Teradyne - 10-Q quarterly report FY

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

OR

Commission File No. 1-6462

TERADYNE, INC.

(Exact name of registrant as specified in its charter)

617-482-2700

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes  x  No  ¨

The number of shares outstanding of the registrant’s only class of Common Stock as of April 25, 2003 was 184,939,144 shares.

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TERADYNE, INC.

INDEX

PART I. FINANCIAL INFORMATION

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TERADYNE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes, together with the Notes to Consolidated Financial Statements included in Teradyne’s Annual Report on Form 10-K for the year ended December 31, 2002 are an integral part of the condensed consolidated financial statements.

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TERADYNE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes, together with the Notes to Consolidated Financial Statements included in Teradyne’s Annual Report on Form 10-K for the year ended December 31, 2002 are an integral part of the condensed consolidated financial statements.

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TERADYNE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes, together with the Notes to Consolidated Financial Statements included in Teradyne’s Annual Report on Form 10-K for the year ended December 31, 2002 are an integral part of the condensed consolidated financial statements.

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TERADYNE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A. The Company

Teradyne, Inc. is the world’s largest supplier of automatic test equipment, a leading provider of high performance interconnection systems and an emerging provider of electronic manufacturing services.

Teradyne’s automatic test equipment products include systems that:

Teradyne’s interconnection systems products and services (“Connection Systems”) include:

Broadband Test Systems and Diagnostic Solutions have been combined into “Other Test Systems” for purposes of disclosing Teradyne’s reportable segments.

B. Accounting Policies

Basis of Presentation

The condensed consolidated interim financial statements include the accounts of Teradyne and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain prior years’ amounts were reclassified to conform to the current year presentation. The year-end condensed consolidated balance sheet data were derived from audited financial statements, but do not include all disclosures required by generally accepted accounting principles.

Preparation of Financial Statements

The accompanying condensed consolidated interim financial statements are unaudited. However, in the opinion of management, all adjustments (consisting only of normal recurring accrual entries) necessary for a fair statement of the results for the interim periods have been made. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates.

Product Warranty

Teradyne generally provides a one year warranty on its products commencing upon installation. A provision is recorded upon revenue recognition to cost of sales for estimated warranty expense based upon historical experience. Related costs are charged to the warranty accrual as incurred. The balance below is included in other accrued liabilities.

When Teradyne receives revenue for extended warranties beyond one year it is deferred and recognized on a straight line basis over the contract period. Related costs are expensed as incurred. The balance below is included in deferred revenue.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

B. Accounting Policies – (Continued)

Employee Stock Option Plans and Employee Stock Purchase Plan

Teradyne has stock-based employee compensation plans. Teradyne accounts for its stock option plans and stock purchase plan under the provisions of Accounting Principles Board Opinion No. 25 “Accounting For Stock Issued to Employees” (“APB 25”) and makes pro forma footnote disclosures as though the fair value method under Statement of Financial Accounting Standard No. 123, “Accounting For Stock-Based Compensation” (“FAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” was followed. Teradyne’s employee stock purchase plan is a non-compensatory plan and its stock option plans are accounted for using the intrinsic value method under the provisions of APB 25. Had compensation for Teradyne’s stock based compensation plans been accounted for at fair value the amounts reported in the Statement of Operations for the three months ended March 30, 2003 and March 31, 2002 would have been (in millions, except per share amounts):

The weighted average grant date fair value for options granted during the three months ended March 30, 2003 and March 31, 2002 was $5.76 and $16.81 per option, respectively. The fair value of options at date of grant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:

The weighted-average fair value of employee stock purchase rights granted during the three months ended March 30, 2003 and March 31, 2002 was $4.90 and $9.04, respectively. The fair value of the employees’ purchase rights was estimated using the Black-Scholes option pricing model with the following assumptions:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

B. Accounting Policies – (Continued)

Other Comprehensive Loss

The components of comprehensive loss are as follows (in thousands):

C. Risks and Uncertainties

Teradyne’s future results of operations involve a number of risks and uncertainties. These factors include, but are not limited to, the slowdown in economies worldwide, current geopolitical turmoil, the continuing threat of domestic and international terrorist attacks, the current and anticipated market for electronics, risks associated with any measures Teradyne takes to address the current slowdown in the market, failure to adequately protect Teradyne’s intellectual property rights, failure to develop new technologies and customers’ failure to accept new products, risks associated with acquisitions and divestitures, securities class action litigation due to past or future stock activity, competition, including new product introductions from Teradyne’s competitors and competitive pricing pressures, risks of operating internationally including the impact of the severe acute respiratory syndrome (SARs) epidemic, risks associated with attracting and retaining key employees, possible requirement to expense stock options, risks associated with Teradyne’s suppliers’ failure to meet Teradyne’s product or delivery requirements, risks associated with, among other things, obligations and potential liabilities under environmental laws and regulations, Teradyne’s debt service obligations with respect to its issuance in 2001 of convertible senior notes and a mortgage financing completed in 2001 with respect to certain of its owned real estate assets, provisions of Teradyne’s charter and by-laws and Massachusetts law that make a takeover of Teradyne more difficult, timing of customer orders and any deferral or cancellation of orders previously received, reliance on sole source suppliers, potential retrofit costs, and the timing of investments in engineering and development.

At present, Teradyne can predict neither the duration of the current economic recession nor when or if the situation is likely to materially improve. In the absence of significant improvement, orders could remain low or decline further, and the amount of Teradyne’s inventory and certain long-lived assets considered realizable could be significantly reduced.

D. Recently Issued Accounting Pronouncements

In February 2003, FASB issued Emerging Issues Task Force 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 requires revenue arrangements with multiple deliverables to be divided into separate units of accounting. If the deliverables in the arrangement meet certain criteria, arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. Applicable revenue recognition criteria should be considered separately for separate units of accounting. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Teradyne does not expect that the adoption of EITF 00-21 will have a material impact on its financial position and results of operations.

In January 2003, FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which addresses consolidation by a business of variable interest entities in which it is the primary beneficiary. The Interpretation is effective immediately for certain disclosure requirements and variable interest entities created after January 31, 2003, and periods beginning after June 15, 2003 for variable interest entities created before February 1, 2003. Teradyne does not expect that the adoption of FIN 46 will have a material impact on its financial position and results of operations.

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TERADYNE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

E. Intangible Assets

Amortizable intangible assets consist of the following:

In the first quarter of 2003, Circuit Board Test and Inspection Systems sold its manufacturing software product line and manual x-ray inspection and rework product line for total cash proceeds of $2.1 million. These transactions resulted in a loss of $5.8 million which has been recorded in restructuring and other charges. Included in the $5.8 million loss is an intangible asset impairment charge of $3.7 million.

Aggregate amortization expense for the quarter ended March 30, 2003 and March 31, 2002 was $1.3 million and $1.9 million, respectively. Estimated amortization expense for each of the five succeeding fiscal years is as follows (in thousands):

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TERADYNE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

F. Net Loss per Common Share

The following table sets forth the computation of basic and diluted net loss per common share (in thousands, except per share amounts):

All options and equivalent shares related to the convertible notes outstanding in March 30, 2003 and March 31, 2002 were excluded from the calculation of diluted net loss per share because the effect would have been antidilutive. As of March 30, 2003, and March 31, 2002, there were 32.7 million and 28.9 million options outstanding, respectively. As of March 30, 2003 and March 31, 2002, there were 15.4 million equivalent shares related to the convertible notes outstanding.

G. Restructuring and Other Charges

The table below summarizes activity for the three months ended March 30, 2003, relating to restructuring and other charges:

The table below summarizes activity for the three months ended March 31, 2002, relating to restructuring and other charges:

The accrual for severance and benefits is reflected in accrued employees’ compensation and withholdings and the accrual for lease payments on vacated facilities is reflected in other accrued liabilities. The lease accruals are expected to be paid out over the lease terms, the latest of which expires in 2010. Teradyne expects to pay out $8.6 million against the lease accruals over the next twelve months.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

G. Restructuring and Other Charges – (Continued)

During the first quarter of 2003, Teradyne recorded charges of $7.5 million for certain long-lived assets held for sale that were impaired as the estimated fair value was less than the carrying value of these assets. The charge for the Connection Systems segment of $4.3 million includes $3.0 million for a reduction in the fair value of properties held for sale in Nashua, NH and San Diego, CA, and $1.3 million for the impairment of manufacturing assets held for sale. The charge for the Semiconductor Test Systems segment of $3.2 million relates primarily to a reduction in the fair value of properties held for sale in Agoura Hills, CA. The charge for the properties held for sale resulted from a deterioration in real estate market conditions. During the first quarter of 2002, certain Semiconductor Test Systems long-lived assets were impaired as the estimated fair value was less than the carrying value of these assets. The charge for the impaired assets was $0.8 million and the assets were sold in the second quarter of 2002. The carrying value of Teradyne’s assets held for sale is $33.2 million as of March 30, 2003. These assets are included in Property, Plant and Equipment.

Teradyne recorded a charge for severance and related benefits during the first quarter of 2003 of $6.2 million for approximately 340 employees terminated across all functional groups during the first quarter of 2003. All remaining severance benefits payable to these employees will be paid by the end of the first quarter of 2004. Teradyne recorded a charge for severance and related benefits during the first quarter of 2002 of $5.0 million. There were approximately 220 employees terminated across all functional groups in the first quarter of 2002. As of March 30, 2003 Teradyne has paid all severance benefits relating to the first quarter 2002 terminations.

In the first quarter of 2003, Circuit Board Test and Inspection Systems sold its manufacturing software product line and manual x-ray inspection and rework product line for total cash proceeds of $2.1 million. These transactions resulted in a loss of $5.8 million which has been recorded in restructuring and other charges.

H. Other Charges

The table below reflects certain operating statement activity for the three months ended March 30, 2003:

During the first quarter of 2003, Teradyne recorded a $6.4 million charge for accelerated depreciation which relates to the incremental depreciation over the normal depreciation expense for long-lived assets as a result of the decision to consolidate locations and therefore shorten the service period. The charge includes $3.4 million at the Circuit Board Test and Inspection Systems segment related to the Westford, MA move to North Reading, MA; $1.8 million at the Connection Systems segment related to the Hudson, NH and Cavan, Ireland facilities; $0.6 million at the Semiconductor Test Systems segment related to the Bedford, MA facility; and $0.6 million at Corporate related to a Boston facility.

Other expense for the three months ended March 30, 2003 and March 31, 2002 includes the following:

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TERADYNE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

I. Operating Segment Information

Teradyne has four principal operating segments which are the design, manufacturing and marketing of Semiconductor Test Systems, Connection Systems, Circuit Board Test and Inspection Systems, and Other Test Systems. These operating segments were determined based upon the nature of the products and services offered. The other segment is comprised of Broadband Test Systems and Diagnostic Solutions.

Teradyne evaluates performance based on several factors, of which the primary financial measure is business segment income before taxes. The accounting policies of the business segments are the same as those described in Note B: “Accounting Policies” in Teradyne’s Annual Report on Form 10-K for the year ended December 31, 2002. Intersegment sales are accounted for at fair value as if sales were to third parties. Operating segment information for the three month periods ended March 30, 2003 and March 31, 2002 follows (in thousands):

J. Commitments and Contingencies

After the August 2000 acquisition of Herco Technology Corp. and Perception Laminates, Inc. the former owners of those companies filed a complaint on September 5, 2001 against Teradyne and two of its executive officers. The case is now pending in Federal District Court, San Diego, California. Teradyne and the two individual defendants filed a motion to dismiss the complaint in its entirety. The court granted the motion in part, and the only remaining claims were that the sale of Teradyne’s common stock to the former owners violated certain California securities statutes and common law and that Teradyne breached certain contractual obligations in the agreements relating to the acquisitions. Teradyne’s subsequent motion for partial summary judgment with respect to the breach of contract claims was granted on November 7, 2002. On December 9, 2002, the plaintiffs filed a motion asking the court to reconsider its summary judgment ruling or, alternatively, for certification under Rule 54(b) which would grant the plaintiffs leave to appeal both the Court’s ruling regarding dismissal of claims and its ruling granting summary judgment to the Ninth Circuit Court of Appeals. Teradyne opposed these motions. On April 22, 2003, the Court denied the plaintiffs motion for reconsideration and the plaintiffs request for certification under Rule 54(b). A small portion of the original complaint relating to alleged fraud in connection with setting the transaction price remains pending before the District Court. Teradyne has answered and denied all liability. Management does not believe that the outcomes of these claims will have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that any such claims would not have a material adverse effect on Teradyne’s financial position or results of operations.

Also arising out of the August 2000 acquisition of Herco Technology Corp. and Perception Laminates, Inc. is a demand for arbitration, made on or about October 19, 2001, by the former owners of those companies, which was filed with the American Arbitration Association. The arbitration is with respect to environmental indemnification claims initially asserted by Teradyne under the respective acquisition agreements. These claims arose in connection with environmental matters related to Herco Technology Corp. and Perception Laminates, Inc. facilities in California. The arbitration demand by the former owners seeks release of certain shares of Teradyne’s common stock being held in escrow pursuant to the terms of the acquisition agreements and damages related to failure to release the escrow. Teradyne has counterclaimed for enforcement of the environmental indemnity provisions of the acquisition agreements. Hearings in connection with the arbitration have been completed and the parties have submitted post-hearing briefs to the arbitrators. Management does not believe that the outcome of these claims will

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TERADYNE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

J. Commitments and Contingencies – (Continued)

have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that any such claims would not have a material adverse effect on Teradyne’s financial position or results of operations.

Teradyne and two of its executive officers were named as defendants in three purported class action complaints that were filed in Federal District Court, Boston, Massachusetts, in October and November 2001. The court consolidated the cases and has appointed three lead plaintiffs. On November 8, 2002, plaintiffs filed and served a consolidated amended class action complaint. The complaint alleges, among other things, that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, by making, during the period from July 14, 2000 until October 17, 2000, material misrepresentations and omissions to the investing public regarding Teradyne’s business operations and future prospects. The complaint seeks unspecified damages, including compensatory damages and recovery of reasonable attorneys’ fees and costs. Teradyne filed a motion to dismiss all claims asserted in the complaint on February 7, 2003. Teradyne’s motion has not yet been heard. Claims asserted in this case are similar to the claims asserted in the case discussed above, which is pending in the Federal District Court in San Diego, California. Teradyne believes it has meritorious defenses to the claims and will defend itself vigorously. Management does not believe that the outcomes of these claims will have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that any such claims would not have a material adverse effect on Teradyne’s financial position or results of operations.

By letter dated October 22, 2002, counsel for Electro Mechanical Solutions, Inc., and several affiliated debtors including PRECISMetals in Chapter 11 bankruptcy cases pending in the United States Bankruptcy Court for the Northern District of California (collectively, the “Debtors”), asserted that Teradyne received payments in 2001 totaling $12.4 million from PRECISMetals in the 90 days prior to the bankruptcy filing and that those payments constitute avoidable preferential transfers. Teradyne believes that it has good faith defenses to the alleged preferential transfers and intends to contest the claims vigorously. Management does not believe that the outcomes of these claims will have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that any such claims would not have a material adverse effect on Teradyne’s financial position or results of operations.

In 2001, Teradyne was designated as a “potentially responsible party” (“PRP”) at a clean-up site in Los Angeles, California. This claim arises out of Teradyne’s acquisition of Perception Laminates, Inc. in August 2000. Prior to that date, Perception Laminates had itself acquired certain assets of Alco Industries Inc. under an asset purchase agreement dated July 30, 1992. Neither Teradyne nor Perception Laminates have ever conducted any operations at the Los Angeles site. Teradyne has asked the State of California to drop the PRP designation, but California has not yet agreed to do so. Management does not believe that the outcome of this matter will have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that any such outcome would not have a material adverse effect on Teradyne’s financial position or results of operations.

In August 2002, Teradyne was designated as a PRP at a site in Whittier, California. Teradyne was identified as a PRP based on shipments from its Woodland Hills, California and Agoura Hills, California sites during 1983 and 1984. Based upon review of the shipping documents, Teradyne considered any potential liability to be limited to that of a de minimus contributor to the site. On April 18, 2003, Teradyne entered into an agreement to settle any potential liability related to the site and pursuant to that agreement paid a de minimus amount as full and final settlement of any potential liability.

In October 1998, a former employee of GenRad, Inc., which Teradyne acquired on October 26, 2001, instituted an arbitration proceeding against GenRad alleging breach of his severance agreement. Teradyne believes that the employee’s claims are without merit. The last arbitration hearing was conducted on October 28, 2002, and a decision is expected by the end of May 2003. Management does not believe that the outcome of this proceeding will have a material adverse effect on Teradyne’s financial position or results of operations but there can be no assurance that the outcome would not have a material adverse effect on Teradyne’s financial position or results of operations.

Teradyne disputes all of the claims above and believes they are without merit, and intends to defend vigorously against them. However, an adverse resolution of any of the claims could have a material adverse effect on Teradyne’s financial position or results of operations. Teradyne is not presently able to reasonably estimate potential losses, if any, related to any of the claims and therefore as of March 30, 2003 has not accrued for any potential losses from the claims.

In addition, Teradyne is subject to legal proceedings, claims and investigations that arise in the ordinary course of business such as but not limited to patent, commercial and environmental matters. There are no such matters pending that Teradyne expects to be material with respect to its business, financial position or results of operation but there can be no assurance that any such matters would not have a material adverse effect on Teradyne’s business, financial position or results of operations.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

J. Commitments and Contingencies – (Continued)

Guarantees and Indemnification Obligations

For “Guarantees and Indemnification Obligations” of Teradyne see Note J: “Commitments and Contingencies” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 28, 2003. There were no material changes in Teradyne’s guarantee and indemnification obligations from those set forth in our Annual Report for the year ended December 31, 2002.

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Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

SELECTED RELATIONSHIPS WITHIN THE CONDENSED CONSOLIDATED

STATEMENTS OF OPERATIONS

Results of Operations

Business Overview

Teradyne experienced its sixth consecutive quarter of net bookings growth in the first quarter of 2003. However, revenues remained relatively flat for the third consecutive quarter after three consecutive quarters of growth in net sales. Uncertainty continues in the general business environment and the electronics industry in particular. During the first quarter of 2003, Teradyne saw customers continue to delay buying decisions until the last possible moment.

Until Teradyne’s customers see significant and sustained increases in their business levels, both in units and dollars, Teradyne’s orders could remain low or see a further decline. If Teradyne experiences further declines in its own order rates, the amount of Teradyne’s inventory and certain long-lived assets considered realizable could be significantly reduced.

Bookings

Net orders increased 37% to $289.0 million in the first quarter of 2003 from $210.3 million in the first quarter of 2002. The increase in incoming net orders was led by a 70% increase in Semiconductor Test Systems, a 53% increase in Connection Systems, and a 9% increase in Circuit Board Test and Inspection Systems. Other Test Systems net orders decreased by 29%. The increase in Semiconductor Test Systems orders was driven primarily by Integrated Device Manufacturer (IDM) customers, which accounted for 84% of the increase, and was spread across Europe, Japan, and South East Asia, with the exception of Singapore which saw a significant decline. The increase in orders in Connection Systems was from a 18% increase in gross bookings due to increased demand from major information technology infrastructure customers, and a 49% reduction in cancellations.

Teradyne experienced cancellations of $14.5 million and $27.2 million during first quarter of 2003 and 2002, respectively. For the first quarter of 2003, cancellations of $2 million and $12 million occurred in the Semiconductor Test Systems and Connection System businesses, respectively. The Connection Systems cancellations were from major customers in the telecommunications and networking infrastructure industries, due principally to product program cancellations.

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Teradyne’s net orders for its four principal operating segments were as follows:

Teradyne’s net orders by region as a percentage of total net orders were as follows:

Customers may delay delivery of products or cancel orders suddenly and without significant notice, subject to possible cancellation penalties. Due to possible customer changes in delivery schedules and cancellation of orders, Teradyne’s backlog at any particular date is not necessarily indicative of the actual sales for any succeeding period. Delays in delivery schedules and/or cancellations of backlog during any particular period could have a material adverse effect on Teradyne’s business and results of operations.

Revenue

Teradyne’s net sales for its four principal operating segments were as follows:

The increase in Semiconductor sales was due largely to increased shipments to IDM customer sites in South East Asia and Japan. Connection Systems sales decreased primarily due to a decrease in shipments from its assembly business. The increase in Circuit Board Test and Inspection Systems sales was due to increased sales of in-circuit test and optical inspection systems in its commercial products business and of the Spectrum 9000 and Digital Test Instruments systems in its military and aerospace business. The increase in Other Test Systems was driven by an 89% sales increase in Diagnostic Solutions as a result of increased business from a leading automotive manufacturer. The increase in Diagnostic Solutions was partially offset by a decrease in sales in Broadband Test Systems of 50%. Teradyne’s sales by region as a percentage of total net sales were as follows:

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Product revenue increased 44% in the first quarter of 2003 to $277.2 million from $193.1 million in the first quarter of 2002. Service revenue increased 4% in the first quarter of 2003 to $57.3 million from $54.9 million in first quarter of 2002.

Gross Margin

Gross margin increased to 25% of total sales in the first quarter of 2003 from 13% of total sales in the first quarter of 2002. Product gross margin increased to 24% of product sales in the first quarter of 2003 from 8% of product sales in the first quarter of 2002. The improved product margin percentage largely results from product sales growth of 44% and an approximate 10% reduction in fixed and semi-fixed manufacturing costs. Included in the gross margin percentage of 25% in the first quarter of 2003 is approximately $3.6 million of incremental accelerated depreciation that was classified in cost of sales. Service gross margin increased to 31% of service sales in the first quarter of 2003 from 28% of service sales in the first quarter of 2002. The improved service margin percentage largely results from reduced fixed costs in the Semiconductor Test Systems parts and field service business.

Engineering and Development

Engineering and development expenses, as a percentage of sales, decreased to 20% in the first quarter of 2003 from 28% in the first quarter of 2002, with net spending decreasing slightly by $0.7 million. Gross expense reductions of approximately $6.9 million offset increases of approximately $5.2 million from the elimination of Company wide pay cuts and the granting of previously frozen salary increases in the third quarter of 2002, as well as incremental accelerated depreciation described below.

Of the gross expense reduction, half was a result of a downsized workforce, with the bulk of the remainder coming from reduced consulting spending. Teradyne recorded a charge for incremental accelerated depreciation of $1.0 million in the first quarter of 2003 which is classified in Engineering and Development.

Selling and Administrative

Selling and administrative expenses decreased to 20% of sales in the first quarter of 2003 from 30% of sales in the first quarter of 2002 with net spending decreasing by $7.6 million. Gross expense reductions of approximately $12.3 million offset increases of approximately $2.9 million from the elimination of Company wide pay cuts and the grant of previously frozen salary increases in the third quarter of 2002, as well as incremental accelerated depreciation described below.

One third of the gross expense reduction was the result of a downsized workforce, with the remainder from a combination of reduced fixed costs, such as facilities costs and depreciation, excluding the incremental accelerated depreciation charge discussed below, and reduced consulting and travel spending. Teradyne recorded a charge for incremental accelerated depreciation of $1.8 million in the first quarter of 2003 which is classified in Selling and Administrative.

Restructuring and Other Charges

The table below summarizes activity for the three months ended March 30, 2003, relating to restructuring and other charges:

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The table below summarizes activity for the three months ended March 31, 2002, relating to restructuring and other charges:

The accrual for severance and benefits is reflected in accrued employees’ compensation and withholdings and the accrual for lease payments on vacated facilities is reflected in other accrued liabilities. The lease accruals are expected to be paid out over the lease terms, the latest of which expires in 2010. Teradyne expects to pay out $8.6 million against the lease accruals over the next twelve months.

During the first quarter of 2003, Teradyne recorded charges of $7.5 million for certain long-lived assets held for sale that were impaired as the estimated fair value was less than the carrying value of these assets. The charge for the Connection Systems segment of $4.3 million includes $3.0 million for a reduction in the fair value of properties held for sale in Nashua, NH and San Diego, CA, and $1.3 million for the impairment of manufacturing assets held for sale. The charge for the Semiconductor Test Systems segment of $3.2 million relates primarily to a reduction in the fair value of properties held for sale in Agoura Hills, CA. The charge for the properties held for sale resulted from a deterioration in real estate market conditions. During the first quarter of 2002, certain Semiconductor Test Systems long-lived assets were impaired as the estimated fair value was less than the carrying value of these assets. The charge for the impaired assets was $0.8 million and the assets were sold in the second quarter of 2002. The carrying value of Teradyne’s assets held for sale is $33.2 million as of March 30, 2003. These assets are included in Property, Plant and Equipment.

Teradyne recorded a charge for severance and related benefits during the first quarter of 2003 of $6.2 million for approximately 340 employees terminated across all functional groups during the first quarter of 2003. All remaining severance benefits payable to these employees will be paid by the end of the first quarter of 2004. Teradyne recorded a charge for severance and related benefits during the first quarter of 2002 of $5.0 million. There were approximately 220 employees terminated across all functional groups in the first quarter of 2002. As of March 30, 2003 Teradyne has paid all severance benefits relating to the first quarter 2002 terminations.

In the first quarter of 2003, Circuit Board Test and Inspection Systems sold its manufacturing software product line and manual x-ray inspection and rework product line for total cash proceeds of $2.1 million. These transactions resulted in a loss of $5.8 million which has been recorded in restructuring and other charges. Included in the $5.8 million loss is an intangible asset impairment charge of $3.7 million.

The restructuring actions described above during the first quarter of 2003 are expected to generate cost savings of approximately $27 million annually across all areas of operations.

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Interest Income and Expense

Interest income remained flat at $4.2 million for the first quarter of 2003 compared to the first quarter of 2002. Decreased cash and marketable securities balances in the first quarter of 2003 compared to the first quarter of 2002 were slightly offset by higher interest rates. Interest expense increased by $0.1 million to $5.4 million in the first quarter of 2003 compared to the first quarter of 2002.

Other Expense

Other expense for the three months ended March 30, 2003 and March 31, 2002, respectively, includes the following:

Income Taxes

In the fourth quarter of 2002, Teradyne recorded a tax provision to establish a full valuation allowance against its net deferred tax assets. As a result of its review undertaken at December 31, 2002, Teradyne concluded under applicable accounting criteria that it was more likely than not that its deferred tax assets would not be realized. Until an appropriate level of profitability is reached, Teradyne will not record tax benefits on operating losses in future results of operations. The first quarter of 2003 tax expense relates primarily to a tax provision for foreign taxes. In the first quarter of 2002, Teradyne was recording tax benefits for losses at an effective tax rate of 36%.

Liquidity and Capital Resources

Teradyne’s cash, cash equivalents and marketable securities balance decreased $33.3 million in the first three months of 2003, to $507.7 million. Teradyne used cash from operating activities of $44.4 million in the first three months of 2003 and generated cash of $15.7 million in the first three months of 2002. Cash from net loss, excluding the effects of non-cash items, used $20.1 million and $86.3 million of cash for the first three months of 2003 and 2002, respectively. Changes in operating assets and liabilities used cash of $24.2 million in the first three months of 2003 as Teradyne accounts receivable balances increased primarily due to higher shipments in the last month of the quarter which was partially offset by decreased inventory balances. In the first three months of 2002, changes in operating assets and liabilities generated cash of $101.9 million as Teradyne received a tax refund in March 2002 of $85.2 million and inventory balances decreased.

Teradyne used $6.2 million of cash for investing activities in the first three months of 2003 and $158.6 million in the first three months of 2002. Investing activities consist of purchases, sales, and maturities of marketable securities, proceeds from the sale of asset disposals, proceeds from the sale of product lines and purchases of capital assets to support long-term growth. Capital expenditures were $18.5 million in the first three months of 2003 and $21.6 million in the first three months of 2002. The decrease in capital expenditures was due to actions taken by Teradyne beginning in 2001 to reduce planned capital expenditures due to current market conditions.

Financing activities provided $18.9 million and $36.7 million of cash during the first three months of 2003 and 2002, respectively. Financing activities include issuance of Teradyne’s common stock through employee stock option and stock purchase plans and repayments of debt. During the first three months of 2003 and 2002, common stock activity provided cash of $19.2 million and $37.1 million, respectively.

Teradyne believes its cash, cash equivalents, and marketable securities balance of $507.7 million will be sufficient to meet working capital and expenditure needs for the next twenty-four months. Depending on market conditions and funding requirements, Teradyne may seek additional external financing. Inflation has not had a significant long-term impact on earnings.

Employee Stock Options

Teradyne’s equity compensation program is a broad-based, long-term retention program that is intended to attract and retain talented employees and align stockholder and employee interests. Teradyne considers its equity compensation program critical to

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Teradyne’s operation and productivity. Approximately 80% of Teradyne’s employees participated in its equity compensation program during 2002. Of the stock options Teradyne granted in 2002, 89% went to employees other than the Chief Executive Officer and the five other most highly compensated executive officers.

Stock option plan activity for the first three months of 2003, and years ended December 31, 2002 and 2001 follows (in thousands):

Employee and Executive Option Grants

Summary of in-the-money and out-of the-money option information at March 30, 2003:

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Executive Options

Options granted to Named Executive Officers, during the fiscal year ended December 31, 2002:

Option exercises and aggregate remaining option holdings and option values of Named Executive Officers during the first quarter of 2003 and as of March 30, 2003: