FormFactor, Inc. (FORM) Earnings Call Transcript & Summary

All right. Good afternoon, everybody. My name is Amanda Scarnati. I am one of the semiconductor analysts here at Citi. I'm joined this afternoon by Mike Slessor, the CEO; and Shai Shahar, the CFO of FormFactor. We also have Stan Finkelstein from Investor Relations joining us. We're going to start off with just a very brief elevator pitch overview of FormFactor just to kind of set the stage for today. And then I'm going to dive into some advanced questions that I have. [Operator Instructions] So with that, Mike, I'll pass it off to you.

Great. Thanks, Amanda, and thank you for having us. Usually, we get a chance to go to Manhattan for the first day after Labor Day weekend and see everybody in person. But we're -- obviously, with this year, we're going to have to make do with this format. But thank you, everyone, for joining us today, and thanks to Citi for hosting us again this year. Briefly, some facts about FormFactor. We're a company that leads in a couple of interesting segments of semiconductor test and measurement. Our trailing 12-month revenues are right at about $650 million. And that leaves us with implied market share of somewhere between -- somewhere mid-30% in our served markets, leading by quite a substantial margin. We've seen these markets grow pretty nicely over the past couple of years, and we've seen ourselves grow market share in these markets. I'm sure we'll get into some of the reasons for this in the questions and answers. But we're a company that's driven by a lot of the major initiatives going on in the semiconductor industry today, one of them obviously being 5G, the communications infrastructure and more importantly for us as a business that really driven by new design starts, all of the new chip designs associated with 5G handsets, the rollout already this year and later this year of initial 5G handsets, a very exciting opportunity for FormFactor. Layered on top of that, we see tremendous growth potential associated with the adoption of advanced packaging in the industry. These techniques to help make up for some of the slowing or challenges in the Moore's Law progression have really seen an increase in test intensity, the amount of testing our customers are doing for each of the chips going into the advanced package as well as the complexity of that test. And so for an industry leader of scale who can bring a lot of the R&D resources to bear to solve these problems, that's a significant competitive advantage. So things to think about us, driven by some of these major initiatives in the industry, like advanced packaging, like 5G, primarily a device-specific consumables business where new designs drive demand for us, and we've been able to drive that revenue growth through substantial margin expansion both on the gross margin line but more importantly on the operating margin and net income line as we stretch and leverage a pretty flexible operating expense structure. And you've seen that in the earnings per share growth that we've delivered over the last little while and that we told you about in our Analyst Day about a month ago. Okay. So with that, Amanda, maybe that's time to turn it over to questions.

Yes. That is a fantastic overview, and I think it really sets the stage for what we're going to talk about today. Let's start off with the logic and foundry business, the biggest piece. How do you see 10-nanometer and 7-nanometer production demand at your largest customer this year? And how could your growth be impacted if this customer decides to start outsourcing manufacturing as sort of that has been indicated in the market?

Yes. So a couple of things. Logic and foundry probe cards are our largest business, have run a little over 2/3 of our total revenue as we've gone through late 2019 into 2020. And we're seeing a lot of continued growth there. Obviously, one of the major components of that is our largest customer. Right now, our business with them is primarily 10-nanometer production but still a strong component of 14-nanometer production. And this gets back to a pretty interesting case study of how probe cards are a device-specific consumable. As that customer or any other customer releases new designs even on their older, more mature nodes, that requires a new set of probe cards. And that new set of probe cards obviously drives refresh demand for us. So we're seeing strong 14-nanometer activity continue as well as 10-nanometer. 7-nanometer, even though there was this significant announcement a couple of months ago from this customer, is still in pretty early stages. It was never planned for volume production here in 2020. They announced something like a 6-month pushout, but this is still a 2021, 2022 kind of event. The exciting thing for us is we're obviously very engaged with this customer on all of the development and pilot production around the 7-nanometer node, which is obviously going to prominently feature the advanced packaging I talk about. You've heard them talk about how advanced packaging, whether it's die stacking or different chiplet-type techniques, really fueling their road map going forward. And that drives both an increase in their overall probe card spend and an increase in the complexity and therefore, competitive advantage for FormFactor. So some pretty -- despite the bumps in the road of node timing and that sort of thing, we see this as a pretty exciting long-term secular opportunity not just with our largest customer but with other customers as well. Now getting to the question of sort of the impact if they fundamentally change their production strategy. I think there's 2 ways to look at this. The first, obviously, FormFactor's worked very hard to establish a strong market share position at the world's leading foundry as well. We've had them as a 10% customer in recent quarters. And we've conveyed that we expect to continue to grow that business and have them on our 10% customer list again. So in some sense, you're trying to put the company in a position to be agnostic to these changes in key customer manufacturing strategy. Obviously, there'll be some puts and takes and -- if they're completely outsourcing, if they outsource to a certain part of their segment. But I do feel pretty good about the position we've put FormFactor in to capitalize on wherever our customers want to do their manufacturing. I think the second point to make is our leading customer, our top customer, has made it pretty clear that they're continuing to invest internally in test and assembly. So regardless of where they have the silicon made, they've made some pretty strong comments publicly that they view their advanced packaging assembly techniques, and therefore the associated testing techniques, as a competitive advantage for them. So again, I don't want to dismiss any impact. I don't want to be Pollyannish about this, but we do feel like we've got FormFactor at a pretty good place to capitalize on that customer and essentially all fabless customers' demand wherever it goes, wherever the wafers get manufactured and tested. But in this case, I do think there's a smaller chance that the overall test and assembly manufacturing happens outside that customer's four walls.

Excellent. Continuing on foundry and logic, on your earnings call, you mentioned that you're more confident in current foundry and logic levels than you were 6 months ago. What gives you this added confidence especially in light of the current macro environment that we're sitting in?

Yes. Well, I think certainly, the current macro environment still provides questions. It's been a remarkably strong year despite the macroeconomic backdrop for FormFactor and the leaders in the semiconductor industry overall, so maybe putting macro aside because there's some very big questions associated with overall stimulus and how the world economy, the U.S. economy goes through the tail end of 2020 and into 2021. But if we look at the fundamental drivers that leave us more confident in foundry and logic demand, they really revolve around some of the notions I talked about in the opening. If you look at the advent of advanced packaging, things like integrated fan-out at the world's largest foundry, high-bandwidth memory and DRAM, where the memory manufacturers are stacking die on top of each other; if you look at some of the heterogeneous integration techniques, chiplets and like we talked about in the last section with our largest customer, these are fundamentally driving higher test intensity. You can imagine if you're going to assemble these chips together in these advanced packages, you better have fairly high confidence that they're going to all work. Otherwise, you end up with some very expensive assembly techniques if one bad die is taking down 8 otherwise good die. And so it turns out the test intensity is going up pretty rapidly. I think the other thing that leaves us quite confident in the foundry and logic space is the advent of 5G as a driver. If you look at how that's driving our business, not just in RF where I think it's pretty clear that the RF content in a 5G handset is a significant step-up from that of a 4G handset, you've also got test complexity playing here pretty significantly as well. 5G is driving higher bandwidth. It's driving more capable application processors in the handset, which drives our foundry and logic business, not just our RF business. And so you see an overall increase in the -- both the test intensity and complexity associated with both advanced packaging and 5G in the foundry and logic space. You see it in the memory space as well but not to as dramatic a degree. Foundry and logic is really being favorably impacted by these 2 mega trends.

At your analyst update that you did a couple of weeks ago, you highlighted that you expect to add $200 million in incremental annual revenue predominantly in logic and foundry. Should we assume that this is all sort of bucketed into advanced packaging? Or is there a way to sort of slice out how this falls between 5G, automotive opportunities and other kind of drivers?

Yes. Yes. It's a great question and one that -- it will sound like I'm trying to sidestep it but I'm really not because these trends are -- they're really convolved on top of each other, right? Again, think about a 5G handset. The processors in these handsets are almost certainly going to be assembled using advanced packaging if only to stack the DRAM on top of the processor has been done in recent handsets. But you've also then got the 5G component of the RF front end and the really 5G-specific pieces of this. So we see a mixing or almost a convolution of these 2 trends, where 5G is driving significant demand in the overall foundry and logic space, but it's resulting in not just pure 5G demand for RF components, it's also driving the regular digital foundry and logic business for things like application processors and modems. It's also driving our memory business. You can imagine that the DRAM content in a 5G handset is going to be significantly higher than that of a 4G handset. And so we see these trends really being co-mingled or correlated with each other, difficult to break out sort of independent components for each as much as we'd like to so that we can measure and report back. Having said all that, you look at the markets that we operate in and how they're expected to grow not just from us but from some of the external forecasting firms like VLSIresearch, we're pretty confident in this $200 million growth for FormFactor.

Shifting gears a little bit to DRAM, and we touched a little bit on it here and there. But on the June quarter earnings call, you mentioned that you expect to see a step-up in the DRAM business in the second half. What gives you confidence in this DRAM business? And how have you been able to decouple from DRAM pricing fundamentals, which are showing some incrementally bad indications for the second half?

Well, I think this continues to be a very interesting validation and case study of the design-specific consumable nature of FormFactor's business. First of all, DRAM supply and DRAM probe cards are definitely a cyclical business. We recognize that many years ago when we started to really work hard to diversify our businesses, whether it was the acquisition of MicroProbe in 2012, the acquisition of Cascade Microtech in 2016 and some of the other smaller tuck-ins we've done. We've grown our absolute DRAM revenue but obviously reduced it to something like 20% to 25% of total company revenue, understanding that we need to manage through that cyclicality. But if you look at some recent history associated with DRAM, in the back half of 2019, we delivered 2 record quarters for DRAM probe card revenue in the midst of what were some pretty weak DRAM market fundamentals and DRAM capital spending. And the fundamental reason for this is the fact that as customers release and ramp new designs, so things like LPDDR5, new architectures, new die sizes, new capacities, we're now seeing things like 16-gig DRAM chips. Those -- because of probe card is specific to each customer chip design, those drive demand for new probe cards. And so as customers go through these new design cycles, they need new probe cards from us. And they typically end up doing that at a little bit different cadence than the end market DRAM fundamentals are. So things like DRAM spot pricing, at least over the past few cycles, have not had a significant impact on our customers' design release road maps and their investment plans. Part of that's because they've got -- I think the DRAM industry in a much better shape than it was a decade ago, right? A decade ago, it was really a boom-bust, where in bust times, you didn't spend money on anything. You just ran your existing fabs, your existing designs and pushed chips out the back door. The DRAM industry is in a fundamentally different space right now. And so no, they're not as profitable as they were a couple of years ago, but they're still profitable and still investing in design innovation and their road maps, which requires new probe cards from FormFactor to support.

Great. Shifting gears to the Systems business. Can you explain this business a little bit more and what end market it addresses? And how it's impacting overall profitability for the company?

Right. So the Systems business came to us as part of the 2016 acquisition of Cascade Microtech that I talked about. It's a business that contributes about $100 million in revenue a year at somewhere high 40s, low 50s gross margin. So of our reported segments, it is the highest gross margin. It is a business where we're helping customers very early on in their development cycles. These are tools that help them handle and measure new kinds of chips, whether it's 3 nanometers at the world-leading foundry, 7 nanometers at our largest customer, some of the electro-optical applications like VCSELs, displays like MicroLED. So it's a very broad swath of helping our customers innovate very early on in their development cycles. So for us, it gives us an interesting extra leg to the engagement with the leading customers in the world. These are still the same customers we serve with our production probe card business, but we get to engage with them much earlier on in their development cycles of exciting new technologies both in CMOS and other related technologies, things like the optoelectronics I talked about. So these are tools used by the engineering and R&D teams in a fundamental development or preproduction activity. That, I think, gives us a bit of a leg up. We've seen it with some applications like VCSELs that as the application moves to production, we've got a pretty good understanding of what's going to be required from a production test perspective. And I think that's given us some interesting competitive advantage in serving the production applications with our probe card business. On the other hand, it also allows us to leverage our operating structure. Our team in Taiwan, in Korea, in China, in Japan, all those teams are supporting both the probe card business and the engineering systems business. And so it allows us to leverage the infrastructure we have in being a global supplier to the semiconductor industry and be pretty effective in stretching that OpEx at least on the sales and marketing side and the infrastructure side. From a financial contribution perspective, it is a nice contributor with the $100 million of revenue at the 50-ish-percent gross margin. But I think its strategic value is equally important to FormFactor, giving us this engagement early on with our customers in what we like to call our lab-to-fab strategy.

Great. Shifting gears a little bit. On your earnings call, you announced the acquisition of Advantest's probe card assets for about $35 million. Can you talk about the rationale behind this acquisition and how it will accelerate your technology road map?

Yes. So this is a business, Advantest, as I think many people are aware, one of the leading manufacturers of automatic test equipment or essentially the testers that our probe cards hook up to, where FormFactor probe cards allow these testers to be used by customers over multiple chip designs. And so we've got a pretty long-standing relationship with Advantest as well as Teradyne, the other major ATE supplier. And this was a business that didn't really fit inside of Advantest. It had come to Advantest as part of -- previous the acquisition of Verigy back a long time ago but was not really central to where Advantest was going. And so we've been in discussions with them to see whether we could carve this out and bring it into the FormFactor family. The rationale for that primarily on the technology side. There is some very interesting technology both on the MEMS probe, which is sort of the key element that contacts the customer wafer, as well as the interconnect, the part that connects that MEMS probe back up to the tester that Advantest had made some significant investments in that we felt like we're attractive additions to the overall FormFactor technology road map. Both in NAND Flash where Advantest currently operates -- and I'll get to the NAND Flash business in a second, but even more so in DRAM and foundry and logic, we think there's some interesting opportunities for these technologies. And so really think about this for us as a technology enabler, the purchase of some elements on our road map that help accelerate our overall probe card road map, not just in NAND Flash. Now these guys do have a qualified NAND Flash product that is competitive in the mainstream of NAND Flash, which was something that was missing from the FormFactor product portfolio. We'd chosen to really focus on high-end NAND and essentially serving it with a stripped down version of our DRAM probe card. The mainstream of NAND Flash really is much simpler requirements at a lower cost point. And so that was not somewhere where FormFactor had been competitive. Advantest's team had qualified and has what we think is a pretty reasonable offering for mainstream NAND Flash. It's obviously going to take a while to integrate that team to take advantage of the worldwide FormFactor infrastructure. But 1 month and a bit into the acquisition, we're pleased with both the technology assets that we've purchased as well as the initial momentum on creating a little bit more NAND Flash market share. I think there's still subsegments of NAND Flash in Korea that are going to be very difficult for us to serve. But being qualified, again, at one of the major NAND Flash manufacturers with a mainstream product is certainly a step forward for us in NAND.

I think this next question is probably better for Shai. But Mike, I'm not dissing you. You can answer it if you want. It's about capital allocation. On capital allocation, you announced on your earnings call a new capacity expansion plan. Have you been capacity-constrained recently? And what are the structural demand changes that are requiring this new capacity? And how does it fit into your overall allocation process?

Sure. So indeed, in our last earnings call and in our analyst update 3 weeks ago, we announced the purchase of a building in our Livermore campus. It is to expand our capacity. As a reminder, capacity for us really has 3 main components: physical real estate, the tools and the labor. And this building purchase was to expand our footprint. In the next few months, we will be working on building the clean room, populating the building with the tools, et cetera. So it's ready for initial production somewhere in 2021. So this expansion was made to answer the strong and growing demand we see in the markets we serve. As you might recall, our revenue in Q4 of '19 was a record high, almost $180 million. And we've been capacity-constrained in the last few quarters as we respond to the strong demand and to the social distancing requirements that are all around us now. And we believe this expansion, together with some other smaller capacity expansion initiatives in our other factories around the world, this will be sufficient to get us to the $850 million revenue target that we showed in our Analyst Day.