Teradyne, Inc. (TER) Q3 2014 Earnings Report, Transcript and Summary

Good morning. My name is Natalia, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Teradyne Q3 2014 Earnings Conference Call. [Operator Instructions] We will now turn the call over to Mr. Andrew Blanchard. You may begin, sir.

Thank you, Natalia. Good morning, everyone, and welcome to our discussion of Teradyne's most recent financial results. I'm joined this morning by our CEO, Mark Jagiela; and our CFO, Greg Beecher. Following our opening remarks, we'll provide details of our performance for the third quarter as well as our outlook for the fourth quarter of this year. The press release containing our third quarter results was issued last evening. We're providing slides on the Investor page of the website that may be helpful to you in following the discussion. This expanded slide presentation contains some of the numerical data that in the past was included in the speaker remarks. Those slides can be downloaded now or you can follow along live. If you don't see the download icon, simply refresh the page. In addition, the replay of this call will be available via the same page about 24 hours after this call ends. 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 take no obligation to update them as a result of developments occurring after this call. During today's call, we'll make reference to non-GAAP financial measures. We've posted additional information concerning these non-GAAP financial measures, including reconciliation to the most directly comparable GAAP financial measures, were available on the Investor page of our website. Also, between now and our next earnings call, Teradyne will be participating in investor conferences hosted by UBS and Crédit Suisse. Now let's get on with the rest of the agenda. First, Mark will comment on our recent results and the general market environment as we enter the fourth quarter. Greg will then offer more details on our quarterly financial results along with our guidance for the fourth quarter. We'll then answer your questions. And you should note that we intend to end is call after 1 hour. Mark?

Thanks, Andy, and good morning, everyone. Today, I'd like to cover 2 topics with you: first, our performance in 2014; and second, our outlook for the test market over the next several years. Greg will then review the quarterly numbers in detail as well as update you on our capital plans. First, our third quarter results keeps the momentum going for a very good growth year in 2014. At the midpoint of our fourth quarter guidance, we will deliver 15% growth in sales and 23% growth in non-GAAP operating income for the company, compared to 2013. Most of this gain comes from our strengthening Semiconductor Test business where sales and profits are likely to grow just over 25% and 50%, respectively. Seasonal swings in our SemiTest business have increased over the past few years, with this year's second quarter product shipments more than double 2013's fourth quarter levels before settling back down again this Q4. This is tied to the semiconductor capacity ramp that occurs a few months in advance of launching new consumer handsets, tablets and other mobile products. While additional test capacity shipments will reach a low point in Q4, all the capacity we've installed in 2Q and 3Q is running at maximum utilization, churning out chips. The good news is that our manufacturing model is designed to handle these sharp quarter-to-quarter swings with minimal impact to our gross margin and operating model. The SemiTest story is built on steady, financially disciplined market share gains. These gains come from a combination of targeting growth segments, such as mobility and automotive, where we grow faster than the overall market. And also by competitive design wins where our products outperform the competition. This rifle shot approach has led us to about 50% share of the SOC test market, and we…

Thanks, Mark, and good morning, everyone. I'll start with the key highlights of 2014 today, and then cover the third quarter details and fourth quarter outlook. I'll then describe how we're thinking about next year and close with a few comments on capital allocation. This year is on track to be over $1.6 billion in revenue with a 19% operating profit rate and about $235 million of free cash flow, which is after putting in place about $75 million of UltraFLEX leases and contributing $30 million to fully fund our U.S. pension plan. 2014 is solidly on track to be the fifth consecutive year of operating above the industry target profit rate of 15%. This consistent string of good financial performance stems not only from our optimized operating model, which we've outlined in prior calls, but also from seeing where the hockey puck is going. This is both in targeting the segments that offer the greatest growth, such as mobility and IoT markets, and carefully teasing out the future product features that our customers value the most. This critical product planning capability comes from having our lights well out in front with the leading device players. Moving to the details of our third quarter. Our sales were $478 million, the non-GAAP operating profit rate was 24%, and non-GAAP EPS was $0.44. We had no 10% customer in the quarter. Non-GAAP gross margins were 55%. You'll see our non-GAAP operating expenses were down $6 million to $145 million compared to the second quarter due to lower variable compensation accruals and certain onetime G&A credits. Moving to the segment level detail. SemiTest orders were $203 million. The sequential decline was in line with familiar consumer seasonal patterns and the strong first half pull in. Our SOC test product orders were $141 million,…

Thanks, Greg. Natalia, we'd now like to take some questions. [Operator Instructions]

[Operator Instructions] You have a question from the line of John Pitzer with Crédit Suisse.

This is Farhan asking a question on behalf of John. My first question is in regards to the secular market trend that you've highlighted where you expect the test market to reverse from a decline to growth going forward. My key question on that is that in regards to the test complexity that you mentioned, that there's a 8% increase per year, and you said in your expectations that in order for the annual growth to -- for the test market to grow at 3% to 5%, one of the key assumptions you had was the test complexity continues to grow at the same rate. However, we are seeing that the transistor cost are not declining any more at the same rate, and companies are being much more reluctant to add transistors and goes straight [ph] into the silicon in order to manage the cost. So don't you think there is a structural headwind in the increase of test complexity going forward as well?

Yes. Thanks for the question. I think test complexity, transistor count isn't the only proxy for test complexity. In a lot of devices, test complexity grows through functional complexity that doesn't scale directly with transistor. So different modes, for example, in a RF SOC device for lots of LTE Advanced would be 1 example of an increasing complexity, could be a tripling or a quadrupling of complexity in that device, but it doesn't necessarily mean a quadrupling or a tripling of complexity of transistors. So for a lot of mixed signal and analog devices, I don't think there's a correlation. On the digital front, there is more of a correlation, but, in fact, if you look at the proliferation of transistors in apps processors, it's been on a tremendous curve that's exceeded the rate of proliferation even in conventional MPUs in the past 5 years. And I think that trend in terms of marketplace proliferation will continue for the rest of the decade. What happens beyond the end of the decade with limitations and scaling down below 10 nanometers or 7 nanometers, I think, is a reasonable question. But in all likelihood, in that case, what will happen is stack dies or multi die packages will become the proxy for increasing transistor complexity and still drive test intensity.

And if you could just provide some color on what you expect in terms of shipments by segment for the fourth quarter?

We don't typically guide shipments for the fourth quarter. SemiTest will clearly be the strongest segment. So I'll leave it at that.

Your next question is from the line of Timothy Arcuri with Cowen and Company.

Couple of things. I guess sort of a follow-up on that last question. So of the 2 factors that have been weighing on the size of the -- or the way that which the SOC test market could grow and actually shrank over time. Is the factor that, that is lifting the -- is that related to Moore's law, and is the parallelism factors still in effect?

Yes, actually, Tim, the Moore's law effect, I think, will continue through the rest of the decade. And that, as I mentioned, gives us about a 30% reduction in, let's say, CapEx per test site every 3 to 4 years, and I don't think that will change for the rest of this decade. The parallelism on the other hand is the area where there is diminishing returns. And a combination of the next step in parallelism having a smaller impact on our market and a bit of a slowing down of that effect is the thing that's ameliorating. And when you put the 2 together, by far the biggest impact of the 2 has been the Moore's law effect, but the mere reduction in the parallelism effect takes that 3% negative CAGR to something on the order of a 3% to 5% growth.

Okay, awesome. 2 more quick things. First of all, certainly, the size of the SOC market this year was boosted by those leases that you've been talking about, but can you give -- sort of, give us some idea of what you think that your SOC test sales will do next year. It, sort of, seems like they are going to be flat, plus or minus, but I just wanted your view there. And then lastly, I wanted your view on the competitive environment in Wireless Test, because given the size that the market is now, it's shrunk down to $600 million, pretty -- it's a pretty small market to have 5 big companies rodeo [ph] and Keysight and you and everyone else chasing after. So I guess, what's going to change the highly competitive pricing environment in Wireless Test to, sort of, get that market to, again, start to growth.

I'll take the first part, and I'll give the wireless to you, Mark. Tim, the leases themselves didn't really escalate the market size of our business, because those are rentals, it gets monthly rentals. They are operative leases. So that didn't have a significant impact on our results. But we, certainly, benefit from total applications processor demand, which -- there were are many testers that were sold for that. So I hope that clarifies what you're getting at.

And then on the wireless question, you're right. I think, certainly, with the market in the $600 million, $700 million range, having 5 large suppliers is too much supply into that market. So there will be a period of shakeout and digestion here. So what we look for in that is are we securing higher rates of adoption than our competitors, so that when it does sort out, we emerge as the dominant supplier of whatever is left standing. And that's the progress we've been making. A year ago, in 2013, we ended the year with essentially our first major designing for LTE cellular testing. And we sit here today going into the fourth quarter with 8 of the top 10 smartphone manufacturers having adopted the LitePoint cellular platform. So we're making progress. It will be a couple of years to sort out, there's is no doubt in my mind. But if we have the most innovative products and demonstration of that is increasing market share, then we believe we'll emerge at the end of that as one of the major players.

Your next question is from the line of C.J. Muse with ISI Group.

I guess, first question, intrigued on your comments regarding the SOC test by rate. And here, I would to love to hear your thoughts on where you expect that inflection to happen first, what we should be looking at for evidence to point that, that will happen? And if you think about the implications over the next 2, 3, 4 years, what could that mean for what the size of the SOC test market could look like?

Sure. It's a good point that various segments inside SOC test will reach this diminishing returns point and parallel test at different rate. So certainly, in the what I would call complex analog SOC device case, those might be things like RF transceivers and power management. Those kinds of devices, I think, are at that point. Applications processors, very high content digital, are also reaching that point. On the other hand, if you look at things such as automotive power, electronics, I don't believe they've reached that point yet. They are still probably several years to go before there is that diminishing return curve. But if you jump it way up, roughly, I would say half to 2/3 of the market is in a phase of diminishing returns. And what I said in the remarks is that if you then work that out for the rest of the decade, we see a 3% to 5% growth. So a negative 3% shrink moving to a 3% to 5% growth. On a $2.2 billion market, that's roughly an extra $100 million a year of market growth on average. And if Teradyne is at 50% market share, that's about $50 million, $55 million of incremental revenue to us. And given the drop through on that business, it translates to about $0.10 per share of earnings on an annual basis. Now, of course, any given year, if you've been around the industry, you know the swings in the market size are quite dramatic. So both on the compression side and from here on out the growth side, these are trend lines that, I think, are averages. And what happens in 1 year versus the next, I bet, will still be noisy.

It's very helpful. I guess as my follow-up, as you stay here today and look at 2015, curious across your adjacent businesses, the LitePoint, HDD, SSD, other system test, where do you see the best opportunity for growth?

Well, for 2015, it's tough sitting here today to get a good read on that, but I'll give a little bit of color. Certainly, we think that the storage test area will be an opportunity for a turnaround in growth. The repositioning we've done for solid-state drive testing and cloud based testing has both resulted in order volume in the second half of the year to get us back to profit. We do see that momentum picking up in terms of orders as we get towards the end of the year and into next year. So that's one area that'll be incrementally positive. I think production board test will be positive. I think the LitePoint business will also be positive. So the real thing that's hard to read right now is SemiTest, because what we said earlier is we had abnormally large tooling year in 2014 around applications processors. We don't expect -- it's possible, but we don't expect that, that in and of itself will repeat next year. On the other hand, there are certain segments this year that were uncharacteristically weak that are strengthening. An example of that might be the area of image sensor testing. Image sensors show up, of course, in handsets, but they also show up in automotive and other applications. We see that picking up dramatically next year. We see automotive, which was strong all year, continuing to build strength. So it could very well be that the emergence of those relatively quiet markets will offset what we expect to be a decline in apps processors. And the one thing that could turn on apps processors for us, that could make it a much larger year next year would be if the market penetration of the premium smartphones in China is high. If the places where our SemiTest business is strong around apps processors finds high penetration in China, that could be an upside.

Your next question is from the line of Jim Covello with Goldman Sachs.

I appreciate the strategic commentary around the business very much. It was very helpful this quarter. In terms of the comment from Mark about there was a record level of testers shipped in the middle of the year, but the good news being that those testers are all running at full utilization rates. So I wonder if we can get a little bit more color on that comment, in particular around given the seasonal element to the business, what would those full utilization rates of those testers translate into in terms of orders, timing wise, as we go to 2015. Is that something we could expect reorders on in the early part of 2015? Or just given the seasonality of the business, would that be a little later?

Yes, I think, one of the things that's a bit unique, actually, just to extend that is, yes, they're highly utilized right now, and uncharacteristically, we will see some additional capacity bought here in our fourth quarter for that kind of segment, which traditionally in the fourth quarter we would not see. So there is actually some momentum carrying forward here into fourth. But I really have to believe that like prior years, the production ramp will slow down a bit in Q1. There won't be additional capacity in Q1, as there hasn't been in past years, and that the next phase, when it emerges, would be more toward the May, June timeframe.

Very helpful there. And then, in terms of capital allocation commentary, that was very helpful as well. And I guess, if I could paraphrase, I just want to make sure I was understanding the message as clearly as possible, it sounded like part of the message was, listen, there is a lot of cash there, but there was kind of a lot of one-off uses for that cash in 2014. There may not be as many one-off uses of that cash in 2015, therefore, we could see more capital allocation going back to shareholders. Is that a fair characterization of what you guys were trying to communicate?

I think that's close, Jim. But the capital return discussions continue each quarter, and it's directly tied to what's in our M&A pipeline. And we've a very good and active pipeline. So it's looking at that, how executable do we think that is relative to we see some good opportunities to return capital. So we want to change it to, we can do both versus it's an either or. So that's where we're going to try to focus on in 2015.

Your next question is from the line of Tom Diffely with D.A. Davidson. Thomas Diffely - D.A. Davidson & Co., Research Division: Maybe another question on your mid to longer-term view. I'm kind of curious, what the IoT, Internet of Things, impact is. We assume a lot of the growth comes from very low cost chips. What does that do to your competitive advantage, and maybe the margin structure over the next couple of years?

This is Greg. On the IoT, this would help both Semi and LitePoint. We've got products that are designed for some of the sweet spots. We have very good strength in microcontroller, which is the, sort of, a hub for some of these applications. We're very strong in any of the wireless standards. So we're approaching it both on the SemiTest and the Wireless side. At the Wireless side, we have some unique advantages that our products are easier to use. And in this segment, there'll be many more competitors who don't have a deep engineering capabilities. So they need a very simple, easy-to-use solution. So I think LitePoint has some opportunities there as well. It is hard, having said all that, what does it mean in numbers couple of years down the road, but we do believe we're well positioned to benefit quite nicely from, kind of, whoever there, we're going to be the solution behind the scenes that helps that takeoff. Thomas Diffely - D.A. Davidson & Co., Research Division: So you think from a competitive point of view, your products are -- the competition is not closer to where you are on low-cost chips.

Correct. We're very strong with microcontroller and wireless. So I think we have a huge advantage in the semi side there.

I'd say on the semi side, for example, one of the lowest cost communications standards out there is Bluetooth. And Bluetooth has been a sweet spot of our whole Wireless Test side of SemiTest. It's certainly a less complex standard than something like an RF, LTE or a WiFi Combo chip. So the test intensity for what will emerge in the Internet of Things around Bluetooth will be lower. On the other hand, when you look at things like machine-to-machine communication in industrial environments, which will more likely be over WiFi or more smart utility applications that will be over LTE Advanced, that will fuel the same level of complexity and technology that you see in smartphones in those applications and that will be a benefit. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. Now, that's good to hear. And then, I guess, moving over to the Wireless side, you said you had 8 of the top 10 as customers. Do these customers typically dual source or tri-source these sets? Or once you're in, do you expect a big slug of business?

They dual source invariably. They usually have 3 vendors, and they'll pick 2. And as we're the new guy and we tend to be the innovator, they choose us because they see we can deliver much more than they would otherwise get. But they start us off with the small amount of the purchase, whether that's 10% or some number like that. So we get the low running product. The incumbent gets the bigger running product, but we would expect over a number of couple of years, we could move up our share. So the key thing strategically for us this year at LitePoint was to get into these LTE Asian accounts, and we've secured 8 of them this year. So it was a very good year for us. But the business starts slow, but I think in a couple of years or a year, we should be in much better shape.

Your next question is from the line of Krish Sankar with Bank of America.

Just to clarify, Mark, did you say that the SOC market would grow 3% to 5% next year? And then, I had a follow up.

Yes, I didn't try to project next year. What did I say is if, I believe, that you go off of a nominal market size of about $2.2 billion, that between now and the end of the decade when we're done, if you run a compound annual growth rate through that, it will be in that 3% to 5% range. So we are going to over time see that sort of trend line. Just like on the downside, it hasn't been a year-over-year, some years are up and down dramatically, 20%, 25% year-over-year, but the trend line has been unfortunately negative. I expect to see that reverse for the next 5 or 6 years.

Got it. So just to follow up on that. Do you have a view for the SOC market for NexGen? Then, I had a follow-up on LitePoint.

I think we said in the prepared remarks that we weren't ready quite to do that. We, certainly, will comment next quarter a little bit more about that.

Got it. And then, just a follow-up on the LitePoint side. I think people understand the competition and the productivity and pricing challenges. I'm just kind of curious if, given the fundamental issues with market share shrink over the last 2 to 3 years, the fact is that LitePoint as a product is really not differentiated anymore? Or is there unique IP to it that competition can catch up to it? Or do you think that you still have some secret sauce out there that can help you drive growth in that market?

We're very confident that we have secret sauce, and that's a new application, NFC, we do the radiated testing. Because we work with a key customer, with their engineers and develop a solution that works for their needs. We have other -- I think I said in last call, we've other tricks up our sleeve, but we don't announce them publicly. But there is other things we can do that are on our roadmap, that we see will help our customers. What happens, unfortunately though as we do that, the customers says to the competitors, do what LitePoint does. So they're constantly chasing us, but we tend to be 6 months, 9 months ahead. These are very fast product cycles, but we expect we'll continue to be ahead. We are clearly the production optimized, easy-to-use, out-of-the-box leader. So I do think on the production side -- not the R&D side. So a lot of our competitors are much stronger on the R&D preproduction side. They're going to win over there. We're not really chasing that. But on the production side, I do believe that's where our DNA is and our innovation, and we've got more we can unleash.

Your next question is from the line of Chad Dillard with Deutsche Bank.

I just wanted to dig a little bit further into the NFC product that you're talking about. Is it a standalone application or is it integrated within the cellular test product? And how big of a market opportunity is it? And where do you see your share there?

So it's not integrated into a cellar product. It's a standalone product, which in terms of again optimizing efficiency for that new test insertion is the best economic way to go about testing NFC. Right now, it's somewhat of an emerging communication connectivity standard in handsets. As it becomes more mission critical, we expect that the market for that will grow. And today, this year being, I would say, a -- we launched the product in January this year at Mobile World Congress. And when we look at the tail of the tape at the end of the year, we'll probably end up in the 40% to 50% share of NFC test this year.

And moving to SOC test, what is your order visibility right now? I mean, how much of 4Q is booked so far, and how is it compared to this time last year?

The fourth quarter looks very solid. We have some, as Mark mentioned earlier, we've some business in the fourth quarter that we don't typically get this late in a consumer cycle. So it's a good quarter. Some customers are still pulling quite hard. So we have good visibility, and we expect it to be one of our better fourth quarters. But just in general, when we go into a quarter, as I mentioned, fourth quarter to second quarter can be a 2 to 1 swing in product shipments. So it's quite volatile, but in any given quarter we go in, we're probably, roughly speaking, 1/2 to 2/3 booked and the rest is turns, even at those peak quarters. And that going into fourth quarter is not that different.

Your next question is from the line of David Duley with Steelhead.

Just a quick clarification. Do you expect your SOC test business to show the normal seasonality that it has over the last few years with, I think, orders being up in December and then revenue being up in March?

It's hard to say that right now, but that's the normal seasonal pattern. The only thing that may be a little bit different is fourth quarter is stronger for SemiTest now. So does that has some impact on Q1, we don't know. But some of the business we're seeing in the fourth quarter is above what you normally expect. And we've seen this year some business pulled in and that can affect the subsequent quarters. But it's hard to give you a definitive response on that. We tend to find the seasonal history has a way of repeating itself at different levels, but it tends to repeat itself.

Okay. And you mentioned somewhere in your prepared comments that you might be seeing a delay in the ramp up of Chinese handsets. Could you talk about what you are seeing there, little bit more color around that commentary? I guess I would have expect LitePoint business to show less seasonality in Q4 or maybe even grow given just rapid shipments of handsets from your biggest customer, and then a bunch of the other Asian guys ramping up.

Yes. Well, I think at the beginning of the year, there was a lot of optimism and some actual forecast that perhaps China LTE shipments could be in excess of 100 million units for the year. As the year has played out, it certainly is beginning to pick up now, there is no doubt. Maybe getting up to a run rate of in excess of 10 million units a month. But as Greg mentioned, the design-ins that we've secured have given us some participation in that ramp that's starting now. But we are still the new comer and getting the smaller portion of that ramp. So as the tooling cycles go on, we believe what happens is we prove out the efficiency claims we've made for the ramps here in Q4 as a minority player and then build share and penetration throughout next year.

Okay. And just one final clarification. You've essentially talked about the buy rate in SOC going up. What was the most -- what do you think the buy rate is in 2014? And over this 10-year period, what do you think the buy rate goes to?

I think, let's say, I haven't done the math on the buy rate over the 10 year period. Looking forward in 2014, it's certainly up. It may be up 1/10 of a point or so. But I would expect that to slowly move up over time. The more thing -- the thing we look at more carefully, buy rate, is the correlation to unit volume growth. So the unit volume growth is what really drives our business. The buy rate as a function of semiconductor revenue is less correlated, it turns out, to our business.

Your next question is from the line of Patrick Ho with Stifel, Nicolaus. Patrick J. Ho - Stifel, Nicolaus & Company, Incorporated, Research Division: As it relates to given Wireless Test business, given the competitive nature that you've seen probably over the last 2 years, have you seen any changes to your operating model for that business segment? And what, I guess, the potential impacts going forward, particularly as we head into 2015?

We haven't seen a meaningful change to our operating model. We're still doing quite well percentage wise, but the dollars are far less. So we have a competitive cost structure, very competitive COGS, and our products because they're designed for the product at hand. They are not general-purpose tester or some tester that was started in R&D and then moved to manufacturing. So at one level, the model looks good, but compared to what it could look like if we got some greater growth, then it would be outstanding. So it's a healthy business now with good percentages, and we've expanded the footprint to get into Asia. So that's all built out. We're not hiring there anymore. And now, it's about expanding out these accounts that we've broken out, which is a couple year process. Patrick J. Ho - Stifel, Nicolaus & Company, Incorporated, Research Division: Great. And maybe my follow-up question, again, on the Wireless Test side of things. The China LTE ramp that you mentioned has been slow to ramp. One, how do you see that shaping up in 2015? And secondly, what other type of market drivers do you see overall as you head into next year?

Well, I think, it's hard for us to predict which supplier will benefit most from the ramp in China, which is why we've had a pretty broad initiative to get installed as broadly as possible. So 8 out of 10 is really trying to get that footprint to be agnostic to who wins. But we're not indifferent, certain suppliers, if they ramp faster than others, would benefit us. So -- but again, that's something out of our control. The other thing that's happening is the LTE standards in China are something that will roll into a couple hundred million unit annual volume next year is our belief. That's a benefit to the industry and to us. Outside of China, the move to advanced Carrier Aggregation and LTE Advanced standards is another follow [ph] in terms of test complexity coming into the equation. So earlier when I commented that we think a lot of the optimization, which has been severe and very rapid, has run its course, it's sort of looking at those 2 trends, a big jump in China LTE and complex Carrier Aggregation LTE Advanced standards proliferating in the U.S. and elsewhere.

There are no further questions.

Great. Well, let's wrap this up. Thank you, everyone, for joining us today, and we look forward to talking to you in the days ahead.

Thank you.

Thanks.