泰瑞達 (TER) 2005 Q3 法說會逐字稿

Good morning.

My name is Dennis and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Teradyne Incorporated third quarter 2005 earnings call. [OPERATOR INSTRUCTIONS] I will turn the call over to Mr. Tom Newman from Teradyne.

Please go ahead sir.

Thanks, Dennis.

Good morning, everyone and welcome to our discussion of Teradyne's most recent financial results.

I'm joined this morning by our Chief Executive Officer, Mike Bradley and Chief Financial Officer, Greg Beecher.

Following our opening remarks, we will provide you with the details of our performance for the third quarter, as well as our outlook for the fourth quarter of 2005.

First, however, I'd like to address some administrative issues.

Teradyne's press release containing our financial results for the third quarter was sent out by a business wire and is posted on our website yesterday evening.

If anyone needs a copy, please call Teradyne's Corporate Relations office at 617-422-2221 and we will provide you with one.

This call is being simultaneously webcast over our website at www.teradyne.com.

A replay of this call will be provided on our site starting at noon today eastern time.

If it's more convenient, you can also access a replay of the call by dialing 1-800-642-1687 in the U.S. and Canada or 1-706-645-9291 outside of the U.S. and Canada and providing the pass code 9838283.

Replays from both sources will be available through the 2nd of November.

It's our objective to use this call to supply with the requirements of SEC regulation FD.

Therefore, investors should accept the contents of this call for the official guidance from the Company for the fourth quarter 2005 and beyond.

If at any time we communicated any material changes to this guidance, it's our intent to do so simultaneously to all investors to the best of our ability.

Investors should note that only Mike Bradley, Greg Beecher and are I authorized on supply Company guidance.

The matters that we discuss other than historical information include forward-looking statements relating to future financial performance and other performance expectations.

The anticipated closing date of the connections systems divestiture, changes in the Company's business, including the sale of our Connections System Business, statements as to inventory, bookings, backlog, orders, shipments, pricing, design-ends and demand for our products, capital spending, and other opinions of management.

These forward-looking statements are made under the Federal Securities Laws.

Investors are cautioned that forward-looking statements are neither promises or guarantees but involve risks and uncertainties that may cause actual results to differ materially from those projected in the forward-looking statements.

Some of those risks and uncertainty are detailed in our filings with the Securities and Exchange Commission, including but not limited to our Form 10--Q filed on August 12, 2005.

And we incorporate here the discussion of those factors.

We caution listeners not to place undue reliance on forward-looking statements, which speak only as of the date they are made.

Teradyne disclaims any obligations to publicly update or revise any such statements to reflect any change in expectations of events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actually results will differ from those set forth in the forward-looking statements.

As a final administrative issue, we want to make clear to investors that our prepared remarks will be presented within the requirements of SEC Regulation G regarding generally accepted accounting principles or GAAP.

Therefore, financial metrics presented by us during this call will be provided in GAAP, unless identified as non-GAAP or pro forma operating terms.

By disclosing this pro forma information, management intends to provide investors with additional information to further analyze the Company's performance, core results and underlying trends.

In addition, certain pro forma information is provided giving effect to the Connections Systems divesture as of January 1, 2005, in order to illustrate the anticipated financial impact of the divesture and to facilitate a better understanding of the fourth quarter guidance, which excludes the Connections Systems operations.

Management utilizes non-GAAP measures such as operating results, earnings per share information, and quarterly break-even targets that excludes certain charges to better assess operating performance.

Pro forma information is not determined using GAAP and therefore, is not necessarily comparable to other companies.

Pro forma information should not be viewed as a substitute for or superior to the data prepared in accordance with GAAP.

In accordance with SEC regulations investors will find reconciliation of our GAAP to pro forma operating results, earnings guidance, and the operating results giving effect to the Connections Systems divesture within our press release of last night reporting our third quarter 2005 results.

A reconciliation of all GAAP versus non-GAAP metrics, which are presented by Teradyne during this call are available on the Company's website at www.teradyne.com by clicking on "Investors" and then selecting the "GAAP-to-pro forma reconciliation" link.

Finally, you may want to note we'll be participating in the following investor events between now and our next conference call.

Moores and Cabot marketing trip in Boston on October 26th.

The Janney Montgomery Scott Luncheon in Chicago on November 9th.

The Credit Suisse First Boston Tech Conference in Phoenix November 28th through December 2nd.

Janney Montgomery Scott Luncheon in Boston on December 6th.

A similar lunch in New York on December 7th.

A Lehman Brothers Global Tech Conference in San Francisco on December 8th and 9th.

In addition, note that Teradyne will host an Analysts Day Event at our North Redding Facilities on November 17th.

Anyone who would like more information on that event, please call the Company's Investor Relations office at 617-422-2221.

Now let's get on with the rest of the agenda.

First, our CEO, Mike Bradley, will review the state of the Company in the industry, as well as our financial performance for the third quarter and some strategic actions we've recently taken to strengthen or focus on our core-test business.

He will also provide guidance for the fourth quarter.

Then our Vice President and Chief Financial Officer, Greg Beecher, will provide more details on our financial performance, our strategic actions, and our guidance.

We will then answer your questions.

For scheduling purposes,you should note that we intend to end this call after one hour.

Mike.

Thanks, Tom.

Good morning, everyone.

We've obviously got a lot to discuss this morning, so let me start with a quick summary of our third quarter results.

We had sales of 387 million, up 21% quarter-to-quarter and a net loss for the quarter of 35.4 million or $0.18 per share.

This net loss included $0.27 of charges for non-FLEX SemiTest inventory and restructuring and other charges as detailed in our earnings release.

Excluding the $0.27 of charges, we would have been profitable for the quarter on a pro forma basis at $0.09 per share.

Moving to orders, they were up 11% from the second quarter to a total of 388 million with SemiTest up 40% and other businesses collectively down 19%.

The upsurge in SemiTest orders was driven by the continued growth in our FLEX customer base.

Overall our subcontract test buying increased significantly in the quarter and the FLEX drove much of that growth.

In our other businesses, orders and assembly tests, connections systems and broadband tests were down sequentially, while Diagnostic Solutions orders grew for the second quarter -- from the second quarter level.

Overall we're very encouraged by the continued momentum of the FLEX and the broadening of our customer base.

In the short term, there continues to be strong demand in SemiTest as customers continue to pull in their delivery requests.

In addition, our other test businesses are expected to deliver both revenue and profit growth in the fourth quarter.

So we're projecting sales between 330 million and 350 million with pro forma earnings between $0.16 and $0.21 per share from continuing operations.

Greg will break down our guidance for you shortly as it reflects continuing operations, a loss from Connection Systems and our discontinued operations and a large gain on the sale of Connection Systems.

In addition, there are complexities in the allocation of taxes under GAAP between continuing and discontinued operations.

All of which need further explanation.

If we could hold that subject for a minute, however, I'd like to delve a little further into two strategic issues.

First the significance of our Connection Systems divesture, and second, our position for growth and profitability in our Core Test Equipment businesses.

On TCS, as I think most of you know, we've had our Connections System business for about 30 years.

It's original purpose was a diversification play outside our Core Test businesses and it also had a side benefit of providing some key enabling technology for our tester products.

The business served us well for many years.

Our strategic focus was and continues to be centered on tests, however, so we've decided to concentrate all of our energy and our growth objectives in the test arena.

We expect that added focus to show up in a tighter connection to our customers and their long-term test needs.

In addition, the sale will add significantly to our financial flexibility.

Our balance sheet postsale will continue almost $1 billion in cash and equivalents, more than at any point in our history.

Now let me make a quick comment on our plans for that cash, as I'm sure we'll get questions on that subject later.

Our net cash balance will be comparable to a number of semi equipment companies, and we would expect to use it for strategic purposes in the future in areas in and around our core businesses.

We believe that this resource invested in those areas will create a higher return than we would likely get outside of that core.

Now to the subject of why I believe we're well-positioned for the future.

First, on that list is the FLEX.

With over 100 units purchased this quarter and a total of over 500 ordered by about 50 separate customers, the FLEX is starting to hit full stride.

FLEX demand is being driven by advanced gaming systems, set top box technology, consumer audio video invasions and advanced automotive, power, and wireless devices.

We're tremendously encouraged by this broad demand in cost sensitive system-on-a-chip applications as it reflects the dual value proposition of the FLEX.

Advanced instrumentation to cover a wide range of technologies.

Number one and two, an innovative architecture that delivers high parallelism and production.

One other facet this past quarter has been the FLEX penetration into subcontract test market.

The FLEX is now running in production in 8 of the top 10 subcontract test houses worldwide and is responsible for our sub con segment growing from less than 20% of our total demand in the second quarter to about 40% this past quarter.

Of course, the FLEX remains only half of the story as our prior generation products still represent just under 50% of our product bookings this last quarter.

While FLEX is the reason why we're well-positioned for the future, I want to reinforce our continued commitment on profitability.

Our progress of our previously discussed break-even sizing program has remained on track through this past quarter, and we're committed to meeting our goals in this area.

Obviously, though, our prior quarterly break-even target needs to be adjusted, as divestiure of Connection Systems and Greg will do that for you shortly.

I will say there are cost reduction and productivity efforts remain on track.

And examples exist across all functions in the Company.

For example, our SemiTest manufacturing organization increased shipments by 40% and doubled FLEX output to over 100 units in the quarter, at the same time reducing its permanent headcount by 4%.

Finally, I want to say a few words about our other test businesses.

While SemiTest has been undergoing a radical product and organizational transformation, each of other test businesses has been quietly advancing in product development and financial performance.

On a segment basis, all our test businesses were profitable in Q2, their profitability increased in Q3 and it's projected to again increase in Q4.

In addition, they're all making headway with their new product offerings.

By the way, the profit improvement in these businesses has not come from growing into their prior cost structures.

It's come from relentless remodeling on the cost, the gross margin and product fronts.

In summary, we're forging ahead as a more focused Company with greater resources, and with product momentum that makes me very optimistic for the future.

Now, let me turn it over to Greg.

Thanks, Mike.

Good morning, everyone.

In the third quarter or sales of 386.7 million were up 21% from the previous quarter and 16% below the level a year ago.

We had a third quarter net loss of 35.4 million or $0.18 per share on 196,835,000 shares.

The net loss included 52.8 million or $0.27 per share in charges that we highlighted in our earnings release.

The 52.8 million consisted an inventory provision of 38.5 million in semi conductor tests related to excess non-FLEX inventory and net restructuring other charges of 14.3 million.

These charges are part of our previously communicated break-even reduction plan.

In the third quarter, Catalyst and Tiger orders increased along with our J750 products still represent about half of our product bookings.

However, the very strong success of FLEX has caused us to temper our longer term estimates of our non-FLEX inventory consumption resulting in this 38.5 million charge.

Our gross profit of 103.6 million or 26.8% of sales was down from 30.7% of sales in the second quarter.

The primary reason, of course, was the inventory charge of 38.5 million in SemiTest, which amounts to 10 points of gross margin.

Excluding this inventory provision, our gross margin on a pro forma basis would have been 36.8% or up 6 points from the prior quarter.

This improvement was a result of several factors, including increased shipments in SemiTests, a more normal product mix, and lower manufacturing costs.

R&D expenses for the quarter were 56.3 million or 14.5% of sales compared to 60.9 million or 19% of sales in the second quarter.

The dollar decline from a quarter ago was primarily due to primarily reduced SemiTest engineering investments.

Investments in FLEX engineering are being lowered as we are moving from a major set of platform investments into further populating the FLEX with instrumentation to cover an even wider range of devices.

SG&A expenses declined 2.2 million to 65.3 million or 16.9% of sales in the third quarter as compared to 67.5 million or 21.1% of sales in the second quarter.

This decrease was due to lower foreign exchange losses among a number of other items.

Restructuring and other charges net were 14.3 million for the quarter primarily consisting of 12.5 million in severance costs for approximately 300 people and 1.6 million for divesture-related professional fees.

We provided 3 million in income taxes in the quarter as compared to 4.7 million last quarter.

This decrease was simply due to the mix of locations where we had income versus a quarter ago.

Our quarter-ending headcount was 6,296 people, including 5,501 regular employees which represents a decrease of 140 people during the quarter.

We are continuing our work force reductions in the fourth quarter in SemiTest as a number of key engineering projects get brought to market.

Our year-end headcount taking into account the sale of Connection Systems is expected to approximate 4,500 employees consisting of 4,100 regular employees.

Now, before I provide further details on the quarter and the outlook, I want to first comment that we are on track against our prior statements about our fourth quarter break-even reduction plan.

Our prior fourth quarter break-even target on a pro forma basis has been $330 million, which excludes both restructuring and other charges and any other possible stock-based compensation charges.

Now, taking into account the anticipated closing of the Connection Systems divesture in the fourth quarter, our fourth quarter break-even target without Connection Systems is currently estimated to be about $260 million on a pro forma basis.

Now, Connection Systems break-even target has been 75 million for the fourth quarter.

However, you should not that another 5 million in break-even dollars actually needs to get added, at least temporarily, to our target for the G&A costs that stay with us at least during the transition period.

This accounts for the net $70 million difference between the original pro forma target of 330 and the new target of 260.

At this 260 target, our gross margins would be about 42%.

Now, I'd like to briefly highlight we have provided additional GAAP and pro forma information and reconciliations in our earnings release at our website to enable you to better understand both the third and fourth quarter financial performance from our ongoing operations without Connection Systems.

Now, I know this information is far from being easily digestible, but let me try and take you from Q3 to Q4, and I'm going to try and highlight both what the impact is of the planned divesture, and what's going on in the underlying core businesses.

So let me start with revenue.

Going from the third to the fourth quarter, we start with third quarter revenue of $387 million.

The first thing we need to do is back out the $94 million for Connection Systems, which was Connection Systems' third quarter revenue.

That leaves us with an adjusted 293 million of third quarter revenue for our test businesses.

If you look at our guidance and just took the midpoint of our guidance for fourth quarter, that would be $340 million.

So the growth from 293 to 340 would be about $47 million or 16% growth quarter to quarter.

Now, let me move down to gross margins.

Looking at gross margins, the changes are very significant.

We increase our pro forma gross margins in the fourth quarter by 10 points.

In the pro forma gross margins, as a reminder, exclude the inventory charge for non-FLEX, which is also worth about 10 points.

So I'm excluding that in this comparison.

So a 10-point improvement stacks up as follows: We get 5 points simply from removing Connection Systems.

Then we get another 1 or 2 points from higher SemiTest volumes, and the final 2 point improvement is from better or more normal product mix and lower cost, and a much healthier gross margin percentage in the fourth quarter.

Now, moving down to operating expenses, R&D and SG&A each go up by about 3 points, simply from removing Connection Systems.

Then R&D stays at the same Q3 percent based upon higher sales and slightly lower cost.

SG&A goes up 1 or 2 points primarily from unabsorbed central company costs which will then be cut in half in the first quarter of 2006.

Now, let me get back to the third quarter news.

SemiTest sales in the third quarter was 59% of the total.

Connection Systems 24%, Assembly Tests 10% and other tests 7%.

On a geographic basis, our third quarter sales broke down as follows.

U.S. 30.6%, Europe 12.2, Singapore, 11.9, Taiwan 11.5, Southeast Asia 16.5, Japan 6.3, Korea 4.6, rest of the world 6.4.

We had net bookings of $388 million in the quarter.

On a quarter-to-quarter basis our total net bookings were up 11% and SemiTest was up 40%, Connection Systems down 9%, Assembly Test down 45%, and other tests down 9%.

On a year-over-year basis, total net bookings were up 37%, SemiTest up 96%, Connection Systems down 10%, Assembly Tests down 29%, and other tests up 4%.

Our book-to-bill ratios were 1.0 for the overall Company, 1.1 for SemiTest, 1.0 for Connection Systems, 0.7 for Assembly Test, and 0.8 for other tests.

At the end of the third quarter, our backlog excluding TCS stood at 389 million of which 81% is scheduled to ship within six months up from 78% in the prior quarter.

We also had about 20 million of pull-ins from the third quarter from the backlog.

Now, on a geographic basis or bookings for the quarter were distributed as follows.

U.S. 29.4%, Europe 13.3, Singapore, 16.2, Taiwan 9.2, Southeast Asia 20.9, Japan 6.2, Korea 4.3, rest of the world.5.

Moving to the balance sheet, we ended the third quarter with cash and marketable securities of $566 million.

Accounts receivable stood at 269 million or a 63.5 days sales outstanding, down 3.5 days from the prior quarter.

We ended the quarter with inventory of 222 million or 5.1 turns, including the semiconductor test products up from 4.18 the prior quarter.

This improvement was largely a result of the inventory charge of 38.5, I mentioned earlier.

We spend 15.6 on capital in the quarter, net of sales of related capital equipment.

This was driven by continuing customer evaluations of our FLEX products and depreciation was 29.8 million in the quarter.

Looking ahead in the fourth quarter, as a reminder, first, our guidance includes Connection Systems below the line and discontinued operations.

As such, our revenue, costs to consult, R&D, SG&A and EPS from continuing operations all exclude Connection Systems.

Also, to further complicate matters, our tax line, as required by GAAP, benefits the 2005 loss in our continuing operations with a portion of the NOL actually used as a result of the sale of Connection Systems.

So instead of reporting the actual tax on the sale of Connection Systems, which is approximately $6.1 million, we expect to report a much larger number by grossing up taxes between continuing and discontinuing.

This is a one-quarter issue only, and our pro forma exhibits should help you understand this better.

Now back to providing fourth quarter guidance.

We expect sales to be between 330 and 350 million with net income from continuing operations per share between $0.42 and $0.45 per share.

This includes or assumes the 45 million tax benefit or $0.23 per share from the anticipated closing of the Connections Systems divestiture in the fourth quarter.

That amount is offset by a small amount for taxes in the core business of 4.5 million.

This guidance also includes the anticipated sale from a building that we hold that is subject to a purchase of a sale agreement.

That gains about $10 million, and then there's other smaller items that go the other way, restructuring related charges in connection with our break-even reduction plan, and that net -- this catagory of restructuring and others down to about $6 million or $0.03 in income.

We expect gross margins in the fourth quarter to run between 45 and 46%.

R&D should run between 15 and 16%, while SG&A should run between 17 and 18%.

Now, moving to discontinued operations.

In the fourth quarter, we expect income from discontinued operations of $0.54 to $0.56 per share.

Now, this consists of the gain on the sale of Connection Systems, which is $0.57 to $0.59.

That's offset to a lesser extent by a loss from the operations of Connection Systems for the first two months of the quarter of $0.03.

Our balance sheet guidance also excludes Connection Systems as we expect to close the transaction before the end the fourth quarter.

We expect our inventory turns to remain flat at about five turns and our accounts receivable day sales outstanding to be at about 66 days or up 2 days.

Depreciation should be around 24 million.

We expect to end the quarter with cash and marketable securities of at least 950 million, including the net proceeds from the sale of Connection Systems, which adds 370 million in cash net or related direct costs.

Let me try to summarize because there's a lot here and it's quite complex and it's hard to take it all in.

We tried to provide information on our website and our release to try to get you better prepared.

First, the key points I would make are, first, Teradyne is on track against our improved break-even sizing plan.

Second, the impact of Connection Systems divesture is quite small in an EPS sense.

The core test businesses are expected to be in double-digit profit rate territory in the fourth quarter.

Finally, our balance sheet will have us positioned much stronger and more flexible to grow in our core test businesses.

Now I'll turn it back to Tom.

Thanks, Greg.

Dennis, we'd now like to open the discussion for questions.

Your first question comes from the line of Tom Diffely with Merrill Lynch.

Good morning.

I was hoping you could tell us a little bit more about the utilization rates for the SemiTest business.

Sure, Tom.

This is mike.

We talked last quarter with the utilization rates inching up across the board, IDM and subcontractors utilization rates are moving on.

That continues on.

It's gradual.

You do see spikes in the utilization rates on a month-to-month base.

They've continued to trend up.

A couple of quarters ago, we described there was a delta of about 15 points of utilization with IDMs higher than subcons by about 15%.

That has continued to close.

That may be within -- our numbers say that's within 5% at this point, and they're both around the 80% level.

Okay.

The recent pickup in business, is the pricing environment easing at all, or is it still pretty touch out there?

What I'd say about pricing is that the pricing environment has been consistent and it's an aggressive pricing environment around new competitive orders.

That has been a consistent trend back all the way back through the last cycle in '04.

There's nothing new on that front.

The pricing visibility is muted some as our customers turn also towards urgent demand requirements.

It doesn't mean the pricing pressure has reduced.

It just means that the lead time subject comes more into the foreground.

So I'd say it's pretty consistent environment on the pricing front.

Then, finally, in regards to the subcons, do you expect them to be around the 40% level again in the fourth quarter?

We think so.

Our outlook is that the subcons have as -- as we said earlier.

The subcons were south of 20% in the second quarter.

They've grown dramatically so that as our bookings have grown, at the same time the subcons -- the subcon total is now about 40% of the total.

In our past upcycle of '04, that got as high as 50%.

We think it will stay in the same range as we've seen in the second quarter. 40% would not be a bad estimate.

Again, it's pretty hard to be precise in forecasting, especially in the lead time environment we have.

I think it's a fair enough number.

Okay.

Thank you.

Your next question comes from the line of David Duley with Merriman.

Yes.

Congratulations on a nice quarter by the way, and thank you for providing the additional details.

It's most helpful.

Can you just, really quickly, the break-even of the core business now, will that go down again in the first quarter from what you targeted exiting the fourth quarter?

And are there -- with what I guess further reductions still to come in the headcounts that you're lowering, can gross margins increase early next year if volumes continue to grow?

Okay.

This is Greg.

I'll take that.

The target we have of 260, yes, it will come down somewhat.

There are some other actions that will occur and will continue to occur in terms of always working the break-even side of the costs structure of the Company.

We've never done with that, and there's more of that that will be done in Q1.

We're not talking about any large step changes.

This is more fine tuning as where we're going to find ourselves for the near-term release.

The gross margin -- the other part of the question -- yes, it would improve with volume.

If I can answer it this way.

We would expect that for every $25 million in sales increase, we get 1 point added to our gross margin, up to $400 million of quarterly revenue, and then once you get over 400 million for every 25 million of sales growth, you'd get a half a point.

So there's still plenty of room to grow gross margins with higher volumes.

David, we don't have a headcount reduction plan going forward that's any different from what we have announced previously.

We have a lot of employees who listen on these calls, and I just want to be sure we're not talking about anything significant on headcount reductions as we enter the new year.

To clarify I just meant the ones that were already in place and how those will impact the cost structure going forward.

Can you give us an idea of what sort of cash generation you might expect in the fourth quarter and you know just talk, you know, at an upper level about the order rate in the fourth quarter?

Why don't I do the order rate first, and then Greg can talk about cash flow.

Obviously, we don't forecast our orders, and that's a reality that we've always been faced with, which is because it's quite difficult to forecast, especially in a demand environment as volatile as we have.

In addition, lead times of our manufacturing cycles are shorter, so the horizon of visibility is truly coming in rather than going out.

Now, the subcontract -- there was a question last quarter as to whether the subcontract test companies were going to come in gradually or come in a rush.

They've obviously come in with more velocity than you would -- they've come in with some velocity this past quarter.

To go from 20 to 40%.

That's a substantial uptick.

It's difficult to forecast what either the IDMs or subcons are going to do.

We're encouraged because the -- if you took the top 20 FLEX customers that we have, 17 of those 20 customers bought for capacity this past quarter.

We think that will continue.

We think there's a broad demand for FLEX.

It's not isolated to any particular pocket.

So we're reasonably optimistic about the demand environment because of the breadth that we're seeing with the FLEX.

Based on cash this quarter, neighborhood of probably 50 million from the operations of the core business and about 370 from the sale of Connection Systems.

Thank you.

Again, congratulations.

Your next question comes from the line of Timothy Arcuri with Citigroup.

Hi.

I had several things.

Number one, I'm just trying to size what the game market opportunity is here for you.

Can you provide us maybe some factors to help us size what that market opportunities is?

I think in the past, you've mentioned that the total opportunities may be 200 to 250 systems.

I wonder, A, if that's still the right size that you're thinking, and, B, if that's true it seems we're maybe 20% of the way through that total opportunity.

Is that the right way to think about it?

I think your second point is -- the number he may not be right, but we're at the early phase of the next generation of gaming systems and the tooling for those.

As you know, not all of the new products are on the market or even have been announced in the consumer space.

So there is tooling that is underway, which is fairly described as the front end of that tooling.

Now, the reason it's hard to estimate the total market is because the testers are typically not dedicated testers.

They get configured for an initial application and then reconfigured for a variety of other purposes, number one.

Number two, the subcontract test space is beginning to participate in the gaming market, tooling.

That segment of our customer base is much more focused on the versatility of the product.

So as you see the demand from subcons related to gaming, it is a mix of demand between gaming configurations and other consumer audio/video applications.

It's very difficult to precisely size that, but clearly, the end demand on the gaming, it would be a fair estimate to say it's greater than $100 million in equipment over the next year.

Well, how about this, then?

Maybe how many devices -- have you thought about it in terms of how many devices could be tested on, say, a FLEX annually per year?

If you take an average CPU for a game device, how many devices could be tested in a year if it was totally dedicated to that application?

Or is that too tough to even answer?

It doesn't really give you a good answer.

The best way of getting at the overall demand is to look at the CapEx rate or the Buy rate.

In truth that has trended down.

That's a sub-2% buy rate at this point.

It's been operating during this year at under 2% even with the uptick in the third quarter, it's still under 2%.

We're close to 2%, but under 2% level.

We've done all of the math that you've described.

It doesn't answer the question, though, because of the versatility of the products.

I guess, last thing for me.

Am I looking at this properly, that your subcon business was about, say, 40 million, your subcon orders last quarter were 40 million, your subcon quarters were about 100 million.

So if you look at the uptick in SemiTest orders, it was almost all subcon.

Is that correct?

So the rest is basically flattish?

Little bit of growth, very small growth.

You're right in IDMs which have been driving our growth over the last three quarters, and those stayed just flat to slightly up.

You're right, the big drive came from the subcon space.

Maybe one more quick one.

Your guidance seems to imply since you're guiding revenue higher than what orders were, your guidance implies that bookings will be up sequentially in December.

Am I not looking at that right?

We've had a positive book-to-bill for three quarters now in SemiTest.

So it's a convergence of a few things.

The breadth of sockets and applications and the end-market philosophy in new products would be one plus factor.

A positive book-to-bit would be a plus factor.

The pull-ins that we've seen and the urgency around delivers would be a plus factor.

As you put the scale of optimism and pessimism, there's more on the optimistic side, the positive side of the equation now and that's what's behind our numbers.

Great.

Thanks.

Your next questions comes from the line of John Pitzer with CSFB.

Good morning, guys.

A couple of questions.

Mike, you talked a little about the use of cash.

I'm just kind of curious, if you could be a little more specific?

What's the plan relative to the debt on the balance sheet?

You talked about sort of strategic areas of investment.

I'm wondering if that's just a euphonism for M&A and maybe on a high level you talk about your M&A strategy and what impact that might have on your cost-cutting programs that have been successful so far?

I've have a follow-up.

I'm going to let Greg in a minute talk about the medium term mechanics around the cash.

First of all, the divesture of TCS was a strategic move in terms of focusing the business on our core test arenas.

So it wasn't directly related to a cash strategy.

Your broader question is what's the strategic use of that asset long term?

Let me outline a little bit of how we're thinking about our mainstream businesses, SemiTest at the center, and our other test businesses around the core.

Our objective is to double-down in those areas and to both build a stronger core in our mainstream business System-on-a-Chip business, and then to explore and extend out into adjacencies, if those adjacencies provide us with the following characteristics.

One is, we have to be able to be profitable in the adjacency.

Number two, that means having some ability to get a lead position.

Three, they have to give us not just a defense of the core but a growth engine.

Four, and the most important, is that those investments have to be leveraged meaning they have been to be leveraged from the technology we have in our core businesses, or they have to be leveraged from the customers.

If we can find a way to get that leverage, we can -- that's where we'll put our investments.

Now, your question on M&A really is -- I think of it both ways.

In terms of what we might acquire, it has to fit those criteria.

Number two, if we have a business that isn't meeting those criteria, then we have to find a way to move that asset into the hands of someone that has a tighter fit to their core.

That was really fundamentally what was behind the TCS divesture, is that it's a mirror image of our growth strategy around our core in that it is -- it is more tightly connected to Anthauls (ph) core.

Those are the various ways that we're thinking about it.

We're obviously not -- wouldn't be talking publicly about anything on the M&A front until that -- until that developed.

Just relative to the debt, Greg --

John, in terms of the debt the game plan is to leave it outstanding.

The simple logic is we could invest in high-grade corporate securities earned 4.25%, and the interest rate on the debt is 3.75%.

So we can earn 50 basis-points on the $370 million or so of debt.

So that gives about $1.8 million of extra income, over the three quarters or four quarters, and also is a pre-payment penalty also, John, of 75 basis-points, which would be 2.8 million.

In total by simply leaving the cash in high-grade securities, we earn or avoid a pre-payment penalty totaling 4.6 million.

Just secondly, guys.

Mike, you talk a little bit about the statability here at these revenue run rates.

After a pretty normal downturn, the back end had a better than normal upturn to date.

We're about eight months into it. 160, 170% off the order bottom of the back end.

As you pointed out, the subcons came back at a velocity that was probably higher than most of us, as well as, it sounds like you guys were expecting.

I'm kind of curious help me on handicap, how much of this is seasonal strength around the Christmas build that we have to worry about as we move into the first quarter of next year?

That's the $64,000 question, John.

Let me say a few things.

First of all, as I said earlier, sustainability is not in the tea leaves of utilization, or it's not in the tea leaves of the short-term forecast.

Questions that we try to answer are "What's the breadth of the momentum?" and on that front, it's quite broad.

It mirrors some of the other upturns in the past in terms of it not being narrow based.

Specific to us, I think what I call the "quality of the sockets" that we've been able to penetrate over the last three to six months gives us some on the optimism about sustainability, because we try to look through to the end products and say will those consumer audio video gaming systems, will automotive electronics, all those drivers are strong in our lens today.

One other thing is that the -- I talked about the buy rate that's not overheated at this point.

The quarterly ship rate in the industry is sub the levels of three of the four quarters in 2004.

So, again, on a macrosense those are not high-temperature indicators.

Finally, while the subcon growth has been strong, it is -- for us it's about half the level that it was in the peak orders of demand in '04.

Now, granted those quarters overheated, but that's -- there's still some room between where we are today and even a more moderate growth apogee in the subcon space.

Mike, real quick, if I could sneak one last one in.

Clarification to an answer you gave to Tim Arcuri.

He mentioned whether or not up revenues in Q4 applies to upbooking.

You stated some about the fact that book-to-bill has been positive the last three quarters.Was the implication of that statement that revenues could be up, even if bookings are down?

Help me understand that.

Given the visibility we have with our customers, we've tried to band the range of revenue.

John, it's consistent with what we've done in the past.

We've put all of those factors in and say this band of revenue is where we think we will operate given what our visibility is today.

So I can't comment further on it outside of the discussion here about whether we think the macro-issues and relatively more positive.

They're relatively more positive, which is why we're reflecting the growth in revenue.

Great.

Thanks, guys.

Okay.

Thanks.

Your next questions comes from the line of James Cabelo with Goldman Sachs.

Good morning.

Thanks so much for the question.

Thanks for the good clarity on the different segments.

That was helpful.

Question on the competitive environment.

Can you comment on it a little bit relative to Advilant, which looked like it was merging or combining with another platform.

It looks like now they may be doing a public offering on their own.

There's been announcements from the open architecture consortium about incremental traction there.

Is that just noise, or is the competitive environment continuing to be very, very aggressive, even in the current demand pickup?

Thanks.

Yeah.

Let me make a few comments.

I don't want to spend too much time on the competitor.

So I'll try to give you what I think our picture is as we've gone through one more quarter here.

I don't think there's a big change, Jim, on the competitive environment front.

You have clearly a lot of players in the space.

The issues around earnings power and profitability still point towards the need for scale and market share.

That's our intent, is to keep pressing with the FLEX platform because it gives us the full energy of the Company behind a unified engineering program.

A number of other -- a number of our other competitors are in that same strategy, but this issue of scale we think is incredibly important for the earnings power of the business.

I think over time that is the constricting power in this space.

It's just unrelenting pressure to be able to sustain the R&D levels that are in the business now.

Many outsiders have looked and said, why can't this accelerate in consolidation versus the natural consolidation you get through market share shift?

The barrier in that concept continues to be that platform rationalization is a requirement in almost every combination that you look at.

By that, I mean, that our customers will immediately ask if we combine with a another company, what happens to the product road maps?

Since this heavy overlap, there has to be -- in order to get a leverage on the combination, there has to be some consolidation, if you will, or rationalization of the product road maps.

Nothing is different on that front.

I think those are the barriers, I think, those will be there going forward.

Agilance.

I don't want to comment on what Agilance is doing.

You've accurately characterized it.

I don't have anything to add on that front.

On the open architecture front, as you know, we have for a couple of years now been working with third-parties on open architecture initiatives around adding instrumentation.

We've announced some new instrumentation over the last three to six months.

Quick interesting characteristic there, is we're finding that third party are migrating in our direction because of elements like parallel test capability in the tester.

So an instrument provider who can bring something to the table in parallelism is attracted to the FLEX architecture.

That's one of the main third party initiatives that has occurred.

On the overall STC front, I don't think there's anything new there.

It's a consortium, as you know, working to establish standards.

The principal objective we have with open FLEX is consistent, and that is to increase the supply of third-party technology that will work inside the system.

That's all so helpful.

Thanks again.

Okay.

Thank you.

Your next questions coming from the line of Murali Abburi with J.P. Morgan.

Hi, thanks for taking my call.

I had a couple of questions.

If you look at the book-to-bill that came out yesterday.

It seems like the back-end bookings crossed the peak that they hit back in the second quarter of '04.

If I look at your SemiTest starters, they're about 30% below when they peaked out back then.

Do you think it's loss or can you talk about what you think is going on there?

Ali, thanks.

That's another question about sustainability and whether there's going to be a continued growth.

I think it's a fair question that all of the observers in the industry are asking.

Not to repeat myself, but the subcon piece of our business still has some growth potential.

Ali, the other issue is the breadth of applications, I think, is the strongest -- you know, the strongest force here that could continue to propel the bookings northward.

Again, the overall buy rate and the quarterly cumulative size of the market is still not -- it's approaching the $800 million level.

So it's only now moving towards the level that existed in a few of the quarters in 2004.

All right.

Maybe let me ask a question another way.

Would you say that your market share today at subcons is higher than it was a year back?

That is a -- we don't think about market share at subcons, because it isn't -- that doesn't mean that you can't try to do the mathematics on what the share is.

We've got a substantial position in the subcon market.

Our view of market share is a socket-oriented one or a specifier market share, where either Fabless (ph) or IDMs specify our platform onto the next generation of Silicon.

That drives growth into the subcon market and into a variety of subcons and it converges with other Silicon being driven.

Overall our subcon position is very strong.

As we try to measure our market share, we do that on a specifier basis more than we do on the subcon basis and obviously, we try to do in the over all market.

The over all market -- market share is -- we're in the middle of a period here of a year, so it's somewhat difficult to measure, number one.

Number two, this is has been an IDM-driven recovery so far through most of this year, certainly the first six months.

So I think we have to get to the end of the year before the subcons are fully on the playing field and where we can do a calculation of what the market share is, in total, or inside any of the segments.

All right.

Then one final question from me.

As I look at your gross margin guidance for the December quarter, it seems look you're looking at drop-through of 60%, which is along the lines of what you've done historically.

Given that you don't have a dilution anymore. (Indiscernible) the rates would be higher?

Am I missing something there?

The gross margin would be a little higher than the 60 you're looking at.

It would be close to her 68%.

I know we provide a bunch of schedules, so I'm not sure exactly what you're looking at, but we would see it closer to 68%.

Do you think that's sustainable going forward, closer to the 70% kind of number?

Going forward with SemiTests we would think that, and we think often that the BPIT drops through first, we're modeling 55% is our target going forward.

We think we can do better, but for now we're modeling 55%.

All right.

Thanks, guys.

Yes.

Your next question comes from the line of Edward White with Lehman Brothers.

Hi.

Couple of questions first.

Not to beat the sustainability question to death, but our analysis of the assembly and test semi data suggests there was probably a one-month spike in demand in orders in August but other than that it's been a pretty steady improvement in demand as in prior normal cycles.

Is that pretty much what you've seen in your business?

Despite -- our spike is traditionally at the back end of the quarter, so it's not an August spike as much as it is a September spike.

Okay.

But I don't read, you know, quarter overlay quarter over quarter over quarter, because it's a back-end loaded order scenario that we've always see with our customers, that's -- that's the tradition in the business, and so the other spikes that you're talking about are -- they're not reflected if you contoured those against our order rates.

Okay.

Second question is, how rapidly do you think the mix of your revenues will shift from Catalyst and Tiger to FLEX?

Clearly, it was enough so you changed -- wrote down some Tiger and Catalyst inventory.

As you look at it going forward, how rapidly do you think that transition will happen?

That's a very good question, and let me tell you how we think about it because at any point in time you're trying to look out over the horizon and estimate future demand when you look at the inventory position you have.

Let me put it in context.

Our Catalyst product has rounded numbers here, 1500 units in our customer-installed base.

Our other mainstream prior generation product, the J750 has about 17 or 1800 units in the installed base.

So through one lense -- as we said, that represents about 50% of our business.

So through one lense, you've got two very strong forces here.

That the installed base will continue to buy at some rate, because it is such a broad installed base of equipment.

At the same time, you have test development engineers who number in the thousands in our customers who are developing programs in the software systems that those products have.

So there's still momentum that we think will be strong on those products.

At the same time the FLEX product is now, as I said, hitting full stride and that is offering in some and in many applications increasing number of applications economic advantages around parallelism.

So it obviously has to have some effect on our prior generation products, because we're helping customers move to get the best price performance they can get.

So you put all those together and we say with that triangulation our best view today is that our customer demand will continue out into the future, and we sized our inventory to reflect that.

The other side of that question that you haven't asked is, can we support demand if the demand increases on the last generation products?

And the answer to that is, we have no problem in flexing or increasing the amount of output on Catalyst, Tiger, or J750 products.

Finally, is there anything to read into the quarterly sequential decline in bookings in Assembly Test?

Not from what we're seeing, no.

I thought you were talking about anything around -- let me comment on Assembly Test because it is -- remember, the business is inside assembly.

Board tests, in-circuit board tests, Diagnostic Solutions is automotive tests, as you know broadband tests, and then in our Assembly Test business.

Three of those four businesses are what we call program businesses.

They are not capacity buys as much as they are tied to specific programs in either model years for automotive electronics for the deployment of broadband technology or to military programs, aeronautics programs that are very much program-based.

We've always described that as a lumpy business.

It is a lumpy business in demand.

So sequential movement in assembly in that grouping of businesses is not what we look at.

The book-to-bill in those combined businesses has been, again, positive over the last three or four quarters and at the same time, we've been improving the financial performance of that.

So we're building those businesses around the underlying average demand and the sequential ups and downs are not -- you don't read significance into those.

Great.

Thank you.

Dennis, we'll take one more question.

Yes, sir.

Today's final questions comes from the line of Gary Sue with CIBC.

Thanks for taking my question.

Just a quick clarification.

Would it be accurate in saying order generation products if terms of orders actually grew significantly sequentially?

They grew somewhat from Q2 to Q3.

So we're up in our Catalyst, J750 and Tiger line.

Okay.

On the back of the prior question, if you look at order products sort of coming in and settling in at a more muted sort of level relative to your current order book for Q3, what kind of gross margins would be expect at that kind of product mix?

The gross margins on the established products -- the non-FLEX products tend to be rough math, probably about two points lower, and a lot of it depends upon how much is in one particular period and what are our fixed costs that we need to have in place.

Rough math, you could probably consider it is a 2-point penalty that we'd have on our gross margins with those products.

Those products, obviously, we have the inventory and we convert ti cash and satisfy many customers who need those testers.

So mentally I should be kind of thinking about 200 BIPs higher gross margin for your guidance of Q4, if order products were at a more normalized level?

That will take a long period of time for us to get to the established products at a very low level because there still is demand.

So I wouldn't want you to put that two points in until further out in time.

Okay.

Thank you.

We're going to have to close here.

Thanks.

Let me make a couple of quick closing comments.

Number one is, we're obviously encouraged by our progress on new products, both inside SemiTest with the FLEX and with some of the products that are driving and have been driving in our Assembly Test business over the year.

The FLEX, as I said earlier, is with 500-plus units it's hitting full stride.

We're very encouraged by the quality of the sockets that the Flex is being designed into.

And I think the other piece there is the unified product for us now really has all the resources of the semiconductor test organization behind it.

Number two, our focus on the long term in our core test businesses, that I believe will pay long-term dividends for us and tighter connectivity to our customers and long-term dividends to our shareholders.

And finally, I just want to re-enforce we are and continue to be committed to our costs and productivity goals, and I say that independent of what part of the cycle we're in.

Thank you everybody.

We'll talk to you next quarter.

Thank you.

This concludes today's Teradyne Incorporated third quarter 2005 earnings call.