FORM - FormFactor On Its Heels As The Semiconductor Cycle Bottoms Out

Summary

• FormFactor's fourth quarter results surpassed lowered expectations, but included a steep 25% year-over-year decline in wafer probe card revenue and major hits to the company's profitability.
• Technoprobe outperformed in FormFactor, but weaker guidance relative to FormFactor for Q1'23 leads me to wonder about the balance between market share and product/customer mix between them.
• I do still see risk that the cyclical semiconductor downturn could last a bit longer, but FormFactor should be leveraged to recovering logic markets in 2H'23.
• FormFactor's valuation is so-so now (a fair value in the low-to-mid-$30s), but rerating and beat-and-raise quarters later in 2023 are plausible.

It took a while, but the semiconductor downcycle is in full effect now, as customers are pushing out orders in response to adequate (if not high) inventories relative to weakening end-user demand in many markets. That’s leading to a period of volume weakness, which while relatively uncommon and not long-lasting in the history of the semiconductor industry, still means difficulties for FormFactor ’s ( FORM ) volume-driven wafer probe card business.

I expect at least a couple more quarters of negative annual revenue comparisons, and I think there’s still a risk to the FY’23 revenue outlook. Longer term, though, I still like the company’s leverage to increasingly sophisticated chip and packaging designs, as those demand more capable (and higher-margin) test cards that relatively few companies are capable of supplying. I still expect long-term revenue growth in the mid-single-digits with double-digit free cash flow growth that can support a fair value in the $30s.

Another Tough Quarter…

The last four months (through December of 2022) have seen growing negative year-over-year comps in semiconductor sales, with memory down the worst (sales down 46% year over year in December as per SIA data), but logic also down double-digits. Trouble has been on the horizon for a little while, though, and with that FormFactor’s customers have been managing their own inventories lower in anticipation of weaker volumes.

FormFactor managed to beat expectations in the fourth quarter, but they were lowered expectations following the prior quarter and revenue was still down 19% year over year and 8% quarter over quarter, with card revenue down 25% yoy and 11%, including a 28% yoy and 9% qoq decline in foundry and logic card revenue. System sales have stayed quite strong, up 6% yoy and up a bit sequentially, but make up only about a quarter of the business.

This is a “razor blade” type of business where margins are very much tied to volumes and the recent weakness has margins hard, leading to a 1,260bp year-over-year and 730bp quarter-over-quarter decline in gross margin (non-GAAP), including a nearly 19-point drop in card gross margins to 25.5%. While there are inventory costs pressuring margins, it doesn’t change the underlying reality that weaker end-user demand has significantly impacted FormFactor’s profitability.

Not surprisingly, then, operating income (also non-GAAP) was exceptionally weak in the quarter, falling about 88% year over year and 77% quarter over quarter, with operating margin down in the low single-digits.

… And Another Tough Quarter On The Way

Management guided to Q1’23 results “similar” to Q4’22, with a revenue midpoint of $162M, and gross margin of around 37%. Management’s call for “moderately stronger” foundry/logic is consistent with a comparatively healthier logic market that should be bottoming in the first half of 2023 and a likely significant decline in memory after significant inventory-building among large memory customers in the fourth quarter of 2022 (to take advantage of attractive prices). Volumes are still going to be lackluster for FormFactor, but restructuring efforts taken in 2022 and more normalized inventory levels will help offset that pressure to some extent.

Share Loss Is Becoming More Of A Concern

FormFactor continues to refer to its market leadership in foundry/logic probe cards, and while that is likely still technically true, it certainly seems that not all is well with the business.

FormFactor reported a 25% decline in probe card revenue in the fourth quarter, but Italy’s Technoprobe (TPRO.MI) posted 1% growth in the quarter and 40% growth for the full year (versus FormFactor’s 7% decline), and Technoprobe management explicitly claimed share gains for the year. I’d also note that TSMC ( TSM ) hasn’t been listed as 10%-plus customer for FormFactor in three straight quarters, while the streak with Samsung (SSNLF) has reached four quarters.

Head-to-head comparisons can be tricky, though, and it’s entirely possible that Technoprobe has picked up share in specific markets. I note, for instance, that while Technoprobe outgrew FormFactor by a meaningful rate in Q4’22 and 2022, Technoprobe’s guidance for Q1’23 calls for a nearly 30% sequential decline in revenue compared to FormFactor’s guide for 2.5% contraction.

With Technoprobe specifically calling out “consumer markets”, it’s credible to me that Technoprobe may have gained share in areas like processors and RF chips for smartphones, where FormFactor may be holding on to more share in areas like data center and auto. It could even come down to something like the difference between Android and Apple ( AAPL ). Android volumes were awful in 2022 (especially with Chinese OEMs), while Apple held up better, but heading into 2023 it looks as though Android should recover some while Apple volumes look vulnerable. If Technoprobe’s cards are getting used preferentially on chips going into Apple phones, while FormFactor is more skewed to Android, that could explain some of the recent performance differences.

It’s also worth noting that customer mix matters. FormFactor has long had a close business relationship with Intel ( INTC ), and Intel’s production issues have been well-reported. While that doesn’t answer questions like whether or not Technoprobe is taking share away from FormFactor at TSMC or Samsung, it can explain at least some of the relative performance differences.

The Outlook

Whatever the breakdown is between FormFactor and Technoprobe in terms of customer/business mix, there is room for more than two companies in this business, and I believe strong long-term demand for leading-edge chips will continue to drive underlying addressable market growth in the mid-to-high single-digits for both companies.

Specific to FormFactor, given the guidance from many logic companies offered with December quarter earnings, I believe a return to sequential growth is possible in the June quarter, provided the global economy doesn’t meaningfully weaken in the meantime. Share gains in logic and memory are also possible, and while I’m looking for a nearly double-digit revenue decline in 2023, I expect double-digit growth in FY’24 and FY’25 and long-term growth in the neighborhood of 6%.

I also expect a return to double-digit non-GAAP operating margins in FY’24, with free cash flow margins recovering to the mid-teens over a three to four-year period. I believe high-teens FCF margins are still possible over the longer term, driving low double-digit FCF growth.

Valuation is a mixed proposition. I do see fair value in the low-to-mid-$30s, which isn’t spectacular, but I also believe that a return to sequential growth in mid-2023 would likely drive a rerating.

The Bottom Line

Technoprobe’s recent strong performance certainly calls some of the bullish thesis on FormFactor into question. How these companies perform relative to each other in 2023 will provide more information, of course, but I still believe FormFactor is placed for mid-single-digit long-term revenue growth on the back of ongoing volume growth in leading-edge chips that require highly-capable probe cards. These shares have already rebounded about 50% from their lows, but as logic chip production recovers in 2023, there should be more recovery potential in the shares.

For further details see: