As a company leveraged to both chip production volume and the increasing complexity of chip design and packaging, FormFactor (FORM) sits in a pretty good spot within the semiconductor equipment industry. Not only is demand for FormFactor’s probe cards tied to chip production volume, but the increasing sophistication of chip designs has increased testing demands and, I believe, expanded FormFactor’s competitive moat as solutions once deemed “good enough” no longer are.
FormFactor has been weak over the past year, hurt in large part by delays in Intel’s (INTC) ramp of 10nm chips. Then again, FormFactor has added a major new customer and the shares have already recovered some lost ground on the prospects for ongoing strength in memory and improving results in the second half of 2018. With the shares still offering some upside here, this looks like a name worth further due diligence.
Complexity Is FormFactor’s Friend
FormFactor’s probe cards are basically sophisticated disposables used to test semiconductors during the production process. Not only does such testing help prevent defective chips from reaching the market, but it can also spare manufacturers the expense of packaging faulty chips and help identify flaws in the manufacturing process. Through acquisitions and product development, FormFactor has become the market leader in probe cards with around 40% share – including strong share in both logic and DRAM chip testing.
Increasingly sophisticated chip designs, including smaller architectures and new design elements like copper pillar, fan-out, and TSV have significantly increased the complexity of the testing process, with Teradyne (TER) noting that it takes 20% longer (or more) to test 10nm fan-out chips. These more sophisticated chips require more sophisticated cards, and that benefits FormFactor on multiple levels. First, more sophisticated cards are more expensive, meaning higher margins for the company. Second, the company’s 3D MEMS spring technology is increasingly valuable – older, less sophisticated designs/technologies simply cannot do the job, bringing more business to those who can. While there have always been numerous probe card companies in the market, many of the also-rans are increasingly relegated to older, simpler architectures.
To highlight this, I’d point to a relatively recent customer win for FormFactor. For years, Taiwan Semiconductor (or TSMC) (TSM), the largest fab, used its own internally-developed and manufactured probes. That changed when the company started moving to 10nm and below, as the company found its own technology simply wasn’t up to the job, and they began using FormFactor’s cards.
A Pothole In The Road
Intel has long been one of FormFactor’s biggest customers, kicking in 20% of revenue back in 2014 and 26% in 2017. Unfortunately, that sizable contribution can cut both ways, and some internal problems at Intel have sapped FormFactor’s near-term prospects. Intel has had significant problems with its 10nm designs, and that led to push-outs in probe card order expectations – first, from early 2018 into the second half of 2018 and, more recently, into the second half of 2019. This is not exactly a rare event, as many companies have had serious production/yield issues with architectures below 20nm, but rare or not, it sets FormFactor’s growth back.
The good news, such as it is, is that Intel will be increasing its production at 14nm to partly fill the gap. That’s not going to patch over everything; Intel dropped to 14% of FormFactor’s revenue in the first quarter and Foundry & Logic card revenue was down 21% yoy (and down 15% qoq), but it is better than nothing. Volume and revenue should improve in the second half of the year, though, as Intel’s production volumes increase and as TSMC ramps up more card demand for the company.
FormFactor is also continuing to benefit from healthy memory demand. DRAM demand remains strong, helping drive 5% DRAM card growth in the first quarter (on top of 78% growth in the prior year’s first quarter), and FormFactor boasts major customers like SK Hynix. Demand for cards used to test flash memory chips has also been improving, but this remains (and likely will remain) a small part of FormFactor’s business.
I like FormFactor’s basic business. The company’s cards are essential to ensuring quality production of increasingly complex chip designs, while the systems (about 20% of the business mix in the first quarter) are valuable tools in the chip design/prototyping phase. The company does have some vulnerability to chip volume, though, whether due to decreasing end-user demand (like the lackluster sales of the latest generation of iPhone) or production delays/yield issues (like the Intel problem). Chip volumes have always been cyclical, and I don’t expect that to change, though I see opportunities for FormFactor to offset that at least partially through share gains tied to ongoing design sophistication.
With growth in chip end-markets like mobile, datacenter, IoT, and auto, I’m bullish on FormFactor’s prospects for above-average growth, and I believe long-term revenue growth in the mid-single-digits is attainable. I also expect the company to generate double-digit FCF margins, with double-digit operating margin next year and 20%-plus EBITDA margins down the road.
The Intel issues do impact the company’s valuation based on near-term drivers like 12-month revenue; I believe FormFactor’s near-term margins support a 2x forward EV/revenue multiple, which in turn supports a roughly $16 fair value. The company is more or less at my fair value estimate on a DCF basis, but that still leaves room for double-digit annual returns from here.
The Bottom Line
I had my doubts about FormFactor management when the FormFactor-Cascade deal was announced (I was a long-time bull on Cascade, but not so much on FormFactor), but the company has done pretty well since then. I believe the Intel issue is completely beyond their control, but I do believe that winning business from TSMC is at least partly testament to the value of the company’s proprietary technology(ies) and the company’s leverage to increasing volumes of leading-edge chip designs. Although not shockingly cheap, I think there’s enough here to merit a closer look.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.