Earnings Call Transcript - FORM Q1 2020

Jason Cohen, General Counsel

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 impacts of the COVID-19 pandemic, the impact of regulatory changes, the anticipated demand for products, customer requirements, our future ability to produce and sell products, the development of future products and technologies 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 2019 and 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, May 6, 2020, and we assume no obligation to update them. Also, as an aside, since this is an entirely remote earnings call for us, please bear with us on any audio delays or issues. With that, we will now turn the call over to FormFactor's CEO, Mike Slessor.

Michael Slessor, CEO

Thanks, Jason. Thank you, everyone, for joining us today. Before discussing our results and outlook, I want to recognize and thank peers and employees for their effort, dedication and perseverance during the COVID-19 pandemic. Our global team quickly reacted to a variety of government directives that shifted focus to reorganize manufacturing operations to restart our California factories, all while closely collaborating with our customers, ensuring our key products were prioritized and quickly delivered. Their performance demonstrates agility and resilience, and I'm extremely proud of our team. This first quarter had two distinct efforts, a strong start followed by two weeks where our ability to produce and ship products was substantially reduced. You'll recall that our first quarter outlook was dependent on following shelter-in-place orders and the temporary shutdown of our Livermore sites, including all manufacturing operations. Subsequent to the orders for Oregon and California, our Beaverton and Carlsbad sites were also impacted. However, through the implementation of essential infrastructure business and development of a set of on-site employee procedures, we restarted our production at each site in the final days of the quarter. We'll review details of the first quarter results, but it's noteworthy that the unexpected results we delivered clearly validate our targeted financial model. Viewing the quarter on an annualized basis, we delivered $643 million in revenue at a 46% gross margin, with $1.32 of non-GAAP earnings per share and $110 million of free cash flow. Taken together with our fourth quarter, these results demonstrate achievement of our target financial model, and we plan to update it later this year when overall conditions have stabilized. Our first-quarter revenue contained a strong mix of foundry and logic probe cards, consistent with the commentary we provided on our February 5 earnings call. This demand was broad-based, spanning both 10- and 14-nanometer microprocessor designs, as well as multiple foundry 5- and 7-nanometer mobile and high-performance compute designs alongside various 5G-enabling RF filter and antenna devices. DRAM probe card revenue was down in the first quarter during an expected digestion period following several sequential quarters of record revenue. We are currently working closely with each of the new DRAM manufacturers on new mobile designs on both 1Y and 1Z nanometer nodes, which are expected to go into volume in the second half of 2020. Our engineering systems delivered steady results in what is seasonally our weakest quarter, with customers continuing to engage FormFactor to solve electrical and measurement challenges in R&D. As an example, we delivered our ultra-low noise, 300-millimeter automated system to a leading foundry to assist in the development of 3-nanometer technology. FormFactor's results demonstrate the resilience of our diversified leadership position in probe cards and engineering services. That leadership is again documented in VLSI Research's annual survey of the probe card market, where FormFactor's 13% annual growth in 2019 outpaced 9% market growth in the same period. This market growth is in sharp contrast to the 2019 decline in semiconductor capital equipment spending and provides further proof of the consumable nature of probe card demand. As a reminder, probe cards are specific to each new chip design, generating demand from both node transitions and the release of new chip designs on existing nodes. Our market share gains to 32% of the advanced probe card market are driven by themes we've discussed before, namely the increase in test complexity associated with advanced packaging schemes like chiplets and heterogeneous integration. The high interconnect densities and challenging electrical test performance requirements in advanced packaging applications continue to be spaces where FormFactor's differentiated MEMS probe technology provides significant cost of ownership and performance advantages. In view of the continued uncertainty regarding COVID-19 restrictions in the regions where FormFactor and our suppliers operate, we are not providing a formal outlook range this quarter and will instead provide insight into near-term demand and supply constraints. As I mentioned, our quarter results were limited by manufacturing capacity constraints due to shutdowns and a lack of customer demand. At present, with five factory operations operational under social distancing requirements, the capacity constraint situation continues, and we expect it to persist at least through the second quarter. We continue to experience robust demand for foundry and logic probe cards, with steady demand for memory cards and engineering systems extending the same basic theme for the first quarter. We've maintained close and transparent communication with our customers, starting from our factory shutdown through the restart in the limited production phase to ensure we are focused on delivering their highest priority products and designs. Our operations team continues to systematically resolve both internal and supplier constraints, steadily increasing throughput and capacity to best meet customer production and design release schedules. Our present view of the various output constraints limits second quarter factory output to approximately 10% below overall first quarter output. Although our visibility is even more limited than usual, demand for FormFactor's design-specific consumables and R&D-driven products would be expected to produce sequential growth in the second quarter if not for these output constraints. Shai, over to you.

Shai Shahar, CFO

Thank you, Mike, and good afternoon. FormFactor's first-quarter revenues were $161 million, a 10% sequential decrease from our Q4 2019 record high revenue and a 22% year-over-year increase. These are impressive results, especially in light of the impacts of COVID-19, which included a temporary shutdown of our California factories for the last two weeks of the quarter. These results are a testament to our team's focus on the agility necessary to deliver for our customers while safeguarding employees and supporting our supply chain partners during a period of unprecedented challenges. As Mike noted, there is also compelling evidence of our ability to perform at our long-term target financial model levels across nearly all lines of our P&L in a very challenging environment. Probe card segment revenues were $135 million in the first quarter, a decrease of $19 million or 12% from Q4 2019. Systems segment revenues were $26 million in Q1, an increase of $0.6 million or 2% from Q4 2019, with strong sales of our advanced 300-millimeter systems. Within the probe card segment, robust demand for foundry and logic continued, with revenue increasing 1% from Q4 to $106 million, comprising 66% of total company revenue in Q1, up from 59% in the fourth quarter. DRAM revenues were $25 million in Q1, a decrease of $18 million from the fourth quarter and were 15% of total quarterly revenue compared to 24% in the fourth quarter. DRAM demand was down largely due to customers absorbing purchases made in several recent peak revenue quarters. Flash revenues of $4.3 million in Q1 were $1 million lower than in the fourth quarter and were 2.7% of total revenue in Q1, similar to the 2.9% in Q4. We continue to expect flash revenue to be lumpy from quarter to quarter. GAAP gross margin for the first quarter of 2020 was $67 million or 41.9% of revenues, 30 basis points higher than the 41.6% GAAP gross margin in Q4. Cost of revenues included $6.7 million of GAAP to non-GAAP reconciling items, which we outlined in our press release issued today and in the reconciliation table available on the Investor Relations section of our website. We had $0.8 million of reconciling items in the fourth quarter related to the acquisition of FRT that did not reoccur in Q1. On a non-GAAP basis, gross margin for the first quarter was $74 million or 46.1% of revenues, 40 basis points higher than the 45.7% non-GAAP gross margin in Q4, mainly as a result of higher Systems segment gross margin. Our probe card segment gross margin was 45.1% in the first quarter, a small decrease of 30 basis points compared to 45.4% in Q4. The decrease from Q4 was a result of lower volume, partially offset by a more favorable product mix and a lower performance-based compensation. Our Q1 systems segment gross margin was 51.2% as compared to 48% in the fourth quarter. The increase of 320 basis points was driven mainly by a more favorable product mix. As we have said previously, we expect our Systems segment gross margin to range between the high 40's to low 50's. Our GAAP operating expenses were $49 million for the first quarter, $1.6 million lower than in the fourth quarter. The decrease in first-quarter GAAP to non-GAAP reconciling items from $6.8 million in Q4 to $6.2 million in Q1 is mainly due to lower stock-based compensation. Non-GAAP operating expenses for the first quarter were $43 million or 26.6% of revenues compared to $44 million or 24.5% of revenues in Q4. A decrease of $1 million is mainly due to lower performance-based compensation and lower travel expenses, partially offset by the impact of the typical beginning of the year benefits reset. Company noncash expenses for the first quarter included $7.3 million for the amortization of intangible assets, $5.6 million for stock-based compensation, and $4.6 million for depreciation. Stock-based compensation was $0.5 million lower than in Q4 due to the timing of annual grants. GAAP net income for the first quarter was $16 million or $0.20 per fully diluted share compared to GAAP net income of $19 million or $0.24 per fully diluted share in Q4. The non-GAAP effective tax rate for the first quarter of 2020 was 17.6%, similar to 17.3% in Q4 and within the range of 15% to 20% estimated for the year, as communicated in our previous earnings call. As a reminder, our cash tax rate is expected to remain in the 6% to 8% range of non-GAAP pretax income until we fully utilize our remaining U.S.-based NOLs and R&D credits. First-quarter non-GAAP net income was $26 million or $0.33 per fully diluted share compared to $32 million or $0.41 per fully diluted share in Q4. Moving on to the balance sheet and cash flows. As you would expect, we are especially focused on cash flow management at this time. We generated $28 million of free cash flow in the first quarter compared to $32 million in Q4. This brings our free cash flow over the trailing 12 months to $110 million and takes our total cash and investments to $243 million at the end of the quarter. Almost 9% of these cash and investment balances are in the U.S. The sequential decrease in free cash flows in the first quarter was mainly a result of lower revenue and profitability and an increase in investment in capital expenditures. We have two term loans on our balance sheet, totaling $45 million. The first loan, related to the acquisition of Cascade Microtech in 2016, had a remaining balance of $24 million at quarter end and is expected to be fully repaid by the end of June 2020. The second loan is a 3-year, €21 million denominated loan we took to fund the FRT acquisition in Q4 2019, utilizing low euro-based interest rates to optimize our cost of capital. The remaining balance of this loan as of the end of the first quarter was €19.3 million. We spent $13.4 million on principal and interest payments on these two term loans during the quarter. At quarter end, our total cash balance exceeded the debt balance by $198 million, an increase of $32 million. While paying down these term loans remains our first priority for using cash, we continue to invest in R&D and capital expenditures that support our organic growth as part of our multiyear plan. M&A also continues to be an important part of our strategy, and we intend to continue to explore opportunities to apply capital and acquire leadership positions that expand our served markets, as we did with the acquisition of FRT last year. We invested $12 million in capital expenditures during the first quarter of 2020 compared to $6.6 million in Q4. The increase in CapEx in the first quarter is part of our multiyear plan to support the demand for our products that we anticipate over the medium to long term. We will continue to be very disciplined in our spending, as part of aligning our expenses with customer demand while rationing capital that is not directly related to additional capacity or technology development. Our liquidity position and capital structure are solid. Together with our disciplined approach to spending and our flexible cost structure, we retain significant resilience to weather an economic downturn. In light of our recent results and to better align our target financial model with growth in the markets we serve, we plan to hold a webcast strategy update for the investment community later this year, at which we will update our long-term model. We will provide more details closer to the event. Turning to our Q2 outlook. Although we are not providing a formal outlook given the continued uncertainties related to COVID-19, I can share some things for you to consider when thinking about our second-quarter financial performance. We are continuing to experience capacity limitations with adjustments to factory operations that implement social distancing and other safety measures. While demand appears to remain strong, we are output constrained. Capacity challenges will negatively impact our revenue and gross margin in Q2. As Mike noted, absent these capacity constraints, we would have expected sequential growth in Q2. Based on our current assessment of capacity constraints, we expect Q2 revenue will be lower than Q1 by approximately 10%. This estimate is subject to considerable uncertainty, of course, with the evolving COVID-19 landscape and its broader potential impacts. Given these uncertainties, we are not providing an outlook range for gross margin or EPS for the second quarter. With that, let's open the call to questions. We ask that when you ask your question, please indicate if you direct your question to Mike or to me, since, as you can imagine, we are not in the same room.

Thomas Diffely, Analyst

Yes. So Mike, I'm curious when you talk about the constraints for manufacturing, is that purely just manufacturing capacity issues? Or are you having supply chain issues as well in getting the parts and pieces?

Michael Slessor, CEO

Yes. Good question, Tom. Before I address that, I understand the fidelity of my prepared remarks wasn't great. So for all participants, we've distributed the written script for you as well. So apologies there, but hopefully, we get better information transfer here. Your question really, the answer to your question is both. There are continuing to be constraints, both internally at FormFactor as well as through our supply chain. As you can imagine, our supply chain is global in nature. And so different government directives have had different impacts on different suppliers in different regions over varying times, starting with China early in the quarter. Our operations team has done a great job of resolving those conflicts and constraints as well as continuing to add capacity to our operations in California and Oregon factories as we grow and experience operating within these social distancing measures.

Thomas Diffely, Analyst

Okay, great. And then you talked about demand being strong, but is there a relative strength between the logic and memory sides of your business from a demand point of view?

Michael Slessor, CEO

Yes. In the prepared remarks, we tried to detail it for you, really continued strength in foundry and logic. First-quarter DRAM revenues were relatively weak coming off a very strong 2019, where we had several sequential record quarters. Our customers are digesting those record shipments. At the same time, we're seeing very strong activity in foundry and logic, both in the microprocessor space and the RF space. I think this is a good example of FormFactor's overall diversification strategy playing out nicely. When some segments are weak, others are strong, and we manage to balance our overall manufacturing capacity to deliver for each of them and deliver relatively stable results as segment demand fluctuates.

Thomas Diffely, Analyst

Okay. And then finally, for Shai, when you're not giving gross margin guidance, I understand, but when you look at the additional costs imposed by COVID-19, is there some way to quantify what the near-term impact will be?

Shai Shahar, CFO

So I think when we think about gross margin, we need to consider the main drivers of it. It's true that we do incur some additional costs related to COVID-19, like additional cleaning and sanitation measures. However, I think the most significant impact on gross margin relates, as in previous quarters, to product mix. This changes quarter-to-quarter and will continue to have the biggest impact. The second factor will be volume, as you noticed in Q1 versus Q4. Q1 volume was lower than Q4, leading to some impact, although that was offset by product mix. Our operational excellence is also crucial; our team continues to excel in executing even in these challenging times. So while I didn't quantify exactly for you, those are the main factors impacting gross margin and that will continue to affect Q2.

Tianyan Goellner, Analyst

First question just for Shai. On the OpEx, and I remember you gave the guidance probably last quarter in the range of $42 million to $45 million per quarter. I know we don't give a formal guidance now, but I'm just wondering, will this still be a reasonable range for us to look into for 2020?

Shai Shahar, CFO

Yes, that's a great question. As you saw in Q1, OpEx decreased by $1 million. This is despite adding a full quarter of FRT versus approximately 2.5 months in Q4. Additionally, we had the annual benefit reset in Q1, which also impacts Q1 and usually Q2. The main reason for this decrease is lower travel, which, in this environment, has had an impact. The performance-based compensation, a portion of our expenses is tied directly to our performance and varies with it. Hence, you saw a decrease in Q2. Looking at the rest of the year, I anticipate similar trends; we'll continue to control these expenses, although a portion will be impacted by performance. I expect in Q2, we will still see less travel, and R&D may be somewhat affected because some projects require being in the lab to perform that work. Thus, Q1 is a good estimate, but it includes lower annual benefits and lower performance-based compensation compared to previous quarters. This factor will continue to impact upcoming quarters.

Tianyan Goellner, Analyst

Okay. And then a follow-up for Mike. When we look at foundry and logic, which are really strong, on the other hand, DRAM is lower, as you've mentioned, with customers digesting previous purchases. I'm just wondering, how should we think about 2020 regarding foundry and logic remaining at a similar level? When will DRAM return to higher levels due to node transitions and new technologies?

Michael Slessor, CEO

Let me start with DRAM. One interesting point right now is we're very actively engaged with the major DRAM manufacturers on new design additions. Designs are expected in the second half of the year according to current schedules. I think we're in a preparation period for the next ramp of DRAM, and we look forward to second half activity. Obviously, there are tremendous caveats around macro-economic conditions and the memory market, but that's the current perspective. Regarding foundry, the strength right now is broad-based, and the issues we encounter with customers indicate that we should be prepared for foundry and logic demand to remain robust for the balance of 2020. Again, there are caveats associated with the macroeconomic impacts of 2019, but for now, that’s how we perceive the situation.

Craig Ellis, Analyst

Congratulations on your execution in a challenging environment. The first question I wanted to ask is really just a clarification. Maybe I'll direct this to Shai. As we look at the revenue level that was reported versus the initial guidance, the variance being due to shelter-in-place issues impacting manufacturing. How did that impact revenues on an end market basis? Was it more concentrated in one area or the other, or was it evenly distributed across DRAM, foundry, logic, etc.?

Shai Shahar, CFO

Sure. The factories that were impacted were mainly in California and subsequently in Beaverton, while our factories in Germany were not affected. This resulted in minimal impact on the Systems business. Thus, the main impact, or almost all of it, came from the probe card business. Within that market, our factories in California—Livermore, San Jose, Carlsbad—serve all these markets. It would be challenging to extrapolate the exact impact of the couple of weeks the factory was shut down across each segment since they also feed into each other.

Michael Slessor, CEO

Yes. That's a very good observation, Craig. If you look at the major probe card suppliers and our competitors, we're all situated in regions affected by the pandemic and government responses. There is a concern regarding overall probe card supply. I would say that ongoing discussions with our customers are very active and involve other parts of the supply chain as well. Prioritizing reactor activities continues to this day, as we shift design priorities and reallocate resources to ensure we support them effectively. My view is that this situation is occurring throughout the industry, both in probe cards and in capital equipment.

Craig Ellis, Analyst

That's helpful. And lastly, Shai, please come back to you. Given our view on the second quarter is impacted by some near-term supply constraints. What do you need to see from the operational teams and more broadly to be comfortable that output can return to optimal levels by the end of Q2? A short list of 2 or 3 factors would be very helpful.

Shai Shahar, CFO

We are currently impacted by government orders. We have some capacity constraints primarily due to social distancing. We're implementing measures to ensure employee safety. We are improving continuously and making adjustments by shifting tools around the fab and other factories to make room for social distancing and boost capacity. It’s an ongoing process, and we are getting better at it. I expect output to improve. That said, there are still many uncertainties, including lead times, which are relatively short, and evolving government guidelines. Additionally, we are collaborating intensely with our supply chain partners to secure what we need to continue producing.

Christian Schwab, Analyst

Mike, you had really strong revenues from China. Can you segment it between domestic and multinational, as well as between logic, foundry, and DRAM?

Michael Slessor, CEO

Certainly. For several quarters, China's revenue has constituted about a percentage of total company revenues. As Chris mentioned, the mix consists of multinationals and domestic operations, and the blend may vary depending on spending cycles. So while I won't segment it precisely, foundry has also seen a mix of activity recently, particularly in memory, which has been strong from both multinationals and demand channels.

Christian Schwab, Analyst

Got it. Fair enough, Mike. And then as a follow-up, I'm aware of your supply constraint. Your typical lead times are probably about half a quarter or so. Are you seeing lead times stretch out, and if supply normalizes by the end of Q2, should we expect a snap back in Q3 due to pent-up demand?

Michael Slessor, CEO

Yes. In terms of lead times, they have extended somewhat in the second quarter, primarily due to the overall lowered capacity that both we and competitors are experiencing. I think it is a realistic assumption to presume that things will not immediately snap back. We are preparing for a gradual loosening of restrictions, which will impact our throughput. Even as we add capacity through CapEx and long-term measures, we are working under the notion of a gradual buildup to meet demand moving through Q2 and into Q3.

Quinn Bolton, Analyst

Just to follow up on that last question. As you build out capacity, is any of that involving clean room capacity, which may be more capital intensive? Are you experiencing any spacing issues in the clean room?

Michael Slessor, CEO

Yes, Quinn. Certainly, some of the challenges we've faced involve spacing issues in our various clean rooms, whether they be in our MEMS fab or our assembly area. We are allocating funds to enhance spacing measures while ensuring that our new distancing protocols are adhered to as much as possible. Our operations team is actively optimizing existing footprints as well as identifying ways to increase space in our clean room areas, which naturally requires significant capital investment.

Quinn Bolton, Analyst

When you seek additional space for a clean room, how long does it typically take to install and equip that clean room space? Is it possible to accomplish that in a quarter’s time, or does it usually require multiple quarters?

Michael Slessor, CEO

It varies depending on the scale of the project. Up until now, we have primarily used existing labs inside our footprint, and that does necessitate some capital investment. As in our previous conversations, we are nearing the point where we can break overall capacity limitations. When we share a new target model and a long-term strategy, we will include that as part of the discussion.

Quinn Bolton, Analyst

It seems your Q4 upsides were notable, and back at the end of the year, you thought that strength was perishable, yet you managed to capture that demand. Does it feel like the demand environment has now fundamentally improved, or do you perceive the factors driving upside late last year and into Q1 are still temporary? How sustainable are your largest CPU customers running two nodes at high volumes? Is that now more sustainable?

Michael Slessor, CEO

I believe some of these trends do indeed seem more sustainable than we initially thought back in the fourth quarter. Analyzing what we achieved in Q1, despite missing much of the quarter's last part, indicates that some macro trends associated with advanced packaging and 5G investments are driving increased demand and testing requirements. This momentum is more agile than we might have anticipated, not just for one particular segment but across the spectrum. As we know, the stringent requirements associated with testing chiplets and high frequencies of a 5G front end support sustained demand for our services.

Craig Ellis, Analyst

Reflecting on some of the key themes here versus three months ago, it seems that 5G is becoming a significant incremental driver for probe card demand and customer engagement. Can you provide insights into how this trend is playing out over the back half of this year and into 2021?

Michael Slessor, CEO

Absolutely. 5G is creating momentum for FormFactor, not just in our RF probe card business, but more broadly. Considering a 5G handset, our exposure mainly covers the handset side of the business due to the large unit volume, rather than the infrastructure sector. As content growth occurs—more DRAM, more NAND, a more complex display, and enhanced applications processing—the industry's shift to 5G on handset manufacturers' roadmaps is indeed presenting significant growth opportunities for us. We feel relatively well-positioned with both RF fabless customers and in the digital domain, as well as in the memory segment. Therefore, I think your observation regarding 5G's contribution to our overall business is accurate, especially given the uncertainties surrounding handset launches in the near-term.

Craig Ellis, Analyst

Congratulations on strong performance in the VLSI report indicating market share growth. With FormFactor’s strong execution in recent tuck-in deals, how do you perceive the potential for at least mid- to high-single-digit growth for the company if your execution remains consistent?

Michael Slessor, CEO

I believe continued strong growth aligns with our capacity to leverage leadership opportunities as well as expanding into adjacent markets. Trends affecting the probe card space indicate high single-digit growth potential as probe cards remain a design-specific consumable. Customer design changes, whether through node shifts or transitioning from DDR4 to DDR5, stimulate this demand. Hence, I think it's reasonable to project that as we execute our strategy to reinforce organic growth while strategically pursuing acquisition opportunities, we will maintain our leadership position in this market. Thank you, again, everyone, for joining us today. Apologies for some of the technical difficulties. If we need to follow up with you and schedule something to ensure that we address your questions, please reach out to Stan and our investor relations department. Thanks again, and stay safe.

Operator, Operator

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.