Formfactor Inc Q4 FY2021 Earnings Call

Thank you. Today the company will be discussing GAAP, P&L results and some important non-GAAP results intended to supplement your understanding of the company's financials. Reconciliations of GAAP to non-GAAP measures and other financial information are available in the press release issued today by the company and on the Investor Relations section of our website. Today's discussion contains forward-looking statements within the meaning of the federal securities laws. Examples of such forward-looking statements include those with respect to the projections of financial and business performance, future macroeconomic conditions, the benefits of acquisitions and investments in capacity and in new technologies, the impacts of the COVID-19 pandemic, anticipated industry trends, the disruption in our supply chain, the impacts of regulatory changes, the anticipated demand for products, our ability to develop, produce, and sell products, and the assumptions upon which such statements are based. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed during this call. Information on risk factors and uncertainties is contained in our most recent filing on Form 10-K with the SEC for fiscal year ended 2020 and in our other SEC filings which are available on the SEC’s website at www.sec.gov and in our press release issued today. Forward-looking statements are made as of today, February 2, 2022, and we assume no obligation to update them. With that, we will now turn the call over to FormFactor's CEO, Mike Slessor. Mike?

Thanks everybody for joining us today. FormFactor posted record results in the fourth quarter, delivering revenue of over $200 million for the first time in company history, with non-GAAP earnings per share at the high end of our outlook range. This caps a record 2021 that produced over three quarters of a billion dollars in revenue and over $150 million of non-GAAP operating income. And I'd like to take this opportunity to thank the worldwide FormFactor team for their perseverance and dedication to produce these outstanding results. As we start 2022 and the Year of the Tiger, we continue to benefit from solid demand across all our served markets in probe cards and engineering systems, and we're excited about the important role we're playing in enabling innovation and growth in the semiconductor industry. In addition to our record financial results, we were recently recognized by Newsweek for our ESG leadership as one of America's most responsible companies. In addition to an environmental and social focus, FormFactor's overall ranking was supported by a high score in corporate governance. Driving FormFactor's ESG performance to a world-class level has become a major focus for our leadership team and Board of Directors in recent years, and we're very proud to have been recognized for these efforts. Like many manufacturing companies, we continue to face a variety of supply chain and labor challenges. Our long-term investments in automation and vertical integration helped us mitigate the effect of these headwinds, enabling us to deliver strong results throughout 2021. However, the recent spread of the Omicron variant has caused labor shortages in our U.S. factories in the early weeks of 2022 and is partially responsible for the sequential reduction in revenues in our first quarter outlook. We are also experiencing extended lead times for some of our products, primarily in the system segment, caused by delayed deliveries for specific sub-components in subsystems from certain suppliers. Our team remains focused on actively managing and resolving these challenges, both by working closely with our current suppliers and rapidly qualifying and ramping new suppliers. Minimizing impacts to our supply chain and labor availability is especially important in view of our capital investments to meet growing customer demand. As we previewed in our October earnings call, we began customer shipments from our new Livermore Manufacturing Center in the fourth quarter, and these shipments contributed to our record quarterly revenue. We're gradually increasing capacity in Livermore to meet customer demand by adding both tools and labor. We're also expanding other facilities across our global manufacturing network, which will create the capacity to meet and then exceed the $850 million revenue target of our current financial model. Turning now to segments and market level details. Foundry and Logic probe cards, our largest business, was responsible for most of the sequential growth in the fourth quarter, tracking to a seasonal pattern, it has been in place the past few years. Consistent with that seasonality, we expect to see a slight decrease in overall first-quarter foundry and logic revenues with a reduction in RF probe cards partially offset by strong foundry demand. This foundry strength provides some real-time insight into the differences between the demand drivers for consumables like probe cards and for capital equipment like automated test equipment. As we often note, probe cards are consumable specific to each new chip design. And so we benefit from both node transitions and the release of new designs on existing nodes. In the first quarter, our foundry business is being driven by this second component, the release of new designs on existing nodes, as we enable reuse of our customers' installed base of testers to test new chip designs, primarily in high-performance compute applications. Our expectation for continued long-term growth in the Foundry and Logic Probe Card market is one of the primary drivers of our ongoing capacity expansions. Customers are investing in both leading edge capacity, as evident from record levels of wafer fab equipment spending, and early-stage innovative advanced packaging architectures like EMIB, Foveros, and 3DFabric to help offset the slowing of front-end driven Moore's law. As we've discussed in the past, these chiplet or tile-based integration schemes drive both higher test intensity, which expands the number of probe cards required per wafer out, and test complexity, which widens FormFactor's competitive advantage. Together, both these dynamics create tailwinds for long-term foundry and logic probe card demand. Turning to DRAM. Demand for DRAM probe cards in the fourth quarter sustained near the high levels of the second and third quarters as customers continued to release and ramp multiple new designs in volume. We do expect a moderate sequential decrease in DRAM revenues in the first quarter after several quarters at these near-record levels. New design activity with each of the major DRAM manufacturers continues to be strong with our diverse mix of new DDR4 and DDR5 designs in both mobile and PC server applications. We expect this new design activity will continue to sustain healthy DRAM demand from each of our customers. FormFactor's ability to absorb these short-term fluctuations in demand from each of our customers, served markets, and specific applications within these markets is the result of our long-term initiatives to be a diversified market leader supplying all major semiconductor markets and manufacturers, and it remains a key tenant of our operational strategy. Our engineering systems business also delivered record results in the fourth quarter, with revenue of nearly $40 million, and we continue to experience sustained demand in the first quarter. This demand is driven primarily by the adoption of FRT optical metrology tools and advanced packaging applications, along with continued customer investments in engineering progress to enable industry innovation in new CMOS architectures like gate-all-around and optical applications like Silicon Photonics. In addition, we recently launched an exciting new program to offer state-of-the-art cryogenic test tools and capabilities as a service, enabling quantum computing developers to rapidly and cost-effectively characterize their qubits and resonators. Using FormFactor's cryostats with innovative probe sockets adapted from our market-leading probe card business, customers can utilize this service to dramatically accelerate development cycles with no upfront capital investment. Let me close by noting that with solid demand over an increased capacity to meet that demand, we're well along the path to achieve the target financial model that delivers $2 of non-GAAP earnings per share on $850 million of revenue. Our leadership position in our attractive served markets, paired with our differentiated strategy and disciplined execution will drive continued growth and share gains as we progress towards our target model and beyond. Shai, over to you.

Thank you, Mike, and good afternoon. As you saw in our press release and as Mike mentioned, Q4 represented a strong finish to a great year. We concluded the year with record quarterly and annual revenues and record quarterly non-GAAP operating profit and pretax income achieved while opening our new manufacturing center during the quarter. Fourth quarter revenues were above our outlook range and non-GAAP EPS was at the high end of the range while non-GAAP gross margin was at the low end of that. FormFactor's fourth quarter revenues were $205 million, an 8% sequential increase from Q3 and an increase of 4% year-over-year and contributed to a total fiscal 2021 revenues of $770 million, an 11% increase compared to 2020. Probe cards segment revenues were $166 million in the fourth quarter, an increase of $11 million or 7% from Q3. The increase was driven by higher revenues in older markets we serve, with the biggest increase in Foundry and Logic revenues. System segment revenues were a record $39 million in Q4, an increase of $4 million or 11% from the third quarter, mainly as a result of higher sales of 300 millimeter systems and cryogenic probers for quantum applications, partially offset by lower thermal systems revenue. Within the probe cards segment, foundry and logic revenues increased by $9 million from Q3 to $114 million in the fourth quarter, comprising 56% of total company revenues, slightly higher than the 55% in the third quarter. DRAM revenues were $40.3 million in Q4, $0.4 million or 1% higher than in the third quarter and were 20% of total quarterly revenues as compared to 21% of revenues in the third quarter. Flash revenues of $11.6 million in Q4 were $1.2 million higher than in the third quarter and were 6% of total revenues in Q4, the same as in Q3. GAAP gross margin for the fourth quarter was 43.7% of revenues as compared to 42.2% in Q3. Cost of revenues included $1.3 million of GAAP to non-GAAP reconciling items, which we outlined in our press release issued today and in the reconciliation table available in the Investor Relations section of our website. On a non-GAAP basis, gross margin for the fourth quarter was 44.3%, within our outlook range, reflecting lower gross margins in both segments and 170 basis points lower than the 46% non-GAAP gross margin in Q3. Gross margin improvement remains an area of focus. As a reminder, we expect that margins will fluctuate from quarter to quarter, mainly as a result of changes in product mix. Our Probe cards segment gross margin was 44.1% in the fourth quarter, a decrease of 100 basis points compared to 45.1% in Q3. The difference is mainly due to a less favorable product mix and higher wafer processing expenses related to production flow timing, partially offset by lower indirect material spending. Our Q4 System segment gross margin was 45.5%, 460 basis points lower than the 50.1% gross margin in the third quarter. This decrease is due to a less favorable product mix and year-end inventory adjustments. As we've said previously, we expect our system segment gross margin to range between the high 40s to low 50s. Our GAAP operating expenses were $58 million for the fourth quarter, $1 million higher than in the third quarter. Non-GAAP operating expenses for the fourth quarter were $49.7 million or 24.2% of revenues as compared with $48.5 million or 25.5% of revenues in Q3. The $1.2 million increase relates mainly to higher marketing, travel, and sales commissions expenses in line with the increase within revenues and business activity. Company non-cash expenses for the fourth quarter included $7.8 million for stock-based compensation, $2.4 million for the amortization of acquisition-related intangible, and depreciation of $6.5 million, all levels similar to the third quarter. Non-GAAP operating income for the fourth quarter was $41 million, a company record, and $2.3 million higher than the third quarter. GAAP net income for the fourth quarter was $26 million, or $0.33 per fully diluted share, compared to $20.5 million, or $0.26 per fully diluted share in Q3. The non-GAAP effective tax rate for the fourth quarter was 16.7%, 220 basis points lower than the 18.9% in Q3. This brings our 2021 full-year non-GAAP effective tax rate to 18.2% within our anticipated non-GAAP effective tax rate of 15% to 20%. As a reminder, our annual cash tax rate is expected to remain at 6% to 8% of non-GAAP pre-tax income until we fully utilize our remaining U.S.-based R&D credit. Fourth quarter non-GAAP net income was $34.7 million, or $0.44 per fully diluted share, compared to $31.6 million or $0.40 per fully diluted share in Q3. The fourth quarter's non-GAAP net income was second only to the fourth quarter of 2020. Moving to the balance sheet and cash flows. We generated $24 million of free cash flow in the fourth quarter compared to $14 million in Q3, bringing 2021 free cash flow to $74 million in a year that included a significant investment in capital expenditures of $67 million. We had total cash and investments of $280 million at the end of the quarter. The fourth quarter $10 million sequential increase in free cash flow reflects a decreased investment of $5 million in working capital and a $5 million decrease in capital expenditures. As of the end of the fourth quarter, we had two term loans remaining on our balance sheet totaling $24 million. We invested $50 million in capital expenditures during the fourth quarter, compared to $20 million in Q3. This brings our year-to-date CapEx to $67 million, just below our previously communicated range of $70 million to $80 million. This investment was chiefly related to the capacity expansion in our Livermore Manufacturing Center, which went online during the fourth quarter as expected. In 2022, we expect to continue to invest in increasing capacity to meet customer demand. Accordingly, 2022 CapEx is planned to be between $60 million and $80 million. As a reminder, we expect CapEx to return to the 3.5% to 4% of revenues in our target financial model after we conclude these capacity expansions. No significant share repurchases were made during the fourth quarter. And for year-end, we purchased just over 620,000 shares with an average purchase price of $38.62 under our two-year $50 million share repurchase plan. This brings our total share repurchases under this plan to about 0.8% of our outstanding shares. The main purpose of the plan is to offset dilution from stock-based compensation. And at year-end, $26 million remains available for future repurchases. Turning to 2022 first quarter non-GAAP outlook. As Mike mentioned, we expect the seasonal decline mainly in foundry and logic revenues and a moderate decrease in DRAM revenues. These factors will result in a Q1 revenue outlook in the range of $188 million to $200 million. Non-GAAP gross margin for the first quarter is expected to be in the range of 44% to 47% on a more favorable product mix, partially offset by higher input costs and labor expenses. At the midpoint of these outlook ranges, we expect Q1 operating expenses to be higher than Q4 by approximately $1 million mainly due to annual benefits research and additional hiring. Accordingly, non-GAAP earnings per fully diluted share for Q1 is expected to be between $0.35 and $0.43. Reconciliation of our GAAP to non-GAAP Q1 outlook is available on the Investor Relations section of our website and in our press release issued today. With that, let's open the call for questions.

Please stand by while we compile the Q&A roster. Our first question comes from the line of Brian Chin of Stifel. Your line is open.

Hi, good afternoon. Nice Q4 results and thanks for letting us ask a few questions. Maybe the first question, just housekeeping wise, how large is the Q1 revenue impact from the labor and component constraints you referenced?

Brian, it's Mike. If you look at the midpoint, it's down roughly $10 million. I would attribute about half of that to supply chain and labor constraints we've faced early in the quarter, with the other half due to the seasonal trends we usually observe going from Q4 to Q1 in foundry and logic. We have noticed larger seasonal declines transitioning from Q4 to Q1. While this does play a role, the foundry aspect of the business remains robust. So, to summarize, the $10 million decrease at the midpoint can be divided roughly in half between constraints and seasonal demand.

Okay, that's really helpful. I have an observation that relates to the Foundry and Logic segments of the business. In the fourth quarter, the company is achieving record quarterly revenue, even though revenue from your largest customer appears to be down by 30 to 40% compared to its run rate in 2020, which seems like a positive sign. From a timing perspective, when do you expect that logic devices using seven nanometer process technology and significant heterogeneous die integration will become a more substantial part of your revenue stream?

Yeah. So it's a great observation, Brian, and one that I do want to emphasize for people. We talked about some of the 2020 run rates for the customer probably not being at sustainable levels at least for the 10-nanometer manufacturing model. And indeed, you see in the second half of 2021, we did come back to some more normalized levels. But if you look out a little bit further to heterogeneous integration, chiplet strategies, or tile strategies, those definitely are raising test intensity, which is going to require more probe cards to wafer out. That for us right now is a very significant R&D activity, but I wouldn't expect it to significantly help with revenue until maybe late in this year or early into 2023. If you look at the usual delay or lag between customer product releases and the probe card demand, you can see there's a couple of quarters in there. And so although, again, a very active part of our R&D engagement with that customer and all leading customers in the foundry and logic space, I do expect it to be a late in the year or early '23 impact to the revenue.

Got it. And then maybe just one step back question, Mike, before I hop off. If you were to carve out the advanced foundry logic part of the probe card market, TAM, what do you think the market CAGR might be for that over the next two-year horizon?

So it's an interesting question because there's components of some real structural tailwinds there, but some also unpredictable headwinds that we've obviously dealt with over the last couple of years. The most recent being the Omicron issues to start 2022. You look at the overall probe card market it's probably a high single-digit grower. That piece, the high-end foundry and logic, I think that's where the biggest tailwinds are. And although they're difficult to quantify with the different puts and takes associated with high-end wafer fab equipment spending, some of the advanced packaging adoption, heterogeneous integration adoption that we just touched on, I do think there's the potential for that sub-segment to outgrow the single-digit growth for the Probe Card market, and we've seen that in a couple of recent years. Fortunately, it's our biggest market and one which we continue to innovate.

Our next question comes from Krish Sankar of Cowen & Company. Please go ahead with your question.

Hi. Thanks for taking my question. I actually have three of them. To Mike, in your prepared comments you mentioned that the supply constraints impacted the systems business but not the probe card. I just want to make sure I heard that right. And if that is the case, I understand probe card is a consumable, but it some of the front-end equipment folks are having issues with constraints and in shipping it to your customers, how does that, if at all, impact probe card demand?

Yeah. It may impact part of the demand and the seasonal downtick we're seeing here in Q1. It's obviously hard to tell in the moment. But if the customers don't have the front-end capacity in place to produce wafers, qualify them, and ramp new designs, they're not going to need probe cards. And as we've discussed in the past, we typically lag the WFE spending in installed by somewhere between two and four quarters, depending on customer yield ramp and the details of that. So any delays in WFE are going to result in delays in the overall probe cards business. Having said that, there was enough WFE stand and capacity added across the industry in 2021 that led to some strong demand in the back half of the year, that led to the record results and continued pretty good momentum here into 2022.

Got it, that's very helpful. I understand that most of your probe cards are for leading-edge technologies. Is there a way to clarify your revenue split between leading-edge and lagging-edge, which I assume refers to 14 or 16 nanometer and above? I know one of your foundry customers likely handles in-house probe cards for lagging-edge.

Gosh, that's a tough one that we'd probably have to get back to you on. I don't want to guess on my feet, but you're right. The majority of our revenues are driven by leading-edge nodes and new designs ramping on those leading-edge nodes. The one significant exception is things like the automotive industry. We do a reasonable business from microcontrollers and special chips in automotive that are obviously fabricated on trailing edge nodes. But as a probe card manufacturer sort of in between the front end and the back-end, often we don't have a ton of visibility into the specifics of the nodes unless it's a very significant design where there's a lot of visibility from the customer.

Got it. Fair enough. And then a final question for Shai. I mean, the target model you laid out in 2020, $850 million, $2 in earnings. Clearly, it looks like you are almost there. And between then and now, obviously the Foundry Logic WFE, or demand has meaningfully moved higher. So I'm just kind of curious, $850 million, $2 in EPS is still the target, or do you feel good about exceeding that?

So we feel very comfortable with the target model we put in place and the progress we made so far. And we are not there yet, making great progress with $205 million in Q4. And as we get closer to the model, if we run a couple of quarters in a run rate which is close to this run rate, we'll provide an update on the model similar to what we did a year ago when we got closer to achieving the previous model.

Thank you. Our next question comes from Charles Shi of Needham & Company. Your line is open.

Good afternoon, and thank you for taking my question. Mike and Shai, maybe my first question a little bit about your indirect customer Apple in terms of your seasonality pattern here. I think over the last couple of weeks we did hear that some people got hurt because of the node migration of Apple being delayed by one year, but we also heard that there are some other semiconductor device companies seeing pull ins as Apple filled early inventory. I did hear you that the foundry seems to be strong, and you did highlight the HPPC strength. I don't know if that's really coming from your indirect customer, this indirect customer or not but on the mobile side, are you seeing some of the pooling effect as well or do you see a slightly different seasonality pattern here? Thank you.

Yeah. I think it's an important piece to our business to understand, and that's why I took the time to make the point in the prepared remarks. Probe card demand is driven by new designs. If they're on existing nodes that drives probe card demand, they're still on new nodes that obviously drives probe card demand. So you can often see these local dislocations between our consumables business and capital equipment businesses that are very closely related. For example, if I look at the foundry strength at present, as I said, it's primarily associated with HPC, high-performance compute. There are mobile elements to it, no question about it but I think if I were to draw a single dominant theme to it, it is high-performance compute in the foundry segment, which is not too surprisingly given the rapid innovation and some of the very interesting chip designs you see ramping through that ecosystem.

Got it. Maybe the next question on your supply chain, I think you did provide some quantitative color, thank you for that. I want to ask if you can provide some direction or color. In terms of the supply chain impact of what you're seeing right now, is it more impacting the Probe card side of the business or the System side of the business?

Yes, it's definitely more impacting the system segment. And it’s pretty targeted things, pretty targeted sub-components from a handful of suppliers. And when you get to the fundamental root cause of what's causing those suppliers to push out their deliveries to us, somewhat ironically, it comes back to the semiconductor shortage or at least electronic component shortages. Our team's done a very good job of working with existing suppliers and qualifying new suppliers. But as with many other semiconductor supply chain companies, we're constrained in a couple of places that is having a big impact on the lead time at present. Again, very focused in the system segment. We've managed to avoid any impact in the probe card segments and continue to be very focused on doing that. But it's such an active part of managing the business and managing any semiconductor supply chain business right now. That is a big part of management's attention.

Got it. Maybe my last question a little bit switching to longer-term view. I want to ask you about the DRAM. Obviously, DDR5 is a big driver for your Probe card business. But assuming you have some visibility into what probe cards really supporting DDR4 and what are really supporting DDR5. Are you seeing the crossover in terms of either the volume or dollar value of the transition from DDR4 to DDR5 in terms of the probe card demand? Yet, if you haven't seen that, do you expect you'll see that this year? That's my last question. Thank you.

I believe we are nearing a point of parity between DDR4 and DDR5. I am surprised by how long DDR4 has lasted. In previous transitions, such as from DDR3 to DDR4, there was a significant increase in design activity, with most new designs quickly adopting DDR4. However, that is not happening with the current transition to DDR5, as many designs are still using DDR4. This might be linked to other components in the ecosystem, like processors and various peripheral chips. It's noteworthy that we are currently seeing nearly equal levels of new design activity for both DDR4 and DDR5. All right. Thanks, Charles.

Thank you. Our next question comes from Craig Ellis of B. Riley Securities. Your line is open.

Yes. Thanks for taking the questions. The first one is just a clarification and understanding some of the issues that are play in the first quarter outlook around supply chain and labor issues. Mike, I heard you say that if we look at the change in revenue, about half of that is supply chain related things. And I think I'm hearing from this call that supply chain is some issues on the system side and then some labor issues. The question is this, do you feel like you have good visibility to getting better supply dynamics with some of the things that are impacting systems and with respect to some of the things that are more labor-related? When do you think you'd have staffing back where you want it to be? Is this something that persists through the first quarter or should you have it largely behind you by the time you get into the second quarter?

Let me address a couple of aspects of that question by separating it into supply chain and labor. On the supply chain side, about a quarter of the impact relates to sub-component supply in the systems business. Our supply chain team is actively working to find alternatives and collaborate with existing suppliers to mitigate the overall impact of shortages while keeping our commitments to customers and minimizing lead times. The other issue, mainly in the Probe card sector, is related to labor shortages earlier in the quarter due to quarantine requirements linked to Omicron. Many of our employees, particularly those in our U.S. manufacturing operations on the West Coast, were either infected or had close contact with someone who tested positive. Our safety policies necessitate that anyone who has been in close contact with a confirmed case must not enter the factory, significantly reducing our labor capacity in January. Fortunately, the situation in our surrounding communities has improved recently. However, trying to predict COVID infection rates hasn't been reliable, and we want to ensure the safety of our workforce. Assuming there are no new variants that heavily impact our workforce, it seems like the worst is behind us. But as we’ve learned in the past two years, making predictions about the end of the pandemic is quite challenging.

Yes, that's correct. The second question was regarding the DRAM business. The company effectively increased its market share in the third quarter, and the business is performing well. You mentioned the strength in DDR4 and DDR5 across manufacturers. The question is, how do you assess your current market share, and do you see opportunities for further share growth in the DRAM market as we move through 2022?

I think it's like the high-end foundry and logic market. It's essentially a market where there's two primary suppliers, us and a Japanese company. We did manage to gain some share over the past year on our key competitors. And I think there's the opportunity, at least to hold that share if not gain some more. Some of those share gains are specific to the kinds of devices and the test strategies that our customers are releasing and ramping. We've talked a lot in the past about dips in DRAM and two touchdowns versus one touchdown configurations. There's a lot of subtleties in where FormFactor has competitive advantage. But I think the share gains we've been able to achieve and execute on in 2021, I am optimistic we will be able to hold those and hopefully push them further.

Yeah, makes sense. And then lastly for me before I hop back in the queue. This is at least the second call that you've mentioned quantum computing and some opportunities in the systems business. Can you just talk about how material that opportunity is now and what you think might be possible over the next couple of years?

Yes. Quantum for us is really a long-term play. And by long-term, I mean outside the $850 million target model, an achievement to that. But it was fundamental to the acquisition we made of HPD Colorado a little over a year ago. The reason we did that is because we had major customers coming to us really asking us to help them figure out strategies, build tools, and build capability to test these quantum computing devices. Now, the subtlety here, the difficulty here is that most of these quantum computing devices have to operate at very low temperatures in a very well-controlled environment, so close to absolute zero and things like essentially no magnetic field. That drives some very specialized test requirement. A pretty natural fit to our engineering systems business and an exciting long-term opportunity for us to enable this nascent industry. But it's a few years off, no question about it. I would not expect to see significant impact on our financials over the next couple of years. But again, it's one of the longer-term initiatives that we're making to continue to drive growth and SAM expansion for FormFactor. And just to finish the point, as part of the reason why we introduced this test as a service that we announced earlier this week, we're really helping this nascent industry get their characterization and test done quickly while learning side-by-side with them, and monetizing both the acquisition that we made and the capabilities that we have internally.

Yes. As a follow-up, I want to note that the systems-related revenue of $39 million this quarter appears to be the highest we've seen in six to eight quarters, possibly even the best ever. I didn't catch the details from the prepared comments regarding what led to such high sales. It seems there may be a slight ease in the first quarter compared to our guidance. What is the potential for us to move to a new higher level of system sales, perhaps closer to the $40 million range per quarter instead of the low-to-mid thirties?

Yeah, I touched on it a little bit in the prepared remarks but it's worth expanding on. That level of the system segment being up around $40 million really has three primary factors. One is a lot of strength in the core engineering of our business augmented by some strength in the thermal piece of that business. Our foundry and logic customers are dealing with trying to test devices with very high powered entities, hundreds of watts to dissipate the power out of that, and so there's some real technical need there that we're solving a problem. But the other piece on top of that is the benefit of the acquisitions we've made, HPD to a lesser extent as I just told you, but there has been some nice growth out of the FRT optical metrology business as their tools get adopted for advanced packaging applications. So the systems business operating at the upper end of the $40 million level is a consequence of the legacy systems being nice and strong because of the industry innovation and yield improvement, along with good benefit from the acquisitions that we've made over the past couple of years. Thanks, Craig.

Thank you. Our next question comes from Christian Schwab of Craig-Hallum Capital. Your question please.

Guys. Just a quick follow-up on DRAM. When should we think about DRAM growth in calendar '22, given we will have new designs on DDR5 and probably continuation of new designs on existing nodes. But DRAM was especially strong this year. Can you give us a framework of growth expectations there?

I would like to revisit our discussion on potential growth in the high-end foundry and logic probe card market. Observing the entire probe card market, which is projected to grow at a mid-to-high single-digit CAGR, we do not anticipate DRAM to significantly exceed that growth. This is due to a few factors. Our customers generally manage their spending effectively and focus on reducing testing costs by utilizing FormFactor's capability to test entire wafers simultaneously. Therefore, we do not foresee substantial market growth in this area. As we've mentioned in this call and previous ones, the real opportunity for growth lies in foundry and logic probe cards, where there is considerable investment and increasing complexity and intensity that raise our customers' costs as they strive to ensure high-quality yields, particularly with the introduction of chiplet-style products.

That's a great segue into discussing your third largest customer this year. Do we have a clear path or visibility for them to be a more consistent 10% customer throughout 2022? Can you provide some guidance on how we should approach that? I know we've previously mentioned that this customer might be able to scale significantly higher. Could you give us an update on that?

Sure. Yeah. And I think reiterating our expectations for that customer, we do believe we can get them up to something like a $100 million a year. One of the challenges with them appearing as a 10% customer is we continue to grow the business quite substantially, and so is the bar to get on our 10% list continues to grow. Their business continues to be pretty seasonal. We do expect first-quarter strength, as I mentioned in the prepared remarks, and I think it's indicative of higher test intensity on some of these advanced high-performance compute designs that really drive a higher probe card spend. But I would also expect seasonality to continue as they prepare for second half releases for some of these things by buying both guards in the first half and qualifying everything and ensuring they have proper testing done.

Okay. So difficult seasonality kind of to last year, as a customer fluctuates the first half and not quite as strong in the second half, is that right?

Yeah. And they are sort of within striking distance of being 10% in most quarters, sometimes on the list, sometimes not.

Okay. Perfect. Thanks, guys. No other questions.

Thanks, Christian.

Thank you. Our next question comes from Amanda Scarnati of Citi. Please go ahead.

Thanks. Can you talk a little bit about the competitive environment that you're seeing in Logic and Foundry, and have there been any shifts over the last 12 months, either Intel or TSMC as the dynamics change a little bit in those businesses?

Yes, we discussed the competitive dynamics earlier. In DRAM, foundry, and logic, there are two dominant suppliers along with a privately-held Italian company that has demonstrated good growth. They have effectively secured a strong position as a second supplier with many key customers, but I wouldn't say this represents a fundamental shift in the competitive landscape. Market share will fluctuate as transitions occur, but overall, the probe card market is not significantly different from other areas like etch and depth, though lithography may differ. In these markets, two reliable suppliers will compete design by design and node by node for various opportunities and share gains. I consider the competitive environment to be relatively healthy, not only in DRAM but also in foundry and logic.

Can you discuss the M&A strategy moving forward? It appears you have developed a strong portfolio with growth activities and recent acquisitions fueling growth from 2020 to the beginning of 2023. Is there a desire for more M&A in the near future, or do you believe the portfolio is currently well positioned?

There is certainly interest in pursuing more mergers and acquisitions, which is a vital part of our strategy focused on broadening our served markets. However, we believe we can continue to execute and strengthen our leadership position in our existing served markets without allocating M&A resources there, mainly due to the dual supplier dynamic I mentioned earlier. When considering the system segment and some related consumable segments, we see some attractive opportunities where we want to invest the revenue generated from our operations, particularly in the probe card business, to establish leadership positions in new areas. The recent acquisitions we've made, such as FRT's growth in optical metrology and advanced packaging applications, serve as excellent examples of effectively investing that capital to acquire strong technologies and quality products. We aim to leverage our relationships with FormFactor customers and the broader industry to achieve significant growth from these acquisitions. This approach will be a consistent theme in our ongoing strategy.

Perfect. Thank you.

Thanks, Amanda.

Our next question comes from Tom Diffely of D.A. Davidson. Your line is open.

Yeah. Good afternoon, and thanks for the question. Mike, one more question on the DRAM market. When you look at potential growth going forward, is it more impacted by capacity as new wafer starts, or by node transitions, or the changing from the model safety of DDR4 to DDR5? What's the biggest driver of gains going forward?

I think the key factor is wafer starts. In the DRAM sector, node transitions or shrinks don't provide much bit growth for our customers, so they are primarily increasing bit growth through more new wafer starts. By processing more wafers in a DRAM fab, there will be a greater need for probe cards, which I believe is the main driver of demand. However, as we mentioned earlier, there isn't much growth anticipated in the DRAM probe card market. Our customers are quite effective at managing their spending and reducing their testing costs using our technology that allows for testing entire wafers at once. Therefore, we don't foresee significant growth in that market. As we have discussed in this call and prior ones, the real growth is coming from foundry and logic probe cards. There is substantial investment in that area, alongside increasing complexity and intensity, which is boosting our customers' testing as they aim to ensure they are yielding high-quality parts, particularly with the shift towards chiplet-style products.

Okay. That makes sense. So looking at the foundry logic market, seems like every week we hear about several more $10 billion fabs going up all over the world. Is there a role on that, a $10 billion fab or a 20,000 wafer start fab would drive X amount of probe card business on an annual basis?

Not really, because different customers have different test strategies, which is evident in our revenue composition. If there were a straightforward rule, we wouldn't observe such a significant variance between customers driving substantial wafer start demand. It really depends on those customers’ test strategies. However, all of these high-end foundry and logic fabs coming online will need to test those wafers regardless of their test strategy, whether it involves high or moderate wafer test intensity. As these fabs continue to expand, I believe this will be a long-term positive for the overall industry and for us as well.

Thank you, that's helpful. Shai, when I look at the expected incremental spending of around $50 million to $100 million in capital expenditures over the next year for the new facility, what will be the impact on COGS or OPEX from this increased spending?

Yes. So you might recall that we actually purchased the building, the new manufacturing serving in Livermore. This really helps with amortizing most of the expense over a longer period of time. So we don't expect the amortization and going the line to be a significant impact. And it is built into the 47% target model. So somewhere in there, we take that into consideration, or took it already.

All right. And you said it's on schedule. Can you give us a sense for what percentage field it is or how much more capacity there is to expand out over the next several years?

I think the way to look at it is, we purchased the entire building. It's about 100,000 square foot. For now, we've built the clean room and some offices around it, etc., for only half of the building. In Q4, we had tools in the building, we started manufacturing and producing revenue started in December, so some contributions to Q4 revenue but not a lot. This building, what we have now, will help us get to achieve the $850 million and beyond, as Mike mentioned in the prepared remarks. And we are in the process of formalizing our plans for the next level, the second half of the building, and additional capacity extensions which we need in other parts of the world, they're still in process of formalizing.

Great. Well, thank you both for your time today.

Thank you.

Thanks Tom.

Thank you. Our next question comes from David Dooley of Steelhead Securities. Your line is open.

Thanks for taking my questions, a couple. As far as if the wafer fab equipment business, let's say, grows around 15% in 2022, what do you think the growth rate of your probe card business will be or what do you think FormFactor's growth rate will be with that kind of WFE number?

It remains challenging to connect specific WFE expenditures to probe card expenditures, as customers have varying testing strategies. However, historically, increases in WFE do generally lead to increases in probe card spending, which is expected. As mentioned in response to Tom's question, with more wafers being produced, there's a corresponding increase in the demand for probe cards. There are various correlations to consider over time, and they differ across market segments, with distinct trends in DRAM compared to high-end foundry and logic. Nevertheless, I believe that the market's growth, reflected by a high single-digit growth rate, is a positive sign for the probe card market, which typically shows less volatility than capital equipment in both growth periods like the current situation and downturns we've observed in the past.

So what I was really trying to get at is what do you think your growth rate is going to and your answer is, 'high-single-digits is the best guess at this point?'

Yeah, I think so. For those of you that have followed us for a long time, you know that visibility is a challenging part of this business. We continue to drive lead times and cycle times down so that we're able to meet customer demand, essentially racing wafers through the fab. And so beyond even the current quarter, visibility can be a challenging thing but you look at all of the spending and investment that's going on and increasing leading-edge capacity and obviously directionally whether it's 2022 or 2023 for our business, more probe cards are going to be required.

You've touched on this earlier but I'm just curious, with the delay of three nanometers at TSMC from 2022 to 2023, I would imagine that would have been a nice bump in revenue for you guys, that it happened this year. Is there some way we can quantify the impact of that delay? I realize that there's going to be a lot more designs on five nanometers or four nanometers. But maybe just when you look at the overall impact, how do you look at it for FormFactor?

Yes. I don't think it has that big an impact for us. If you look at these well-orchestrated, well-planned node transitions, customers are still releasing new designs on the existing nodes, as you say five or four. And that's a good part of the strength here in Q1. One of the things that does happen when you go to a new node, especially a new node with substantially lower yields, is the probe card intensity does go up, the test intensity does go up at least initially, because customers, one, if they're operating at lower yields that you have to start more wafers to get more good die and then test those die and spread them out. But also they're testing a lot of different aspects of the chip to try and improve their yield. And so a new node, it's not a huge difference. Maybe call it 10% to 20% in overall test intensity. But there is a slight uplift there. I think the far more interesting thing to look at for us is the fact that designs continue to release on nodes like five nanometer or four nanometers, continuing to drive a pretty healthy business, at least in the first part of it.

One final clarification for me is if you think about high single-digits as the overall growth rate for FormFactor, I'm assuming, is it a good assumption to think that the foundry logic business would be low double-digits and the DRAM business and the other stuff would be below that high single-digit rate?

You can easily go back and read between the lines of some of the questions we’ve talked through in this session. It is clear that we had higher expectations for the high-end foundry and logic market. It's essential that they outgrow the overall prepared market.

Thank you

Thank you.

Thank you, this time I’d like to turn the call back to Mike Slessor for closing remarks.

Thanks everyone for joining us today, we’re looking forward to a strong 2022 and hopefully seeing you again in person at some point during the year, take care.

This concludes today’s conference call, thank you for participating you may now disconnect.