Form Factor Appears Deeply Discounted

Apr.24.08 | About: FormFactor, Inc. (FORM)

Stock Black Book’s idea this month is one of those rare opportunities to buy a company that is discounted so deeply you get almost as much cash in the bank as the company is worth. This limits the down side risk assuming it continues to deliver positive free cash flow [FCF], which it has done the past three years in a row. The part that is even better is they have no debt so you get to keep all the cash. Sound too good to be true, well it’s not. This is the great part about a cyclical business like semiconductors. When the market is angry investors have a huge opportunity to take a relatively low risk investment. Last month I brought to your attention a well run company with a large amount of debt. This month I decided to discuss the opposite extreme.

Company Profile Form Factor (NASDAQ:FORM) designs, develops, manufactures, sells and supports high performance advanced semi conductor wafer probe cards. This is an industry I am very familiar with and will help show you the value proposition that a company like FORM has to offer to their customers. FORM has a proprietary microspring technology that allows their customers to buy leading edge advanced technology to test full silicon wafers in the DRAM and Flash markets. DRAM and Flash are both crucial memory products that are part of the bill of materials for items like computers, cell phones, iPods, digital cameras and many other consumer electronics. DRAM currently makes up 70% of their revenue, Flash is 18% and Logic is 12%. This is a critical test for semiconductor companies as it allows them to sort good die (product) from bad die to avoid adding more value to a bad product (i.e. throwing money away). This would be like checking to see if a loaf of bread is moldy before adding all the meats, cheese, vegetables and condiments so you avoid wasting food. The die is expensive, but the value added later by packaging it, testing it and stacking it with other working die can be very costly and significantly erode margins if not caught early in the manufacturing process. FORM makes every probe card custom for every customer and each product a customer manufactures. This is a very specialized high margin business used to make commodities that produce relatively lower margins.

SWOT Analysis

For those of you new to the SWOT analysis this is a tool to help review a company’s internal Strengths and Weaknesses as well as the external Opportunities and Threats to gauge how competitive FORM truly is versus the rest of the industry.

Strengths: FORM is a technology leader in the industry offering the highest pin count product, smaller pads, wider temperature range capabilities and strength in known good die. These terms likely are meaningless to people outside the industry, but it all translates to better and more flexible products for its customers to make higher profits. It also translates to more sales and higher prices, which means significantly higher profit margins (cash back to the bank). Management is also saying the right things and taking the proper actions by investing more (as % of revenue) into R&D (This supports all future products = future revenue = future margin = future cash). I also like that they announced cuts in the workforce outside of R&D in the tune of 14% (They are reducing unnecessary costs during a down cycle, while investing in new product technology). These cuts will reduce earnings by $4-$5M in Q1’08, but benefit all future quarters by the same amount. FORM is also sitting on a war chest full of cash ($570M to be precise) that gives them ample opportunity to take investor friendly actions (I’ll talk more about this in the Opportunities section). The fact that FORM continues to generate cash and have $0 debt lets me sleep really easy at night with no concerns of this stock going to $0 any time soon especially considering it has 68% of their market capitalization parked in cash. FORM is taking steps to reduce both manufacturing labor costs and taxes by opening a new plant in Singapore. They have negotiated a deal with the Singapore government to get tax exempt status for the products that are produced locally.

Weakness: There are a number of near-term worries, which is why you see the bargain basement sale on the stock price (60% off it’s 52 week high of $48). Last quarter the slide started with a delay of their new Harmony technology causing FORM to lose designs to the competition that have inferior products. In Feb ’08 they announced the Harmony technology was qualified for both DRAM and Flash, which now reduced their lead time by 30%. This is good news that should allow FORM to win back designs on new products for new and existing customers. Most product life cycles (length of time a product is sold to customers) are very short (1-2 years). Now, Q4’07 came in light on revenue from the aforementioned delay as well as new information of an industry slow down driven by below manufacturer costs in the DRAM market. Since the DRAM market is 70% of their revenue they took another big hit citing weak expectations in the first half of ’08. Their customers are expected to reduce capital expenditures until DRAM/NAND Flash memory prices stabilize. Now… the good news. I believe the market has dramatically over reacted in on pricing concerns that FORM’s customer receive for DRAM/NAND. Every year right after the holiday season everyone is shocked when prices fall 50%+, but there is a great and very obvious reason. Santa went back to the North Pole and all the good boys and girls wait until “back to school” and next Christmas to buy electronic gadgets that consume DRAM and NAND. Computers, iPods and cell phones consume a vast majority of this silicon so demand is seasonal. Usually around April or May prices magically begin to increase or level off as demand picks up for inventory builds. I presume this will help semiconductor manufacturers to loosen their purse strings once again on capital expenditures.

Another big secret is that every manufacturer needs to reduce costs to be a price leader in this commodity business and in order to do this they must develop new products on more cost effective technologies that require new probe cards. This is music to FORM’s ears as they are needed to help drive down DRAM/Flash/Logic product costs.

One other issue is that five customers make up ~77% of FORMs revenue so they are very dependent on a few large customers. The DRAM/Flash market has a fairly limited number of manufacturers so this is really no surprise, but should be called out as a risk.

Lastly, on February 29th 2008 FORM announced their CFO Ronald C. Foster resigned to pursue other business opportunities after three years in his current role. I do not believe this announcement is indicative of any major financial issues and I have strong confidence in the CEO/founder Dr. Igor Y. Khandros.

Opportunities: I believe FORM has a multitude of opportunities to reward shareholders with its $570M in cash. I would not be surprised to see either a large one time dividend, a 10-20% repurchase of outstanding shares (they would still have $400M+ left), or some strategic investment to grow their business. I firmly believe that the DRAM and Flash markets are poised to grow substantially over the coming five years driven by PC growth in emerging markets, as well as cell phone growth in both the rich feature market (i.e. iPhone) and low end introductory phones (hello China/India). There will also be a huge shift toward the NAND Flash hungry Solid State Drive (NYSE:SSD) devices. SSDs are a storage device developed primarily to compliment and eventually replace hard disk drives in computers. These will begin to replace the old hard drives that crash easily, consume too much energy and are slow to boot up your PC. SSD’s will make huge improvements to all of these issues and FORM will benefit if they continue to grow their Flash memory business. The industry is also moving toward stacking multiple chips together to produce products with more memory. This will drive the need for more probe cards as these products consume more bits (It takes longer to test requiring more probe cards) and are more costly requiring larger more extensive tests before stacking good product with potentially bad product.

Lastly I think FORM has a huge opportunity to sell more probe cards into the fast growing NAND Flash market (If you believe products like the iPod, cell phones and computers will continue to grow quickly). They may also consider expanding into other products for the back end of semiconductor manufacturing. Equipment to test final packaged products may be a growth opportunity in the future that is closely aligned to the front end probe card testers.

Threats: There are a fair number of threats that always put unwanted pressure on the semiconductor supplier business. This industry is very cyclical as replacements come in waves and there is also a fair amount of seasonality from quarter to quarter with a high percentage of sales happening in the second half of the calendar year. Reduced sales from FORMs customers means less capital expenditures to spend. Less capital expenditures mean FORM will suffer until business returns. The other big issue is that the pricing FORMs customers get determines their margin structure due to a higher fixed cost structure. DRAM is seeing the worst price decline since 2001, but supply and demand will rebalance along with prices. NAND and DRAM are flexible in some factories with minimal impact to production volume if the manufacturer decides to switch products due to market pricing. It is likely that big manufacturers like Samsung will switch from DRAM to NAND. This will lower the supply and increase or stabilize the price decline.

Competition

Competition is tough, but not tough enough to remove the high gross margins FORM receives (53% GM in 2007). High margins are likely attributed to the complexity of the products because each customer requires a custom probe card and each product for that customer requires a custom probe card. FORM is also a technology leader by investing large in R&D to offer new products that are differentiated from the competition. They do not have an extremely wide moat as we witnessed when they had a technology slip and FORM’s customers went to the competition to get substitute products. FORM needs to stay on their A game as the competition is continuously looking to eat FORM’s lunch.

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Financials

FORM has an extremely safe balance sheet with 68% of their market value in cash and no debt. It also competes in an industry that allows for healthy margins, which minimizes the erosion of cash in a down market. The last down market in ’01 FORM was still able to make a small profit. FORM has put up superior financials over the past few years. Below are examples of their financial strengths:

o Maintained a fairly steady net margin of 14% over the past 5 years

o CFO (Cash Flow from Operations) growth of 41% per year over 5 years

o FCF (Free Cash Flow) growth of 29% over the past five years. This metric is behind CFO due to the growth investments for the future.

o ROE (Return on Equity) has averaged about 10% per year. ROE would be closer to 40% if they returned the large sum of cash to the share holders as a dividend. This would reduce FORM’s equity by giving it back to shareholders.

o FORM currently holds $570M on its balance sheet in cash and short-term investment with $0 in debt. Arguably they have too much cash and will likely need to pay a dividend, buy back a large amount of stock or make a strategic acquisition for growth.

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Graph 1 above demonstrates the significant improvements FORM’s management has made over the past four years and why this stock is over sold. First of all both CFO and FCF have grown at a break neck pace since their initial public offering (NYSEARCA:IPO) in 2003. CFO is up 550% and FCF is up 791% while shares outstanding have risen 69%. One would assume the share price should be up significantly after the amount of cash generated, but the share price since the IPO is down 6%. FORM began trading at $18.25 and today has been pushed back down to the same levels. Let’s take a quick look at Table 2 to see what the 2003 financials looked like versus 2007. This illustrates why this price disparity is unwarranted:

It truly baffles me to look at how impressive FORM’s financials have been since 2003 and to see the stock price right back down to where it was at the IPO. I will admit that they have issued close to 70% more shares, but even with that said the cash position, CFO, FCF and revenue have all grown multiple times that and warrant a much higher stock price.

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Graph 2 depicts a ratio I like to look at called Owner’s Earnings Yield (Cash Flow from Operations/Enterprise Value). This ratio in a nut shell shows how much cash this business generates based on the current cost to out right purchase the company (Current Market Capitalization + Debt – Cash). This ratio is at its highest level ever over the past 5 years (currently 32%). Not only is it at a high level, but it is 1.6X higher than it has ever been before. This is a signal that this stock is extremely undervalued and is a better time than ever before to invest in FORM. Historically this ratio has traded on the low side of 2-5% (red line) and on the high side of 6-13% (green line). The tan colored bars show the enormous amounts of cash flow from operations [CFO] that FORM has generated over the past five years and they continue to set new records every year. 2008 is shaping up to be a tough year for this industry, but the market has pushed this stock down to 1.16X book value (i.e. you could almost sell off the assets and get your investment back).

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Graph 3 is another strong indicator that FORM is trading at a bargain multiple. Their current P/E ratio is 12 and the lowest P/E FORM has traded at over the past four years. FORM’s five year expected growth rate is ~21%, which typically means it should trade at a P/E multiple of 21. If FORM traded at 21X their current EPS of $1.47, then this would suggest a stock price of $31. I believe that the market is short sighted and is discounting FORM as the aforementioned company and industry difficulties have pushed down 2008 earning estimates to $.46/share. The analysts are then expecting the short-term problems to be cleaned up and 2009 estimates are back up to $1.31. This again shows how short-term the current issues are and long-term investors should be salivating to make a handsome profit.

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FORM ‘s ROE at first glance appears to be moderately ok, but well short of the 15% plus returns I like to see. It has produced about 10% per year on average over the past five years. However, if one removes the large amount of cash FORM has been incubating on its balance sheet you expose a very different story. Graph 4 above shows a purple bar that reflects a what-if analysis based on FORM either paying a large one time dividend, buying back 30M shares (60% of outstanding shares) or investing in a business that returns similar amount to FORM’s core business. Once you adjust for this factor it shows an ROE of closer to 40% versus the 10% with the large cash balance. Now, if FORM chooses to continue and grow this cash and do none of the above I think this is a disservice to the shareholders, but I believe management will sooner rather than later need to make a decision as to what shareholder friendly policy they want to adopt.

FORM Valuation

The eighteen proprietary variables Stock Black Book uses to score FORM generated a score of 75 out of 100. I believe FORM is a relatively safe investment since it has a tremendous amount of cash with $0 debt. FORM has had nothing short of a stellar financial performance over the past five years with cash, CFO and FCF all growing between 200% and 800% (see Table 2 above). I really like to invest in companies that are still being successfully managed by their founder like FORM. FORM was founded by Dr. Igor Y. Khandros in 1993 and has been extremely well run since their IPO in 2003. Dr. Igor Y. Khandros is only 53 years old and presumably has another 10-20 years ahead of him successfully running FORM. Lastly I always like really bad short-term news and especially when it is industry centric versus company centric. FORM did have some company bad news in Q4 as a key product (Harmony) was late due to issues, but this should be cleaned up by now and FORM can begin winning designs on this new product that has since been qualified. The bigger news lately is that the DRAM industry has seen prices drop below cash cost. While it may be more significant this year, these price issues happen quite frequently and I feel that by April or May we will see better pricing as inventory gets pre-built for “Back to School” and holiday season occurring in the second half of 2008.

As far as intrinsic value is concerned I believe this stock should be valued at $30 per share today (1.5X the current price) and in five years could be as high as $50 per share (2.6X the current price). This would create an average return over the next 5 years of ~21% based on today’s $19-20 price reaching $50 in 5 years. I am assuming a cash flow growth rate of 21% over the next 5 years (The prior 5 years averaged 41% per year) and a net margin erosion (back to ~10% from 16% the past two years) as the industry pricing may slow down demand resulting in lower economies of scale.

FORM should have a theoretical bottom of somewhere between $12-$16 per share. I believe this because it currently has ~$12 per share in cash with $0 debt. If you look at it from a book value basis it currently has close to $16 of equity per share. This leads me to believe that the down side risk is likely ~30% versus the upside reward or 50% (based on $30 current intrinsic value).

Stock Black Book believes this is a great opportunity for an investor looking for a high tech company that is well capitalized and has lots of growth opportunities ahead of it. I also firmly believe management is solid and may be rolling out some good news for investors with all that cash on hand. Pick up shares today as I believe the sale may be ending before the summer ends.

Disclosure: No positions