Teradyne Inc. Q3 2009 Earnings Call Transcript

Executives

Andy Blanchard - VP of Corporate Relations

Mike Bradley - CEO

Greg Beecher - CFO

Analysts

CJ Muse - Barclays Capital

Jim Covello -Goldman Sachs

Gary Hsueh - Oppenheimer

Krish Sankar - Bank of America-Merrill Lynch

Vis Vellore - Credit Suisse

David Duley - Steelhead Security

Patrick Ho - Stifel Nicolaus

Jagadish Iyer - Arete Research

Krish Sankar - Bank of America-Merrill Lynch

Robert Weaver - Forest Investments

Raj Seth - Cowen & Company

Atif Malik - Morgan Stanley

Teradyne Inc. (TER) Q3 2009 Earnings Call October 29, 2009 10:00 AM ET

Operator

Good morning. My name is Molly and I will be your conference operator today. At this time I would like to welcome everyone to the Q3 Teradyne Earnings Call. (Operator Instructions). Thank you. Mr. Blanchard, you may begin your conference.

Andy Blanchard

Thank you, Molly. Good morning, everyone and welcome to our discussion of Teradyne’s most recent financial results. I’m joined this morning by our Chief Executive Officer, Mike Bradley and our Chief Financial Officer, Greg Beecher. Following our opening remarks, we will provide details of our performance for the third quarter of 2009 as well as our outlook for the fourth quarter.

First, I would like to address several administrative issues. The press release containing our most recent financial results was sent out via Business Wire last evening. Copies are available on our website or by calling our Teradyne’s Corporate Relations office by 978-370-2221.

This call is being simultaneously webcast over our website at teradyne.com. Note that during this call, we are providing slides on the website that may be helpful to you in following the discussion. To view them, simply access the investor portion of our site and click on ‘Live Web Cast’ followed by ‘Click Here’ for webcast. In addition, replays of this call will be available via our website starting approximately 24 hours after the call ends. You will find it by going to teradyne.com and click on Investors. The replays will be available along with the slides through November 13, 2009.

The matters that we discuss today will include forward-looking statements that involve risk factors that could cause Teradyne’s results to differ materially from management’s current expectations. We encourage you to review the Safe Harbor statement contained in the earnings release as well as our most recent SEC filings for a complete description. Additionally, those forward-looking statements are made as of today and we do not take any obligation to update them as a result of developments occurring after this call.

During today’s call, we will make references to non-GAAP financial measures. We have posted additional information concerning these non-GAAP financial measures, including reconciliation to the most directly comparable GAAP financial measure that is available on our website.

To view them, go to investor portion of our website and click on the GAAP to non-GAAP reconciliation link. Also, you may want to note that between now and our next conference, Teradyne will be participating in the Sidoti & Co. New York Emerging Growth Conference on November 20, the Credit Suisse First Boston Technology Conference in Phoenix on December 2 and, the Barclays Global Technology Conference in San Francisco on December 9, and Eric May luncheons in Chicago, Boston and New York on November 11, December 14 and 15 respectively.

Now, let’s get on with the rest of the agenda. First, our CEO, Mike Bradley will review the state of the company in the industry in the third quarter of 2009 and review the outlook for the fourth quarter. Then our CFO, Greg Beecher will provide more details on our financial performance in the third quarter and our guidance for the fourth quarter of 2009. We will then answer your questions. For scheduling purposes, you should know we intend to end this call after one hour. Mike?

Mike Bradley

Thanks, Andy. Good morning, everyone. Thank you for joining us today. I want to focus my comments this morning in three areas. First is the momentum we were seeing in our semiconductor test business, second is the important milestone we’ve achieved in the high-speed memory market, and third is the increasing strength of our System Test Group, which is contributed to the trajectory of our recovery from the trough of this cycle just six months ago.

Later, Greg will take you through the financials where you can see the positive affects of our cost controls and our balance sheet initiatives. He will also outline our financial model going forward including hard disk drive and high-speed memory, which we’ve added to the portfolio.

Let me start with the semi test side of the house. Last quarter you will recall our overall semi test booking doubled from the level of Q1. In this third quarter, we topped the Q2 total with bookings of just over $230 million or about a 70% growth over the second quarter. Our IDM and fabless specifiers led the way with bookings more than double the level of Q2.

The OSAT business totaled about $50 million, equal to our second quarter order rate. So, both customer segments have more than tripled since the low levels of six months ago. From a device segment perspective, we saw very strong growth in power management applications, while our wireless business was still strong it was complimented by micro controller, storage and analog segments, which posted healthy growth in the second quarter.

Within these numbers, we are pleased with the upsurge in business from our Eagle Test product line, which recorded its strongest bookings quarter in a number of years. New demand for automotive and image sensor systems remains below our historical levels, so we’ve clearly got some segments that will add to our totals as the recovery broadens.

As I mentioned last quarter, we are hitting on many but not all cylinders. That remains true in the total memory market as flash and high-speed memory test demand remains much lower than in prior periods. We’ve seen our first new ordering in flash this quarter, after virtually no business in the first half of the year. So, we are now more optimistic of albeit cautiously so the flash could start to participate more in the recovery, which brings me to high-speed memory.

I’m very pleased to report that we’ve met the important milestone of receiving multiple orders for our [UltraFLEX M] system. These systems are now installed at our customers in both engineering and production and we expect full acceptance and revenue recognition for them in this the fourth quarter.

This is significant event as it represents a beachhead in a potentially large new market for us, one that has historically yielded the largest concentrated buying power in the automatic test equipment industry. I do want to say, however that we don’t intend to delineate the specific applications of our customers as we are obliged to protect all information of a strategic nature, for our customers and ourselves, especially in this early phase of business.

I will say what we said publicly in the past and that is our UltraFLEX M system combines test capability to handle the most advanced DDR3 and GDDR5 devices and is architected for multigenerational device coverage. We believe we have a very solid offering for these advanced technologies with the parallelism to provide very competitive test economics. One last note of clarification; and that is that, we are combining our HSM and flash memory numbers in Greg’s summary without a specific breakout of each for the reasons that I mentioned.

Now, let me turn to our systems test business. The outstanding news there is that we’ve achieved record revenues and strong profitability from this group this quarter. The systems test group has accounted for one-third of our orders this year and over $200 million in bookings.

The steady performance of our defense business has been supplemented by our new hard disk drive venture and we continue to focus on improving our product cost structure in HDD so that it can make a proportional contribution to the bottom line. Like semi test though we still have businesses that haven’t seen much recovery. Our in-circuit commercial board tests and automotive diagnostic units remain at pretty low demand levels. However, they are not a drain on the bottom line given their fixed cost structures.

Please note that we are not going to delineate any specific numbers relative to the individual businesses of defense, board test, automotive diagnostics or hard disk drive, as this would expose some sensitive information about customer buying patterns in our concentrated customer segments. We know you will understand this if we don’t flesh out those particulars in the Q&A session as well.

Now, turning to our revenue guidance for the fourth quarter, our semi test revenue will again grow sequentially while our systems test revenues decline due to the lumpy nature of some of their businesses. In short, we will have system test shipping at the past Q2 level while semi test will have doubled over that same time frame. I also want to mention that this rapid ramp in semi test business has in fact put strains into our supply chain. The front part of the ramp was achieved through some inventory drawdown throughout the supply chain. With that inventory consumed, we were experiencing more part shortages which is moving our lead times out of a bit. Greg, will comment more on that shortly.

As I mentioned earlier, Greg’s also going to elaborate on the company’s financial model as we want to give you assistance in how that model can move given the volatility of some the underlying components. I do want to emphasize that we are keeping a tight rein on spending especially anything that has a fixed component to it. That doesn’t mean that we won’t make some investments going forward just that we will continue to run things as tightly as possible so the drop through on top line growth is attractive.

Finally, the downturn of this last year is not yet a distant memory, but instead a harsh reminder of the volatility in the space. I’m extremely proud of how our workforce has adapted and how our customers have collaborated with us. In less than two years, we’ve added four new businesses, two acquisitions and two organic undertakings, and we’ve reshaped the company for stronger over-the-cycle performance, all while the world economy had its most severe meltdown. We’ve got a lot of work ahead, but I’m pleased with our progress. Greg?

Greg Beecher

Thanks, Mike, and good morning everyone. In addition to providing a recap of third quarter results and details on the fourth quarter, I’ll focus my remarks on our model, our balance sheet and how we are responding to this latest increase in demand.

Let me first start with our third quarter results. As you know, we generated a 9.6% non-GAAP operating profit on sales of $262 million. Given our current cost structure and breakeven, this is seven points to eight points higher than we achieved at comparable sales levels during the last five years. Though much improved from prior periods, it is lower than our target model at $275 million as we had record hard disk drive sales and systems test this quarter, which has lower gross margins than the company average.

So, as I mentioned in last quarter’s call, I’d like to update you on the model that we were using to manage the business when the mix of business swings due to seasonality or the inherent lumpy buying that occurs in some of these businesses. Before I update our model for the added variability from entering hard disk drive and high-speed memory, I should first point out that the bottom line contribution from all of our businesses has the same 15% or better objective.

However, some businesses have higher gross margins and higher operating expenses than the company average, while others have lower gross margins and lower operating expenses, but they all need to get to the same 15% or better objective over a normalized cycle.

In the past, we’ve included the full operating spending of hard disk drive and high-speed memory, but we didn’t update the model for the combined lower gross margin percentage. We wanted to first get a better picture of the relative contribution to the total.

As you might expect, the model will be affected in two dimensions. First is the amount of revenue that we will need to achieve our model 15% profitability, will increase as we fold-in these new businesses into our model as our combined gross margins are lower than the company average.

So we’d expect to be at our historical 15% model when sales are at $275 million and there are no hard disk drive or high-speed memory sales. Again, this is just a reiteration of our prior model. An example of the mixed impact is, if sales of hard disk drive and high-speed memory in a quarter are $35 million together, then we would need company sales of about $300 million to hit our 15% model.

A quick note that I should add is that the gross margins on hard disk drive are lower than high-speed memory but for simplicity we’ve combined them together in this example. In addition, high-speed memory margins should improve over time as performance requirements intercept our products capabilities. We’ve brought in some exhibits on our website that show the variability that we may experience. We also included a quarterly breakeven and margin drop through information for your models. So the overall story is, attractive operating leverage with an expanded serve market that we are making good progress penetrating.

Moving next to the balance sheet. Cash and marketable securities increased from $373 million to $468 million since the last quarter. The majority of this increase came from advanced customer payments to secure their position in our slot plan. However, we’ve also maintained very competitive receivable, day sales outstanding at 49 days which reflects strong customer satisfaction. Overall, our balance sheet continues to be strengthened.

Turning next to the continued surge in demand. Product shipments increased 78% from the second quarter to the third. As we said a quarter ago, we staged some finished goods inventory to respond to the anticipated demand increase. This along with draining the existing inventory in the supply chain helped keep our third quarter lead times quite short.

However, as we move through the quarter lead times extended on average to about 6 to 10 weeks. We continue to work with our key suppliers to respond to this increased customer demand. Overall, we are very pleased with the responsiveness of the supply chain as it gets stoked up after quite a respite. However, the fact is that we are carefully monitoring the total supply chain along with our major contract manufacturer to ensure that the lead times remain in line with customer needs.

Before I review the third quarter results in some detail, I should mention that we’ve also posted on our website an exhibit on the convertible debt delusion at different stock prices, including both the economic delusion and the much more conservative accounting delusion calculation.

Now, moving to the third quarter results. The top line of $262 million was up $92.6 million or 55% from the second quarter. Semi tests contributed $70 million of this increase for a total of $173 million and system tests contributed $22 million of the growth for a total of $89 million. Within that $262 million, service revenue was $56.9 million, up slightly from $54 million a quarter ago. Semi test service revenue was $40.6 million, up from $37.6 million a quarter ago. Product turns business was 37% versus 40% a quarter ago. In semi tests, product turns business was 50% versus 62% a quarter ago. Memory revenue was $7.9 million in the quarter, up from $2 million a quarter ago, which was all flash memory.

Moving down the P&L, non-GAAP gross margins increased from 29.5% in the second quarter to 42.5% in the third quarter due to higher volume. Product margins were adversely affected by mix in system tests and a product obsolescence charge of $6.9 million.

R&D expenses were $38.3 million or [14.6%] of sales compared to $38.5 million or 22.7% of sales in the second quarter. SG&A expenses were $46.3 million or 17.7% of sales compared to $47.3 million or 27.9% of sales in the second quarter. Operating expenses of $84.6 million were down slightly from the second quarter and included the benefit of about $6 million from temporary seller related reductions.

Our net non-GAAP interest and other expense was $1.8 million, taxes were a benefit of $1.5 million in the quarter, and our headcount totaled about 2,900 people. In the third quarter, semi test sales were 66% of the total and system test group was 34%. Systems test sales were at record quarter levels. Our book-to-bill ratio for the third quarter was 1.10 for the overall company, 1.3 for semiconductor test, and 0.62 for a system test. At the end of the quarter our backlog stood at $336 million, of which, 83% is scheduled to ship within the next six months.

Cash flow from operations totaled approximately $94 million after capital additions of $9 million. Again, the majority of this increase was from advanced customer payments. Depreciation and amortization for the third quarter was $34 million, including $6 million of stock-based compensation, $8 million for acquired intangible asset amortization and $2 million for amortization of the GAAP imputed debt discount. As noted in the press release, sales for the fourth quarter are expected to be between $255 million and $270 million, and non-GAAP EPS range is $0.12 to $0.17 on a 181 million diluted shares.

I should add that the guidance includes the full reversal of a temporary pay cuts and a more normal product mix, but also excludes the amortization of acquired intangibles, the purchase accounting inventory step-up charge, and the non-cash imputed interest on the convertible debt. Our GAAP EPS range is $0.04 to $0.09.

Now, moving to the P&L percentages expected in the fourth quarter. We expect gross margins to be 47% or 48%, while R&D should be 15% or 16% and SG&A should be 19% or 20%. Non-GAAP net interest expense is expected to be about $2.3 million and the tax provision should be about $2 million. In summary, our model is performing quite well. We are penetrating new markets and we are adding muscle to the balance sheet. Our main focus short-term is making sure our supply chain responds to demand in addition to maintaining very strong cost discipline.

Now, I will turn the call back to Andy.

Andy Blanchard

Thanks, Greg. Molly, we would now like to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of C.J. Muse with Barclays Capital.

CJ Muse - Barclays Capital

I guess the first question on the high-speed memory front, in terms of the multiple orders there. Can you comment, does that mean you were named the second source vendor there or are they still looking at three different vendors?

Mike Bradley

CJ, this is Mike. What I can tell you is that I can’t give you details on that, and I don’t think the customers have stated anything about first or second suppliers. What I will say is, our initial HSM evaluations have concluded in this past quarter and they are for both production and engineering applications. So, that sets the stage for some growth in 2010. Obviously, our objective here was to get this milestone achieved this year and we’ve done that, but in terms of first or second suppliers, none of those determinations have been made.

CJ Muse - Barclays Capital

Just to confirm, I believe you said memory, total revenues was $7.9-million?

Mike Bradley

Yes.

CJ Muse - Barclays Capital

Can you expand on the trajectory from here I guess including high-speed memory, what the puts and takes are and what we could expect as we enter 2010 for that line item?

Mike Bradley

Our customers are putting their CapEx budgets together now, and it’s a pretty uncertain picture actually. I think everyone assumes that 2010 is going to have production buying both on the DDR3 and on the GDDR5 front. Very hard to size that. We’ve made some estimates about the size of the market. How big we think that will be? Then obviously, you can take calculations as to what our share might be. I will say it’s shaping up. The customers are talking about adding capacity in 2010 where they’ve been really at very, very low levels here in ‘09.

CJ Muse - Barclays Capital

In terms of the non-GAAP pro forma, there is a line for profit sharing. Is that stock base compensation?

Greg Beecher

No. As we make adjustments in non-GAAP such as removing the amortization of intangibles, in theory, that would create more of a profit sharing charge as we improve income. So, we are just penalizing non-GAAP income for profit sharing had these other items that we’ve taken out not been in the P&L.

CJ Muse - Barclays Capital

Did you say that’s a tax effect?

Greg Beecher

No, no. Some of the items we adjust for in non-GAAP increase our income. So for increasing our income, our profit sharing calculation is basically 10% of whatever your pre-tax profits are. So, if we make adjustments and increase our pre-tax profits in non-GAAP, we put a profit sharing charge on that just so it’s consistent with how we would compensate people. Now, that cost is never paid because we pay profit sharing based on GAAP results, but to give a clearer non-GAAP picture we thought it was fairer to penalize ourselves for a profit sharing charge.

Operator

Your next question comes from Jim Covello with Goldman Sachs.

Jim Covello -Goldman Sachs

I guess first of all, if I look at the orders that you were able to recognize in the third quarter versus the fourth quarter revenue guidance. The fourth quarter revenue guidance is below third quarter orders even though the last few quarters of revenue have been above the previous quarters’ worth of orders. Can you help me understand that dynamic a little bit?

Mike Bradley

Jim, two things there. One is that we have some advanced ordering that goes out beyond the quarter. Some customers wanted to strategically get positioned against what they view as a tight supply chain, so they positioned themselves essentially not at the front of the queue but they’ve taken a piece of capacity up front. The other thing is, we are a little bit constrained on the supply chain and have some parts shortages. So we are working through those but there is a little bit of caution in our tone here as not all of those things are resolved yet. So, those are the two components.

Jim Covello -Goldman Sachs

Would that potentially give better visibility into the first half of 2010 with the extended orders and maybe orders that you couldn’t be able to fulfill from a revenue perspective until the first quarter?

Mike Bradley

I think that’s fair. Of course, the orders there and the delivery schedule on those orders could still change. I think it gives you a little bit more confidence that those customers put an expectation that their business is going to grow. So, we feel a little bit better about that.

Jim Covello -Goldman Sachs

One of the big packaging in test side customers suggested that their 2010 CapEx would double this week. Without commenting on that customer specifically, have you started to see orders or shipments to reflect that level of CapEx yet? Or do you think that’s in front of you still?

Mike Bradley

The OSEC segment came back pretty strong in the second quarter, tripled from Q1 to Two quarter, but stayed steady for us in Q3. It’s nowhere close to the levels; it’s almost two and a half times as high in the high point of the last cycle, the ‘08 part of the cycle. So, from afar I’d say there some energy still in that. That’s not an overheated segment for us.

Jim Covello -Goldman Sachs

Very helpful. On the high-speed memory, congratulations on getting the recognition there, what do you think the timing could be for; A, following orders from that customer, and then; B, potentially orders from a second customer who I believe you might be engaged with now?

Mike Bradley

I will say, we’ve gotten orders from more than one customer. So, those are in the house at this point. I think your question is what the potential for follow-on orders is for both of those customers or from expansion beyond that. That’s a tough call because that’s all wrapped up in their CapEx plans. I think we vote along with what conventional wisdom is that that will start in the first half of next year and probably be heavier in the second half. Obviously, we are trying to make sure these engineering systems and the early production use of this system goes well so that we can participate. It’s very, very hard to size that.

Operator

Your next question comes from the line of Gary Hsueh with Oppenheimer.

Gary Hsueh - Oppenheimer

I’m trying to get a sense of normalized revenue and earnings. I think on the earnings and the margin front you guys were helpful there, but in terms of normalized revenue, what are you guys thinking in terms of buy rate sort for a number next year. Just off the back of Jim’s questions, and it just sounds like the foundry and subcon world in Taiwan particularly in 2010 is feeling in close approximation to the spending levels in 2004, and I know your subcon revenue number is far below what it was in ‘08 and ‘04. Does that change your kind of 1% test or buy rate sort of notion in terms of the normalized numbers for 2010 and what kind of test or buy rate numbers are you expecting for next year?

Mike Bradley

Buy rate in this downturn has been a less useful number to us. I think everybody knows that it’s sub 1% this year in total, in both in memory and in SOC. Here is how I’m thinking about it. We are exiting this year in total CapEx at around a $1.5 billion. Okay? With 80 plus percent of that non-memory, and that’s down from $3 billion which was down from $4 billion which was down to $5 billion.

So, we’ve been on this downward slide here and the CapEx rate or the buy rate has gone down. If you annualize fourth, quarter that gives you about a little over $2 billion total market. So, if everything stays flat and I know there are different prognostications as to dip in the first half, recovery in the second half and so on, if everything stays flat, you’ve got a $2 billion market. We think it goes up some from that because we think that this buy rate is artificially low. I don’t know whether that’s 1.2 or 1.3, but it’s certainly not at the 2% or the 1.5% level.

Gary Hsueh - Oppenheimer

So it would seem to argue to me that you are looking at basically a base case for semi test revenue on a normalized basis in 2010 somewhere around a $1 billion, and consensus right now is at 1.1, and I think there is a lot of short-term fear about how seasonally week Q1 could be. In terms of the overall market, you guys believe for sure that if semi CapEx is growing then you revenue should grow and semi test buy rates should grow?

Mike Bradley

Did you say a billion in SOC?

Gary Hsueh - Oppenheimer

Yes.

Mike Bradley

Yes, so a billion on SOC, then the market has to be over $2 billion. Do the math around $2 billion and 40 plus percent share you get 800. So, 800 to 900 is probably okay.

Gary Hsueh - Oppenheimer

Just along these lines, did you give a number in terms of a target revenue range for HDD test next year?

Mike Bradley

You mean in estimating for different models what might you put in?

Gary Hsueh - Oppenheimer

Yes, for HDD test next year, was number given out?

Mike Bradley

No, but we’ve been using a windage number that says that could be $30 million, $50 million. It could be higher than that because our penetration into the market has been at a higher rate than that. So, the range is pretty wide and it’s lumpy, so it’s hard to make a call on it.

Operator

Your next question comes from the line of Krish Sankar with Bank of America-Merrill Lynch.

Krish Sankar - Bank of America-Merrill Lynch

Mike, you said about Eagle Test having record bookings in Q3. I was just trying to understand, is it fair to assume the Eagle Test business is running at its traditional peak capacity which is about mid to high $30 million run rate for revenue and maybe like a $40 million bookings run rate?

Greg Beecher

Not currently. It’s below that. Some of the bookings, we are securing capacity over the next couple of quarters. So, it’s not quite at that level but it’s working its way up to mid-20s in attractive profits.

Krish Sankar - Bank of America-Merrill Lynch

On the HDD side of the business, I know you guys said $30 million to $50 million and it could be higher. Did you see any pull-ins this year from 2010?

Greg Beecher

We don’t think so. We don’t think there was pull-ins with the equipment are being used, very high utilization. So, we don’t think there are pull-ins, but having said that we would not be surprised if from a seasonal perspective Q1 and Q2 could be dry. That’s not uncommon for this business.

Krish Sankar - Bank of America-Merrill Lynch

Just a final question, on the high-speed memory not to be beat a dead horse, but in terms of DDR3 specifically, can you tell like how many customers are you actually engaged with today?

Mike Bradley

That horse isn’t dead. We said multiple customers so that’s where we will leave it, Krish. If you remember, a couple of quarters ago, we ran a valuation of one, we expanded that to two. So, we’ve been able to secure business here from multiple customers.

Operator

Our next question comes from the line of Satya Kumar with Credit Suisse.

Vis Vellore - Credit Suisse

This is Vis Vellore for Satya. Actually can you share what the service revenues were for semis and system tests for the September quarter?

Greg Beecher

Yes. The semi service revenues were $41 million and the system test service revenues for the third quarter were $16 million.

Vis Vellore - Credit Suisse

Okay. Then at these levels of $250 million to $270 million revenue run rate, how should we think about OpEx coming back?

Greg Beecher

OpEx will come back to around $92 million in the fourth quarter, but as we approach our model of 15% profit, we would expect OpEx closer to $96 million, $97 million, maybe even $98 million, that neighborhood, upper 90s as variable compensation that’s tied to profitability kicks in.

Operator

Next question comes from the line of David Duley with Steelhead Security.