Ceradyne Is an Under-the-Radar Energy Play

This article is part of ourRising Star portfolio series.

When I mentioned Ceradyne (NAS: CRDN) to Nick Crowe, my Foolish colleague who works on our Motley Fool Pro and Motley Fool Options services, his response was, "What, the body armor company?" It's that kind of messed-up expectation that I look for in my real-money Rising Star portfolio -- one where investors haven't caught up to the facts of a company.

You see, Ceradyne, a maker of technical ceramic, was a body armor company back in 2007 and 2008, during the height of the wars in Afghanistan and Iraq. But management saw the writing on the wall and has worked hard to pull the company away from dependence on a single class of product and diversify its revenue stream. And so far, they've done a pretty good job.

Diversity is life
In 2007, 74% of the company's revenue came from selling to the defense industry; last year, that had been cut almost in half to 39%. The replacement revenue came from significant growth in sales to industrial clients (increasing from 17% of revenue in 2007 to 29% last year) and, more important, to the energy industry (rocketing from 3% of sales in 2007 to 23% in 2011). Today, Ceradyne is much more than just body armor.

One of the newer products I'm excited about is PetroCeram, a ceramic filter to remove sand and other particulate matter from oil as it is pumped out of the earth. The problem is well-known and has traditionally been solved using stainless steel filters. The trouble is that stainless steel wears down from friction with the sand. PetroCeram, made of technical ceramic, holds up much better, which means improved performance and more uptime for oil drilling. The company estimates this market to be $1 billion. For a video with CEO Joel Moskowitz and a close-up of this PetroCeram product, click here.

What else is it good for?
Technical ceramic isn't the stuff that makes decorative planting pots. It is a careful mixture of inorganic materials fused together to form products that are highly resistant to heat (e.g., to make containers used to melt metal), are chemically inert, and are often electrically insulating. They're used in automotive brakes, high-friction engine parts, catalytic converters, dental and joint replacement products, tools to cut and form metal, electrical heating elements, electrical insulators, and permanent magnets. That's hardly an exhaustive list. Oh, and it also makes body and vehicle armor and helmets.

The advanced technical ceramic industry is expected to grow by about 6% annually to $14 billion in 2015. Growth is expected to be especially strong in transportation-related products, thanks to increased production of medium- and heavy-duty vehicles. Growth for diesel engine makers Cummins (NYS: CMI) and Westport Innovations (NAS: WPRT) will mean growth for Ceradyne, which makes parts for them, such as cam rollers used in the valve trains of heavy-duty diesel engines.

The $10.5 billion industry is highly fragmented with at least 36 players of note. Kyocera (NYS: KYO) is a significant competitor, but I prefer Ceradyne's higher return-on-asset and return-on-equity ratios. Neither company is highly levered, and both have similar revenue-to-asset ratios, so the difference in ROE between the two is mostly a function of higher net margin at Ceradyne.

Why I'm buying
As I wrote above, I don't believe investors have quite wrapped their heads around the fact that Ceradyne is no longer just a defense-related company -- and that's reflected in the current price. Using a simple DCF model, current expectations are for just 6.7% growth in free cash flow for the next five years, dropping down to 3.4% for the following five, and then a terminal growth rate of 2.5% (discounting at a high hurdle rate of 15%). Given the rapid growth in energy sales over the past several years and the resurgence in automotive and other industrial sales, I believe that to be too low.

Building a more formalized DCF model where I let defense-related sales decline steadily, along with growing but slowing sales in other sectors (dropping to less than 10% annual growth after just two years), I get a value estimate of about $50 per share (discounting at a 10.6% cost of equity). If it can maintain 10% growth in nondefense sales for even a few years, and if military sales don't decline as quickly as I model (after all, this is armor to protect soldiers), then shares could potentially be worth significantly more.

One further point in its favor: It just initiated its first-ever quarterly dividend at $0.15 per share, a 1.9% yield.

Tomorrow, I'll open an initial position in Ceradyne and look to add after seeing how it does after reporting the first quarter's results in a few weeks.

Feel free to come and discuss these and other investments on my Messed-Up Expectations discussion board, or follow me on Twitter.

Ceradyne isn't your "typical" energy play. For a more traditional choice in filling the energy portion of your portfolio, check out this free report describing "The Only Energy Stock You'll Ever Need."

At the time thisarticle was published This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).Fool analyst Jim Mueller owns shares of Westport. He's an analyst for the Motley Fool Stock Advisor newsletter service. Motley Fool newsletter services have recommended buying shares of Cummins and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed up.

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