FormFactor: Why The Tug-Of-War Could Continue

Summary

• FORM has faced a number of headwinds in 2023, but the prospect of what AI could bring has drawn interest to FORM.
• Big things are expected from HBM memory where FORM has a role to play, but it may not be enough to totally offset the headwinds elsewhere.
• After a fast start in 2023 and appreciating by almost half, the stock has not really gained in seven months and there could be a reason for this.
• FORM would likely have done much worse in 2023 if not for AI, but more is needed if the stock is to break out.

genkur

FormFactor (NASDAQ:FORM) has slowed down. The stock got off to a fast start in 2023, but the stock is now below where it was after the first six weeks or so of the year. FORM has gone up and down the last seven months due to a tug-of-war with an industry slowdown at one end and the promise of an industry rebound at another end. Why will be covered next.

Why FORM has gained interest as an investment

FORM is a supplier of test and measuring solutions for the semiconductor industry. In recent years, semiconductor demand expanded greatly, but the opposite has happened in 2023. As a result, the semiconductor market is expected to contract in 2023, which will have an adverse impact on those depending on a healthy semiconductor market, FORM included.

However, while overall demand is down, there are some market niches that are going against the overall direction. For instance, demand for HBM memory is doing very well thanks in large part to huge investments in generative AI. It just so happens that the leading manufacturer of HBM memory is SK Hynix, a long-standing customer of FORM.

SK Hynix has a leading position in the HBM market with an estimated share of about 50%. SK Hynix is the main supplier of HBM memory to Nvidia (NVDA), the leader in server GPUs, which requires the high bandwidth provided by HBM memory for its high-performance GPUs. With GPU demand expected to soar in the coming years due to AI, some forecasts predicts the market for HBM memory will more than double by the end of 2024 in terms of bit supply. In terms of value, the market is predicted to grow by 127% to reach $8.9B by 2024.

FORM supplies products like probe cards to SK Hynix. On paper, this means that FORM stands to benefit from the explosive growth in demand for HBM memory, although this growth may be somewhat lumpy in nature. HBM memory is also more test intensive compared to conventional DRAM, which implies more opportunity for FORM. It's a big reason why FORM believes its addressable market will grow in the coming years.

The market is down, but a rebound is expected

In addition, overall demand for semiconductors is expected to rebound in 2024. According to WSTS, the semiconductor market is predicted to contract by 10.4% YoY in 2023, only to expand by 11.8% YoY to $576B in 2024. All the above has boosted sentiment towards FORM as it can be regarded as somewhat of an AI play. This can be seen in, for instance, how the stock has appreciated in 2023, even though FORM continues to deal with various headwinds elsewhere.

The stock has gained 49.6% YTD, an impressive gain considering the difficult circumstances FORM finds itself in. However, while the overall direction of the stock looks favorable with higher lows and higher highs, gains have been harder to come by. In fact, most if not all of the 2023 gains came in the first six weeks of 2023. The stock is currently back to a level it reached in early February as shown in the chart below.

Source: Thinkorswim app

The big YTD gains in the stock stand in contrast to the decline in the quarterly results. As mentioned earlier, FORM is dealing with headwinds, including weak overall demand in the semiconductor market. The table below shows how earnings have taken a hit from deteriorating market conditions this year compared to last year.

(Unit: $1000, except EPS)
(GAAP)	Q2 FY2023	Q1 FY2023	Q2 FY2022	QoQ	YoY
Revenue	155,916	167,448	203,907	(6.89%)	(23.54%)
Gross margin	38.7%	36.5%	46.3%	220bps	(760bps)
Operating income	(1,312)	91	32,646	-	-
Net income	828	1,342	30,242	(38.30%)	(97.26%)
EPS	0.01	0.02	0.38	(50.00%)	(97.37%)
(Non-GAAP)
Revenue	155,916	167,448	203,907	(6.89%)	(23.54%)
Gross margin	40.6%	38.4%	47.4%	220bps	(680bps)
Operating income	11,166	13,206	42,250	(15.45%)	(73.57%)
Net income	11,238	12,492	36,775	(10.04%)	(69.44%)
EPS	0.14	0.16	0.46	(12.50%)	(69.57%)

Click to enlarge

Source: FORM Form 8-K

Management was also relatively subdued as to the state of the market. While there are some green shoots to be spotted, particularly in the DRAM market, most end markets have yet to recover. Excess inventory is still a problem in a number of markets. From the Q2 earnings call:

“I think it is different in different segments and end markets. If you look at something like Flash, Flash has a long way to go. At least NAND Flash has a long way to go. DRAM probably in a little bit better shape, but you heard narrative from some of the big DRAM manufacturers in the last several weeks where they feel like that is turning. But there is still a significant amount of inventory to get through.

Mobile probably a few quarters to go as well. Some of the areas where we don’t have as much exposure, things like automotive trailing edge nodes, analog, things like that, where there is still a pretty healthy supply, demand balance and relatively little inventory, those are pretty cleaned up.

So I think you have got the whole gamut across the semiconductor industry, but the areas that drive significant volumes of new probe cards for us and new unit volumes higher unit volumes of probe cards on new designs, there is still some inventory to get through here.”

A transcript of the Q2 FY2023 earnings call can be found here.

However, guidance was better than expected. Q3 guidance calls for Q3 FY2023 revenue of $162-172M, which is down YoY, but up QoQ. The forecast of non-GAAP EPS of $0.13-0.21 is better than the expected $0.15 at the midpoint and a sequential improvement.

(GAAP)	Q3 FY2023 (guidance)	Q3 FY2022	YoY (midpoint)
Revenue	$162-172M	$180.9M	(7.68%)
Gross margin	36.5-39.5%	34.4%	360bps
EPS	$0.01-0.09	$0.06	(16.67%)
(Non-GAAP)
Revenue	$162-172M	$180.9M	(7.68%)
Gross margin	38.5-41.5%	39.0%	100bps
EPS	$0.13-0.21	$0.24	(29.17%)

Click to enlarge

A look at Wall Street estimates shows that as far as earnings estimates go, the worst has passed for FORM. Consensus estimates predict non-GAAP EPS of $0.64-0.72 on revenue of $661-670M in FY2023, which becomes $1.00-1.53 on revenue of $711-770M in FY2024. In comparison, FORM earned $1.25 on revenue of $747.9M in FY2022 and $1.59 on revenue of $769.7M in FY2021.

Earnings are expected to improve in the coming quarters and this can also be seen in how multiples have expanded for FORM. For instance, FORM trades at 48.1 times forward non-GAAP earnings with a trailing P/E of 55.7, above the 5-year averages of 25.3x and 23x respectively. Note that FORM has posted a GAAP loss of $0.08 per share in the last 12 months, which explains the absence of trailing GAAP multiples.

	FORM
Market cap	$2.55B
Enterprise value	$2.37B
Revenue ("ttm")	$670.2M
EBITDA	$42.8M
Trailing non-GAAP P/E	55.75
Forward non-GAAP P/E	48.13
Trailing GAAP P/E	-
Forward GAAP P/E	278.73
PEG GAAP	-
Price/sales	3.78
Price/book	3.04
EV/sales	3.53
Trailing EV/EBITDA	55.30
Forward EV/EBITDA	28.18

Click to enlarge

Source: SeekingAlpha

FORM may be at fair value

Recall how revenue grew from $530M in FY2018 to $748M in FY2022, which implies a CAGR of 9%. In terms of the bottom line, non-GAAP EPS grew from $1.01 in FY2018 to $1.25 in FY2022, which implies a CAGR of 5.5%. However, FORM has stated that it can improve margins to the high forties during a recent presentation, which is up from a non-GAAP gross margin of 42.3% in FY2022.

FORM also believes it can hit $2.00 in earnings on revenue of $850M with such an increase in gross margin according to its target model. This would require annual EPS growth of 26.5% on average. While fair value is subjective, then it can be argued that with earnings growing by 26.5% per year, the fair value for FORM is around $33. This is quite close to its current price of $33.15 and helps explain why the stock has spent a lot of time in the $32-34 region for the last seven months as shown earlier.

Investor takeaway

One of top themes for 2023 has undoubtedly been artificial intelligence or AI. It’s the main reason why NVDA tops all other big-cap semiconductor stocks in terms of gains for 2023 due to its status as the main supplier of server GPUs in the market and the role NVDA could play as a facilitator of AI applications.

This has spilled over into ancillary players such as FORM. FORM is the main supplier of test probes for SK Hynix, which controls roughly half the market for HBM memory. HBM memory is used along side server GPUs. Demand for HBM is therefore on the rise with some forecasts predicting a more than doubling of the market by 2024.

In theory, this should rub off on FORM, which helps explain why the stock has done so well in 2023 even though FORM is faced with a host of headwinds that have slashed earnings. If we take a look at the most recent report, then there are some signs of FORM getting an AI boost. For instance, while the top and the bottom line shrank QoQ in Q2 FY2023, DRAM revenue jumped higher by as much as 54% QoQ to $30.5M. This shows that the HBM memory tailwind is not just hype, but something that can have a real impact.

With that said, the ability of AI to move the needle may be overstated for FORM. For instance, even if the HBM market more than doubled to $8.9B in 2024, the HBM market would still account for a relatively small portion of the memory market, which is expected to total $120B in 2024. The memory market itself is a small part of the overall semiconductor market. In other words, even if HBM demand rises, the expected tailwind can be more than offset by headwinds elsewhere. According to FORM itself, most end markets are not in good shape. Whatever is gained from AI could be lost elsewhere.

FORM has posted non-GAAP EPS of $0.59 TTM, which translates to a P/E ratio in the mid to high 50s with a stock price of $33.15. Granted, such a multiple could drop if semiconductor demand rebounds and earnings recover as a result, but bear in mind that recent forecasts have turned out to be overly optimistic as the semiconductor market has turned out to be weaker than expected. Double-digit growth in 2024 is not guaranteed.

I am neutral on FORM with the above in mind. There is a reason why the stock has essentially moved in circles with nothing to show for since the early rally in 2023. The semiconductor market has ways to go before growth is back. Multiples are high. While AI seems to be providing a lift, it’s a small lift as it cannot completely offset weakness everywhere else due to the relatively small size of the HBM market compared to the overall market for semiconductors. The stock may already be close to fair value and that’s assuming EPS growth will be much faster than it has in recent years.

Bottom line, the fact that the stock is now below where it was in mid-February says it all. Anyone long will have basically nothing to show for the last seven months. If the stock is to do more than trade sideways, then there needs to be something else than just AI/HBM as that can only go so far. AI/HBM is a plus, but it cannot be the sole focus. FORM needs more. As long as the rest of the market does not improve, the tug-of-war FORM finds itself in will continue.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.