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Testing Four Electronics Testers

Posted: Aug 14, 2007 07:43 AM by Dean Lundell

Tickers in this Article: FLEX, A, VRGY, CMOS, TER, ATE

To say the test equipment business is "difficult" would be a bit of an understatement. "Intensely competitive" is still too soft a characterization. Downright cut-throat would be a more apt description. Price competition and commoditized products characterize the market for semiconductor and electronics test equipment. Right now the concentrated customer base is enjoying an unusually competitive market environment at the expense of the providers, but one has to wonder at what point the customers will become the victims of this own mentality.

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The Major Player
With a market capitalization approaching $7 billion and sales of more than $2 billion, Advantest (NYSE:ATE) is the industry's leader. Based in Japan, the company also enjoys direct sales through the United States, Asia and Europe as well.

Advantest manufactures and sells electronic measuring devices to the semiconductor and printed circuit board industries. This equipment is highly automated and necessary in the manufacture of chips.

Even the big guns like Advantest have a tough time in this business because of the commoditization. Advantest's "growth" in earnings last year was -14.9%. It averaged 29% during the previous three years. The company dedicates roughly 12% of its revenue to research and development which is a must in this business. The firm manages just over a 15% net margin from a gross of 53.7% and scores a return on equity of 12.9%

New Platform Gaining Acceptance
Teradyne, Inc. (NYSE:TER) is the second largest player in this business with a market capitalization reaching for $3 billion and sales of $1.27 billion. It enjoys a 20% share of this market and recently sold its Teradyne Connection Systems so it can solely focus on automatic test equipment for semiconductor firms. It is, in essence, putting all its eggs in one basket.

Teradyne typifies the adverse cyclicality of this business. The company earned $454 million in net income for 2000. It then gave all this money back, and then some, in 2001 and 2002 by losing $920 million over those two ensuing years. In the last few years, returns on invested capital have ranged between 30% and -25%.

On the plus side, TER seems to be gaining considerable market acceptance of its new FLEX platform which will give increased responsiveness to customer's orders and a less expensive manufacturing system. This new system will also give it a common platform for automotive and military applications.

On Its Own Now
Verigy (Nasdaq:VRGY) was spun off from Agilent Technologies (NYSE:A) in 2006 after years of dragging profits down. Since then, the company seems to be doing better, experiencing a year-over-year growth in revenue of 70%, a net margin of 8.1% from a gross margin of 44.8% and a respectable 14.2% return on equity.

Verigy has outsourced its manufacturing to Flextronics (Nasdaq:FLEX) and employs a scalable platform that gives its customers the flexibility they need. So far, the response has been positive with Verigy gaining market share. Financially, the firm's $1.4 billion market capitalization generates a little more than $760 million in sales, and its 45% gross margin translates into an 8% net margin and a 14% return on equity.

VRGY has to deal with the same cyclicality and market dynamics as all the others in this business including a concentrated customer base. The firm's underlying advantage is the creation of innovative technology which gives its customers the ability to expand or contract capacity as needed.

Looking for Easy Answers
Credence Systems (Nasdaq:CMOS) is the small cap entry contesting this market. With a market capitalization of $220 million and sales of $463 million, there is zero net margin from a gross margin of 39.3% and no return on equity. Credence systems has chosen to grow by acquisition and has an ongoing program to outsource production. The company does not have a good record in integrating its acquisitions. For example, its $170 million acquisition of IMS eventually resulted in discontinuing IMS's next generation of technology.

Credence's strategy is to win market share by acquisition - hopefully with innovative technology that can compliment or augment its existing architecture.

Conclusion
If you have done the math along the way, you will have discovered an interesting fact. Market capitalization as a multiple of sales varies vastly with size, as economies of scale are a very big deal in this business.

Market Cap to Sales Ratio:
#1. Advantest is 3.7
#2. Teradyne is 2.3
#3. Verigy it is 1.8
#4. Credence Systems trails at 0.54.

There has been a certain amount of consolidation to date and one can only guess who will be tested and who the survivors will be.

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By Dean Lundell

Dean Lundell is a former vice president at Merrill Lynch Capital Markets, a principal of a regional investment bank, an independent futures trader and licensed commodity trading advisor. He has written for McGraw-Hill, the Chicago Mercantile Exchange and several financial magazines. Prior to his career on Wall Street, he served with the 82nd Airborne Division in Vietnam.

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