Teradyne Inc (TER) — Q2 2022 Earnings Call Transcript

Thank you, Latif. 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; President, Greg Smith; and our CFO, Sanjay Mehta. Following our opening remarks, we’ll provide details of our performance for 2022’s second quarter, along with our outlook for the third quarter of 2022. Press release containing our second 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. Replays 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 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. 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 measure were available on the Investor page of the website. Looking ahead, between now and our next earnings call, Teradyne expects to participate in technology or industrial-focused investor conferences hosted by KeyBanc, Davidson, Jefferies, Deutsche Bank, Citi, Evercore, Piper Sandler, and Goldman Sachs. Now let's get on with the rest of the agenda. First, Mark and Greg will comment on our recent results and the market conditions as we enter the new quarter. Sanjay will then offer more details on our quarterly results along with our guidance for the third quarter. We'll then answer your questions, and this call is scheduled for one hour.

Hello, everyone, and thanks for joining us. Greg will summarize our Q2 results, and I'll comment on the full year outlook and technology drivers we expect in 2023. Sanjay will then take you through the financial details, including our outlook for the third quarter.

Thanks, Mark, and good morning, everyone. Teradyne's second quarter sales and profits were above the midpoint of our guidance in revenue and profit with sales of $841 million and $1.21 in non-GAAP earnings per share. From a market perspective, we're seeing mixed signals. While the pressure to improve lead times in some test markets is as strong as ever, and we continue to work through supply issues, we have seen some softening in mobility demand, our largest test market. Also, it now looks like IA growth in the second half will be similar to first half growth. In today's call, we'll try to provide some context on how we're navigating this complex environment. Diving into the details of the second quarter, semiconductor test revenues were in line with our plan as were profits. The automotive and industrial end markets served by our Eagle platform were notably strong in the quarter. In memory, flash final test and DRAM wafer sort was the strongest markets. From a strategic perspective, Semi Test had a strong quarter of competitive design wins for both R&D applications and for devices that we expect to ramp in volume production over the next year or so. The design wins were in a wide range of end markets. There were Ultra Flex family design wins in mobility, where the systems architecture supports higher throughput for large complex devices especially when time to market is an important factor. Eagle Test had a significant design win in a battery management application where the system's highly accurate voltage measurement capability enables customers to get to market faster with better device specifications, delivering higher value. In Systems test, sales were on plan in the quarter with solid year-on-year growth for storage test and production board test. At LitePoint, strong wireless test demand for Wi-Fi 6C, Wi-Fi 7 R&D and ultra wideband test products drove double-digit year-on-year growth. Notably, we're seeing strong interest in Wi-Fi 7 development test where we are qualified at all major chipset vendors and to date, we have won 20 of 21 design-in opportunities with end product design teams. This sets us up to expand our already high share of Wi-Fi production test as these products ramp. In Industrial Automation, revenues grew 10% from last year's Q2 and 19% for the first half. This lower than planned growth in the first half is attributed to two primary factors and warrants a few comments. The first factor was foreign exchange. The majority of IA revenue is linked to the euro. For example, within Europe, at UR, we saw a robust 34% unit growth in the first half of 2022 but the decline of the euro with respect to the dollar has muted UR revenue growth in that region to 20%. The dollars appreciation was a revenue headwind in the first half and Sanjay will comment further on the full year foreign exchange outlook. The second factor is lower regional demand that can be traced to a variety of region-specific causes, including COVID lockdowns in China and distribution partner staff shortages in North America where end demand remains quite strong. Staff shortages for integration partners is an ongoing challenge. In the past, we've noted that our distribution partners struggle to grow staff at the same rate as IA demand growth. Our strategy to overcome this is to use software technology and plug-and-play applications from UR+ and MiRGo partners to shorten the deployment time to make these critical staff more productive. But an equally important part of the strategy is to build a robust OEM channel. For example, at Universal Robots, our OEM channel, which includes verticals like welding, power grid maintenance, and order fulfillment is doing very well, growing 39% in the first half of 2022. The OEM channel is an important complement to our distributor-based channel because these OEM partners deliver a mostly complete solution to their customers that can be put in operation almost immediately. In many cases, these OEMs have an existing distribution network that can reach customers beyond our traditional channel. These partners can scale much more efficiently than distributors that add staff in proportion to revenue growth for customer support. We are actively adding new OEM partners to serve these and new market verticals. Now I'll hand it back to Mark more on the market, the second half outlook and the demand drivers for next year.

Thanks, Greg. While the long-term drivers in our test and automation markets remain firmly in place, the recent deceleration we're experiencing in test will impact our full year results. Over the past few weeks, we've seen a marked slowdown in SOC and wireless tester demand in the second half related to declines in end market shipments of smartphones, compute products and associated infrastructure. These demand adjustments are happening in real time, and we are projecting this will continue over the next several weeks as the market continues to align their production plans and inventory levels to this new reality. This extends across multiple customers and device types, including apps processors, power management, and RF. I will note that auto MCU, industrial, and memory test demand remains strong entering Q3, and we've seen no deceleration of demand in these markets. When forecasting the second half of 2022, we are expecting the test realignments we've seen in the past few weeks are not a blip and that further adjustments are coming. Beyond the reductions we've already seen, several customers have indicated they are in a capital review phase, which we are assuming will lead to some additional impact to Q4 demand. At a macro level, we also assume that China's smartphone volumes will not accelerate through the remainder of the year. We also believe that short-term global economic conditions will remain weak, resulting in softening consumer demand and associated electronics inventory digestion. In IA, we forecast that our second half business will continue to grow at about a 20% year-over-year level, consistent with our achievements in the first half, but below our 35% goal. As Greg highlighted, we believe that China demand will remain muted. Distributor labor shortages in North America will limit the rate of installation expansion in the short term and FX headwinds will not abate. Summing it all up, we now expect our second half revenue to be slightly lower than the first half, resulting in a roughly 52%, 48% first half, second half split. Our latest forecast projects that 2022 SOC test market will be in the range of $4.2 billion to $4.6 billion, down from our April estimate of about $5 billion, while in memory, we expect the market will remain at about $1 billion. To reiterate, much of our forecasted slowdown assumes continued yet to be identified demand decline in the fourth quarter. Looking further ahead, after six consecutive years of robust SOC test market growth, we have entered a period of demand slowdown in digestion. This is not uncommon as we've seen this most recently in 2013 and 2015. And over the years, we've built our operating model to anticipate these kinds of demand swings. Predicting the depth and duration of these corrections is challenging, but in each of the last three corrections, growth returned after six to 12 months with the subsequent year showing strong growth. The ramp of 3-nanometer starting in 2023, followed by gate all around and increasing multi-chip packaging remains unaltered drivers of growth ahead. Interface transitions in both Flash and DRAM are also imminent. Hyperscalers continue to expand their chip design starts and AJI as a new class of silicon application gaining momentum. In Industrial Automation, the value proposition has only strengthened as the short ROI remains compelling, while increased resiliency in a world of questionable labor supply as another motivation to automate. So while the first half of 2022 unfolded roughly as outlined in January, the second half is looking considerably softer than we expected just three months ago. However, we are confident of our long-term growth strategy and are focused on execution of our design-ins and R&D programs so that we are positioned to capitalize on the growth of these markets that we serve. Sanjay will now take you through the financial details.

Thank you, Mark. Good morning, everyone. Today, I'll provide details on our Q2 results, offer additional color on how we're addressing the slowdown in some markets and supply shortages in others, and describe our Q3 outlook. Now to Q2. Second quarter sales were $841 million with non-GAAP EPS of $1.21, non-GAAP gross margins were 60.2% and our non-GAAP operating expenses were $251 million, $14 million below mid guidance. The main driver of the lower than planned OpEx was in Industrial Automation Group or IAG due to lower variable compensation tied to lower revenue projections and slower than planned hiring. Non-GAAP operating profit rate was 30.3% we had two 10% customers in the quarter. The tax rate, excluding discrete items for the quarter was 16.9% on a non-GAAP basis. Please note, you should now use 16.5% for the full year non-GAAP tax rate. Looking at the results from a business unit perspective. Semi Test revenue was $541 million. SOC revenue was $461 million, driven by strength in automotive and industrial markets. Memory revenue was $81 million, led by flash final test and DRAM wafer sort. System Test group had revenue of $135 million, which was up 29% year-over-year. Storage Test sales, including both HDD and system-level test solutions were $86 million in the quarter, up 49% from Q2 2021. Defense and aerospace and production board test combined grew 4% year-on-year. At LitePoint, revenue of $64 million was up 16% from prior year due primarily to strong shipments in Wi-Fi 6C and Wi-Fi 7 and UWB test systems. Now to Industrial Automation. Industrial Automation revenue of $101 million in Q2 was up 10% year-over-year. This was lower than expected, as Greg noted. Despite the lower growth, we still expect IA revenue to follow the historical pattern and grow as we move through the year. UR sales were $83 million in Q2, up 8% year-over-year with the highest growth in Northern Europe. MiR sales were $17 million, up 9% from Q2 2021 in the quarter. From a financial perspective, in IA the group was slightly under breakeven on a non-GAAP operating basis in the second quarter. And for the full year, we expect to be towards the low end of the 5% to 15% profit range we discussed in past calls. We view the roughly 20% growth rate in IA as a short-term situation, as Greg noted. Like the company model, the IAG Group operating model naturally flex spending down based on profitability, and we're tightening discretionary spending where appropriate. But our long-term IA growth strategy and related investment plans remain unchanged. Shifting to supply. Our Q2 guidance excluded approximately $50 million of revenue tied to our inability to supply customer demand. In Q3, we're excluding a similar $50 million of revenue from our guidance range, primarily in our test businesses. The shortage of semiconductors ranging from FPGAs to industrial analog continues to impact our production. As I've noted in prior calls, we're taking numerous actions to harden our supply chain but even with these actions, we expect supply line constraints to remain challenging. I will note these actions and other factors improved our supply situation in Q2, mainly in test, which enabled higher shipments. Shifting to the balance sheet and cash flow. Our cash and marketable securities at the end of the quarter totaled approximately $900 million, down from $1.2 billion at the end of Q1. We had $70 million in free cash flow in the quarter, reflecting the timing of shipments and supplier prepayments. Over 80% of our shipments occurred in May and June saw our DSO expanded to 74 days, which we expect will decline in the second half of the year. Other uses of cash in the quarter included share buybacks of $331 million, dividend payments of $18 million, and debt retirement of $22 million. At the end of Q2, we're more than two-thirds of the way through our $750 million share repurchase plan for 2022 with $217 million remaining. In our October call, we'll note any updates to our share buyback plan. Regarding debt. To date, $386 million of convertible bonds have early converted. I'd also like to note several points regarding the strong US dollar and its impact on our results. In our Test portfolio, the majority of revenue and expense are in dollars, so there's not a material foreign exchange impact. In IA businesses, on the other hand, have a large amount of euro-linked expenses and about 50% of their revenue is tied to the euro. The result as the strong dollar reduces IA's revenue and gross margin in dollars. In the first half, the FX impact reduced our IA growth rate approximately four points. Assuming exchange rates remain consistent with July's exchange rate, we expect six points of growth headwind for the full year compared to our January projection. For IA, the strengthening dollar has a marginal benefit on the OpEx side. IA revenue and margin degradation is offset by the OpEx gain, yielding a neutral effect on our operating profit for that segment. Now to our outlook for Q3. A combination of slowing demand and test, extending lead times due to material shortages and reduced automation demand in Europe and China results in a lower Q3 outlook than we expected three months ago. As noted, the guidance excludes approximately $50 million of shipments due to material shortages primarily in test. Also, the guidance assumes we won't see any extended shutdowns of production facilities due to COVID, and we won't see any new trade restrictions. With that said, sales in Q3 are expected to be between $760 million and $840 million, with non-GAAP EPS in a range of $0.90 to $1.16 on 166 million diluted shares. The third quarter guidance excludes the amortization of acquired intangibles. Third quarter gross margins are estimated at 58% to 59%, down from Q2 due to product mix, 2022 investment supply chain resiliency, and wage inflation. Some of these effects are transitory, and we expect our mid-term earnings model gross margin range of 59% to 60% to remain intact. OpEx is expected to run at 31% to 34% of third quarter sales. The non-GAAP operating profit rate at the midpoint of our third quarter guidance is 26%. As Mark noted, we expect second half revenue to be below the first half, approximately 48% of full year sales. Given the reduced revenue outlook for the second half of the year, our operating expenses are now planned to grow just 4% to 6% annually versus 11% to 13% planned in our prior guidance. The OpEx reduction from prior guide is driven by two factors. First, our variable compensation model is approximately half of the decline tied to reduced revenue. Second, we have delayed some expenditures in both test and IA, which we believe will not impact our long-run competitiveness. Spending savings are roughly evenly split between engineering and go-to-market. Summing it all up, we're expecting revenue and profit in Q3 and the second half of the year to be lower than we projected three months ago, but our operating model is resilient to varying revenue levels. With the reduced revenue level, our model reduces variable compensation expense, and we're taking other steps as appropriate. A downturn is always challenging, but we're confident we have the operating model, strategy, and experience to lead us through whatever lies ahead, while keeping our focus on the needs of our customers and the long-term opportunities in the test and industrial automation markets. With that, I'll turn things over to Andy.

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

Thanks for taking my question. I just wanted to clarify that you're guiding Q4 roughly around $670 million, $675 million, which seems to be kind of pre-COVID levels. And I think if I take your IA guidance into account, it suggests that non-IA Q4 sales will be $430 million, which would be almost 20% below pre-COVID levels. Did I get that right? And I realize that there are headwinds, but why is such a sharp decline in your Q4 outlook?

Yeah, those figures are approximately accurate. As I mentioned in my prepared remarks, we likely reduced our revenue targets for the second half by about $300 million to $350 million. One-third of that reduction is due to known customer weakening where demand has softened according to their feedback. The remaining two-thirds is a projection of further issues to come based on initial conversations with customers. This isn't a clearly defined portion of the decline, but our experiences in previous cycles in the test industry suggest that more challenges are ahead. For instance, in 2013, the market experienced a significant year-over-year correction of 30%, and that marked the beginning of that trend. Currently, we are seeing the market correct about 9% from last year's peak, which is a more modest adjustment. This is how the market shifts, and we are relying on historical data to inform our projections for these yet-to-be-identified phases of adjustment.

Got it. And then, Mark, I'm curious, what is your exposure to Android smartphones this year versus last year? And how much of a headwind is that continuous? And do you think that will alleviate next year, or can that still be an offset to any 3-nanometer testing benefits on the iOS side? So just the interplay between Android and iOS this year and what you're thinking about from a next year perspective? Thank you.

I believe our exposure to Android smartphones is somewhat higher this year compared to previous years. We've gained a bit of market share in that area. However, that segment has experienced significant declines in unit volume this year, which is the main reason for the decreases we are anticipating in the second half. Looking ahead to 2023, it's difficult to predict the outlook for Android phones. The declines in 2022 were partly related to China, and we are trying to assess how China will recover in 2023 as consumer demand hopefully picks up. Unfortunately, we do not have a strong forecast for the Android sub-segment of smartphones for 2023 yet, so I cannot provide much insight on that.

Hi, good morning. Thanks so much for taking the question. I had two as well, one on Semi Test and the other on IA. On the Semi Test side, Mark, I was hoping you could speak to your expectations in terms of market share for the year. Given the incremental weakness you're seeing at the market level and given that you had derisked your opportunity for this year with your largest customer. I feel like your market share position as of today is perhaps a little bit better than what you were thinking three months ago. I just wanted to clarify that on the Semi Test side?

Yes, I believe there are two components to consider: Semi Test Memory and SOC Memory. We expect to maintain a market share of around 40%, consistent with last year. For SOC, our outlook largely hinges on developments in the compute sector, particularly regarding how much decline we might see in that market, where our competitors tend to excel. We have anticipated a significant downturn in mobility and believe a decrease in compute is likely as well. However, we will gain more clarity on this in the coming weeks as we gather insights from our competitors. Overall, I estimate our share in SOC Test this year to be in the mid to upper 30% range, influenced by a strong compute market and a weaker mobility market, while also considering customer shifts between suppliers, which can vary significantly year-to-year.

Got it. That's helpful. And then as my follow-up on the IA side, I guess a two-part question. The first part is I just wanted to clarify that fundamentals in the business remain pretty strong. And I asked the question because the reasons you noted for, I guess, the reduced outlook for the second half seemed technical and transitory. You talked about FX. You talked about COVID lockdowns in China and staff shortages in the US. So fundamentally, is the business still healthy and intact? I guess that's number one. And then number two, on the OEM channel dynamic, just curious, how big is that channel today as a percentage of IA? And where do you see that going in a couple of years? And how does that impact profitability as OEM grows vis-à-vis your distribution business? Thank you.

Hi, this is Greg. I will address that. We believe the fundamentals in the IA market remain strong. The impacts of the China lockdowns and staffing shortages should ease somewhat for the remainder of the year. We anticipate that the foreign exchange headwind will remain consistent throughout the year, and we do not expect a significant appreciation of the euro. Therefore, the translation into dollars will continue to subtract a few points from our revenue growth for earnings denominated in euros. Regarding your second question, our OEM channel currently constitutes approximately 16% of the total UR revenue, which is lower compared to the entire Industrial Automation Group. For the first half of the year, it grew by 39%, and we expect to maintain that growth rate.

And impact on profitability?

So our pricing in the OEM channel is a little bit favorable to pricing through our normal distribution channel. So we don't expect to see any negative impact to profitability as that channel grows.

Thanks for taking my questions. I have a couple as well. I think within Semi Test, you mentioned you're continuing to see robust demand in autos and industrial within Semi Test. So I was just wondering, given the trends you're seeing in industrial automation, are you baking in any incremental weakness as you go through the remainder of the year in autos and industrial as well within Semi Test? And then I have a follow-up.

No, not really. Most of the weakness we're baking in, again, in the fourth quarter that we've yet to really get confirmation on is in more in mobility and compute and infrastructure. But we think industrial and auto will remain strong through the end of the year.

I would like to follow up on the cost structure. You've clearly reduced some of your planned expenses for this year. However, regarding SG&A, your spending is in line with last year when revenues were significantly higher. As you consider strategic capital expenditures, such as acquiring some customers, as well as potential delays in your long-term growth drivers, what is the flexibility to reduce or adjust your cost structure in light of the revenue delays you're experiencing? Is it possible to defer spending as you've mentioned today? Thank you.

It's Sanjay. I want to share some thoughts on our business model regarding our cost structure. The majority of our test portfolio relies on contract manufacturing, which allows for great scalability with our outsourced partners' fixed assets, benefiting our margins. From an operating expense standpoint, a significant portion of our wages is linked to a flexible or variable compensation plan. This means that as revenue and profit rise, part of that increase is shared with our employees. Conversely, when revenue declines—one of the factors contributing to the expected growth reduction from a midpoint of 12% this year to 5% as mentioned in my prepared remarks—variable compensation plays a significant role. As the market evolves, especially if it declines, we will have the capacity to lower our operating expenses on a variable basis while maintaining our workforce and investing for the long term. Of course, if the market improves, our revenue will increase, which will subsequently raise our operating expenses on a variable basis.

Thank you. Thanks for the color.

Yeah, good morning. Thank you for taking the question. I guess first question on gross margins. If I look at what you've discussed in terms of mix, that's actually a positive on the SOC side, yet you're guiding gross margins, I think the worst is mid-2020 at a revenue run rate, I think that exceeded back then. So curious what is driving the gross margin hit here? Is it a much worse mix in SOC than what perhaps I'm contemplating, or is it kind of the FX other issues around IA?

Sure, C.J. So yeah, so I think when you think of the product mix, there is some mix degradation within Semi Test, but also as there's less wireless test, which is higher than the corporate average and less than expected IA, which is higher than the corporate average. So you are seeing mix. But a couple of other drivers that I noted in my prepared remarks. And that is we've spent a lot of effort and money on making our supply chain resilient through component qualification through multi-country manufacturing, etc. A lot of those costs are going to be incurred in 2022 and the second half of 2022. So think of those as transitory. And then we're also seeing a little bit of wage inflation for both ourselves and our partners.

Thank you for the information. As a follow-up, regarding the slowdown you're experiencing in testing, are you noticing delays or actual cancellations? Considering 2023, there are significant changes with heterogeneous computing, larger die sizes, and smaller die sizes using chiplets and advanced packaging. I’m interested in your perspective on the overall impact for 2023, whether you anticipate growth or further declines, and what your market share might be. Thank you.

Thank you. Yeah. So on the heterogeneous computing and the effects in 2023, I think that's all positive for us. 3-nanometer is coming as planned. We don't see any changes or delays in anything associated with that. The trends toward chiplets, multichip packages and the associated test intensity increase around known good die, more pins to test in a chiplet design than there would be in a monolithic design. All are tailwinds for test. Now those have been occurring in the market and we'll continue to phase in over the next several years as that method of, let's say, package assembly gains more and more prevalence. So that is another one of the tailwinds that gives us confidence in the midterm earning model that we produced earlier in the year. So no change to our beliefs around 2023 at this point. And in terms of pushouts versus cancellations versus anything else, we're not seeing any cancellations. But what we have seen is that there's been a few pushouts, but more significantly, we do hold some capacity in place for some of our key customers on a basically 12 to 16-week delivery window basis that were unbooked and it's the demand for those unordered testers principally that disappeared.

Very helpful. Thank you.

Good morning. Thank you for my question, and welcome aboard, Greg. I have a couple of theoretical questions if you don’t mind. The first is regarding the beginning of the year when our largest customer decided to reduce tester purchases. As we understand, their product launch this year didn't have the complexity to justify a new tester. The intention was that their 2023 launch would feature much more complexity due to 3-nanometer technology. Given the current weakness in the smartphone market, has anything changed in your perspective on this situation, or more importantly, what feedback are you receiving from your largest customer, Mark?

There have been no changes in that regard. Our largest customer has performed quite well this year, even with overall declines in smartphone units. This segment of the smartphone market remains strong. We expect that there is nothing we've encountered that would alter our perspective for 2023.

Very good. And then as far as this whole six to 12-month slowdown that you've seen in the past, which is obviously documented in the numbers, Mark, in your eyes, does that actually start in 3Q because the first half was more a Teradyne specific thing with that large customer? Does that essentially six to 12-month timetable start now?

I believe the slowdown begins in the third quarter. The market declines in the first half were largely due to one customer's significant impact on the overall market. We are now moving into a more typical phase. While this is partly a projection, we have observed similar trends in the smartphone sector and anticipate they will extend to broader markets like computing and infrastructure. There are also excess inventories that typically undergo a digestion phase, which can take six to 12 months to resolve. As we move into a period of slower economic growth and with more inventory in the channel than usual, we expect people to be more cautious, which will likely reduce demand for repeat orders in these categories. Therefore, I believe the slowdown will start in Q3 and a six to 12-month timeframe seems reasonable. We’ll see how things unfold.

Mark, if I could just add a question. In relation to that, does the 2024 framework suggest that the lower end is now more likely, or is the lower end at risk? I'm curious because you didn’t include that framework in the presentation.

No, I think if you look at the history of the market, our earnings model and projection for 2024 is intact and in play, and I wouldn't characterize it as low end either. When examining how much the markets fluctuate year-to-year historically, we could easily see a rebound of 20% to 30% growth in a following year. Therefore, I wouldn't label 2024 based on what we are observing right now.

Good morning and thanks for letting us ask a few questions. Maybe just backtrack to the $600 million reduction in the SOC TAM. Can you maybe just delineate again whether it's mobility versus compute within that reduction? And also just sort of zooming in on the compute TAM, are you seeing or anticipating any weakness outside of processors for client PCs, hyperscale or server high-performance compute chips as well?

I'll discuss the total addressable market. Based on our estimates related to the $4.4 billion midpoint, we are anticipating a decline of about $300 million in compute, a $400 million decrease in mobility, and an increase of around $100 million in auto. That's where we're seeing the changes.

And then on the question of where in the compute market are we anticipating or getting some early signals of weakness. Certainly, right now, the immediate corrections are occurring related to consumer laptops, a little bit of enterprise PC area. We're not seeing at the moment the correction in cloud infrastructure or service. However, there are I would say, discussions going on in those areas that suggest that that's probably coming. And so part of what we've assumed in our both market projections and Q4 revenue projections are some declines starting in Q4 in those segments, modest relative to mobility, however.

Okay. That's interesting. Maybe just switching gears then back to automation. We've also heard that supply issues, not even your MiR, but for other complementary products like 3D cameras or conveyance had also been delaying automation projects. I'm curious if that's something you're also seeing? And then kind of the second part of that is, and it's not totally fair to ask, but how are you thinking about IA growth rates for next year given the existing and anticipated headwinds, including demand, not only supply?

Hi, this is Greg. Regarding supply issues, our partners are experiencing difficulties in procuring certain components for the solutions they are developing. This contributes to the challenges we are facing in North America, where there are workforce limitations and a significant number of incomplete projects that need to be resolved. We anticipate that as supply constraints begin to improve, this will no longer be a hindrance, likely occurring in the latter part of this year. While it's still early to make definitive growth projections for 2023, we don't see any reason to change our anticipated growth rate of 30% to 45% for IA in the long term. The fundamentals in the end market remain robust, with low market penetration and ongoing labor shortages across all the markets in which we operate.

Okay. Thanks Greg. I appreciate the color.

Great. Thanks. I want to double-click on the mobility market. I think most of us understand the order pattern of the largest customer. But excluding that customer, is your revenue growth more closely tied to smartphone sales, meaning they are more reflective of current demand? The reason I ask is that if we start hearing smartphone inventory getting closer to normal levels, say, by the end of this year, does that mean you will start seeing more tested revenue growth in Q1, or do we have to wait a little longer because your customers may not meet extra tested capacity until later?

Good question. I would say that in the smartphone industry, tester capacity typically lags behind unit production by about three months. Therefore, the decline we are observing in tester capacity demand during our third quarter indicates a reduction in smartphone unit production for the fourth quarter. Looking ahead to next year, we should expect to see an increase in tester demand about three months before major phone launches or a rebound in the China market, following this pattern.

Okay. That's helpful. My follow-up question is on the memory test. You called out the strength in memory test in second quarter, and you still expect the TAM to be about $1 billion this year. But many memory suppliers are likely going to cut CapEx quite a bit and slow down production. When do you think you will feel these adjustments in your revenue, or is increased complexity and market share gains enough to offset these headwinds? Thanks.

I believe the situation in memory is somewhat unique, and we do not anticipate a significant correction. This is largely due to the obsolescence of testers related to the new DDR5 and LPDDR5 interfaces, which are gaining traction in the DRAM market and necessitating entirely new testers. The fabrication capacity that was established in 2022 to manufacture this new device class is expected to increase in both the server and phone markets in 2023, requiring new testers in the latter half of this year and into next year. There seems to be a delay between the capital expenditure investments made initially and the subsequent need for tester investments. We expect this dynamic to continue at least through the early part of 2023. While we are hearing various forecasts from memory suppliers regarding bit growth, we believe these technological obsolescence challenges will require additional tester capacity, as the older testers cannot be repurposed.

Okay. Thank you.

Thank you. Previously, you discussed the connection between the wafer fab equipment market, especially the logic segment, and your SOC test business. However, it seems that these areas are now diverging. While I don't expect you to predict the wafer fab equipment market, which many of us believe may contract, could you elaborate on the relationship you're observing and the discrepancies? It appears to contrast with the amount of new logic capacity being introduced and the corresponding need for testing. Please provide some context regarding this relationship.

You're correct, it does seem contradictory. It indicates that there may be some underused fabrication capacity for a while, or there could be some wafer die banking occurring. This means the fabs will continue to operate, but the devices may remain untested, undiced, or unpackaged for a certain time. I believe this situation is likely to persist for a short period in the next six to nine months. However, historically, this tends to balance out by the end of a six to twelve-month adjustment period. That's what I expect.

Okay. Thank you. And then for my follow-up, on the last question, you kind of referenced technology transitions in memory. If you talked about DDR5, I didn't hear it, but can you talk a little bit about is DDR5 timing getting pushed back? Is that a factor in DRAM being a little lower this year, and what does that tell you about kind of your Memory business prospects for next year?

Yes, it certainly does. This year, we anticipated that DDR5 would play a larger role in our business in 2022, following the fourth quarter of last year. However, due to the delay of Sapphire Rapids into 2023, many of our plans were pushed back. Despite this, the market remained stable, largely due to significant investments from new suppliers in China who have been aggressively increasing their capacity throughout the year. As a result, 2022 has turned out to be a strong year for Memory. Looking ahead to 2023, there may be additional delays, especially with reports that Sapphire Rapids might be postponed by a few months. Nonetheless, we are approaching a point of significant progress, and we are starting to see increased orders for capacity, which gives us more confidence in the Memory segment compared to the SOC side.

Okay. Thank you very much.

I have two questions. First, for Mark or Greg, can you share your thoughts on next year? Are you concerned that as mobile demand begins to improve next year, the auto-industrial segment might decline, and could that negatively impact your margins? How are you preparing for that transition? I also have a follow-up.

I don't think the margin between auto and mobile is significant for us. I wouldn't say there is a mix shift that will act as a headwind or tailwind. They are quite closely blended. In terms of when we expect mobile to return, based on the pattern from our largest customer, we see this happening in the second and third quarters. We do not anticipate any change to that timing considering their product introduction cycles. From Teradyne's perspective, we expect the major changes to occur during those two periods. There should be a slight increase in the first quarter, primarily linked to some other manufacturers' phone launches, but the second and third quarters will be the key periods.

Got it, got it. That's very helpful. And then a follow-up, you touched upon a little bit of a decoupling between front-end WFE and test investments. I just wanted to like go into one subset of that, which is China. It seems like some of the Chinese OSATs have slowed down spending, but the front-end spending is still continuing. I'm just kind of curious of your view on how China evolves for test spending and for Teradyne?

China's fab investments are continuing at a steady pace, not just in China but generally. In relation to the utilization question, it appears that the 3-nanometer investments made over the past year are currently underutilized, as they haven't yet generated revenue. The advanced process for tooling and optimizing the 3-nanometer technology has become an unusually lengthy cycle. Consequently, all that fab capacity remains underutilized until revenues begin to flow next year, particularly from China. There is a gap between testing lead times and fab times. Fabs typically have a significant amount of capacity and equipment installed months before actual production kicks off. Testing is often added on an as-needed basis. Once a fab begins operation, initial capacity in testing is ramped up within a quarter while production ramp-ups take place in subsequent quarters, with testing increasing gradually as well. Overall, testing has a smoother rollout compared to fabs. Additionally, in China, there is a national emphasis on technological independence, which primarily targets fab technology, making it simultaneously viewed as a threat and an enabler. As a result, there has been a notable push to invest in fab capacity there. Our performance in China remains robust. However, we face one significant challenge: Huawei, the largest consumer of test equipment in the country, is currently a customer we cannot serve. Beyond that, we are experiencing solid growth in other areas.

Thank you very much.

Thanks for taking my question. I want to revisit the SOC test. Mark, examining the trends since 2015, the SOC test has shown year-over-year growth. There are likely two factors contributing to this: the discontinuation of the parallel test towards the end of the last decade and the incremental boost from 5G that started in late 2019. Currently, you're projecting $4.4 billion, which remains above the 2020 levels. Given this context, what gives you the confidence that we will see a swift recovery in SOC test in 2023, especially since your largest customer is expected to continue the bifurcation and not transition everything to the next leading nation? I also have a follow-up.

Okay, Mehdi. You are correct. We have experienced consistent growth since 2015. Even with the current market expectation of $4.4 billion for 2022, the growth trend from 2015 reflects a 10% compound annual growth rate. We've always managed the business while anticipating volatility, keeping our focus on this growth trend. This 10% rate aligns with our midterm earnings projections. It might be challenging after so many years of steady sequential growth to adjust to this information. However, those of us who have been around long enough understand that it's part of our history and not unusual. Regarding 2023, I want to emphasize that our tester market's demand is highly responsive to our customers' growth rates. For instance, if a customer grows unit sales by 4%, it generates a specific demand for testers. If their growth increases from 4% to 5%, despite being a small change for them, it can lead to a 20% to 25% increase in demand for us, as our demand closely follows customer growth rates. Thus, we are very aware of the macroeconomic conditions affecting our customers' growth in 2023. The technological transition with our largest smartphone customer to 3-nanometer has already been accounted for. However, it's difficult to predict the broader economic climate and how inventory adjustments from Q4 into early Q1 may influence us. We're currently trying to gauge the situation based on what we've observed, which suggests a potential demand drop of about $100 million compared to our expectations. So, I prefer not to make definitive predictions for 2023, but those are the considerations we are facing.

Thank you. Thanks for the detail. And one quick follow-up for Sanjay. Given all the color and guide, it seems like this year, revenues could be down mid-teens, plus-minus. And you're adjusting your OpEx growth of only 4% to 6%. Looking to next year, if we get a snapback, you do benefit from an easy compare from 2022 into 2023, should I assume that your OpEx growth would accelerate again, or should I assume that the OpEx growth will be minimal to like, let's say, mid-single-digit percent, 5%?

This year, we had a planned approach. As Mark mentioned, we handle the business based on trends, and we believe the fundamentals we outlined in our January call and earnings model are still solid for Test and IA. With this in mind, we initially intended to increase operational expenditures by 11% to 13%, but we've decided to postpone certain expenditures that won’t affect our long-term competitiveness. While we haven't finalized our detailed planning for 2023, we'll provide an update in January. My expectation is to maintain focus on long-term success, particularly in industrial automation, which we see as having less than 5% market penetration. We have strong positions within our portfolio companies for this market, and I believe we will continue to operate between 5% to 15% growth to drive topline expansion. In the Test portfolio, we plan to maintain a robust roadmap and effective go-to-market strategies. While I don't have the exact figures at the moment, the fundamentals of our business remain consistent. We do expect a slightly weaker second half than we initially thought, but we are confident that a rebound will occur at some point, though we can't predict the exact timing. We plan to keep our investment strategy intact.

And variable comp pool with revenue as we talked earlier.

Right. Thank you.

Okay. Folks, we are out of time. Mehdi, thank you for the question, and thanks, everybody for their questions and attention. If you have follow-ups, please reach out, and we look forward to talking to you in the days and weeks ahead. Bye-bye.