Teradyne’s Chip Testing Prowess Merits a Wide Moat, but It Still Faces Cyclicality

Analyst

William Kerwin

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Teradyne is a heavyweight supplier of automated test equipment for semiconductors, boasting market-leading capabilities that run the gamut of chips. It is one of two companies worldwide that can produce testers for the most cutting-edge semiconductors, thanks to robust engineering talent across hardware and software and a structural lead in organic investment. The firm is a vital partner to chipmakers across the industry and has an impressively strong relationship with Apple and Taiwan Semiconductor. Teradyne’s market leadership exhibits itself in industry-leading margins, strong returns on invested capital, and a top market share. We give the firm a wide economic moat rating. 

Beyond its top-tier capabilities, we think Teradyne is a strong operator. It appears to have found a good balance between organic investment in development and profitability, and it is a good generator of free cash flow despite its capital intensity. We approve of the firm’s use of extra cash for shareholder returns and opportunistic mergers and acquisitions, which have recently focused on the high-growth industrial automation market. We also applaud Teradyne’s strong balance sheet, which shows a net cash position. 

We expect Teradyne to complement continued investment in chip testing with investment in the high-growth robotics market. We think the firm’s collaborative and autonomous robots will augment top-line growth over the next five years as well as be accretive to gross margins. In semiconductor testing, Teradyne will benefit from increasing complexity, specifically the expansion of 3D NAND memory capacity and advancements to new architectures and smaller geometries in digital chips, like 3-nanometer platforms and gate-all-around transistors. We also expect domestic onshoring and capacity expansion to generate demand for the firm’s automated test equipment in the medium term. We view Teradyne as an agnostic play on the global chipmaking market with muted cyclicality arising from its vital role in the supply chain and nature as a capital expense at customers.

Business Strategy & Outlook

We assign Teradyne a wide economic moat rating based on a combination of intangible assets in semiconductor automated test equipment and switching costs created at chipmaking customers. We think Teradyne’s proficiency, which has led to a leading market share in ATE, will enable the firm to earn impressive returns on invested capital that will continue for the next 20 years. 

Teradyne provides testing equipment for semiconductors, wireless products, and storage and avionics systems alongside a robotics segment for industrial automation. Teradyne’s automated test equipment for semiconductors drives our wide moat rating, and we observe similar competitive dynamics at wide-moat-rated wafer fabrication equipment leaders under our coverage. Teradyne’s test equipment is highly capital-intensive and serves a relatively concentrated number of chipmaking customers. 

In our opinion, Teradyne’s ability to design testing equipment for bleeding-edge chips is the biggest driver of its competitive advantage, representing intangible assets that we don’t think are easily replicable. Teradyne provides testing solutions for nearly every semiconductor on the planet during production, both at the wafer level and final device package level. Teradyne offers testers specialized to processors, microcontrollers, sensors, memory, and analog chips, with the value proposition for each being the ability to test many devices reliably in parallel. Wafers or packaged chips are run through a testing machine to ensure that the final product meets every specification of its design and to detect any potential defects. Chips and wafers are typically tested at multiple temperatures, and Teradyne’s machines can pinpoint the specific manufacturing step that caused a defect. Building cutting-edge testing machines takes immense engineering effort across ASIC design, software programming and mechanical engineering. According to management, Teradyne’s latest machine took over five years, 600 engineers, and $500 million of cumulative research and development spending to develop. Furthermore, as chips become more advanced, with increasing transistor counts, smaller geometries, and new architectures like 3D NAND in memory and GAA transistors, testing grows more complex. Testing chips with more transistors and smaller, more intricate architectures is significantly more time-consuming than it is for their legacy predecessors. With reducing time to market being the end goal of chipmaking customers, Teradyne earns revenue by bringing new testers to market that can validate newer chips more quickly. 

Teradyne and its largest competitor, Advantest, are the only suppliers able to service the latest process technologies across such a wide breadth of products and the best at reducing customers’ time to market. The ATE market is a practical duopoly between Teradyne and Advantest, which together hold more than 80% of the market, by our estimation, with Cohu as a clear-cut but distant tertiary player. Teradyne and Advantest are broad-reaching generalists distinguished primarily by their customer relationships and leadership for certain product types. For example, Teradyne has Apple as its largest end customer and is particularly strong in NAND memory testing, while Advantest has a strong relationship with Samsung and has historically been strong in DRAM testing. Beyond Advantest, we don’t think any player can match the depth or breadth of Teradyne’s capabilities across semiconductor testing, providing market-leading equipment for the most cutting-edge chips across numerous chipmakers and product categories (digital, analog, memory). 

In our view, Teradyne holds a durable position at the cutting edge of automated chip testing due to a hefty R&D budget that has led to its leading market share. Teradyne is able to spread a massive development budget across multiple capital-intensive business lines, allowing it to service every chipmaker in the world with testing equipment for a broad variety of cutting-edge products. Market shares can fluctuate year to year with order patterns of large customers, but by our assessment Teradyne has historically edged out Advantest in overall share and the size of its R&D budget. Teradyne’s R&D spending has grown steadily with sales, and roughly quadruples that of Cohu. When combining investment in R&D and capital expenditures, the difference is even more stark, and edges out even rival Advantest. While we expect Teradyne and Advantest to continue slugging it out at the top of the market, we think the sheer size of the investment both firms can put into developing new equipment is a massive barrier to upstart competitors. We expect Teradyne to continue to pump cash into R&D and capital expenditures to retain its leading market share and expect steady competition with Advantest, with no significant encroachment from smaller competitors at the bleeding edge. 

We contend that Teradyne’s equipment also elicits switching costs at customers. We view Teradyne’s installed base of expensive equipment across customers as sticky, especially given the software the firm layers on top of its hardware; customers become accustomed to its Teradyne machine interface and integrate it into their workflows. In our opinion, a customer would be averse to switching to a new brand of tester due to the cost and integration time required for the transition. Beyond installation, it takes a customer time to develop new testing programs, ramp up use of a new machine, and integrate it fully into its back-end workflow. When adopting a new machine, a customer’s engineering teams will take a training class and develop smoother and more efficient workflows over the course of a few years as they become familiar with its capabilities. When moving to a new generation of Teradyne tester, many of the hardware and software intricacies will be familiar, if not identical, and enable a much quicker ramp up to full speed. If a customer switched test suppliers, it would have to teach its engineers wholesale new intricacies of the new hardware configuration and software interface, as well as face the opportunity cost of lost productivity and slower time to market with a less familiar staff in the first year or two. 

We think the addition of services augments Teradyne’s existing switching costs, but these are a small contributor to revenue and overall stickiness. The majority of services are break/fix, but about one fourth of them are professional services, where Teradyne service engineers help a customer develop test programs on its machines. We think these services are especially sticky, as a customer is reliant on Teradyne’s know-how to troubleshoot the program and will rely on its services to transfer existing programs to new testing machines. 

Teradyne’s competitive advantage in ATE—driven by leading capabilities, robust investment, and sticky customer relationships—exhibits itself clearly in the firm’s profitability and returns on invested capital and is evidence of a wide economic moat, in our view. Furthermore, Teradyne’s profitability leads the industry, with gross margins consistently above Advantest’s and materially higher GAAP operating profitability. We think its structural competitive advantages and excellent profitability resulting from strong execution will combine to drive market leadership and an enduring economic moat over the long term. 

While we think Teradyne’s moat is driven by its semiconductor testing abilities, we think its industrial robotics businesses will quickly contribute more to overall returns. We would award this segment a narrow economic moat in isolation. Out of industrial automation, Teradyne sells collaborative robots (cobots) and autonomous mobile robots into manufacturing applications. Via its 2015 acquisition of Universal Robots, Teradyne holds a leading market share for cobots, which are designed to work alongside humans. Similarly, Teradyne entered the autonomous robot market in 2018 with its acquisition of MiR. We think both of these businesses elicit switching costs at customers, given long useful lives and integration into workflows that we think customers would be averse to upending. In cobots, we think Teradyne bought significant intangible assets, which are exemplified by it continuing to hold a leading share of the market. Its cobots offer hundreds of different attachments to fit different uses and feature an open network of third-party development, UR+, for more to be developed. We think these robots provide immediate and material value to customers by taking both mundane and arduous tasks out of human hands and increase a customer’s overall return on investment in human capital.

Wide

Economic Moat

Teradyne

Teradyne, Inc. engages in the development and sale of automatic test systems. It operates through the following segments: Semiconductor Test, Industrial Automation, System Test, Wireless Test, and Corporate and Other. The Semiconductor Test segment designs, manufactures, and markets semiconductor test products and services. The Industrial Automation segment includes the operations related to design and manufacture of collaborative robotic arms, mobile robots, and advanced robotic control software. The System Test segment markets products and services for defense instrumentation test, storage test, and circuit-board test. The Wireless Test segment is composed of wireless test products and services. The company was founded by Alexander V. d'Arbeloff and Nicholas DeWolf in 1960 and is headquartered in North Reading, MA.

Earnings data Q1 2024

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Teradyne, Inc. engages in the development and sale of automatic test systems. It operates through the following business segments: Semiconductor Test, System Test, Robotics, Wireless Test, and Corporate. The Semiconductor Test segment designs, manufactures, and markets semiconductor test products and services. The System Test segment markets products and services for the Defense/Aerospace, Storage Test, and Production Board Test business units. The Robotics segment includes operations related to the design, manufacturing, and marketing of collaborative robotic arms, autonomous mobile robots, and advanced robotic control software. The Wireless Test segment is involved in wireless test products and services. The Corporate relates to other automatic test systems and robotics products. The company was founded by Alexander V. d'Arbeloff and Nicholas DeWolf in 1960 and is headquartered in North Reading, MA.

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