FormFactor, Inc. (NASDAQ:FORM) Q2 2023 Earnings Call Transcript

FormFactor, Inc. (NASDAQ:FORM) Q2 2023 Earnings Call Transcript August 2, 2023

FormFactor, Inc. beats earnings expectations. Reported EPS is $0.41, expectations were $0.12.

Operator: Thank you and welcome everyone to FormFactor’s Second Quarter 2023 Earnings Conference Call. On today’s call are Chief Executive Officer, Mike Slessor; and Chief Financial Officer, Shai Shahar. Before we begin Stan Finkelstein, the company’s VP of Investor Relations will remind you of some important information.

Stan Finkelstein: Thank you. Today the company will be discussing GAAP P&L results and some important non-GAAP results intended to supplement your understanding of the company’s financials. Reconciliations of GAAP to non-GAAP measures and other financial information are available in the press release issued today by the company and on the Investor Relations section of our website. Today’s discussion contains forward-looking statements within the meaning of the Federal Securities laws. Examples of such forward-looking statements include those with respect to projections of financial and business performance, future macroeconomic and geopolitical conditions; the benefits of acquisitions and investments in capacity and in new technologies; the impact of global, regional, and national health crisis including the COVID-19 pandemic; anticipated industry trends; potential disruptions to our supply chain; the impact of regulatory changes including the recent U.S.-China trade restrictions; the anticipated demand for products; our ability to develop, produce, and sell products and the assumptions upon which such statements are based.

These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed during this call. Information on risk factors and uncertainties is contained in our most recent filing on Form 10-K with the SEC for the fiscal year ended December 31, 2022 and in our other SEC filings, which are available on the SEC’s website at www.sec.gov and in our press release issued today. Forward-looking statements are made as of today August2, 2023 and we assume no obligations to update them. With that, we will now turn the call over to FormFactor’s CEO, Mike Slessor.

Michael Slessor: Thanks everyone for joining us today. FormFactor’s second quarter revenue was below our outlook range due to shipment push outs. However, higher than expected gross margin and good operating expense control produced non-GAAP earnings per share at the top end of our outlook range. We continue to operate in an overall demand environment that remains relatively stable. This is evident from our third quarter outlook. As we navigate the current cyclical downturn, we continue to benefit from FormFactor’s diversification strategy, which differentiates us from our direct competitors with a broad lab to fab product portfolio across Foundry and Logic, DRAM and flash probe cards together with our system segment products.

This unique portfolio enables us to compete for business across diverse demand pools at all major customers producing the relatively stable top line results we have demonstrated for the past several quarters, and that we expect again in the third quarter as we exploit growing areas like high bandwidth memory and DRAM probe cards and co-pack silicon photonics and systems. Helping to offset the impact of areas that are presently soft, like mobile handsets and CPUs in Foundry and Logic probe cards. While the demand softness that has persisted for several quarters continues in some of our most important high unit volume end markets like client, PC and mobile, we are carefully balancing short-term results and long-term investments with discipline cost control that maximizes quarterly profitability and protects our strong balance sheet.

We continue to invest in R&D for new product innovation and competitive differentiation, as well as in the long lead time facilities and equipment components of our capacity increase plans. These investments are designed to produce market share gains and above industry revenue and profit growth when we emerge from the current cyclical trough enabling FormFactor to achieve and then surpass the levels of our current target financial model. Turning now to segment level details. In Foundry and Logic probe cards, our largest business, we experienced the expected moderation in demand in the second quarter as customers digested first quarter shipments for initial production ramps of five nanometer and three nanometer mobile application processors, tile based client microprocessors and high performance compute chips.

In the third quarter, we expect to deliver sequential growth in Foundry and Logic as we see modest strengthening in both mobile and client PC markets, primarily driven by adoption of advanced packaging processes like Foveros and 3D Fabric. Advanced packaging and chiplet innovations were prominently featured at the recent Semicon West Industry Trade Show where a variety of major front and backend suppliers along with leading customers, highlighted the increasing role advanced packaging and chiplets are playing in reaccelerating industry innovation in the face of the slowing of front-end driven morph law. As we have noted in the past, advanced packaging integration schemes drive both higher test intensity, which expands the number of probe cards required per good diode and higher test complexity, which raises the performance requirements for each probe card.

Probe card architectures like form FormFactor’s MEMS technology are essential to meeting these challenging performance requirements on short lead times at a compelling cost of ownership. In memory, as expected, we experienced stronger second quarter demand for DRAM probe cards, while flash remained weak. The sequential increase in DRAM was driven almost entirely by DDR5 and third generation high bandwidth memory designs that are enabling the rapid growth in Generative Artificial Intelligence. DDR5 and HBM together more than offset the softness from each of the memory manufacturer’s reductions in wafer starts that are helping consume the high inventory of older memory designs like DDR4. HBM is yet another example of how advanced packaging is enabling the industry’s innovation and long-term growth since one HBM Chip is a stack of eight, 12 or even 16 individual DRAM die.

To ensure high yields of this stack DRAM chip customers probe and test each component. DRAM die prior to stacking and probe and test the multi die DRAM stack at various points during the stacking process leading to an increase in the overall probe card intensity for good die out. In addition, the technical requirements for HBM tests are significantly more advanced than for standard unstacked DRAM products involving higher test feeds and more challenging thermal scaling specifications. As one example of increased test complexity, the 100,000 MEMS probes on a single HBM probe card must remain within a few microns of their target position across an entire 300 millimeter wafer. As the wafer temperature varies by almost a hundred degrees. FormFactor’s MEMS based smart matrix DRAM probe card architecture meets these advanced requirements providing significant value to our customers and differentiation for FormFactor.

We believe our superior performance capabilities will drive both market share and profitability gains, as HBM grows from a current single-digit percentage of DRAM wafer starts to 20% by 2026 as projected in a recent Wall Street Journal article. Shifting now to systems, our systems business continues to deliver strong results with revenue at near record levels again in the second quarter. These levels were however, less than we expected in our outlook due to some delivery push outs caused by a combination of customer facilities, readiness delays, single point supplier issues and internal first-pass yield shortfalls. We expect these systems to be shipped in the current third quarter and we expect to again deliver strong system segment revenues in the quarter.

The strength is driven by our market leading test and measurement products for early development of applications like co-pack, silicon photonics, quantum computing, and advanced packaging metrology. Co-packaged optics enabled by silicon photonics continues to be an important and exciting driver for form factor’s current and future business. This technology is poised to revolutionize chip-to-chip communication in the data center with significantly reduced power consumption at high-speed, driving industry forecasts of 30% plus growth rates for silicon photonics devices over the next several years. In the transition from early R&D to low volume production, customers are deploying FormFactor’s turnkey electro-optical measurement systems built on our CM300 and Summit200 engineering probers with subsystems from leading partners like Keysight Technologies and PI.

As production volumes increase over the next several years, our product roadmap delivers both systems and consumable probe cards to test and improve yields of electro-optical silicon photonics chips, enabling our customers to seamlessly transition their co-package optics devices from the lab to the fab. Ramping quickly to high volumes to meet the demand for these revolutionary and innovative devices. Finally, I want to share an important customer highlight from the second quarter. FormFactor was one of only six suppliers to receive the exclusive Intel Epic Program outstanding supplier award for 2023. This award recognizes the absolute top performers in the Intel supply chain for their dedication to continuous quality improvement, performance, collaboration, and inclusion over the past year.

I’m extremely proud of the global FormFactor team for the dedication and performance that resulted in this top tier recognition from Intel. And I would like to take this opportunity to thank and congratulate our world class team. In closing, let me reiterate that in the short-term, we continue to be encouraged by the stabilization of demand across our diversified product and technology portfolio as we progress through the cyclical challenges of 2023. Over the longer term, we remain excited and confident in the growth prospects for FormFactor in the industry overall, driven by the fundamental trends of semiconductor content growth and innovations like chiplets and silicon photonics. These are trends where FormFactor is well positioned as an industry and technology leader, and we are confident that our commitment to invest in R&D and capacity will position FormFactor to emerge from the current cyclical downturn, a stronger and leaner competitor enabling us to achieve our target model delivers $2 of non-GAAP earnings per share on $850 million of revenue.

Shai over to you.

Shai Shahar: Thank you, Mike, and good afternoon. As you saw in our press release, and as Mike mentioned, Q2 revenues were slightly below the low end of our outlook range. Non-GAAP gross margin was above the high end of the range and non-GAAP EPS was at the high end of the range. Second quarter revenues were $156 million, a 6.9% sequential decrease from our first quarter revenues and a year over year decrease of 23.5% from our Q2, 22 near record quarterly revenue. Q2 revenues were $1 million below the low end of our outlook range due to push outs of shipments in our system segment. Probe card segment revenues were $115.3 million in the second quarter, a decrease of $12 million or 9.4% from Q1. The decrease was driven by lower Foundry and Logic and flash revenues partially offset by an increase in DRAM revenues.

The system segment continues to operate at near record levels and revenues were $40.6 million in Q2, a $0.5 million increase from the first quarter and comprised 26% of total company revenues, slightly up from 24% in Q1. Within the probe card segment, Q2 Foundry and Logic revenues were $81.9 million a 19% decrease from Q1. Foundry and Logic revenues decreased to 53% of total company revenues compared to 61% in the first quarter. DRAM revenues were $30.5 million in Q2, $10.7 million or 54% higher than in the first quarter and increased to 20% of total quarterly revenues as compared to 12% in the first quarter. Flash revenues of $2.9 million in Q2 were $3 million lower than in the first quarter, and were 2% of total revenues in Q2 as compared to 4% in Q1.

GAAP gross margin for the second quarter was 38.7% as compared to 36.5% in Q1. Cost of revenues included $3 million of GAAP to non-GAAP reconciling items, which we outlined in our press release issued today and in the reconciliation table available in the investor relations section of our website. On a non-GAAP basis, gross margin for the second quarter was 40.6%, 2.2 percentage points higher than the 38.4% non-gap gross margin in Q1 and 110 basis points above the high end of our outlook range. Both segments gross margins were higher than Q1 gross margins and higher than forecasted with a more significant upside in the probe card segment. Our probe card segment gross margin was 36.5% in the second quarter, an increase of 2.2 percentage points compared to 34.3% in Q1.

The increase from Q1 is due to the net effect of three main factors. First, 600 basis points of the increase relates to improved factor utilization and lower manufacturing spending. The improved factor utilization, even at lower revenue levels relates to higher manufacturing activity near the end of the quarter. Second, 90 basis points of the increase relates mainly to reduced excess and obsolete inventory reserve. Partially offsetting these two positive factors was 400 basis points related to lower revenue and a less favorable product mix with lower Foundry and Logic revenues and higher memory revenues. Our Q2 system segment gross margin was 52%, 30 basis points higher than the 51.7% gross margin in the first quarter, reflecting slightly higher revenue and the more favorable product mix.

Our GAAP operating expenses were $61.6 million for the second quarter as compared to $61 million in the first quarter. Non-GAAP operating expenses for the second quarter were $52.1 million, or 33.4% of revenues as compared with $51.2 million or 30.6% of revenues in Q1. The $0.9 million increase relates to G&A expenses specific to Q2 partially offset by lower performance based compensation. Company non-cash expenses for the second quartering included $9.2 million for stock waste compensation, $2.7 million for demo amortization of acquisition related intangibles and depreciation of $7.5 million, all at similar levels to the first quarter. GAAP operating loss was $1.3 million for Q2 compared with GAAP operating income of $0.1 million in Q1. Non-GAAP operating income for the second quarter was $11.2 million compared with $13.2 million in the first quarter.

Gap net income for the second quarter was $0.8 million or $0.01 per fully diluted share compared with a GAAP net income of $1.3 million or $0.02 per fully diluted chair in the previous quarter. The non-GAAP effective tax rate for the second quarter was 14.2%, similar to the 13.9% in the first quarter, we expect our annual non-GAAP effective tax rate to be between 13% and 17%. Second quarter non-GAAP net income was $11.2 million or $0.14 per fully diluted share compared to $12.5 million or $0.16 per fully diluted share in Q1. Moving to the balance sheet and cash flows, we generated free cash flow of $2.1 million in the second quarter compared to a negative free cash flow of $7.3 million in Q1. Cash provided by operating activities in Q2 was $22.5 million, $10.2 million higher than the $12.3 million in Q1.

The main reason for the increase in cash provided by operating activities is improved working capital management. We invested $20.5 million in capital expenditures during the second quarter compared to $19.7 million in Q1 with the core drivers underpinning our strategy still in place, we continue to execute on increasing our long lead time facilities and equipment portions of our capacity increase plans, albeit placing equipment in service at a slower rate to ensure capacity does not significantly outpace demand. Accordingly, we are updating our expected CapEx for 2023 to range between $55 and $65 million, $5 million higher than the previously communicated range. Overall at quarter end total cash and investments were $240 million similar to Q1.

As of the end of the second quarter, we had one term loan remaining with a balance totaling $15 million. Regarding stock buyback during the second quarter, we did not purchase additional shares under our $75 million two-year buyback program. At Q2 quarter end, $18.6 million remained available for future repurchases. Turning to the third quarter non-GAAP outlook, we expect Q3 revenues to be higher than in Q2 with higher systems and Foundry and Logic revenues. This results in a Q3 revenue outlook of $167 million plus or minus $5 million. Third quarter non-GAAP gross margin is expected to be 40% plus or minus 150 basis points. At the midpoint of these outlook ranges, we expect Q3 operating expenses to be $53 million plus or minus $1 million. non-GAAP earnings per fully diluted share for Q3 is expected to be $0.17 plus or minus $0.04.

The reconciliation of our GAAP to non-GAAP Q3 outlook is available on the investor relation section of our website and in our press release issued today. With that, let’s open the call for questions. Operator.

Q&A Session

Operator: [Operator Instructions] Our first question comes from the line of Krish Sankar of Cowen.

Krish Sankar: First one for Shai, it seems like the mix is queuing more towards foundry logic in September quarter, but the gross margin still seems flattish. Kind of like what is going on there because I thought the Foundry logic has better growth margin than DRAM. I’m going to add a follow up for Mike.

Shai Shahar: Sure. Thanks, Krish. I want to start with the – we have talked before about expecting high 30s gross margin at the current revenue level. So we are obviously encouraged by the Q2 results and by the Q3 gross margin outlook of around 40% at the midpoint of this outlook. So we expect gross margin to increase to low 40s once we achieved quarterly revenues of about 180 million on our way to our target model of 47% of revenue levels around $200 million, $210 million, as we demonstrated a year ago, right, with the record revenue. And we expect the gross margin to fluctuate along this trend line as we make progress. Now, specifically for Q3 gross margin as compared to Q2, the mix impact is actually expect to be flat, once you go down to one level below the segment revenue and the impact of the higher revenue versus the second quarter is expected to be offset by a return to normal factor utilization after strong manufacturing activity during the second quarter of Q2 for Q3 shipments.

Also, we expect some higher material cost in Q3 as compared to Q2.

Krish Sankar: And then a bigger picture question for Mike. Thanks for the color on HBM. When I look at GPUs, historically it looks like they use legacy probe card technology, but with AI and COAS at Lean seems like you need to use MEMS. So I’m just kind of curious, is it true if, so, kind of when are you expecting to see the benefit and how to kind of like quantify the revenue opportunity set for FormFactor as we go into MEMS based probe card technology for COAS? Thank you very much.

Michael Slessor: Yes, thank, Krish. Good question, and I agree with the underlying assumptions in it. Historically, the leading GPU manufacturer has used legacy non advanced probe card technologies and hasn’t needed a MEMS probe card from us or our major competitor. As you note, that is changing with the adoption of COAS and advanced packaging. And both of us are in the middle of qualifying MEMS based technologies for these advanced packages for these COAS technologies. It is a relatively modest number of wafer starts at this stage which I think you know. So hopefully this trend continues this growth in AI certainly is expected to continue, and we will be able to see that as a more significant part of our 2024 revenue as the MEMS adoption associated with the COAS technology for GPUs really takes hold and we see that ramp in more significant volume.

Operator: Thank you. Our next question comes from the line of [indiscernible] of Jefferies.

Unidentified Analyst: So guess my first question, I guess, last earnings call, you talked about seeing very strong design activity and the volumes were muted. And then can you just compare and contrast how this has changed this quarter? Like in terms of design activity? Has that increased significantly from last time, what you saw in either volume starting to come back now that AMD and Intel are noting recovery in their PC business? I have a follow up after that, so.

Michael Slessor: Okay, Alright. So design starts and design activity. We are seeing similar levels as we have for the past couple of quarters. Remember that a probe card is specific to each customer chip design. And so as customers release their new designs, they work closely with our design teams to customize the probe card architecture to meet the specific test requirements they have for that chip design. And as we have noted in the past couple of quarters, we have got very robust design activity where, but not shipping very many probe cards units on each new, on each new NPI. In an upturn, we might to expect to ship tens or even hundreds to meet the production ramp. Now we are shipping a few, and this is really a dynamic that most of our customers are adapting to as they try and consume the inventory that they have on their balance sheets that the channel has of their parts.

Obviously, they don’t want to obsolete this inventory by overwhelming it with new designs. And so we are seeing a nice setup as that inventory does get consumed, where these new designs that we have already qualified and are ready to ship in volume will then refill the channel. But as you know, there is a few green shoots in some areas like client PC, I don’t expect a rapid turn there. I don’t expect a rapid turn in mobile, but I do think we are well positioned and we are seeing a little bit of increased activity. I wouldn’t say the situation on design versus units has substantially changed from previous quarters.

Unidentified Analyst: And then on the HBM side, so can you help me understand how, so, you know, your, maybe your largest customer on HBM has talked about their revenues doubling in two quarters. How does that translate to your business? Like for going forward in the second half of 2023? Do you think the DRAM portion of your business would be much bigger than where it is now or is that kind of coming in?

Michael Slessor: Well, the second quarter is a pretty good example of the strength in HBM, as we said in the prepared remarks, most of the increase we saw was really attributable to HBM, some to DDR 5 as well. You know, if you look at from Q2 to Q3, I’m sorry, from Q1 to Q2, we grew the DRAM revenue by about 50%. And almost all of that growth comes from HBM. So you are seeing that already. We do expect continued strength there as we go through 2023. But there will be some digestion. I wouldn’t expect it to double again in the third quarter, for example, from an HBM perspective. But it is a great considering how commodity DRAM or, non HBM DRAM is still relatively weak in working through some significant inventories that are still on our customer’s balance sheets and in the channel, HBM is an awfully nice growth vector to be exposed to right now.

Operator: Our next question comes from the line of Charles Shi of Needham & Company.

Charles Shi: Want to ask about the gross margin glad to see margins back to the forties range for – has been for Q2 and going to be for Q3. After I know we have a few quarters of margins in the 30s range, are you comfortable to really call maybe that low margin period like in the 30s? So, it is going to be behind us and going forward maybe we will be able to maintain at above 40s kind of gross margin?

Shai Shahar: Yes, so the two main factors that influence gross margin at this point are revenue levels and mix. I answered the previous question by repeating what we said before, that in order to gross margin to increase to the low 40%, call it 42%, 43%, we need quarterly revenue to go up to around 180. And in order to get back to the 47% that our target model gross margin like we did a year ago, we need revenues to grow to 200 and 210 million. And we also need this growth to come from a higher margin markets, which is mainly Foundry and Logic. Now, along this trend line that I just described from where we are now, let’s call it 40% to 47% if revenue stays at these levels and mix remains similar, we should be able to maintain this trend line that I was talking about, but we do expect to continue and experience fluctuations along that trend line.

Charles Shi: Maybe the other question glad to see some strength on DRAM proof card. Well, certainly, I was not expecting it to bounce back to 30 million plus per quarter this soon. Maybe this is a question from Mike. Originally, we were expecting maybe it is going to take a lockdown in the middle part of 2023, but now we are not quite seeing that, although you did provide some more cautionary statement around, okay, maybe it is not going to go 50% higher next quarter, but really just want to understand this 30 million plus per quarter. Do you think that this is going to be a sustainable quarterly runway for your DRAM business going forward or maybe some fluctuation will get us get us back to the twenties range.

Michael Slessor: Yes, it is an interesting question, Charles, and maybe to come at it from a different direction. Our DRAM card business right now is really the tail of two submarkets. One, which is very strong that we talked about in the prepared remarks and have touched on here in Q&A is HBM driven by generative AI, right. I think everybody understands the connection where HBM is one of the key enabling semiconductor components along with a GPU for generative AI. And so we are seeing some very strong growth there. The other part of the DRAM business, sort of legacy DDR4, low power DDR4 is really very weak, right. And if I were to estimate it for you the second quarter revenue was composed for DRAM, almost a third in HBM. We have never seen that kind of contribution level from HBM before.

And an initial ramp like that HBM is still only probably 5% of industry-wide DRAM wafer starts, projected to grow significantly over the next couple years. It is going to be a little bit lumpy on the way there. If we can get both components of DRAM healthy and active. If you had HBM on top of the, if you like, commodity or legacy DRAM, then I think you have got the opportunity for DRAM probe card revenues and DRAM probe card spending intensity to drive up significantly. But I would expect some lumpiness on the way there.

Charles Shi: So the standard DRAM sounds like a roughly 20 million-ish was from the standard DRAM, but it was kind of like a in line with the Q1 numbers. Do you think that is really probably the cyclical bottom level round rate there? Because I did notice that was probably the case historically, reform factors DRAM business over there.

Michael Slessor: Yes, I think as long as DRAM continues to get healthy from an end market perspective, you have heard all our customers talk about inventory starting to be consumed. They’ve taken down wafer starts, they are managing their way through this a as long as that continues, I think it is a reasonable assumption that the 20 million-ish level is the cyclical low for DRAM. We should see it build from there, and hopefully we will see continued growth associated with HBM and AI that will put another leg up on the overall DRAM market with our strong market share. I think you can extrapolate those into FormFactor’s growth and results.

Operator: Our next question comes from the line of Craig Ellis of B. Riley.

Craig Ellis: As long as there is attention on high bandwidth memory given its surge, I will go in with a few more. First Mike, can you talk about your customer shipment diversity within bandwidth memory? Clearly, there is been one player that is led that market historically, another aspires against or another is interested in getting product out. But where are we now with respect to customer shipments and how should we think about the coming two to four quarters and what will happen there from an OEM standpoint and related to high bandwidth memory? Given how tight we are on supply, where is Form on being able to deliver probe cards, when and where customers need them right now?

Michael Slessor: Yes. So on the customer HBM side of the equation, I think for those of you who follow this market, you do understand that there is one pretty significant leader in terms of current market share of HBM. And it turns out that that is a customer that has a very strong historical relationship with FormFactor, and one where we have relatively high market share. So that is helping us right now. If you think about our engagements with the other two major DRAM manufacturers, I think they line up reasonably well with the shared dynamics. We are active with each of them, we are engaged with each of them. But if I think about the current shipment profile, it is heavily biased towards the leading provider of HBM memories right now.

If you think about constraints, as far as we sit, we are in pretty good shape and I don’t feel like we are a constraint on the overall HBM ramp. There is probably other areas of process tools, some yields which secondarily help us, right. A lower yield part needs more probe cards to get a certain number of diode and test intensity is going to go up in that situation. I think we are currently enjoying that, and helping resolve those yield problems. So I don’t think we are the current constraint on HBM production and the ramp associated with those things. And you can imagine that given the capacity investments we have made and the CapEx we have deployed, if we need to turn on a few elements of that to meet this HBM demand, we are at the ready to do that.

Craig Ellis: And then following up, and I will just spin it over to Foundry and Logic. When I look at the supplement that shows revenue mix by customer, we do see Intel dropping to the lowest percent of sales, and I believe it would be lowest dollar sales in the last four quarters. Charles asked about, you know, a trough in DRAM. Do you feel like your largest customer is at trough levels, or how do we think about the gives and takes as we look into the back half of this year and 2024 there?

Michael Slessor: Yes, I think your observation’s a good one. I think there is two components to this. One is, you know, our largest customer and generally Foundry and Logic there is some important leading edge designs that are beginning to ramp on advanced packaging technologies, 3D packaging chiplets, those kind of enabling technologies. And we are just in the middle of that transition and ramp with that customer. I think layered on top of that, you know, you have seen some pretty significant weakness in the client PC business analogous to what is happened in memory. It looks to be now rationalizing and recovering, but it is also going to take end market growth, consumer PC refresh cycles to really start to pull the inventory and some of these new products through where customers are going to ramp wafer starts significantly, buy probe cards for those wafer starts.

So I think as long as things stay in this relatively stable situation that we currently have, and start to consume inventory, new products coming into the channel that need new probe cards to test and get to the back end, I think we will probably see things turn up from here. And I made a comment in the prepared remarks that one of the areas of strength sequentially in Foundry and Logic we do see is client PC. And I think that is consistent with our customers and their narratives over the past couple of weeks associated with that market.

Craig Ellis: You and Shai noted that systems was an area where there was a push out in the business, but if we adjust for that push out, if not for that systems would have been at significant record levels in the quarter. And so the question is given where a natural demand is, if not for that shift, can you talk about how you are feeling about the trajectory of the systems business, and are we starting to move into new higher levels of revenue, generative capacity given some of the trends that you talked about earlier in your remarks?

Michael Slessor: Yes, we are very excited about the systems business. We are disappointed in the push outs. You know, if you, extrapolate, you know, $5 million to $6 million gap to our midpoint in the outlook, again, reiterating that we are planning to ship those systems in here in Q3. So it is not perishable demand, but relatively high ASPs as you might infer. And, you know, tools that are really enabling the next generation of semiconductor innovation. I highlighted co-package optics and silicon photonics in the preparing remarks. That is a real driver, but there is some other ones where we have unique capabilities, whether it be cryogenic systems for test and measurement in quantum computing metrology and inspection for advanced packaging.

It is an area where customers continue to invest. Semiconductor R&D spending by our customers continues to be at record levels as they continue to innovate in all these exciting areas. And our tools in the system segment are really enabling that and customers continuing to spend aggressively on that. And so a good example of FormFactor’s diversified strategy where we have got some strength in the systems business, good momentum in the systems business that is helping Elise partially offset some of the softness overall in the production probe card business because of the cyclical downturn.

Operator: Our next question comes from the line of David Duley of Steelhead Securities.

David Duley: Mike, I have asked this question in the past, but I would just like a little bit of further elaboration. You know, you have talked about how high bandwidth memory is more probe and test intensive for two reasons. One is it is packaged and there is more steps in the stack of packages, and then also because the chips themselves are more complex. So when we add those – these two things up, how much more probe intensive do you think high bandwidth memory is versus standard memory?

Michael Slessor: Yes, on a like-for-like basis, let’s call it bits out the door. HBM as with most advanced packaging technologies somewhere between 20% and 30% more test intensive as we see it now, early in any of these technology ramps, you are going to get an intensity bump, because yields are low. Customers are working through all of the yield improvement challenges associated with things like stacking dye, and that is one of the areas where form factor provides unique value, the high fidelity tests, at speed tests we offer really allows customers to detect and then fix these yield problems associated with new technologies so that they can then ramp them aggressively in volume at higher yields. So rule of thumb, I think we see it in HBM, we see it in most chiplet technologies somewhere around 20% to 30% more test intensive on a like, for like out spaces.

David Duley: Then as my second question, the Foundry and Logic business was declined. I think you mentioned 19% or 20% or so sequentially. Can you just talk, elaborate a little bit about what the key weakness was behind that drop? And then as just a kind of a similar question what percentage do you think of three, five and seven nanometer nodes are using MEMS technology now for Probe? Are there other big segments that don’t use MEMS such as the GPU segment that is switching over at this point?

Michael Slessor: So Foundry and Logic was down in the quarter. If you go back to what we said on the Q1 call, that was an expected decline. We had a quite a strong Q1 in founder and Logic, and we had a expectation for some digestion there. That is exactly what we saw. We now, in our third quarter outlook, see Foundry and Logic rebounding some, some strength driven by both modest increases in mobile and client PC. But as our largest business, this is an important one that we continue to compete hard in and continue to make sure we are engaged with all the top customers. If we think about areas of that market that are still unserved or underserved by MEMS probes, we have talked already on this call about the GPUs, and that is really because they are very large footprint and don’t need the density that a MEMS probe has.

So customers can still utilize the older technologies with probably quite a bit lower cost. And so that is a rational decision for them. As they move to some of these advanced technologies, like COAS at 3-nanometer and 5-nanometer, you really have to use a MEMS probe. And so that is an opportunity that is in front of us. And in front of — the two primary MEMS probe suppliers in Foundry and Logic. That is probably the last real hole in the advanced node adoption of MEMS probes. We see widespread adoption across most of NPUs, application processors, any kind of high-performance compute, GPUs is really the whole at this point.

Operator: Our next question comes from the line of Christian Schwab of Craig-Hallum.

Christian Schwab: So following up on the GPU MEMS movement in the last advanced node adoption, I mean, how big of a business could that be in two to three-years bigger than it is currently?

Michael Slessor: Yes. I think the one thing to be somewhat cautious about it is, and I think most people who have understood the GPU dynamics in generative AI adoption is the units are relatively low. These are very large and complex products that bear extremely high ASPs for that customer. And so, when you think about it in terms of test intensity, dollars spent on probe cards more specifically, there is probably not a huge needle mover there, at least in the initial adoption. The boundaries are talking about adding a few thousand wafer starts associated with COAS. If you contrast that to mobile and some of the big projects of the industry, those high unit volumes associated with mobile completely dwarf the increases we are talking about with COAS.

And so, while it is an exciting opportunity and we are seeing its impact in DRAM with HBM, it is an area where we want to be somewhat cautious in creating expectations and adding capacity and planning around it. I think we will see exactly the same dynamics as we have seen in other parts of the business with the adoption of MEMS probes where you see increased value, increased test intensity associated with both the probe card sale, but also the, the test intensity as these customers try and adapt their integration strategies to the advanced packaging techniques like COAS.

Christian Schwab: Okay, great. And then my last questions have two pronged, have to do with Foundry and Logic. First of all, how do you guys view your market share position on Meteor Lake, by your largest customer? Our checks suggested it would be greater than the previous generation Sapphire Rapids. Just want to confirm that and this is a chip that Intel is massively excited about thinks it is the biggest chip introduction, since bringing WiFi to laptops and in2000, is they are going to bring AI to the edge, into the personal computer. So, if they are remotely directionally accurate about that, that should be a big deal if you are positioned well there from a market share perspective. That is part one of the question. Part two of the question is, it is my understanding that you guys are close to potentially, you know, selling to Intel, let’s call it Intel’s largest CPU competitor, A person you previously haven’t had material market share with that could ramp to be a material business.

So if you could give us a quick update on both of those, that would be great.

Michael Slessor: Sure, sure. I think a couple of things, you know, with our largest customer, you know, a design like Meteor Lake has us all excited for a couple of reasons. One, I think the value it delivers to their customers is significant, and there is some fantastic innovation in what it does to the client PC experience. The other reason it is exciting is it is the first major high unit volume consumer product that is going to utilize advanced packaging is dye stacking. And so it is exciting from a couple of different perspectives, compared to some of the server chips like Sapphire Rapids we do have a better share position in the client products like Meteor Lake. And so it is an area where we are excited about that ramp.

I think you still need to be a little bit circumspect, given the weakness in the client PC market. It does appear to be stabilizing and improving, but we are definitely not off to the races like we were in the midst of the pandemic when everybody was refreshing their PCs. The other point I would make before shifting to the second part of the question is, you know, we were one of six suppliers who received the highest supplier award from Intel, and we were the only test and measurement supplier. So I think that is an indicator of the strength of that relationship, the robustness and health of that relationship, which presumably translates into market share as well. On qualifying the other MPU customer, we, it continues to be an extremely high priority for FormFactor.

Clearly to be only qualified at one of them, you are then exposed to whatever share shifts occur in that market. And those share shifts I think everybody understands have not been friendly to our largest customer. Having said that, you know, we are still working with that customer to modify our technology, to adapt our technology to their specific test requirements, which, like many customers are unique, you know, their test engineering teams have built up a strategy that they believe offers them unique value and we continue to modify our technology, develop our technology so that we can be qualified and grow our business there. So it continues to represent a growth opportunity for us, continues to represent a high priority for us. We understand the strategic imperative of getting qualified there.

Christian Schwab: When would we, you know, verify or validate, you know, the fact that you would get there and then how long if you did, would it take you to get, you know, a meaningful, you know, market leadership position at that customer? I assume it would take two to three years, but it could be faster depending on how your competitor’s doing. But my guess is, you know, they may spend at least a hundred million dollars out of these products a year. So it is kind of a substantial opportunity for you in the ballpark, or is that not right?

Michael Slessor: I think you are a little high, but let’s call you are close to the ballpark maybe in the parking lot. They are a significant spender. When you think about the timing that you just articulated, that is about what it takes to get qualified and then win a few designs and ramps. So this is an opportunity that is very much still in front of us. I want to reiterate that it is a strategic imperative for FormFactor to get ourselves qualified and realize that significant amount of share of that significant spend on probe cards in the industry.

Operator: [Operator Instructions] Our next question comes from the line of Linda Wally of DA Davidson.

Tom Diffely: So, previously, earlier you referenced some inventory issues at your clients that was still kind of gating your ability to ship some new product. Where do you think the industry is, or your clients are in the burn of their excess inventory levels at this point? Are there still a few quarters left of that?

Shai Shahar: I think it is different in different segments and end markets. If you look at something like Flash, Flash has a long way to go. At least NAND Flash has a long way to go. DRAM probably in a little bit better shape, but you heard narrative from some of the big DRAM manufacturers in the last several weeks where they feel like that is turning. But there is still a significant amount of inventory to get through. Mobile probably a few quarters to go as well. Some of the areas where we don’t have as much exposure, things like automotive trailing edge nodes, analog, things like that, where there is still a pretty healthy supply, demand balance and relatively little inventory, those are pretty cleaned up. So I think you have got the whole gamut across the semiconductor industry, but the areas that drive significant volumes of new probe cards for us and new unit volumes higher unit volumes of probe cards on new designs, there is still some inventory to get through here.

Tom Diffely: And Mike, I was curious, I was wondering if you could give us just a little more information on the silicon photonics opportunity for you. Maybe how big it is today, how you think the ramp happens in that space over the next few years and how big it could be?

Michael Slessor: Yes, so silicon photonics and co-package optics, we talked about on the prepared remarks is a really exciting area for us. One, because, we have got a strong position with our tools and the partnerships we have with companies like Keysight and PI and providing a turnkey electro-optical measurement system. And what customers need to do is test these chips both optically and electrically and we are one of a handful of suppliers, maybe the only supplier in the world who can bring those technologies together to provide that kind of hybrid electro optical test system. Now, this is still in late R&D, early pilot production. So one of the things we are now focused on is how do we take those hybrid electro optical technologies and really capitalize on them as silicon photonics grows.

It has got 30 odd percent growth rates from most external third-party market research firms, co-package optics in the data center a wonderfully compelling trend just because of the power efficiency improvement. So what we are trying to do right now is position a business that is maybe 10% to 20% of system segment revenues and really position ourselves to take advantage of the growth of that in our production business and the probe card business. And probably this is one of the places where we extend the systems business into a more production-like environment over the next couple of years. So I would expect it is one of the reasons why we keep talking about it. It is one of the areas where we are investing a lot of R&D, we are coupled with the leading customers in the industry, and it is an area where we would expect to track this 30% odd growth rate of the industry when we are successful in execute.

Tom Diffely: So if it is in late R&D at this point, are we a couple years away from meaningful production or could it be faster than that?

Michael Slessor: It could be faster than that. A couple of customers have timelines that are – they are still into late 2024, but I think that is a reasonable expectation for some of these production ramps to start.

Operator: Our next question comes on the line of Gus Richard of Northland Capital Markets.

Gus Richard: If you think about Silicon photonics, can you give us an idea how many people you are engaged with?

Michael Slessor: Yes. So we have sold tools to many, many customers, numbering in the dozens, but I think this is one area where you have new technology where you really want to partner with the people who you feel are going to be the leaders. And so we focused a lot of our R&D engagement on a handful of customers, making sure we are working closely with them in developing the systems and modifying the systems, and making sure we understand their roadmaps to go into production. So while, it is a fairly broad installed base of silicon photonics tools that we have again, numbering in the dozens, really focused on a couple of driver customers, and that is a strategy that is consistent with the way we drive most of our R&D across all of our businesses.

Gus Richard: And then thinking about your Foundry and Logic business, if you kind of cut that segment by say, how much of it is mobile and PC client, and how much of it is, say chiplets? Now I know they are two different categories, but if you can kind of give us a sense of how big chiplets are and sort of how big the client piece of it is, that would be helpful.

Michael Slessor: Well, I think it also depends on what timeframe you are talking about. If you go back to 2021 when client PCs were on fire, it was a very large piece of the business, and we also had mobile and 5G layered on top of that. So you can probably back into what the percentages are based on some of the historicals. I don’t have that off the top of my head and would not really want to speculate on the segmentation. It can often be difficult to tell, especially in mobile exactly where a chip is destined for. So we want to be careful with some of those. But definitely they are very large components of the Foundry and Logic business, well north of 50%. If you then think about the cut through chiplets, it is relatively smaller in Foundry and Logic, because we are just in the early innings of adoption.

We talked about Meteor Lake in somebody else’s question. That is an example of really the first high volume client or consumer driven part, whether it is client, PC or mobile that is adopting these chiplet architectures. And so, if I were to hazard a guess, we are still in Foundry and Logic, probably mid-single digits, high single digits relatively low percentage. It is one of the reasons why it is such an exciting opportunity, the increases in test intensity and test complexity associated with advanced packaging and chiplets, as chiplets become a bigger part of the overall Foundry and Logic industry that is an exciting growth opportunity for us.

Operator: Thank you. Our next question comes from the line of Brian Chin of Stifel.

Brian Chin: Hi there. Thanks. Thanks everyone. Let me ask a few questions. Maybe just to clarify something, so the push out sounds like it is, you know, kind of $5 million, $6 million and you expect to recapture that in 3Q was that entirely the systems for those sort of non-demand related reasons that you laid out? Or was there any, delay in terms of the probe card revenue as well?

Michael Slessor: Well in the probe card segment, because it operates on such short lead times, you know, we often have differences from the assumptions we have made in our outlook. You know, right now we have still got essentially two months to go in the quarter. And so what we do see changes in the probe card business as the quarter evolves and as we book and ship things. We still have a good chunk of turnovers to go here in the third quarter, and the same situation existed in the second quarter. So a little more difficult to make those comparisons in the probe card business. But if you look at, you know, what we said on the call, the systems business, the lead times are longer and so we do have backlog level visibility for what we should be shipping in the quarter.

And in the second quarter, you can look at the delta to the midpoint of guidance that we gave. It is about a $6 million delta, and we had about a $6 million delta of shipments that we expected, systems that we expected to ship that we didn’t.

Brian Chin: Got it. Okay. Thank you. And maybe Mike, a kind a bigger picture question. It kind of ties into things that have been discussed already, but specifically things are clearly a bit more depressed currently, and I think, you know, everyone expects some time that there will be some better improvement off the bottom. But that being said, over the midterm, say two to three years, are you upbeat on IC unit growth similar to the past five to 10 years or moving forward, do you think the complexity might have to do a little bit more of the heavy lifting to drive strong growth in the industry?

Michael Slessor: Yes, it is a really interesting question. I think over a two to three year timeframe, we are optimistic about overall, IC growth, IC revenue growth. If you look at the industry historically, it is always gone through these cyclical ups and downs, but imposed on that a very, very strong long-term growth trajectory. And so over a two to three-year timeframe, we are confident that the industry is going to emerge from this cyclical downturn. And that we will begin to see IC unit growth and dollar growth. Layered on top of that, though, you know, you, the degree of complexity and value in each of these IC units is pretty significant, right. If you think about some of the projects we talked about on the call, whether they are HBM, whether they are projects like Meteor Lake, you know, the complexity in those and the value they provide is certainly going to be part of the revenue growth superimposed on top of the IC unit growth.

Operator: Thank you. Our next question comes from [indiscernible] of Jefferies.

Unidentified Analyst: I guess just from a long-term perspective, so you know, on your prepared remarks, you talked about HBM, you know, adding complexity to your probe cards, the number of steps increase. But is there a point, as you know, like three or four-years down the line, as HBM stacking continues and you see more and more stacks of DRAM. Do you think that could drive your margins on memory similar to similar levels as given that the complexity, I mean, these cuts are complex as compared to what your DRAM probe cards would be?

Michael Slessor: Yes. It is a good question and it drives to some of the underlying gross margin fluctuations that Shai talked about. Whether it is increasing the value of what we do in a market like DRAM by making sure that we have compelling differentiated products for new things like HBM that certainly helps gross margins out in a segment that has been gross margin challenged over the past several years. We are also investing in R&D to improve our competitiveness and profitability with some of these platforms. So over that kind of timeframe, I think you said three or four-years, over that kind of timeframe, you can see both of those things at work. It is one of the reasons that we are confident in the progression back towards the 47% of the target model.

And if you have seen FormFactor’s long-term gross margin, gross margin improvement, gross margin evolution, you can see that that is a very important metric for us. Tough to overcome the volume reductions we are having in the current cyclical downturn, but in the area of both increasing value because of things like HBM and increased complexity, but also us driving, our internal efficiency and gross margin improvement to deliver a better cog structure in the gross margin line.

Operator: I would now like to turn the conference back to Mike Slessor for closing remarks, sir.

Michael Slessor: Thanks everybody for joining us today. We have got as we usually do at this time of the year, several investor conferences lined up here as we go through the late part of the summer, and hope to see you at some of those. Until then, take care.

Operator: This concludes today’s conference call. Thank you for participating. You may now disconnect.