Always Striving to Add More Value
We are researching and writing a multi-part series covering established companies engaged in technology, automation, and robotics. Depending on the outcome of our analysis and demand from subscribers, we will write at least two more articles on companies with similar value propositions.
While our primary focus is and always will be income-oriented stocks, the breadth of our firm’s research expands well beyond these important areas of the market.
This article serves to provide even more value to subscribers and our followers. We hope this type of work sparks new ideas and educates readers on market segments they may not be as familiar with.
Better Lucky Than Good
Source. Uli Emanuele flying through a two-meter gap in a rock formation in a wingsuit at about 70mph.
Differentiating between luck and skill is not as easy as we’d all like. Well-managed companies hit potholes out of their control while others see their valuation triple because they were in the right place at the right time.
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Over the long term, the market adjusts company values and valuations appropriately. Over the short term, it doesn’t really matter whether it’s luck or skill as long as the company is well-positioned and executes when opportunity arises.
This frustrates investors but we humbly suggest shifting the focus: find stocks that are undervalued, avoid those that are overvalued, and profit as the market aligns the stock price to the fundamentals. Take advantage of dislocations rather than being subjected to them. Intelligent portfolio management and risk-management enable the navigation of volatile seas. We designed our marketplace’s diversified equity and baby bond portfolios with this philosophy.
In Teradyne’s (TER) case, it’s a combination of fortuitous events and a sound business model developed over many decades. Let’s discuss the key aspects of Teradyne’s business, then the structural drivers we believe are strengthening.
Note: This report will include a mix of Q1 and Q2 as the latter was released within 24 hours of this being submitted for publication. All material financial data is updated but some charts may only be through Q1.
Teradyne is not a one trick pony. The firm tests and aids in the manufacturing of a large array of products. Teradyne thoroughly and systematically tests new technology-oriented products. Consider the importance of a new iPhone working correctly upon launch all around the world; the reputational risk cannot be overstated. Teradyne performs advanced and rapid testing for many of the largest electronics manufacturers globally.
The other pillar of Teradyne’s business is industrial automation. Its expertise in robotics, programming, and problem solving is a difficult to reproduce competitive advantage. Who better to design a reliable and quality automation system than the firm most skilled at evaluating them?
Teradyne has amassed a portfolio of industrial automation solutions. Imagine a team of executives desperate to reduce exposure to China or Southeast Asia and relocate critical facilities back to the U.S., a scenario that is widespread across numerous sectors including automotive and healthcare. In low-cost Vietnam, efficiency through advanced robotics and better quality control is unlikely to be a top priority. When that operation is relocated into the much higher-cost and more strictly regulated U.S., that company is greatly incentivized to seek guidance from firms like Teradyne to develop and build new manufacturing processes and products as quickly as possible.
Due to its relationship with top cell phone makers, it’s likely that every electronic device you’d encountered was incorporated into a Teradyne manufacturing or testing process.
Specifically, Teradyne focuses on repetitive manual tasks and electronic testing.
Task Automation – industrial automation solutions, including collaborative robotics, automate tasks, deliver fast ROI and free people to reach their potential
Electronic Test – automated test equipment (ATE) speeds time-to-market for new electronics, in markets where reliability and performance are critical
Semiconductor sales and service represent the bulk of revenues and are well-diversified globally. Teradyne’s exposures provide diversification benefits to most U.S. investor portfolios with 46%, 31%, and 20% of Industrial Automation Revenue derived from Europe, North America, and Asia, respectively, as one example. Much of its semiconductor business is also outside the U.S.
Resurgence of U.S. Manufacturing
The resurgence of manufacturing in the U.S., particularly technologically advanced manufacturing, is undeniable. The momentum started before the coronavirus; a respected 2018 report calculated that the growth in the manufacturing sector would outpace general economic growth for many years. This report assumed higher 10-year treasury and lending rates would curtail investment in the U.S.; interest rates are instead at record lows.
The report (of course) did not anticipate the impacts of the coronavirus. While all key components of capital investment outside of Transportation were more or less flat between late 2015 through mid-2018 (Transportation grew nearly 20%), there is exceedingly rare bipartisan and government/corporate agreement that critical manufacturing should return to the U.S. The maintenance of recently established more competitive corporate tax rates further reinforces the trend of U.S. based operations.
Company executives literally cannot travel to many of their overseas facilities. These firms recognize that the coronavirus may rotate in and out of significance for several years. While they may disagree on the severity and timeline of the crisis, they all know the probability of this continuing is non-zero.
New manufacturing facilities in the U.S. – including distribution centers for companies like Amazon (AMZN) – need advanced robotics to ensure short-term economics and long-term competitiveness. There are few companies as qualified as Teradyne to assist in that transition. Teradyne could easily double its activity in the U.S. in the next 12-24 months based on its sales and relationships in similarly sized Europe.
The Relentless (And Well-Funded) March of Progress
Another wave that Teradyne is riding is the exponential growth in technological development and utilization. While it may be possible for three engineers and a good salesperson to build the next Snapchat (SNAP), it requires decades and tens of thousands of hours of experience and research and development to build a firm like Teradyne.
This matters because while technological progress never stops, it has periods of unusually rapid growth. The relatively recent invention of the iPhone and its competitors (the original iPhone was released on June 29, 2007, or almost exactly 13 years ago) has an immeasurable impact on global productivity and access to knowledge. Even more recently, capital flows into technology companies around the world at eye-popping levels.
This analysis of public companies excludes the incredible performance of large-cap technology stocks in the last six weeks. Nonetheless, capital flows into these firms are maintaining record-breaking momentum. AMD (AMD), Intel (INTC) and NVIDIA (NVDA), all companies included in the above chart, are perfect examples of the companies Teradyne works with directly and indirectly.
Automotive Transformation and Relocation
Since Honda opened its first U.S. plant in 1982, almost every major European, Japanese, and Korean automaker has produced vehicles and invested more than $75 billion in the United States. The U.S. affiliates of majority foreign-owned automotive companies directly support more than 400,000 U.S. jobs. Additionally, many automakers have U.S.-based engine and transmission plants, and conduct R&D, design, and testing in the United States. Total foreign direct investment in the U.S. automotive industry reached $114.6 billion in 2018.
Teradyne’s advanced testing and automation systems and services align perfectly with the unique attributes of the expansion of automotive companies and manufacturing in the U.S. Global automakers’ incentives to locate major facilities in the U.S. are many but there are a few standouts. Currency risk mitigation is the first. The ability to produce and sell cars in the same market goes a long way to minimizing the financial impact of currency exchange rates. Labor costs in the U.S. are also comparable or lower than Germany and other Western European nations while taxes, regulations, and general costs of business are lower. The construction of new facilities is faster on average. Certain states like California and New York have levels of regulation, taxes, and construction impediments similar to Western Europe, which is in part why automotive companies have left these areas completely with the exception of Tesla (TSLA) in California.
The coronavirus has shifted the risk versus reward equation further toward automotive companies expanding operations in the U.S. Not only that, the multi-hundred billion dollar valuations of the electric car market are almost entirely based in the U.S. This segment is ideal for Teradyne and offers major growth potential.
The automotive industry is also at the forefront of innovation. New R&D initiatives are transforming the industry to better respond to the opportunities of the 21st century. According to Auto Alliance, of the $105 billion spent on R&D globally, almost a fifth ($18 billion) is spent in the United States.
R&D spending in the automotive sector is another area Teradyne is well-positioned to capitalize on. For better or worse, cars are as much computers as they are traditional machines. Even back in 2016, the average car had 25 to 50 CPUs and that number is growing exponentially. Self-driving capabilities, improved user interfaces and sensors, and integration of cars with people’s cell phones and even homes is deepening with each new model year. All these systems require the type of testing Teradyne specializes and excels in.
The firm is also benefiting from increased interest and spending in the electric-semi industry and 5G infrastructure and device compatibility. Wall Street analysts seem to get caught up in a specific trend that Teradyne can capitalize on but we think they miss the forest for the trees. No matter what the next trends are in technology, those involved will need services from firms like Teradyne.
In a very real sense, an investment in Teradyne permits us to profit from the next big trend without having to identify it beforehand.
Financial Statements Analysis
If these trends are in fact real, we should see evidence in Teradyne’s financials.
Q1 2020’s sales grew 42.5% year-over-year and 7.5% quarter-over-quarter despite the negative impacts of the coronavirus. Teradyne consistently maintains 58% margins while keeping R&D and SG&A (general costs of running the business) at an attractive 30% of revenue. Q1’s $209 million in operating profit equates to a highly compelling 29.7% margin. Teradyne’s earnings per share (“EPS”) nearly doubled from $0.54 in Q1 of 2019 to $1.00 in Q1 of 2020. Despite doubling from March lows, TER still trades at well under a 30x P/E ratio despite these incredible growth numbers. As a bonus, Teradyne is reducing its share count rather than issuing more shares like most “high-flying” technology companies.
Teradyne’s average repurchase price is $32.95 on the $2.049 billion in buybacks compared to today’s share price of $88.
We greatly appreciate Teradyne’s track record of disciplined and prudent acquisitions totaling only $551 million since 2014.
Just released Q2 data shows equally favorable year-over-year growth in Q2. Last quarter’s revenue grew from $704 million to $839 million; this is an incredible figure given the challenging environment. GAAP and non-GAAP EPS also managed to improve on Q1’s already very strong results. We analyzed the factors involved in converting GAAP to non-GAAP EPS and the “true” figure falls in between. Teradyne’s Q2 results beat the street’s already optimistic revenue and EPS estimates by $83.5 million and $0.13, respectively. Q3’s guidance is also around $1.0 per share in EPS, though management has consistently beaten its own guidance by 5-15%.
Liquidity is favorable with $1.0 billion in cash and marketable securities on the balance sheet, minimal interest expense of $5.5 million quarterly, and total assets well over twice total liabilities (with minimal goodwill on the asset side).
Teradyne faces tough competition from multiple international companies. Lower cost providers overseas are a constant threat. As the firm’s growth and profitability expands, we expect that competition to intensify.
Huawei, one of Teradyne’s largest clients, is another significant risk.
On May 15, 2020, the U.S. Department of Commerce published new regulations expanding the scope of the U.S. EAR to include additional products that would become subject to the Entity List restrictions relating to Huawei and the designated Huawei entities including HiSilicon… These new regulations restrict the sale to Huawei and the designated Huawei entities of items, such as semiconductor devices, manufactured by Huawei’s contract manufacturers under specific, detailed conditions set forth in the new regulations. While the new regulations do not impose any new restrictions on Teradyne directly, the new regulations may impact Teradyne’s sales to third party contract manufacturers used by Huawei and HiSilicon to manufacture and test semiconductor and other electronic devices… Teradyne does not know the potential extent of the impact of the new regulations on its business”
Teradyne’s exposure to China and Chinese companies is a double-edged sword.
On April 28, 2020, the Department of Commerce published new export control regulations for certain U.S. products and technology sold to military and civilian end users in China. The regulations went into effect on June 29, 2020. Teradyne does not expect that compliance with the new export controls will significantly impact its ability to sell products to its customers in China or to manufacture products in China. The new export controls, however, could disrupt the Company’s supply chain, increase compliance costs and impact the demand for the Company’s products in China and, thus, have a material adverse impact on Teradyne’s business, financial condition or results of operations…its compliance controls could be circumvented, exposing the Company to legal liabilities.
Teradyne often states that “no single direct customer accounted for more than 10% of our consolidated revenues” in its SEC filings. That’s technically true, but after average levels of research (even for us) and dissection of the last few quarterly and annual reports, we came to a different conclusion regarding calculating Teradyne’s true exposure to Huawei.
OSAT customers, such as Taiwan Semiconductor Manufacturing Company Ltd., often purchase our test systems based upon recommendations from OEMs, IDMs and Fabless companies….We estimate consolidated revenues driven by Huawei Technologies Co. Ltd. (“Huawei”), combining direct sales to that customer with sales to the customer’s OSATs, accounted for approximately 11%, 4% and 1% of our consolidated revenues in 2019, 2018 and 2017, respectively.
Note that sales to Huawei are growing exponentially.
This shouldn’t be a surprise given the cell phone market share data provided above. Huawei is a major player in the space and outsells Apple (AAPL), is recognized as the 10th most valuable brand globally, and generated over $120 billion in revenue last year. Huawei isn’t publicly traded on any exchange, so we have limited access to its financials.
The direct and indirect relationship with Huawei is a risk for Teradyne though the firm’s solvency or long-term outlook will be hampered, not destroyed, if the relationship were to contract.
Q2’s results also included a concerning ~20% decrease in its Universal Robots division. This group should be experiencing rapid growth, and although it’s not a major contributor to current financial results, we expect better results going forward. If this key division continues to experience weakness, we will revise our estimates accordingly.
Unlike many technology companies making headlines today, Teradyne can be valued by earnings and cash flow metrics. Given its modest acquisition history, relatively simple financial structure, consistent profitability, strong liquidity, and well-capitalized balance sheet (we couldn’t find any recent credit ratings from the major issuers), GAAP EPS is an appropriate valuation tool (if any of these variables are far outside the norm, significant adjustments are needed before EPS is worthwhile). Teradyne consistently maintains $1.0 billion in cash.
Automotive sector spending and business slowed considerably in Q1 and Teradyne was negatively impacted. Despite this, the firm generated 85% non-GAAP EPS growth year over year. As conditions normalize in that segment, we expect automotive to drive higher earnings and cash flow in the second half of 2020 and beyond. Increased testing demand has easily offset the reduction in automotive spending.
From a cash-flow perspective, our range for Teradyne’s average annual cash flow for the next three years is $475 million on the low end to $625 million on the high end. For context, 2017, 2018, and 2019 generated $521 million, $370 million, and $444 million, respectively. Our calculations put Teradyne’s average free cash flow multiple over the next three years at 24.5x.
With the first half of 2020 now in the books, Teradyne has generated approximately $2.10 in GAAP earnings and is guiding for a similar Q3. Adjusting for the various factors outlined in this article, we think Q4 will be one of the firm’s best in recent years, bringing full-year EPS to $4.0 to $4.50. This results in a very inexpensive 17.75x to 22x forward earnings multiple. Forgoing the growth we expect to occur in 2022 and beyond, Teradyne is already cheap on an absolute basis and incredibly attractive for its growth levels and compared to its technology sector peers.
Source: Seeking Alpha
This chart goes back to Teradyne’s inception over 50 years ago and its implications are unavoidable: Teradyne quadrupled during the tech bubble, crashed to where it traded previously, and only began its second climb a few years ago. We created a chart with only the most GAAP profitable tech companies that were also around in 2001 but it didn’t turn out very useful. AAPL, for example, was up over 24,000%, making GOOG’s paltry 4,000% return almost invisible. The point of the exercise is that Teradyne’s recent appreciation is nowhere near the levels of its profitable peer group, much less firms like Carvana (CVNA) and Snapchat who lose hundreds of millions of dollars a year yet are up 61% and 42% year-to-date, respectively.
Source: Seeking Alpha
Teradyne has increased in value by 95% in the last 12 months. That’s a tough pill to swallow but revenues and earnings increasing 50% (or +85% on the latter using non-GAAP EPS) over the period helps. In order to achieve our optimum risk-adjusted entry point, we are targeting an entry point moderately below today’s levels. We reserve specific entry points and risk ratings for subscribers but hope this analysis has been useful.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TER over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.