TER - Teradyne: Stormy Waters - Overcoming Challenges In A Downturn

2023-06-21 12:41:20 ET

Summary

• Teradyne, Inc. is currently experiencing a challenging period due to a downturn in cyclicality.
• Once Teradyne's prospects stabilize, it has the potential to generate around $700 million in free cash flow, in line with previous years.
• The near-term revenue outlook for Teradyne is discouraging, with a projected decline of around 19% y/y in Q2 2023.
• Despite challenges, Teradyne has a history of generating strong free cash flows, and the recent cash burn is not a significant concern.
• I'm neutral on this name.

Investment Thesis

Teradyne, Inc. ( TER ) has hit a rough patch. The business right now is facing a once-in-decade trough in cyclicality. In fact, there's an absence of good news for investors to latch onto right now.

However, when Teradyne's prospects stabilize, I believe that Teradyne could see around $700 million of free cash flow again, in line with a normalized figure for 2021-2022.

This puts the stock priced at about 25x forward free cash flows. Not cheap, but far from shocking expensive either. Therefore, I'm on the sidelines right now, but happy to review higher my rating, if I see an improvement in its free cash flows.

Why Teradyne? Why Now?

Teradyne manufactures automatic test systems and robotics products. Their automatic test systems are used for testing semiconductors across various industries. This is by far its biggest segment.

They also offer robotics products, including robotic arms, which are utilized by manufacturing customers to enhance efficiency.

They operate in a market with a limited number of significant customers, and they expect the demand for their test products to remain concentrated. Case in point, in 2022, about 25% of their business was focused on its top 5 customers. Indeed, Qualcomm ( QCOM ) alone makes up about 10% of its revenues.

Furthermore, as we'll next move to, Teradyne's near-term prospects don't inspire much confidence.

Revenue Growth Rates Could Be Close to a Trough

As alluded to already, the outlook for Q2 2023 doesn't inspire much hope, as revenues are guided to be down around 19% y/y.

That being said, consider this quote from Teradyne's management during the Q1 2023 earnings call :

In semiconductor test, lower end market demand and high channel inventory is persisting. And our measures of tester utilization in Q1 of 2023 are at their lowest level in over 10 years.

It's not often that businesses face such challenging cyclicality. But when they do, they more often than not get put up against a wall and strive to figure out a better solution to deal with the underlying market. To echo this insight, consider this quote from Teradyne's management,

One of our challenges is our distribution approach, which we believe has limited our longer-term growth.

We are executing a solid plan to move to an omnichannel, which we believe will significantly enhance our growth potential.

To be sure, this doesn't necessarily mean that when things improve, there will be a dramatic bounce back.

However, my argument here is that when things improve, there's a change in investor perception. And that's where rewarding returns can be made.

Furthermore, Teradyne does have a history of being highly free cash flow generative, so it's not like other businesses where they've always been unprofitable and they have to figure out how to become self-sufficient.

Indeed, the insight that inventory levels are high and that end customer demand is subdued is old news by now. Asides from AI-exposed semiconductor companies, the rest of the semi-space has been lackluster in 2022-2023.

Some Negative Considerations

The business is burning through free cash flows. Not much of a cash burn right now, but still, around $35 million of free cash flow was burnt last quarter.

For a business that in the prior quarter was oozing free cash flow, for Teradyne to go from oozing cash flow in one quarter to burning free cash flow in the next, is a reminder of the challenges of operating with just high fixed costs.

While not a bull case thesis breaker, rather, just a pesky detail, it's insightful to consider that Teradyne's management gets payments related to employee stock compensation awards on top of its stock-based compensation. For context, about $70 million per year is going out the door to incentivize management, a figure that is on par with Teradyne's shareholder dividend payout.

This is not an egregious figure but rather a pesky consideration. After all, given its aggressive repurchase program where Teradyne deployed about $650 million towards share repurchases in the past 12 months, these repurchases still managed to bring down Teradyne's share count by 5% y/y.

The Bottom Line

Teradyne is currently facing a challenging period due to a downturn in cyclicality, but once its prospects stabilize, it could generate around $700 million in free cash flow, in line with a normalized figure from 2021-2022.

This makes the stock priced at about 25x forward (hypothetical) free cash flows.

The near-term revenue outlook is discouraging, with revenues expected to decline by around 19% year-on-year in Q2 2023.

Despite challenges, Teradyne, Inc. has a history of generating strong free cash flows. While there was a cash burn in the previous quarter, it is not a significant concern.

Moreover, Teradyne's management receives payments related to employee stock compensation awards, but this is not an egregious figure. Teradyne has implemented an aggressive share repurchase program, reducing the share count by 5% year-on-year.

All in all, I'm neutral on this stock.

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