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The Inoculated Investor http://inoculatedinvestor.blogspot.


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) 2008 % Total 2007 % Total 2006 % Total
$62 $5
US $496.2 72.95% 0.6 82.00% 56.8 84.00%
136 10
Foreign 184.0 27.05% .2 18.00% 6.1 16.00%
$75 $6
Total $680.2 100% 6.8 100% 62.9 100%

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 Q1 2009 2008 2007 2006

Advanced Ceramic Operations (ACO) 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
Corporate 0.53% -5.37% 1.48% 3.87%
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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.

Backlog Q1 2009 Dec-08 Dec-07 Dec-06

Amount ($US millions) $177.2 $126.4 $238.9 $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.

1. Unlevered Free Cash Flow

2006 2007 2008 LTM/Current

FCF $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

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
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

2009 Guidance (April 28, 2009) Implied

Low End $1.60 14.25x
High End $2 11.40x
Revenue TEV/Revenue
Low End $465 1.04x
High End $500 0.96x
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

2000 2.20x 2000-2002
2001 1.97x 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

2000 2.34x 2000-2002
2001 2.06x 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 $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%.

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 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)

1999 $7.3 2004 $49.5
2000 $8.0 2005 $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) $465

Conservative Run Rate Gross

Margin 30%
5 Year Average GM 37.6%
10 Year Average GM 31.4%
Implied Gross Profit 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 Current Market Cap Margin Of Safety
9% 7 608.76 32.67%
10% 5 608.76 25.19%
11% 7 608.76 17.71%
12% 3 608.76 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

Q1 2009 2008 2007

ORB Revenue Op Income Op Margins Revenue Op Income Margins Op Margins
Launch Vehicles $119.2 $4.3 3.61% $454.3 $33.6 7.40% 9.99%
Satellites and Space
Systems 110.2 7.8 7.08% 422.3 32.2 7.62% 6.58%
Advanced Space 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% 7.85%
ROE 9.40% 8.20% 13.20%
Net Debt ($207.9) ($184.6) ($92.1)
US Government Contracts N/A 73% 68%

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 2008 2007

FRPT Op Margins ROE Op Margins ROE Op Margins ROE
Armored Vehicles Sales 6.20% 10.50% 5.70% 18.4% 0.60% 3.40%
Net Debt (CASH) ($119.8) ($79.3) ($90.5)
US Government Contracts* 94.1% ~100% ~100%
*Estimate based on Q1 2009 Accounts Receivable data

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

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.

9 Months Ended
31-Jan-09 LTM Apr-08 Apr-07
AVAV Op Margins ROE Op Margins ROE Op Margins ROE
Unmanned Aircraft & Efficient 13.8% 12.4% 13.2% 14.0% 16.3% 24.3%
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Energy Systems
Net Debt (Cash) ($123.4) ($118.4) ($109.2)
US Government Contracts N/A 84.0% 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

Average Multiple
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


2005 1.69x NM NM 5.64x
2006 2.32x NM NM 5.07x
2007 3.00x 8.44x 3.68x 3.81x
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

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
The Inoculated Investor

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 Date Recent Activity

Joel Moskowitz CEO/Chairman 1449K Co Founder, CEO since 1983 May-09 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
The Inoculated Investor

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

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
The Inoculated Investor

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
The Inoculated Investor

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 pre-
war 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..
The Inoculated Investor

However, the more cost conscious the environment, the more difficult it will be for CRDN to
convince potential customers to switch.


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,
The Inoculated Investor

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.