Teradyne, Inc. Q2 2008 Earnings Call Transcript

Jul.28.08 | About: Teradyne Inc. (TER)

Teradyne, Inc. (NYSE:TER)

Q2 2008 Earnings Call

July 24, 2008 10:00 am ET

Executives

Tom Newman – Vice President, Corporate Relations

Michael A. Bradley - President, Chief Executive Officer and Director

Gregory R. Beecher - Chief Financial Officer, Vice President, Principal Accounting Officer & Treasurer

Analysts

Satya Kumar – Credit Suisse First Boston

Timothy Arcuri – Citigroup

CJ Muse – Lehman Brothers, Inc.

Brett Hodess – Merrill Lynch

Bill Ong – American Technology Research

Jim Covello – Goldman Sachs

Gary Hsueh – Oppenheimer & Co., Inc.

Michael Chu – JP Morgan

Patrick Ho – Stifel Nicolaus & Company, Inc.

Krish Sankar – Banc of America Securities

Steven Pelayo – HSBC

Jeff Richards – Piper Jaffray

Operator

Welcome to the quarter two 2008 earnings conference call. (Operator Instructions) Tom Newman you may begin your conference.

Tom Newman

Welcome to our discussion of Teradyne’s most recent financial results. I’m joined this morning by our Chief Executive Office, Mike Bradley and our Chief Financial Officer, Greg Beecher. Following our opening remarks we’ll provide you with details of our performance for the second quarter of 2008 as well as our outlook for the third quarter.

First however I’d like to address some administrative issues. The press release containing our most recent financial results was sent out by a business wire yesterday evening. Copies are available on our website or by calling Teradyne’s Corporate Relations office at 978-370-2221. This call is being simultaneously webcast over our website at www.Teradyne.com. Note that during this call we are providing some slides on our website that will be summarized and that reinforce some of the highlights. They may be helpful to you in following the discussion. To view them simply access the Investor portion of our site and click on live webcast followed by click here for webcast.

In addition replays of this call will be available starting around noon today Eastern time. The phone replay number in the US and Canada is 800-642-1687. Outside the US and Canada the number is 706-645-9291. The passcode for both numbers is 12340. A web replay is also will also be available. You’ll find it by going to www.teradyne.com and clicking on Investors. The replays will be available along with the slides through August 7.

The matters that we discuss today may include forward-looking statements about events or the future financial performance of the company. Such statements involve risks and uncertainties. Actual results can differ materially from such forward-looking statements. Some of those risks and certainties are detailed in our press release and our filings with the SEC. Additionally those forward-looking statements including guidance are made as of today and we do not take any obligation to update them. Investors should note that only Mike Bradley, Greg Beecher and I are authorized to provide company guidance.

During today’s call we will make reference to non-GAAP financial measures. We have posted additional information concerning these non-GAAP financial measures including a reconciliation to the most directly comparable GAAP financial measure were available on our website. To view them, go to the 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 call, Teradyne will be participating in the Morgan Stanley Midwest Semi- and Semi-Cap day in Chicago on August 26 and Citigroup’s 15th Annual Global Tech Conference in New York on September 2 through 4th.

Now let’s get on with the rest of the agenda. First our CEO and President, Mike Bradley, will review the state of the company and the industry in the second quarter of 2008 and will review our outlook for the third quarter 2008. Then our Vice President, Treasurer and CFO, Greg Beecher, will provide more details of our financial performance in the second quarter and on our guidance for the third quarter of 2008. We will then answer your questions. For scheduling purposes you should note that we intend to end this call after one hour.

Michael A. Bradley

Let me give you the conclusions first then I’d like to expand a bit on what’s contained in our Q2 results and in our projections for this next quarter plus I’d like to also give you an update on our longer term strategy.

First of all we’re making steady bottom line progress as reflected in our second quarter results and third quarter guidance. Second we’re on plan with our new product rollouts in our SOC test business after a very good first half. Third our memory test business is making good headway with its new product rollouts as well but is not seeing any significant amount of capacity buy. Finally we’re on pace to meet our end of the year break even target of $250 million or less. We’re not immune to the headwinds in the general economy but our ties to many of our customers’ new product programs and continued docket wins have driven our progress this year.

Greg will go through the financials shortly but you can see that from the fourth quarter of last year to this coming quarter our steady work on the cost and productivity side of the equation continues to have an impact on the bottom line.

Now let me spend a few minutes on our SOC new product progress this year as that’s the centerpiece of our 2008 plan. If you remember we’ve got five new products where we’re shooting to get $150 million to $200 million in business this year. As planned we about doubled our new product orders in this last quarter so we’re more than halfway to that goal. The big story in this area for us is wireless. We just completed the strongest six month order period for wireless configurations in our history, demand for our 12-gigahertz ultra-wave subsystem is growing rapidly and this is buttressed by continued strong buying of our high volume fourth generation product. In the RS segment where we have more than 50% market share we have nearly doubled our bookings in the first half of this year versus the second half of 2007.

I think we’ll see continued adoption as the ultra-wave instrument is coupled with some of the other new products and subsystems that we’ve launched such as our high density version of the Ultra Flex. I should note that although total SOC bookings were flat system demand that is non-service bookings climbed 8% sequentially after 14% sequential growth last quarter. This was driven in addition to the surge in wireless by power management, consumer and base band segments. OSAT demand grew over 35% sequentially while specifier buying dropped just under 30% resulting OSATs accounting for about 55% of our demand this quarter up from 40% in Q1.

In total the appetite for our products has continued to grow through the second quarter despite a pretty harsh economic climate. There are some soft spots of course some driven by weaker end markets and others by cyclical supply and demand patterns. We have seen a sequential decline in the image sensor area and in micro-controller applications besides the normal lumpy demand patterns. In addition the LCD driver space is over capacity so we’re not seeing volume buying there in spite of very strong qualification activity. The overall new product order rate has been quite good for us in the first half.

Finally we’re closing in on the 2000 system mark in flex products and will likely break through that market in the next few months. Similarly we expect to get the 3000 unit mark for J750 products by year end. I mention this only to reinforce the ongoing strength of these products in the market.

Now you can see from our $20 million lower guidance range for Q3 that we’re pulling in our horns somewhat in the short term in booked SOC and memory applications. This obviously reflects the near end caution that we’re hearing from customers. With a very flexible supply line we can move this up or down of course but the very close end indicators from customers are increasingly on the side of caution and close monitoring with their capacity needs.

Now let me give you a few words on the memory side. There’s good news on the new product front and not so good news on overall market demand that I know you’re all aware of. You’ve probably seen our recent announcement of the Magnum II product. This product incorporates higher frequency and enhanced redundancy analysis thereby broadening our test capability for advanced flash technologies and other applications like multi-chip packages. We have a number of installations in place now with full customer acceptance and expect those to broaden in the months ahead. The Magnum II development was one of the linchpins in convincing us the next test could expand its served market and gain share long term. The product gives us access to multi-chip package tests where NAN, DRAM and controller functions can now be tested on a single pass. We’re very pleased with the momentum of the Magnum line and we’ve made important inroads this last quarter in Taiwan and Korea. The overall memory test market has dropped by 50% or more in recent quarters so we’ll be shipping at slightly reduced revenue level in the third quarter held back by this overall market decline.

Now in our system test business it’s a somewhat similar story but with revenue projections about flat from Q2. Our mil/aero results remain solid and we’ve seen increased in-circuit test demand from PC, server, notebook and telecomm test applications. Automotive test is in a lull due to a different program buy. We’re likely to see softness in the automotive sector for the next six months or so, so we’re counting on continued good performance from the mil/aero business.

Our customers’ forecast visibility remains extremely short right range. Our revenue guidance is set by our backlog plus a very short demand horizon. Over that horizon it’s difficult to predict. Since much of our energy focuses on our customers’ new products I’m confident that we’ll continue to make headway, competitive shootouts and strengthen our position in the market.

Now the longer term picture for us remains very promising. In addition to the TAM expansion in memory driven by next test we intend to enlarge our presence in memory test next year for high speed test applications. In addition we’re exploring a potential new adjacency in hard disk drive testing which has the promise of technology leverage from some of our other businesses. Now I can’t comment further on these areas but we’ll certainly do so when they have secured a customer [v-chip] and are expected to make a meaningful bottom line contribution.

So our growth strategy continues to unfold in a consistent way. First, to enlarge our SOC core through steady market share gains in that $2.5 billion to $3 billion market. Second, to enter the flash market through next text then expand our served market in testing more complex memory architectures with our next generation platform for next test. Third, to leverage our SOC technology into the high speed memory space and fourth to venture into test segments outside our core such as hard disk drive testing that have market scale and where we can bring unique solutions based upon our enabling technology.

All of this expands our served market by over $1 billion by this time next year. Now let me turn it over to Greg for some further explanations on the financials.

Gregory R. Beecher

I plan on covering three main subjects in our call today. First, is an update of our progress in achieving model profitability by year end at this cycle revenue? Next provide some color on our second quarter results and lastly I’ll provide some details for my third quarter guidance.

So how are we doing in achieving 15% model profitability by year end at this cycle revenue? The short answer is that we’re on plan. We remain on track in lowering our quarterly operating break even level as well as achieving our new product rollout goals. As Mike has already covered the new product momentum I’ll focus my comments on the cost side of the ledger.

As you will recall we described that we would get our quarterly operating break even level to $250 million or lower by the end of 2008. This would fully offset the $20 million a quarter break even increase from the addition of next test and would amount to just over 3 percentage points at the operating income line. So where do we stand against this commitment? At the halfway point in 2008 we have about two-thirds of this $20 million reduction behind us and are on plan to get the full amount by year end. The final one-third improvement will show up in engineering and in gross margins. In engineering the savings will come from the completion of engineering projects, higher levels of module reuse and improved development processes.

Moving to gross margins I’m pleased to report that the flex outsourcing to [Chuso] China was completed during the past quarter ahead of schedule. We’re not unique in that our full flex manufacturing line from board assembly to final configuration and test is all in one low cost outsource cite which has many benefits including lower freight costs, less in transit inventory, lower oversight costs and high responsiveness. There are some other smaller contributors across the company to lowering break even which range from low cost offshoring of some transactional work to further reducing our real estate footprint.

For modeling purposes what does all this mean using mid-cycle revenue against our operating break even levels in the second, third and fourth quarter of this year? Well we would be at 13% operating profit in the second quarter, 14% in the third and of course we’d get to 15% in the fourth quarter. So we’re making good steady progress. We’re also spending at a much higher level than in recent years in developing products for new adjacencies. These new adjacency revenue streams are not in our model revenue but the costs are in our current engineering spending. More will be said on this front when we have customer acceptance of these new products.

Now for the second quarter financial highlights, sales were $317.7 million up 7% from the first quarter, earnings per share totaled $0.16 on a non-GAAP basis and $0.06 on a GAAP basis. Note that our second quarter P&L included a full quarter of next test fixed costs which pulled down the EPS drop through on the higher second quarter sales. Gross margins were 48.4% of sales up from non-GAAP gross margins on 47.7% of sales in the first quarter due primarily to higher buying. R&D expenses were $56.2 million or 17.7% of sales compared to $55.1 million or 18.5% of sales in the first quarter. The dollar increase resulted from including a full quarter of next test engineering spending versus two months in the first quarter. Increase in SG&A for a full quarter of next test were offset by synergies and other reductions leaving SG&A essentially flat at $65.5 million or 20.6% of sales from $65.2 million or 29.1% of sales in the first quarter.

Our net interest and other income was $2.5 million down from $5.1 million in the first quarter due primarily to lower cash balances. We had $5.9 million of income tax expense for a tax rate of 17% on a non-GAAP basis in the quarter and our quarter ending headcount was approximately 3,600 employees. In the second quarter semiconductor test sales were 83% of the total and the system test group was 17%. On a geographic basis our second quarter sales broke down as follows, Asia 57%, US 19%, Japan 11%, Europe 10% and rest of world 3%. Our book-to-bill ratio for the second quarter were .97 for the overall company, .99 for semiconductor test and .87 for the system test group. At the end of the quarter our backlog stood at $364 million of which 87% is scheduled to ship within the next six months. On a geographic basis our bookings for the quarter were distributed as follows, Asia 60%, US 22%, Europe 7%, Japan 10% and rest of world 1%.

Now moving to the balance sheet, we ended the second quarter with cash and marketable securities of $414 million, cash flow from operations after deducting capital additions of $14 million totaled approximately $19 million. Since last quarter we used $58 million of cash to repurchase approximately 4.7 million of our shares at an average price of $12.46. As we speak our remaining share buy back authorization totals $297 million. Depreciation and amortization for the second quarter was $31 million including $5.7 million of stock-based compensation, $4.5 million of accelerated depreciation for real estate to be sold and $4.8 million for intangible in position.

Accounts receivable stood at $212.5 million for a 61 days sales outstanding an improvement of one day over the prior quarter. We ended the quarter with product inventory of $118.4 million an increase of $14 million over the prior quarter primarily associated with new products. Sales for the third quarter are expected to be between $290 million and $310 million. Non-GAAP earnings per share in the third quarter are expected to be between $0.10 and $0.15 excluding amortization for acquired intangibles and special items.

Now turning to P&L details, we expect gross margins to be between 38% and 49%, R&D should run between 18% and 19% and SG&A should run between 21% and 22%. The non-GAAP tax rate for the third quarter and for the year should be around 20%. Our longer term tax rate remains at 28% to 30%. We expect to end the quarter with diluted share count of 172 million shares.

Stepping back, in summary we’re making steady progress on our financial model. We’re lowering our operating break even, riding out more market share gains in our core SOC test market and we’re investing in adjacencies that expand our served markets at a rate much higher than our recent past. Our workforce is dominated by designs and customer support personnel, our supply line is highly optimized and we’re on the offense. Despite the near term difficult macro economic environment we’re facing we’re pleased with our progress and our longer term prospects.

Now I’ll turn the call back over to Tom.

Tom Newman

We’d now like to take questions.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question is from Satya Kumar – Credit Suisse First Boston.

Satya Kumar – Credit Suisse First Boston

I was just wondering if you could give us your assumptions; once again remind us of the product mix for that type of revenues?

Gregory R. Beecher

The product mix would generally be 80% semi-test and 20% STG.

Satya Kumar – Credit Suisse First Boston

What growth levels are you able to get this 15% operating margins? What is the cycle?

Gregory R. Beecher

It’s $340 million, $345 million.

Satya Kumar – Credit Suisse First Boston

As you ramp these new products in SOC how would that impact the gross margins in the back half of the year?

Gregory R. Beecher

Part of our path to get to model includes improving gross margins and the improving the gross margins comes from both the new products, they will improve our gross margins as well as the continuation of the outsourcing which has been completed and the benefits of the outsourcing now will start to be realized in full force in the second half of the year.

Satya Kumar – Credit Suisse First Boston

So the new products are basically not in line with the gross margins or better, right? [Inaudible] gross margins?

Gregory R. Beecher

They’re generally better.

Satya Kumar – Credit Suisse First Boston

Final question for me, I’m curious about this hard ware opportunity that you talked about. Can you talk about the market in general and opportunity for this versus the LCD test initiative and who are your competitors in the hardware test market right now? Where do you seem to have value versus the competition?

Michael A. Bradley

You said in comparison to?

Satya Kumar – Credit Suisse First Boston

LCD markets, LCD test markets.

Michael A. Bradley

The LCD driver market. Let’s see, I think there’s some significant similarities in the cost drive in both markets and the need for high parallelism. That’s an obvious similarity between the two. At the moment the LCD driver test market has over capacity so it is not driving any capacity buying, it is only driving qualification work. The hard disk drive market which I’ll just touch on very briefly because we don’t want to get into what we’re doing there with regard to product but the growth in that market for this next generation of smaller hard disk drives is significant over the next few years, on the order of 40% compound annual growth and we think that drives a market of a few hundred million dollars a year in total available market and the capability that we’re going to develop will call upon some of the capabilities and enabling technology that we have in other businesses.

Major competitor in that market, commercial supplier, is [Iratex].

Operator

Your next question is from Timothy Arcuri – Citigroup.

Timothy Arcuri – Citigroup

Couple things, how much of the $150 million to $200 million that you’re saying for new product revenues this year, how much of that cannibalizes current revenue?

Michael A. Bradley

Let’s see, Tim. Let me see if I can get it because obviously a chunk of that is a conversion. What we’re shooting for is to get about a third of that in for new customers so that would be share gains of $50 million to let’s say $65 million is the target. The rest of it complements our overall product portfolio. To put the math all together, the hope is when we do all of that, that we would get a point to two points of share in the SOC core this year.

Gregory R. Beecher

On the two-thirds we would expect to get more attractive gross margins because we’re putting in new technology in place of some technology that is less competitive.

Timothy Arcuri – Citigroup

So the right way to think about that is really that you’re only adding about $50 million to maybe a little more million dollars in flat out new revenue this year?

Michael A. Bradley

That’s the way to think about it on the new product side. At the same time, the existing products also have a role and a have a job to do of expanding socket-by-socket. So we expect a bit more from that. The short end on this is if you’re trying to gain net gain one point of share we think you have to get a gross gain of a point and a half because we don’t win every contest. We don’t go undefeated. So we’ve got to win more than the net share that we gain each year.

Timothy Arcuri – Citigroup

I had a couple more, so what do you think that that number, let’s say it’s $50 million this year, what do you think that number is just sheer new revenue next year? Is it double that, maybe $100 million?

Michael A. Bradley

We haven’t done that yet, don’t know.

Timothy Arcuri – Citigroup

Next thing, can you give me some breakout in terms of the OpEx by semi versus non-semi- because I guess I’ve looked at the semi- OpEx and I’ve talked to Tom about this before but if you look at the semi- OpEx it just looks like in the semi- business you’re spending a lot more money than peers are so I’m just wondering if you could break that out for me?

Gregory R. Beecher

In the second quarter in semi-test we spent $47 million, this is with next test too, and this is all semi-test, $47 million in R&D and $55 million SG&A.

Timothy Arcuri – Citigroup

Maybe just two more quick things, can you break the $264 million in semi-test revenue? Can you break out how much of that was memory?

Gregory R. Beecher

The memory in the second quarter was $14 million.

Timothy Arcuri – Citigroup

What’s embedded in your September guidance for memory?

Gregory R. Beecher

Likely flat to down a little.

Timothy Arcuri – Citigroup

Last thing, maybe my memory is not correct on this, but isn’t there a lawsuit right now that’s pending relative to your HDTV, your entry into the HDTV market?

Michael A. Bradley

Tim, I can’t comment on any legal activities around it. What is out there you can get access to but we can’t make any other comments.

Timothy Arcuri – Citigroup

Right, but you can comment factually, there is in fact, you are named in a lawsuit relative to that new product, correct?

Tom Newman

On that front, yes.

Michael A. Bradley

Yes, that is true and we’re going forward with the product.

Operator

Your next question is from CJ Muse – Lehman Brothers, Inc.

CJ Muse – Lehman Brothers, Inc.

If I could take you back on that last question, could you tell us what your core SOC revenues were as well as what LCD driver revenues were in the quarter?

Michael A. Bradley

We can give you the SOC revenues in total. As we said last quarter we’re not breaking out the five product revenue pieces at this point but do report to you on how we’re doing in the overall package of those products. On that front I don’t know if I said it, we’re about halfway to the objective that we’ve got this year in the $150 million to $200 million so we feel pretty good about the momentum on that front so far.

CJ Muse – Lehman Brothers, Inc.

On the LCD driver part of things we talked about excess capacity there, have you revenued tools yet?

Michael A. Bradley

There is no revenue yet on that product.

CJ Muse – Lehman Brothers, Inc.

Thinking about overall guide for September at the midpoint, running my numbers I think that suggests roughly SOC down $20 million if you assume that your service holds relatively flat, where are you seeing the softness there?

Michael A. Bradley

The softness going forward?

CJ Muse – Lehman Brothers, Inc.

Yes, exactly.

Michael A. Bradley

It’s a number of places, it’s not one place. We expect that things will trend down; we’ve had a record demand in wireless. We think that comes down a little bit in the third quarter. Base span was very strong so those are the two places where we are seeing signals from customers that they’re in a digestion mode. Memory is down a little bit because the capacity buying is really off. I think the overall memory market quarterly run rate now is 50% or less than it’s normal rate. But there’s a pretty broad set of places where the short term demand I’m talking about, in other words the visibility we have over the next month or so appears to us to be off. So as I said we pulled our horns in ship level across the board in those products. At the same time we’ve got many of the new products are all ramping through this period?

CJ Muse – Lehman Brothers, Inc.

In terms of your incremental revenues from new products, on the last quarter call you talked about $50 million to $70 million, this call $50 million to $65 million. Are you changing your thoughts there or is that just $5 million is not a big deal there?

Michael A. Bradley

No changing the thoughts.

CJ Muse – Lehman Brothers, Inc.

Last question here, can you give us an update on the move to wafer tests with our Magnum tool set?

Michael A. Bradley

We introduced the Magnum II higher frequency more capability for the next generation of NAN parts and the multi-chip packages. On the wafer front as we talked last quarter we have a very small position on wafer test with Magnum I and with Magnum II and that’s under 10% of our total business. That’s an available market to us that hasn’t really been developed yet. This quarter we expanded our customer base with two new customers in Taiwan for wafer probe so we’re expecting that that rate of penetration into the probe market will expand for us. We’re hoping to get that to about double that level in 2009, north of 20%.

Operator

Your next question is from Brett Hodess – Merrill Lynch.

Brett Hodess – Merrill Lynch

You talked about the resurgence in the OSAT group in the second quarter, the high sequential growth rate, when we look into the second half and the caution and some of the weakness that you talked about, does that flow back from the OSAT group or is it mainly in the IBM? Depending on the mix of those two how much impact does that have on your margins?

Michael A. Bradley

Definitely the OSAT numbers here have grown dramatically. We’re at a eight quarter high in our OSAT demand so they’re into a very, very high digestion phase right now. So we think that has to come down a little bit. We don’t have it broken out in terms of what the expectation around this quarter’s demand will be but a 55%, 45% split with OSATs at 55% is high. So we think that’s definitely a piece of the pullback.

Brett Hodess – Merrill Lynch

Does that help or hurt margins as that piece pulls back?

Michael A. Bradley

I think it’s neutral to margins, I think the margins would not be expected to vary in any significant way based upon the customer. It’s more dependent upon the application versus the end customer.

Operator

The next question is from Bill Ong – American Technology Research.

Bill Ong – American Technology Research

We’ve been seeing in pricing in raw materials and component costs. I just want to see if that has impacted your cost of goods and if so, have you been able to pass the cost on to your customers?

Gregory R. Beecher

The impact to date has been small. We have ongoing discussions with our suppliers where we’re obviously trying to get them to lower their cost, they’re trying to pass on items you mention as well as currency if there some client from overseas. But net-net we expect to hit our material costs down target goals this year so the impact of what you’ve heard about has not been significant to Teradyne as of yet.

Michael A. Bradley

Bill we typically don’t have a cost pass-through. We just work against value of the product and try to drive the pricing off that.

Operator

Your next question is from Jim Covello – Goldman Sachs.

Jim Covello – Goldman Sachs

Couple quick things, as it relates to the memory business I think ScanDisk was about 40% of next test business and obviously they reported some weak results and talked about cutting back on their capacity growth. Should we use them as a leading indicator for what we could expect for that business? When they start to see better trends that ought to map pretty closely given that they’re already cutting back?

Michael A. Bradley

I think that would be fair. The capacity buying as I said is off, that’s a piece of it. That wouldn’t be a bad element. Our overall memory business hasn’t gone down the level that the overall market has so that means that it’s new product driven, new applications driven for us. Having said that we don’t have a large market share in that segment so we’re able to buck the tide a little bit there.

Jim Covello – Goldman Sachs

Moving over the SSG and the competitive environment there, how are you feeling about a share? In particular, one of your big competitors is highlighting two pretty significant order wins and shipments. Were those situations that you are involved in bidding on or is that not something that you were interested in?

Michael A. Bradley

Let me talk in general about the competitive landscape versus specific sales situations. So far through this year we think we’re continuing on a trajectory here of share gains and we get those, they’re not all marquee one shot deals where you get one thing and say that’s accounting for the lion’s share of the share movement. We have so many markets that we’re in, we get them in smaller pieces. We have had some important platform wins in the first half, one of those in the automotive space which I think you’re aware of, another win in the ASIC space. Neither of those has yielded significant revenue to date so they are really in our future. But as you look through the first half of the year we think the market’s about $1.3 billion so far through the first half and we think we’ve gained some position on that. Having said that, market share numbers don’t solidify until you get a little bit past the end of the year. If you count noses the net effect of our design ends, wins and losses puts us slightly ahead of the game for this year and our target as I said before is to gain one to two points net which is what we’ve done the last three years.

Operator

Your next question is from Gary Hsueh – Oppenheimer & Co., Inc.

Gary Hsueh – Oppenheimer & Co., Inc.

Some things don’t quite square with me. Mike, you basically talked about LCD drive IT tests and the flat panel display business being in over supply and it sounded like you’re hinting that could potentially dampen your view on volume buys for your LCD driver IT test products. If that product is part of the $150 million to $200 million new product revenue stream that you still expect this year, shouldn’t that number be cut down maybe by $20 million or $30 million so really it’s $120 million to $170 million now?

Michael A. Bradley

The answer is that of the five new products, some are ahead of pace, some are behind in pace. In particular the wireless new product is ahead of that pace. We were hoping that that would give us 20% or 25% of that growth, it’s closer to 35% to 40%. So some of the new products are lagging because of market conditions, others have accelerated dramatically. Just to give you a bit of a feel for that we’ll ship about 50 ultra-wave products this quarter. On top of that we’ll ship about a third additional units for internal use. So the ultra-wave is well ahead of plan and that’s more than made up for the softness in the LCD space.

Gary Hsueh – Oppenheimer & Co., Inc.

My second point is just on the inorganic part of that $150 million to $200 million, with the LCD driver IT diminishing in terms of prospects for volume buys, is most of that $150 million to $200 million now, most of it seems to me is organic contribution, either a replacement cycle or share gain. Is that a right characterization?

Michael A. Bradley

Yes, it’s all of that set of products that we’re talking about is inside SOC and you’re right, you could carve out LCD as a place we haven’t played in the past. So all of the other portfolio of products, for example the new image sensor product, micro-controller product or the high density version of the ultra-flex, all of those build on and fan out from an existing position that we have.

Gary Hsueh – Oppenheimer & Co., Inc.

If I look over the last five years just doing fill in math and averaging the sequential growth rate in Q4 over the last five years, I get something like 12% decline quarter-for-quarter in Q4 at the top line, anything different this year or this cycle that would make that seasonal down 10% to 15% for Q4 out of the norm this year?

Michael A. Bradley

If you are looking out and modeling it that way and I see why you do it, I think that we would have no argument with the fact that the seasonality in this, I think that there’s this very, very intense utilization push on by our customers and if you look at our utilization numbers, we’re actually up in utilization for the last two quarters. As I said before we’ve been pretty steady but the curve goes up in the March quarter and the June quarter for us and to what that’s reflective as we look at softening in the third quarter demand, we see unrelenting pressure on the utilization side of it. So I think that might have some impact on how the trending will go in 08. Having said that I’m really not speculating about Q4 at this point because visibility is so short given lead times.

Gary Hsueh – Oppenheimer & Co., Inc.

I was just wondering if anything stood out like a sore thumb this year versus any other year. Last question here for Greg, not sure I caught it, but according to my math at least on a GAAP basis gross margin came in 40 basis points above the top end of the range, revenue obviously not at the top end of the range. What drove a better margin there? Is it mix?

Gregory R. Beecher

The gross margin improvement was largely better mix.

Gary Hsueh – Oppenheimer & Co., Inc.

Mix was a bigger driver for gross margin then cost reduction?

Gregory R. Beecher

It was cost reduction but mix was the bigger driver and what was behind mix was some of the new products. So the new products are kicking in, replacing products that have lower margins.

Operator

Your next question is from Michael Chu – JP Morgan.

Michael Chu – JP Morgan

Could you provide an update on your DDR III activity? Also maybe help us get the size for the part of the market that you’re interested in in particular?

Michael A. Bradley

I’m maybe a little bit redundant from what we said in the past and that is all we’re going to describe at this point is that we do have ongoing R&D efforts in the high speed memory space, the DDR III and beyond space and we would build on technology that we have in our instrument space and portfolio in our SOC market as well as the history of knowledge in the memory business plus the next test input. That’s the nature of what we would have. I don’t want to get into how we’re targeting that market and what the product attributes are at this point but we do intend to build product for the 09 timeframe in that market segment.

Michael Chu – JP Morgan

Could you provide us a sense of maybe the size of that market that you’re specifically addressing, the high speed portion of the industry?

Michael A. Bradley

We think that if you have, let’s take the last few years of market break down, let’s see it’s close to $1.5 billion in the overall memory space, that includes everything, flash, etc. We think this is about a third of that overall market or would be a third of that market when we intersect it.

Operator

Your next question is from Patrick Ho – Stifel Nicolaus & Company, Inc.

Patrick Ho – Stifel Nicolaus & Company, Inc.

Just following up on that question about the high speed memory market, in terms of the revenue growth opportunities I can see the rationale for the entry into that market, can you just give your take on what the profitability levels will be like given how competitive that marketplace is about to become?

Michael A. Bradley

That is very, very hard to call. Greg, do you want to talk about how we might model that?

Gregory R. Beecher

When you go into a new adjacency you do need to go with a product that has differentiation. If we go with the [ME] II product it would be brutal. We believe our product has very distinctive advantages that we are getting validated with key customers so if you accept that we have a product that is not a ME II we would expect this to look like SOC test. In the past the memory market has been highly profitable for largely one dominant supplier, the buy rate has actually been higher there too. I think what could happen over time is more competition. The buy rate could come down a little bit but I would expect the margins would like they are in SOC test.

Michael A. Bradley

As we get closer to that we’ll try to give you better guidance. I know you have to try to build a model here on this, that’s the best we can say at this point.

Patrick Ho – Stifel Nicolaus & Company, Inc.

The gross margins for the overall company obviously held up pretty well, can you just comment on the type of platform leveraging you’re getting with the new products? How much commonality, how much of the supply sourcing are you getting and is that a big contributor to the overall margin profile going forward?

Michael A. Bradley

Let me just comment on the engineering side of it, one of the ways that we’re reducing our engineering have been and continue to do is through a much heavier reuse model than we’ve had in the past. We’re now at the point where we’ve got a flex product line and a 750 product line at very, very high volumes in both spaces. As you look at our product line architecture roadmap a big piece of our productivity improvements there come from the reuse of technology components, generation to generation.

Operator

Your next question is from Krish Sankar – Banc of America Securities.

Krish Sankar – Banc of America Securities

I have a question on your mid-cycle assumption; you said 80% of that was coming from semi, what is your assumption for the memory dollar contribution? I remember next test used to be the high teens mid cycle revenue, are you doing the same thing or is it different this time around?

Michael A. Bradley

For the flash memory as we said in our last call our game plan was to get that to $100 million or $25 million a quarter run rate.

Krish Sankar – Banc of America Securities

In terms of R&D are there any duplications going on in terms of R&D, i.e., like you have an excess product and you’re trying to work on a Teradyne based memory product too or are you just focused on just one product at this point?

Michael A. Bradley

No, there’s very little duplication. When we combine with next test the obvious thing in this space is if you have a lot of overlap you both have to squeeze the overlap out from a cost standpoint and then rationalize the products for customers. So next test had very little overlap since they were predominantly driving into the memory space. Now going forward we’re clear about where we’re headed with the memory product line and that is that next test is expanding in what I’ll call the flash or low speed applications and on the high speed end that would be a product for next year and that’s built off the flex product line. But there’s no contention there, there’s no debate.

Krish Sankar – Banc of America Securities

If I look at your September guidance and look at your long term operating model would you see $45 million in 15% operating margin? It seems like at that target model you need to probably have like a $120 million in OpEx and it seems like you’re already there. So is it fair given everything that’s going forward to reach the target model is more top line driven, new products than the gross margin outside?

Gregory R. Beecher

I’m going to say yes with one exception. On the OpEx if we were at model we’d pay out more in profit sharing and variable compensation so we need to take some more costs out of OpEx so that when we’re at model our OpEx numbers add up to about $118 million. So we will do that. All your other assumptions are accurate.

Krish Sankar – Banc of America Securities

Do you have a number for the market size for HDTV testing?

Michael A. Bradley

For that subset segment?

Krish Sankar – Banc of America Securities

Yes, or is it lumped into a bigger bucket?

Michael A. Bradley

It’s really into the consumer space. We think about what instrumentation we have for that space but no, don’t have the size for it.

Operator

Your next question is from Steven Pelayo – HSBC.

Steven Pelayo – HSBC

Could you just quantify, you said next test the run rate goal is to get to $100 million, $14 million this quarter, flattish to down, is this year looking like more of half that rate for 2008? Is that the right way to look at that?

Gregory R. Beecher

At the moment, if you look at the prior quarter, they were up higher than the $14 million, but they’re at $18 million last quarter on a full quarter basis so there’s no doubt that significant growth is needed in flash to get them up to that $100 million run rate but there’s a big [ham] and there’s plenty of opportunities for them to expand into probe.

Michael A. Bradley

I think one of the things that is mixing in that is that we’re talking in this sentence about memory and next test is combined has some SOC business so, Steve, I don’t whether we’re confusing you on that.

Steven Pelayo – HSBC

Greg, just a quick question for you, I noticed your 10-Q last quarter you are doing 37% gross margins in service again. That’s a level we haven’t seen in quite a long time. Is that the new run rate you’re looking at?

Gregory R. Beecher

No, we’re going to do better than that. We’re going to be in the 40s.

Steven Pelayo – HSBC

By what timeframe?

Gregory R. Beecher

How about second quarter?

Operator

Your next question is from Jeff Richards – Piper Jaffray.

Jeff Richards – Piper Jaffray

I was hoping you could talk a little bit about capacity utilization, SOC and on the flash side. Where do you see that currently, where do you see it trending over the next couple of quarters?

Michael A. Bradley

Don’t know over the next couple of quarters but the trending has been up a few points. We’ve said in the past we’re operating 80% to 90%. We’ve been in that tunnel here for many, many quarters. That’s notched up a couple of points, two to three points over the last two quarters and the science of this isn’t perfect, there’s not a meter on every system but the indicators we get are consistent with the discussions with customers and they are doing everything possible to squeeze out the capacity because of the uncertainty in the markets that they are serving. I don’t actually have capacity utilization numbers on the flash side, we’re going to try to get those over the next couple of quarters but right now we don’t have the same picture on that front. I do know it’s high by the way, that that capacity utilization in our equipment remains quite high.

Jeff Richards – Piper Jaffray

Back on the DDR trade market it looks like the Halum, the new architecture out of Intel, has been pulled forward in terms of release, will that accelerate the transition to DDR or do you still have to wait for the tear away platform in Q1 of next year?

Tom Newman

We’re gated by the next tier in that food chain so we’ve got a list of customers we’re working with and we’re going to do our best to try to meet their ramp plans for DDR III but that’s what we’re focused on as opposed to the more macro issue at Intel.

Jeff Richards – Piper Jaffray

Let me try it this way, your expectation is for DDR III to start to move into production in a meaningful way in Q1 still?

Michael A. Bradley

For the market.

Tom Newman

For the market, correct.

Jeff Richards – Piper Jaffray

Didn’t know, no curvation in that over the last couple of months or weeks?

Michael A. Bradley

Not on our end, no.

Operator

Your final question is a follow up question from Timothy Arcuri – Citigroup.

Timothy Arcuri – Citigroup

I’m just sitting here looking at your model and I’m looking at you spending roughly 40% of your revenue on OpEx and I was looking at [inaudible] spends about the same amount. So we have the two biggest SOC companies spending about 40% of their revenue on OpEx in they’re semi-test business. As you look sustainably at the business that doesn’t seem like a sustainable number in terms of OpEx. Do you think that there is still another round of realization that all the companies in the industry have to go through that maybe the market opportunities in that as big as what the industry thinks and that it’s not sustainable to run at 40% of your revenues for OpEx and it’s not like we’re in a huge downturn right now. Yes, it’s a downturn but your business has been reasonably okay and yet you’re still spending 40% of your revenue on OpEx.

Gregory R. Beecher

A large percentage of our engineering spending, very significant piece, is to get into new markets, it’s not trying to grind out more share in SOC tests. So that’s a very significant portion of our operating expenses in R&D. Stepping back further from your point, I do think depending upon what the market size ultimately ends up to be down the road it is certainly possible that there is too much spending. I wouldn’t say that today but that is a concern I think all companies have and it really ties back to what is the market size.

Michael A. Bradley

And I think the consolidation moves that are underway are reflective of that, that the spend rate to cover the amount of the market that can give you a decent bottom line return drives a very significant variety of R&D projects in this space and the companies in the market are moving and have been moving over the last few years towards being the general purpose suppliers where that R&D is high or into niche suppliers where they try to contain it and narrow it and just go after a subset of market. But I think as you see these consolidation moves that’s an obvious signal that the table stakes are very, very high in this market.

Timothy Arcuri – Citigroup

Mike, I’m just thinking about most other sizable markets and it just seems to have the two biggest players in SOC spending that much of their revenue on OpEx suggests that yes, there have been some small M&A deals but it suggests that there has to be even more going forward because it doesn’t seem to me to be a sustainable model where folks can make money when there’s two big companies spending that much on OpEx. That was my point.

Michael A. Bradley

Yes, that’s a good point.

Timothy Arcuri – Citigroup

Greg, when do you think that you’ll switch to your long term tax rate? Do you think taxes are going to jump up to the 20% to 30% next year?

Gregory R. Beecher

I think Q1 2009 we’d likely be using the long term tax rate.

Operator

There are not further questions at this time.

Tom Newman

I think that we’re fine and thank everybody for participating. We’ll see you next quarter.

Michael A. Bradley

Thanks everybody.

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