company has very low debt ($103.6M of convertible notes that pay only 2.875% interest) and a very reasonable debt to equity ratio (16.4%). So, there is very little balance sheet risk, especially when you consider the company’s $127M net cash position ($4.90/share). However, the earnings risk is very real and probably requires at least a 15% return, even with treasury rates so low. I think it needs to be mentioned that I usually refrain from relying on any forecasts, either by management or

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analysts. However, due to the contract and backlog nature of the business, I am assuming that the management team does have at least some visibility even in a very tough environment to predict. 3. Price to Book and Price to Tangible Book Avg Multiple P/BV 2000

2.20x

2001

1.97x

2000-2002 Avg.

2002

1.70x

1.96x

2005

5.64x

2006

5.07x

2007

3.81x

2008

1.62x

Current

0.97x

4 Year Average

4.04x

P/TBV 2000

2.34x

2001

2.06x

2000-2002 Avg.

2002

1.76x

2.05x

2005

6.24x

2006

5.35x

2007

4.09x

2008

1.91x

Current

1.21x

4 Year Average

4.40x

As shown above, CRDN is currently trading at less than book value. This depressed valuation is usually reserved for financial institutions that have assets on their balance sheets that are hard to value and many market participants believe are not marked properly. CRDN on the other hand has assets on the balance sheet mainly made up of cash ($230.6M), accounts receivable ($64.1M-which should be collectible since a good portion of revenue comes from government entities), PP&E ($246M-carried at historical cost minus accumulated depreciation) and inventory ($99.6M). Even in the 2000-2002 period before the wars, when the company’s yearly revenue ranged from $45M-$61M and EBIT margin never went above 10.6% for the full year, the average price to book value was 1.96x. While this multiple may have included anticipated growth in revenues, the company did not have the track record it has today. Out of the major asset categories the only one that could potentially be worth less than the stated value is the inventory. It is true that the ESK Ceramics segment has limited customers outside of its production of powders for CRDN and other armor manufacturers. Management has commented that this segment will suffer as armor demand falls because there are few other applications for these powders. Therefore, in the case in which most of the inventory was mostly raw powder it would be reasonable to expect a large write down at some point. However, the bulk of CRDN’s inventory is finished and work in process goods that are likely to maintain their value due to the high-end nature of their applications. Inventory

2007

2008

Q1 2009

Raw Materials

$22.8

$18.4

$17.80

Work in Process

46.9

45.2

45.7

Finished Goods

23.2

37.5

36.1

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Total

$92.9

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$101.1

$99.6

As management indicated on the Q4 and Q1conference calls, the company has been operating cautiously, especially when it comes to body armor production. The team seems cognizant of the uncertainty regarding the timing of XSAPI orders and has tried to maintain a lean cost structure and lean inventories. Over the past 15 months CRDN let go of close to 600 people or 33% of the work force. The company also recently closed an ESK plant in France that will lead to a charge between $11M and $13M. mostly coming in Q2 2009. This will decrease headcount by another 95 employees and is in response to the continued lack of profitability in the ESK division. To be conservative, I believe it is valuable to look at the book value and tangible book value multiples that the stock traded at before the wars in Iraq and Afghanistan. These values give an investor an idea what kind of multiple the market was willing to pay prior to expectations of sustained revenue growth. Specifically, from 2000 to 2002 the average book value multiple the company traded at was 1.96x and the average tangible book multiple was 2.05x. Both of these figures are substantially above the current multiples the company is trading at now and a return to those multiples would lead to at least a doubling in the share price. While past multiples are in no way indicative of future values, this comparison indicates that even if CRDN is unable to grow book value any further, the company may benefit from a more rational multiple eventually being placed on book value when the overarching market pessimism dies down. In addition, there is a past performance metric that makes the current market valuation of the stock look questionable. While ROE has declined over the past few years as a result of less demand for primarily body armor, the 2004-2008 average ROE for the company was 27%. I would argue that most companies with healthy balance sheets and an average ROE in the upper 20%’s do not usually trade for less than book. Obviously the market is pricing in a severe earnings decline that last a number of years. The 2009 EPS guidance of $1.60-$2.00 implies an ROE of 6.6% on the low end and 8.25% on the high end (using current share count and book value). The question potential investors have to ask is if 2009 is going to be a trough or aberrational year, is it likely that CRDN’s ROE will revert back near the 5 year mean when the commercial and industrial markets pick up and the government officially commits to upgrading the military’s supply of body armor? If Q1 is any indication of the trouble CRDN will have if body armor orders never come back fully, ROE may more likely revert to the 10 year average of 19.1%. LTM Q1 2009

2008

2007

2006

2005

2004

ROE

12.2%

17.7%

29.3%

39.1%

24.3%

24.9%

5 Year Average ROE

27.0%

EPV EPV is a measure of earnings power and is a simple, short-hand way in which to determine if a stock is undervalued. The process involves taking a normalized (or average) EBIT and then dividing that by the company’s cost of capital in order to determine a reasonable value for the entire company. Then, a value investor takes his or her desired margin of safety off of this price when determining the price he or she is willing to pay for a certain stock. In the original EPV analysis for this report I assumed that the very minimum run rate EBIT would be 40% below the five year average of $144M. However, based on Q1 2009 EBIT of $3.3M and looking back to results from before the wars, I have had to make my analysis even more conservative.

Historical EBIT ($US millions) EBIT

EBIT

1999

$7.3

2004

2000

$8.0

2005

$49.5 $81.6

2001

$9.1

2006

$192.8

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2002

$12.4

2007

$220.8

2003

$25.7

2008

$175.4

5 Year Average EBIT

$144.0

10 Year Average EBIT

$78.3

EPV Calculation ($US millions) Low End Revenue Guidance (2009) Conservative Run Rate Gross Margin

$465

30%

5 Year Average GM

37.6%

10 Year Average GM Implied Gross Profit

31.4% $139.5 0

Conservative Run Rate EBIT Margin

17.5%

5 Year Average EBIT Margin

25.3%

10 Year Average EBIT Margin

17.6%

Implied Run Rate EBIT

$81.38

EPV Based on Run Rate EBIT 9% 10% 11% 12%

$904.1 7 $813.7 5 $739.7 7 $678.1 3

Current Market Cap

Margin Of Safety

608.76

32.67%

608.76

25.19%

608.76

17.71%

608.76

10.23%

For this analysis I took the low end revenue guidance for 2009 and applied some conservative margin assumptions, making sure to take into account historical margins that included pre-war periods. By using this revenue figure I have assumed that CRDN has established itself as a major defense player and offers products that are technologically advanced enough that it is highly unlikely that revenues revert back to pre-war levels less than $100M per year. Over the past three years full year revenue has averaged $700M, so the $465 figure represents a 35% drop from that average. However, in the event that the US significantly reduces the number of troops in combat environments worldwide, it is not out of the question that the run rate figure I am using is too optimistic. As a result, I believe investors should look for a larger margin of safety, keeping in mind that the company does have a $1.1B armor contract with the US government over the next 5 years. Specifically, I would not be comfortable purchasing shares of CRDN without a 50% margin of safety at the very minimum. Using a 11% cost of capital and $81.4M in run rate EBIT that implies a share price around $14. Comparable Company Analysis While there do not appear to be any great publicly traded comps for CRDN (companies whose main focus is armor with similar market caps) there are a few defense companies that are as highly levered to niche products as CRDN is to armor. Specifically, I chose Orbital Sciences (ORB), AeroVironment (AVAV) and Force Protection (FRPT) as my comps because they had similar market caps (less than $1B) and were dependent on military spending on emerging products and technologies.

1. ORB: Orbital Sciences is a company that develops and manufactures small rockets and space systems for applications in the commercial, military and civil government spaces. The majority of

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the company’s revenue and operating profit comes from the Launch Vehicles and Advanced Space segments. Q1 2009 ORB Launch Vehicles Satellites and Space Systems

2008

2007

Revenue

Op Income

Op Margins

Revenue

Op Income

Op Margins

$119.2

$4.3

3.61%

$454.3

$33.6

7.40%

9.99%

Op Margins

110.2

7.8

7.08%

422.3

32.2

7.62%

6.58%

68.3

-0.9

-1.32%

298.1

19.1

6.41%

7.08%

Consolidated

$295.7

$11.2

3.79%

$1,168.6

$84.3

7.21%

ROE

9.40%

8.20%

13.20%

($207.9)

($184.6)

($92.1)

N/A

73%

68%

Advanced Space

Net Debt US Government Contracts

7.85%

As the above table shows, ORB’s margins and ROE over the few years have been significantly less robust than those of CRDN even as revenue has increased over 52% from 2006 to 2008. It appears that ORB has benefited from the US war efforts (US government contracts represent an increasing percentage of revenue) but this has certainly not led to significant margin expansion. Accordingly, in comparison, growth in CRDN’s armor division is much more profitable than growth in any of ORB’s segments. 2. FRPT: Force Protection is a provider of blast protected vehicles for the US military. The company’s main product is called an MRAP (Mine Resistant Ambush Protected) and sales of the Cougar and Buffalo and the associated spare parts to the US account for just about all of its revenue. Q1 2009 FRPT Armored Vehicles Sales Net Debt (CASH)

2008

2007

Op Margins

ROE

Op Margins

ROE

Op Margins

ROE

6.20%

10.50%

5.70%

18.4%

0.60%

3.40%

($119.8)

US Government Contracts* 94.1% *Estimate based on Q1 2009 Accounts Receivable data

($79.3)

($90.5)

~100%

~100%

Like CRDN, the company has benefited from the war efforts as revenue has increased from $49.7M in 2005 to over $1.1B during the 12 month period ended 12/31/09. However, unlike CRDN, the company’s ROE and operating margins have been inconsistent and that fact has limited the profitability of the revenue growth. At first blush this looks like a company uniquely exposed to revenue declines resulting from troop withdrawals. 3. AVAV: AeroVironment is a designer and producer of unmanned aircraft systems (UAS) for the US Department of Defense. The company also has a commercially focused segment that supplies industrial vehicle batteries to customers. However, for the 9 month period that ended 1/31/09, the UAS segment generated about 85% of the company’s revenues, a fact that makes the company’s stock price highly dependent on the defense spending of the US military.

AVAV Unmanned Aircraft & Efficient

9 Months Ended 31-Jan-09 Op Margins 13.8%

LTM ROE 12.4%

Apr-08 Op Margins 13.2%

ROE 14.0%

Apr-07 Op Margins 16.3%

ROE 24.3%

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Energy Systems Net Debt (Cash) US Government Contracts

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($123.4) N/A

($118.4) 84.0%

($109.2) 83.0%

As is a recurring theme among the niche defense contractors, the wars in Iraq and Afghanistan have helped AVAV increase revenue from $139.4M for the year ended April 2006 to $235.9M over the last year. But as with the other two companies, CRDN’s margins and ROE have been consistently better than those of AVAV. Average Multiple TEV/LTM Total Revenue

ORB

FRPT

AVAV

CRDN

2005

0.87x

6.53x

NM

3.46x

2006

1.21x

2.84x

NM

3.09x

2007

1.34x

5.12x

1.98x

2.31x

2008

1.08x

0.28x

2.14x

1.18x

Current

0.52x

0.43x

2.00x

0.76x

2005

8.73x

NM

NM

14.25x

2006

12.51x

NM

NM

11.11x

2007

13.47x

NM

11.76x

7.15x

2008

11.31x

3.79x

13.99x

3.67x

Current

6.49x

2.50x

12.55x

2.69x

2005

4.50x

NM

NM

24.99x

2006

29.41x

NM

NM

20.63x

2007

32.90x

NM

22.54x

12.58x

2008

25.33x

7.11x

26.59x

7.24x

Current

20.44x

7.00x

24.53x

7.84x

ORB

FRPT

AVAV

CRDN

2005

1.69x

NM

NM

5.64x

2006

2.32x

NM

NM

5.07x

2007

3.00x

8.44x

3.68x

3.81x

TEV/LTM EBITDA

P/LTM EPS

P/BV

2008

3.03x

.97x

2.96x

1.62x

Current

1.76x

2.09x

2.83x

0.97x

2005

2.23x

NM

NM

6.24x

2006

2.69x

NM

NM

5.35x

2007

3.46x

8.47x

3.68x

4.09x

2008

3.46x

.98x

2.96x

1.91x

Current

1.99x

2.09x

2.83x

1.21x

P/TBV

This table contains a lot of data but the overarching theme is that despite having better and more consistent margins and ROE than these other companies, CRDN trades at the lowest TTM P/E ratio. There is no question that earnings are at risk when it comes to CRDN and trailing earnings multiples may not be particularly relevant. However, one could argue that the same is true for all these companies that depend on US military spending. The troop withdrawals and ramp down of the war efforts should affect all of them (but perhaps not equally). There may also a large effect when it comes to margins. With President Obama

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vowing to cut costs out of all facets of government spending, these companies may not enjoy the same pricing they have previously. In any case, what really stands out is the price to book and price to tangible book discrepancy. All of these companies have net cash positions and relatively healthy balance sheets. But CRDN trades at much lower multiples than its peers and well below its recent averages. Obviously, the entire defense space has seen multiples contract for a variety of company specific and economic reasons. However, for potential investors it is interesting to see that market is pricing CRDN at a discount to similarly situated peers. Company Management: (Source: CAP IQ and company filings) CRDN is a company that has had a lot of management continuity over the past few decades. The current CEO Joel Moskowitz co-founded the company in the late 1960s and has been the CEO since 1983. The CFO has been at CRDN since 2002 and a number of the Board members have been at the company since at least 1989. Accordingly, in terms of experience and tenure the company has a strong management team. What is more important, however, are the capital allocation decisions made by the company over the last few years. First off, the company has spent a significant amount of money building and upgrading the crucible plants in China in anticipation of the coming solar energy boom. With oil in the mid $60’s, this certainly looks more risky than it did when oil was over $100 (this topic is discussed further below). Also, CRDN has been relatively acquisitive recently. In 2008 it purchased SemEquip, “a leader in the development of cluster ion implantation sub-systems and advanced ion source materials for the manufacture of logic and memory chips” for about $50.5M. Of that purchase price, about $48.2M was attributable to intangible assets for patented technology rights. Next, in July 2007 the company purchased Minco Inc., a powder supplier to the company’s Thermo Materials group, for about $28M, with over $10M of that price attributable to goodwill. Finally, in August 2007 CRDN purchased EaglePicker Boron, a producer of boron isotopes, for $71.3M (with over $36 attributable to goodwill and customer relationships). It may be too early to tell if CRDN overpaid for these acquisitions, but it is clear that the company is focused on diversifying its end markets and being vertically integrated in the production of body armor. In the process the company has added a significant amount of intangible assets to its balance sheet. Potential investors would be wise to follow what the company says and does regarding these assets as they were purchased in much more benign circumstances and there is a real possibility that CRDN will be forced to take an impairment on them. During 2008 the company repurchased 1.58M shares at an average cost of $28.29, a price that is well above the current stock price. It is definitely concerning that management thought that the best use of capital was buying back stock at price over 80% higher than the current price but individual members have not been active in purchasing shares themselves. It is also somewhat concerning that the CEO sold 15K shares in May. Furthermore, on the Q4 conference call the CEO made a point to remind analysts and investors that there is still $55M left on the buy back authorization and that the company intends to use it. However on the Q1 2009 call there was no mention of the buyback at all and the company only repurchased 50K shares in Q1, leaving $54.5M available under the $100M repurchase program.

Insiders

Position

Shares Held

Tenure

Joel Moskowitz

CEO/Chairman

1449K

Co Founder, CEO since 1983

Date May-09

Recent Activity Sell 15K

Jerrold Pellizzon

CFO

67.6K

2002

Apr-09

N/A

Frank Edelstein

Director

35.5K

Member of Board Since 1984

Apr-09

N/A

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Richard Alliegrio

Director

32.7K

Member of Board Since 1992

Apr-09

N/A

David Reed

VP- President of N.A.

29.4K

1983

Apr-09

N/A

Milton Lohr

Director

28.7K

Member of Board Since 1989

Apr-09

N/A

Richard Kertson

Director

26K

Member of Board Since 2004

Apr-09

N/A

The previous table provides the holdings of some of the top people from the company. Aside from the CEO, the rest of the holders have basically held steady since then, occasionally selling a few hundred shares at much higher prices. Notably there have been very few purchases of stock when it was trading at much lower values. So, overall the insider activity has been rather negative, especially since the share price has run up. From what I can see management does have a reasonably good track record when it comes to meeting its targets. For the full year 2007 the company guided for $720-$740M in sales and $5.20-$5.40 in EPS and subsequently beat the revenue guidance and met the low end of the EPS guidance. For 2008 the company initially guided for sales in the range of $715M-$836M and earnings in the range of $4.55 to $5.05 per share but then was forced to (understandably, given the circumstances) revise that down to $680M and $4.00 per share, both of which were met. It certainly has to be mentioned that it is very easy to meet and beat guidance when the tide is rising and secular tailwinds are strong. It is much more difficult to do so when the favorable economics may have potentially been reversed. Accordingly, this discussion should only be used as one data point in the broader evaluation of management. Potential Catalysts and Positives: (Sources: Seeking Alpha, company filings, AcquisitionResearch.Net and Jane’s Defense Industry, Washington Post)

1. Stock buyback: With over $125M of net cash on the balance sheet and $54.5M remaining on the current buyback authorization, CRDN could choose to buy back shares. At the current price the company is authorized to buy back more than 2.39M shares, which is about 9.2% of current shares outstanding.

2. XSAPI: If the US government decides to completely replace the current ESAPI armor with the newer XSAPI armor, this would be a huge opportunity for CRDN over the next few years. As management indicated on the Q4 conference call, the government has indicated a desire to purchase up to 120,000 XSAPI units during the first phase of the upgrade. If CRDN could command its usual 60-70% market share, this would translate into 72,000-84,000 units. A multi year replacement cycle for body armor would at least mitigate the damage done to demand due to troop withdrawals and could delay a permanent drop in revenue for the company. The 5 year ID/IQ contract provides CRDN with some revenue visibility in body armor assuming the company can continue to meet the US’s specifications. However, the concern has to be about CRDN’s future after all the XSAPI orders are filled: • • •

•

Will there be an innovation that leads to a new replacement cycle in a few years? Is CRDN in position to create a lighter product that maintains the ability to protect against sniper rifles and machine guns? What happens if a competitor develops a better product before CRDN? o Does the company immediately lose its large market share? What happens if the government changes the weight specifications and CRDN is unable to meet those criteria?

3. Revenue diversity: The company has indicated that it would like to get to a sustainable point in which defense and non-defense revenues are about equal. The company has projected a 50:50 split in 2009 as a result of the reduced demand for body armor. The reason management is looking to diversify the revenue base is that once the US has upgraded to XSAPI, it will probably be years before the military needs to purchase new armor, regardless of the innovations that come over the following few years. Also, CRDN always faces the risk that a competitor achieves a breakthrough

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that allows it to manufacture body armor at a lower cost or at a lower weight with the same protection. Accordingly, to mitigate this innovation risk, CRDN has been pushing hard into commercial and industrial applications. The opportunities in solar, nuclear, and automotive certainly do sound relatively compelling. However, it is hard to determine how profitable revenue growth in these areas will be due to the lower margins of the segments that cater to them. It is possible that increased scale will lead to increased leverage and higher margins, but as of now it is difficult for investors to bank on profitable non-defense sales growth as they are evaluating the company. Finally, even though the company has successfully increased its percentage of international sales over the past few years, the international body armor market is not necessarily that robust. Therefore, it does not seem reasonable to assume that the company will be able to offset reduced demand from the US military with orders from other countries to any meaningful degree.

4. Valuation: The pages above include a number of valuation analyses that point to CRDN being undervalued relative to the past. Of all of the metrics, I believe the most compelling is the fact that the company trades at book value and tangible book value multiples significantly below historical averages. While earnings are expected to decline for numerous reasons, such a low multiples should provide the shares with some downside protection. Furthermore, as the EPV analysis illustrates, there could be a margin of safety between intrinsic value and the current price even assuming a very pessimistic and lasting impact on earnings.

5. Acquisition: Many of the large defense contractors (such as Lockheed Martin) have built up large cash positions over the past year. With CRDN’s market cap down to a little over $600M, there are a number of companies that could be interested in an all-cash and cash and stock deal that included a healthy premium. While there is no guarantee the management team at CRDN would be willing to sell at the current levels (the CEO owned over 4.8% of outstanding shares upon his last filing), the current price could attract an acquirer interested expanding its commercial and defense portfolio of products. In terms of potential acquirers, it would seem that BAE Systems would be a logical candidate. BAE competes with CRDN in the armor space and with close to 2.6B pounds in cash as of the end of 2008, could be interested in a tuck-in acquisition of CRDN. The problem is that BAE is a British company and there could be all kinds of national security and nationalistic concerns about such a deal. Having said that, the defense industry has seen a tremendous amount of consolidation over the past few years. According to AcquisitionResearch.Net, since 1996 Boeing has made 19 acquisitions, Lockheed Martin 25, General Dynamics 36, Raytheon 18 and Northrop Grumman 27. Just looking at a list of deals in 2009 from Jane’s Defence Industry illustrates the number of deals that continue to occur in this space. In the past 6 months, despite the adverse economic circumstances, Level 3, General Dynamics, BAE, Boeing, and Lockheed Martin have either announced or completed acquisitions. According to the Washington Post’s analysis, one reason for all of this activity is the scathing comments in April 2008 from the Government Accountability Office of the US that recommended dealing with fewer total contractors and having more of a “one stop shopping” environment in an effort to get costs down and efficiency up. With valuations compressed and the bigger players having significant dry powder, it would not be surprising to see the recent trend continued.

Concerns and Risks to the Downside:

1. Solar: CRDN is in the process of finalizing its 200,000 square foot facility to augment its existing 98,000 square foot facility that manufactures crucibles used in the production of solar cells. The

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cost of the new facility is estimated to be at least $22M. When oil was at $145 a barrel, alternative energies like solar and wind power were starting to look like viable substitutes for fossil fuels. However, the precipitous fall in oil and natural gas over the past 8 months has once again created a situation in which these sources of power have to survive on government subsidies to be viable. Either that or countries will have to start taxing carbon emissions in order to make the costs of producing energy somewhat commensurate. President Obama has repeatedly focused on the need to create some type of cap and trade system for carbon emissions and to provide subsidies for the development of cost effective green energies. However, with the world in the middle of a recession and a significant number of opponents gathering, it may be very difficult for the President to implement his clean energy strategies. With consumers already hurting from job losses and asset deflation, there could be significant pushback on any proposal that would raise energy costs. CRDN appears to be prepared to ramp up production of the crucibles in anticipation of significantly increased demand for solar cells. However, any delays in that demand could lead to an oversupply of crucibles and could negatively impact margins and inventory values. In other words, if the current global economic conditions preclude or delay the proliferation of solar energy, CRDN may be stuck with a huge factory that is not capable of producing other items and a lot of inventory that cannot be sold.

2. Pre-war EBIT is not a useful barometer: For companies with long but relatively cyclical track records, it is often prudent for conservative investors to go back to pre-boom periods to get a sense of what revenues and earnings looked like in either down cycles or less bullish times. That is usually a good way to get a normalized EBIT figure that can be used in an EPV analysis. However, before the US went to war in Iraq and Afghanistan, CRDN was not the company it is today. In 2001, revenue was only $43.5M and net income was only $4.1M compared to $680.2M and $106.7M, respectively, in 2008. Also in 2001, the defense end market made up only 29% of sales versus 61.8% in 2008. Since 2001 the company has established itself as a main supplier of products to the defense sector. For an investor looking for a worst case scenario, a return to prewar net income of $4-5M probably represents the full downside risk. Net income in 2008 was close to 25x net income from 2002 so it is safe to assume a return to 2002 profitability would result in a rather dramatic fall in the stock price. It is a bit troubling to me that the 2001 10-K includes many of the same market opportunities as the 2008 10-K. While some new applications have been added, CRDN has limited proven success and profitability in these new areas. An investor looking at this company for the first time might logically assume that the rise in the company’s stock and increase in earnings had more to do with the US’s involvement in Iraq and Afghanistan than any other factor. In that way the stock is likely to be relatively cyclical and the price will reflect perceptions and realities of wars and occupations. While it would be hard to argue that the world is getting any safer, the combination of troop withdrawals by the US, the budget deficits in many countries and the limited visible opportunities for CRDN after the current armor replacement cycle is complete, all add to the uncertainty regarding future profitability.

3. Higher price of ceramics: As discussed briefly above, ceramic materials are often more functional and safe than other materials, but often cost substantially more. In an environment in which companies are looking to cut costs at every corner and both businesses customers and consumers are increasingly cash strapped, CRDN’s position as a high cost producer is not advantageous. Accordingly, the company has decided to focus on high end applications that are less dependent on cost. But if any of these new uses do not gain traction or become less attractive as a result of the global slowdown, CRDN could wind up being stuck with high priced inventory it cannot sell and factories that cannot be easily altered in order to make products that are actually in demand. While the specialized manufacturing facilities do serve as a barrier to entry for the industry, the fixed costs associated with them can destroy margins in a reduced demand cycle. In an attempt to alleviate this concern, the company makes a compelling case that ceramic products are often preferable to whatever the industry standard is and can be used in many new applications..

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However, the more cost conscious the environment, the more difficult it will be for CRDN to convince potential customers to switch. Conclusion: Looking at CRDN solely on a valuation basis the stock was pretty cheap before the recent market-wide rally. It currently trades below tangible book value. Now, at the low end of 2009 guidance, the stock trades at more than 14x forward earnings versus an average of 16.36x from 2005 to 2008. Next, using an EPV analysis the value of CRDN does not appear to be appreciably more than the current share price. In addition, a potential investor has to be aware of the downside in this case. While CRDN is not a one trick pony, the company’s earnings are highly dependent on the sale of lightweight body armor to the US military. The company has been trying to diversify its revenue base in anticipation of fewer troops being deployed around the world in the coming years. However, despite how attractive these new applications for ceramic products sound, CRDN has yet to be able to show investors that the operations that produce them can be sustainably profitable. In the same vein, the Advanced Ceramics division that produces the body armor has had by far the most consistent and highest margins of all of the segments. That means that revenue diversity away from body armor will likely negatively impact margins and ROE. Aside from these relatively acute issues, it is unclear where CRDN will turn for revenue and earnings once the current replacement cycle for body armor is complete. Over the next few years CRDN may see consistent revenue as the US military ramps up spending on the XSAPI armor, but after that subsequent replacement trends will likely depend on innovation that can come from CRDN or any of its competitors. Just as Warren Buffett does not like to hold tech stocks that are at the mercy of technological revolutions and changes in user behavior, investors looking at CRDN should be cautious about a company that relies on difficult product upgrades to maintain revenues and earnings. In the end what needs to be ascertained is whether or not the current share price reflects all the current and future headwinds and includes a margin of safety. Unfortunately, with all the uncertainty regarding an appropriate run rate (non-war) EBIT, any EPV analysis should be taken with a grain of salt. I think it makes sense to look at CRDN a little like a cyclical commodity stock that requires a large margin of safety to be attractive in the current US equity market environment. Management has indicated that it expects 2009 net income to drop anywhere from 50-60% and free cash flow from 60-70% in comparison to 2008. Investors have to be careful not to extrapolate the current economic environment and negative sentiment too far into the future so as not to become paralyzed by uncertainty. However, with this particular stock, it is my belief that the secular tailwinds that buffeted the company over the past few years are fading as the company has to deal with an increasingly less robust global economy. Accordingly, despite the large decline in the share price, the low valuation multiples relative to the competitors and to the past, and some pessimism surrounding the stock, I am not sure the risk-reward potential justifies purchasing shares at this level. The downside is pretty clear: without a sustainable competitive advantage, profitable non-defense divisions, or a multiple-front war on terror, earnings could continue to fall and the multiple people are willing to pay for those earnings could contract as well. While the strong balance sheet and the stock price below book value per share do offer some downside protection, it is hard for me to see the upside that justifies the risk. Specifically, without significant innovation or an accelerated replacement cycle in body armor, it seems unlikely that the company will be able to get back to the revenue levels achieved from 2006 to 2008. Also, no matter how much faith management is putting into the new applications for solar and nuclear energy, CRDN does not have a proven track record in the energy space and growth in these areas is not certain to be robust, feasible, or profitable. In a no growth scenario CRDN becomes nothing more than a company trading at about 14x forward earnings and 19x free cash flow without much (or any) margin of safety. There is no question the 52 week high over $50 is enticing and is easy to get anchored to. However, the 10 year chart on CRDN shows that the stock traded under $10 for 18 years before breaking out as the US increased the number of troops deployed around the world. Therefore, my advice is to continue to follow the company, watch the share price, and keep track of the US government’s orders for XSAPI body armor. At a certain price level the stock may offer a free call on potential growth, with the potential downside backstop of the company’s stable, unlevered balance sheet,

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discount to book value and consistently high ROE. If the company is able to maintain free cash generation in the $30-$40M range and can avoid losses and/or write downs that reduce book value, eventually the company may benefit from a more reasonable multiple being placed on book value. However, on a potentially cyclical stock such as this one, I believe it is appropriate for an investor to expect at least a 15% return. A desired 15% return would imply an EPS multiple of about 6.67x and a stock price around $10.50 when applying the low end of management’s EPS guidance for 2009. With over $3 in net cash per share and the stock hypothetically trading at 45% of tangible book value, I think a stock price at that level would offer a margin of safety and appropriate risk-adjusted return potential.