In previous posts we have discussed Ceradyne’s (CRDN) increased reliance on military body armor for revenue and the potential consequenses should orders flatten or, worse, decline significantly once the military has all the units it needs. In the latest quarter, military sales made up 80 per cent of CRDN’s overall business. Because the issue is so important for potential Ceradyne investors, this article conducts a sensitivity analysis on Ceradyne’s sales and earnings.
When a company increases its sales, most of the time its earnings can grow by a greater amount. This is because some of the company’s costs are fixed and do not fluctuate with the level of sales. This factor is called the operating leverage effect (OLE). According to The Analysis and Use of Financial Statements, (p. 138) OLE can be estimated as the percentage change in operating income divided by the percentage change in sales.
Looking at the last three years for Ceradyne, we find an approximate OLE of 130%, which suggests that each 10 per cent change in CRDN revenue will result in a 13 per cent change in operating income. Using that, we can now create some basic scenarios for the company. First, we will assume that 2006 results are in line with management’s guidance (which implies a 170 per cent OLE in 2006.) Given the range of OLE estimates we have seen, we will settle on 150 per cent for our analysis. From there, we will start with three scenarios for 2007:
- Base Case: After 2006, military sales are flat as replacement units make up for the initial order fulfillment. The rest of the company can grow 15 per cent. Due to the 80/20 mix of military/other, this translates into total revenue growth of three per cent.
- Bull Case: After 2006, military sales rise at the company-average 15 per cent per year due to technological advances the military needs or market expansion (i.e. into vehicle armor.) This would mark a total revenue growth rate of 15 per cent.
- Bear Case: After 2006, with the initial order filled, there is a 50 per cent drop in military orders, but the remainder of the business continues to grow 15 per cent. Given the 80/20 revenue mix, this would mean an overall sales decline of 37 per cent.
For those who fear the bear case is too… well, bearish, note that the latest 10Q warns:
Based on our current backlog, we expect our shipments of ceramic body armor to be higher in fiscal year 2006 than in 2005. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2007 from levels we expect to achieve in 2006.
On the other hand, the bull case is also possible. For example, Newsday recently reported that the Army is seeking a replacement design for the current body armor vest. Ceradyne could potentially win this design, although the upside to such a win is uncertain given that Ceradyne already makes the armor plating that is inserted into the current generation vest.
Finally, in Q12006, operating income more or less equaled net income. This is because the interest earned on cash was enough to offset interest paid on the company’s convertible bonds. So, after applying the 36.5 per cent tax rate we should be at a rough estimate of net income for each case. So let’s see them:
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So now we have a set of three potential outcomes for Ceradyne in 2007. You can assign your own weight to each potential outcome, or play with the scenarios. But at least it should now be apparent that the $3.54 consensus estimate for 2007, and even the $3.15 to $4.27 range, are subject to a good deal of uncertainty.