泰瑞達 (TER) 2006 Q2 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Teradyne Incorporated second quarter 2006 earnings call.

All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS] I will now turn the call over to Mr. Tom Newman.

Please go ahead, sir.

Thank you, 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 our Chief Financial Officer, Greg Beecher.

Following our opening remarks, we'll provide you with details of our performance for the second quarter of 2006 as well as our outlook for the third quarter.

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

Teradyne's press release containing our most recent financial results was sent out by a business wire yesterday evening and is available on our web site or by calling Teradyne's corporate relations office at 617-422-2221.

This call is being simultaneously Webcast over our web site at www.teradyne.com.

A replay of this call will be provided on our site starting around 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 1810932.

Replays of both sources will be available through the third of August.

Investors should accept the contents of this call as the official guidance from the Company for the third quarter 2006 and beyond.

If at any time we communicate any material changes to this guidance, it is 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 I are authorized to supply company guidance.

The matters that we discuss today, other than historical information, include forward-looking statements relating to future financial performance and other performance expectations, statements as to inventory, bookings, backlog, orders, shipments, pricing, design ends and demand for our products, capital spending and other opinions of management.

Investors are cautioned that forward-looking statements are neither promises nor guarantees but involves risks and uncertainties that may cause actual results to differ materially from those projected in the forward-looking statements.

Some of those risks and uncertainties are detailed in our filings with the Securities and Exchange Commission, including but not limited to our form 10-K filed on March 14, 2006, and we incorporate here the discussion of those factors.

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

While Teradyne is under no obligation to update the forward-looking statements made today, any updates that we do make will be broadly disseminated and available over the web.

We want to make it clear to investors that our prepared remarks will be presented within the requirements of SEC regulation G regarding generally accepted accounting principals or GAAP.

Therefore, if we use any non-GAAP financial measures during the call, you will find the required presentation of and reconciliation to the most directly comparable GAAP financial measure on the Company's web site at www.teradyne.com by clicking on investors and then selecting the GAAP to non-GAAP reconciliation link.

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

First our CEO, Mike Bradley will review the state of of the Company in the industry as well as our financial performance for the second quarter of 2006.

He will also provide guidance for the third quarter, 2006.

Then our Vice President and CFO Greg Beecher will provide more details on our financial for Q2 and on our guidance for Q3.

We will then answer your questions.

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

Mike.

Thank you, Tom.

Morning, everybody.

We have very good second quarter with $392 million in sales, $0.40 per share of earnings on a GAAP basis and $0.31 per share on a non-GAAP basis.

Total bookings were up 11% with SemiTest up 3% and our System Level Test businesses up 56%.

We set a number of highest ever records in the quarter in a variety areas.

SemiTest bookings in Japan and Korea hit all-time highs.

We set another new record for FLEX orders in the quarter.

Our inventory turns have continued to improve and our net cash position is at its highest level ever, resulting in our board's approval of a stock buyback plan.

So we're very pleased with how our people are delivering on our business model.

Greg will flush this out for you in more detail in just a couple of minutes.

But before I expand on the second quarter, I want to get to the outlook for Q3 where we're guiding revenue in a range 20 to $50 million below our second quarter revenue level.

I'm sure this is a primary area of interest so let me describe what's behind our guidance.

First of all, we're coming off a period where early quarter demand was very strong.

First eight weeks of Q2 were exceptional as tooling increased in Asia and in our subcontract test accounts.

The final month of the quarter saw orders slacken, and that's continued into the beginning of this quarter.

So we're adjusting our ship rate to accommodate for this after seven quarters of sequential growth.

It's impossible to extrapolate monthly demand fluctuations, of course, but there's enough short-term evidence that there should be a pause in buying this quarter.

Now if we're wrong in demand surges later in the quarter, we'll be able to respond given our manufacturing cycle times and supply line responsiveness.

So I'm not worried about calling this wrong.

In fact, the macroarguments for continued strong demand in SemiTests are pretty compelling.

Fire rates are not overheated, subcons still have not bought at excessive levels, there've been very few pushouts and test utilization continues to run at peak levels.

But other indicators like capital tightening at some of our customers, caution in end-market consumer product growth, and economic worries all make our market less predictable.

So we think it's better to play this on the more cautious side.

The important point I'd make is that we're not losing sleep about calling these inflections perfectly.

Our variable cost structure and break even discipline are performing very well, and we don't have a massive inventory pipeline that will impact us if business turns down.

So our focus can be on customers, design ends, and product development rather than on hiring and firing as we ride the cycles.

So let me now turn back to what we accomplished in the second quarter and the momentum we're continuing to build with our test product portfolio.

Our SemiTest business had orders increased for the 7th quarter in a row, as I mentioned, by 3% this time.

FLEX unit orders set another record and we're now approaching 1,000 units ordered.

FLEX family accounted for about 60% of our SemiTest product bookings, up from about 50% last quarter.

Our J750 based products posted their second highest bookings level, continuing to represent between 25 and 30% of total SemiTest product bookings.

As I mentioned earlier, all-time order highs were recorded in Japan and Korea, where we had very strong demand for our image sensor, microcontroller and consumer SOC Test solution.

From a test segmentation point of view, orders were strong in RF, image sensors, base band, power management, automotive and consumer electronics.

These represented strength in end markets such as cell phones, digital cameras, automotive electronics, laptops, and audio video products.

Orders tilted more towards subcons this quarter as they grew from about 35% of total bookings last quarter to over 40% in Q2.

This represented about a 25% quarterly uptick in subcon bookings.

You'll recall that the 2004 cycle had subcons at much higher levels of buying in peak quarters, actually over 50% higher.

This speaks to my earlier comment about more orderly buying patterns this cycle.

On the utilization front, we continue to see consistently high utilization levels at both IDM and subcontract test customers.

These have been unchanged over about the last eight months and offer some evidence that there's been a far less of a build-it-and-they-will-come mentality this time around.

Our System Level Test businesses had a very strong order rebound in Q2 from seasonally weak Q1 levels and they achieved about 90% of their high order levels of Q4 2005.

We saw commercial print [indiscernible] circuit board test orders increase about 10% sequentially, driven by our best performance in Asia in many years.

Strong end markets for us were storage, servers, consumer digital, telecom and automotive.

Our Mil/Aero business also had a good bookings quarter driven by all sectors, factory system test, instrumentation and service.

The military programs behind the increases include the C17, the Joint Strike Fighter, BF22 and the F-16.

Our Diagnostic Solutions business saw orders more than double in the second quarter following a weak Q1.

Primary driver for the increase was our newest product, the Vehicle Measurement Module or VMM.

Demand for this product has exceeded expectations since introduction in Q4 of 2005.

VMM's ability to detect subtle faults inexpensively in complex automotive electronics should allow for a growing market for the product for many years to come.

So despite some caution for the short-term, the overall picture is strong.

We continue to have exceptional acceptance of our FLEX and J750 products.

Our System Level Test businesses are consistently contributing to the bottom line, and our cost discipline allows us to concentrate on issues more important than calling each turn in the market.

Let me now turn it over to Greg for a more detailed view of the financials.

Greg.

Thanks, Mike.

And good morning, everyone.

Before I dive into our financial performance and outlook, let me first summarize that our operating model in the second quarter delivered record gross margin percentage performance at comparable levels of revenue.

We also matched the highest ever cash generation from operations of $104 million that is after deducting capital additions.

Our balance sheet has never been stronger with net cash and marketable securities of $822 million.

That is after subtracting our outstanding convertible debt of $285 million.

Inventory turns are improving from about 100% from where they were in the past with our much leaner manufacturing and optimized outsourcing model and are also at record levels.

Our business model is much better equipped to hold profits over a full cycle as the inevitable drops in demand occur.

We are a much more focused and healthy company with strong design and momentum with both FLEX and J750 and SemiTest.

Now, let me take you through some of the details.

Our sales in the second quarter of 392 million were up 7.9% from the previous quarter and 73.2% above the level a year ago.

Our non-GAAP earnings per share for the second quarter totalled $0.31 per diluted share.

On a GAAP basis, we achieved $0.40 per diluted share.

Our non-GAAP results exclude gains from the sale of real estate offset to a much lesser expense by some employee severance charges.

A reconciliation of the GAAP to non-GAAP results is provided in our earnings release.

Our second quarter gross margin percentage of 49.3% of sales, up 2.3 percentage points from 47.0 in the prior quarter.

The prior gross margin percentage included $8 million charge, or 2.2 percentage points for excess nonFLEX inventory and SemiTest.

Our gross margin percentage in the second quarter reflects our highest gross margin percentage at this sales level in the history of the Company.

In fact, to find a higher gross margin percentage, you would have to go back to the fourth quarter of 2000, and that's when sales were 41% higher, clearly a very overheated buying bubble.

This performance reflects a much more responsive and leaner manufacturing model.

R&D expenses were 53.6(ph) million or 13.7% of sales.

As compared to 52.2 million or 14.4% of sales in the first quarter of 2000.

The dollar increase from a quarter ago was due entirely to higher variable compensation given the strong operating results.

SG&A expenses were 75.6 million or 19.3% of sales, as compared to 72.2 million, or 19.9% of sales in the first quarter.

This increase was also due to higher variable compensation in addition to a charge of 2.2 million related to a loss of spare parts in Taiwan due to a fire at a third party site.

We are attempting to fully recover this loss through our insurance, because as of yet cannot be certain that we will, hence the charge for now.

Restructuring and other was a net credit of 19.7 million for the quarter and has been detailed in our earnings release.

Our net interest income was 8.10 million, up from 6.1 in the prior quarter, due primarily to higher cash balances and higher interest rates.

Our income tax expense was 9.4 million in the second quarter, reflecting a tax rate of 10.2%.

This rate is about 3 points lower than what we would normally expect, given the real estate gain of about 21.7 million was taxed at only 2%.

Our quarter-ending head count was about 4400 people.

This includes 3900 regular employees.

Year-over-year our regular head count is down 11% from 4400 to 3900 while sales are up 73% from 226 million to 392 million.

We had the highest sales per employee since the third quarter of 2000 when sales were at 67% higher.

Second quarter SemiTest sales were 80% of the total, assembly test 11% and other tests 9%.

On a geographic basis, our second quarter sales in descending percentage order broke down as follows: U.S., 20.6%;

Southeast Asia, 19.6;

Europe, 15.8;

Taiwan, 12.1;

Singapore, 12.0;

Japan, 10.6;

Korea,8.4; the rest of the world, .9.

We had net books of 403.7 million in the quarter, on a quarter to quarter basis, our bookings were up 11%.

SemiTest was up 3%, assembly tests up 35% and other tests up 92%.

On a year-over-year basis, that is Q2 '05 to Q2 '06, total bookings were up 60%, SemiTest was up 77%, assembly tests down 3% and other tests up 62%.

Our book to bill ratios was 1.03 for the overall company and 1.01 for SemiTest, 1.14 for assembly test, and 1.08 for other tests.

At the end of the quarter, our backlog stood at 435 million, of which 86% is scheduled to ship within the next six months.

This compares to 423 million at the end of the first quarter of which 84% was scheduled to ship within the next six months.

On a geographic basis, our bookings for the quarter, again, in descending percentage order were distributed as follows: U.S. 25.2%;

Southeast Asia, 14.6;

Taiwan, 13.9;

Japan, 13.3;

Europe, 13.1;

Korea, 10.7;

Singapore, 7.7; rest of the world, 1.5.

Now, moving to the balance sheet.

We ended the quarter -- the second quarter with cash and marketable securities of $1.1 billion.

That's up 149 million from 966 million as of the end of the first quarter.

Capital additions, net of sales of related capital equipment were $15 million in the second quarter.

Therefore, our free cash flow or cash from operations net of capital additions of 104 million in the second quarter matches the all-time record for the Company.

Depreciation and amortization for the second quarter was 24 million, this includes 6.2 million of stock-based compensation.

Accounts receivable stood at $277 million, or 65 days sales outstanding, consistent with 65 days in the first quarter.

We ended the quarter with inventory of 112 million, that's down 4 million from the end of the first quarter.

This is also another new record in inventory turns for Teradyne.

In dollars, we have about 120 million more cash with this level of inventory turns than what we would have had had with our prior model.

Our much shorter final configuration and test cycle time from about 15 days with Catalyst and Tiger to about 60 hours or less with FLEX and J750, and what we call Supply Chain Express is what has enabled the record inventory turns.

With our very healthy balance sheet and much improved business model, we are able to buy back some of our common stock.

As noted in our release, we have received board approval to buy back $400 million of our stock over a two-year period.

In the third quarter of 2006, as Mike mentioned, we expect sales to be between 340 and 370 million with net income from diluted share from continuing operations of $0.17 to $0.24 on a GAAP basis.

We expect gross margins to run between 48 and 49%.

R&D should run between 14 and 15%, and SG&A should run between 21 and 22%.

SG&A will have higher costs in both the third and fourth quarter of 2006.

This is due to transition expenses from increased outsourcing of our IT and consolidation of real estate into our north-running campus.

Both of these transitional expenses will disappear in early 2007 and we expect to experience a slight reduction in our ongoing costs compared with levels prior to these transitions.

In addition, the real estate consolidation should also add another $45 million of cash.

We expect to hold flat in both inventory turns and accounts receivable days sales outstanding.

In addition, we expect to spend 33 million or less on capital.

This capital includes about $8 million for the fitup of our north running campus.

In the third quarter, our depreciation and amortization should be around 24 million, and that will include $6.3 million of stock-based comp.

Our tax rate is expected to be about 15% to 17% in the third quarter.

Now, a slowing of demand is inevitable in our business at some point, as many of you -- as many of you have been projecting.

The operating adjustments that we would make in a slowdown are minor compared to the level of actions that we would have taken with our prior model.

Simply said, we expect to continue to hold our quarterly operating break even about flat through an upturn and through a downturn, except for normal variations due to product mix and variable compensation.

You obviously can see how we've performed in the up cycle, as well as what we expect next quarter with the expected lessening of short-term demand.

However, the broader question for everyone in our space is what we look like over a full cycle, and what growth is needed to get to model profits?

First, let me update you on our model over a full cycle and this includes stock-based compensation in our model.

The model projects gross margins of 49%, R&D of 15%, and SG&A of 19%, and PBIT of 15%.

Well, how far are we from this performance?

Well, we estimate that in SemiTest, starting from our low 30% share level today, we need to add about about 3 to 5 points of SOC Test market share to get to the 15% PBIT on average.

This includes a number of what we believe are reasonable assumptions on market size and cost structure among other things that I'd be happy to discuss if there is greater interest.

In summary, we had record performance in gross margin percentages, at comparable levels of revenue and matched the highest free cash flow in our history.

Our new business model is clearly delivering both very attractive gross margins of 49.3% and strong net income at 16.2% on a non-GAAP basis and 21% on a GAAP basis in the second quarter.

Our balance sheet is the strongest it has ever been, giving us the opportunity to begin to lower our share count through a stock buyback.

We are sharply focused on growing market share through stong designing momentum with FLEX and the J750 product lines, while holding break even in [indiscernible].

This is a game plan that will play out over the next few years rather than the next few quarters and we are very excited about our growth opportunities.

Now I'll turn it back over to Tom.

Thanks, Greg.

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

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Timothy Arcuri with Citigroup.

Hi, guys, a couple of things.

First of all, Greg, can you go into what the models going to look like here during -- during the next few quarters in a downturn?

Can you maybe talk to what the margin structure looks like at say, $300 million and maybe another 250?

What it would generally look like, let's pick 300. 300, we would expect gross margins would look about 48%.

R&D would be about 17%, and SG&A would be about 22%.

Okay.

As a -- the rule of thumb, you probably should expect that the profit drop through on the way down should be similar to what it is on the way up, and you can use 50% as a conservative number that -- if you look at large chunks of revenue for Teradyne over periods of time, you'll generally see that 50% is about what you'll find.

Okay, can I just ask two more questions?

I guess, also, can you go through what the revenue and orders by division were again?

I'm sorry.

Let me go back.

Tim, could we do this offline.

We did it in the script, and I'd be happy to give it to you later.

But we're tying up a lot of people.

Fine.

Okay.

Last question.

If we assume that this is a cyclical peak and you look at this peak relative to the 2004 peak, it looks like SemiTest is going to be down, 5-10% from cycle to cycle.

If you look at [wafer fad] equipments so you look at front end, front end is up 10% roughly if not more, cycle to cycle, and chip units are up roughly 20%.

So is there an argument to be made here that because of a lot of structural factors that the SemiTests might not even be growing at all.

That the long-term might be negative actually?

Well, the comparison between the last -- it's Mike, Tim -- the last cycle, the '04 cycle and this one had some significant differences.

The major one being the over buying that occurred in the first half of '04.

So I think the comparison of peaks is, has to factor in that difference.

The growth rate in the market, as you know, is tied to both the semiconductor growth and the buy rate.

Our assumptions are is that the buy rate is around 2% and the market will grow at the rate of the semiconductor market.

Okay, so you think that the 2% buy rate has not changed?

No, it really hasn't.

It moves around, that number, obviously, on a quarterly basis, but over the last three years, it's been -- this will be the fourth year, if you average it all, it's been about 2%.

Okay, thanks.

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

Question about the market share gain that you'd need in SOC Test in order to get to the margin model.

You talked about 3 to 5 percentage points, but does it matter which segment of the SOC Test market.

Because, from what we hear out there, there are some segments that are going to be more profitable than other segments.

Does it depend on which market segments those would happen to be within SOC?

Ed, we don't think we would have our gains exclusively in one segment.

So in one sense, it doesn't matter.

The buy rates for equipment and the margins for equipment in segments is a little bit different, but it's not significant.

Obviously, the lower performance segments where there's more competition have higher margin pressure because of the number of competitors in the space.

Okay.

Second question is, looking at FLEX and the success it's had, can you sort of contrast how you're doing within the -- going up to the microFLEX and the UltraFLEX, within the FLEX family, where you're seeing the greatest interest?

What's the level of success?

And how is that comparing to what you would have thought you'd get?

Let me give you a profile of where we are.

Remember, FLEX came out first, microFLEX second, and UltraFLEX third.

And at this point in time we thought -- and I'm giving you a rough picture, we said we're over 900 units now.

About half of those units are the lead product of FLEX, the first product out of the chute.

And that's followed sequentially with microFLEX being second highest, and UltraFLEX third.

But the UltraFLEX, microFLEX are pretty close together, so if you said 50%, 25-25, you wouldn't be far off.

Okay.

Great, thank you.

Your next question comes from the line of Gary Hsueh with CIBC world markets.

Good execution and a great quarter for Q2.

Just want to kind of focus on the downside here.

In your comment about heading into inventory-driven downturn in late '04, the subcons buying at a 50% higher rate.

Now, if I assume subcons were roughly 30% of SemiTest, and I assume a 50% higher buying rate in this downturn, giving less excess capacity at your subcons, and I kind of roll in the last prior trough and other test, broadband test and assembly test, I get to a number of around 230 million versus the last downturn in March '05 where you guys hit 210 million.

Is that how you guys are thinking about it?

There's about $70 million of delta between the last peak and this peak in subcon business.

So for about 130, there'd be another 70 on that to get to 200.

Is that answering your question?

Ask it a different way.

Yes, no -- I'm just looking at the numbers here and kind of weaving in your commentary about subcons now being more rational and your implying that they're spending at a 50% kind of lower rate in terms of overcapacity.

And, if I looked --

I'm sorry, I don't mean to interrupt you.

But the -- for them to be equal to what they were spending in the last peak of the last cycle, it would have to be 50% higher.

So, 130-plus 70 is 50% higher.

The numerator and denominator are different in your calculation.

Okay.

I'm just looking at the trough in their spending.

I'm saying now that their trough in subcon spending in this downturn should be 50% higher.

And so I'm looking at a trough analysis.

Is that right, first of all, to assume that they'll be spending at roughly 50% higher levels in this trough compared to the last trough?

We don't know.

All we know is that the subcons have been much more orderly in the way in which they have bought in this cycle.

I think it's a different profile for that customer.

They are much more carefully operating with, and trying to maximize utilization.

So as things moves down and as -- if you had, for example, IDMs pulling back, I don't know exactly what the trough would be, obviously they would be impacted.

I don't really know if there's a way to measure it from the last trough, because the overshoot was so high that they just -- it took them about nine months to use up the excess capacity that they put in place in the first half of '04.

And so that -- the excess is what drove the reduced spending in that case.

And to say it might be 50% higher this time, I think, there's just no reference for it that I would make to the last trough spending level.

Okay, okay.

I get you. and my last question is basically, you guys talked about on the upside, one percentage point of gross margin for every $25 million in incremental revenue.

On the downside, you're saying that's going to be about the same?

Correct.

Okay.

All right, great.

Thank you.

Your next question comes from the line of Chris Blansett with J.P. Morgan.

Thanks for taking my call.

A couple of questions.

Did you actually specify the test utilization overall rate for the quarter?

And if you could give any color if there are any strengths or weaknesses from what you were seeing?

It has been a flat line, meaning, it's been very high utilization.

External numbers put that in the 90s, our numbers, we track a subset -- a large number of our individual pieces of equipment.

We've been talking on the conference call over the last year and a half.

So I'll use those same types of numbers.

We continue to see utilization very high and unchanged.

We've measured that in the mid- to high 80s for the IDMs, about 5% lower in the subcons, that has been unchanged, so we're mapping consistently along.

And then, kind of looking out on some of the way -- the way the subcons are spending.

They have been aggressively looking at getting into packaging memory products.

I wasn't sure how this plays into your strategy to use UltraFLEX for memory-related test applications.

I don't know if -- could you give some color on that?

I can't give any color on market segments that we're not in yet and our plans in that area.

Certainly, the UltraFLEX product has been architected so that it can be adapted and to move into adjacent markets.

So that would be in the future.

One last question.

Prior, you had given some numbers of how many J750s you booked during a quarter.

I think you had two quarters of over 100 system bookings.

If you can give, like, how are they this quarter?

What kind of similar levels?

Similar levels, second best quarter, 100 plus.

Okay, thank you very much.

Your next question comes from the line of John Pitzer with Credit Suisse.

Hello?

John?

I think this is Adam Pollan(ph).

A couple of things.

To allow your customers to configure and price their products more efficiently, what are you guys doing to streamline the selling process? [indiscernible] accuracy?

Adam, I did not get your question.

I'm sorry.

To allow your customers to configure and price their products more efficiently, what are you guys doing in the selling process to streamline your overall selling process or with just order and accuracy?

Got it.

This is Greg Beecher.

We're in the process of putting in some new processes and some oracle applications that will help us get prices to customers and configurations much, much faster using available tools today.

With some of our products, customers can do thir own configuration for some of the lower-end products, but we continue to currently invest in ways to get a commitment back to a customer in a very short period of time, whether it's hours versus some other period of time.

So we're in the midst of doing that, confronting it this year.

Probably [indiscernible] sometime early next year.

Adam, the biggest thing we did was to shorten the lead time of manufacturing.

Shorten the lead time on manufacturing?

Pardon me?

You said shorten the lead time on manufacturing?

Right.

As Greg said, we're into 60 hours on manufacturing in house cycle time.

And, lead times are in the 6-8 week time frame.

It's great you're addressing that issue.

What are the challenges you've been seeing in the marketplace to allow you to address those issues?

The challenges are around looking all the way up to our supply chain and eliminating any of the material bottleneck flows that keep us from moving very rapidly up and down capacity.

You see the inventory levels that we've got on the lead times reflect, we've got a very, very good picture of how to move our supply base both up and down.

I think, Adam, an overview would be, it starts with the design of the product and then you design your supply chain system around it.

Okay.

What's been the response from your dealer channel regarding challenging customer and market needs?

They been saying there's a lot of challenges out there that they're facing, what have they been telling you?

We don't have dealers, we sell direct.

So, we're working very tightly with customers directly.

And final question.

For the remainder of the year, what is the top initiative you'd like to accomplish?

Over the cycle, profitability.

Thank you very much.

Thanks.

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

A couple of questions.

Could you give us a comment on how you think your game console business is doing?

And then what size are you using for the SOC market and your market share assumptions?

And then finally, which, probably talks a little bit more pontification is, do you think we're in a downturn?

And, does -- when we're guiding down in revenues with our orders up, typically investors when they see a down quarter, think there are going to be several more.

So, maybe give us some commentaries on how it feels this time?

In reverse order, are we in a downturn, we are certainly in a pause.

Our customers are much more cautious at this point.

Digestion is a word that we hear a lot.

Short-term, you see some customers holding on capital.

A few weeks later opening up.

So, it's very, very volatile at this point.

I don't think there's any question that a pause has been predicted outside for quite some time.

We're seeing that pause.

There is some evidence that the pause would be less severe or the downturn would be less severe.

That's related to the things we talked to before, subcon, buy rates and so on.

But I don't -- we wouldn't be guiding down from our prior quarter guidance if we didn't feel that short-term pause underway.

On the size of the market, we think the overall size of the SOC market this year would be somewhere around 3.5 billion, plus or minus.

That would track with the buy rate I talked about a little bit earlier.

I think that number would be -- we use that for planning purposes right now as we look at the completion of '06.

Game console business, as you know, is a piece of market share gain over the last year, year and a half.

There's no segment, individual segment that drives our business heavily.

We're all -- various segment that we're in are all under 10% of our business.

Somewhat agnostic on the subject of the winners and losers in the game console end market since we're supplying to all of those companies, and we're all hoping that the game consoles take off, because it will help our business, but at this point it's not a big piece -- we're not assuming heavy growth in the second half of the year on that.

We'll have to wait and see what the consumers do.

Final thing for me is, why were the Japanese -- why was the Japanese business at record levels?

Good question.

In the past -- if you looked at our business in Japan two years ago, you would see a profile that was dominated by an image sensor business, cell phone, digital camera, digital technology.

And that was a, really a single horse in the Japan market for us.

That was the 750-based solution.

Really a niche product, if you think about it in terms of a narrower scope.

We've expanded in Japan over the last year on two other areas.

The first would be in microcontrollers.

That again is a very economic-driven plus sensitive market, high parallel test market and the J750 has made in-roads in Japan in share in that segment.

And then, the third piece is the FLEX and UltraFLEX has gained a position now in Japan on some very high performance SOC segments.

So we've got three engines going now versus the one we had a couple of years ago.

Thank you.

Your next question comes from the line of Mehdi Hosseini with FBR.

Thank you.

Couple of questions.

If you could help me understand the margin profile for different business group tests system and other and how is the margin profile going to change going into Q3 with the lower revenues?

And then, if you could help us understand the trend in bookings so far in Q3, are we looking at subcon cutting significantly so that your overall SemiTest booking will be down substantially?

If you could add any color that will help us understand the trend.

Thank you.

I'll start with the gross margin question.

The gross margin should go down sightly consistent with the model we provided in the past depending upon levels of revenue, how the margin would go down.

And you look at our mix of businesses, SemiTest has a higher gross margin than our other businesses.

SemiTest gross margin right now would be above 50%.

The other businesses are lower, therefore, we average down to about this 49.3.

So as we go down and we lose SemiTest business that's higher margin business.

And that is consistent, generally speaking, with our model of every $25 million of margin movement, you generally lose a point of gross margin percent.

Mehdi, on the trend in bookings, we don't give guidance, as you know, on the coming quarter.

I did say that our early quarter bookings looked like our end of quarter Q2 bookings.

Which was that we had a very strong first two months of the second quarter and that then tailed off.

So in the very short-term, we're seeing this pause that I've commented upon.

Now, the subcon segment, in my view, is unlikely to be the hard-on hard-off market that it's been in the past because of the way in which they have bought on the way up.

So I'm not predicting a total shutdown in the subcon segment.

Would it be fair to say that given your exposure to some of the game console and the PC chips that that may also have a hangover, so until we see a recovery in the PC systems, you wouldn't see subcons coming back more aggressively?

Actually, we have a smaller position in PC chip sets.

So what happens there in terms of up and down it doesn't impact us as much as if you were into storage or wireless applications.

So on that front, there's less impact.

And the game console exposure, as you described, is also a -- it's a fractional piece of our business.

If I may just ask one more?

You talked about the bookings strength for FLEX and J750.

Does that mean the catalyst was down substantially?

Catalyst Tiger business is trailing off.

We continue to have both system buys and instrumentation buys on it, but the trend line is down first quarter to second quarter and we expect that to continue to trail off.

Remember, there's a 1700 to 1800-unit catalyst installed base, so we still -- we continue to see business there and would expect to see some.

But that's clearly a smaller piece.

When you said trading up, are you talking about 20 -- down 20%, 30%, 50%?

Let's see.

Let me go back to the math I had mentioned earlier.

The FLEX demand was about 60%.

The J750 and the image sensor product that's built off the 750 is somewhere between 20 and 30%.

So the remainder of the system business would be in the catalyst side.

So you can quickly do the math and see it's a 10-15% piece of business.

Your next question comes from the line of John Pitzer with Credit Suisse.

It's actually Brian [indiscernible] for John Pitzer.

Can you guys hear me?

Yes.

Just quickly to follow up on that last point, I thought you said 70% of SemiTest orders were FLEX, so that number is actually 60 60%, is that correct?

Correct.

Which is still kind of a big jump up from 50% of the prior quarter?

Right.

And that's order?

Orders, yes.

Orders and -- order dollars not units?

Order dollars, correct.

So there probably will be some sort of a gross margin benefit, 10 percentage points in terms of the concentration shipped in FLEX, a little bit of flow through through the gross margin line, can you sort of quantify what that will be?

As those get taken into the revenue line?

Sure.

The impact at this point is pretty much a fractional point.

We're down maybe to a half a point.

We said sometime back in 2004 that we expected to get two points and essentially we have about a point and a half and that has gotten us in part to the margins we have today, which are consistent with our gross margin models.

The other thing that did happen over that period of time, we were able to improve our catalyst cost structure and our catalyst pricing, so we got some help from where we did not expect it.

But, right now, there's probably a half a point left to go and a half a point is not a lot, up and to this point.

Okay.

Just quickly in terms of catalyst, are you continuing to manufacture any catalyst, or are these all out of inventory and was that the case earlier in the year?

No, we manufacture them.

We manufacture them, take orders.

Still a high need in certain segments for the product.

Okay.

In terms of -- Intel last night talked about how -- they referenced efficiencies in their back end on their conference call last night allowing them their reduced CapEx.

Subcons have maybe been more rational in their spending and has held fairly high utilization rates while growing the business.

Is there some, maybe level or layer of efficiencies that still are sort of to be had and maybe are sort of meeting CapEx or they're spending behavior in the third quarter?

Well, the subcons that are a substantial part of the market now are -- their financial models depend upon utilization, so they have tremendous efficiency improvements that have been made.

So you can say that that's -- the amount that's left on the table there, in terms of what can be done at the subcon level has to be decreasing.

But I think all of the segments, whether it's IDM, or subcontract tests, have made tremendous gains on efficiency.

That's reflected in the fact they've been able to keep their CapEx rates down around the 2% level at the same time that the complexity of devices is moving up.

So we've been helping, right?

We've had much more parallel test solutions, the overall market has offered a lot of different capabilities there to improve utilization as have we.

But the 2% rate now is a what our customers are buying at and I expect that'll continue.

Okay.

And just, I know maybe historical patterns don't necessarily hold up for the subcons anymore, but isn't the typical buying behavior is that they typically don't spend of much in 4Q relative to the rest of the year?

That wouldn't be reflected.

It's much more the macrobusiness cycle than it is the seasonality cycle that I think all of the segments operate to.

Okay.

And just one very last question.

Someone asked about the gaming console exposure that you have.

It kind of sounds like you're not anticipating much growth, I guess it was heavy growth there, in terms of the third quarter, fourth quarter, but is that a little bit of a moderation, I guess, than from what you were commenting on earlier in the year?

No, I think I've been saying the same thing, that the gaming consoles are a small piece and we'll be much more tied to the overall market demand for that, which is very uncertain.

But we're less tied to the winners and loser -- we're less concerned about the winners and losers.

Thank you.

Your next question comes from the line of Tom Diffely.

Good morning.

I'd like to dig a little deeper into the third quarter pause.

Are you seeing equal weakness with the IDMs or is it really just an o-stat(ph) driven phenomenon right now?

It's across the board.

Okay.

If you look at the SOC market, is the importance of testing embedded flash driving orders and wins today, or is it kind of a similar situation to where it's been in the past?

It seems like we've added a lot of embedded flash over the last couple of years and that could be a driver.

It has been a driver and we've got capability in that area.

So that's not a new phenomenon.

The newer phenomenon is these system in a package stacked dyes(ph), where you need very, very capable equipment that can test all of the modules in the system and package.

That's a bigger, more current trend.

Okay.

And, finally, just in terms of the share buyback, does that change your plans as far as retiring the outstanding convert?

No, it doesn't.

The outstanding convert, if we like the price, we will buy it back.

And if we don't like the price, we'll be buying the common stock, or maybe both.

Thank you.

Your next question comes from the line of Mark Fitzgerald with Banc of America.

I was curious if when you look at the marketplace if the memory side of the business is starting to take up a bigger piece of the overall test pie, and if that causes you any interest in looking at that part of the market more aggressively?

Mark, the memory overall -- the market size on memory is about half the size -- a little bit less than half the size of the system on a chip business.

So it's not growing larger as a piece of the pie.

It clearly is an adjacent market as technologies on devices merge.

So, what we explore is, is there some way to leverage our currently capability into the memory segment?

So there's no interest going back in the DRAM market or?

No, I haven't commented on whether there's interest or not.

The issue would be, can we get leverage in our engineering so that we could bring a product or products to market there, and would we be able to get differentiation against the changing technologies and the memory devices.

That's the way we look at it.

There may be opportunities that occur in the future where we'll be able to do that.

Okay, thank you.

Your next question comes there from the line of Robert Drytsis(ph) with Bear Stearns.

Couple things.

I'm not an expert on this like a lot of the other questioners, but it seems to me like the orders are pretty lumpy.

Like you exceeded last quarter's guidance by a significant amount.

Do you think that there was -- and you've done this in the past.

You've had some -- you've beaten your prior guidance, so is there -- I mean, do the orders are somewhat lumpy, therefore it's not really crazy, it was the pause, it's just basically lot of guys making sure they had the stuff, and then go through a couple of quarters and then it comes back.

Can you explain that?

Well, Robert, you should stay on the line and talk to some of these other guys, because you'll get an earful on the history.

As far as lumpiness goes, the history has been that when you get these turning points, it drops dramatically.

That's what everyone would tell you.

And, the question is whether if we're at a turning point whether it will drop dramatically.

And I think you've heard pieces of the debate, both sides of the argument.

There is no question that, in past cycles the demand has been much more spiky in the SemiTest space.

And there is some evidence that is less so now as you have managing utilization a much heavier driver versus building capacity for tests and trying to get business attracted to it.

So that's the big question as to how steep the inclines will be?

Our point is --

Okay, the second question -- [MULTIPLE SPEAKERS] The second question I have, which this I can do, you have over $800 million net cash.

You're going to buy back $400 million.

Your stock is trading down a buck, it's $11.00 or $11.50 or whatever.

So how aggressive are you going to be?

That will tell me what you guys think of it.

If you're wimps and don't buy back stock, that tells me you're nervous.

And, if you're aggressive, that tells me you're good, you feel so.

So can you give me a flavor on how you proceed the buyback will occur?

Like if you'll be ready buy in about three days, I think that's what it usually goes.

So how you going to look at this?

First of all, I don't think I'm a wimp, but we would buy back, at this price it's attractive to us and we would tend to be more aggressive at this price.

So we'll make judgments along the way but it looks very attractive to us.

All right.

That's what I wanted to hear.

I didn't accuse you of being a wimp, I said you could be. [Laughter]

It's okay, Bob, we didn't take it personally, don't worry.

Thanks, Tommy.

Your next question is from the line of Patrick Ho with Stifel.

Thanks a lot and nice quarter.

In terms of the slowdown or the pause that you mentioned over the past month and into early this quarter, are there any specific chip applications where you're seeing more of this pause or is it generally across the board?

There's not a standout.

Again, there's so many segments we're in, there's nothing that is standing out.

We had a very, very strong wireless quarter.

So because that was so strong, we could see declines there because that was the strongest quarter -- the strongest segment that we had last quarter.

But it's -- it's a bit early.

And remember, the visibility we get from our customers is really, really quite spotty.

And our move here to position ourselves down in our guidance range really gives us the ability to either move up or down based upon what does happen.

In the short-term, we're seeing across the board hesitation and a slower capital cycle approval process.

Okay, fair enough.

In terms of the expenses that are going to be -- I guess the higher SG&A expenses over the next two quarters, should we expect, I guess, a sharp fall off as we enter into early 2007 once some of these transition expenses are done over the next two quarters?

Yes, you should.

Okay, great.

Thanks a lot.

Your next question comes from the line of Jim Covello with Goldman Sachs.

Good morning, buys, thanks so much.

Most of my questions have been answered so I'll ask kind of a big picture question which is;

After having gone through a full upturn now with the new business model where you were a lot more profitable, does it change your mind set at all relative to the, kind of M&A landscape in the industry?

Certainly, a lot of folks would agree that, academically, it would make a lot of sense for some consolidation in the industry of for you guys to drive it.

It's a lot tougher in practice, but has this kind of upturn and now the beginning of the downturn caused you to think any differently about how much you might stretch to want to try to consolidate the industry given everything you're seeing?

Thanks.

Jim, it really does not change our view.

I'd characterize our view as, we would engage in M&A activity to the extent that we could leverage our core business and build and expand on that core, complement our products with extensions of technology.

And I'd contrast that with a strategy of diversification.

So, that would be point one.

Point two may be the most important point with regard to your question.

That is if we would have a criteria of an acquisition being complementary, not being an overlap, so consolidation in the space is hard to do without an overlap consequence.

And thirdly, anything we would do in terms of acquisition would have to move us into attractive profit pools.

There are adjacentsies to the market there are not very attractive in terms of profitability available.

There's -- if I could ask you a quick follow up on that, I mean, there's no question that any acquisition or M&A activity in your closest space would drive overlap.

But, I guess the question is, would the removal of some of the excess suppliers in the industry create a much more profitable environment for the industry as a whole?

I mean, do you think that would be the case or do you think you guys driving M&A activity in this space would just sort of make the environment better for the second or third tier providers and not really change the environment that much for you guys?

This is Greg.

I think it's possible it could make it better but the company that is generous and is the acquirer, it would likely not make it better for them.

They would be doing a great service to the other test companies.

So, I think there would be a lot of pain and hemorrhage to the acquiring company.

And after that, yes, maybe the other providers are in a better shape.

And final question for me on this, and then I'll go away, isn't there -- I certainly agree with that analysis, but isn't there stock prices in the industry at which that the pain is going to be worth what you're paying?

So, obviously, you're going to suffer some pain, but if you don't have to pay that much, and the stocks are already down, your competitor's stocks are already down very significantly, there's a price at which it might make some sense to endure whatever pain you would to have to from relative to the price you would pay.

The only flap coming on that one is, that I presume your assuming you'd keep all the customers.

You may not keep all the customers if you change the road map.

So, it's a high-risk proposition.

But it's not religious, meaning, if the price was low enough, absolutely, the answer has to be yest to that.

But, we don't see the prices that low.

Thanks so much.

We've run over our time.

Mike, do you have any closing comments?

Well, obviously, we're seeing a period here where the market has been tremendously strong for many, many quarters in a row.

Our message, of course, is that there's some caution that's being shown in the market outside.

I'd just reiterate two points.

First is that through this upturn, the FLEX has been the lead product for us.

The J750 as a complementary software-based product.

Those our are two horses for the future in SemiTest and their momentum is very, very strong.

And finally, our commitment here to our business model is unflagging.

We're going to see it exercised, we intend to keep the same discipline in that business model going forward.

Thanks for your interest, we'll talk to you next quarter.

Ladies and gentlemen, this does conclude the Teradyne Incorporated second quarter 2006 earnings call, you may now disconnect.