With a new factory churning out high-quality, next-generation computer chip testing cards, it was surprising that analysts didn't have much foresight when it came to FormFactor (NASDAQ:FORM) achieving any significant results this year. They expected increased pressure from competitors like Cascade Microtech (CSCD) and Japanese chip-testing companies like JEMs, Phicom, and Micronics Japan. Kulicke & Soffa (NASDAQ:KLIC), a one-time competitor, recently exited the field, but analysts believed the industry leader was still a "no moat" company.

Seems they misunderstood the business potential, although their valuation was closer, albeit a bit off the mark.

FormFactor began the year by reporting its fourth quarter and full-year results for 2005, but year-over-year comparisons were essentially meaningless because of the new factory being able to handle so much more of the increased demand. Sequential comparisons carried more weight, but even so, with Q4 revenues coming in at a record $71.4 million (up 15% from the third quarter) and earnings of $10.5 million, or $0.25 per share, the results far surpassed what even the most enthusiastic backer of the company expected.

The first quarter showed why FormFactor is the industry leader. With revenues up 14% sequentially and earnings holding steady at $0.25 per share, the advanced test wafer probe manufacturer reported that it had its "one touchdown" card in testing and should roll it out soon. A single-touch probe card has been the industry goal for some time as it shortens the testing period, reduces the potential damage of multiple tests, and reduces the total cost of ownership for the customer.

Once again, FormFactor increased revenues 14% in the second quarter, up to $92.4 million, while GAAP EPS came in at $0.32 a share -- a 28% sequential increase. Margins for the company have been steadily improving, and gross margins came in around 53% -- right where management said it wants to be. What's been driving this growth all along has been the surprising demand for DRAM chips. It's always represented the bulk of FormFactor's revenues, but it was expected that slack demand for PCs would curtail it. That hasn't been the case, and DRAM still represents more than 70% of revenues.

As the third quarter rolled around, analysts were no longer underestimating the potential of what FormFactor could achieve. Where management said to expect revenues in the range of $93 million to $95 million, analysts figured they were going to overdeliver once again and set the top of the bar at $97 million. FormFactor lived up to those expectations, with revenues coming in at $96.8 million. Funny, but that was the point at which the stock turned south. Perhaps because we didn't have blowout numbers like before, management forecast flat sequential revenues, or perhaps because there were lingering concerns that the overall computer chip industry will soon be in a funk, the market has sold off the shares.

While the stock remains flat in anticipation of what the fourth quarter will bring, it hasn't dimmed the enthusiasm of the players at Motley Fool CAPS, where FormFactor has garnered a 5-star rating.

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5 Stars

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Is this company a touchdown? CAPS player dilute thinks that barring Armageddon, FormFactor has huge potential: "Recent weakness prompt me to add this to my CAPS. Dominant player in the semiconductor probe card field, their technology is very far ahead of the competition, so unless the computer chip industry stops advancing (WWIII ?!?!) chip manufacturers will continue getting their probe cards for testing."

FormFactor was recommended over two years ago to readers of Motley Fool Hidden Gems. Back then it was a small, underappreciated, relatively unnoticed company in a broad and diverse computer chip industry. The fact that analysts have taken up the cause shows just what executing on your plan will do for you, but it seems they still haven't fully appreciated the potential of remaking the chip-testing industry.

You can appreciate what FormFactor has achieved with these related Foolish articles:

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Fool contributor Rich Duprey owns shares of FormFactor but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.