TER - Teradyne: Strong Position In Semiconductor Testing But I Remain Cautious For Now

2023-11-10 11:11:39 ET

Summary

• Teradyne's Q3 performance exceeded expectations, driven by strong shipments of robotic products and growth in the Semiconductor Test segment.
• The company's outlook for Q4 suggests a decline in chip tester sales due to seasonal factors.
• The stock is trading at a premium multiple which keeps me cautious for now.

Thesis

Teradyne, Inc. (TER) is one of the two main players in the Semiconductor Testing industry and has strong relationships with key customers, making its position quite stable. I remain cautious for now on Teradyne since the earnings recovery in fiscal year 2024 will be less robust than what is currently expected by the market consensus. Even though the company is making substantial investments in growth areas, I see limited upside in the near term, given that the stock is already trading at a premium valuation. Hence, I stay cautious for now and assign a hold rating to the stock.

Post Q3 Review and Outlook

In the third quarter, Teradyne reported revenues of $704 million, reporting a 3% increase compared to the previous quarter, exceeding Street expectations. Teradyne attributed this strong performance to better-than-expected shipments of robotic products and growth in the Semiconductor Test segment. The gross margin for the quarter was 56.6%, and the EPS of $0.80 also exceeded market expectations. The outperformance in EPS was primarily driven by higher revenue and lower operating expenses. In terms of Teradyne's fourth-quarter sales, there is an expectation of a decline compared to the previous year and sequentially from the third quarter, which saw a 3% sequential growth. This decline is anticipated in chip tester sales due to the usual seasonal drop in demand. While demand from automotive customers is expected to remain solid, orders from smartphone customers might decrease due to seasonal factors. On the positive side, there could be a gradual increase in demand from advanced DRAM customers driven by artificial intelligence needs.

Teradyne's guidance for the fourth quarter and for the full fiscal year suggest that the magnitude of the recovery that the average investor is looking to be bullish about the company's prospects is going to be challenging. While factors like the adoption of the 3 nm node by key semiconductor test customers, the adoption of DDR5 and HBM technology in memory, and growth in the recovering industrial sector and robotics product cycle are positive growth drivers for the company in fiscal year 2024, the combined impact may not result in a double-digit percentage increase in revenue unless there is a significant change in the overall economic conditions, particularly a notable increase in smartphone industry volumes. The company is expected to have a slow start in fiscal year 2024, with first-quarter revenues projected to remain flat year-over-year, making it unlikely to achieve the 20% revenue growth that consensus estimates for 2024 suggest, unless there is a substantial shift in the economic landscape.

Weakness in Mobility and Compute Segment

There is currently weak demand in the company's Mobility and consumer Compute segments, resulting in low utilization of testing equipment by customers. However, the management has noted that the current downturn is not as severe as previous ones, which could make the path to recovery less certain. Teradyne's expectations for recovery in 2024 largely depend on the extent to which the Mobility sector bounces back, with the potential for the Mobility Total Addressable Market to reach approximately $2 billion by 2025. Nevertheless, there are several factors, such as government funding stability, recovery in consumer demand, and trade tensions between China and the United States, that could significantly impact the recovery process.

Growth Driver Remains Complexity and Production Volumes

In TER's end markets, both mature and emerging, the primary driver of revenue growth for Teradyne is the combination of complexity and volume. Aside from the cyclical nature influenced by semiconductor demand, especially in sectors like Mobility, Teradyne's revenues benefit from semiconductor manufacturing node transitions. These transitions bring about a significant increase in complexity, which can outweigh short-term changes in volume within these markets, resulting in greater revenue opportunities. Node transitions involve advancements in semiconductor technology that lead to higher transistor densities, necessitating more extensive testing before reaching normal volume levels. Teradyne estimates that with every substantial increase of 30-40% in transistor count, there is a corresponding capacity increase of around 20% required for testing.

Financial Outlook and Valuation

Teradyne has the potential to achieve annual sales growth ranging from 10% to 15% in the coming years, primarily driven by increasing demand for its advanced chip-testing equipment. The company's medium to long-term sales growth prospects for its chip-testing equipment can be attributed to the shift towards 3- and 2-nanometer logic chips featuring novel transistor structures. Additionally, the industrial automation division may experience growth due to long-term demographic changes and the adoption of lean manufacturing practices, which require collaborative and autonomous robots. There is also the possibility of expanded sales in the wireless test segment, driven by the introduction of new Wi-Fi technology. Teradyne's target of achieving a non-GAAP operating margin between 31% and 34% by 2024 also appears to be attainable.

The stock is currently trading at a forward PE of 32x, above the sector median of 25x. The premium multiple is justified in my view, given the company's robust top-line trajectory, industry-leading operating margins, and diversification into Industrial Automation. However, I find the current NTM multiple is quite rich, and see limited upside in the near term through multiple re-rating. Hence, I currently remain cautious and assign a hold rating to the stock.

Investment Risks

The rate at which semiconductor nodes advance, for example, moving from 3 nanometers to 2 nanometers, significantly decreases because companies encounter physical constraints related to transistor counts on smaller nodes. Additionally, delays in transitioning to chiplet architectures, primarily due to the increased complexity involved, contribute to this slowdown. When growth in complexity decelerates or transitions to newer architectures occur more slowly, it results in reduced demands for testing and a decreased need for testing time.

Conclusion

I believe Teradyne will continue to grow at a mid-double-digit rate in the near term, primarily due to its investments in high-growth areas and increasing demand for its advanced chip-testing equipment. However, the company is experiencing weak demand in some segments due to the macro environment, and the recovery in 2024 remains uncertain for now. The stock is trading at a high valuation, and I don't see a good enough risk/reward profile at this stage, which is why I remain cautious and assign a hold rating to the stock for now.

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