Description

I originally submitted this write up as my club application in April when Teradyne was trading at about $26 per share. Although I personally would not buy the stock until the price is at or below $25, I am posting this write up with only a few modifications since the stock is currently at $30 and seems to be heading back into 20’s and may possibly reach the teens and there have been no developments during the past few months that have changed my views about this company.

SUMMARY: Teradyne is the leading worldwide manufacturer of automated test equipment and connection systems for electronics. The company was founded in 1960 by MIT students, has been public since 1970, and trades under the symbol TER (NYSE). Since the company supplies products to the electronics industry, its performance is closely related to the boom-and-bust cycles in that industry. Currently, Teradyne is out of favor with the market due to the electronics recession. Teradyne’s earnings will decline substantially from 2000 levels this year (and maybe even for the next couple of years) depending on the depth of the electronics recession. However, I believe Teradyne is an outstanding company that has an owner-oriented management with a long-term view, an excellent balance sheet, large competitive advantages, and a good ROE (average 10 year ROE of 15%, average 5 year ROE of 17%). Over time, this company should continue to grow revenues in a rapid, but lumpy fashion, at a minimum rate that matches the high-end electronics industry (12% to 20%). Also, the ROE of the company may increase above 20% if the connection systems division of Teradyne continues to grow rapidly (157% last year, representing 20% of Teradyne’s net income). For reasons that I will explain later, the connection systems division serves as a way to buy into future high growth tech sectors such as storage, networking, telecom, and servers without having to predict the eventual winners or pay a high price. Being conservative by assuming that the connection system division only grows at the rate of the high-end electronics industry and using an average long term ROE of 17%, I believe that Teradyne at $24 to $28 per share represents fair value and should provide over the next five years an average annual return between 13% to 19%. However, there may be an opportunity to generate substantially higher returns by buying later this year if the lower earnings lead to lower share prices, if the electronics recession is shorter than usual, or if during the next boom phase, Teradyne is significantly overvalued by the market.

THE COMPANY: Because Teradyne is a technology company, I will provide a long description of the company and its competitive advantages. The main point of this description is to provide a more-than-just-the-financials understanding of the business to people not familiar with the electronics industry and to point out why I believe Teradyne has a high probability of remaining the dominant company in its markets five to ten years from now.

Although the company has four main product groups, the company logically breaks up into two main businesses: automatic test equipment (ATE) and connection systems. Automatic test equipment is used by every electronic component manufacturer to design and test their products. It is not an exaggeration to say that almost every electronic component gets tested several times during production to reduce cost by ensuring yield and to achieve the best pricing by sorting products according to performance (for example, 1.2 GHz Pentiums versus 700 MHz Pentiums, or high temperature automotive components versus commercial components). Teradyne specifically manufactures test equipment for semiconductor, circuit board, and broadband (communications) systems. Although most the electronic components that Teradyne’s ATE customers manufacture are commodities, its products are custom, high value add, long lead time machines that cost millions of dollars that can only be obtained from a handful of vendors. Currently, ATE accounts for about 75% of Teradyne’s revenue and 80% of its income. Teradyne has about a 50% worldwide market share in ATE. It principal ATE competitors are Advantest (Japan), Schlumberger, LTX, and Credence. The annual reports of Credence probably provide the best introductory description of ATE.

The other main business of Teradyne is the connection systems division, which currently accounts for 20% of its revenue and income. This business has been around since 1980 for military customers (Teradyne sold the military portion recently), but in the last three years, it has started to grow very rapidly (157% growth last year) as the requirements for commercial electronics have become more demanding and key investments that management made ten years ago have started to pay off. The connection systems division manufactures products that provide for the interconnections of electrical signals between components in an electronic chassis without a loss of signal integrity. Teradyne manufactures two basic products within the connection systems division - high density connectors and backplanes – which are used in high-end electronic applications such as servers, telecom, and storage where performance/volume and time-to-market, not price are the main selling points. High-density connectors do exactly what their name implies, connect many inputs and outputs in a small amount of space. Currently, Teradyne’s principal competitors in the manufacture of connectors are AMP (Tyco International) and MOLEX. A potential future competitor that I regard as much more dangerous to Teradyne than either of these companies due to its agressiveness and competence is FOXCONN (the US name of a Taiwanese company: Hon Hai Precision Industry Company – currently #11 worldwide in the connector market and #1 in Asia), which has been accumulating many of the facilities and R&D people jettisoned by Tyco after the AMP acquisition. A backplane forms the backbone of a high performance electronic chassis by connecting different circuit boards and components. Because the design and manufacture of backplanes is difficult, the connection systems division also has a contract-manufacturing group where it builds the electronic chassis for major OEMs using its backplanes and connectors. Unlike other contract manufacturers such as Flextronics, Solectron, and SCI which are mainly electronic assemblers, Teradyne’s contract manufacturing is restricted to high-end systems that require its connectors, backplanes, and/or technical expertise.

Teradyne’s main competitive advantages are its management, intellectual property, existing customer relationships, and synergy between the connection systems business and ATE. Teradyne’s management are seasoned veterans of the ATE and electronics business. There is very little turnover among senior management or key technical staff and most have been with the company for decades (for example, the principal founder D’Arbeloff worked at the company for 40 years until early last year when he retired to become chairman of the Massachusetts Intitute of Technology Corporation). This group has survived many electronic recessions/depressions and boom cycles that have weeded out other competitors. These electronic recessions have hardened and disciplined the company’s leadership. During boom times, they are prudent and conservative. They set aside cash and do not over expand operations. During recessions, they continue investing in research, product development, capital equipment, and their employees to be prepared for the next upswing in the electronics business. Despite their cautious nature, the leadership of the company has shown itself to be adaptable and entrepreneurial. They have tried many ideas on a small scale, and although they have had several failed acquisitions and funded several startups that have not panned out, they have had their share of successes.

Teradyne technical superiority and existing intellectual property is a large, sustainable competitive advantage. In both ATE and high-end connection systems, Teradyne basically pioneered and created the market. Test equipment was originally custom made by the electronic component manufacturers. With the advent of the integrated circuit in the 60’s, Teradyne realized that testing would be a key requirement and rapidly became so good at it that it became uneconomical for manufacturers to build their own testers. Today, Teradyne still dominates the test equipment market with about 50% market share and the barriers to new competitors have only gotten higher. The industry has changed significantly and requires a much higher level of technical expertise and customer service and support to meet customer requirements such as yield, sorting, mixed signal analysis, and reliability. The connection systems division also has significant technical advantages. In the late 80’s, the connection systems division was the first company to realize that the connector was going to be a key to maintaining signal integrity in high performance systems. During the 90’s, Teradyne established fundamental intellectual property, especially in the areas of modularity, density, and configurability, that give the connections systems division manufacturing and speed-to-market advantages that its competitors like AMP and MOLEX (licenses Teradyne’s technology to provide a second source for customers) can not match. Also, because Teradyne understands the technical details behinds its connectors (and is not just injection molding plastic and copper), it is able to provide significant design advantages to the engineers of its customers. A final indication of the depth of Teradyne’s technical expertise and intellectual property is that it is one of the few US companies that is able to sell into the Japanese electronics market.

Teradyne has long standing customer relationships with all the major manufacturers. ATE is the preferred vendor for many electronic manufacturers and subcontractors customers due to its technical superiority, time-to-market, and reliability. Many of Teradyne’s ATE customers have been with them for decades. The connections systems business has also begun establishing relationships with major OEMs and contract manufacturers. For major affiliated manufacturers, the connection systems division has built contract-manufacturing sites near their locations. In addition to these customers, sales to unaffiliated customers grew 97% last year.

Finally ATE has a significant time-to-market and manufacturing cost advantage over its competitors. Automatic test equipment require extremely high performance electronics, and the connection system division can supply ATE with connectors, backplanes, and contract manufacturing for its testers faster and cheaper than its competitors can obtain them in the open market.

FINANCIAL ANAYSIS: Teradyne has a strong balance sheet with essentially no debt, $464 million in cash ($2.56 per share), and $758 million in working capital. The company has indicated this working capital, together with cash flow from operations, should be enough to meet requirements for the foreseeable future.

It is difficult to estimate Teradyne’s short term (1 to 2 year) revenues and earnings due to the cyclical nature of the electronics business, the unpredictability of current economic conditions, and the difficulty in separating the expenditures that Teradyne makes in engineering, research, and capital equipment into the amount required to sustain operations and the amount left to grow the business. However, over the long term (3 to 5 years), annual revenue and earnings growth should match those of the high-end electronics industry (12% to 20%). This estimate also corresponds to Teradyne’s per share growth rates over the past five years (17% for revenues and 23% for earnings).

To subtract out the average expenditures needed to sustain operations and estimate the average future owner earnings and prices of a cyclical company such as Teradyne that has no debt and retains all earnings, I prefer to use a ROE approach. Using a conservative ROE of 17%, equity per share should increase from $9.88 to $21.68 in five years. With this equity base, Teradyne should have average earnings of approximately $3.70 per share. Since, Teradyne typically traded between at 10x to 20x earnings before the tech bubble, Teradyne’s price per share should range between $37 and $74 per share in five years. Assuming a typical mid-teens price/earnings multiple, Teradyne’s stock should be fairly valued at $55 per share in five years (current fair value $25). This results in average annual returns of 13%, 15%, 17%, and 19% if the stock is purchased at $30, $27, $25, and $23 respectively. The stock traded at $23 as recently as October 2000.

I think that my estimates for the company’s valuation, ROE, and average annual returns are conservative because I believe that Teradyne’s connector business will continue to grow rapidly during the next ten years, Teradyne has invested about $1 billion in research and capital equipment over the past five years, and Teradyne has made significant improvements in its operations (as indicated by reductions in required working capital, a 3% decrease in SG&A expenses and 5% decrease in accounts receivables as a percent of net sales). I expect that Teradyne’s ROE will probably average over 20% during the next five years.

One simple method that I have used repeatedly in the past with success to invest in Teradyne is to buy around 8x the previous cycle’s peak earnings – after making sure this price is not higher than my conservative calculation of fair value using the ROE method – with the expectation of selling at higher than 16x the previous cycle’s peak earnings in three to five years. The previous cycle peak earnings were $2.86 per share ==> 8x = $23 per share, 16x = $46 per share. Due to the recent extreme volatility in the prices of semiconductor capital equipment industry stocks, the increase from 8x to 16x previous cycle peak earnings sometimes occurs very rapidly, resulting in an unexpected opportunity to get large returns on this stock within a few months (such as the recent run up from the low 20’s to the mid 40’s during the past eight months). However, this volatility is a two edged sword, which makes Teradyne only suitable as an investment to investors who are willing to hold the stock for 3 to 5 years and tolerate a significant downswing.

The main risks to investing in Teradyne are that the electronic recession is deeper and longer than expected. With a deep recession, Teradyne can usually be bought at much less than fair value or 8x previous cycle peak earnings. With a long electronic recession, the expected annual rate of returns would be lower than those stated above. As an aside, I think that the clockspeed (business cycle peak to peak and key product/technology lifetimes) in the electronics industry have decreased from about 4 to 5 years to about 2 to 3 years during the 1990’s.

Summarizing, Teradyne is an excellent company in a cyclical business whose stock is currently priced to return 13% to 19% annually over the next five years using conservative assumptions. Due to the cyclical nature of the electronics industry, improvements in operations, and the growth of the connector business, there is an opportunity for significantly larger returns over the long term. Although Teradyne is an excellent long-term investment, it may also provide large short-term returns due to the high volatility of semiconductor capital equipment stocks. However this volatility also makes Teradyne suitable only for investors who are willing to invest for the long term and tolerate a significant downswing.

I think that my views of Teradyne are similar to the opinions Marty Whitman of Third Avenue Funds has expressed in Outstanding Investor Digest about Kemet, Electroglas, and the other passive electronic component and specialty semiconductor equipment companies. It is hard to predict which active component companies are going to prosper over the next ten years; it is much simpler to predict which passive components and equipment suppliers are going to dominate five to ten years from now. However, I think Teradyne is a safer investment than passive component companies like Kemet because its competitive advantages are increasing and there is no chance of its products becoming commodities faster than expected or of a price war due to over capacity. In term of quality, I think that only Applied Materials is a better company in the semiconductor equipment industry.

As I mentioned earlier, Teradyne’s stock is currently at $30 seems to be heading back into the 20’s and may possibly reach the teens. It posted its first quarterly loss in ten years and has warned that it expects widening losses on lower revenue – hopefully these announcements will translate into significantly lower prices. After buying in October and selling in May, I plan to start averaging into Teradyne at prices below $25 per share if the share price reaches that level.

Catalyst

CATALYSTS: boom or bust electronics industry cycle provides an opportunity for high returns, rapid growth of connector division and increased dominance in automatic test equipment improves ROE, and market looks for low risks ways to participate in tech growth