Earnings Call Transcript - FORM Q2 2022

Stan Finkelstein, Vice President of Investor Relations

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 projections of financial and business performance; future macroeconomic and geopolitical conditions; the benefits of acquisitions and investments in capacity and in new technologies; the impacts of the COVID-19 pandemic; anticipated industry trends; the disruptions in our supply chain; the impact 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 2021 and in our other SEC filings which are available on the SEC's website and in our press release issued today. Forward-looking statements are made as of today, July 27, 2022, and we assume no obligation to update them. With that, we will now turn the call over to FormFactor's CEO, Mike Slessor.

Michael Slessor, CEO

Thanks, everyone, for joining us today. FormFactor, again, posted strong results in the second quarter, delivering the second highest quarterly revenue in company history and again exceeding the non-GAAP gross margin of our target financial model. Together with good operating expense control in the current inflationary environment, this produced earnings per share at the high end of our outlook range. The second quarter financial results and overall themes were similar to the first quarter's as major customers continued to release and ramp new designs to meet demand for their products, driving strong results in our probe card business in both Foundry & Logic and DRAM. Customers also invested in their technology road maps with development of innovations like gate-all-around transistors, advanced packaging, silicon photonics and quantum computing, driving solid results in our systems business. During the second quarter, we made a small but important acquisition to augment our capabilities as a key supplier in the emerging quantum computing market, buying the dilution refrigerator product line of JanisULT. Dilution refrigerators are a key enabler for the operation of quantum computers, being capable of tooling qubits to the ultra-low sub-10 millikelvin temperatures required for operation of superconducting quantum computers. This acquisition makes FormFactor the largest commercial dilution refrigerator supplier in the United States, strengthening and expanding our position with key customers as the leading supplier of not just test-and-measurement products but also now enabling infrastructure for quantum computing. Turning now to our third quarter outlook. Our sequentially weaker outlook is due primarily to reduced demand for Foundry & Logic probe cards from several major customers in both mobile and compute applications. As these customers adapt to the changing conditions in their end markets, driven by global macroeconomic uncertainty and inflation, they're changing their short-term wafer start-and-design release road maps by delaying selected new design releases and, in some cases, reducing their volume ramp plans for specific chip designs already in production. As a reminder, probe cards are a consumable specific to each new chip design and so changes to production volumes of individual chip designs also change the number of probe cards required to manufacture that specific design. As Shai will discuss in detail, this reduction in anticipated Foundry & Logic demand results in a significant reduction in forecasted third quarter gross margins and earnings. We view this reduction in Foundry & Logic probe card demand as a short-term response by our customers to changing conditions in their end markets and not a structural change in our business. Lead times for probe cards remain less than a quarter. And although the past several years have been characterized by universally robust and growing demand across all probe card segments and end markets, changes like these are not uncommon in times of rapidly changing industry conditions as customers adapt their production plans to match short-term fluctuations in their product-specific demand profile. We continue to view Foundry & Logic as an exciting long-term growth driver for FormFactor. Customers are investing in both leading-edge capacity as evident from continued wafer fab equipment spending; and early-stage innovative advanced packaging architectures like EMIB, Foveros and 3D fabric. As we've noted in the past, these chiplet tile-based integration schemes drive both higher test intensity which expands the number of probe cards required per wafer out; and test complexity which raises the performance requirements for the probe card. Advanced probe card architectures like FormFactor's MEMS technology are essential to meet these challenging technical requirements at a compelling cost of ownership with a short delivery lead time needed to support our customers' rapid and dynamic production ramps. For these reasons, despite the anticipated third quarter pause in the steady and gradual progress we've made towards our target financial model, we're continuing our planned capital investments and remain committed to our target financial model and the strategy that underpins it. The main tenet of this strategy is our expanding position as a diversified supplier to the broader semiconductor and electronics industry with a defensible leadership position serving multiple consumables and equipment market segments. Over the past few years, while each of these segments has delivered robust demand and growth, we've been consistent in our belief that our markets are cyclical with each market unlikely to deliver robust growth every quarter. Operating in multiple segments with a diversified set of demand drivers allows us to better amortize our fixed cost structure, including manufacturing overhead, facilities and global customer support infrastructure. This segment diversification provides the broadest set of technology and manufacturing capabilities in our served markets, offering significant value to our customers and competitive advantage for FormFactor. Our third quarter outlook offers a proof point to the value of serving multiple market segments as we anticipate that the expected reduction in Foundry & Logic demand will be partially offset by growth in the Systems segment with steady demand for DRAM and flash probe cards. We remain committed to gross margin improvement in all of our product lines so that this diversification strategy is fully effective in mitigating the impact of these product mix shifts on both revenue and profitability. I'd like to close by affirming that we remain confident in the long-term growth prospects for the industry overall driven by the fundamental trends of semiconductor content growth and advanced packaging. These are trends where FormFactor is well-positioned as an industry and technology leader and we're confident that our resilience and agility will drive continued growth and share gains as FormFactor progresses towards our target model that delivers $2 of non-GAAP earnings per share on $850 million of revenue and beyond. Shai, over to you.

Shai Shahar, CFO

Thank you, Mike, and good afternoon. As you saw in our press release and as Mike mentioned, FormFactor, again, posted strong second-quarter results, delivering the second highest quarterly revenues in company history with revenues and gross margin above the midpoint of our outlook ranges, EPS at the high end of the range and non-GAAP gross margin again exceeding our target financial model. Second-quarter revenues were $204 million, a 3.4% sequential increase from our first-quarter revenues and an increase of 8.4% year-over-year. Probe card segment revenues were a record $167.7 million in the second quarter, an increase of $7.7 million or 4.8% from Q1. The increase was driven mainly by higher Foundry & Logic revenues. Systems segment revenues were $36 million in Q2, a decrease of $1 million or 2.7% from the first quarter. Within the Probe Card segment, Q2 Foundry & Logic revenues were a record $122 million, a 7.3% increase from Q1, comprising 60% of total company revenues, slightly higher than the 58% in the first quarter. DRAM revenues were $37 million in Q2, $2 million or 7% higher than the first quarter and were 18% of total quarterly revenues as compared to 17% of revenues in the first quarter. Flash revenues of $8.5 million in Q2 were $3 million lower than in the first quarter and over 4% of total revenues in Q2, lower than the 6% in Q1. GAAP gross margin for the second quarter was 46.3% of revenues as compared to 47.8% in Q1. Cost of revenues included $2.3 million of GAAP to non-GAAP reconciling items which we outlined in our press release and in the reconciliation table available on the Investor Relations section of our website. On a non-GAAP basis, gross margin for the second quarter was 47.4%, 160 basis points lower than the 49% non-GAAP gross margin in Q1 with lower gross margin in both our markets. Our probe card segment gross margin was 46.8% in the second quarter, a decrease of 150 basis points compared to 48.3% in Q1. The decrease is mainly due to a less favorable mix, higher manufacturing headcount and spending. Our Q2 Systems segment gross margin was 50.5%, 170 basis points lower than the 52.2% gross margin in the first quarter. The decrease is due to lower revenue and a less favorable product mix. Our GAAP operating expenses were $62 million for the second quarter, $2 million higher than in the first quarter. Non-GAAP operating expenses for the second quarter were $54.5 million or 26.7% of revenues, as compared with $51.9 million or 26.3% of revenues in Q1. The $2.6 million increase relates mainly to an annual salary increase, higher headcount, and higher R&D project spend. Company noncash expenses for the second quarter included $6.4 million for stock-based compensation, $1.1 million lower than in the first quarter; $2.7 million for the amortization of acquisition-related intangibles, $0.3 million higher than in the first quarter; and depreciation of $7.2 million, $0.2 million higher than in the first quarter. GAAP operating income for Q2 was $32.6 million as compared with a record $34.2 million in Q1. Non-GAAP operating income for the second quarter was $42.3 million, lower than the last quarter's record by $2.5 million. GAAP net income for the second quarter was $30 million or $0.38 per fully diluted share, the same as in the previous quarter. The non-GAAP effective tax rate for the second quarter was 14.4%, 60 basis points higher than the 13.8% in Q1 and slightly below our estimated non-GAAP annual effective tax rate of 15% to 20%. As a reminder, during the first quarter, the required capitalization of R&D expenses changed, resulting in higher foreign-derived intangible income benefits, also known as FDII, and vastly lower effective tax rate. We expect to be on the lower end of this 15% to 20% range for the remainder of the year. As previously communicated, our annual cash tax rate is expected to remain around mid- to high single digits of non-GAAP pretax income until we fully utilize our remaining U.S.-based R&D credit. Second-quarter non-GAAP net income was $36.8 million or $0.46 per fully diluted share, second to the record set in the first quarter of $38.7 million or $0.49 per fully diluted share. Moving to the balance sheet and cash flows. We generated $28.3 million of free cash flow in the second quarter, similar to the record $28.7 million in Q1. Net cash provided by operations and capital expenditures were at a similar level to the previous quarter. Total cash and investments were $270 million at the end of the quarter. As of the end of the second quarter, we had two term loans remaining on our balance sheet, totaling $20 million. We invested $14.5 million in capital expenditures during the second quarter compared to $15.6 million in Q1. As Mike mentioned, we are executing on our capacity expansion and continue to expect full-year CapEx 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 this capacity expansion. Regarding stock buyback. During the second quarter, we fully utilized our existing $50 million stock repurchase program and our Board of Directors approved an additional two-year $75 million program. We purchased 1.2 million shares under these two buyback programs during the second quarter for a total of $45 million, and this brings our repurchases under these two programs through the end of Q2 to 2.3 million shares. At quarter end, $46.6 million remained available for future repurchases. Turning to the third quarter non-GAAP outlook. As Mike mentioned, we expect a decrease in Foundry & Logic revenues, partially offset by growth in the Systems segment with a steady demand for DRAM and flash probes. These factors result in a Q3 revenue outlook of $183 million, plus or minus $6 million. Non-GAAP gross margin for the third quarter is expected to be 39%, plus or minus 150 basis points. At the midpoint of our outlook range, about one-third of the expected decrease in non-GAAP gross margin relates to a less favorable product mix, reflecting the expected decline in Foundry & Logic revenues as well as a less favorable mix in the other markets we serve. Another one-third of the expected decrease relates to the overall lower revenue levels and similar fixed costs, and the last third is attributable to higher manufacturing costs. At the midpoint of these outlook ranges, we expect operating expenses to be lower than Q2 by approximately $2 million to $3 million, mainly due to lower performance-based compensation and other employee-related benefit expenses, partially offset by the impact of new hires. Accordingly, non-GAAP earnings per fully diluted share for Q3 is expected to be $0.21, plus or minus $0.04. A reconciliation of our GAAP to non-GAAP Q3 outlook is available on the Investor Relations section of our website and in the press release issued today.

Craig Ellis, Analyst

Appreciate all the color on the dynamics in the business, team. Mike, I wanted to go back to some of your comments on what's happening in Foundry & Logic. As you look ahead to the third quarter, I think you identified compute and mobility issues were at play. Can you give us some sense of the degree to which this is a mobility issue or a compute issue? And as you work with your customers as they're managing product cycles, what's your sense for when we actually work through what we're seeing in the third quarter and potentially rebound back to those $200 million-plus revenue levels for the company?

Michael Slessor, CEO

Yes. Thanks, Craig. As I said in the prepared remarks, we are seeing multiple sources of reduced sequential demand in Foundry & Logic probe cards coming from multiple customers in both mobile and compute and there's a lot of different factors involved. I would say the components of each are similar in nature and the result of the customers changing their wafer start plans on specific designs as they adapt their product release road maps to their changing end-market conditions. And since probe cards are specific to each design, lead times, as you well know, are well within a quarter; there's some short-term volatility there we're dealing with in our demand profile. I do want to draw a parallel, I know it's a while ago but back to the fourth quarter of 2019 where we saw exactly the same dynamic but in reverse. If you remember, we guided up inside the fourth quarter as Foundry & Logic customers, many of them similar Foundry & Logic customers we're seeing now, responded to stronger demand and drove our business up on these short lead times. So we have seen these dynamics work before. We remain excited about Foundry & Logic, as I said on the call. Advanced node wafer fab equipment investments and advanced packaging are driving up test intensity and spending on probe cards, and I think it’s still an exciting growth opportunity for FormFactor despite the short-term volatility we see here.

Shai Shahar, CFO

Thanks, Craig. Yes. So most of these additional manufacturing expenses in Q3 actually relate to capitalized variances that we were capitalizing to our inventory as part of the Q1 and Q2 inventory build, and they’re going to be amortized in Q3. So that big change, I don't expect it to happen again. There is some element of higher labor cost and higher cost of materials. We talked about it in previous calls as well. But these are built into the forecast and are built into our longer-term target model of 47% gross margin which we are still committed to.

Charles Shi, Analyst

I want to dig into the weakness you're seeing in mobile for a minute. I believe within the mobile, you have both the SoC probe card and RF probe card. Can you kind of tell us which one may be the bigger factor here in terms of the weakness in smartphone you are seeing here?

Michael Slessor, CEO

Yes, Charles, it's Mike. It's mostly related to SoC applications, processors, modems, things like that. As we've told you, as we've moved through the first half of the year, coming off a very strong 2021, the RF business has moderated somewhat in the first half of the year. But as you saw from the SoC results, the general Foundry & Logic results, and our narrative around it in the first part of the year, we're seeing some real strength there. In the third quarter, we're seeing that sequentially down, again, associated in mobile with design release road map changes, customers pushing out and, in some cases, reducing volume for certain chip designs and that has an impact on the overall probe card demand for those individual designs. So going from Q2 to Q3, I'd say the delta is primarily associated with reduced mobile SoC demand, if I carve it up between the mobile and compute sections.

Shai Shahar, CFO

Yes, I'll take that. So we believe these headwinds are temporary in nature. We remain confident in both our strategy and the market position, and we are continuing to plan capital investment as we track towards the long-term target model. These investments that we started a couple of years ago are required to maintain our industry leadership. That's why we didn't change the CapEx plans for the year and continue to expect to be between $60 million to $80 million for 2022. This is mainly in expanding capacity. Now I think it's important to understand that our customers are adding capacity, which means they will need more probe cards, and we need to be ready to capture the growth in the market share here.

Brian Chin, Analyst

Let me revisit the gross margin trend briefly. I appreciate the breakdown and attribution. To be straightforward, I know there are some effects I'd like to clarify. Even with a potential 20% decline in Foundry logic quarter-over-quarter, which suggests a decrease in the third quarter, I would still anticipate gross margins in the mid-40% range, and I don't expect an 800 basis points drop quarter-over-quarter from the revenue levels in the second quarter. So, is my understanding of the segmentation correct? Furthermore, if we consider that revenues might remain flat in the fourth quarter, and there can be a late boost from customers regarding foundry, what are the implications for gross margins? Would some of the pressures on gross margins dissipate, and where might gross margins stabilize if we assume flat revenue in this scenario for the fourth quarter?

Shai Shahar, CFO

Yes. For revenue in Q3, we're looking at a figure similar to Q2, around $200 million. With a comparable revenue profile and product mix to Q2, we estimate our gross margins would reach the target of 47%. Considering the factors I mentioned, including the mix and the impact of fixed costs on lower revenue levels, I've addressed similar levels of revenue and gross margins for Q2. The increase in manufacturing expenses is primarily due to higher labor costs and material costs, but a significant factor in Q3 is the timing of manufacturing costs that were capitalized in the first half of the year, particularly in Q2, which we will amortize in Q3. We do not expect these costs to recur. Overall, I remain confident that we can achieve our goal of 47% gross margin.

Brian Chin, Analyst

Okay. And in terms of understanding, I'm not surprised by this adjustment phase for some of your customers. It kind of makes sense relative to my understanding of the business. What sort of duration or how long do you think this adjustment period will take based on history, based on your discussions? Because it could be a quarter, it could be two, but is the understanding here that they'll release probe cards against future products and wafer starts once they're through this adjustment period?

Michael Slessor, CEO

Yes, Brian, it's Mike. The timing, as always in this business and the visibility, is a little bit uncertain given that lead times are well within a quarter. But as you might imagine, we're having some very detailed conversations with these customers to make sure we understand what their demand profile is going to be, what some of these rescheduling scenarios look like. And right now, it does seem like a pretty short-term event. I'm not sure I want to create expectations right now that there's a snapback in early Q4. But right now, things like us continuing with our capacity expansions, continuing to invest in R&D. I think, are pretty good indicators that we don't view this as a structural long-term change in the Foundry & Logic market. We remain excited about the growth prospects for Foundry & Logic.

David Duley, Analyst

Yes. I guess I have a couple. Just to clarify things, I think one of your big customers are going to grasp the three nanometer sometime next year. When will that start to impact demand from moving from five or seven nanometers to three nanometers? When will you start to see an increase in three nanometer probe card demand?

Michael Slessor, CEO

David, it's Mike. Considering the lead time aspects of the Foundry and Logic probe card business, you are nearing the wafer start ramps linked to that. It's not a lengthy lag of two to three quarters before the wafer ramp; I would estimate it's closer to one quarter. This aligns with the dynamics we've previously discussed that fuel our confidence in the Foundry and Logic market, as customers keep investing in wafer fab equipment for these advanced nodes, whether three nanometers or others. We are quite confident they will leverage these for new designs and ramp those designs, but that is still ahead of us. We're likely looking at about a one quarter lead in terms of wafer starts compared to wafer outputs for a node like three nanometers.

Shai Shahar, CFO

Yes, I'll address that. Regarding expenses, including both cost of sales and operating expenses, some of our costs are designed to be variable, such as performance-based compensation and overtime. This is reflected in the Q3 outlook we shared today. For instance, we expect operating expenses to decrease from $54.5 million to about $52 million in Q3. Overall, we are maintaining our cost structure and capacity to support increased revenue quarters and stronger demand as we progress towards our target financial model. There are no significant structural changes to operating expenses at this time, but we will continue to review and make adjustments as necessary in the future.

David Duley, Analyst

Okay. Final one for me is, I think you described a vast majority of the reduction in revenue sequentially from $204 million to $183 million was coming from the Foundry & Logic business. I guess that suggests that the memory business is going to be flat in Q3. Would you expect there to be weakness in that market as well given all the kind of difficulties we've seen from players in that space and the weakness in PCs? Or are other markets for DRAM absorbing that and you feel like you can make it over the next few quarters without a reduction in DRAM demand?

Michael Slessor, CEO

At this stage of the game, David, I think it's more of the latter. It's something we're obviously keeping a very close eye on given some of the CapEx announcements from our customers, most recently SK Hynix last night. But we are seeing DRAM probe card demand and flash probe card demand hold up reasonably well here. Part of that, I think, is customers are continuing to release new designs, DDR4 and DDR5, both mobile and server. They're definitely shifting mix around as our Foundry & Logic customers are between the different end market segments. But so far, that memory business seems to be holding up as well. The one caveat again that I'll remind you of is our lead times are relatively short. So memory probe cards, lead times well within a quarter as well. But for now, we do see decent design activity, continued strong demand at approximately the levels we've seen in the first half of the year.

Robert Mertens, Analyst

This is Robert Mertens on behalf of Krish Sankar of Cowen. Just looking into the September quarter guidance, you'd mentioned the turn in the foundry logic demand both from the compute and mobile markets. Are you able to break down a bit more if this is a function of unit cuts or push out on designs? Just trying to get a better sense of when the slowdown started or when you were able to see demand start to slow down and then maybe what the duration of the current pause would be. And then I have one follow-up.

Michael Slessor, CEO

Yes, Robert, it's Mike. This is a pretty rapidly changing situation. We've seen customers, again, reacting to their end market conditions and changing design releases, ramps on different products, and different, I'll call it, volatility in the Foundry & Logic demand. It's obviously difficult for us, with our industry vantage point, to pinpoint exactly what the root cause of this is. But I think it's at least plausible that it's tied to some of the reduction in consumer spending we've seen on things like handsets and PCs. So in terms of duration, difficult to say right now. But again, I'll point back to our continued plan to increase our capacity, our continued commitment to the $2 non-GAAP earnings per share model at $850 million in revenue. We don't see a structural change here. We see some short-term volatility. And especially in Foundry & Logic, we remain very bullish about the growth prospects given all of the advanced node wafer fab equipment investments and the shift to advanced packaging at those advanced nodes.

Christian Schwab, Analyst

I'm wondering what your thoughts are just kind of bigger picture when the Foundry & Logic demand could kind of come back, right? We're seeing a pretty pronounced normalization of smartphone and PC demand. But pre-COVID, PC demand was down five out of seven years and smartphones shrank for four years going into it on a year-over-year basis as replacement cycles extended. Being the two most important markets as far as units are concerned, semiconductors, are you at all fearful that this could kind of be a prolonged level of less volume than maybe we've seen in the last few years?

Michael Slessor, CEO

Christian, it's Mike. I don't think fear falls, right, the way I'd like to describe it, but we're certainly watching that. And I think, as I said on one of the previous questions, I think this all comes back to consumer and macro drivers. If demand for PCs, for handsets does materially slow down for a long period of time, this has to result in lower chip demand and therefore lower probe card demand. One of the things we have seen historically, though, is in times like that, many of our customers accelerate their innovation road maps and start to release more new designs to try and differentiate their positions in tough market conditions for them. So again, watching the situation, as I'm sure everyone on this call is. But for now, things still seem to be structurally pretty strong in the industry. Again, that's why we're continuing to invest in capacity to make sure that we can meet continued growth in demand in Foundry & Logic and in our other segments as well.

Christian Schwab, Analyst

Great. And then a follow-up on the investment in additional capacity. When you guys decided to do that, was there an assumption on wafer starts or one million square inches of silicon or number of chips that you determined that you needed to make these future investments? Or is there anything behind the scenes where you believe any of your three largest customers that you've talked about previously, that there was an opportunity for market share gains versus other players in the space?

Michael Slessor, CEO

Yes. There's a set of different variables that led us to commit to the significant capacity additions and capital expenditures we've been making and are continuing to make. Some of it is wafer starts on advanced nodes in the industry and million square inches of silicon tends to be not a bad proxy for that. But the other is, and we brought this up before, the increasing test intensity associated with both advanced nodes and advanced packaging. Simply put, each wafer start needs more probe cards because customers are investing more in wafer test both to improve yields and to reduce their overall cost. So when you put all those things together, along with some very detailed and specific conversations with our key customers about their long-term capacity needs, that's what led us to embark on the capacity increases a couple of years ago. So that as Shai said, we can retain our leadership position and even increase our leadership position in the markets we serve. Thanks, everybody, for joining us today. We're scheduled to attend several of the late summer investor conferences where we're eager to update you on our continued progress towards the target model. So I hope to see you then. If we don't, stay safe and we'll talk to you on our Q3 results call. Take care.

Operator, Operator

Thank you and welcome everyone to FormFactor's Second Quarter 2022 Earnings Conference Call. On today's call are Chief Executive Officer, Mike Slessor; and Chief Financial Officer, Shai Shahar. Before we begin, we will remind you of some important information.