FormFactor passes the Test

Maker of chip testing equipment was hit too early by fears of a peak in the semiconductor cycle.

By guest author Dan Gallagher from the Wall Street Journal

Three months ago, chip-testing equipment maker FormFactor FORM looked like a company in the wrong place at the wrong time. The truth is actually the opposite.

Semiconductor stocks were riding high earlier this year amid a chip production shortage that has crippled industries from automotive to consumer electronics. That shortage has driven chip manufacturers to boost expansion plans to keep up with demand, which in turn fuelled stock prices in the sector. The PHLX Semiconductor Index hit a decade-high valuation of more than 27 times forward earnings by mid-February.

Naturally, that sparked worry among more seasoned investors long accustomed to the chip equipment industry’s cyclical nature. So when FormFactor posted its first-quarter results in late April, investors were looking hard for any signs of a peak. FormFactor’s disappointing gross margin projection for the second quarter triggered a hard selloff, costing the company nearly one-third of its market value over the next two weeks.

The stock has recovered only a bit of ground since, putting its year-to-date loss at 19%. By contrast, the 30 largest U.S.-listed companies in the semiconductor equipment space have averaged a year-to-date gain of 24 %, according to S&P Global Market Intelligence. FormFactor’s share price has budged little since its second-quarter results on July 28 that showed gross margins coming in better than the company had originally expected.

A beaten-down stock creates an opportunity, given FormFactor’s unique position to capitalize on shifts going on in semiconductor manufacturing. The company specializes in probe cards that allow semiconductor manufacturers to test chips at the wafer level, thus saving on the cost of separating and packaging bad chips.

The world’s biggest chip makers— Intel Corp. , Samsung and Taiwan Semiconductor Manufacturing, or TSMC—are all FormFactor customers. Those three and others are blowing out their capital equipment budgets to keep up with demand. Intel alone projects to spend between USD 19 billion and USD 20 billion this year compared with its average of USD 13.4 billion over the past five years, as the chip maker looks to catch up with TSMC in advanced production processes and start making chips designed by others. TSMC, meanwhile, expects to spend USD 30 billion in capital expenditures this year after averaging USD 12.8 billion annually over the past five years.

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The Intel-TSMC race could prove especially lucrative for FormFactor. As part of its revamped approach to manufacturing, Intel is embracing the use of so-called tiles—in which a processor is broken down into smaller components in an effort to improve overall performance. Such an approach demands more-complicated chip packaging, which in turn drives more need for the type of testing that FormFactor’s products deliver. As Brian Chin of Stifel Nicolaus put it, Intel is “going to have to ante up the test coverage to lessen the likelihood of putting bad chips on their package.”

Intel has averaged about one-quarter of FormFactor’s annual revenue over the past three years. And the chip maker is early in a multiyear effort to significantly boost its manufacturing, with new fabrication facilities under way in Arizona, Oregon, Israel and Ireland.

FormFactor is expanding as well, adding a 100,000-square-foot manufacturing center to its main Livermore, Calif., campus that is expected to begin shipping products in the fourth quarter. Chief Executive Mike Slessor says this will remove a “growth constraint” the company has operated under for the past 18 months. Changes by Intel will help FormFactor in the years ahead, while a pressing need for all chip makers to boost output now could also prove helpful to a company with investors thinking very short-term.