Teradyne Guides Lower; Expects To Return To Growth In 2024 (NASDAQ:TER)

A Good Quarter But Lower Guidance

• Teradyne (NASDAQ:TER) Q4 Non-GAAP EPS of $0.92 handily trounced estimates by $0.17 or 22%. Revenue of $732M beat estimates by $20.16M.
• However, guidance for the first quarter of 2023 was way off the mark clearly indicating a slowdown; revenue of $550 million to $630 million or a midpoint of $590 vs. $636.93M consensus, was off by a whopping 7%.
• It guided for GAAP net income of $0.26 to $0.49 per diluted share and non-GAAP net income of $0.28 to $0.52 per diluted share vs. $0.57 consensus. At a midpoint of $0.40 compared to $0.57 this is again a huge drop of 30%!
• Teradyne has a lot of work ahead in 2023 and 2024 to regain growth – We are likely still only midway through the semiconductor cycle, with huge weaknesses in memory, slowing demand for PC’s and slowing growth in cloud. As Microsoft (MSFT) indicated in its Dec 2022 Quarter results, demand for its flagship Azure cloud product slowed to the low 30% range; with likely even slower growth in the first half of calendar 2023.

The Challenges

The 3 Nanometer Delay

Clearly Teradyne’s fortunes were riding on the launch of 3nm production in the first half of 2023. As with every improvement in production nodes from Taiwan Semiconductor Manufacturing (TSM) – one of Teradyne’s largest customers, Teradyne benefits hugely. There is the obvious need for testing the massive increase in volume as more customers such as Apple (AAPL) and NVIDIA (NVDA) start ordering the new chips. Additionally testing gets more complex, which helps margins.

TSM’s Conference Call poured cold water on any expectations of first half benefits to Teradyne. From TSM’s CEO:

Our N3 has successfully entered volume production in late fourth quarter last year as planned, with good yield. We expect a smooth ramp in 2023 driven by both HPC and smartphone applications. As our customers’ demand for N3 exceeds our ability to supply, we expect the N3 to be fully utilized in 2023. Sizable N3 revenue contribution, we expect to start in third quarter ’23 and N3 will contribute mid-single-digit percentage of our total wafer revenue in 2023. We expect the N3 revenue in 2023 to be higher than N5 revenue in its first year in 2020.

N3E will further extend our N3 family with enhanced performance, power, and yield and offer complete platform support for both smartphone and HPC applications. Volume production is scheduled for second half ’23.

Despite the ongoing inventory correction, we continue to observe a high level of customer engagement at both the N3 and N3E with a number of tape-outs more than 2x that of N5 in its first and second year.

Similar sentiments were expressed on the January 26th, 2023 Teradyne earnings call with analysts, where there were clear indications that Teradyne was not likely to get much growth from 3nm processors in 2023. Vivek Arya is an analyst for Bank of America and Greg Smith is Teradyne’s President.

Vivek Arya

Got it. And for my follow-up, I’m curious, for the 3-nanometer transition, do I absolutely need new testers? Or is it possible to just reuse existing tester capacity?

Greg Smith

Yes. Vivek, that’s an excellent question. So unlike the memory market or the Wireless Test market, where you need new equipment for new standards, and that drives replacements, in node transitions like 3-nanometer, for the most part, the installed capacity is perfectly capable of testing the new part. And so the tester demand is really driven by increased complexity.

So if you are testing a part that takes longer to test, you’re going to need to add to your test capacity, test the part on both the stuff you already own and then the new testers that you buy. And so we look really carefully at how much of the industry is on a particular node because that drives basically the number of transistors that have to get tested. So it’s definitely — there’s a high degree of reuse in the SOC market as nodes transition.

Vivek Arya

Got it. So there is a scenario where, if 3-nanometer volumes are low enough, that they don’t really need to buy new testers in the back half, right?

Greg Smith

Yes. That’s certainly one scenario. It’s not our current best view, but things could certainly play out that way because of this balance of units versus complexity.

The Slow Growth in Industrial Automation

The IA market is not as compelling as I originally thought it to be; growth in Q4-22 was way below expectations at 7% in constant currency and 2% YoY as reported. It did grow 15% in constant currency in 2022, however that too was way below the 20% estimates made earlier in 2022.

The main reasons for the slowdown were a reduction in manufacturing activity and labor shortages in distribution in Europe. Management still expects IA to grow 20% in constant currency in 2023. However, I am skeptical and expect growth to be tepid and likely in the low teens in 2023. They expect the first half to be sluggish but the second half to make up lost ground – turnarounds seldom happen that fast, especially in the industrial sector with difficult economic conditions, higher interest rates and weaker PMI’s.

Management remains confident that IA will reach 19% of sales by 2026, growing about 250% to $1Bn. However, I see competition creeping in, which at the least, will reduce pricing power to some extent. Fellow contributor Zen Analyst speaks of competition in the market in his article, citing operational flexibility and affordability of Cobots as two competing factors from younger and more nimble entrants that would likely dent Teradyne’s market share.

The Current Forecast – More Realistic and in Line with Historical Growth

Management has pushed out their earnings and revenue model by two years. in Q3-2022, they had Earnings reaching $7 to $9 in 2024, which is now pushed out $7.50 to $10 in 2026. In my opinion, this is reasonable and achievable. Growth will be achieved only in 2024-2026, given that 2023 revenues are likely to be flat for the following reasons.

a) SOC (Systems on Chips) tests are likely to be about 20% below 2022.

b) Major SOC producers are only likely to transition to 3-nanometer later in 2023 and not in the beginning.

c) Memory Test Markets are likely to be lower to flat compared to 2022, which given the overcapacity in memory might be over optimistic.

d) Storage and Wireless testing are also not going to help demand in 2023 because of excess capacity in HDD and lower smart phone shipments.

The Previous Teradyne Forecast.

The Bright Spots

Autos

The best news I felt was the strengths in autos. Continued growth in a user segment – ADAS (Advanced Driver Assistance Systems) is a major positive for the company because this segment has a huge runway for the next decade. It has more and more regulatory and compliance requirements, which mandate safety and almost compels automakers to make ADAS components mandatory in all vehicles as we move towards full autonomy. This market is widely under penetrated and as costs come down, it will widen for semis. This widely confirms trends that we saw from Nvidia, which had a 60% growth in autos and has spoken of an $11Bn opportunity over the next 5 years.

Hyperscalers – Vertically Integrated Producers

This segment showed strength for Teradyne in Q4-2022, a segment where they have been weak in the past, and also a segment which has not shown the need for complexity in testing. As President Greg Smith, mentioned below in their earnings call – this is a growing segment with strong demand from Hyperscalers, which should mitigate the 2023 weakness from SOC’s and Memory.

We have seen these technology transitions drive demand for test as the new nodes enable more complex chips and multichip packaging technologies like chiplets drive higher quality level requirements. Both of these factors drive longer test times and higher ATE TAMs. But the landscape is changing. These complex chips are increasingly developed by a new class of vertically integrated producers, or VIPs, including hyperscalers and automakers.

We’ve had good design-in success to date with this emerging customer type, and these VIPs provide Teradyne with an opportunity to grow share in a space long dominated by legacy x86 architectures, where our share has historically been lower. These large, complex devices are used in uptime-critical applications and will require exceptionally low defect levels. To achieve this quality level, our customers will increasingly adopt an additional test step, system-level tests or SLT. We have a strong footprint in this growing market, and our design-in success with new customers is expected to be a growth driver over the midterm.

The new vertically integrated producers, including hyperscalers, are running to it on a different track. They have new parts that they’re designing, that they’re releasing to production. And those parts typically need different tester configurations that are driving capacity in different places than the traditional compute specifiers. So we do think that, that’s going to be a stronger part of the compute market in 2023 than the traditional — there’ll be softness in the traditional market.

The Investment Case

I still believe in the reasons why I recommended Teradyne as a Strong Buy in Sep 2022.

• It remains the best in its class.
• The Automated Test Industry is largely a duopoly with Advantest (OTCPK:ATEYY).
• Complexity in testing will continue to give it pricing power.
• Automated Testing Equipment is too vital a cog in the semiconductor industry arms race and Teradyne has close to 50% market share.
• The size and growth of the industry continues to give it sustainable earnings.

Management has clearly become more cautious – Even as growth gets pushed out, I have more faith in management that has a more realistic sense of its own strengths and prospects. In my opinion, a midpoint of $8.75 EPS is a solidly achievable target in 2026.

When I recommended Teradyne as a strong buy at $79 in Sep 2022, I had a 3 year target of $145, hoping to make 22% a year by 2024. I continue to recommend Teradyne as a Buy, but my expected return on investment has definitely lowered given the slowdown in 2023.

At a midpoint of $8.75 in 2026 earnings, Teradyne should get a PE of 20, with a 2026 target price of $175 – or a four year CAGR of 15% from today’s current price of $100.