Wafer probe card company FormFactor (FORM) has had a terrible time of it on a long-term basis. After trading in the $40's back in 2007/08, the shares have chopped steadily down into the single-digits as the company has gone from being a cash-generating double-digit margin company to one that has posted years of losses. This decline has been spurred in part by major fundamental shifts in the company's previously core memory markets and company-specific execution issues.
The view in the rearview mirror is decidedly ugly, but the real question is whether FormFactor has positioned itself for a better future. The 2012 acquisition of MicroProbe has positioned the company as a meaningful player in the faster-growing system-on-a-chip (SoC) market, but manufacturing issues in the third quarter draw attention back to years of execution and performance issues. This is definitely a high-risk situation, and I'm not sure FormFactor can or will build on what MicroProbe brought them, but expectations are at a point where I think aggressive investors may want to take a closer look.
Testing … One, Two, Three
FormFactor is one of the largest companies in the wafer probe card space, using lithographic patterning to create custom cards for its customers' die and device testing needs. Cards are basically the interface between automated test equipment and the actual product being tested, allowing chip producers to test at the wafer level instead of the final finished package (saving time and money).
Unlike Cascade Microtech (CSCD), which has largely focused on the engineering/development side and more focused/specialty areas of the production side (eschewing memory), FormFactor has historically focused on the memory market. With that, FormFactor boasts long-standing relationships with most of the major memory chip companies, including Micron (MU), Elpida (now part of Micron), Hynix, and Samsung.
While the memory market has historically offered large volumes, the changes in that market over the last six or seven years have been very hard on FormFactor. With that, the company has attempted to shift more of its business toward the SoC space. The company's efforts took a major step forward in 2012 when it acquired MicroProbe, the leading probe card supplier for SoCs and the dominant supplier to Intel (INTC).
Now FormFactor generates about 50% of its revenue from the SoC market, where it holds roughly 30% share, and where it hopes that a focus on new technologies like copper pillar flip chip will serve it well in the coming years. At the same time, though, memory is still a very important market for FormFactor and still generates meaningful business from Micron/Elpida and Hynix.
Internal And External Challenges Cannot Be Ignored
One of the issues for FormFactor has been a shift in the memory market toward less complex, less profitable cards as the space has matured. Coupled with the long-standing cyclicality of the memory market, that has made profitability a great deal more challenging. FormFactor also faces fierce competition in the space, as Micronics is a strong competitor in memory and Cascade is no slouch in advanced logic and SoCs.
It also hasn't helped matters that some potential clients have been pursuing "DIY" solutions. Taiwan Semiconductor (TSM) uses its own self-made probe cards, and other probe card customers have designed chips with built-in self-test (BIST) features that reduce testing costs for the wafers and take potential revenue out of the probe card market.
FormFactor has taken a challenging situation and made it worse with its own self-inflicted issues over the years. Management has been focused on cutting costs and streamlining operations in recent years, and that has led to a recovery in gross margins (though they're still less than a third of what they were in the 2006/2007 period) and smaller operating losses.
Even so, there is a history here of manufacturing missteps. FormFactor saw a weak third quarter set of results (and issued startlingly bad guidance for the fourth quarter) due in part to manufacturing issues with a major DRAM customer, leading to higher warranty and service costs. FormFactor also experienced some delays and problems with third-party components that led to a customer withdrawing orders until FormFactor convinces them that the situation has been resolved and will not be repeated. As is customary, there were no names named, but a look at the 10-Q reveals meaningful declines in business from Samsung and Hynix (which also experienced a significant fire in the third quarter).
The Potential Is There, But Potential Doesn't Pay Bills
Microprobe has definitely changed FormFactor, for the better in my opinion, as it increases the company's exposure to the more attractive SoC market. The combined company has good technology, and provided they can keep clients like Intel happy, the potential for growth in the next few years (particularly from new, sophisticated chip architectures) is significant. Looming over that, though, is the spectre of both competition from companies like Cascade and Micronics and self-inflicted execution wounds.
I'm looking for FormFactor to generate revenue growth in excess of 8%, as the company benefits from increased SoC production and recoveries in the memory market (and transitions to new generations of products). With that, I'm also looking for a free cash flow margin recovery into the double-digits by 2017, followed by a gradual decline back into the single digits. If that plays out, a discounted cash flow analysis suggests a fair value around $7.50.
The Bottom Line
There are a lot of "ifs" and "maybes" with any projections for FormFactor, and that's just the nature of the industry. That said, the fact that the shares are trading below book value provides some measure of comfort (though less than I'd like, given that free cash flow is still negative). While I think Cascade is the higher-quality company, the relative undervaluation definitely favors FormFactor from both an absolute and relative return standpoint. FormFactor is by no means a "bet the farm" type of investment, but aggressive investors may want to take the time to investigate the turnaround/self-improvement opportunity here.
Disclosure: I 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. (More...)
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