Undervalued by 34%, This Is One of the Best Stocks to Buy in Its Sector

Teradyne TER stock has been left behind in this year’s tech rally: Low smartphone demand and a downturn in the memory chip market have weighed down the company’s results. We think the shares are deeply undervalued and expect improving demand to act as a catalyst in 2024. Teradyne is among our analysts’ favorite 33 undervalued stocks for the fourth quarter and one of Morningstar chief U.S. market strategist Dave Sekera’s five cheap stocks to buy before interest rates fall.

Teradyne is a heavyweight supplier of automated test equipment for semiconductors, boasting market-leading capabilities that run the gamut of chips. It is one of two companies worldwide that can produce testers for the most cutting-edge semiconductors, thanks to robust engineering talent across hardware and software and a structural lead in organic investment. The company is a vital partner to chipmakers across the industry and has impressively strong relationships with Apple AAPL and Taiwan Semiconductor TSM. Teradyne’s market leadership exhibits itself in industry-leading margins, strong returns on invested capital, and top market share. Beyond its top-tier capabilities, we think Teradyne is a strong operator. It appears to have found a good balance between organic investment in development and profitability, and it is a good generator of free cash flow despite its capital intensity.

Key Morningstar Metrics for Teradyne

• Fair Value Estimate: $147
• Star Rating: 4 Stars
• Economic Moat Rating: Wide
• Uncertainty Rating: High

Economic Moat Rating

We assign Teradyne a wide economic moat rating based on a combination of intangible assets in semiconductor automated test equipment and switching costs created at chipmaking customers. We think its proficiency will enable the company to earn impressive returns on invested capital for the next 20 years. Teradyne’s test equipment is highly capital-intensive and serves a relatively concentrated number of chipmaking customers. In our opinion, the ability to design testing equipment for bleeding-edge chips is the biggest driver of Teradyne’s competitive advantage, representing intangible assets that we don’t think are easily replicable. In our view, Teradyne holds its position thanks to a hefty research and development budget that has led to its leading market share. We contend that its equipment also elicits switching costs. We view Teradyne’s installed base of expensive equipment across customers as sticky, especially given the software the company layers on top of its hardware, and think the addition of services augments Teradyne’s existing switching costs.

Read more about Teradyne’s moat rating.

Fair Value Estimate for Teradyne Stock

Our $147 fair value estimate implies a 2023 adjusted price/earnings ratio of 48 times and a 2023 enterprise value/sales ratio of 9 times. Both of these figures are off cyclically depressed sales and earnings. We project 8% compound annual sales growth through 2027, inclusive of a cyclical downturn in 2023. We expect the largest contributors to overall sales growth to be the semiconductor test segment and the industrial automation segment. We forecast GAAP gross margin will return to 60% as the chip market rebounds. We think Teradyne will keep up strong organic investment in terms of operating expenses, especially from investing to scale its robotics businesses. Still, we expect modest operating leverage as the industrial automation segment becomes more profitable. Overall, we forecast non-GAAP operating margin to reach the low 30s by 2027.

Read more about Teradyne’s fair value estimate.

Risk and Uncertainty

Teradyne faces uncertainty arising from the cyclical semiconductor market, which accounts for a majority of sales. In periods of lower demand, chipmakers could pull back their capital expenditures, lowering demand for Teradyne’s testers. We think customer concentration is a risk; the company’s five largest customers account for roughly 30% of sales. However, we don’t foresee a scenario where Teradyne would lose a whole customer in one fell swoop. We believe competition with rival Advantest ADTTF poses a risk, although we don’t expect either firm to exhibit irrational competitive behavior. Also, Teradyne’s entrance into the industrial automation market bears uncertainty.

Read more about Teradyne’s risk and uncertainty.

Teradyne Bulls Say

• We think Teradyne’s depth, breadth, and steep investment in chip testing capabilities form structural competitive advantages that would be extremely difficult to replicate.
• We expect immense growth out of Teradyne’s industrial automation segment. We expect the total addressable market to grow rapidly and for Teradyne to maintain its large market share with aggressive investment.
• Secular trends toward greater chip complexity, capacity expansion, and onshoring should be durable demand drivers for Teradyne.

Teradyne Bears Say

• We expect continued competition with Advantest to be a headwind to Teradyne’s growth and profitability.
• We are skeptical of the fit of the industrial automation segment into the business; management may be chasing growth that isn’t aligned with its core competencies.
• Teradyne’s customer concentration with Apple can lead to occasional swings in sales based on Apple’s order cadence, which can lead to volatile financial results.

This article was compiled by Susan Dziubinski and Sylvia Hauser.