A More Lucrative Chip Play

12/15/2008 11:09 am EST

Focus: STOCKS

George Putnam

Editor, The Turnaround Letter

George Putnam IV, editor of The Turnaround Letter, says one semiconductor-testing firm may be a good way to profit from the next upturn in chips.

Founded in 1960, Teradyne (NYSE: TER) is the leading maker of automated semiconductor testing equipment. It also produces testing equipment for circuit board assemblies, aerospace and defense instruments, and automotive systems.

The company’s results have been hurt by a worldwide slowdown in semiconductor production. Investors have reacted ferociously, driving the stock down from its 12-month high of $4.50 in May to its current level [around] $4.00.

Semiconductors are key building blocks for most electronic products. However, the semiconductor industry tends to go through wide cyclical swings, and the stocks of the chip makers can be very volatile. The current short-term prospects for the semiconductor industry are weak, and so many of the chip stocks are down hard.

Buying a testing company like Teradyne may be a better way to profit from the next upturn in the semiconductor markets. Drawing an analogy to the gold rush in the mid-19th century, the people who sold picks and shovels to the prospectors made a lot more money than most of the prospectors did—with a lot less risk.

Testing is a key element of semiconductor production, and so the testing equipment producers will prosper when the chip makers rebound. Teradyne has been the dominant player in the semiconductor testing market for many years. At the end of 2007, the company estimated its market share to be more than 35%, which was double that of its nearest competitor. During 2008, the company has further solidified its leadership position by acquiring two smaller competitors.

Teradyne has a seasoned management team and a strong balance sheet, both of which will help it weather the current industry downturn. Chief executive officer Michael Bradley has been with the company in various capacities since 1979. Most of his key lieutenants have almost as much industry experience, much of it at Teradyne.

Over the past couple of years, Teradyne has used a good deal of its excess cash to acquire competitors and buy back stock. However, the balance sheet remains very solid with little or no debt. And even though financial results have weakened, the company is still producing decent cash flow.

Many of Teradyne’s remaining competitors are not as well off. Teradyne could further boost its market position by buying more competitors—or just watching them go out of business.

We view Teradyne as a very solid company whose stock should soar when the semiconductor industry begins to rebound. We recommend buying Teradyne up to $6.

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