TER - Advantest: The Hidden Gem That Will Benefit From AI Growth

2023-04-25 08:51:50 ET

Summary

• Advantest and Teradyne are the two duopolists, which control a substantial share of ATE (Automated Test Equipment) semiconductor testing market.
• Advantest counts Nvidia and AMD amongst its clients and it has a more diverse and wider base than Teradyne.
• Advantest will get a significant boost from AI related chip production, both in sheer number and complexity.
• Though Advantest is almost double its 52 week bottom of $45, it is still priced at 16X earnings and an excellent way to ride the Semis and transformative AI boom.
• This would be a great stock to own in a recession as a duopoly and a vital cog in a rising transformative industry.

The Automated Test Equipment Industry Duopoly

Advantes t (ATEYY) and Teradyne ( TER ) control a substantial share of the ATE (Automated Testing Equipment) market.

The main characteristics of the ATE industry are:

Significant barriers to entry - Advantest and Teradyne have more a century of experience between them and a stranglehold in the ATE business, making it very difficult and costly for new entrants to come in.

Sweet Spot with a lot of growth : The ATE industry has an annual revenue or market size of roughly $5.5Bn, based on Advantest's estimates from their 2022 annual report, or 1% of the total semiconductor market of $550Bn. McKinsey however, pegs the total semiconductor market size $50Bn higher at $600Bn, growing at 6-8%.

The size is too insignificant for a foundry like Taiwan Semiconductor (TSM) , which does $80Bn in revenues and too diverse for fabless designers like Nvidia ( NVDA ) and Advanced Micro Devices ( AMD ).

A specialized business with a long learning curve : This is a very specialized business that needs strong decades of long relationships with customers, such as Integrated Device Manufacturers (IDM's) like Intel ( INTC ) and foundries like Taiwan Semiconductor Manufacturing ( TSM ) and Samsung (SSNLF) among others.

High Switching Costs: Switching costs are high for machines that cater to diverse set of semis such as SOC's and phones, or high volume requirements for memory or storage chips, or different solutions for a gamut of industries from IOT to Auto. Besides, the cost of re-training staff even from Advantest to Teradyne is expensive and customers rarely change between the two.

Great Pricing Power resulting in excellent margins of 27-29% on a regular basis and over 31% in exceptional years. Pricing and revenues depend on complexity of the chips and as Nvidia, AMD and others rush to build their transformative AI chips, this will only increase revenues for Advantest.

Advantest and Teradyne have been a duopoly for decades and likely to continue to be so for the foreseeable future.

The arms race for semiconductors, which are indispensable in data centers, generational and transformative AI, gaming, computers, defense, auto and IoT, should provide Advantest sustainable revenue for at least the next decade.

A Slowdown after 3 years of massive growth

Advantest is a Japanese company and reports in Yen; I have reported some of the numbers in constant currency to show growth trends, not distorted by currency differences.

In the last three years, Advantest rode the semiconductor wave growing revenues at 26% and operating income at 42%! a rate reminiscent of industry stalwarts like Nvidia and AMD. Advantest decreases revenue only in 2023, due to a worldwide, cyclical semiconductor slowdown, unlike Teradyne, which went through a difficult 2022 because of the delay in TSMC moving to the N3 node and is still facing a slow 2023 with TSMC expecting a ramp up only in 2H-2023. The reason they still did well in 2H 2022 was because of the long lead times as their CEO explained in the Dec 22, earnings call.

From Advantest's Dec 2022 Quarterly Investor Presentation, emphasis mine.

Tester demand has weakened lately due to the inventory correction underway in semiconductors for consumer electronics. However, we booked orders in excess of our sales in 1-3Q. The reason we are able to maintain a high level of sales is that we have long lead times of nine to 12 months, and while we have seen cancellations or deferral requests from some customers, they have not been substantial enough to significantly impact our sales. Moreover, our testers enable flexible configuration by switching out modules on a single platform, so when a customer defers a delivery, we are able to allocate that product to a customer requesting immediate delivery instead, thereby maintaining our sales.

Advantest has a March year ending, and 2023 is mentioned interchangeably as FY March 2024. For March 2024, Advantest expects a revenue drop of 10% after expecting to recover some of the demand weakness in 2H FY24.

Testing is an industry where you can make to with older equipment and cost conscious customers will stretch the life of machines - it is not like a variable cost, that you have to spend each time you test. The older machines have a long shelf life and it is only when there is an increase in complexity or change of process or enhancement to a much better node, for example down to a 3N (or Nanometer) node is when new testing equipment becomes necessary.

To Advantest's credit they were not heavily exposed to Apple's ( AAPL ) and TSM's fortunes the way Teradyne was.

As reported in their Dec 2022, earnings call, emphasis mine.

For high-performance computing ((HPC)) and AI, there is a growing range of applications. In addition, new entrants from other industries are expanding the customer base beyond the existing players. As such, we believe that these markets will remain strong in 2023. Semiconductors remain in short supply for automotive and industrial applications, so semiconductor manufacturers are investing in additional production capacity. We therefore expect a solid trend in that part of the tester market.

If what began in 2H 2022 is a typical economic correction , then a recovery should begin three or four quarters later, which would be in 2H 2023. We therefore think we should have ample opportunities to grow our sales between now and March 2024.

Strengths and Growth Opportunities

Riding the coattails of AI : As Nvidia, AMD and others rush to build their transformative AI chips, this will only push the limits of miniaturization and packaging, increasing the complexity of chips, which increase the chances of defects, hence boosting the demand for more complex and expensive testing equipment.

Yasuo Mihashi, co-chief strategy officer, Advantest, stated the following in an article from finance.stockstar

The global race to develop powerful computing clusters and next-generation artificial intelligence training systems is spurring chipmakers to buy more test tools. We are the dominant player in the chip testing industry, so when something like ChatGPT expands the use of high-performance computing, we benefit.

In the same article , Hideki Yasuda, an analyst at Toyo Securities stated

Worldwide revenue from testing tools for high-performance GPU chips may surpass that of testing tools for smartphone chips in the next few years. "Chips for servers are going to get bigger, more complex, and take more time to test," he said. "There's no magic way to shorten test time. The only solution for chipmakers is to buy more tools. Test more chips at the same time."

Reducing exposure to memory testing: Advantest made a very good strategic decision a decade ago to reduce their exposure to the memory segment of the semis market. A segment beset by overcapacity, overproduction, cyclicality and little pricing power. Memory chips reduced further from 22% of sales to 18% in the last 4 years.

Increasing Services: Services grew from 15% of revenues to a high of 21%, before dipping to 18% in March-23, growing faster than semis and Mechatronics. Services is a high margin business likely to continue to take more segment share from Mechatronics and memory testing.

Challenges and Weaknesses

Cyclicality : Advantest, just like Teradyne is heavily exposed to the vagaries of the semiconductor market. The worldwide glut of used gaming cards, for Ethereum mining eventually dumped by miners, forced Nvidia take a $2.17 Bn hit in inventory charges, plus 3 quarters of just getting rid of excess inventory -- is just one example of how things can go south very rapidly in the semiconductor industry. Over supply and stretched budgets have hit the hyper scalers and CSP's like Amazon ( AMZN ), and in turn hurt AMD to push data center revenue out by a few quarters. Teradyne is suffering an at least 18 month delay in expected revenues because of the delay in 3nm launch from TSM. And so on..

While there were several years of consistent growth for Advantest, FY March 2024, is not going to be one of them. Advantest has estimated a 10% drop in revenue this fiscal. Cyclicality will remain a characteristic of the semiconductor industry and expecting or assigning a secular growth industry multiple would be a big mistake, which means that there will also be prudent sellers beyond too rich a price. That's a good thing, actually, we've seen how badly the markets were mis-priced in 2021.

Strong customers : This industry is characterized by strong customers. By default most of Avantest's customers will be large players and the nature of the industry demands long relationships with them, usually giving them the bigger hand for negotiating.

The Bull Case for Advantest

A Great Chance to invest in the AI boom at a reasonable price.

Testing is a vital cog in the semiconductor arms race, and no chip leaves the factory gate without one. I believe in the transformative AI story started by Microsoft ( MSFT ) and Nvidia's ChatGPT. This is just the beginning - there will be other competitors in this arena, expanding use cases and applications far and wide. We will need a lot of complex testing for example, for the Hopper, Nvidia's H100 or the Grace, its first CPU iteration. And as Nvidia pushes 22X forward sales and over 50X forward earning, the stock has become prohibitive for many. While I do own and have recommend the stock here and here , I always get feedback that it is way too expensive. Advantest is still just 16x earnings and 4x sales, as shown below and expected to grow revenues at least 12% and earnings 18% over the next 4 years. The growth rates would have been better had it not been for this year's 10% revenue drop.

Wide and diverse base of clients across sectors : While Advantest, too will drop 10% revenues this year, it's a whole sight better than the two years of revenue drops for Teradyne, solely because of one client - TSMC which was more than 15% of revenues.

Being in a Duopoly gives it sustained revenues, pricing power and barriers to entry, plus a decent multiple of 16x earnings or 4x sales, unlike the commodity players at the bottom of the semis market at 8-10x earnings. Besides reasonably priced earnings and sales, Advantest's operating margins are stellar at 28 to 31%, that allows it to throw up lots of cash.

Advantest stacks well against Teradyne, both expect a drop in revenues this year, with solid expectations of growth in the following three. It's price is a lot cheaper at 16X current and 17X Forward earnings as compared to Teradyne's 30X forward. However, Teradyne, expects to rebound much stronger with a 35% growth once TSM starts ramping production. I've estimated Advantest's growth at 14% revenues and 18% earnings, it has very strong March 2023 comps -- a whopper of a year with 32% revenue and 48% operating income growth. Given the vast potential of revenues from complex testing of AI related chips, this could well be a conservative estimate, especially in earnings; Advantest has a lot of operating leverage and in good years could easily surpass these estimates. Nonetheless, even with these estimates it's a great buy. I own some and continue to buy around these prices, expecting to double in 3-4 years or a return of 18 to 24% per year.

Three degrees of reasonable: 1) 16x earnings is a reasonable multiple for a company growing at 14% and 18%. 2) it's a cheap multiple for a duopoly and 3) Even more reasonable for a leading company in a fast growing industry, being given priority by governments around the world.

This would be a very valuable stock to own in a recession.

For further details see: