Teradyne Inc (TER) — Q3 2020 Earnings Call Transcript

Thank you, Josh. 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, Sanjay Mehta. Following our opening remarks, we'll provide details of our performance for 2020's third quarter, along with our outlook for the fourth quarter of 2020. 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. Replay of this call will be available via the same page after the call ends. The matters that we discuss today will include forward-looking statements. They 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 statements contained in the earnings release as well as our most recent SEC filings. 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 have posted additional information concerning these non-GAAP financial measures including the reconciliation to the most directly comparable GAAP financial measure, where available on the Investor page of our website. Also, please take special note of the Safe Harbor Statement in the press release and slide deck for risks related to the COVID-19 pandemic and changes to U.S. export regulations. Looking ahead between now and our next earnings call, Teradyne expects to participate in technology or industrial focused investor conferences hosted by Baird, Wolfe Research, Credit Suisse, and UBS. Now, let's get on with the rest of the agenda. First, Mark will comment on our recent results, current market conditions, trade regulations, and our future outlook. Sanjay will then offer more details on our quarterly results, along with our guidance for the fourth quarter. We will then answer your questions. And this call is scheduled for one hour. Mark?

Thanks, Andy. Good morning, everyone, and thanks for joining us. My prepared remarks today will cover three topics. First, the highlights of our third quarter and first nine months of the year; second, the impacts of the latest trade regulations on Teradyne; and third, I'll share with you how we're thinking about the test and automation markets as we close out 2020 and look into the next year and beyond. Our third quarter results were above guidance and reflect the continued strength of our test businesses. Additionally, our industrial automation businesses grew 17% from the Q2 trough and we are now operating at 2019 quarterly levels as manufacturing activities in Europe and North America improve. At the company level, sales in Q3 were 41% above Q3 2019 and non-GAAP EPS grew 53% from the year ago level. Throughout 2020, we have seen increased short-term upside demand across our Semi Test end markets. The impact of this is clear in both our above guidance results in Q3, and in our Q4 guidance, which at the mid-point is substantially higher than we forecast in July. Throughout 2020, the semiconductor ecosystem has seen somewhat cautious initial forecasts, which were replaced with better than expected actual demand, and tests have been no exception. We continue to run a manufacturing pipeline that allows us to respond to this upside. Stepping back and looking at our performance to the first nine months of the year, the results show the success of our new products and related designing efforts and the resilience of our employees, supply line partners, and operating model. Teradyne sales through nine months are up 44% and our non-GAAP earnings per share are up 79%. Our test businesses collectively grew 52% year-to-date, while industrial automation revenue on a as reported basis contracted 10% reflecting the pandemic impact. In Semi Test, we estimate the SOC market will be about $3.3 billion, roughly flat with 2019's level as automotive, industrial, and linear markets remain depressed. However, our SOC test business is up 53% year-to-date due to strong investments in mobility test, and the shipment of our new UltraFLEXplus platform, which is ramping significant design wins. The principal driver of mobility test demand continues to be increases in complexity of cell phone silicon. This is especially notable in 2020, when smartphone unit shipments are expected to decline about 10% to 1.2 billion. Yet the collective test intensity of each unit continues to grow at a rate in excess of this unit decline. Within smartphones, the mid to high tier is the place to be in test and that's where Teradyne is solidly positioned. These phones are seeing disproportionate growth and complexity related to multiple high-density camera arrays and the associated processing power and storage to manage this data. Another complexity driver is 5G. And these high-tier phones are early adopters of the extra silicon needed to enable these features. Less than 250 million phones are expected to be 5G-enabled in 2020 and only a fraction of those will support millimeter-wave communication. So despite the bump in 2020, we are still in the very early stages of 5G adoption. Memory test is another bright spot. The market is likely to be up about 50% from 600 million in 2019 to about 900 million in 2020. The shipment ramp of our Magnum EPIC product LPDDR5 win last year, combined with continued strength in flash demand has driven our year-to-date memory revenues up 70% from 2019. In System Test, revenues are up nearly 50% through nine months on growth in storage test and defense-related investments. Recall storage tests served HDD and System Level Test markets and we expect sales to more than double in 2020 to over $200 million. And at LitePoint, sales are up 18% year-to-date due to increasing adoption of advanced connectivity standards like WiFi 6E, and our growing share in 5G production test. As noted earlier in industrial automation, we saw a significant uptick in demand in Q3 with growth of 17% off the second quarter trough. UR grew 23% as demand in Europe, North America and China showed steady gains. AutoGuide continues to win new accounts and we expect over 50% growth in 2020 on a pro forma basis. Regarding trade, as we noted last quarter, the China military end-user restrictions require increased compliance work and costs. But we do not expect any material impact on our sales into China. In the case of Huawei restrictions, the fleet of testers previously installed at OSAT to support their device tests are already being reabsorbed into the market to test the alternative sources of silicon supply that's growing to fill in the gap created by these regulations at Huawei. For example, in the third quarter, we have seen an increase in upgrade orders at these OSAT customers to reconfigure installed testers to meet the unique needs of new customers. This upgrading and repurposing continues into the fourth quarter. Shifting to the future, it's difficult to make the call on how 2021 will shape up as it's been difficult to predict 2020 even on a quarterly basis. Customers will likely continue to forecast conservatively and respond close in to demand. However, semiconductor complexity growth has proven itself resilient to COVID and is the fundamental driver of our test business. With that in mind, I'll comment on a few of the key indicators that we will be watching. In SOC test, we will be watching the smartphone market for complexity increases to support higher performance video and still photography, the adoption rate of 5G and millimeter-wave, AI integration, enhance that unit growth. We'll also be watching the automotive and analog markets for signs of a sustainable recovery in test demand. Longer term the increase in edge AI devices should drive billions of additional complex chip units into the market by 2025, so early design wins in that area are key. In memory, the transition to higher performance DDR5 standards is just underway and should accelerate in 2021, along with newer high-speed UFS and NVMe flash interface. The roadmaps for both flash and DRAM show continued growth in interface speeds, which is another driver of test intensity beyond the traditional bid growth and should drive healthy memory test demand over the mid-term. At LitePoint, the continued growth of WiFi 6, 6E, and ultra-wideband connectivity standards, along with 5G will be drivers for continued growth. A bit further out we expect the next-generation WiFi 7 standard will require another refresh of the entire existing connectivity install base of testers. Consistent test, storage test is the interesting wildcard. After a torrid growth in 2020, the underlying demand drivers remain in place. In HDD both increasing complexity and 30% plus annual exabyte growth. And in system level tests increasing device complexity and higher quality requirements are driving the additional test intensity. However, both are narrow markets and prone to swings in investment levels at individual customers. Our industrial automation businesses are well-aligned to long-term economic and technical trends in manufacturing and material handling so we are confident in their ability to return to high growth. The only question is how quick the manufacturing economy returns to health. We continue to scale our distribution capability and invest in R&D to widen our leading position. Among other things, AutoGuide adoption by key logistics, e-commerce, retail, and automotive customers in 2021 will set the stage for multiple years of double-digit growth. Despite these comments, as I've noted in the past, we do not spend too much time trying to predict the various short-term demand drivers as they generally don't affect our investment plans. We do spend a lot of time trying to predict the underlying long-term growth drivers. We want to be positioned with the right products at the right customers at the right time. We believe the use of semiconductors across the global economy will continue to expand and chip complexity will grow along with that expansion. Similarly, in industrial automation, the cost performance of the sensor software and mechanical building blocks of advanced automation continues to improve making our products economically attractive to an expanding universe of customers. We have built our strategy on these fundamental beliefs and built our operating model with the flexibility to deal efficiently with the inevitable ups and downs of economic cycles. So while we can't predict what lies ahead in 2021, we finished 2020 on an optimistic note; across the company, our employees delivered remarkable results under very difficult circumstances. Our new test and AI products are seeing strong market acceptance, and our R&D pipelines are well-stocked with future products to drive future growth. With that, I'll turn things over to Sanjay for the financial details.

Thank you, Mark, and hello everyone. In my remarks I'll review our Q3 financial results, comment on how COVID is impacting our business, provide Q4 guidance, and comment on our full-year financial outlook at the mid-point of our Q4 guidance. Our third quarter sales of $819 million were just above the high-end of the guidance range, which enabled a 30% non-GAAP operating margin and a $1.18 non-GAAP EPS, which is also above the high-end of our range. Strength in Semi Test and storage test were the revenue highlights. Improved profit was a result of higher sales, partially offset by a higher than forecasted tax rate. Our non-GAAP operating expenses were $211 million and our non-GAAP diluted share count in the quarter was $175 million. In Q3, our non-GAAP tax rate was 17.4%, which included a year-to-date catch-up as our estimated 2020 annual non-GAAP tax rate increased to 15.5% from our prior forecast of 14.5%. The increased tax rate is driven by higher foreign earnings, which resulted in an increase in the U.S. minimum tax on foreign earnings. We generated $280 million in free cash flow in Q3. We paid $17 million in dividends, had capital expenses of $63 million, and ended the quarter with cash and marketable securities of approximately $1.3 billion and no short-term debt. Inventory decreased to $191 million. DSO in the quarter decreased to 65 days. We had one 10% customer in the quarter. At the business unit level, Semi Test sales were $592 million, up 49% from Q3 2019. SOC shipments were $449 million and memory test had record shipments at $143 million. Semi Test saw strength in mobility and compute applications in SOC, where we continued to ramp our UltraFLEXplus test system. In Memory, we saw broad shipments across flash and our Magnum EPIC solution enabled continued strength in DRAM. We expect these products to continue to gain new applications as market acceptance has been very encouraging to date, and they're well-aligned to technology trends in both SOC and memory tests. As Mark noted, the automotive microcontroller and analog markets remained at historically low levels in 2020. But we did see some pickup in the analog markets in Q3 versus our expectations. Several analog companies have outperformed their expected results, and we are seeing some unexpected short lead-time demand as a result. Shifting to System Test. Sales in the quarter were up 61%, from Q3 2019 to $118 million. Storage test was the star at $76 million as both HDD and system level test delivered strong results. Defense and aerospace and production board tests combined to deliver $43 million in the quarter. Rounding out the test portfolio, after a very strong second quarter, LitePoint sales softened to $41 million down 4% from the Q3 2019 level. Industrial Automation revenue was $69 million flat from Q3 2019 and growth of 17% quarter-over-quarter. UR contributed $53 million, MiR $10 million, and AG and Energid made up the remainder. While the COVID pandemic has negatively impacted our go-to-market efforts in industrial automation, we are seeing signs of improvement in several geographies across the globe, and some are seeing year-over-year increases in sales. These positive signs in different territories should be balanced by a continued uncertainty tied to COVID-19 in predicting the pace of the global recovery and IA over the short-term. Turning to the impact of COVID-19. At Teradyne, our priorities remain consistent during the coronavirus pandemic: safety of our employees, supporting our customers, and a focus on execution to achieve our financial objectives. In line with my prior earnings call remarks; I want to acknowledge the continued challenges during the pandemic that our employees, customers, suppliers, and their families are going through. Operationally we continue to work through supply line issues in the quarter. And again, I must recognize the incredible work and skill of our operations team and our supplier partners to successfully overcome a wide variety of challenges to meet our customer requirements. Great execution also by our engineering teams in introducing new products and delivering products during the quarter, while overcoming significant supply chain issues along the way. In late October, we're in a much better spot than six months ago. That said, there's still uncertainty of how this pandemic will impact global supply chains and market demand going forward. We still expect to encounter spot shortages and other issues through the remainder of the year and likely into 2021. Our guidance range continues to be wider than typical to reflect the potential impacts of these uncertainties and some short-lead time business noted earlier. Our test portfolio continues to execute, grow share and revenues. As a result, we are investing alongside our contract manufacturers to increase capacity and resilience in our supply chain. Specific actions include building larger buffer stocks in some components and increasing the geographic diversity of our supply and contract manufacturing. During the pandemic, we reduced our OpEx spending, types to travel, trade shows, and other go-to-market activities. The savings were approximately $8 million to $10 million per quarter. Post the pandemic, when returning to normal, we expect these expenditures to come back to our P&L. Moving to the outlook for the fourth quarter. We expect revenue of $680 million to $740 million and a non-GAAP EPS of $0.90 to $1.06 on 175 million diluted shares. This guidance excludes the amortization of acquired intangibles, and non-cash imputed interest on convertible debt. In prior guidance, I noted headwinds on gross margin in the second half of the year before returning to historical levels in 2021. I'm happy to report we're ahead of that plan and gross margins are now expected to be 58% to 59% in Q4, up from 56% in Q3. The earlier than expected improvement in margins is driven by increased volume, improved mix, and supply chain execution in our new product ramps. In Q4, we expect operating expenses to be 29% to 31% of sales. The operating profit at the mid-point of our Q4 guidance is 29%. As Mark noted, you can see we've been positively surprised by both SOC and memory test demand since our last call. Continued strength in mobility test solutions for several customers was the primary driver, but we've also seen unforecasted demand with expedited lead times elsewhere in our test portfolio. For example, analog solutions utilizing our Eagle test systems and DRAM memory applications for our Magnum EPIC systems have also driven up demand in Q4. We have seen this pattern play out over the last several months. Looking at the full-year from a financial perspective, the short-term slowdown in IA has been more than offset by the growth in our test businesses. At the mid-point of our Q4 guidance, our 2020 revenues should be above $3.1 billion and non-GAAP EPS will be approximately $4.50. Gross margin for the full-year should be above 57%, down from 58% in 2019, reflecting the impact of high semiconductor shipments for mobility, along with a short-term impact of faster than expected ramps of new products. Our 2020 non-GAAP operating profit rate will be in the high 20s, up from 25% in 2019. And our full-year tax rate is expected to be 15.5%. Through nine months, we spent $147 million on CapEx and we expect we'll spend $193 million for the full-year. At the start of the pandemic, it was unclear as to the depth and the duration of the economic consequences. As a result, we took actions to strengthen our liquidity and cash position. For example, we suspended share buybacks on April 1, and expect to end the year with approximately 175 million diluted shares. Given that share repurchases have historically been a part of our balanced capital allocation strategy, we'll update you in our January call on our Capital Return Plan for 2021. Looking ahead, in 2021, from a modeling perspective, macroeconomic conditions, timing of pandemic recovery, and political environment all add uncertainty. The environment and demand uncertainty prevents us from speculating on 2021 market sizes. But at a high level, we expect gross margins to return to historical levels and OpEx to grow. From a longer-term model perspective, you can see that at the mid-point of our Q4 guidance we will be inside the revenue range and above the EPS range of our 2022 earnings model. We'll provide you an update of the earnings model in our January call. To summarize, we closed out Q3 with outstanding financial and operational performance in a difficult working environment, and I again thank our employees and partners for their incredible efforts. We entered Q4 with a forecast of higher than expected sales and earnings on the strength of mobility and memory. For the full-year, share gains in Semi Test and increased traction in our storage business enable us to exit the year stronger than when we entered. The industrial automation market is showing early signs of improvement, and we continue to invest in this segment as we monitor the market progress closely. While we're not immune to the macroeconomic shocks and our market visibility is limited, overall, we feel good about our execution during 2020 in a challenging environment. It's too early to estimate demand in 2021, but we'll be prepared from a product, operation, and balance sheet perspective for whatever comes our way. With that, I'll turn things back to Andy.

Thanks, Sanjay. Josh, we would now like to take some questions. And as a reminder, please limit yourself to one question and a follow-up. Please.

Thank you for taking my question and congratulations on the strong results and execution. Mark, I'm interested in knowing how much 5G contributed to your results in 2020 compared to your expectations at the beginning of the year. Given that your large mobility customer now has all their models equipped with 5G, and U.S. models already support millimeter wave, does this indicate that you will rely more on unit growth rather than content growth in the mobility sector going forward? Additionally, what do you see as the current total addressable market for 5G, and what is your progress in that journey?

Yes. To recap on the 5G total addressable market, we have been discussing a $400 million increase in market potential. We are currently about $200 million to $250 million into that $400 million increase and expect it to peak around 2023 or 2024, a time when we anticipate that more than 50% of cell phones will have millimeter wave capability integrated. We expect that level to sustain for three or four years, establishing a baseline. This year, the 5G content in cell phones is approximately $50 million higher than our initial expectations, which indicates it's more than we anticipated, but not by a large margin. Therefore, instead of a potential $200 million market, it may be closer to $250 million. Regarding the test equipment for 5G, it is designed to support about 300 million to perhaps 250 million units of 5G capability, which is still a small portion of what will occur in the coming years. Focusing on Teradyne's position, we believe that for the additional 1.25 billion phones expected to transition to 5G in the next few years, our market share in that segment is around 50%. Although we are well-positioned this year, we also have a strong standing for the future developments.

For my follow-up, I know you're not providing a specific outlook for 2021, but I'm interested to know which of those markets you believe will face more challenging comparisons next year after such a strong performance across almost every division this year, excluding IA. Were there any unique factors, either from the end market, customer, or product perspective, that could lead to tougher year-on-year comparisons as you look ahead? Thank you.

Yes. And it probably sounds like a cop-out, but no, I don't. All the markets that in test showed growth this year have their own story. And the one thing I would maybe cite that I said in the script that's a bit of a wildcard is the storage test piece where we had a phenomenal year, more than doubling of sales there. If again, if we listen to what customers are telling us, we think that still has room to run, but it's a thin market in terms of the customer base. And that one's a bit more of a wildcard than the others. But I don't see any other one-off issue with what we've seen in 2020 that would sort of say, boy, that's going to be tough to beat next year.

Hi. Good morning, and thanks for letting us ask a few questions. I guess, first, for you, Mark. Yes, just curious again, is those what you're seeing from a test utilization and/or market breadth standpoint could you at least say a degree of confidence that these stronger market conditions are likely to sustain into next year? And I realize that again, it's early to provide any official outlook on the test TAM, but can you at least give us a directional sense because in a vacuum, if smartphone unit demand growth, say 5% to 10% next year instead of contracting 10% and 5G mix continues to shoot up, is there a reason to think that yours and the market TAM would not grow next year?

Yes. In the scenario you mentioned, it seems unlikely that the market's total addressable market wouldn't expand. However, there are many variables involved. We've demonstrated that we aren't particularly good at forecasting even the current or the next quarter. Therefore, we are hesitant to make predictions. The supply issues you mentioned regarding the decreased demand for automotive and cell phones are notably impacting unit sales this year, yet our test performance is still quite strong. A recovery in these areas next year should be beneficial. However, with COVID still present and the global economic situation uncertain, we prefer not to make bold speculations.

Okay. That's fair enough. And maybe second, just citing the recovery you're seeing in UR sales in Q3 and sounds like that's ongoing into Q4. I would assume maybe this is occurring absent any real sizable recovery in key markets such as auto. And maybe you can provide more color on the applications and markets that have begun to exhibit some improvement?

Yes. Hi, it's Sanjay. So just, obviously, we've seen growth quarter-over-quarter and a little bit more color. In UR we grew, in IA 23%, and actually was one of the reasons why we exceeded our guidance this quarter. What we've seen as manufacturing kind of comes back online, we've seen the U.S., Europe and China bode strength. And really it's a function of both growth in the quarter and a couple of those markets we're actually seeing year-over-year growth.

Good morning. Thanks for taking the question and congrats on the strong quarter and guidance. Mark, I wanted to ask you on market share in both SOC test and memory test. You're clearly executing really well in both segments. On the SOC test side I guess the question is, is the growth that you're seeing in market share this year, primarily due to your largest customer having strong year or are you picking up share elsewhere within SOC test? And then, similarly, on the memory test side, again, very big quarter in Q3. How should we think about sustainability into 2021? Are you seeing when that would support continuity in the current trajectory or should we consider this to be more of a one-off? And I've got a quick follow-up.

It's a good question because market share can be quite volatile year over year, making it difficult to draw insights. For instance, Teradyne's market share in SOC last year was around 40%, but this year it's expected to be in the mid-50s. To clarify, last year's 40% was likely closer to the mid-40s in terms of actual market share. This year, we're likely normalized around the low to mid-50s. We have gained real market share year-over-year due to designs from last year, amounting to about five or six points of real share. So, from that 45% base last year, we are now functioning at approximately 50 to 55%. Various factors are influencing this, such as some equipment buyers exiting the market, like Huawei, which causes shifts in market share. Although Huawei was a significant customer for us, our share with them was slightly below the average. As silicon suppliers redistribute, it benefits us. Additionally, the UltraFLEXplus has entered new segments that we've not engaged with for over a decade, and these are just starting to ramp this year. This platform may help us reach a significant portion of the 60% target we need. If analog contributes a couple of points and UltraFLEXplus adds another five, we could reach around seven points. Furthermore, we're also seeing positive momentum with edge AI devices, and if we can secure early design wins, this could help us grow in that segment toward the 60% share level. However, it's worth noting that this journey may take five to six years; it’s not imminent.

Thank you for the color. And then, as a quick follow-up, I wanted to ask on industrial automation profitability. I suppose over the past several years, you've been in investment mode in the business growing your distribution network, investing in R&D. I think currently, you're around break-even given muted revenue levels. But how should we think about kind of through cycle profitability in IA and if you could remind us what your long-term margin target is for the IA business, that would be super helpful. Thank you.

Sure. Hi, it's Sanjay. So one question there, but maybe I'll give you a little bit of color. Recall in 2019, our IA business had an operating profit of about 10%. We entered the year in 2020 a big investment year, but we expected to be around that same operating profit. COVID hit and a lot of the go-to-market OpEx; we reduced obviously because it was run-rated towards the higher revenue levels. And in the first half of the year, we lost money. In Q3, we were slightly profitable and as we've said in Q4, we expect revenues to continue to increase and to grow that profit level. We haven't concluded on our 2021 plan, but my expectation assuming that revenue continues, we're going to then obviously increase some of the go-to-market, and obviously, with travel, trade shows, et cetera. But the engineering investment has not really wavered from that standpoint. And so we expect to continue to heavily invest in industrial automation. So over the next several years, you would expect that our profitability wouldn't be at kind of a company average because it's still in investment mode as we grow. And then what we said over the horizon is that, or sorry, over the mid-term, is that we expect the revenues to grow between 20% to 35%.

Yes. Good morning. Thank you for taking the question. I guess, Mark, wanted to, I guess, go back in time and use your memory because I can't remember. But if you look back to AP, and all of mobility in the kind of 2014, 2015, 2016, 2017, 2018 period, despite, I guess, some constant issue around, Apple, fully buying your testers, you continue to see strength in that businesses as other players came in. So curious, as you look back in time, around the 4G ramp, and then look forward to 5G, and what you're seeing in terms of silicon content, on the RF side in particular millimeter wave as well as some of the processing capabilities required, how does that make you feel around what you think the trajectory of mobility test could look like, over the coming one, two, three years relative to the strength that you're seeing here in 2020?

Yes, that's a great question. If we take a moment to reflect on the total addressable market for mobility, in around 2016 and 2017, it was approximately one billion dollars for test equipment. This year, we project it will reach nearly 1.6 billion, which is one significant data point, especially considering the decrease in unit volumes. Additionally, if we evaluate a 4G phone and calculate the silicon testing time required a few years back, and then compare that to a high-end 5G phone entering the market today, we find that the testing time for the RF components in the application processor has increased by about 60% on a per unit basis. This does not account for other components like cameras and power management. As we continue to introduce 5G phones, we anticipate that as long as cell phone unit numbers remain stable and 5G technology keeps progressing, there will be strong upward momentum in the growth of the mobility market.

It's very helpful. I guess as a follow-up question you talked about mid 50's share here in 2020. On the last earnings call, you talked about a target of 60%. And I guess can you kind of speak to what can bridge those five points, particularly around anything you can say around wins with UltraFLEXplus as well as the fact that auto and linear are probably down 35% this year versus last year? So I would say simply right there that could bridge you to 60 in 2021. Thank you.

Yes. Regarding the shift, I mentioned earlier that our normalized share is currently around 50, not 55. To achieve an additional 10 points, we have a clear strategy. One part of this is when automotive and linear markets recover, where we hold a higher than average market share, which will boost our share. The UltraFLEXplus is also a critical element of our strategy. We've already entered some segments we've been absent from for a while, and those are starting to ramp up this year. This platform alone should help us reach at least half of the needed 10 points. If analog contributes a couple of points and UltraFLEXplus adds about five, we can get into the seven-point range. Additionally, as I mentioned, edge AI devices are expanding, and our presence in that area is promising. If we secure early design wins as this segment grows, we can reach the desired 60% share level. However, this journey could take five to six years; it’s not happening right away.

Can we have the next question, please?

Yes, sir. Thanks for taking the question. Couple of follow-ups regarding your Q3. So if upgrading some of the install testers that last year were useful; how should I think about looking forward and its impact on the SOC tester? To what extent system upgrades of the past six months would have an adverse impact on new SOC tests demand? And as a second question or follow-up, can you elaborate on the mix of HDD system and to what extent a strength in advanced packaging like chiplets have impacted; any detailed color that would help us separate HDD from system level test would be great. Thank you.

Yes, hi Mehdi. It's Sanjay. I'll address the first question. From a services standpoint, we did experience a decline in surprise demand during the quarter, which was largely connected to the upgrading and reconfiguration of current testers at OSATs for different silicon providers. However, it was still a strong quarter for our services. We also saw some growth in new testers. We anticipate that this business will remain stable, and once we transition through the migration or repurposing of existing testers at the OSATs for other customers, we expect a slight increase in the short term, with a return to normal levels in the mid-term.

And then the HDD and SLT?

Yes. Regarding HDD and SLT, the current revenue split is nearly 50-50, though it does fluctuate. Looking ahead, there is potential for growth in both areas. The HDD business has historically been driven by increasing exabyte growth rates, coupled with advancements in test intensity. The production of drives exceeding 18 terabytes, along with our sophisticated roadmaps, facilitates high-density, error-free read-write operations, which leads to increased testing requirements. This results in a compounding positive effect on the HDD side, which gives us confidence that this segment of storage testing will continue to expand. SLT is a bit more challenging, as we are reconfiguring testers at OSATs to accommodate additional silicon providers, and we did see significant service-related revenue this past quarter. We have also experienced an uptick in new testers. While we anticipate some early growth post-migration of existing testers for other customers, we expect the business to return to normal levels in the mid-term.

Operator, we're getting some noise here, by the way.

On the SLT side, the complexity of chiplets presents an opportunity for more system-level testing. Testing the module before it enters a higher-value sub-assembly is becoming increasingly important. We are conducting various trials with different customers to evaluate if it makes economic sense to add a test insertion for those specific components. This approach has proven beneficial for some mobility parts, which are produced in billions of units annually. However, we have not yet determined how far down the unit volume equation SLT can go to remain viable. This aspect remains somewhat uncertain.

Hi. Thank you for taking my questions. The first one is for Mark. Could you remind us about the opportunity in the compute sector? There's a discussion that the demand for CPUs for North American customer notebooks next year could be three to five times larger than what's used in tablets. Can you discuss the compute opportunity for Teradyne this year and next year?

Well, compute is an area that Teradyne really hasn't participated in since the '90s. The UltraFLEXplus was specifically designed to give us that opportunity to break back into that segment. And again, roughly just to give you numbers, you can think of compute as somewhere in that $600 million a year TAM in the total market right now. I expect that's going to grow because the diversity of suppliers of compute devices is growing. There's a bit of a disaggregation of the supply chain for compute devices. So the UltraFLEXplus is targeted there. It's had some success already in that mission and we expect that will continue. So I do think it's a rich area for us, but to put it in perspective, it's a market that's about maybe around $600 million on average now could grow to $800 million in the next year or two.

Great. And then, Sanjay, there was no material impact to your sales from military end-use China restrictions like you talked about. But can you talk about if the demand from domestic China's semiconductors memory and logic was higher than what you expected in both Q3 and Q4, and how big is domestic China's semiconductors as a percentage of the total sales?

Yes. To begin with, in Q3, approximately 15% of our sales were related to the base market. It's accurate that the regulations associated with Huawei, discussions regarding SMIC, and military end-use have led to significant internal compliance efforts to ensure we meet these regulations, but this has not materially affected our revenue. As we've previously mentioned, the end market remains stable, and different silicon providers are delivering solutions for that market, which leaves us confident about our position. Currently, we are experiencing some short-term disruptions due to service upgrades for testers that are being redeployed at the OSATs, moving from providing high silicon solutions to servicing other products. However, we are optimistic about our long-term outlook because we foresee a shift in market share that positions us favorably.

Yes. Hi, thanks for taking my question. I have two of them. Mark thanks for the qualitative color on calendar 2021. And I understand it's very hard to quantify it at this time. But if you look at the SOC test market, it's kind of grown for the last four or five years, a lot of it is because of increased complexity, but the memory test market in the last four years has been more cyclical up and down. Do you think memory is at an inflection where you could see as LPDDR5 and everything else comes along that you might be in a prolonged strength for memory like SOC? And then I had a follow-up.

Yes. So on memory, you're right. Absolutely, it's been cyclical for the past two years. There are good compelling arguments that it could be pretty less volatile and more sustained high-level investments over the next few. Certainly our memory team believes that. And because of LPDDR5 and DDR5 transitions that are eminent, that's going to compel a lot of investment on the DRAM side. So I just don't see the downside in memory nearly as typical as we've seen in the past decade. I think the DRAM story alone is going to keep the memory market pretty healthy. So then the question is flash. And flash is a tougher one to read. The only thing I'd say that's encouraging is this relentless innovation around the interface speeds of flash drives a lot of tester demand and drives obsolescence of the fleet, and the roadmaps there are pretty robust. These cell phones and the camera systems in the cell phones just generate an incredible amount of data that need to be quickly moved in and out of flash. So I'm kind of optimistic that memory in the next four years won't be as volatile as it's been, let's say, in the last four or five.

Got it. Thanks Mark. It's helpful. And then as a follow-up, on the industrial automation side how much of your IA revenues are from the auto vertical and how much are coming from small and medium businesses?

35%.

Yes, from the auto perspective, it's around 35%. And could you remind me of your second question?

How much from SMB?

I don't know. We'd have to dig that one out. But it's been running in that sort of, I'd say, 75% range, so it's still the vast majority of our sales. The larger enterprises have been a growing percentage over the past three to four years, but that's a rough number.

Yes. Good morning, guys. Thanks for letting me ask the question. Mark, just a follow-up to Mehdi's earlier question on Huawei. Now to the extent that they were historically a large customer and a lot of those testers are sitting at OSATs and can be repurposed, I'm just kind of curious how much insight you have into kind of that installed base and its ability to move to additional customers or new customers? And, I guess, are you putting up these results, despite the fact of that or is that something that we need to kind of worry about in future quarters?

We have a good understanding of how those testers are being utilized. For instance, if there are 100 testers used for Huawei that were testing a billion parts annually, and if Huawei can no longer supply those parts, the immediate assumption might be that those 100 testers will be idle. However, the reality is that other suppliers need to step in to fulfill the demand since the overall end-user demand remains relatively stable. Currently, suppliers filling that gap are mainly from outside China. Consequently, the idle testers will transition from testing parts associated with Huawei to ones from these other suppliers, which are quite similar. The upgrades necessary to facilitate this shift began in earnest in the third quarter. Despite the ongoing repurposing of these testers, we are still achieving the performance numbers we projected, and we anticipate this trend will carry on into the fourth quarter. When the entire fleet will be fully repurposed is uncertain, and it’s likely we won't see that completely realized until the second quarter of next year.

That's really helpful. And then, Mark, as my follow-up, in the quarter, you guys created a new role at the IA division and to put in place there a very credible guy in the form of Greg Smith. I'm wondering if you could spend a little bit of time just kind of helping us understand the rationale and how we should think about this Greg's sort of efforts in IA and what it means to the overall strategy there.

Thank you for your question. Greg is a highly accomplished leader who has successfully managed our semiconductor test business for the last five years. His appointment reflects both our company's and his personal vision for growth opportunities in IA. Greg's goal is to analyze our portfolio to identify areas where we can gain leverage, improve our M&A strategy, and seek common investments that will enhance our differentiation in both software and hardware. Many of our businesses have completed their earn-out phase, which previously limited our operational flexibility. With that behind us, we now have greater freedom, and Greg will be an invaluable asset in guiding us forward.

Great. Thanks for taking my question. I have two. My first question is on the SOC test market; the mobility is roughly half of the SOC TAM today. I think, Mark, you mentioned 1.6 billion of the 3.3 this year. Can you remind us what are the other main buckets within the SOC test markets, and which segments are still below the normal run rate? Maybe help us decide how much below the normal levels in some of those markets be?

Okay. I'll provide the rough numbers. The compute segment, which includes CPUs, FPGAs, and AI, is about 600 million and is experiencing some growth. For automotive, linear, and microcontrollers, the market this year is approximately 200 to 250 million, which is less than half of its usual run rate of around 500 million. This segment is declining compared to last year. Lastly, for the industrial segment, it's around 300 million, down from a normal run rate that might be close to the high 300s or 400 million. Yes. Regarding the shift, I mentioned earlier that our normalized share is currently around 50, plus or minus. To gain an additional 10 points, there is a clear path in my mind. One aspect is that when automotive and linear come back, we have a higher than normal market share there, which will help boost our overall share. The UltraFLEXplus is also a key part of our strategy. We have already secured some segments we haven't participated in for a while, and those are just starting to ramp up this year. This platform alone should bring us at least halfway to that additional 10 points we need to reach 60. If analog contributes a few points and UltraFLEXplus adds about five more, we're looking at the seven range. Additionally, I mentioned earlier that edge AI devices are growing, and our position in this area is promising. If we can secure an early design win as the segment establishes itself, it could help us achieve that growth at the 60% share level. However, this journey could take five to six years; it’s not something that will happen overnight.

Can we have the next question, please?

Thanks for including me, Andy. I have two questions. First, Mark, I’m still trying to understand the situation with the SOC SharePoint. The total addressable market of 3.3 doesn’t seem significantly different from what you expected at the beginning of the year. At that time, you anticipated your market share would increase from about 40% to roughly the mid-40s. Now we’re seeing it at approximately mid-50s this year. I’m curious about where that additional thousand basis points of share originated. Was it due to your largest customer ordering more, or was it influenced by other factors? Could you provide more insight on this? Also, regarding my follow-up, you mentioned that 5G only represents about a 50 million swing factor for the entire market. I’m still trying to grasp how that plays into the share growth compared to what you expected.

Yes. At the highest level, the semiconductor supply market has moved in favor of our customers. A key factor that we didn’t anticipate at the start of the year was the introduction of further regulations on Huawei, which pushed them out of the silicon and testing market. As a result, other suppliers had to fill that gap, and we were well-positioned among those suppliers. This has positively impacted us. Additionally, our traditional customers are buying more than we had predicted, which adds another layer of positive momentum. Those are the two most significant factors. Lastly, while not directly related to system-on-chip (SOC) products, the strong demand in the memory market and the better-than-expected ramp of our LPDDR5 products have also contributed positively.

Got it. For my second question, regarding Huawei, you initially noticed an increase in capacity needed for Huawei from the OSATs, and now there's additional growth from fleet upgrades. Can you quantify how much these upgrades are contributing? Specifically, how much of the 449 SOC revenue comes from the upgrades for non-Huawei OEMs?

Yes. It's less than 10%, but more than 5%.

Okay. Folks, we are out of time. Thanks so much for joining us again this quarter. And I'll follow-up with folks individually that are still in the queue. Again, thanks so much. Take care.