//FormFactor Surges

FormFactor Surges

There seem to be a few companies in the semiconductor supply sector that managed to escape the general malaise, with stock prices way off their highs this year for many names.

We believe one of these companies is FormFactor (FORM), the leading producer of probe cards for the semiconductor industry. There are a couple of structural tailwinds for the company:

  • Increasing amount of electronics in ever more goods (IoT, Mobile, Datacenters, Automotive, etc.).
  • Increasing complexity of electronics (not only smaller nodes, but stuff like advanced packaging and multi-layered stacks, higher speeds and bandwidth, etc.).
  • Customer wins.

Here is how the main end markets are developing (from the earnings deck):



Here is what management argued about the main drivers (Q3CC):

“So to get everybody on the same page, we talked about these three components advanced packaging, mobile data and automotive but essentially being the constituent growth drivers to get us to our target model which delivers $650 million on the top-line and $1.50 of non-GAAP earnings per share. As I break down the three of those, I think far and away the leader from our perspective in executing against those opportunities is advanced packaging whether it would be HBM in memory which we talked about previously, and a little bit on this call, or integrated fan-out which is one of the key drivers for our expanding foundry business at 10 and 7-nanometer, advanced packaging were probably two-thirds, three quarters of the way there to achieving the opportunity that we laid out, but we see more headroom beyond that with advanced packaging. This is a very exciting trend for us.”



As a general (and fairly simplified, as there are more moving parts here) rule, advanced packaging is simply 20%-25% more test and probe card intensive, hence the tailwind.

These tailwinds have led to the following development (last quarter not included but that was pretty similar to Q2):

Chart

FORM Revenue (TTM) data by YCharts

The big jump in revenues in mid-2016 was due to the merger with Cascade. There is also something of a headwind (the flip side of the increasing complexity, if you like), which is the relative stalling of Moore’s Law.

It is becoming ever more difficult (and expensive) for semis to move to the next node, witness FormFactor’s biggest customer Intel (INTC) having to postpone the movement to 10nm several times already.

The big customer win for the company was with Taiwan Semiconductor (TSM), which is significant for two reasons:

  • Competitive strength
  • Growth opportunity

The win testifies to FormFactor’s competitive strength as Taiwan Semi used to use its own cards, but with the increasing complexity, these were no longer good enough.

It also expands FormFactor’s market significantly and lessens their dependence on Intel as their biggest customer, right at a time when Intel is struggling a bit with the transition to 10nm. Here is management during the Q3CC on this opportunity:

“We’ve said in the past, we expect long term this opportunity be comparable to the business we have with our largest customer and nothing we’ve seen so far has changed us, has changed our view on that.”

While the industry as a whole (its memory part in particular) is rather cyclical, the fact that each customer has different node changing and new product cycles evens that out considerably.

Intel is still by far their biggest customer, responsible for 24% of revenues (with Micron (MU) second at 12%). Intel’s 10nm node transition will translate into increased activity for the company from Q1 next year onward.

But it seems that management warned against expecting too much from that; while node change goes hand in hand with an intensification of testing and increased demand for probe cards, it is substituting 14nm designs. The net effect is still positive though.

In DRAM, there is also some node transition showing up in Q1 next year, but activity is also driven by new designs on existing nodes.

The company also generates income from Engineering Systems, although revenues were basically flat from last year. Demand is coming increasingly from opto electronics (Q3CC):

“…as the industry innovates in sensors, displays, and other devices that rely on a combination of electrons and photons. Our team and products have been supporting development and initial production of such innovative devices as vixels, micro LED displays, and silicon photonics.”

Q3 Results and outlook

Here is the target model (and how they are getting close), from the earnings deck:



And how they are diversifying revenue streams, getting less cyclical:



Here are the last couple of quarters and the outlook for Q4:



The Q3 result did of course exceed expectations by nearly $2M in revenues and 3 cents in EPS. The shares had a bit of a blast as a result, rising 31% in the day after the earnings were presented:



While revenues are stagnant, the company is escaping much of the cyclical nature of some of its markets.

Margins

The company is already quite close to its target model here:



In Q3, gross margin fell back a bit to 43.5% (from 45.9% in Q2) due to product mix (the biggest driver in gross margins), but with increasing volume, the 46% target will get easier.

The company has enjoyed a considerable amount of operational leverage already and it is now in a sort of steady state where this remains around 27% of revenues.

Part of the earnings surprise, despite a fallback of gross margin, was good operating cost control. Non-GAAP operating expenses were $37.5M, down $2.1M sequentially, much of it due to lower performance based compensation.

Cash

Chart

FORM Cash from Operations (TTM) data by YCharts

The third quarter isn’t yet included in the figure, but the company generated $13M in free cash flow for the quarter (down from $16.8M in Q2).

Their total cash now sits at $143M at the end of Q3 and the company keeps on paying off its term loan ($13.2M for the quarter including $5M prepayment, the last quarter where they will pay in advance of the schedule).

Cash minus the remaining balance of the term loan is $71M, an improvement of $12M in the quarter. Repaying loan is the priority, after that they will look at M&A opportunities.

Valuation

Chart

FORM PE Ratio (TTM) data by YCharts

EPS is expected to reach $0.91 this year, rising to $1.2 next year, which makes the shares reasonably priced, given the fact that the company is less cyclical than many of its customers.

Conclusion

The company has a strong market position and it’s benefiting from structural tailwinds. It also generates sufficient cash flow to deleverage its balance sheet and clean that up sufficiently for the next acquisition.

The shares had fallen away a little too much, but they recouped all of that in a single session, rising 30%+. We don’t see any immediate catalysts for this to increase significantly beyond this short term, but in the longer run, the structural tailwinds should still move the shares up. 5G could be the next growth driver from next year onward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.