The Ultimate Competitive Advantage

In our Motley Fool Hidden Gems service, we aim to be disciplined small-cap investors. We're focused on companies that will grow and appreciate over long, sustained periods of time. We prefer companies that are somewhat shielded from macroeconomic trends, the day-to-day whims of the market, and the traders that constitute a substantial amount of the daily volume.

One of the newsletter's selections is a unique company with the less-than-sexy name of FormFactor (Nasdaq: FORM). FormFactor produces wafer probe cards that allow semiconductor manufacturers to figure out which of the chips they produce are good -- prior to committing to the added expense of packaging and before final testing.

A look into the business
The secret sauce here is that FormFactor has revolutionized the industry by using a patented technology called micro electronic mechanical systems (MEMS). This allows the firm to make mechanical objects, in this case micro-springs, using typical semiconductor manufacturing processes. These springs serve as contact points on the bare wafers that produce an unparalleled ability to deal with the extremely small dimensions the semiconductor manufacturers use to build things like cell phones, game players, and memory chips to support Microsoft Vista.

While the large players in the industry -- Applied Materials (Nasdaq: AMAT), KLA-Tencor (Nasdaq: KLAC), and Lam Research (Nasdaq: LRCX) -- are quite dependent on continually increasing chip fabrication capacity, FormFactor lives off technology advances. When something changes -- feature size, wafer size, or higher performance architecture -- it sells new probe cards. If the industry isn't expanding from a sales perspective, it is bringing forth technology innovation -- and FormFactor benefits. It is a demand-cycle-proof business.

There's more to this story
Even more exciting are the trends being driven from the consumer electronics side of the equation. As Apple (Nasdaq: AAPL), Nokia (NYSE: NOK), and Motorola (NYSE: MOT) continue to innovate with new handheld platforms with increased functionality, the demands on the semiconductor manufacturers increase.

The packaging requirements on the integrated circuits that allow these devices to operate become increasingly complex due to size and power limitations. Manufacturers have developed stacked package techniques in which several integrated circuits are interconnected and placed in a hermetically sealed package.

This complex packaging technique has increased the desire for better testing at the bare wafer level. After all, once a stacked-package is created, if any of the circuits inside prove bad during final testing, the entire package must be scrapped.

Again, FormFactor comes to the rescue. The MEMS process allows the contact springs on the probe card to be fully integrated with high-speed electronics and work across a broad temperature range. These cards can therefore be used to test bare circuits during high temperature burn-in and at high frequencies, akin to what will be required in final operation.

This means that FormFactor can help produce Known Good Die (KGD), which are integrated circuits that have been fully tested prior to packaging. This is being rapidly adopted because it offers enormous cost savings to the semiconductor companies. FormFactor is the only company today producing probe cards that can perform the full suite of KGD tests.

The ultimate sustainable competitive advantage
FormFactor protects its intellectual property with a large patent portfolio and an aggressive defense thereof. It has 389 issued patents globally, with another 447 pending. It also has current patent infringement litigation against two of its major competitors and has had success gaining enforcement action to defend its technology.

As its competitors play catch-up, FormFactor continues to gain market share and attract new customers. It counts Intel (Nasdaq: INTC) and Samsung, the two largest global players, among its largest customers.

FormFactor excels in the highest technology end of the market, where its MEMS advantage is most pronounced, and this is exactly the direction the industry is heading. In an industry that has grown at 28% per year over the past four years, FormFactor has increased its market share in advanced probe cards to more than 50%. It produced revenue last year in excess of its four largest competitors combined.

Tough patents. Unique products. In the sweet spot of industry growth. That is what I call a sustainable competitive advantage.

For a glimpse of the other small-cap companies we've dug up, I recommend a 30-day free trial of Hidden Gems. It was recently named the No. 1 performing newsletter of the past year by The Hulbert Financial Digest.

Stan Huber owns shares of Intel, Nokia, and FormFactor, but no other companies mentioned in this article. Intel is an Inside Value recommendation. The Fool has a disclosure policy.