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

Craig Ellis - B. Riley Patrick Ho - Stifel Nicolaus Tom Diffely - D.A. Davidson Edwin Mok - Needham & Company David Duley - Stealhead Jagadish Iyer - Summit Redstone Atif Malik - Citigroup.

Thank you and welcome everyone to FormFactor's Third 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, October 31, 2017, and we assume no obligation to update them. With that, we 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 another strong result in the third quarter with revenue and earnings at the high end of our guidance range.

Our broad market positioning and diverse set of demand drivers continue to enable FormFactor to capitalize on industry momentum, to deliver growth and strong profitability.

In the third quarter, we achieved our highest DRAM probe card revenues since the second quarter of 2015, realized the highest third quarter sales in engineering systems history and delivered the highest ever quarterly shipments to our largest customer, eclipsing the previous quarterly revenue high for that customer by 20%.

Consistent with comments on our last earnings call, we expect to finish 2017 by delivering revenues in the second half to the proximate revenues we delivered in the first half.

As we look forward, although our quantitative view of 2018 overall is still developing, we are seeing favorable market conditions in data center, mobile and automotive end markets, which we expect will drive meaningful growth in the first half of the year.

As we've discussed on previous calls, industry adoption of advanced packaging processes like integrated fan-out represented significant market growth and differentiation opportunity for FormFactors products, especially for our probe card products serving the mobile space.

To that end, I'm pleased to tell you that we recently received a significant customer order to support preparations for a major 7 nanometer mobile application processor project. We expect to build inventory and make initial shipments late in the current quarter, with volume shipments expected to begin in the first quarter of 2018.

This win represents an important follow on to our initial 2017 10 nanometer penetration serving this key customer in integrated wafer level fan-out applications and demonstrates the differentiation of FormFactors technology in advanced packaging applications.

We are currently focused on planning and preparation to ensure operational execution and product performance that will drive future wins and share growth with this strategically important customer. Continued growth and innovation in the data center is also driving many of our businesses.

With an example being the previously described all time record shipments in the third quarter to our largest customer.

This demand is primarily in support of the early part of this customers 10 nanometer production ramp, although we are also helping enable 7 nanometer development and 5 nanometer path finding with our broad array of electrical test and measurement products.

As with many advanced node transitions there is some short term lumpiness in timing of customer demand and in the fourth quarter we expect some digestion of the record third quarter shipments.

However, as 10 nanometer volumes accelerate in the first quarter of 2018, we are also expecting and planning for return to the record levels experienced in the third quarter, as we support the release of leading edge microprocessors to power next generation data centers.

Driven by a combination of data center, mobile and automotive content growth, demand for DRAM probe card continues at strong levels.

With each of the major DRAM manufacturers executing a combination of no transitions and capacity additions, albeit with each on a slightly different cadence, the new design environment that drives probe card demand remains healthy and robust.

As you have heard recently from both our customers and other suppliers, overall DRAM bid [ph] supply growth appears to be roughly balanced with the content driven demand growth at least in the medium term and we are optimistic this balance will continue through the first half of 2018.

Another trend contributing to our solid third quarter and extending into the fourth quarter is the strength of our engineering systems business.

As a reminder, these systems enable customers to develop processes and improve yields for new semiconductor architectures, new chip designs and even brand new technologies, such as micro LED displays and silicon photonics integrated circuits.

We are seeing particular strength in China where we are supporting initial silicon debug and yield improvement initiatives in both memory, as well as foundry and logic projects. These investments are supporting the initial phases of the aggressive growth and build out plans for the emerging Chinese domestic semiconductor industry.

There's China specific growth, along with the initial momentum in applications such as micro LED that we have discussed previously lead us to expect double-digit annual growth of our systems segment results in 2017.

Another highlight for the quarter was the customer installation of our first product, the combined FormFactor and Cascade legacy technologies. This new probe card architecture delivers heighten levels of productivity and performance to RF SoC wafer test.

We've received positive customer feedback from the testing and evaluation of the initial units and we are now executing the initial production orders and investing in broader product market release activities.

Building on this initial success, our 20:18 planning is increasingly focused on achieving longer term revenue growth synergies from the next steps of product and technology integration, while still retaining a sharp focus on cost and efficiency.

On the operational front, although the underlying third quarter and product and customer mix was substantially different from the unusually strong second quarter, we delivered gross and operating margins that are tracking towards our long-term financial model.

As I mentioned earlier in the call, we are currently preparing our factory network to ensure we can efficiently execute on specific first quarter 2018 demand from our key customers. This demand continues to be resonant with the line of sight opportunities we have described in advance packaging, mobile data and automotive IC's.

With the continued strength of the overall semiconductor industry, augmented by these incremental opportunities, we expect to deliver sequential revenue and profit growth in the first half of 2018, as we progress towards our target financial model to deliver $650 million of revenue and a $1.50 of earnings per share.

I’ll now turn the call over to our CFO, Mike Ludwig for further details on our third 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 another strong quarter, delivering revenue and non-GAAP EPS at the high end of our guidance and delivering another quarter of positive GAAP net income.

FormFactor's revenues for the third quarter were $143.7 million, slightly down from the $144 million in the second quarter. Probe card segment revenues of a $119.4 million decreased 2% compared to the second quarter, while system segment revenues of $24.3 million increased 9% or $1.9 million compared to Q2.

Within the probe card segment, foundry and logic revenues of $81.9 million decrease $6.8 million or 8% compared to our second quarter. The decline was attributable to a reduction in revenue from a customer who utilizes our probe cards in advance packaging applications at leading edge nodes.

Confirming our previous comments that this business would be lumpy as we achieve long-term market share gains at this customer. We saw continued strength and increased revenues from the data center vertical market in the third quarter.

Foundry and logic revenues comprise 58% of total company revenues in the third quarter, down from 62% in the second quarter. DRAM revenues were $32.4 million in the third quarter, an increase of $0.9 million sequentially, as we continue to see a robust demand environment in the quarter.

DRAM revenues comprise 23% of total company revenues in the quarter, a slight increase from the second quarter. Technology node transitions, the strong data center demand environment and increased DRAM content for mobile handset continue to positively impact the market.

Flash probe revenues were $5.2 million in the quarter, an increase of $3.8 million over the second quarter. The majority of third quarter revenues were for NOR flash applications. $1.9 million and 9% sequential increase in system segment revenues was driven by increased revenues from 200 and 300 millimeter platforms and thermal subsystems.

GAAP gross margins for the third quarter was $57.6 million or 40.1% of revenues compared to 42.9% of revenues for the second quarter. The third quarter includes $6.4 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 third quarter was $64 Million or 44.5% of revenues, down from 47.6% in the second quarter. The expected decrease as contemplated in our third quarter guidance is due to lower margins in the probe card segment which decreased to 43.1% of revenues compared to 46.9% in the second quarter.

The segment had a less favorable product mix in the quarter, as our foundry and logic revenues comprise a smaller percentage of overall revenues compared to the second quarter. Our factories continue to perform well at high production levels.

In the system segment, the non-GAAP gross margin was $12.6 million or 51.7% of revenues in the quarter compared to 51.5% in Q2. The increase in gross margin resulted from a favorable product mix offsetting a stronger euro. Our GAAP operating expenses were $43.4 million for the third quarter compared to $42.2 million for the second quarter.

The third quarter includes $6.5 million of GAAP to non-GAAP reconciling items. Non-GAAP operating expenses for the third quarter were $36.9 million or 25.7% of revenues compared to $37.1 million or 25.8% of revenues in the second quarter.

As outlined in our financial model discussions in late June, we are achieving increased leverage on our SG&A infrastructure and current revenue levels. As our SG&A expenses were 13.2% of revenues in Q3 compared to 13.8% in the second quarter.

The non-GAAP effective tax rate for the third quarter was 4% compared to 3.8% for the second quarter, consistent with our expectations of a continued low effective tax rate, while we utilize our previously generated U.S. base net operating losses. We expect our non-GAAP effective tax rate for 2017 to be between 4% and 6%.

GAAP net income was $12.6 million or $0.17 per fully diluted share for the third quarter compared to net income of $0.24 per fully diluted share for the second quarter. We have been GAAP profitable in each of the first three quarters of 2017 and expect our fourth quarter to be GAAP profitable as well.

Third quarter non-GAAP net income was $25 million or $0.34 per fully diluted share compared to $29.2 million or $040 per fully diluted share for Q2. The third quarter - the third quarter results represent another important data point that indicates our financial performance is on a conjecturally to achieve our communicated target model.

Company non-cash expenses for the third quarter included $7.5 million for amortization of intangible assets, $4.6 million for stock based compensation and depreciation of $3.5 million.

Moving onto the balance sheet, the company generated $12.4 million of free cash flow in the third quarter bringing our cash flow for the first nine months for the year to $49 million.

In the quarter, the company spent $9.8 million on principal and interest payments, including a $5 million accelerated principal payment and $6.2 million for capital expenditures.

Capital expenditures for the first three quarters of fiscal 2017 were $14 [ph] million, demonstrating a run rate well within our expected annual capital expenditures of $16 million to $20 million. In total, cash, comprised of cash, short-term investments and restricted cash, ended the third quarter at $135.7 million, $5 million higher than Q2.

The balance of our cash, short term investments and restricted cash exceeded the balance of our debt by $21.4 million at quarter end. Turning to the fourth quarter non-GAAP guidance. We continue to experience broad based demand across product lines and markets in both our probe card and system segments.

Foundry and logic, as well as DRAM probe card demand continue to show strength as demonstrated by our record revenues from our largest customer and higher DRAM revenues in the third quarter and a recent significant follow-on order from our advanced packaging foundry and logic customer. We do however expect to experience some seasonality in Q4.

And as Mike mentioned, we expect a reduction of revenues from our largest customer in Q4, followed by renewed strength from this customer in the first quarter. Therefore, we expect revenues in Q4 to be in the range of $126 million to $134 million.

Consistent with the reduced revenues, fourth quarter volumes and factory utilization are expected to be lower than the third quarter.

But with the product mix that will yield a standard margin slightly higher than the third quarter, we currently expect fourth quarter gross margins to be similar to those of the third quarter in the range of 43% to 46%. We expect to realize fully diluted earnings in the range of $0.24 to $0.30 per share.

Our Q4 non-GAAP guidance assumes consistent foreign currency rates. Achieving the midpoint of our fourth quarter non-GAAP guidance ranges results in fiscal 2017 revenues of $547 million, gross margins of 45% and fully diluted earnings per share of $1.24, demonstrating meaningful progress towards achievement of our long-term target model.

With that, let’s open the call to questions.

Operator?.

Thank you. [Operator Instructions] Our first question comes from the line of Craig Ellis with B. Riley. Please go ahead, sir..

Yeah, excuse me. Thanks for taking the question and to start off just congratulations on the broad based growth you're getting in the portfolio and the nice margin execution.

The first clarification I had was just on the fourth quarter guidance with respect to segment activity and looking at some of the gives and takes is - are we to infer that beyond the foundry and logic business that their segments would be flat or up or is foundry and logic just called out because of its size?.

Hi, Craig. Thanks. This is Mike Slessor.

I think looking at first order, obviously with a business as diverse and having as many different demand drivers as we currently now have in the FormFactor portfolio, there is quite a few puts and takes, but if I were to try and take the highest level view of it, it really is quarter-on-quarter reduction in foundry and logic probe card demand, associated with digestion of record shipments to our largest customer in the third quarter.

As we said were holding capacity and have forecasts and indications that we would expect to return to nominally the third quarter levels in the first part of 2018. So we're pretty confident as that customer ramps 10 nanometer that we're going to see some strong demand in growth there.

I guess the other point I'd make about the fourth quarter and our largest customers, we still expect to operate essentially at the double demand level, doubled over 2015 that we've raised our baseline capacity to. Again, as they ramp 10 nanometer, release new designs, we're expecting to see some growth on top of that.

On DRAM, there's probably a little bit of calendar seasonality that's one of the takes, compared to a very strong second and then third quarter. But as we mentioned in the prepared remarks and you've heard from other people, the overall DRAM environment from a structural standpoint still feel very strong.

So a little bit of a seasonal down tick in the December quarter for DRAM, but nothing significant and we expect to see it continue over the longer term to be relatively strong from an overall alignment perspective..

That's helpful. Then moving on to some of the commentary around specific segments. The company has done quite well with a 10 nanometer program this year and you've got follow-on activity at 7 nanometer, it sounds like with the same customer.

Can you talk about the potential to diversify that business over time? And as that happens what does that mean for growth in the business?.

Yeah. Mike Slessor again Craig. So as we said on the call we have received a significant order to support 7 nanometer production of a mobile application processor project using integrated fan-out technology. We view this is a very important follow-on and validation to our initial 10 nanometer win at this customer.

But I think consistent with a lot of the other suppliers, we're beginning to see the very initial stages of diversification outside both one foundry and to multiple fabulous customers in adopting the integrated fan-out tech.

For sure it's still early innings in this and the majority of both wafer volume and our probe card volume associated with supporting integrated fan-out packaging in particular is pretty concentrated with one foundry and one specific application processor design.

But we're now beginning to both have discussion and work on chip designs for both other foundries and other fabulous customers that utilize advanced packaging technology..

That's helpful. Then the last one for me and it'll probably stay in your court as well. Helpful to get the look ahead, and the comments on meaningful percent growth.

Just clarifying that that was a comment that was intended to be half on half or is that year-on-year and related to that question some larger front end companies have talked about mid to high single digit growth next year.

If we had revenue or if we had industry spending growth that - that was that healthy, against that backdrop, can you talk about the opportunity you would have against the three line of sight opportunities you outlined at the strategic update and what could that mean for top line growth in 2018 perform?.

Sure. I think for our business you know, we've tried to give some view on certainly the first quarter and into the broader first half of 2018. As I said in the prepared remarks, we’re still developing our quantitative view of 2018 overall.

But with the position we're in as the market share leader in our operating segments for sure the industry growth in overall customer spending is going to be one of the key variables that drives our growth. For now, we're pretty optimistic about - for sure the first quarter and into the rest of the first half.

We suffer from a bit of lack of visibility into the second half, but given our market footprint, our relationships with key customers and our penetration in supporting some of the key growth initiatives in the industry, whether they be advanced packaging or automotive IC's, as long as the industry's stays healthy, we feel pretty comfortable about growing 2018..

Great. Thanks, Mike..

Thank you. And our next question comes from the line of Patrick Ho with Stifel Nicolaus..

Thank you very much and congrats on a nice corner as well. Maybe Mike first off, in terms of your capacity and your ability to cater to your customers. A couple of years ago you did have to ramp up capacity for your largest customer.

Given the current demand strength across you know, both logic and DRAM, how do you feel about the company’s total capacity and the ability to keep up with this elevated demand levels that you're seeing across the board today?.

Yeah. So Patrick, a good question, because I think across the industry most of us are continuing to incrementally add capacity, yet still operate with the degree of flexibility that we can modulate the capacity up and down as we need to.

The comments I’ll make, one of the lessons we learned back in the late part of 2015, in early part of 2016 was that we really had to create more fungible capacity and the ability to use our factory network to serve these different elements of industry demand has given us a little more flexibility and a little more leverage in being able to scale up and down.

If you look at the CapEx guidance we've provided for the year, we do believe we're going to be within our $16 million to $20 million CapEx guidance. So we are spending money on increasing capacity and we are adding direct labor incrementally around some different opportunities.

But the fundamental capacity demand balance in our business still feels pretty healthy. We're trying to be as responsive as we can in moving things around and holding world class lead times to make sure that we can continue to lead and compete strongly for business in the industry..

And I think you can see that you know, what we've said in the last two quarters that, recall elevated revenue levels that our factories have really performed well with respect to recalled operation metrics, whether that be scrap on time delivery, quality.

So I think we feel like we’ve got as Mike said a factory network in place that can really respond well to elevated revenue levels..

Right. That’s helpful.

And maybe as my follow-up question in terms of the DRAM probe card market, given your broad base customer base and the different ones that you serve, have you seen any transition over the last few quarters to say below 20 nanometers or still 20 nanometers kind of the sweet spot that you're seeing for your products today?.

Patrick, Mike Slessor again. I think it's different and slightly different for each of the different customers. Obviously, you know, one of the larger DRAM manufacturers has made a pretty bold move to the 1x nanometer node and drive significant wafer volume there.

One of the other manufacturers is getting there and really investing in both the innovation and capacity with the third major DRAM manufacturer maybe running a slightly different playbook.

So I think we've seen at each customer a different mix of tactics and timing as they continue to move forward with both node transition, as well as overall bid [ph] in wafer growth.

So I think in one of our leading customers for sure a significant move to the 1x nanometer node and driving volume for them and volume for us in terms of probe cards on to that node, maybe less so with the other two, but certainly something to look forward to as we move into 2018..

Great. And maybe final question for Mike Ludwig, in terms of the cash flow generation you guys have done a really, really good job since the Cascade deal closed. Is the primary focus still on these accelerated debt repayment.

Is that going to be the primary focus as we look at 2018 as a whole?.

Yes, Patrick, it will. So we are again very focused on de-levering the company and accelerating our debt pay down to the extent that – too the extent that we have a portion of our loan that is hedged. So we definitely want to get that portion paid down and that will take us through or that will take us into the second half of 2018.

So I would I would suggest that through the first half and into the second half that will continue to be a focus of our cash generation and use of some of that free cash flow, in addition to again bolstering our balance sheet and anticipation or looking for M&A opportunities..

Right. Thank you..

Thank you. And our next question comes from Tom Diffely with D.A. Davidson..

Yes. Good afternoon. So I guess first question is on the significant customer order for the 7 nanometer project. So I would assume if you use the term significant it would have been a high volume product that was you know going to the market.

But it's my understanding that 7 nanometer is still kind of in the pilot line state, so I was wondering if you could reconcile those two?.

Sure. Well, it goes back a little bit Tom to maybe Patrick's comment about having capacity in place and making sure that from our customer perspective that they have the certainty of capacity and delivery in place.

I think one of the things we see happening, especially with more strategic relationships with key customers is them making an attempt to secure capacity in place and make sure that we have the commandments, FormFactor has the commitment from them to place that capacity in place, to have them reserved and to be executing on the initial ramps of these things.

So you know, if things were going on a PO by PO, unit by unit basis, I'd agree with you, we'd be looking at somewhere like, probably mid 2018 for the orders to come in.

I think we're operating in a bit of a different mode with everybody trying to ramp significant capacity at leading edge nodes, where technically things are certainly difficult and our customers are doing whatever they can to reduce risk..

Okay.

So you see this capacity you know, fungible for both the 10 and 7 nanometers or whatever projects come up you'll be ready for them?.

We do..

Okay, great.

And then I noticed, you have a nice little step up in the flash business on the NOR, anything in particular going on in the NOR market that we would expect to drive growth on forward [ph] or just kind of one-off?.

Well, I think as we've described before our overall flash revenues, whether they be NAND, planar NAND, 3D NAND or NOR are pretty lumpy because we have a relatively small market share position, given our choice is to prioritize against some of our more profitable and higher return opportunities at least in the short term.

A lot of the NOR growth in the quarter will step up in the quarter has been associated with some of the China activity I talked about. We've had a significant amount of NOR activity in the emerging China memory ecosystem.

And I think overall some of our more classic NOR customers have released some new designs and continue to innovate and try and drive some progress on the NOR flash side as well, more specialty applications in mainstream storage. But as you noted a nice bump up in the third quarter..

Yeah. And it seems to be strength coming from all sorts of different areas right now. So if I – if I look at or listen some of the comments your made about the record levels of DRAM a couple of your record here and the fact that only one of your customers was really going all out on the design activity.

It sounds like you know, there's still potential for upside in the coming quarters if some of these other customers get more aggressive on their 1X ramps?.

Well, yes. I guess, I want to make sure I'm clear on the distinction, we still have all three major DRAM manufacturers releasing new designs on a variety of nodes, whether they be 20 nanometer, 1x nanometer or even now the leading edge 1y nanometer very early production.

So you know, customers as I said in the prepared remarks kind of operating on slightly decoupled cadences for their node releases and design releases, but we see pretty broad based design activity across all of the major DRAM manufacturers here.

With one of them for sure and probably arguably a couple of them, a lot of the wafer start volume is still ahead of us on the 1X nanometer node..

Okay, great. And then a question for Mike Ludwig.

If you look at tax, that 46% is that a good number to use going forward as well?.

I think 4% to 6% is a good effective tax rate to use from a cash basis, at least and so we utilize all of our U.S. base NOLs, which I think will be into the early 2020s..

Okay.

And what is the current level for NOLs right now?.

We expect to end the year at somewhere around $250 million of NOLs..

Okay. Great. Thank you..

Thanks, Tom..

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

Hey, guys. Thanks for taking my question. Thanks for taking my question and great quarter. So first question I want to go back to the 7 nanometer orders that you talked about.

Is that we can think about, does that mean that as order - meaning that you're gaining share at this particular opportunity or – and relative to what you're seeing out of 10 nanometer this year, would it be a higher volume from this customer or both, anyway you can kind of talk more - in a little detail about this particular order?.

Sure. Edwin, Mike Slessor again. Look as Tom noted, it's pretty early in the 7 nanometer production around, but I think the fact that we're participating at this early stage in the 7 nanometer node and with this customer is an indication that we're building that relationship and building share after that first 10 nanometer win last year.

Obviously, we were a little late to the 10 nanometer party relative to – at that customer relative to some of the other suppliers in the overall test and packaging ecosystem, but that represented us getting in the door and I think this now maybe is indicative of a more usual cadence on being engaged early in the development, early in the pilot production ramp and then having the opportunity to go compete for win and earn higher business when it gets into full production, probably more mid year 2018..

Okay, great. That's extremely helpful.

And then on to your largest customer you mentioned you know, you doubled your capacity basically around up to that level, and I remember earlier in the year talk about how they are co-producing in both 14 and 10 [ph] if we know we look forward to more likely transition more to 10 nanometer, is that any risk that that demand might come down to that double level or do you think that’s kind of a sustainable level going forward?.

Well, we’ve said several times that we think that doubled level and doubled with respect to 2015 is a sustainable level. And even with this step down I described in the prepared remarks and with Craig's question, we still expect to be operating in the fourth quarter at that doubled level.

So we feel like even though we’re going through this initial stage of capacity digestion for the 10 nanometer around, we're still going to be operating at the doubled level here in the fourth quarter and we expect to come back up to levels that approximate what we delivered in the third quarter as this customer really starts to ramp 10 nanometer in the first part of 2018..

Right. Great. That's helpful. Last question I have was on the margin type. I guess to my question. First is the foundry mix coming down this quarter and lower utilization, why do you see that – what do you think that your gross margin can actually go up or I think you said flat to up this quarter, but to mid point is sort of flat.

And then also on system gross margin, I remember a year ago that business has - has been trending to the high or let's just say the mid 50s in terms of gross margin, the last two quarters is kind of trending you know, it's still 52%.

Was that business growing, should we expect that you can you know improve the gross margin for that business?.

Yeah. So first question, Edwin in terms of the - why do we think we can hold margins flat in the fourth quarter with a particular logic customer or foundry and logic customer really kind of going down and then what does that mean for the overall business. Again, it really becomes very much a product mix and customer mix discussion.

And again based on what we see right now as product and customer mix in Q4 even with the one change that Mike talked about, we still see that is a pretty strong product customer mix in the fourth quarter. Therefore we believe our standard margins at this point in time will be better than what we had with our - with our third quarter mix.

So that's the reason why we still believe our gross margins in the fourth quarter should be consistent with those in the third quarter.

Your second question with regard to the system's gross margin, so you know, earlier this year we actually had - I think in Q1 we had a margin of about 54% in that business and since that time anywhere from 51% to 52%. And so one thing that has definitely impacted that is the strength of the euro. So most of those revenues are denominated in U.S.

dollars with a lot of cost denominated in the euro. So that definitely has had an impact of a couple of percentage points in each of the last couple quarters. So I'd say that is primarily what we are seeing in terms of impacting that that particular margin. We certainly are not seeing it from a standpoint of reduced ASP per se..

That's great. That's all I have. Thank you..

Thanks, Edwin..

Thank you. Our next question comes from the line of David Duley with Stealhead..

Thanks for taking my question. As far as fan-out goes, you mentioned earlier you have basically one large customer, one large foundry and one large customer that have ramped up on fan-out. Could you give us an idea how many more you would expect to join the party in 2018.

You know, we've heard from other companies that there are certainly several customers who are ramping up fan-out production.

I was just wondering what your perspective was?.

Yeah. So a great question David and one that we're obviously excited about the answer to. And I think you have to look at it in two dimensions. Since this is primarily - since fan-out is primarily a technology that's directed towards the mobile space and the majority of mobile chip designs are produced in a fabulous foundry ecosystem.

I think you first have to look at the foundries aerostats [ph] that are investing in, capable of producing integrated fan-out from a factory or foundry perspective and then you have to look at the utilizers of that technology, the fabulous companies or the mobile chip designers. I think we're seeing increases on – in both of those dimensions.

For sure, everybody who is trying to play at the leading edge of the foundry space is investing and developing and trying to qualify wafer level or panel level fan-out technologies depending on the different flavors.

And so we're seeing you know, there's not that many foundries But we're seeing everyone who's trying to lead the 10 nanometer and below from a foundry production standpoint, start to work through the initial characterization if we're not already there of their fan-out processors.

On the phablet [ph] side, we see multiple customers now releasing designs that we're beginning to design and in some places build probe cards for that utilize the fan-out technology. So I think we're seeing growth beyond the single foundry and the single customer, seeing growth in both of those dimensions.

Hard to say whether it all results in significant volume in 2018, but it's definitely moving in the right direction.

And I think you know, the compelling customer value statement and performance associated with integrated fan out it would lead you to believe that this is really only going to move in one direction Now it's not going to absorb all the way for starts in the world, it's probably pretty restricted to mobile in the short term, but it's got a long way to go before it saturates that..

So I guess to summarize, you might see a couple of foundries investing - incremental foundries investing several test and assembly houses and perhaps some big IDM?.

Yeah, I'm not sure about the big IDM piece. I'd say what I'd say is that phablet customers you’re going to see phablet customers incrementally adopt this technology for their products, utilizing the foundries and OSAPs that you noted earlier..

Okay.

And just remind me how much more probe card intensive this fan-out versus the standard part that's not built on that process?.

Well, it's - there's certainly increased test [ph] intensity associated with not just the fan-out process.

And as we talked about in our June analyst call, one of the things that drives increased test intensity is because you're driving the packaging process now to the wafer level, you want to have pretty high confidence that the guy you're packaging together are good.

And so you're doing a more stringent job of testing that drives probe card volumes up because test times are longer. I think the other piece that's superimposed on that is wafer level fan out packaging is really only happening at leading edge nodes and really enough on leading edge node that the inherent yields aren't great.

Any time the inherent yields aren't great, you're going to do an awful lot of test to screen out bad guy to make sure you're not packaging bad guy.

And so at least at this stage of the game you've got this kind of constructive behavior or additive behavior where you're at a leading edge node that requires a lot of wafer test and you're packaging on a technology that demands a lot of wafer test for essentially no good..

Okay.

Final question for me, do you expect any new DRAM fabs to be built in 2018 outside of China?.

Well, so there are definitely DRAM facilities and DRAM shelves that continue to be upgraded and produced more bids. Whether that's through shrinks, whether that's through incremental, all those things are getting pretty tight from a wafer start perspective.

I don't think there's going to be any major new shelves that come online, but the existing investments that our customers already have outside of China would seem to be continuing to upgrade and produce more bids.

So to drive DRAM supply, at least at the current - you know people have been talking about high single digit quarterly bid growth rates, I think our customers are continuing to squeeze out capacity from their existing fabs or facility. In 2018, I don't think you're going to see any brand new step function facilities come online..

I said that was my final question, I have one more, I'm sorry.

Just a clarification, you know you talked about how you know, you had to have known [indiscernible] to do the fan-out process, which means that you're bit more test intense than probe cards to make sure you have known could dye Do you also - once you attach no good dye you will start to do the fan out process, do you do another probe test before the cut up?.

So that's one that really depends on the customer flow, for things like high bandwidth memory. Again, generalizing advanced packaging a little bit more beyond just wafer level fan out. There are multiple probe steps as you stack this chip.

Most of the wafer level fan out applications that are being contemplated and for sure the one in a high volume production is a combination of two chips.

So you really only have to do the two individual probe steps, as these integration schemes get more complex and integrate more die we would expect to see just like we do with HBM stack DRAM part, multiple probes insertions for one finish chip..

Okay.

So the intensity level will continue to go up as the step is adopted?.

We believe so, yes..

Thank you..

Thank you. [Operator Instructions] Our next question comes from the line of Jagadish Iyer with Summit Redstone..

Yes, thanks for taking my question. Two questions. My first just on the on the significant order that you've talked about. So how should we be thinking about if we have to quantify it of where you are at 10 nanometer with this customer for advanced packaging, vis-à-vis the 7 nanometer and assuming that the wafer starts are kind of flattish.

You know how would you kind of quantify the opportunities at probably 10% more than what you had at 10 nanometer or is there some more color that you can give? And then I have a….

As I said Jagadish, in response to Edwin’s question. You know, we certainly have the opportunity to make it bigger. We are engaged much earlier in the node transition cycle at 7 nanometer than we were a 10 nanometer.

And I think so long as we execute and deliver quality product that continues to perform on the test floor there I think is a fair chance that we can make this opportunity larger than our opportunity - than what we realized at 10 nanometer.

There's still a lot of hard work in front of us and as I said in the prepared remarks, our team is very, very focused on making sure we lay the groundwork to get these right. As we do and I'm confident that we can.

We're going to be in a position to make this business I think 10% a reasonable estimate for where we are right now, but materially larger than it was in 2017 for us..

Okay, that’s fair. Its excellent. Then I have a follow up. You know, a lot of the front end companies have suddenly disclosed how you know - they have been receiving a lot of Chinese orders. So I know you guys break out to Asia Pacific part of it.

But I was wondering how much do you think is the contribution from Chinese memory customers in 2017 and how do you see that going into 2018? Thank you..

Yeah, I think the important thing to remember about our business is because we're probe cards testing production wafers, we're always going to lag not just the orders but the installation and qualification of equipment by somewhere between 6 to 9 months typically.

And so you can think about the equipment guys and them first receiving the orders and then delivering the equipment, qualifying the equipment and ramping the equipment as a bit of a leading indicator for where our business is going to be. Obviously we remain very engaged in the local China - not just memory, but overall semiconductor ecosystem.

I think the commentary we provided on engineering systems growth in helping these customers debug these initial memory chips is also a good leading indicator that there some real activity going on there. But from a production probe card volume, we right now see it as probably a late 2018 event for us.

Once all this equipment gets - again not just ordered, but installed, qualified and running production wafers that need to be probed..

Okay. Excellent. Thanks so much..

Thank you. And our next question comes from the line of Ed Wash [ph] with Sidoti & Company..

Hi. I think I have two questions remaining. But first one is with your probe card business to grow, it looks like low teens this year. I want to check in with what you might done on the market itself which you know it's been forecast to grow to 7% CAGR.

And you know, would you say that your outperformance is primarily on the side of market share gains or do you think that the market itself is well outperforming at 7% rate and what will be some of the drivers there, with ASPs more or volumes, if you could comment a little bit on what you sense from that?.

Sure. I mean, we operate in kind of a niche market, probe cards is covered by a handful of analysts and not really in a real time way that for example front and wafer fab equipment are. So I'm operating with a bit of a visibility problem on the overall market.

Having said that, given that we lead in overall market share, our view is that the market has been stronger than it was going to be assumed to be at the start of the year when the 7% assumption came out. So I think it's fair to say that the market has grown faster or more significantly in 2017 than we initially expected it to.

Having said that though, I also believe that we’ve gained share on top of that expansion in the server market that we've seen. We're going to have to wait until all of the surveys get rolled up and we get our results in early April 2018 because you know it's still outside the top three suppliers.

There's a pretty long tail of suppliers and so there's a lot of work that needs to be done to really understand what the market look like and what different share positions were, given how we've executed on some of the line of sight opportunity, given how our large customers have grown. We do expect that we gain share.

I think the other data point outside of probe card business that we've seen is - we're expecting double-digit growth in our engineering systems business and that's a business that’s historically grown at sort of a few percent. We've talked about the dynamics, around China around micro LED, around Silicon photonics.

Those are still applications that we believe are in front of us, but we're pleased to have delivered some significant growth from that business as well this year..

Okay, thanks. And then on the DRAM side, on a trailing 4 quarter type basis you know, annualized run rate of about $130 million at the peak that of 2015 and it looks like we could approach $125 million with a pretty strong fourth quarter here in 2017.

So I guess you know, turning aside some of the minor differences, but would you expect to peak in this cycle could touch that $130 million that it did back in 2015.

Would you think it could exceed that? What are your sort of your general thought there please?.

So general thoughts on DRAM. I do think the overall volume, given the big growth, the wafer growth and some of the advanced packaging trends like high bandwidth memory that drive more test content. We could certainly approach and maybe even if there's a little more investment on some leading edge nodes exceed that peak of 2015.

Again most of that revolves around the supply demand balance and the continued investment. I don't think it's any surprise given the commentary from either our customers or some of the big suppliers, the DRAMs in a bit of a sweet spot right now where people are growing bids but the demand is continuing to consume that bid growth.

And as long as we say in that situation, I do think we can approach or maybe even sneak over those 2015 run rate levels..

Great. Thank you very much..

Thank you. And our next question comes from the line of Atif Malik with Citigroup..

Hi. Thanks for the opportunity.

I just have one question and a clarification, Mike, the capacity – digestion comments are only respect to one customer correct?.

That's correct. We delivered 20% higher than our previous record revenue to that customer in the third quarter. As we work through and digest some of that capacity in the fourth quarter, we expect that to be - if you like isolated or concentrated behavior with them..

Okay. And then I think that particular customer trimmed its CapEx for this year and is showing a different financial discipline than it has in the past and did not comment on next year's CapEx. So what is the confidence that's driving the outlook that Q1 could kind of return to the higher levels for that particular customer? Thank you..

Yeah. Well, with all of our key customers we work pretty closely on capacity planning and their demand forecasts. And obviously you know, our discussion about the 7 nanometer foundry customer were in many cases receiving orders for Q1 delivery already as our customers try and risk with you.

So I think the combination of the relationships we have, the dependent some of our leading customers have on us to meet their ramp plan and therefore the forecast and in some cases PO commitments we get from them to make sure that capacity is in place is part of what's driving if you like the confidence or our behavior to continue to prepare for increased levels back in Q1 and potentially through the first half.

Operator?.

And that concludes our question-and-answer session for today. I'd like to turn the conference back over to Mike Slessor for any concluding remarks..

Thanks for joining us today and thank you very much to the world wide FormFactor team for delivering solid results again in the third quarter. Our positive momentum continues and we remain focused on driving a strong finish for 2017 and accelerating into 2018. Thanks a lot..

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone have a great day..