I'm in the midst of a torrid love affair with FormFactor (NASDAQ:FORM), the manufacturer of advanced wafer test probe cards. But I'm also under no delusions that I'll ever be married to it. The semiconductor test industry can be fickle, with advances in technology quickly dethroning one leader for another. I know that as soon as I betrothed myself to it, some competitor would announce a new piece of test equipment that would supplant FormFactor's proprietary MicroSpring design.
I'm no Warren Buffett, given that I'm not willing to hold a stock forever. But still, when I give FormFactor an investor's version of "elevator eyes," I sure do like what I see. Hubba, hubba! It's in the midst of a cycle that investors should find appealing.
The semiconductor sector is indeed cyclical, riding waves of boom and bust, expansion and contraction. Driven quite a bit by companies' capital spending phases, semiconductor manufacturers become flush with cash at the beginning of a cycle and flush with inventory toward the end.
Yet smaller trends within those cycles can also transcend and actually overwhelm the cycles. Things like transitions to smaller architectures, migrations to larger wafer sizes, or adoption of a new technology. A convergence of such forces can well up to provide powerful profit drivers for those at the right spot. FormFactor is in the midst of one of those converging trends, and it should prove to be profitable.
The company is the undisputed leader in the advanced wafer test probe market with an 80% market share, a position it has held relatively unchallenged since before it went public nearly two years ago. Revenues were doubling every quarter for the first three quarters of 2004, and you could hear the collective gasp from analyst and investor alike when FormFactor announced a stumble last month. Contamination at its manufacturing facility caused yields to drop, and revenues and earnings would take a hit in the fourth quarter.
On the day I was professing my love for FormFactor, it was releasing fourth-quarter earnings that showed a sequential decline in revenues of $6 million, or some 9% of sales. Gross margins were down to 42% from 50% in the previous quarter. Operating income was down $6.6 million, while net income declined to $5.8 million, or $0.14 per share, from last quarter's $7.5 million, or $0.19 a share. Guidance for the first quarter of 2005 also seemed muted: revenues of $47 million to $48.5 million with earnings under generally accepted accounting principles of $0.08 to $0.10 per share. That's 27% revenue growth but a 15% earnings decline. Not exactly the performance I was expecting when I recommended FormFactor for Motley Fool Hidden Gems, The Motley Fool's small-cap investing newsletter.
So why does my heart still race when I think about the company? Because of the trend convergences I mentioned earlier and because the stumble was a temporary setback. The dynamic random access memory (DRAM) segment of the semiconductor industry makes up the vast bulk of FormFactor's revenues, and it is witnessing a confluence of trends all its own: smaller chip sizes below 110 nanometers, larger wafer sizes of 300 millimeters from which to cut the chips, and a transition to the next memory chip architecture, DDR2, that will be the big profit driver.
As its name implies, DDR2 is the successor to DDR, the most widely used type of memory today. Both Intel (NASDAQ:INTC) and Advanced Micro Devices (NYSE:AMD) have released chipsets supporting DDR2, and with notebook computing expected to be the next big growth driver in the computer industry, the transition is expected to be just as large. DDR2 will effectively replace the entire installed base of products, and most of the migrations will become apparent some time this year.
What that means for FormFactor is that all of these advanced circuits will need to be tested. Its probe cards, which can test for proper functionality better than just about all of the competing products available, will be in demand. Similar trends are under way in the flash market -- the memory segment used in mobile phones, digital cameras, and PDAs -- as well as the logic memory segment.
The company has fixed its contamination problem and will be mothballing the old factory later this year. It has a state-of-the-art new facility that will be fully operational by this year's fourth quarter, so it will see its earnings affected by carrying the costs of two plants. Considering Wall Street's myopic "what have you done for me lately" mantra, investors should be able to find attractive inflection points during which to buy -- opportunities that will be rewarded later on.
There may come a time when I am no longer enamored of FormFactor and will find it necessary to break up, but I don't see it happening for many years. In the meantime, I'll still cast a lecherous eye toward the profits it can generate for my portfolio.
Discuss the company's prospects on the FormFactor discussion board and develop your own love affair by reading more here:
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Obviously, Fool contributor Rich Duprey needs to work out some issues. He owns shares of FormFactor but none of the other companies mentioned in this article. The Motley Fool has a disclosure policy.
