Description

Teradyne, Inc. (TER) is a leader in the semiconductor automated test equipment (ATE) industry. I am proposing to buy TER as a play on the turn around of the semiconductor industry.

The ATE industry is an extremely volatile industry and is known to experience wild swings in revenues and profits. The ATE industry is currently experiencing one of its slow downs. As a result, the stock price of TER and other companies in this industry has dropped by more than 50%. I expect that when the industry comes out of the current down cycle (as it always will, the issue is when) TER will gain market share as its is well positioned with a favorable product line and a favorable cost structure. A gain of over 100% from today’s price will not be unreasonable with minimal risks.

The Semiconductor ATE industry

Companies in this industry typically design and manufacture test equipment for the semiconductor industry. These products are very complex electronic instruments that are sold to the world-wide semiconductor manufacturers, contract manufacturers or contract test companies. The test equipment is used to test semiconductor products either in its wafer stage or in its final packaged stage. Typically, the semiconductor industry expands 1.7% to 2% of its revenue on ATE products. Hence, as the semiconductor industry grows, the ATE industry grows with it.

The semiconductor industry is known for its cyclical nature, just as any manufacturing industry is susceptible to the business cycle. The “high tech” nature does not exempt the semiconductor industry from the facts of economics. As a capital equipment supplier to this cyclical industry, the business cycle of the ATE industry is further exaggerated. It is not atypical that in a normal cycle, revenues of companies in this industry swings 30% to 40% from peak to trough. In the last cycle from 1999 to 2002, the peak to trough swing was as much as 75% to 80%, exaggerated by the internet bubble.

When business is strong on the upside of the cycle, strong companies in the ATE industry can net as much as 15% to 17%. However, at the bottom of the cycle, most businesses lose money. The challenge in managing in this industry is to keep one’s fixed cost low, out-source as much as possible, and keep a lot of cash on hand so that one can continue to invest in the down cycle.

The key to success in this industry is having new products that provide the semiconductor companies with test solutions that are cheaper and performs better than those offered by competitors. Like most technology businesses, “design ins” with one’s products are key to the future revenue stream. New product development is the life blood of this industry. The cost of new product development is very high. Typically, it costs well over $100 million to develop a new generation of products and can take as long as 2 to 3 years. Hence, gaining bulk is becoming important in order to survive in this industry. As a result, we have seem consolidation in this industry. As time progresses, one will not be surprised to have just a few survivors and TER will likely be one of them.

There are three leading companies in the ATE industry. Other than TER, the other two leaders are Agilent Technologies, Inc. (A) and Advantest Corp (ATE, ADR). Examples of second-tier suppliers are Credence Systems Corp (CMOS) and LTX Corp (LTXX). TER is the leader in the system-on-a-chip (SOC) market, whereas Japanese supplier Advantest is the leader in the memory market.

Investing in this industry is not for the faint in heart as the volatility is very high. The beta is very high for the stock price of companies in this industry. For example, the beta for TER as reported in the Yahoo finance page is 2.5. However, for value investors who can stomach the high volatility, a large beta is their friend. As such, by buying in the down side of the cycle and selling in the up side of the cycle, the high beta results in a potentially high rate of return. However, catching the bottom (or the top) is almost impossible. In call cases, one only sees the bottom of the industry in retrospect. When the bottom is evident, it is usually too late to invest. Investors have already bid up the price of companies in this industry already. Hence, to profit, one has to accept the fact that one will buy too early and that prices will drop some more. An investor can draw comfort from the facts that (1) when the price drops, one can average down; and (2) the industry is a cyclical growth industry and has always come back. Hence, the way to play this industry is to buy the strongest company when the “margin of safety“ is large enough, be prepared to average down, and be psychologically ready to ride through a (long) valley.

Details about Teradyne

Teradyne is a leader in the SOC segment of the ATE industry with greater than 35% of the market share. Agilent is second with approximately 25% of the market share. With approximately 190 millions shares outstanding, TER has a market cap of approximately $2.6 B. TER also has $400 millions of convertible notes due 2006, convertible to TER’s common at $26 per share after October 18, 2004. Depending on when you look, TER has approximately $400 millions in cash. Hence, TER’s enterprise value stands at approximately $2.6 B.

TER’s revenue is approximately $1.5 B in the last 4 quarters. (During the internet bubble in 2000, TER generated approximately $3 B in revenue.) ATE business represents approximately 65% of that total. A high performance connector business represents another 20% of the total. However, the ATE business generates close to 90% of the profits. One wonders why TER is still keeping the other businesses, which are really distractions for management.

Net profits peaked at $454 millions (EPS of $2.86) in 2000, representing a 15% net profit margin. Gross profit margin for year 2000 was 47.2%. In the first 6 months of 2004, TER generated $121 millions of net profit (EPS of $0.62) on $957 millions of revenue. This represents a 12.6% of profit margin. Gross profit margin was at 42% for the 6 months.

For other details, I will refer the readers to the Yahoo finance pages.

Investment thesis

The investment thesis for TER at this time are three fold:

1. The ATE industry is in the declining phase of its cycle and it is a good time to buy. As I mentioned before, the semiconductor industry and the ATE industry are cyclical in nature, but have a long term growth trend. The ATE industry has always been cyclical and when orders dried up, it is very painful. However, the business always comes back and it will come back stronger than before. The time to buy is when the business is down and when the business looks bleak.

2. It is expected that the demand of ATE will be strong when the semiconductor comes out of this down cycle. The semiconductor manufacturers purchased excess capacity during the internet bubble years of 1999 - 2000. They are close to absorbing all that capacity. They did buy new capacity in the last several quarters. When they come out of the current cycle, the technology of their capacity will be over 5 to 6 years old. It will be time to buy new technology. Hence, in the next cycle, not only do they have to buy new capacity, they also have to replace existing technology with new technology in order to test the new devices. Hence, I expect that the volume during the next upturn will be much stronger than that of the last cycle. This will benefit those ATE companies that are well positioned. TER is one of them.

3. TER will come out of this down turn well-positioned with its product offerings and cost structure. In the last 4 years of down turn, painful as it was, TER has continued to invest in new products. In the upturn of the previous 3 quarters, TER’s new FLEX product line has been extremely successful. I expect that this product and the new products in the pipeline will continue to do well based on the design-in achieved by TER.

TER continues to reduce its cost of manufacturing by out-sourcing and moving to low cost region. These actions have the effect of reducing its fixed overhead expense and its cost of goods sold. The results of this expense control are showing up in how quickly TER can achieve profitability levels that are close to those of the bubble years even when revenues are only at 50% of the peak level. Given this cost control, I expect that when the cycle comes back, TER can conceivably generate 4-quarter revenues of $2 B, net profits of $280 millions and an EPS of $1.4 (These numbers are swags and should not be taken as precision calculations. The truth of the matter is no one can forecast revenues and earnings precisely). With these results, I expect that TER will trade in excess of $30 per share, providing a greater than 130% gain from today’s prices.

Risks

The primary risk is that the down cycle is deeper and longer than expected, resulting in further price erosion. It is always very difficult to forecast the extend of this down turn in the semiconductor industry. Most semiconductor companies characterize the current slow down as an “inventory adjustment”. The only excess that I can discern was in China, especially in the cell phone market. If that is the case, this cycle may be milder than the typical down turn. However, I do not know if anyone can forecast this market with any precision. I have given up trying long time ago. I have adopted a strategy of buying when the “margin of safety” is large enough and average down.

Catalysts

The upturn of the semiconductor industry.

Catalyst

The upturn of the semiconductor industry.