Sunday, August 10, 2008

Ceradyne: Tremenduous Growth with Risk

Ceradyne (Nasdaq: CRDN) is a manufacturer of advanced ceramic products. One of their major products is ceramic body armor of which the US government has been a major customer.

This company has undergone some amazing revenue growth. In the period 1998 to 2002, the company had compounded annual growth rates (CAGR) for revenues of 24% and during 2003 to 2007 the CAGR for revenues was 65%! This is impressive growth. One major factor for this revenue growth has been the equipping of troops in Iraq using Ceradyne's ceramic body armor.

In addition to achieving this tremendous revenue growth, management has successfully improved both gross and operating margins. Gross margins averaged 23% during 1998-2002 and 35% from 2003-2007. These margins were not lost down the income statement as operating margins improved from an average of 6% in 1998-2002, to 25% in 2003-2007. This is a great combination, massively increasing revenues and improving gross and operating margins.

One of the major risks with Ceradyne's business model is that they are highly dependent on US government defense budgets. One of the risks mentioned by Ceradyne's management is that US government contracts can be terminated abruptly and for the most part without penalty. This could be a major problem for Ceradyne as revenues from defense related products account for 74% of their total revenues. Defense priorities and budgets change and there is no guarantee that the successes of the past will continue. Your business risks are much higher if you highly depend on one major customer versus having many different customers.

Ceradyne's management recognizes the need to expand revenues from outside the defense sector and are working towards that goal. At this point, since it is too soon to tell how successful management will be in diversifying their sources of revenues, I would classify Ceradyne as having a risky business model.

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