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FormFactor beats expections but shares tank

|Includes: FormFactor, Inc. (FORM)

Although FormFactor handily beats expectations today, its shares drop by over 15% in the morning, setting a new all-time low.  This drop is due to the fact that FormFactor is still unprofitable and the path to profit is uncertain.  Citi maintains a "Buy" rating but cuts the price target from $23 to $18.  Citi analyst says:

"While another weak Q from FORM, we didn’t expect much either as it was always more about new mgmt establishing a baseline plan that is refreshingly clear, direct, and realistic about the challenges ahead. At the end of the day, we fell too madly in love w/new Matrix product line given mfg simplicity, robust performance and better margins while we totally missed a complete collapse of its pricing umbrella resulting from product qualification delays. FORM is now admittedly likely to lose significant share – especially at Samsung where it has worked so hard and invested significant resources...Even so, timing is on its side as this tends to be a later cycle play, CQ4/CQ1 revs should be up nicely, and the technology remains far more valuable than the current ~$150MM enterprise value of the company. We are resetting the bar with F2010 EPS from ($1.35) to ($2.09) and F2011 from $1.42 to $0.05."

FORM is expected to recover probably back to around $10 per share the next few weeks since it appears to be oversold currently.  Its cash per share is $8.66 and this should likely set the lower limit below which FORM is unlikely to fall.

Here's the earnings conference call transcript for Q2 2010:
"On today’s call, our Chief Executive Officer, Carl Everett and Chief Financial Officer, Rich DeLateur.

Before we begin, let me remind you that the company will be discussing GAAP P&L results and some key non-GAAP results to supplement understanding of the company’s financial. A schedule that provides GAAP to non-GAAP reconciliation is available in the press release issued today and also on the investor section of FormFactor’s website.

Also a reminder for everyone that today’s discussion contains forward-looking statements and that FormFactor’s actual result could differ materially from those projected in our forward-looking statements. The company assumes no obligation to update the information provided during today’s call, revise any forward-looking statements or to update the reasons, actual results could differ materially from those anticipated in forward-looking statements. For more information, please refer to the risk factors discussed in the company’s form 10-K and subsequent forms 10-Q and in the press release issued today.

With that, we will now turn the over to C.E.O, Carl Everett.

Carl Everett

Thank you and hallo everyone. FormFactor plays an important role in the semiconductor industry by enabling our customers to improve yields, lower overall costs of tests and deliver highly reliable semiconductor devices for all competing applications.

We have just begun the work required to transform FormFactor performance around. As a matter of fact, I expect the next two quarters to show incremental improvements as we position the company for better results in 2011. I am organizing the work in front of us in step with strategic objectives I am setting for the company. Within the strategy framework, we will set detailed targets and goals to measure our progress and drive to results.

For example, Rich will be discussing our key financial targets regarding cash burn, gross margin and OpEx.

Our long term guide focus to work toward is 50, 30, 20, which means a 50% gross margin, a 30% operating expenses as a percentage of revenue and 20% operating profit.

Let me describe the strategic framework. Our first objective; take care of our core business. We are the number one supplier of advanced wafer probe solutions for the DRAM industry. In this role we have several paths to address; first our product line and architecture is changing. We are transitioning from the harmony generation products to a smart matrix and touch matrix product lines. We have notified our customers of end of life plans for Harmony and will begin accepting last time orders at the end of Q3 2010.

The new products enable our customers to achieve better yields and therefore our lower cost of ownership solutions. We are in or have completed the qualification phase of this transition at all of our customers. I am pleased to report the products are well received and coming on line to production.

Through Q2 2010 FormFactor key matrix unit volumes shipments to our customers totaled 200 units. This volume shipped into the market place two and one half times faster than the initial rump up of a harmony product line.

However, on the down side, I do expect to lose market share as we make this transition. This share loss is a result of the time required for the matrix part qualifications and of our customers’ manufacturing lead times as they move from qualification volumes to full commercial production volumes resulting in lost opportunities for us.

I would estimate the share loss to be 8% plus or minus a few points. However we will move in to 2011 and at a much stronger position with the transition behind us. I do know we are making steady improvement in our matrix manufacturing operations, and we see no technical roadblocks. Quarter-over-quarter, our matrix unit volume were at 90% and we expect it to grow another 30% in our third quarter of 2010.

Next, I expect we will be challenged with helping response to strong demand for semiconductors. After 2 years of negative growth, the semiconductor industry has roared back to a Gardner forecast in 27% growth rate for 2010.

The industry capital required to sustain an increased ramp is being deployed and the new output will find its way to the [pump] station. Our customers have asked for faster response times and we are working to deliver.

I have taken action to simplify what was a complex and overreaching manufactuiring strategy at FormFactor. By shutting down the Korean manufacturing site, we eliminated a risk of overbuilding our capacity. We are now focused upon our Livermore, Singapore and Japan sites. Each site has an achievable mission and a stable future. Our output has shown a quick and positive improvement as we reduced our delinquent loss significantly inside the second quarter.

This new factory strategy has enabled us to meet six week general lead times for reorders across our product families. First article designs for new orders require an additional two to three weeks.

Our new matrix products offer reduced complexity for our factory as well as the potential for shorter design times. This will help us in the customer lead time requirements better in the future.

I am driving a weekly cost of goods sold improvement focus internally across our operations and into our supply chain as well. The improvements will be visible as early as Q4 2010. As you are aware, I have taken OpEx actions and will remain focused on operating expenses in our efforts to return to profitability.

Cutting operating expenses alone is not sufficient in our circumstance for a return to profitability. However, we will pursue aggressive new targets for operating expenses in the coming quarters.

FormFactor pricing strategy and guidelines have fallen below normal ICASP cross down trend rates. For example, probe card prices as a percent of IC revenue is less than 50% of what it was in 2007. Over this period, through probe card gains were achieved via substantially more costly probe cards. I have initiated new pricing guidelines that are consistent with normal industry cost learning curves.

Unfortunately, ours missteps on pricing have given our customers the wrong impression and foundation as they plan for the actual upfront purchase cost of our products. We have a lot of work to do to repair the relationships and reestablish the true value our products deliver to the customers. We have already started communicating this message to our customers.

Our second objective; FormFactor technology tidbits to new areas. FormFactor will lead the probe card industry by moving our technology into new areas of opportunity in the semiconductor test phase. We are leading the inclusion of ACRA technology on probe cards across our matrix product lines. We are aggressively pursuing demand memory market and have excellent opportunities to expand our efforts and presence. And new areas of interest are emerging such as Through-Silicon Via and stacked ICs. All will receive my attention as we begin to make investments in the future of FormFactor product line.

Our third objective: FormFactor becomes market focused. FormFactor will focus on enabling out technology to test the semiconductor devices that supply the consumer industry demand drivers. Consistent with our second objective, we have an opportunity to expand our customer base and become the probe technology of choice by engaging major trends and products that are reshaping information technology usage.

In closing, I would add the reception our programs have received from our fellow employees has been especially gratifying in the last 60 days.

I am reaching out to them for their help in driving the turnaround. Not only with our strategies and actions, but also by impacting their potentials for financial rewards; all of our programs by which we deliver financial rewards are being revamped to make sense in our business with regard for affordability, performance of the company and meritocracy.

With that, I will now turn the call over to Rich for details on the financials, Rich?

Richard DeLateur

Thank you Carl, I will begin with summary of our second quarter results. Total revenue was 57.6 million, up 45% sequentially and 85% on a year-over-year basis. Total revenue included 2.9 million from net change in deferred revenue.

Revenue growth came from all three sectors of our business and details as follows; Second quarter revenue for DRAM products was 42.4 million, up 33% from our first quarter and 68% verses the second quarter a year ago. Flash revenue was 8.4 million, up to 144% from Q1 and 355% verses the second quarter a year ago. Both NAND and NOR revenues saw strong growth, with NOR being the larger part of our flash revenue at $6 million. SoC revenue was 6.8 million in the second quarter, up 54% sequentially and 67% worse than the second quarter a year ago.

Revenue from our new product architecture, Smart Matrix and Text Matrix, was 12.3 million, up 71% quarter-over-quarter. Our matrix products were 21% of revenues in the second quarter versus 18% in the first quarter.

Moving down the income statement, second quarter GAAP gross margin was $2.9 million or 5% of revenue. On a non-GAAP basis, gross margin from the second quarter grew 7%. This non-GAAP gross margin of 7% compares to a negative non-GAAP margin of 3% in Q1, providing 10 points or 5.3 million of margin improvement. One would expect a larger increase in gross margin due to increased revenue. But the margin was offset by additional cost of goods sell charges not associated in production, including start up costs from the second quarter manufacturing facility.

On a GAAP basis, operating expenses soared to 37.2 million including 2.5 million of pretax restructuring charges. Excluding these restructuring charges, the GAAP operating expenses were higher by approximately 1.8 million from the first quarter. This increase includes onetime items highlighted in the press release.

As we announced in June, we’ve reduced our workforce and changed the operations structure of the company to better align with the current environment. As Carl mentioned, adjusting headcount does not get us to where we need to be. We are taking additional steps to reduce and in some cases eliminate spreading on certain programs and outside services.

We are also reevaluating our [indiscernible] partners. Our goal is to reduce operating expenses as a percentage of revenue to approximately 30%. This will however take some time to achieve.

Total cash and investments comprised of cash and short-term investments ended the quarter at 398 million, approximately 35 million lower with the previous quarter, an improvement from our guidance of a cash burn out 40 million. Well 35 million worked better than our guidance, it is still an unacceptable large number.

Our goal is to keep the cash run downs to single digits by yearend. Depending on the level and primary [derivative], this could be difficult but there are some elements of cash flow we can move in our favor. Whether we succeed or not, I want to be clear on what we are trying to achieve; a significant reduction in cash burn.

There are some other financial details; our depreciation, amortization in the second quarter was 8.3 million, our capital spending was 9.1 million and our rate was at -0.6% for the second quarter. Before I get into where we are for Q3, I want to address for the commentaries around breakeven, that were made prior to my arrival.

In the near future, it is unlikely that FormFactor will be GAAP or non-GAAP breakeven at the 60 million revenue level. More of you believe 60 million is sufficient to achieve cash flow breakeven in Q4 this year. Further out, our products and ambitions, restructuring plans and back to basics philosophy should yield non-GAAP breakeven result at 65 million.

Incremental revenue beyond 65 million should drop through at approximately 60% on then to strategic quarters. We are not giving Q3 guidance but there are a number of terms that I can speak to. Although seasonally the third quarter has traditionally been the strongest quarter, full bookings status suggests the flat Q2 to Q3. At a higher level, Q3 will look a lot like Q2, so the revenue in the lower to mid fifties. Part of the flatness is delivered decisions turned up some very low margin as well as the current product transitions. The gross margin will be similar to Q2. OpEx however will be substantially lower, approximately five million lower in Q3. Tax rate will be lowered low but not where we want it to be. Looking at Q4, there is reason to believe the current design activities and qualifications would result in significant growth. But given our limited bookings visibility and Q4 seasonality, we are not giving Q4 guidance at this time. However looking forward you should expect continued improvement on operations expenses, cash burn as well as improved drop-through rate for gross margin."

Disclosure: No positions