FormFactor, Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

FormFactor, Inc. is a leading provider of essential test and measurement solutions used in the production of semiconductors, which makes it a key player in the semiconductor manufacturing industry, enabling chip manufacturers to bring their new designs to the market.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

FormFactor designs and manufactures probe cards, which are used to test semiconductor chips during various stages of production. These probe cards are highly specialized, customized, and precision-engineered devices that connect electronic testing equipment to individual microchips on silicon wafers for testing to ensure their quality and performance before being packaged into final product.

Business Overview:

  • Revenues by Segment:
    • FormFactor operates through two main segments: Probe Cards and Systems.
      • The Probe Cards segment which accounts for the bulk of the company’s revenue (around 80% of sales for the first nine months of 2023), provides a range of advanced probe cards, including those for DRAM and Flash memory, silicon interposers and high-density testing.
      • The Systems segment (around 20% of sales for the first nine months of 2023) focuses on selling advanced wafer and die sort test systems, including thermal test systems, cryo systems, and systems for parametric and materials characterization.
      • While both segments have an impact, Probe Cards is the driver of both revenues and profits.
      • FormFactor has been focusing on driving more sales in the Systems business and increasing their profit margins on it.
  • Industry Trends:
    • The semiconductor industry is highly cyclical and relies on constant research and development to bring new and better performing chips to the market.
    • The ongoing chip demand increase has been driven by artificial intelligence, high-performance computing and electrification, that all require highly specialized semiconductors, which drives the demand for the advanced probe cards and systems that FormFactor offers.
    • However, in 2023 the semiconductor market experienced a downturn, resulting in weaker demand for probe cards, inventory corrections and reduced capacity utilization at the chip manufacturers. This has especially hit the memory segment, where FormFactor has most sales, and the demand has been reduced sharply. In Q3-2023, net revenue of FormFactor decreased by 14.8% year-over-year, with Probe Card revenues declining more significantly by 18.7%. On the other hand, growth in the Systems business has helped lessen the decline.
  • Competitive Landscape:

  • FormFactor faces competition primarily from domestic competitors, including Cohu, JMT, and Micronics, and from international competitors such as Technoprobe and MPI, but is a leading player in its market, possessing a variety of technologies, customer relationships, and capabilities to make it more competitive than many of its competitors.

  • What Makes FormFactor Different?:

    • FormFactor’s probe cards are highly customized and technologically advanced, requiring close interaction with their customers and are thus difficult to reproduce. This strong customer intimacy and their ability to design highly complex parts are a strong factor in creating their moat.
    • The long and intense relationship between FormFactor and their clients, means that the clients will have to change their whole testing infrastructure if they decide to go with a competitor, a difficult undertaking, creating a strong lock-in that increases customer willingness to pay.
    • FormFactor has a broad technology portfolio and works very hard on R&D, being the first to achieve some milestones in the industry, increasing its competitiveness.
  • Financial Performance & Metrics:
    • Revenue: FORM’s financials are strongly tied to the semiconductor production cycle. It has experienced rapid growth in recent times, driven by the increased global need for chips, but the recent semiconductor downturn and inventory correction has led to declining revenues. However, its revenues have still grown at around 10% annually over the past few years, which is a high figure compared to most companies.
    • Margins:
      • Gross margins have historically ranged between 45 to 50%, which is fairly stable, but recent challenges have forced them down, reaching 42% in Q3-2023. However, they have been working to improve efficiencies, reduce costs, and improve margins.
      • EBITDA margins have generally been above 20%, showing that they are very profitable when the market conditions are favorable. But, the same dynamics that influence the gross margins influence the EBITDA margins, lowering these as well in bad periods, to reach 14% in Q3-2023.
    • Profitability:
      • FormFactor has historically had strong profitability, as it was highly benefited by large growth and profits in the semiconductor market. The ROIC was high, at around 20% or more, but due to current challenges, it is currently around 10%, much lower than its past performance. FormFactor’s business model also has low capital expenditure needs, enhancing returns on capital even more.
    • Financial Health:
      • FORM has good financial flexibility. Has a manageable debt and positive and growing cash flow, that can be utilized to reinvest into the company and new acquisitions or returning capital to the shareholders. The balance sheet is overall healthy, with enough liquidity and limited liabilities to ensure safety.

Moat Assessment (3/5):

FormFactor has some attributes that give it a moat, but they are not unbreachable. The moat is based on:

  • Customer Lock-in: It has good integration into its customers’ testing processes, as well as switching costs. As it is very difficult and expensive for clients to replace all their infrastructure for a competitor. This gives them some pricing power, and stickiness of their customers.
  • Intangible Assets: They have some specialized proprietary technology that enables them to design the highly complex probe cards that are needed by its customers to make the newer generations of semiconductors.

However, the moat is not very deep.

  • They still have competitors, even if most do not have same technology or strong customer relationships.
  • A large portion of their revenue relies on the memory chip segment, which is cyclical. If a new technology were to displace memory chips, the company’s moat would be heavily affected.

Risks that Could Harm the Moat:

  • Technological Disruption: Rapid advancements in semiconductor technology could render FormFactor’s products obsolete if they fail to adapt. Similarly a new type of testing equipment could decrease the need of probe cards.
  • Customer Concentration: Having a few large customers who can leverage their significant purchase power to negotiate lower prices. Also if any of them decides to move production elsewhere, or start producing equipment themselves, it can lead to significant drops in revenues.
  • Economic Downturns in the Semiconductor Industry: Being tied so closely to the cyclical semiconductor market makes it extremely vulnerable to boom-bust cycles. If the chip market declines or slows, FORM will also experience declining revenues. Also the inventory corrections can cause big drops in sales.
  • Failure of Acquisitions: If it fails to integrate acquired businesses or those businesses fail to achieve their goals, it can erode value. The recent acquisition of Cascade Microtech by FormFactor may not work out as expected.

Business Resilience:

  • Customer Intimacy: The company is highly integrated with its clients and focuses on developing unique value for them that make them a valuable partner that will likely be used in future endeavors, making FormFactor resilient during hard times.
  • Low Fixed Costs: FormFactor does not own much in manufacturing equipment and other such assets, which provides it with more flexibility than competitors that do. This would allow it to adjust expenses in a bad period, protecting profitability.
  • Strong Balance Sheet: A healthy balance sheet and a positive cash flow can also help it withstand downturns.

Understandability (3/5):

The business model is a little more complex, mostly because it relies on understanding the nuances of semiconductor manufacturing and the importance of testing in the production pipeline. Understanding the technology behind the company also needs some knowledge of electronics and engineering. Overall it needs some specific domain knowledge to understand the company fully.

Balance Sheet Health (4/5):

The balance sheet is relatively healthy, with a low level of debt and an above-average current ratio, indicating good short-term liquidity and a strong position to withstand future challenges or pursue further expansion. The cash flows are still positive, but recent downturns in the chip market make it a point of focus. While debt/equity is low, there is a debt of 449.7 million at the end of September 2023, and it is something to take note of, as is the increasing interest rates. All in all, the financial health is good, but needs monitoring.