Archive: Ceradyne (CRDN)

CRDN: Ceradyne Offers a Good Example of the Risks and Benefits of a Put-Write Strategy

When I first became an analyst, my boss was fond of saying he’d rather have luck than brains. There are so many times, as an investor, when I have considered the understated wisdom of those words. The whole field of behavioral finance is devoted to the tricks our brains like to play on us, and there are certainly plenty of examples of cases where investors simply became too smart for their own good.

I had a little case of luck last week, when I was going to write puts on either Ceradyne (CRDN) or Verizon (VZ - Annual Report), having the capital available for only one of the trades. I chose Verizon primarily out of luck, and it has rallied nicely from the intra-day lows near which I wrote my puts, making it quite unlikely that they will be exercised against me. Meanwhile, Ceradyne lowered guidance Tuesday and lost more than 25% of its market value.

Although I have often expressed the benefits of a put-write strategy (lowering the effective price of stocks you were willing to buy anyway, or collecting a more generous yield if the stock doesn’t fall below the strike price) I thought an analysis of the Ceradyne case would offer a good illustration of the risks – and why I like the strategy even when those risks are considered.

First of all, the 25% decline in Ceradyne was going to knock put sellers or long investors regardless of any stop-loss or other strategies commonly described as “risk reduction” tools. In fact, it nicely illustrates the criticisms of the Black-Scholes option pricing model so recently discussed in Conde Nast Portfolio. Namely, the big event risks are underestimated. Only having bought puts at a lower exercise price (and thus eroding the potential returns) would have offered some protection against the sudden price drop. 

That said, does the exposure to sudden price drops invalidate the strategy? I don’t think it does, provided investors focus on the stocks that they understand and are willing to be long anyway. In fact, when I looked at the put-write on Ceradyne in December I pretty much nailed the potential risks.

“Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.40. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.15.

“Then the company announces that earnings will only be $3 a share in 2008, and the stock drops to $30. You’re down $12.15, or 27% of the money you put at risk. So much for low risk.

“On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6.15 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.”

Whether simply buying a stock, or using a put-write strategy, knowing the risks is imperative. I always try to look at a disaster scenario (like the one I illustrated for Ceradyne) that is outside the limits of what most investors consider. Usually these disasters don’t occur, but they happen more often than investors like to admit. Planning for them – and mitigating them when possible – should pay off over time.

Disclosures: William Trent has written put options against the shares of Verizon (VZ - Annual Report).

Topics: Aerospace and Defense, Capital Goods, Ceradyne (CRDN), Verizon (VZ) | No Comments

CRDN: Considering Options on Ceradyne Again

The following is a reprint of my December 11, 2007 RealMoney column.

Ceradyne (CRDN) develops, manufactures and markets products based on highly technical ceramic materials. It is best known for selling ballistic plates used for body armor and light-weight vehicle armor by the U.S. military. Such sales accounted for more than 75% of total revenue during the last several years.

Much of that time, shares of Ceradyne have appeared very cheap on a price/earnings basis. Persistent fears that the body armor market would peak have kept a lid on the price. As an example, in October provided guidance for next year’s earnings per share of $5.60 – $6.65. Such a wide range would normally not be much help, but in Ceradyne’s case it means the stock is trading somewhere between 7x and 8x next year’s earnings.

Although I like a cheap stock as much as anyone, I too have been concerned that the military orders would peak. Although the company is expanding into other areas, it will be several years before any of them is likely to offset a potential decline in military sales. As a result, I have taken a very cautious approach to Ceradyne over the last couple of years.

Because of my caution, I missed the run from $50 – $80 per share over the last 12 months. But I also missed the run from $80 back down below $50. In the meantime, I still managed to earn $16 per share on CRDN – after transaction costs – mostly by doing my best not to have a position in the stock.

The really good news is that I think investors can once again profit from a relatively low-risk approach to Ceradyne. Here’s how it would work today.

Selling Options

If you don’t own Ceradyne today, you would sell a put option forcing you to buy the shares at a specific price on a specific date if the shares are trading below that level. Essentially, you are selling downside insurance to someone who owns the shares, and they are willing to pay you a premium for that privilege.

Today, that premium depends on exactly what risk you will allow them to insure. You could get about $0.55 to insure a drop below $45 before December 22, or about $1.60 to insure the same price until January 19, 2008. In either case, you get a return of close to 2% per month for the $45 you put at risk.

Alternatively, you could sell put options at $50, especially if you are confident of the current valuation being cheap. Since these options are in the money, a January $50 would bring in about $4.00 – $1.60 because it is already in the hole, and the other $2.40 being a higher premium than the $1.60 you get (see previous paragraph) for insuring a less likely drop below $45.

So what happens if the stock does drop and your counterparty makes you buy it? Then I would sell a call option. To illustrate, let’s assume you write the put option for $50 and the price doesn’t change between now and January.

You write the put option for $4.00 and on January 19 Ceradyne is priced at $48. Your put option is exercised against you and you pay $50 per share to buy it. Your net purchase price is $50 less the $4.00 premium or $46, and you are $2.00 ahead of the game.

You immediately sell a $50 call option expiring in February. Judging from today’s option prices, you might get $1.50 for this option, bringing your total outlay to under $45 per share. If the stock rises to, say, $51 you get called and sell your shares for $50, for a net profit of more than $5 per share even though you bought and sold at the same price. You may even want to write a new $50 put option at that time and start the process over again.

If the stock isn’t above $50 when the option expires in February, sell another one expiring in March and collect another premium. Incidentally, this is also the way investors who currently own Ceradyne can play this game – instead of starting with a put option, you start with the call.

Risks are Real

I described this strategy as low risk, and I believe it is. But anyone interested in giving it a try should be aware that there are indeed risks, and potentially substantial ones.

Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.60. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.35.

Then the company announces that for some reason earnings will only be $3.00 per share in 2008 and the stock drops to $30. You’re down $12.35, or 27% of the money you put at risk. So much for low risk.

On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.

Pick Your Value

I did a sensitivity analysis on Ceradyne earnings more than a year ago, and would highly suggest doing a similar one today. Given the range of estimates the company provided (and the possibility that future earnings could be lower) it is a good idea to get a feel for the worst-case scenario.

Once you get comfortable with the worst outcome, you can decide at what price you would be willing to have exposure, and can use options to limit your risk around that level. Small price swings can have a large impact on option prices, so you need to be aware of the market and I often use limit orders for this type of strategy.

Topics: Capital Goods, Ceradyne (CRDN) | 1 Comment

CRDN: Looking For Growth in All the Right Places

I have discussed Ceradyne’s operating leverage in the past, and noted that what is more important than the quarterly results is whether they will prove sustainable.  To that end, the company’s latest press release is interesting:

Ceradyne, Inc. (CRDN) announced today the opening ceremonies for its new 98,000 square foot factory in Tianjin, China. This newly constructed factory will produce high purity ceramic crucibles for the forming of large polysilicon ingots for use in the manufacturing of photovoltaic silicon solar cells.

Wow! China and solar energy. Can’t get much growthier than that. Of course, they are making the crucibles that will make the ingots that will make the solar cells… kind of like saying a cement company makes the product used to build buildings in which cutting-edge pharmaceuticals are developed.

Breathless headlines aside, however, the plant marks a step in the right direction. Namely, diversification away from the body armor products that are approaching their natural demand limits.

Topics: Ceradyne (CRDN), Stock Market | 1 Comment

CRDN: Ceradyne Slowing, Still Cheap

Ceradyne, Inc. (CRDN) Reported Record 2007 First-Quarter Results:

Sales for the first quarter increased 38.2% to a record $188.4 million from $136.3 million in the first quarter of 2006. Net income for the first quarter of 2007 increased 54.8% to a record $38.1 million, or $1.38 per diluted share, compared to net income of $24.6 million, or $0.90 per diluted share, in the first quarter of 2006.

Analysts were expecting the company to earn $1.32 per share on $180 million in sales. We have discussed Ceradyne’s operating leverage in the past, and noted that what is more important than the quarterly results is whether they will prove sustainable.  The company did not provide guidance in the earnings release, but did provide some indications of future potential:

First-quarter 2007 new orders were $176.5 million compared to $154.7 million in the first quarter of 2006. Total order backlog on March 31, 2007 was $332.3 million compared to the prior year backlog of $294.8 million.

The year/year growth in orders of 14% and backlog growth of 12.7% are much slower than the 38% growth in sales over the last year, making it fairly clear that the sales growth will slow substantially. However, the fear isn’t so much of slow growth as it is that sales will actually decline once the military is fully stocked with body armor. The stock would be trading much higher than 13x trailing earnings if investors believed the company could continue to grow at the 12-15% rate indicated by orders and backlog.

Topics: Ceradyne (CRDN), Stock Market | No Comments

The Week Ahead (22 April 2007)

The Economic Calendar is relatively light this week. Potential market movers include:

  • Wednesday’s Durable Goods report (consensus 2.2%)
  • Friday’s advance report on Q1 GDP (consensus 1.8%)

Earnings are another story. We are in the peak part of earnings season this week. A few of the stocks we follow:

Monday

  • Altera (ALTR) – valuation is rich but looks set up to beat on earnings.
  • Texas Instruments (TXN - Annual Report) – March and June quarters have both had significant downward revisions. Will day of reckoning be forestalled?

Tuesday

  • AU Optronics (AUO) – Forecasting losses, but panel business may have bottomed out.
  • CDW Corporation (CDWC) – 14.6% sales growth doable given Berbee acquisition.
  • CH Robinson (CHRW - Annual Report) – Could beat.
  • CSG Systems (CSGS) – earnings should be a piece of cake. If private equity buyers don’t take them out they’ll do it themselves the slow way.
  • Lexmark (LXK) – Estimates are doable but we’re always waiting for this company to trip up.
  • ST Microelectronics (STM) – Doing the right thing. Hopefully will pay off.
  • AT&T (T - Annual Report) – Estimates and stock both keep rising.

Wednesday

  • Apple (AAPL) – Hunch: company will blow away earnings, issue horrible guidance and blame it on iPhone build.
  • Arkansas Best (ABFS) – We’re staying away from truckers who own trucks.
  • Corning (GLW - Annual Report) – current quarter ok, guidance at risk.
  • LSI Logic (LSI) – May blame their poor guidance on Agere.
  • Maxim (MXIM) – Company is out of gas but focus will be on whether they might sell out.
  • Qualcomm (QCOM) – Nokia Nokia Blah Blah Nokia ad nauseam (excerpt from pending conference call transcript)
  • Silicon Laboratories SLABSold wireless just when biggest customer began to recover. What other surprises may be in store?
  • UPS (UPS) – They shouldn’t have trouble beating the estimates (but that doesn’t mean they won’t).
  • Xilinx (XLNX) – Altera with more risk to the earnings target.

Thursday

Friday

  • Dassault Systemes (DASTY) – We like Ansys (ANSS) better but don’t see why this name wouldn’t beat.
  • Ceradyne (CRDN)  – Earnings could be anywhere and don’t really matter.

Enjoy!

Disclosure: William Trent has a long position in SMH.

Topics: ANSYS (ANSS), AT&T (T), AU Optronics (AUO), Altera (ALTR), Apple (AAPL), Arkansas Best (ABFS), CDW Corp (CDWC), CH Robinson Worldwide (CHRW), CSG Systems (CSGS), Ceradyne (CRDN), Corning (GLW), Curtiss Wright (CW), Dassault Systemes (DASTY), KLA-Tencor (KLAC), LSI Corp. (LSI), Lexmark (LXK), MEMC Electronic Materials (WFR), Maxim Integrated Products (MXIM), McAfee (MFE), Microsoft (MSFT), Qualcomm (QCOM), STMicroelectronics (STM), Sandisk (SNDK), Silicon Laboratories (SLAB), Stock Market, Texas Instruments (TXN), United Parcel Service (UPS), Watch List, Xilinx (XLNX), YRC Worldwide (YRCW) | 4 Comments

XLNX: Xilinx Joins the Dumb Financing Decision Parade

For some reason, the latest fashion appears to be issuing convertible notes. The practice allows companies to reduce the apparent share count, but assuming the share price rises (which stockholders are presumably rooting for) the shares willl just come right back. We’ve seen this with Ceradyne (CRDN) and Finisar (FNSR), and now Xilinx prices $900 mln 3.125 pct convertible debentures | Reuters.com:

Xilinx Inc. (XLNX) said it priced $900 million of 3.125 percent convertible junior subordinated debentures due in 2037, and expects the sale to close March 5.The debentures will initially be convertible into shares of Xilinx’s common stock at a conversion rate of 32.0760 shares of common stock per $1,000 principal amount of debentures, the company said.

At recent share prices, the company should be able to buy back between 32 and 33 million shares with the proceeds. If the company does well and the shares rise above $31.18 before 2037, the company will then exchange the bonds for approximately 29 million shares. So, for a net reduction of 3-4 million shares the company will be paying a 1.725% premium (the convertible yield less the dividend yield on the stock) for 30 years.

The additional interest expense relative to the dividends that would otherwise be paid amounts to $15.5 million per year. That would allow the company to buy 600,000 shares annually at the current price, which would give them the same net share reduction after just 5 or 6 years rather than the 30 year term of the convertible bonds.

Or alternatively, the company could buy back shares with the $300 million it used in the December quarter to increase its balance of short term investments. That would allow them to buy back 11.5 million shares and retire them permanently, never having to worry about the dilution again, and never incurring the interest payments on the debt. Over time, that would quadruple the net share buyback and they would recover more than 100% of the initial outlay in interest savings over the life of the convertible. If, for some reason, the company then failed to generate sufficient cash flow to run its operations (which appears to be an unlikely outcome) they could always then turn to the convertible securities market for a cash injection.
Of course, the company won’t have to reissue the shares if the stock does not rise above $31.18 by 2037. But we’re pretty sure shareholders aren’t interested in that potential outcome. No matter how you slice it it is hard to see how this deal is positive for existing shareholders.

Topics: Ceradyne (CRDN), Finisar (FNSR), Stock Market, Xilinx (XLNX) | 4 Comments

CRDN: Ceradyne Earnings Great, Guidance Raised

Ceradyne, Inc. Reports 2006 Fourth-Quarter and 12-Month Results

Ceradyne, Inc. (CRDN) today reported results for the fourth quarter and twelve months ended December 31, 2006.Sales for the fourth quarter 2006 increased 56.6% to a record $178.7 million from $114.2 million in the fourth quarter of 2005. Net income for the fourth quarter of 2006 increased 135.1% to a record $37.7 million, or $1.38 per diluted share, compared to net income of $16.1 million, or $0.63 per diluted share, in the fourth quarter of 2005. Fully diluted average shares outstanding for the fourth quarter were 27,443,000 compared to 25,479,000 in the same period in 2005.

Sales for the year ended December 31, 2006, increased to a record $662.9 million, up 80.0% from $368.3 million in 2005. For the year ended December 31, 2006, net income increased to $128.4 million, or $4.69 per diluted share, on 27,352,000 average shares outstanding, from $46.8 million, or $1.86 per diluted share, on 25,107,000 average shares outstanding, for the year ended December 31, 2005. Net income for the year ended December 31, 2006 was up 174.5% over last year, and earnings per diluted share for 2006 increased 152.2% compared to 2005.Fourth-quarter 2006 new orders were $313.5 million compared to $200.9 million in fourth-quarter 2005. For the year 2006, new orders were $730.1 million compared to $443.6 million in 2005. Total order backlog on December 31, 2006 was $344.3 million compared to the prior year backlog of $276.4 million.

We have known for some time that the near-term earnings outlook is very positive. The question is always what will come next, for once everyone in the military is supplied with body armor the sales should at best level out and could even drop off dramatically to a modest replacement pace. We said in early January:

While the news has lifted the shares this morning, it will be more interesting to see what the company predicts for 2007 when they hold their conference call in late February. So far the company has not only beaten consensus estimates but even the most wildly bullish ones. However, we are still concerned that military body armor orders are peaking and the leverage will work both ways.

On the conference call, the company raised its 2007 guidance to $720-740 million of sales and $5.20-$5.40 in EPS. The consensus estimate is for $178 million in sales and $1.24 in Q1 EPS and for $716 million in sales and $4.96 in EPS for 2007. The improvement remains based on the orders they have received, as well as preliminary discussions with the military for body armor. While management stressed opportunities to diversify the revenue stream away from body armor, the overwhelming dominance of that product line makes the strategy by necessity a long-term one.

Topics: Ceradyne (CRDN), Stock Market | 1 Comment

The Week Ahead (25 February 2007)

Economic Releases

The Economic Calendar gets busy. We have durable goods (consensus = -3.0%) on Tuesday, preliminary GDP (consensus = 2.3%) on Wednesday, and ISM Manufacturing (consensus = 49.7) on Friday.
Earnings Reports

Ceradyne (CRDN) reports on Monday. It did not make it on any of our watch lists, but is nonetheless a name we follow. Consensus calls for $1.18 on $171 million in revenue, with forward guidance of $1.24 on $178 million.
Tech names Brocade (BRCD) and Marvell (MRVL - Annual Report) are also up on Monday. Brocade is expected to earn $0.10 on $215 million in revenue and guide to $0.08 on $337 million. Marvell is expected to earn $0.08 on $625 million in revenue and guide toward $0.10 on $650 million.
Autodesk (ADSK) reports on Tuesday. The company has some business overlap with Mid Cap Watch List (Track at Marketocracy) member Dassault Systemes (DASTY). Autodesk is targeted to earn $0.46 on $497 million revenue and guide to $0.44 on $500.
The big earnings news for the week will be Dell (DELL) on Thursday. Estimates call for $0.29 EPS on $14.9 billion in revenue, and for guidance of $0.28 on $14.3 billion.

Topics: Autodesk (ADSK), Brocade (BRCD), Ceradyne (CRDN), Dassault Systemes (DASTY), Dell (DELL), Marvell Technology (MRVL), Stock Market | No Comments

Birthday Bash: Who’s Cooking the Books?

In honor of Stock Market Beat’s birthday next week, we are looking through the archives for some of our best posts. As it happens, several of them investigate whether companies are using aggressive accounting practices. Who’s cooking the books?
Is it DELL?

Is it Xerox?

Is it Fidelity National Information Services?

Is it Ceradyne?

Or maybe Finisar?

The comment box is open.

Topics: Ceradyne (CRDN), Dell (DELL), Fidelity National Information Systems (FIS), Finisar (FNSR), Stock Market, Xerox (XRX) | No Comments

CRDN: Ceradyne Makes More Sales We Already Knew About

The way the defense spending process works, companies selling to the military generally receive a blanket order covering multiple years, but the actual spending must be approved by Congress each year. As a result, companies typically report both the blanket order (which allows investors to anticipate the likely future revenue stream) and the follow-on orders (which allows investors to see that the expected revenue will actually materialize.) With large companies like Lockheed Martin (LMT), the announcements are seldom sufficiently significant to move the market. However, with smaller companies investors must pay careful attention, as is the case with today’s announcement from Ceradyne (CRDN).

Ceradyne, Inc. Receives $113 Million Ceramic Body Armor Order for U.S. Army: Financial News – Yahoo! Finance

Ceradyne, Inc. received a $113 million delivery order for ESAPI (Enhanced Small Arms Protective Inserts) from the U.S. Army, Aberdeen Proving Ground, Maryland. This new delivery order is scheduled to be shipped beginning April 2007 through early September 2007. This delivery order will be shipped against a larger indefinite delivery/indefinite quantity (ID/IQ) contract announced earlier. The Company records as firm orders only delivery orders, such as the above, that have firm scheduled delivery dates.Dave Reed, Ceradyne President North American Operations, commented: “This delivery order is the largest single ESAPI order ever received by Ceradyne.”

The delivery is the follow-on order from a previously announced contract, so the only incremental information is that the order will actually go through as expected. Hopefully the 5% rise in the share price today is due more to investors appreciating Ceradyne’s attractive valuation than to a misunderstanding over whether this is a new order.

It also serves as a good illustration of  PR word-mincing, as this $113 million “largest single ESAPI order ever received by Ceradyne” should not be confused with the $133 million ESBI order they received in December. For the record that, too, was a follow-on order as part of a previously announced contract.

Topics: Ceradyne (CRDN), Lockheed Martin (LMT), Stock Market | No Comments