High Grades for a Chip Test Gear Maker
By Richard Tortoriello
In 1960, two former Massachusetts Institute of Technlogy classmates, Alex d'Arbeloff and Nick DeWolf, founded Teradyne (TER ) based on the premise that electronics testing would become a bottleneck to high-volume production of components unless tasks that had been performed by hand were automated. Now, the Boston-based outfit is the world's largest supplier of automatic test equipment to the electronics industry.
Semiconductor automatic test equipment (ATE) makes up just below 50% of sales at Teradyne, which holds the leading market share in nonmemory test equipment. The remaining 50% come from "backplane connection systems" (32% in 2002), which are large panels used to interconnect circuit boards in electronics systems; printed circuit-board tests (14% in 2002); and other products. Teradyne's position in printed-circuit boards and inspections was broadened significantly through the October, 2001, acquisition of Genrad.
Teradyne sales surged to $3 billion in the boom year of 2000 but then plunged to $1.4 billion in 2001 and to $1.2 billion in 2002, representing a total decline of 60%. In the same period, industrywide sales of ATE to the semiconductor industry fell by an estimated 70%, according trade group Semiconductor Equipment & Materials International (SEMI).
Recently, test-equipment bookings have shown strength, with SEMI reporting month-to-month growth in North American test and assembly bookings for six of the last seven months. Indeed, Teradyne's bookings have grown from a trough of $113 million in the third quarter of 2001 to $300 million in the second quarter of 2003. Its semiconductor ATE bookings rose 23% in the second quarter from the first, and the semiconductor segment dominated during the quarter, accounting for 70% of sales and 61% of bookings.
Teradyne also noted that its backplane connection systems business, which is heavily tied to computer and telecom markets, has begun to improve for the first time in a long while. We at S&P expect sales to the semiconductor market to drive Teradyne's business, with backplane connection systems and printed-circuit board gear gradually improving as the U.S. economy continues its recovery.
Teradyne has been winning a significant number of so-called design-in wins in recent quarters, with momentum particularly strong for its high-end Catalyst and Catalyst Tiger system-on-a-chip systems, which test complex integrated circuits that combine logic, memory, and analog functions on a single chip. While having a product "designed-in" to a customer's test process doesn't guarantee future sales, design-in wins are a key indicator of sales potential.
Given a semiconductor test equipment market that in 2000 was about $1.5 billion to $2 billion per quarter and is now $400 million to $500 million per quarter, pricing has been extremely competitive, with vendors offering customers significant discounts. Recently, however, we've seen signs that pricing is beginning to improve. In addition, we believe Teradyne is well-positioned in the upper end of the test equipment market, where utilization rates have been high and pricing pressure the weakest.
Teradyne reports that utilization rates at customer facilities using its mainstay Catalyst and J750 testers are running at 85% to 90%. We believe that overall test-industry utilization rates are well over the 80% mark. With semiconductor unit volume sales up 14% in 2002 and 6% for the first seven months of 2003, we expect the utilization number to rise past the critical 85% to 90% range that has historically spurred tester capacity additions.
We also believe that the semiconductor test industry, which consists of a relatively large number of players -- including Teradyne (ranked 5 STARS, buy), Advantest (ATE ), Agilent (A ; ranked 3 STARS, hold), Credence (CMOS ; ranked 4 STARS, accumulate), LTX Corp. (LTXX ; ranked 3 STARS), and other smaller companies -- is ripe for consolidation. We expect that to happen over time, as smaller players are less able to afford the significant research and development spending necessary to stay ahead of competitors in this fast-paced market.
Teradyne spent about $290 million on R&D in both 2001 and 2002, and we expect that to decline only modestly to $260 million in 2003, before picking up next year. As of June, Teradyne had $290 million of cash and equivalents, which we believe is more than enough to support both working capital and R&D needs.
One of the most recent testers Teradyne developed is the FLEX system, which was introduced in 2002 and designed for high-throughput testing of system-on-a-chip and mixed-signal (combining digital and analog functions in one chip) devices. FLEX combines the instrument flexibility of the higher-end Catalyst system, which enables it to test many different kinds of devices, with the ability to test multiple devices simultaneously of the popular J750 system. FLEX is initially being targeted at the high-volume market for consumer chips.
With an industry downturn resulting in large losses at Teradyne, it consolidated its facilities, reduced the number of employees, and cut material costs by buying from lower-cost areas, such as China. Teradyne cut its headcount by 30% since yearend 2000, resulting in significant recent improvements in productivity, as measured by revenue per employee. In addition, it discontinued some lagging product lines and has been improving its equipment designs to reduce manufacturing costs.
That has boosted gross margins from a low of 6.1% in the fourth quarter of 2001 to 27% in the second quarter of 2003. We expect margins to keep improving, due to both cost benefits and volume increases, and we see average gross margins of 40% in 2004.
While we expect an operating loss (excluding restructuring, asset impairment charges, and associated charges) of 57 cents per share in 2003, we forecast earnings per share of 47 cents in 2004 and 95 cents in 2005. Although we expect moderate sales growth compared with previous upcycles -- 12% in 2003, 18% in 2004, and 13% in 2005 -- we believe our EPS forecasts are achievable due to the high degree of operating leverage Teradyne is building through its consolidation and other cost-reduction programs.
The shares, which closed at $20.01 on Sept. 11, trade at 2.8 times trailing 12-month sales and 3.9 times book value, nearly in line with their 10-year historical averages of 2.7 times sales and 3.6 times book value. On a p-e basis, Teradyne traded at 21 times our 2005 cycle-peak EPS estimate, vs. previous cycle-peak multiples of 19 to 40 times.
Our target price is $26, or three times our 2004 sales estimate of $1.6 billion, or $8.77 sales per share. With many signs that both the U.S. economy and the world semiconductor industry are entering a cyclical recovery, we at S&P recommend that investors buy the shares. We note, however, that Teradyne's share-price movements are more volatile than the average stock's. Therefore, we view the shares as having high risk.
Analyst Tortoriello follows semiconductor equipment stocks for Standard & Poor's
Edited by Karyn McCormack