Jason Cohen - General Counsel Mike Slessor - President and Chief Executive Officer Michael Ludwig - Chief Financial Officer.

Brian Chin - Stifel Nicolaus Jagadish Iyer - Summit Redstone Edwin Mok - Needham & Company.

Thank you and welcome everyone to FormFactor's second quarter 2017 earnings conference call. On today's call are Chief Executive Officer Mike Slessor and Chief Financial Officer Mike Ludwig. Before we begin, Jason Cohen, the company's General Counsel, will remind you of some important information..

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 the anticipated effects and benefits of the completed merger between FormFactor and Cascade Microtech, projections of financial and business performance, future macroeconomic conditions, business momentum, business seasonality, the anticipated demand for products, our future ability to produce and sell products, the development of future products and technologies, 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 2016 and 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, August 2, 2017, and we assume no obligation to update them. With that, I will now turn the call over to FormFactor's CEO Mike Slessor..

Thank you, Jason. And thank you, everyone, for joining us today. FormFactor delivered a strong second quarter, setting a revenue record and sequentially improving all profitability metrics to levels above the high end of our guidance range.

For perspective, the $0.40 of non-GAAP earnings per share we delivered in the second quarter exceeded the non-GAAP EPS we generated in the entire year of 2015. As indicated by the go-forward guidance in today's press release, we continue to see solid demand.

In addition, now that we're well into the third quarter, our visibility into the second half naturally continues to improve and we are incrementally more positive for the year overall than we were in prior calls.

Even with our reported first half revenue significantly above what was previously expected, we now anticipate revenues for the second half to approximate first half levels.

As we discussed, our acquisition of Cascade Microtech provides FormFactor with a broader customer and end market footprint and the ability to capitalize on a wide set of diverse demand drivers.

This diversification continues to pay off as we are experiencing positive momentum across the board from robust data center, mobile and automotive end markets.

As we described on our June 28 analyst call, the line-of-sight growth opportunities from advanced packaging, mobile data and automotive ICs in these end markets are key drivers that will help us achieve our target financial model.

As a reminder, our target model produces $1.50 of non-GAAP EPS from $650 million of revenue when our served markets reach $1.7 billion. Our second quarter performance offers an important initial proof point to FormFactor's opportunity from advanced packaging in the mobile space and the revenue and profitability growth it produces.

As we discussed in the past, advanced packaging processes like the integrated wafer level fan-out and 3-D through-silicon vias drive some fundamental shifts in customer test strategies. These shifts are a powerful tailwind for both overall probe card demand and FormFactor's technical differentiation.

During the second quarter, we benefited from both demand and differentiation as we supplied significant volumes of probe cards to test devices supporting a major second-half mobile handset release, including an application processor packaged with integrated wafer-level fan-out.

While this advanced packaging-driven demand continues in the current quarter, we executed on customer pull-ins during the last few weeks of June to meet production ramps. This was a primary reason our revenue exceeded the high end of our guidance range.

With adoption of advanced packaging processes like integrated fan-out confined to a few customer devices at present, we do expect some continued near-term lumpiness from this opportunity.

That said, with this initial proof point established, we are increasingly excited by the high-growth adoption of advanced packaging in both the mobile and data center end markets.

We expect to see broad impact from this across our product lines, from engineering systems to probe cards, with the present benefit primarily in foundry and logic as well as DRAM probe cards.

Staying with the mobile space, we're also presently executing on typical mid-year demand for a variety of new chips, targeted by our customers for the current handset refresh cycle.

Although volumes continue to grow on a year-over-year basis, the demand seen here are largely consistent with prior years and include RF BAW and SAW filters, low-power DRAM devices, cellular modems, and a variety of auxiliary chips.

We are also supporting the initial development of 5G modems and RF front-ends with key customers, as the industry begins to define both the underlying standards and resulting test strategies for 5G.

With the increased electrical performance and fidelity required by the much higher 5G carrier frequencies, this will be an opportunity where the RF probe technology we acquired as part of the merger with Cascade Microtech provides significant competitive advantage.

In addition, we remain on track for the initial beta shipments this quarter of the first product that combines technologies from the legacy FormFactor and Cascade roadmaps with that innovation bringing a new level of productivity and performance to RF SoC wafer tests.

Continuing data center growth is also providing broad momentum across our businesses as leading customers shrink their processes to the 10 nm microprocessor node and the 1x nanometer DRAM node.

These shrinks are producing demand from our largest customer that continues above the doubled level we attained in 2016 and shipment levels of DRAM probe cards approaching mid-year 2015 levels.

As recently reported by both the DRAM manufacturers and other suppliers, there is significant current and planned investment in new nodes, new designs and additional capacity.

We're encouraged that the pace of that investment appears to be sustainable, with recent comments by our customers indicating they are focused on preserving the current supply/demand balance.

We're also supporting the silicon validation test and debug activities for emerging China memory projects, with both our engineering systems and small volumes of probe cards products.

As that market becomes significant in the coming years, we are looking forward to combining our test technology leadership and applications knowledge, with our decade-long operational presence in China, to further grow our overall business.

Turning now to automotive, overall semiconductor growth in this end market continues to be impressive, with the mid-year analyst reports now projecting 20-plus-percent growth for automotive semiconductors in 2017.

As the primary supplier for many of the key IC manufacturers in this demanding supply chain, FormFactor continues to benefit from this end market growth. For example, in the second quarter, we were honored to receive the 2016 Supplier Excellence Award from Texas Instruments.

TI's award process highlights technology, responsiveness, assurance of supply, and quality as major factors, and we believe FormFactor's market share leadership, scale and ongoing R&D investment provide competitive advantage in meeting these stringent technical and commercial requirements, requirements that are typical of all automotive semiconductor manufacturers.

As evident from our second quarter results, operational execution continues to be a very high priority for our team. Our long-term commitment to continuous improvement of cycle time, quality and cost are producing significant manufacturing efficiencies and operating leverage.

Even with our factory network operating at record output levels in the second quarter, we saw improvement of several major internal manufacturing metrics.

When combined with our line-of-sight revenue growth opportunities, where we compete with differentiated products, this operational execution paints a clear path to achieving our target financial model. We're pleased to have validated several aspects of this path in the second quarter.

I’ll now turn the call over to our CFO Mike Ludwig for further details on our second quarter results and to provide insight into FormFactor's outlook..

Thank you, Mike, and good afternoon. As you saw from our press release and heard from Mike's comments, we had an outstanding second quarter, delivering another quarter of record revenue, achieving solid GAAP earnings per share and non-GAAP EPS that was significantly above our guidance.

In addition, we delivered free cash flow of over $21 million in the quarter, thus ending the quarter and a net cash positive position. We recently crossed the one-year anniversary of the Cascade acquisition, so I thought it would be useful to also highlight our combined company performance.

During the 12-month period ending July 1, we generated revenues of $520 million, non-GAAP diluted earnings per share of $1.06 and free cash flow totaling $68 million. These results clearly show the power of bringing the two companies together.

Turning back to the second quarter results, FormFactor's revenues were $144 million, up 12% or $15.2 million sequentially. Probe Card segment revenues of $121.6 million increased 14% or $15.1 million compared to the first quarter, while our Systems segment revenues of $22.4 million were up slightly compared to Q1.

Within the Probe Card segment, foundry and logic revenues of $88.7 million increased $14.4 million or 19% compared to our first quarter, resulting primarily from increased strength in advanced packaging demand at leading edge nodes and continued strength in data center, mobile and automotive applications.

Foundry and logic revenues increased to 62% of total company revenues in the second quarter, up from 58% in the first quarter. DRAM revenues were $31.5 million in the second quarter, an increase of 9% sequentially as we continue to see a robust demand environment in the quarter.

DRAM revenues comprise 22% of total company revenues in the quarter, consistent with Q1. Technology node transitions, the strong data center demand environment, and increased DRAM content for mobile handset are trends we think will drive DRAM probe card revenue through the remainder of 2017.

The slight sequential increase in Systems segment revenues was driven by increased 300 mm platform shipments. GAAP gross margin for the second quarter was $61.8 million or 42.9% of revenues compared to $47.6 million or 36.9% of revenues for the first quarter.

The second quarter included $6.7 million of reconciling items, which you can find outlined in our GAAP to non-GAAP reconciliation table available on the Investor Relations section of our website. On a non-GAAP basis, gross margin for the second quarter was $68.5 million or 47.6% of revenues, up from 42.6% in the first quarter.

This 5 percentage point increase was driven entirely in the probe card segment where the non-GAAP gross margin increased to 46.9% of revenues, meaningfully higher than the 40.3% achieved in Q1. The segment had a favorable product mix.

The increased volume allowed for higher fixed cost absorption and our factories executed well against the higher demand. In the Systems segment, the non-GAAP gross margin was $11.5 million or 51.3% of revenues in the quarter compared to 54.3% in Q1.

The decrease in gross margin resulted from a stronger euro and a slight decrease in fixed cost absorption. Our GAAP operating expenses were $42.2 million for the second quarter compared to $40.5 million for the first quarter. The second quarter includes $5.1 million of GAAP to non-GAAP reconciling items.

Non-GAAP operating expenses for the second quarter were $37.1 million or 25.8% of revenues, $1.7 million higher than Q1 expenses of $35.4 million or 27.4% of revenues. The increase in spending was driven by incentive compensation expenses associated with the better quarterly performance.

The non-GAAP effective tax rate for the second quarter was 3.8% compared to 4.4% for the first quarter, consistent with our expectations of a continued low effective tax rate, while we utilize our US-based net operating losses and continue to carry a valuation allowance against our deferred tax assets.

The lower effective tax rate in the second quarter reflects the anticipated higher mix of US generated pretax income in fiscal 2017. We expect our non-GAAP effective tax rate for 2017 to be between 4% and 6%.

GAAP net income was $17.6 million or $0.24 per fully diluted share for the second quarter compared to net income of $5.2 million or $0.07 per fully diluted share for the first quarter. Consistent with our comments last quarter, we expect to be GAAP profitable for 2017.

Second quarter non-GAAP net income was $29.2 million or $0.40 per fully diluted share compared to $17.3 million or $0.24 per fully diluted share for Q1. The strong performance reflects higher revenues, outstanding factory execution and leverage on our operating expenses.

Company non-cash expenses for the second quarter included $7.9 million for the amortization of intangible assets, $3.4 million for stock-based compensation and depreciation of $3.4 million.

Moving on to the balance sheet, the company generated $21.2 million of free cash flow in the second quarter, bringing the total to $36.7 million for the first half of 2017.

In the second quarter, the company spent $9.8 million on principal and interest payments, including a $5 million accelerated principal payment, repurchased shares for $7.4 million and spent $4.3 million for capital expenditures. Capital expenditures for the first half of fiscal 2017 were $7.8 million.

Consistent with past guidance, we expect 2017 annual capital expenditures to be in the range of $16 million to $20 million. In total, cash, comprised of cash, short-term investments and restricted cash, ended the second quarter at $130.7 million, $7.7 million higher than Q1.

The balance of our bank term loan was $122.9 million at July 1, a decrease of $8.6 million from April 1. Therefore, as of July 1, the balance of our cash, short-term investments and restricted cash exceeded the balance of our debt by $7.8 million.

Our excellent second quarter resulted in financial performance above the target model communicated in late June. Our second quarter non-GAAP gross margin of 47.6% is higher than the 46% outlined in our target model.

And our second quarter non-GAAP operating expenses as a percent of revenue at 25.8% were favorable to our target model at 27%, resulting in second quarter non-GAAP operating income of 21.8% compared to 19% in our target model.

Our second quarter benefited from a favorable product mix and the acceleration of revenues Mike noted earlier, resulting in greater factory utilization and increased leverage of our operating infrastructure. In addition, we want to point out the financial metrics in our target model represent annualized performance.

Quarterly results will fluctuate with different revenue levels and product mix. That said, we are obviously pleased with the results produced in the second quarter and believe the results validate the path to achieving our target model.

Turning to the third quarter non-GAAP guidance, we continued to experience strong broad-based demand across our product lines in both of our segments.

Foundry and logic as well as DRAM probe card demand continue to show strength in the second half of 2017, although we expect to see slightly less revenue in Q3 due to the previously mentioned Q2 pull-ins to support our customer requests. Systems demand continues to be steady in Q3.

As such, we expect our revenues for the third quarter to be in the range of $136 million to $144 million. We anticipate continued strong factory execution in the third quarter. Volumes and factory utilization are expected to be lower than the second quarter and with a more typical product mix.

We currently forecast third quarter gross margin in the range of 43% to 46%. We expect to realize fully diluted earnings in the range of $0.29 to $0.35 per share. Our Q3 non-GAAP guidance assumes consistent foreign currency rates. With that, let's open the call to questions.

Operator?.

Thank you. [Operator Instructions] The first question comes from the line of Patrick Ho with Stifel. Your line is open..

Hi, thank you. And this is Brian Chin calling in for Patrick. Very nice results and thanks for letting me ask a few questions. I guess, first, North America provided some nice incremental lift in the quarter. Your big customer there has been operating at relatively high levels there already.

So, I was curious if you could characterize what drove the additional upside here.

And I think it's separate and probably rolls up into Taiwan perhaps, but were the pull-ins in the quarter related to the large second half mobile processor win?.

All right, Brian. Mike Slessor. A couple of different moving parts in both the North America and Taiwan bump ups.

As we said in the prepared remarks, there was a lot of activity in general for us around supporting the overall supply chain for the mobile handset refresh cycle that's going on right now, and the major handset releases anticipated in the fall. Certainly, a part of that is the application processor win we had associated with advanced packaging.

But if you look around, there was elements of DRAM as well, which are in both North America and Taiwan. And to throw another element on to the mix, certainly, our largest customer continues to utilize capacity and have demand above the double demand levels we achieved in 2016. So, we saw a variety of different elements of momentum.

I would say the theme around the second quarter pull-ins, the second quarter acceleration were broader than just one customer, but certainly obviously helped out the overall results..

Great, thank you. Also, maybe on the DRAM side, you touched on the aggressive migration of some of the key players there in DRAM and how that should continue to benefit you maybe through the end of the year.

Is it fair then to expect DRAM maybe to even be up a bit more sequentially and is that also factoring into your gross margin outlook for Q3, off the strong Q2 level?.

Yeah. I think, in general, DRAM, obviously, remains pretty robust. The end markets, the supply/demand balance, as we mentioned, that our customers seem keen on maintaining, certainly the behavior is consistent with that. I don't know that I expect a lot of increased DRAM revenue from here.

If you look at our forecast through Q3 and into Q4 and the discussions we're having with key customers on what capacity they need to be in place, I think to first order, we had set the expectation that DRAM revenues should be above where they were in the second quarter as we move through the back half of the year.

Obviously, it's an industry where people continue to be very agile and flexible in adding capacity, and so that could change. And I think it's probably biased to the upside. .

Thanks. And maybe one last quick question about CapEx. I heard the outlook –consistent outlook for this year.

When I think about the $650 million target model, is there any sort of change in the trajectory of CapEx spending from here to that revenue level?.

No, we really think that – again, that $16 million to $20 million, we think is sufficient in order to provide the capacity that we need to deliver the $650 million..

Okay, great. Thanks a lot. .

[Operator Instructions]. Our next question comes from the line of Jagadish Iyer of Summit Redstone. Your line is open..

Yeah. Thanks for taking my questions. Two questions. My congrats for a strong execution. First, if you look at the second half in terms of the – of how we should be thinking about gross margins because if you have a really favorable mix, I was just wondering that 2Q gross margins was up near high-level watermark.

So, how should we be thinking about second half gross margins? Are there some upsides post-Cascade that you might be able to benefit? Any color on that would be great? And then I have a follow-up..

Yea. There were a couple of different elements that I think characterizing, in the near-term, with the structure we're operating on with Q2's gross margins as maybe the high watermark is a pretty good characterization.

Obviously, we see elements of gross margin expansion, again, as we execute on our line-of-sight opportunities and compete with more differentiated products. But Q2 represents a very favorable product mix, and as we mentioned, outstanding factory execution across our network..

Given that we were accelerating shipments at what we certainly call the high end of our capability and differentiation spectrum in serving this next-generation handset release, we see a bit of a normalization of product mix to more normal levels here in Q3 and to the extent we have visibility on the specific product mix into Q4 as well..

Just as a follow-up, Mike, in your prepared remarks, you talked about the packaging and this opportunity with the apps processor with this customer.

Obviously, I was wondering whether – how should we think about proliferation to other customers? Do you think you have line of sight with at least other one or two customers possibly this year or is it mainly a 2018 event? Thank you..

I think with some of the elements of advanced packaging, as we described on the June 28 call, one of the major ones is certainly integrated fan-out. That's really, for 2017, I think fair to characterize as a single customer, even a single design project in the industry.

And that's one of the key benefits we experienced in Q2 and continue to experience at some level in Q3 and through the back half of the year.

If you look at the discussions we're having with key customers and some of the industry research and where we're focusing our R&D, really integrated fan-out through-silica via, things like the EMIB silicon bridge, all of these packaging techniques that are helping the industry innovate beyond Moore's law are really key drivers for our business.

And so, advanced packaging, for us, Q2 and into Q3 here represents an initial proof point, as we said. I see this as a much longer-term trend where we're going to see continued progress and continued positive impact to our P&L as we move into 2018 and beyond..

Congrats again. Thank you..

Thank you..

Thank you. Our next question comes from the line of Edwin Mok of Needham & Company. Your line is open..

Hi, guys. Thanks for taking my questions. Sorry, I jumped on the call a little late. So, if I missed it, I apologize.

On the foundry logic growth sequentially from 19% based on my math, how much of that is driven by this new win, the new customer penetration versus just growth on the other mobile? As you mentioned on the call, you mentioned mobile is a big part of it..

Edwin, Mike Slessor again. It's a mix of both. Obviously, 10 nm, for us, in foundry and logic, as customers ramp up both in the foundry area and in the microprocessor area, we saw significant contributions from both of those drivers in the second quarter.

And although we see the foundry piece tailing off a little bit in the third quarter, we see continued strength in the microprocessor element of it.

So, I would say, as we've talked about in previous questions here on this call, there were several different drivers and moving parts that all helped the increased revenue in Q2 and the momentum we see continuing here into Q3 and into the second half..

Okay, great. That's helpful. You guys are ramping R&D expense, as you talked about new product coming.

Is there a way to kind of think about R&D expense either as a percentage of OpEx or percentage of sales? And then kind of maybe – we always want to discuss, see what [indiscernible] going, right? I think, firstly, you guys talk about the new RF probe product, when should we expect that product to start contributing revenue?.

I’ll address the product piece and then Mike Ludwig will jump in with the R&D spend and some of the ways we're articulating the model.

We did mention in the prepared remarks that the first product that's a joint effort between the former Cascade former and former FormFactor is going to beta here in the third quarter on the schedule we've shared with you guys in the past.

It's really a combination that tries to take the operational efficiency and productivity that FormFactor technology offers and fuse it together with the RF performance that the Cascade roadmap offered. As I said, that's going to beta here in the third quarter.

I would expect sort of some level of revenue contribution in possibly the third quarter, but more probably the fourth quarter.

And at the levels the whole company is operating at – I don't know how you want to define material, but we do expect to see an impact that we'll be able to see on the P&L as we move through the second half of 2018 and go through the design win cycles and adoption cycles associated with a new product..

Hey, Edwin. This is Mike. And talking about R&D spending level, so in our model, we have communicated that we believe that number will be in the 14% range. Obviously, with this quarter, with the acceleration of revenues and whatnot, we were down closer to 12% range, but not because we're limiting spending.

We're spending on plan against the projects that Mike has articulated, and that spending again just happened to result in 12% in this particular quarter. But we think in most quarters and on an annual basis, we still believe that somewhere between 13% and 14% is the right way to think about our spending levels on R&D..

Okay, great. Last question I have, I know you guys have [indiscernible] visibility.

But I think on prepared remarks, Mike, robust second half year growth, right? Maybe a good way to think about that is – can you talk about typical seasonality you see from foundry, DRAM and the system business and how this year could be different or same as that?.

Yeah, sure. That is a good question, Edwin. So, in the call and the press release, essentially, what we've said is the second half is going to look an awful lot like the first half from a top line revenue perspective, even though the first half is essentially above the expectations we had at the last call – at the last earnings call.

If we think about the seasonality profiles inside that, certainly, most of our businesses have a typical seasonal profile or calendar seasonal profile that looks a lot like strong second quarter, strong third-quarter, little bit weaker fourth quarter and first quarter.

I think by and large, given the strength we've seen and continue to see in supplying some of these major mobile handset releases, some of that calendar seasonality is going to continue in place.

But as we've continued to diversify our business, doing things like acquiring systems business from Cascade Microtech, getting more exposed to automotive which has a different seasonal profile, we see those seasonal ups and downs being damped a little bit.

I think it's still a reasonable expectation that you'll see some imprint of the typical Q2, Q3 strengthening Q4, Q1 weakness, but at a much less extreme level than maybe we've seen in some past years..

Okay, great. That's very helpful color. That's all I have. .

[Operator Instructions]. I'm showing no further questions. I'd like to turn the conference back over to Mike Slessor for any closing comments..

Great. Thanks for joining us today. And thank you especially to the worldwide FormFactor team for delivering record results in the second quarter. Our positive momentum continues. We remain focused on delivering a strong second half to the year. Thanks again..

Ladies and gentlemen, that concludes today's call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day..