Testing the functionality of semiconductor chips -- the processors and memory chips that go into our computers, cell phones, digital cameras, PDAs, and MP3 players -- is a business that requires complex processes with little or no room for error.
Since it was recommended in Motley Fool Hidden Gems last year, FormFactor (NASDAQ:FORM) has performed admirably in that area. It is the leading manufacturer of advanced test probe cards, and it virtually owns the high end of the market for testing the most complex chips. With business booming, the company built a new manufacturing facility to meet the demand.
Despite the fickleness and vagaries of the semiconductor industry, each design change or architecture modification requires a new probe card to be created. As chips get smaller and the wafers from which they're cut get larger, FormFactor has a steady supply of customers.
So it was with some consternation that I read its latest earnings release, which reported that profits dropped 26% to $5 million this quarter compared with the same period last year. While revenues ($52.3 million) and bookings ($58 million, a 14% increase), or future orders, both hit record highs, the company was experiencing some misfires that Hidden Gems investors have not been accustomed to.
For example, the new facility has apparently been experiencing some unforeseen glitches. Last year, the company dropped a bombshell that contamination had infiltrated its old plant -- news that led to a major sell-off. But with the new facility coming online, the problem was thought to be only temporary, and the stock soon recovered. Out with the old, in with the new, and on to ever bigger profits.
Well, management then revealed that the company is still capacity-constrained and, more disturbingly, is going through a "debugging" process of the new equipment. The company, executives said, is experiencing some "learning curve" inefficiencies and continues to focus on these "mission critical" projects.
FormFactor's new facility, though still on target, is producing at only about 15% of its capacity. That means the probe-card maker is still relying on its old factory to produce the bulk of its product. As a result, it can't take on new projects to meet future customer demand.
In that respect, the company is fortunate that the semiconductor industry has been slumping. Even though FormFactor remains a generation or two ahead of competitors such as Kulicke & Soffa (NASDAQ:KLIC), Wenworth Labs, or even tiny Cascade Microtech (NASDAQ:CSCD), itself a "Tiny Gems" micro-cap pick, customers will turn to the competition out of necessity if there are too many missteps.
Yet as disappointing as the earnings news was, the company is still poised to reap the benefits of the coming shift to smaller chips that will translate into greater demand for probe cards. Moreover, FormFactor suggests that the industry may move to an interim chip size, around 80 nanometers, before moving decisively onto a sub-70-nanometer chip. It was a similar story when the industry migrated from 110-nanometer chips to 90 nanometers. And the larger wafer size, 300 millimeters, is still in transition.
FormFactor is also seeing increased business from its flash and logic segments, areas where it has had a somewhat smaller footprint. Revenues and bookings are at record levels here, too. What has hurt margins and profits are the continuous one-time costs associated with moving to the new plant.
The market reacted to these developments in typical fashion, selling off the stock by some 14% Thursday and then an additional 5% by around midday Friday. That makes the price of this technological market leader exceedingly attractive. At around $22 a share, I foresee a double in price over the next three years.
Why? Well, FormFactor's market is not drying up, its customers are not going away, and though the transition to the new facility has been more difficult than expected, the company will be primed to take advantage of the industry changes once the kinks are worked out -- and there's no reason to think they won't be. Let's just hope that the errors reported are in the chips FormFactor tests and not in its operations.
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Fool contributor Rich Duprey owns shares of FormFactor but none of the other companies mentioned in this article. The Motley Fool has a disclosure policy.
