Formfactor Inc Q2 FY2024 Earnings Call

Thank you, and welcome, everyone, to FormFactor's second-quarter 2024 earnings conference call. On today's call are Chief Executive Officer Mike Slessor, and Chief Financial Officer Shai Shahar. Before we begin, Stan Finkelstein, the company's VP of Investor Relations, will remind you of some important information.

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 projections of financial and business performance, future macroeconomic and geopolitical conditions, the benefits of acquisitions and investments in capacity and new technologies. The impact of global, regional, and national health crises, including the COVID-19 pandemic, anticipated industry trends, potential disruption in our supply chain, the impacts of regulatory changes, including the recent US-China trade restrictions, 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 the fiscal year ended December 30, 2023, and in our other SEC filings, which are available on the SEC's website at www.sec.gov. In our press release issued today, forward-looking statements are made as of today, July 31, 2024, and we assume no obligation to update them. We will now turn the call over to FormFactor's CEO Mike Slessor.

Thanks, everyone, for joining us today. FormFactor's second-quarter revenue, non-GAAP gross margin, and non-GAAP EPS all exceeded the midpoint of the outlook range we provided in May. Expected strength in our probe card business drove second quarter results as we recorded sequential increases in all three probe card markets. DRAM probe-card revenue reached record levels with revenue from high-bandwidth memory or HBM doubling for the third consecutive quarter to nearly 75% of our DRAM revenue. In the current third quarter, we're experiencing steady overall demand for FormFactor's products as we continue to make progress towards our target financial model. Our second quarter results and third quarter outlook illustrate the unique value of FormFactor's diversification strategy, which differentiates us from our direct competitors with a broad lab to fab product portfolio across foundry and logic, DRAM and Flash probe cards, along with our Systems segment products. This portfolio enables us to compete for business across diverse demand pools at all major customers, producing relatively stable results during last year's downturn and the top line growth we're delivering this year. Our revenue growth is being driven by exposure to expanding areas like high-bandwidth memory and DRAM probe cards, as well as co-packaged silicon photonics and systems, enabling FormFactor to grow even as we await refresh cycles in important high unit volume end markets that drive foundry and logic probe card spending like mobile handsets and client PCs. FormFactor's third-quarter outlook also demonstrates several unique features of probe card demand. As we often note, probe cards are a consumable that's specific to each new chip design, meaning we benefit from both technology node transitions and from the release of new designs on existing nodes, together with our broad market and customer exposure. This produces a more stable demand profile than the more volatile demand cycles that characterize capital equipment. This difference is particularly evident in the current environment as FormFactor's stable third quarter outlook contrasts sharply with the sequentially weaker third quarter outlooks offered by several companies in the test and assembly capital equipment. Turning now to market and segment level details. As I noted, we set a record for DRAM probe card revenue in the second quarter, driven by the sequential doubling of HBM revenue, layered on top of steady DDR5. To put HBM toward growth into perspective, in the first half of 2024 alone, we doubled the HBM revenue we delivered in all of 2023. In addition, our second quarter HBM revenue is greater than FormFactor's total quarterly DRAM revenue in each quarter of 2023. This activity is a direct result of the large hyperscaler investments in generative AI infrastructure and our customers' corresponding ramps of HBM capacity and output. HBM, which is a stack of 8, 12, or even 16 individual DRAM dies assembled with advanced packaging processes like through-silicon vias and thermo-compression bonding, continues to offer a powerful example. Advanced packaging is driving our current results and also foreshadows our long-term opportunity as we benefit from the increased test intensity and increased test complexity inherent in advanced packaging architecture. In the third quarter, demand for DRAM probe cards continues to be robust, and we expect a slight increase in revenue from the second quarter record. We do, however, expect a shift in our DRAM product mix with a sequential increase in DDR5 shipments and a reduction in HBM shipments. We mentioned in the past that our customers often have one to two quarter periods of digestion following a strong quarter of shipments, with lead times of less than a quarter leading to short-term visibility that's always challenging. However, given our customers' continued strong investment in HBM capacity, we expect the third quarter pause in HBM growth to represent a temporary digestion phase and that growth will resume in one to two quarters. Shifting to the foundry and logic probe card market, we delivered the expected second quarter sequential growth driven by the seasonal ramp of new mobile application processor designs and stronger probe card demand for client PC and server microprocessor designs. In the current third quarter, we expect foundry and logic demand and product mix to be similar to that achieved in the second quarter. Advanced packaging processes like Foveros are being increasingly used to architect foundry and logic chip designs. As with HBM and DRAM, this disaggregation of a chip into subcomponent chiplets or tiles increases both test intensity and test complexity compared to an equivalent model of the chip. The increase in test intensity is driven by the need for our customers to prove and test each component chiplet prior to stacking and then to prove and test the multi-chip flip stack at various points during the assembly process. The resulting increase in probe card use per good die out is the same dynamic that is driving strong probe card spending by our customers for HBM, DRAM, and as the source of relatively strong midyear Foundry and Logic demand, despite the lack of recovery in important end markets like mobile handsets and PCs. At the same time, the technical requirements for probe cards for Foundry and Logic designs built using advanced packaging processes are significantly more demanding than for standard unstacked products, involving higher test speeds and more challenging thermal and power specifications. As we've seen with HBM and DRAM, our differentiated ability to meet these performance requirements drives both market share and profitability gains as the adoption of advanced packaging in foundry and logic continues. In the Systems segment, we expect a slight sequential increase in Q3 revenue as customers continue to engage us to solve the most complex electro-optical test and measurement challenges in areas like quantum computing and co-packaged silicon photonics. In co-packaged optics, which is poised to revolutionize chip-to-chip communication in the data center by significantly reducing power consumption at high data rates, we're collaborating with key customers in the early stages of the lab to fab transition from R&D to low-volume production. In these collaborations, customers are deploying FormFactor's turnkey electro-optical measurement systems built on our CM300 and SUMMIT200 engineering probers, together with our proprietary optical probes. The highly differentiated optical probes enable either surface or edge coupling to the photonic die with unrivaled coupling efficiency, providing our customers with higher yields and shorter test times. As silicon photonics matures and moves to high-volume production in the coming years, we expect that our leadership positions in combined electrical and optical test will provide a new growth vector for both our systems and probe card businesses. In closing, we're excited about both our strong second quarter results and our solid third quarter outlook as the accelerating adoption of advanced packaging drives increased demand across FormFactor's lab to fab product portfolio. Longer term, we're confident in the growth prospects for FormFactor and the industry overall, driven by the fundamental trends of semiconductor content growth in advanced packaging innovations like HBM, chiplets, and co-packaged silicon photonics. It is evident from our recent results and outlook. These are trends where FormFactor is well-positioned, and we're confident that our investments in R&D capacity and talent will further enhance FormFactor's market leadership. This will enable us to achieve and then surpass our target model that delivers $2 of non-GAAP earnings per share on $850 million of revenue. Shai, over to you.

Thank you, Mike, and good afternoon. As you saw in our press release, Q2 revenues were $197.5 million, $2.5 million above the midpoint of our outlook range. Non-GAAP gross margin of 45.3% was 0.3 percentage points above the midpoint of the range. These, together with OpEx slightly lower than the midpoint of the outlook, resulted in non-GAAP EPS at the top end of the range. Second quarter revenues increased 17% sequentially from the first quarter and increased 26.7% year-over-year from Q2 '23 revenues. The upside versus the midpoint of the outlook range was due to higher revenues in our probe card segment. Probe card segment revenues were $167 million in the second quarter, an increase of $30 million or 22% from the first quarter. The increase was driven mainly by higher Foundry and Logic and DRAM revenue. Systems segment revenues were $30.7 million in Q2, a $1.3 million decrease from the first quarter and comprised 15.5% of total company revenues, down from 19% in the first quarter. Within the probe card segment, Q2 foundry and logic revenues were $104 million, a 19.5% increase from the first quarter. Foundry and Logic revenues increased to 52.5% of total company revenues compared to 51.4% in the first quarter. DRAM revenues were a record $58 million in Q2, $12.1 million or 26.5% higher than in the first quarter and rose to 29.4% of total quarterly revenues as compared to 27.2% in the first quarter. Within HBM, revenue almost doubled from $22 million in Q1 to over $43 million in the second quarter. Flash revenues of $5.1 million in Q2 were $1.1 million higher than in the first quarter and were at 2.6% of total revenues in Q2 as compared to 2.4% in Q1. GAAP gross margin for the second quarter was 44% as compared to 37.2% in Q1. Cost of revenues included $2.5 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 second quarter was 45.3%, 6.6 percentage points higher than the 38.7% non-GAAP gross margin in Q1 and 0.3 percentage points above the midpoint of our outlook range. The increases compared to Q1 were mostly the result of higher gross margin in the probe card segment. While we expect fluctuations quarter over quarter, mainly due to product mix changes, achieving this 45.2% gross margin in the second quarter validates our progress towards our 47% target financial model non-GAAP gross margin at annual revenue of $850 million. Our probe card segment gross margin was 45.1% in the second quarter, an increase of 8 percentage points compared to 37.2% in Q1. Our Q2 system segment gross margin was 46.2%, an increase of 0.9 percentage points compared to 45.2% gross margin in the first quarter. As compared to Q1, approximately two-thirds of the increase in non-GAAP gross margin is attributable to the higher volume, and the remaining third relates to a more favorable product mix. Our GAAP operating expenses were $69.4 million for the second quarter as compared to $61.7 million in the first quarter. Non-GAAP operating expenses for the second quarter were $60.9 million or 30.8% of revenues, as compared with $52.3 million or 31% of revenues in Q1. The $8.5 million increase relates mainly to higher performance-based compensation. Company non-cash expenses for the second quarter included $10.2 million for stock-based compensation, $0.6 million for amortization of acquisition-related intangibles, and depreciation of $7.4 million, all similar to the first quarter. GAAP operating income was $17.8 million for Q2 compared with GAAP operating income of $21.3 million in Q1. Non-GAAP operating income for the second quarter more than doubled to $28.5 million compared with $13 million in the first quarter, an increase of $15.6 million or 120%, demonstrating the leverage in our operating model. GAAP net income for the second quarter was $19.4 million or $0.25 per fully diluted share compared with a GAAP net income of $21.8 million or $0.28 per fully diluted share in the previous quarter. GAAP net income in Q1 included a gain of $20 million from the divesture of our Chinese subsidiaries. The non-GAAP effective tax rate for the second quarter was 15.4%, 1.7 percentage points higher than the 13.7% in the first quarter, and we continue to expect our annual non-GAAP effective tax rate to be between 14% and 18%. Second quarter non-GAAP net income almost doubled to $27.3 million or $0.35 per fully diluted share compared to $14.3 million or $0.18 per fully diluted share in Q1. Q2 EPS was $0.17 higher due to significantly higher revenues and higher gross margins with relatively flat OpEx as a percentage of revenue. Moving to the balance sheet and cash flow, we generated free cash flow of $14.2 million in the second quarter compared to $19.7 million in Q1. The main reasons for the decrease in free cash flows were increased working capital attributable to revenue growth, partially offset by lower capital expenditure spending of $5 million. We invested $8.4 million in capital expenditures during the second quarter compared to $13.4 million in Q1. There's no change in our previously communicated expected CapEx range for 2024 of $35 million to $45 million. At quarter end, total cash and investments were $366 million, an increase of $8 million from Q1. At the end of the second quarter, we had one term loan remaining with the balance totaling $14 million. Regarding stock buyback, during the second quarter, we used $2.9 million to buy back shares under the $75 million two-year buyback program that was approved in Q4 2023. At quarter end, $53.5 million remains available under that authorization. As a reminder, the main purpose of the share repurchase program is to offset dilution from stock-based compensation. Turning to the third-quarter non-GAAP outlook, we expect Q3 revenue of $200 million, plus or minus $5 million with a slight increase over Q2 coming from DRAM systems. Within DRAM, we also expect a mix shift with a higher percentage of DDR5 versus HBM revenue. Third quarter non-GAAP gross margin is expected to be 43%, plus or minus 150 basis points, and we expect a decrease in non-GAAP gross margins in the third quarter at the midpoint of the outlook range on slightly higher revenues related to a less favorable product mix with DRAM revenues as a percentage of total revenue expected to increase and HBM revenue within that route expected to decrease. At the midpoint of these outlook ranges, we expect Q3 operating expenses to be $61 million, plus or minus $2 million, similar to Q2. Non-GAAP earnings per fully diluted share for Q3 is expected to be $0.31, plus or minus $0.04, and a reconciliation of our GAAP to non-GAAP Q3 outlook is available on the Investor Relations section of our website and in our press release issued today.

Our first question comes from Craig Ellis of B. Riley Securities.

Thanks for taking the question and congratulations on the execution, guys. And Mike, I wanted to start just by following up on a point you made about high-bandwidth memory. I think you indicated the company expected that after some digestion, the third quarter growth could reaccelerate there. I was hoping you could just share some of that either customer interaction or things that you're seeing that lend confidence to the reacceleration? And any color on timing would be helpful. Thank you.

Yeah. So Craig, good question. Just to level set, we again, in the second quarter, doubled HBM revenue to 75% of our DRAM revenue. So really significant contribution from that, as I think most of you know, is pretty concentrated with a single customer, although each of the three major DRAM manufacturers has contributions in there. It's not unusual when we ship at that scale for a customer to have a period of digestion where they then use the probe cards for a quarter. You can see this historically through our major customers as they're in their cadence quarter to quarter that we report for a 10% customer. And so what gives us confidence that this is that digestion? I think a couple of things. If I look at it from a macro level, continued hyperscaler investment in generative AI, which in turn is driving our DRAM customers to increase their capacity and output of HBM3 and three, currently beginning to do development on HBM4 and HBM5 production. In conversations with those customers, there’s no pause in that. They really are continuing to invest very heavily in this lucrative part of the DRAM market, again driven by hyperscaler investments. Our direct visibility is pretty limited. We operate with lead times of less than a quarter. In terms of POs and backlog, we can't see much past the end of the third quarter here. But when we look at the conversations we're having with these customers and the investments the hyperscalers are making, it does seem reasonable to attribute this Q3 to still have HBM at healthy levels during this digestion period.

That's really helpful, Mike, thanks. The follow-up question is somewhat similar: three months ago, you noted that a foundry logic customer, formerly the largest customer for this last quarter where it's now DRAM, would at times in the past, go through a period of digestion after a really strong quarter? Are you seeing signs? And is that baked into the guidance that we will see that digestion in the third quarter? Or how are you thinking about the risk that that could happen at this point?

Yeah, foundry and logic overall, we see in the third quarter pretty comparable to the second quarter, both from overall levels and customer and product mix. I think this is really another proof point associated with how advanced packaging is driving our business. You see major customers, certainly in compute, but also to some extent in mobile beginning to adopt advanced packaging tech more. We're seeing pretty solid demand for probe cards because of the increase in test intensity and complexity driven by advanced packaging in the sector. So Q3 looks pretty similar to the second quarter in foundry and logic from an overall customer and product mix perspective, again driven by advanced packaging.

That's really helpful. An observation on that, Mike, would be that those heterogeneous die-based products are such a small part of the mix now, but over time will become a majority of the mix. That would seem to be a real nice long-term secular tailwind for the business?

Yeah, across the industry, it's a really interesting and compelling secular opportunity for those of us exposed to advanced packaging.

Thanks, Mike. Good luck in 3Q.

Thank you.

Our next question comes from the line of Charles Shi of Needham & Company.

Hi Mike, so good afternoon and thanks for letting me ask two questions. The first one, it's about DDR5 versus HBM. I think prior to this quarter, the way you characterized the DRAM probe card market was if you back out HBM, the standard DRAM or DDR probe card was still running around that, I would say, $20 million-ish downturn level. Basically, it looks like next quarter, the September quarter, you're expecting a somewhat similar DRAM total revenue, but you're talking about a mix shift from away from HBM more to DDR5. Would you characterize maybe this as the beginning of the standard year-end recovery or this is maybe just a one-off quarter? I just wanted to know the sustainability of the DDR5 probe card growth from here?

Yeah. It's an interesting question as you might imagine, we're having similar discussions internally and with our customers. I think if you look at the overall non-HBM DRAM market, we're characterizing it as DDR5 but that's a pretty broad brush, that low-power server and compute, and you're seeing a significant step-up here in the third quarter to levels comparable to the previous cyclical highs. Now when we see and where HBM is, we said there's a bit of a one quarter digestion period, and that's not unusual. Remember, probe cards are specific to each customer chip design. As customers move their wafer starts back and forth between technologies and different products, they optimize their output for their market. We see significant swings between designs and market segments and submarkets. Whether this is the start of a DRAM upturn, I think is still to be seen, but it is encouraging if you've seen DRAM spot pricing and heard from our customers on the overall DRAM market improving. Certainly, that may be the beginning of an upturn. For now, we just don't have the visibility to say so, but it's nice to be operating our DRAM business—a very important business for us—up at record levels.

Thanks, Mike. I have a follow-up on the foundry logic side of the business. The foundry logic probe card was up in Q2 quite a lot, but your largest microprocessor customers—the revenue you disclosed on a quarterly basis—generally went up. So, up means much, I mean, it doesn't explain all the incremental you're seeing in the foundry logic side. Is there kind of a mid-year strength you could clarify a little bit about what's driving that outside of this microprocessor company, and more importantly, going into next quarter, who is driving that incremental growth in foundry logic probe card?

Yeah, we often see this mid-year strength in mobile application processors. If you look at phone release cadences and work back to the timing where customers are going to need probe cards for those. That's exactly what we're seeing right now. We talked about it on the last call with the anticipated second quarter strength, which materialized being associated with both microprocessors but also at midyear, our releases of these mobile application processors. That's a theme that we see carrying through the second quarter. Again, we see foundry and logic having a similar level and profile in the third quarter as in the second quarter, so beyond that, again, visibility is pretty limited, but we're happy with how we're executing in the broader foundry and logic market. Always some improvements, always some share to gain, but it's both of these factors driving our Foundry Logic strength in the middle part of the year.

And maybe a quick follow-up to that. Do you see a little bit of a mix shift in foundry logic probe cards from Q2 to Q3? Thanks.

No, it's very similar, Charles.

Our next question comes from the line of Tom Diffely of D.A. Davidson.

Yes, good afternoon, thank you, Mike. I was curious, when you look at the high-bandwidth memory ramp that you've had this year, how much of that was driven by just increasing volumes of high-bandwidth memory versus a design change? And then if there is a big shift to the next generation design, what does that do to your business?

Yeah, as we've said, probe cards are a design-specific consumable, and so there are these two pieces. There's the release of a new design, and there's also the number of wafer starts and number of test cells, and therefore, probe cards that need to run on this design. I'd characterize the growth in the second quarter of the HBM business as being concentrated across, let's call it in round numbers, 10 designs that are really the high runners driving the growth. Remember, HBM is a stack of mostly eight high DRAM, but there's a base die. There are test insertions for the eight core die, and then a test insertion when the customers are done stacking. Each of these three sets of probe cards is a unique fleet of probe cards, and that's part of the test intensity increase associated with HBM in particular and advanced packaging in general. More than a handful of designs are really driving the strength.

And then when you look at the business next year in '25, do you think it's pretty well split between the three main suppliers? Are you still going to be very leveraged to one of the players?

No, I think you know, as I said, we currently see contributions from all three manufacturers, although we're over-indexed to the leader in HBM market share. A fundamental tenet of our strategy is to make sure that we're a key supplier at the leading edge to all major customers. Qualification work is ongoing, and both of them are in a position to compete for that business as HBM3 and HBM4 roll out. Those are opportunities for our customer share development and for us to compete for new business as well.

And then the final question, Shai. When you look at the margin guidance for the next quarter, is it simply the decrease of high-bandwidth memory as a percentage of product mix issue?

While, it's a combination of DRAM revenue overall as a higher percentage of revenue and within DRAM, the shift from HBM to DDR5. So this is both of them.

Our next question comes from the line of Christian Schwab of Craig-Hallum.

Great. Thanks for taking my questions. So just again on high-bandwidth memory, we can back into the math, pretty modest revenue from the other two big guys as we get into 2025. Do you think you have no three meaningful customers in that space, or do you think that there's the potential for, as the other two guys get up to speed and begin to take share? I'm just trying to size what your expectations in '25 and '26 are for high-bandwidth memory as the other two guys come to market that I've talked about being sold out for next year.

Yeah, if we back out a little bit, we're a key supplier to all three major DRAM manufacturers in DDR4, DDR5, and we hope to be for HBM as well. Currently, one of them owns the lion's share of HBM shipments. That's why we're over-indexed to that customer. As the other two DRAM manufacturers gain share in the transition from HBM3 to HBM4 and work their way through some significant technical and yield challenges in ramping this up, we do expect that share to balance out a little bit. As we look into '25, the transition to HBM4 is exciting for us. It raises the speed requirements for the probe cards, which means a notch-up in complexity and as customers go to stacking 12 and even 16 high dies, that will obviously increase the overall test intensity and complexity associated with testing that overall stack. We feel like we're in a pretty strong competitive position even as the share starts to balance among all three DRAM manufacturers.

In the follow-up to that, on the high-bandwidth memory for transition, given as you said, the speed and increase stacking capabilities, I would assume that there should be some pricing power on those probe cards—not all the way, obviously, to foundry and logic levels, but potentially higher than where we sit today. Is that fair?

Yeah, that's fair. One of the reasons, right, we touched on it in a question a couple of minutes ago, but the mix shift away from HBM towards DDR5 inside DRAM at these high levels certainly presents a gross margin hit. Our ability to build probe cards that are highly differentiated and provide a lot of value to our customers in testing at speed and across multiple temperatures in a complex mechanical situation is crucial. You're testing a whole 300 millimeters wafer of the stacked die across a temperature range of over 100 degrees Celsius, and you can imagine the thermal scaling challenges that are significant. That's why HBM probe cards are worth more.

Great. And then my second question is now we've got two quarters of roughly $200 million, which is kind of the target model. Do you guys have set expectations on when you plan on updating your target model?

Sure. We are two quarters at $200 million, but the target model is a little higher than that, right? If you take the $850 million target revenue, we're getting closer to it, but we're not there yet. What we want to do is what we have done in the past: Once we have a quarter or two at this model run rate, we'll set up, schedule, and announce a new analyst day to work on publishing the new target model. So we're not there yet, but please stay tuned.

Got it, sounds great. Thank you, guys.

Thanks, Christian.

Our next question comes from Brian Chin of Stifel.

Thanks for letting us ask a few questions, Mike. Can you comment on whether you expect sort of that the mix shift you're seeing in the DRAM business to persist into Q4? And I guess that's kind of the first question, because I guess maybe it's like I heard 50 basis points to 80 basis points headwind or something relative to what it was in Q2. And so, that's the first question.

Yeah, Brian, it's Mike. I'll take that. I think in terms of timing, I'll again caveat this with our visibility—not much beyond the end of Q3 here. We're operating with short lead times. We certainly have forecasts from our customers, but the dramatic shift in DRAM towards production capacity for DDR5 is a relatively dynamic situation. Whether it persists or not is something that probably we need a few more weeks or months to read on from our direct backlog. Having said that, you know, if you do look at the underlying DRAM market, DDR4 and DDR5, low-power server and PC, they do seem to be strengthening, so it wouldn't be all that surprising if there was a shift of some capacity towards those markets and we saw a bit of growth in the non-HBM parts of the market. It's a little early to tell, and our visibility doesn't go that far into the future, but some of the fundamental factors are in place for a DRAM recovery agenda.

I was even thinking, yes, Samsung seemed pretty confident last night that their HBM3 shipments, if they are the dominant player, would accelerate substantially in the back half of the year. So maybe that Q3 could factor into your outlook for HBM at some point in the second half?

That's right.

And I don't know if anyone asked, but in terms of the—I'm not sure I missed this part—but the China increase Q-on-Q, was that mainly just multinational? Do you have any kind of additional color on what drove that?

You know, that’s an important topic to touch on. In Q2, a little over 10% from China as a percentage of revenue. Inside the Q3 look, we are forecasting a moderate increase. It will still be in the single digits—nowhere near the 40% to 50% some of the WFE suppliers have for China. We've been proactive in managing the situation; we divested our China operations and formed an exclusive distributorship with the purchaser of that business. Therefore, we are serving the domestic China business as best we can despite significant geopolitical headwinds from both direct export controls and the China industry's semiconductor response to standing up its own domestic semiconductor industry. We see a moderate increase, but I don’t see it as a theme where we’ll get significant contributions from the China business.

And let me just kind of get off topic here for one last question. On your energy efficiency usage, these are obviously key themes in the data center. I understand that silicon photonics is an area the company has invested in. Where are we on the adoption curve for co-packaged optics and how significant of a market opportunity could that be in maybe a couple of years?

Yeah, we are very early, as I said, just inching out of the lab where we've been engaged with customers for years and co-developing the fundamental measurement technologies like our Pharos optical probe, that allows customers faster test times and better overall yield because of its better signal-to-noise and coupling efficiency. But we've got a handful of tools inside production sites that are in the very early stages of pilot production. This is one of the ways to help solve not entirely solved, but it helps to address a significant problem associated with data centers: energy consumption. Going to silicon photonics on chip-to-chip communication in the data center has the potential to impact energy budgets for these data centers. The broader compute industry is going to have to confront this as data centers become bigger users of electricity worldwide. We view silicon photonics as something that’s not yet fully realized in terms of its market potential. Yes, I think the timing is probably at the earliest, late '25 to '26, where we start to see significant volumes inside the foundries worldwide.

Thanks, Mike.

Our next question comes from the line of Robert Mertens of TD Cowen.

Hi, this is Rob Mertens for Chris. Thanks for taking my questions. You mentioned the better-than-expected gross margins in the probe card business, largely due to higher volumes and maybe around 200 basis points or so attributed to the mix. Was the positive mix largely the high-bandwidth memory increase or more of a general mix throughout both the Foundry Logic and memory end market?

If you refer to Q2, we were right on spot. Gross margin was 45.3% versus midpoint of the outlook of 45%. I'm not sure what to clarify.

Just in terms of the gross margins, I thought I heard two-thirds driven by volumes and a third driven by mix?

That’s correct. The increase from Q1, which was in the high 30s at 38.7%, to 45.3%, saw about two-thirds of it relate to volume and about a third to mix. And that change in mix is from more HBM and more Foundry Logic.

And then could you just provide a little more color on the progress with qualifications of MEMS-based probe cards for GPU tests and maybe what the size of the market opportunity could look like?

Yeah, I think in sizing it is interesting. To get everybody on the same page, as the largest GPU manufacturer transitions to advanced packaging, you're primarily co-packaged at the world's largest foundry that requires MEMS brokers. The legacy probe cards they used for monolithic GPUs no longer work. We are in a qualification process there. I'd say our major competitor has been ahead of us and has got initial business, which we've been more focused on with HBM. But it's a strategic imperative for us to qualify there here in 2024 and make some progress. It's difficult to seize the opportunity, but as you heard from some of the memory manufacturers, there's an interesting asymmetry associated with some of these AI products—where the amount of memory in the package is almost 10 times that of the GPUs. For unit-driven businesses like ours, HBM becomes a much more compelling opportunity. That’s not to diminish the importance of qualifying during this important transition of GPUs to needing MEMS-based technologies for probe. But we like the exposure to HBM.

Got it. Thank you.

I would now like to turn the conference back to Mike Slessor for closing remarks.

All right. Thanks, everybody, for joining us today. We've got a couple of conferences in late August and in early September that we hope to see you at. Until then take care.

This concludes today's conference call, and thank you for participating. You may now disconnect.