FormFactor, Inc.

our 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.

Thank you. Today, the company will be discussing gap panel results and some important non-gap results intended to supplement your understanding of the company's financial Reconciliations of gap to non-gap 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 projections of financial and business performance future macroeconomic and geopolitical conditions, the benefits of acquisitions and investments in capacity and in new technologies, the impacts of global, regional, and national health crisis, including the COVID-19 pandemic, anticipated industry trends, potential disruptions in our supply chain, the impacts of regulatory changes, including the recent US-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 deform 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 end of 2021 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, October 26, 2022, and we assume no obligation to update them. With that, we will now turn the call over to FormFactor CEO, Mike Schleser.

Thanks, everyone, for joining us today. As anticipated, FormFactor's third quarter revenue was down sequentially from the second quarter, chiefly due to the expected reduction in demand for Foundry and Logic probe cards, and this produced the forecasted decline in gross margins and profitability. Partially offsetting this reduction in probe card demand was record strength in our systems business, highlighting the benefits of our lab to fab diversification strategy. Compared to our outlook range, revenue was slightly below the midpoint, non-GAAP gross margin was at the midpoint, and non-GAAP earnings per share were near the top of the range. We do not view the current reduction in probe card demand as a fundamental change in our business. Rather, we see it as a response by our customers to cyclical declines in their businesses, especially in consumer-driven segments like client PC and mobile. Based on the customer, industry, and macroeconomic data we have at present, we expect this reduced demand to extend well into next year. In response, today we announced decisive steps to better align form factor's cost structure with these temporarily reduced demand levels. Shai will describe in more detail the steps we are implementing during the fourth quarter, which are designed to preserve profitability at the revenue run rates we believe are likely to prevail until the current downturn ends. This operational restructuring notwithstanding, we believe the core tenets of our strategy remain firmly in place, and we remain committed to achieving our target financial model. These core strategic tenets are first, sustained semiconductor content growth in both consumer and enterprise applications. Second, the industry's relentless investments in new technology and capacity. And third, the device-specific consumable nature of advanced probe cards, which when combined with our customers' innovation-driven investment in engineering systems, have historically resulted in less volatile demand cycles than way for fabrication equipment. Consistent with this strategy, we are continuing to invest in both R&D for new product innovation and competitive differentiation, as well as in the long lead time facilities and equipment portions of our capacity increase plans. These investments are designed to position form factor for market share gains and above industry revenue and profit growth when we emerge from the current cyclical downturn. Turning now to our fourth quarter outlook. Our sequentially weaker outlook is due to three primary factors. One, the new U.S.-China trade restrictions announced on October 7th. Two, weaker DRAM probe card demand. And three, further softness in foundry and logic probe card demand with specific weakness in RF probe cards. As we're a U.S.-based supplier with significant exposure to the leading-edge foundry and memory technologies affected by the recent U.S.-China trade regulations, These restrictions are a headwind in all of form factor's businesses. An example is our DRAM probe card business, where approximately half of our forecasted fourth quarter sequential decline in that market is due to hold on shipments and service of advanced DRAM probe cards to leading edge domestic customers in China. FormFactor has taken the necessary steps to ensure full compliance with the new rules by holding shipments and support as required by US-China trade restrictions. As the situation evolves, our local China team is working closely with customers and our trade compliance team to obtain releases and licenses to enable permitted shipments of the existing backlog. In Foundry and Logic Probe Cards, our largest business, we expect a further reduction in demand for core microprocessor and logic probe cards in the fourth quarter, although not as steep a sequential decline as we experienced in the third quarter. Inside the foundry and logic market, RF probe card demand continues to decline as customers burn off excess inventory of existing BAN saw filters and other RF front-end components like modems, switches, and power amplifiers, especially in low- to mid-tier 5G mobile handsets. Significantly, in the microprocessor business, we've begun volume shipments of probe cards to support pilot production of a major chiplet-based client CPU product. Advanced packaging chiplet architectures like EMIB, Foveros, and 3D Fabric are an exciting opportunity for FormFactor. As we've noted in the past, whether based on conventional solder-based assembly processes or more revolutionary processes like copper-to-copper hybrid bonding, These chiplet or tile-based integration schemes drive both higher test intensity, which expands the number of probe cards required per wafer out, and higher test complexity, which raises the performance requirements for the probe card. Advanced probe card architectures like FormFactor's MEMS technologies are essential to meet these challenging technical requirements at a compelling cost of ownership. while also meeting the short delivery lead times needed to support our customers' rapid and dynamic production ramps. Turning to memory probe cards, we expect a significant sequential fourth quarter reduction in DRAM probe card demand, partially offset by moderate strength in flash probe cards. As discussed above, approximately half of the reduction in DRAM is directly attributable to the new U.S.-China trade restrictions. with the other half the result of well-publicized weekend market conditions for DRAM chips, which is causing our customers to reduce the magnitude and speed of their new product ramps. It's worth noting that the third quarter all-time high in system segment revenues is expected to sustain in the fourth quarter, showing the benefit of participating in customers' early-stage R&D programs and the positive impact of successfully integrated tuck-in acquisitions completed during the last several years. Even in the current downturn, customers are aggressively investing in their technology roadmaps, with development of innovations like gate all-around transistors, advanced packaging, silicon photonics, and quantum computing together producing solid results in our systems business. I'd like to close by affirming that we remain confident in the long-term growth prospects for form factor in the industry overall, driven by the fundamental trends of semiconductor content growth and innovations like advanced packaging. These are trends where form factor is well positioned as an industry and technology leader, and we're confident that our resilience and commitment to invest in R&D and capacity will position form factor to emerge from the current downturn a stronger and leaner competitor. enabling us to achieve our target model that delivers $2 of non-GAAP earnings per share on $850 million of revenue. Shai, over to you.

Thank you, Mike, and good afternoon. As you saw in our press release, and as Mike mentioned, Q3 revenues were slightly below the midpoint of our outlook range, non-GAAP gross margin was at the midpoint of the range, and non-GAAP EPS were at the high end of the range. Third quarter revenues were $181 million, an 11.3% sequential decrease from our second quarter revenues, and a decrease of 4.8% year-over-year. Probe card segment revenues were $139.4 million in the third quarter, a decrease of $28.3 million, or 16.9%, from the record Q2. The decrease was driven mainly by lower foundry and logic revenue. System segment revenues were a record $41.5 million in Q3, an increase of $5.3 million or 14.6% from the second quarter. Within the ProbCard segment, Q3 Foundry and Logic revenues were $90.6 million, a 26% decrease from Q2. Foundry and Logic revenues comprised 50% of total company revenues, 10 percentage points lower than the 60% in the second quarter. DRAM revenues were $35 million in Q3. $1.9 million or 5.2% lower than in the second quarter and were 19% of total quarterly revenues as compared to 18% of revenues in the second quarter. Flash revenues of $13.9 million in Q3 were $5.4 million higher than in the second quarter and were 8% of total revenues in Q3, higher than the 4% in Q2. Gap gross margin for the third quarter was 34.4% of revenues as compared to 46.3% in Q2. Cost of revenues included $8.3 million of GAAP to non-GAAP reconciling items, which we outlined in our press release issue today and in the reconciliation table available in the Investor Relations section of our website. Q3 reconciling items included a $6 million inventory write-off related to the restructuring we announced in September 2021. On a non-GAAP basis, gross margin for the third quarter was 39%, 8.4 percentage points lower than the 47.4% non-GAAP gross margin in Q2, with a lower gross margin in the probe cart segment, partially offset by an increase in system segment gross margin. Our probe cart segment gross margin was 34.6% in the third quarter, a decrease of 12.2 percentage points compared to the 46.8% in Q2. The decrease is mainly due to higher inventory reserve and lower overall segment revenues, specifically lower Foundry and Logic revenues, partially offset by higher Flash revenues, which resulted in less favorable product mix. Our Q3 system segment gross margin was 53.7%, 320 basis points higher than the 50.5% gross margin in the second quarter. This increases due to higher revenue and more favorable product mix. Our GAAP operating expenses were $58 million for the third quarter, $4 million lower than in the second quarter. Non-GAAP operating expenses for the third quarter were $49.5 million, or 27.4% of revenues, as compared with $54.5 million, or 26.7% of revenues, in Q2. The $5 million decrease relates mainly to lower performance-based compensation, lower R&D spend, and higher PTO utilization. Company non-cash expenses for the third quarter included $8 million for stock risk compensation, $1.6 million higher than in the second quarter, due to the increase in fair value of the annual RSU grants as a result of a higher stock price at the time of rent, $2.8 million for amortization of acquisition-related intangibles, similar to the second quarter, and depreciation of $7 million, $0.2 million lower than in the second quarter. GAAP operating income for Q3 was $4 million as compared with $32.6 million in Q2. Non-GAAP operating income for the third quarter was $21 million compared with $42.3 million in the second quarter. GAAP net income for the third quarter was $4.4 million or $0.06 per fully diluted share compared with $30 million or $0.38 per fully diluted share in the previous quarter. The non-GAAP effective tax rate for the third quarter was 19%, 460 basis points higher than the 14.4% in Q2, and within our estimated non-GAAP annual effective tax rate of 15 to 20%. We expect to be on the lower end of this range for Q4 and for the full 2022 fiscal year. As previously communicated, Our annual cash tax rate is expected to remain around mid to high single digits of non-GAAP pre-tax income until we fully utilize our remaining U.S.-based R&D credits. Third quarter non-GAAP net income was $18.3 million of $0.24 per fully diluted share compared to $36.8 million of $0.46 per fully diluted share in Q2. Moving to the balance sheet and cash flows. we generated $15.5 million of free cash flow in the third quarter, $12.8 million lower than the $28.3 million in Q2. Net cash provided by operations was $18.4 million lower than in Q2, and capital expenditures were $5.6 million lower than in the previous quarter. At quarter end, total cash and investments were $255 million. As of the end of the third quarter, we had two term loans remaining on our balance sheet, totaling $17.5 million. We invested $8.9 million in capital expenditures during the third quarter, compared to $14.5 million in Q2. With the core drivers underpinning our strategy still in place, we continue to execute on our capacity increase plans, albeit at a slower rate. As we approach year end, we are narrowing the range of the full-year expected CapEx to $60 to $70 million. We still expect CapEx to return to 3.5% to 4% of revenues in our target financial model after we conclude these capacity increases. Regarding stock buyback, during the third quarter, we purchased approximately 570,000 shares under our $75 million two-year buyback program for a total of $19.2 million. At Q3 quarter-end, $27.5 million remain available for future repurchases. Turning to the fourth quarter non-GAAP outlook, we expect lower revenue in the fourth quarter due to the three factors that Mike mentioned. In this environment, we are focused on reducing spending while investing to capture both short and long-term demand in our markets. Accordingly, we today announced an operational restructuring plan to reduce costs and improve the efficiency and effectiveness of our business. The plan includes lowering headcount by approximately 13% of our workforce, mostly in the probe card segment and SG&A. We expect these actions will be largely completed by the end of 2022. We estimate that these actions, once fully implemented, will reduce our cost structure by $25 to $30 million on an annual basis, with approximately two-thirds of the savings benefiting cost of sales and one-third benefiting OPEX. The reduced demand results in a Q4 revenue outlook of $155 million plus or minus $5 million. Since the restructuring plan was implemented in mid-quarter, the savings that I mentioned will only partially benefit Q4. Accordingly, together with the impact of the decline in revenue and a less favorable product mix, fourth quarter non-GAAP gross margin is expected to be 33% plus or minus 150 basis. At the midpoint of these outlook ranges, we expect Q4 operating expenses to be similar to Q3, mainly due to lower performance-based compensation and a lower headcount as a result of the restructuring we announced today, offset by the impact of one additional working week. Accordingly, non-GAAP earnings per fully diluted share for Q4 is expected to be $0.03 plus or minus $0.03. Reconciliation of our GAAP to non-GAAP Q4 outlook is available on the Investor Relations section of our website. ending our press release issue today. With that, let's open the call for questions. Operator?

Thank you. At this time, to ask a question, please press star 1-1 on your telephone. Again, that's star 1-1 on your telephone to ask a question. Our first question comes from the line of Brian Chin of Stifel. Please go ahead, Brian Chin.

Thanks for letting me ask a few questions. Maybe just to start here, can we just clarify, I guess, in terms of the revenue step down from 3Q into 4Q, about $25 million-ish at the midpoint, how much, I guess, is DRAM, half of which is tied to the China restrictions? How much is RF? And then how much is Logic Foundry XRF?

Yeah. So, Brian, this is Mike. Good question. As you said, $25 million reduction at the midpoint sequentially. I'll start with the biggest impact, which is the impact of the October 7th China regulations. This is between $10 and $15 million sequentially. And to calibrate you to that, if you remember, we've talked about our China revenues being approximately two-thirds coming from multinationals, which all the multinationals have received licenses, so they're not part of the step down in the quarter. But one third, a significant chunk of what's been a $40 to $50 million quarterly run rate comes from the domestic customers. And given our exposure at the leading edge in both Foundry and Logic and in DRAM, these regulations do have a significant impact. So about $10 to $15 million in the quarter, call it $50 million annualized associated with these. Moving to the next biggest component is DRAM. a little over a $10 million step down in DRAM demand sequentially. More than half of that is an overlap with the China regulations. We've talked about it in the past. I think we've done a good job supporting and gaining share inside the high-end China domestic DRAM market. But these regulations really kind of crimp that, at least in the short term. And then Foundry and Logic, a smaller impact. Most of the reduction in Foundry and Logic associated with RF, unsurprisingly, because of the softness in mobile. But again, some overlap with China as well, less so than in DRAM. So those are the three components and the rough magnitudes of each. But as we look forward, you know, we think that the restructuring plan we've put in place allows us to protect the profitability of the company while still investing in the long-term growth. These are obviously short-term headwinds, but You know, we like the position we're in in these markets and looking forward to demand returning to some robust levels as we get through the middle part of 2023.

Okay, got it. And further clarification, within the 10 to 15 million sequential that's tied to local China and excluding, backing out the 5 million that might be tied to DRAM, so I guess I give you a residual 5 to 10 million. Did I hear correctly that you're seeking licenses to possibly ship to some of those entities? And that could provide some sort of upside maybe this quarter, maybe next, or at some point moving forward?

Yeah, so the China DRAM impact is more than $5 million. It's more than half of the overall $10 to $15 million China impact. But to the core of your question, both we and our customers are working at shipment releases a variety of different license that could help us realize that revenue i think as i said in the prepared remarks we're taking a a balanced view of this and making sure we're both compliant with these new regulations but also doing the best we can to support our customers in the region And it's a pretty actively evolving situation with the regulation, something like 19 days old. We're working through this with both our trade compliance team, our China team, and our customers to either obtain licenses or convince ourselves that the regulations do not apply to some of the shipments that we're trying to release.

Got it. My next question, I guess, is do you have any indications that this revenue run rate, kind of the mid $150 million, level that either in terms of discrete segments or in the aggregate, this represents some sort of a stabilization in terms of the revenue run rate and also kind of conjoined with that, how low can you lower quarterly revenue break-even to?

I'll take the first part of the question and then I'll let Shai talk about the cost structure and the run rate profitability. Obviously, there's a lot of headwinds right now in the fourth quarter. We're in the middle of a pretty substantial DRAM downturn, as you heard from all of our customers, but most recently, one of our major customers who was a 10% customer on their earnings call last night. The world's largest foundries talked about an inventory correction in place. And then on top of that, we've got these new China restrictions. So there's a lot of headwinds right now. We are cautiously optimistic that some of these things are going to turn as we work our way into 2023 and through the middle part of 2023. Typically, cyclical DRAM downturns and inventory corrections in the foundry space do take several quarters to work their way through, but we're now well into the second, maybe even the third quarter of those things. So I think we are optimistic that some of these things can turn a little bit in terms of market headwinds and at least become neutral, if not tailwinds.

And when it comes to the breakeven question, Brian, after these cost reduction measures are fully implemented, we expect a breakeven point of revenue between $140 and $145 million a quarter. That's the breakeven.

Yeah, that's a tough one. Just, Mike, to clarify something you just mentioned there, when you talk about that optimism sort of things turning middle part of 23, are you kind of discreetly factoring in things like moving from pilot to volume production for, you know, marquee products next year that use 3D packaging in terms of those devices? Is that sort of part of what you're saying there, or is that sort of even incremental discreetly in terms of what could get better next year?

Well, I think as we look at advanced packaging and the impact it can have on our business, there's definitely a positive impact there. In the prepared remarks, I highlighted that we've begun volume shipments for a major client-based chiplet processor. And that's a big step forward in the validation of the technology and the industry moving forward. I think timing's still pretty uncertain. We are We are assuming some of that is going to start to ramp in the middle part of 23. So that is definitely an element of our cautious optimism. But I think a lot of the other pieces as well, whether they're advanced packaging related or a three nanometer ramp inside the foundry space, there's a few things that do offer some degree of hope as we work our way through mid 2023 into the back half of 2023.

Thank you.

Thank you. Our next question comes from Charles Shi of Needham. Your line is open, Charles Shi.

Good afternoon. I'm Mike Shi. I certainly want to look at your restructuring plan. You are lowering headcount by approximately 13%. Obviously, this is never easy and probably quite painful. But sounds like you are expecting the current weakness to probably continue. Well, it's not going to be just a one-quarter, two-quarter thing, maybe a little bit more prolonged. Otherwise, I would imagine you wouldn't be taking decisive actions like this. I mean, it's quite painful for sure. Mind if you give us some sense, I mean, compared to like, let's say one, two months ago, What exactly have deteriorated? Because I remember there was quite some rapid and abrupt inventory correction actions in late June, early July. In August, maybe a little bit, well, slowing down in terms of the actions, but it seems to accelerate again in September into October. Can you kind of walk us through what exactly happened over the last three months to really lead you to take decisive actions like what we just announced today?

Charles, it's Mike. I think you touched on it in the first part of the question. It's really the duration that we're seeing that motivates us to protect the cost structure, the profitability of the company, so that we're generating cash, so that we're profitable as we work our way through But certainly, based on all the available data we have, looks like a fairly sustained, not a one to two quarter, demand reduction. I think in discussions with our customers, in looking at industry forecasts, in understanding the general macroeconomic conditions that are in place, we felt like, and you're right, it is painful and a little bit frustrating given how hard we've worked to increase capacity. But we felt like based on all that available data, this was not going to be a one to two quarter downturn and reduction in demand, but one that extended into the middle part of 2023. You know, we're not calling an end to a downturn in the middle part of 2023. As you know, our visibility is pretty limited. But in answering Brian's question, I think I touched on some of the things that leave us cautiously optimistic as we work our way through 2023. But between now and then, We really felt motivated to protect the profitability of the company so that we can make the investments in R&D and long lead time capacity items like facilities to make sure as we come out of this, and anybody who's been in the industry for a while knows we always come out of these cyclical downturns, better prepared to win and gain market share and grow the company. Thanks.

Maybe I want to, next question, I want to double-click some of the comments you made on FoundryLogic probe card. If I hear you correctly, I think you are implying roughly 10 million-ish kind of reduction in the FoundryLogic segment into next quarter. So a couple more specific things. RF probe card, are we going to see some run rate back in the teens? I remember that's the run rate when you first acquired Cascade Microtech, which is when you got the RF probe card business in 2016. That's number one. Number two, definitely you did signal that your number one customer may, your sales to that particular customer may come down slightly into Q4, maybe not at the same amount of decline as you had in Q3, but it does sound like maybe the mobile side, I mean, the foundry, the pure play foundry side seems to be holding up relatively okay. I just want to check with you when I try to think about the puts and takes of your Foundry logic probe card business. Is that what's going on in Q4?

Yeah, I think that's a pretty good summary. Let me expand on it a little. You know, the magnitude of the total reduction definitely dominated by a sequential reduction in RF probe cards. We are seeing quite a bit of weakness in the RF supply chain, whether it's filters, power amplifiers, all the different new RF front end devices that drive RF probe card demand. So that's by far the biggest element of the sequential step down. We're not quite back to the levels as, you know, the run rate levels when we acquired the business. but this is probably the weakest we've seen since we acquired the business, integrated it, and have been growing it in the present quarter. Some other elements to look at, the core foundry space, a little bit of sequential weakness there, but I think of all the different big chunks of revenue inside that foundry and logic market, that one's holding up reasonably well. And then in the microprocessor space, We're seeing continued weakness in the client PC, client microprocessor space. Probably not too surprising given how those customers have talked about their end market associated with client. And given the volumes that the client drives and therefore the number of probe cards required, that's taking a nominal step down here as we go from Q3 to Q4.

Thank you. That's all from me for now. Okay. Thanks, Ross.

Thank you. Our next question comes from Chris Sankar of Cohen. Please go ahead, Chris.

Hi. Thanks for taking my question. I have two of them, and I'll ask both of them up front. Mike, the first one, you know, I'm kind of curious. You said there's some weakness because of, besides China, some of your memory customers slowing down. But I thought most of the CapEx cuts are scheduled for next year. Is this like, you know, ProbeCard being a leading indicator? Conversely, when I look at smartphones, you mentioned RF is slowing, but smartphones actually started slowing earlier this year. So I'm kind of curious, is this specific vertical to smartphones that you're seeing out of ProbeCard slow down? That's the first question. And then the second question is that, you know, ProbeCards are considered consumables and should be resilient in a cyclical downturn, but it looks like It's kind of following the same trend line as WFE or equipment CapEx. So I'm kind of curious how to kind of think about ProCut as a consumable on a go-forward basis. Thank you. Yep. Thanks, Chris.

So let me start with the memory and RF piece. There's... several elements to how primarily our DRAM customers are behaving. As we said, we do see some sequential strength in Flash, although off a lower market share position. In DRAM, what we see happening is customers essentially reducing the speed and the magnitude of their new device ramps. We haven't seen any device cancellations in the DRAM space, nor have we in the Foundry and Logic space. But the number of probe cards required per design is coming down as those customers manage their new design ramps, their new design releases, and make sure they're consuming their inventory. And I think that's probably that inventory consumption piece is probably one of the biggest dynamics we're seeing in DRAM. Similar dynamics in RF. For sure, the handset softness in the end markets has been going on for a while. We started to see it in the RF business earlier in the year, but it's particularly acute here as customers replan their different wafer start plans to meet new device cycles, maybe that happened in the early part of 2023. So again, looks primarily like inventory digestion in that RF space. But again, similar to memory, we haven't seen any major device cancellations design activity stays pretty strong it's just the magnitude of these ramps and the speed of these ramps is much slower than we've seen in the past um sorry the second question can you remind me uh mike it was about um you know oh yeah yeah cyclicality and yeah so a great question certainly One of the interesting things we've seen in both the third quarter and the fourth quarter is some very rapid changes from our customers on their design release roadmaps. As we talked about on the last earnings call, we had several customers react very quickly and decisively to softness in their end markets. We see the same thing happening here. And even though probe cards are consumables and we're doing things like shipping you know, the first volume probe cards for pilot production for a chiplet-based microprocessor driving advanced packaging forward, you know, the magnitude number of probe cards required for design is definitely less than it has been in previous up cycles. And so, yes, it's still a consumable. The fact that we're operating on shorter lead times and our customers are responding pretty quickly to their end market conditions, I think is why you're seeing us, you know, have two quarters here of sequentially, pretty significant sequential declines in ProCards.

Thanks a lot, Michael. I really appreciate it. Thank you.

Thank you. Again, to ask a question, please press star 11 on your telephone. Again, that's star 11 on your telephone to ask a question. Our next question comes from the line of Craig Ellis of B Reilly. Please go ahead, Craig Ellis.

Yeah, thanks for taking the question. Mike, I wanted just to start by going back to the breakdown you've given us in terms of the three things that are impacting revenues you should look into before supporting the question really is helping us understand the degree to which some of these things that I think it's more foundry logic and some of DRAM that's more cyclical and just due to the sudden decrease in demand that we're seeing in some application areas and customer adjustments versus some things that might be more structural, such as the inability to ship to China. And I think you indicated that the BIS impacts were at a midpoint about 12.5 million. Is it reasonable to think that the more long-term impact, the more structural impact of the 25 million decline is the DIS piece and that we would just need to find growth in other parts of the business to offset that? Or for whatever reason, would you see that coming back at some point?

Yeah, I think it's an interesting question. And as you might imagine, Craig, a current topic of hot debate here at FormFactor. I think We're very, very focused right now on making sure we do whatever we can to support our customers. They're obviously depending on us to ramp their technologies, but we also have this compliance overlay, which is limiting our ability to do that. I think in the very short term, we're focused on resolving that. If we're able to do that, at least in the short term, we may see some upside associated with that, either as we move through the back part of the year or into 2023. But I think, and there are people who study this all the time, so I may not be the best one to opine on it, but I think the direction associated with being a U.S. supplier to the China domestic semiconductor industry certainly is not a tailwind. You've heard some of the WFE suppliers talk about it, providing a haircut to their businesses next year, at least where they have high exposure. I think probably the middle case is this is definitely going to be a headwind, you know, sort of around the magnitude that we talked about, the $12.5 million a quarter, $50 million annualized, where we're going to have to go find other places to grow the business. I think one of the highlights, we haven't talked about it much on Q&A, Where we have seen some nice growth is in the system segment, a record quarter, even with some of the China headwinds in the systems business, which are less onerous because of the details of where we ship from and those products. You know, we expect similarly strong Q4 and with things like silicon photonics and quantum computing. That may be one area where we can grow the business. I wouldn't want to create the expectation that it makes up for a 50 million delta in 2023, but there are some growth prospects inside there, as well as in the broader Foundry and Logic and DRAM preferred space.

Got it. The second question is really one more for Shai. Shai, with regard to the cost savings program that the company has implemented, At the midpoint, I think that's $27.5 million. Can you talk about the timing with which that will be realized, both on the COGS portion and the APEX portion, since you may be at a different cadence on those two?

Yeah, the timing is actually the same. We expect to fully implement these cost savings. by the end of 2022. So if we think about Q1 2023, that should reflect all the savings for both OPEX and cost of sales.

And I think you said that there are some things that are going to benefit the fourth quarter's numbers in OPEX and cost of sales. So for whatever is executed through the fourth quarter, what's the incremental benefit did it expect two POGs and two OPX for the first calendar quarter?

Well, we announced it today, which means we still have a third of regular run rate expenses in Q4, and then only two thirds of the quarter will reflect savings. So I think that's a good approximate, although we have some moving parts here, right? If you go into 2023, you have the annual benefit reset that's going to increase OPEX a little bit in the beginning of the year. But the run rate, if I think about OPEX run rate for Q4, which is about 49 million at the midpoint of the range we provided today, I think we can assume a similar number next year after we have more savings, but we have the benefits reset.

Got it. Okay. And then lastly, and this is on the COG plan, I think you mentioned that there was an inventory reserve that was included in, I believe, the third quarter. Can you just quantify that? And are there any such reserves included in the fourth quarter's 33%?

Yeah, we had a couple of inventory reserves in Q3, just to be clear. About $6 million was GAAP only. That relates to the restructuring we did last year. and just the last piece of it that we recorded in Q3. The other inventory reserve we recorded in Q3 was kind of the normal E&O reserve after running our usual access and obsolete inventory model. That was about $3 million in Q3. Okay.

Got it. Okay. And then lastly, Mike, can you just provide a little bit more granularity in terms of how you're thinking about capacity, expansion, intensity through the fourth quarter, my sense was we were moving at a pretty rapid clip in the first quarter and into the second quarter. And we were progressing at perhaps slower pace. But given where revenues are, I'm a little bit surprised that we're continuing to expand, unless there are things that are just very long lead times. It would seem like given that, I don't know if you'd have time to pick up the pace again in one or two weeks.

Yeah, and that's exactly it, Craig. It's the long lead time items. Obviously, in reducing headcount and capacity through labor, we've taken down the effective short-term capacity of the company pretty significantly so that we can get the cost structure more in line with the revenue. But we've got some things associated with, especially facilities that are multi-year projects to really get the kind of facilities that we need to manage our business as it grows back towards the $850 million model and beyond, where we want to make sure that we have the footprint facilities ready to go. We probably don't fill them with tools, but we think those are good investments because, again, as I said in the prepared remarks, the strategic tenants behind this business remain firmly in place. So it's purely an issue of timing where we're feeling the need to continue to invest in the longer term future with some very long lead time items like facilities that are ready to produce probe cards.

Got it. Okay. Thank you.

Thank you. Our next question comes from David Dooley of Steelhead. Your line is open, David Dooley.

Yeah, thanks for taking my question. I was wondering if you could just help me understand. I think you've guided gross margins down from about 47% in Q2 to 33% in the current quarter. Could you just talk about, which is like roughly 1,400 or 1,500 basis points, could you just talk about what the biggest magnitude of that reduction is? What are the three or four biggest pieces? I'm going to have a follow-up on the gross margin after you answer.

Sure. So just to make sure we are talking about the same numbers. So Q2 of 2022 was 47.4%. We guided down to 39% in Q3 and we hit 39%. And we're talking about 33% in Q4. And two main factors impacting that. One is the overall revenue going down. We have fixed costs that are needs to be observed. And when revenue goes down from a level of $204 million in Q2 to $155 million at the midpoint of the range for Q4, you can understand that this is a negative impact on the gross margin. But even more specifically, where we saw the increase was mostly in Foundry and Logic. Foundry and Logic, as a market, has the highest probe card gross margin in the markets that we serve. And with most of the decline coming from Foundry and Logic, and then in Q4, within Foundry and Logic, in the RF, which is even the highest within the Foundry and Logic, that has, again, a negative impact on the growth margin. So these are the two main factors impacting the decline in the growth margin. Okay.

What would you expect gross margins to do if revenue were to stay flat, let's say, in Q1 and Q2? How much gross margin recovery would you expect? I guess assume the same product mix because, you know, if we're going to assume revenue is flat, we're just going to assume the same kind of breakout that you have now. What can we expect for a trajectory of recovery of gross margins, or is it all tied to revenue?

So I think in the midterms, So I think we talked about Q4, and we're implementing the restructuring planning Q4. Once it's fully implemented, at revenue levels similar to Q3 and the similar product mix, as you said, to Q3, I expect gross margin to be at the low 40s going forward. Longer term, we still expect to reach gross margin of 47% at our target model revenues of $850 million. Again, with the higher fixed costs we currently have because we put some capacity in place, mainly facilities and tools, we need to get back to the above $200 million, $210 million of quarterly revenue. And we need that growth to come from our higher margin Foundry and Logic markets to achieve this target model.

So just to ask it another way, if you get back to $210 million in quarterly revenue, will your gross margins be back at this 47% to 48% range, or because of the incremental capacity that you added, will you need more than 210 to get to 47% or 48% with the similar mix?

Well, yeah, so 210 is going to be around the 47%. I don't know if it's 40% or 40%. I don't know if it's 40%. I don't know if it's 40%. I don't know if it's 40%. I don't know if it's 40%.

And then help me understand, you know, I guess this is a similar question on the gross margins, but if you just – you've added capacity recently and your revenue has kind of declined. So currently, what do you think your overall utilization rate is? And maybe help us understand – you know, after you cut costs, what your quarterly revenue capability is. That's it for me. Thanks.

Yeah. So think about the three components of capacity. Facilities is one of them, and it's the less flexible, but the longer time to add. You have tools that also has long lead time, but, you know, we've been adding them in a good rate recently. Not everything is fully functional and operating, but we have been adding capacity. And labor is the third piece, which is the most flexible, and this is when we reduce the capacity in this restructuring. This restructuring, we have the facilities in place, we have the tools in place, and we have enough labor to get to you know, Q3 levels and probably more than that. And we have the ability to add labor back if we need to on a relatively fast pace, because we usually use temp employees in the beginning. Yes, there is some training time, so it's not immediate, but we have the ability to add back employees when we need to, when the demand comes in. So we have the facilities, we have the tools, labor I would say Q3 levels is sufficient to what we have after the restructuring. And going back, we'll add as the demand comes in. Thank you.

Thank you. Our next question comes from Hans Chung of DA Davidson. Your line is open, Hans Chung.

Thank you for taking my question. I have a couple. First, so as your business is sort of design-driven and then, but also on the other hand, also sort of impacted by the unit as the number of the product demand per design could be impacted by the customer plan. So can you help me understand like as we look out into 2023, And I think last week I did them see also talk about, uh, the new design, uh, tape out for three nanometers, more than double than five nanometers in the first couple of years. And things like design momentum, uh, things still very robust, right. Um, at least on the fund design. And then we also have the new, uh, the platform from logic customer. And then, so, uh, by on the other hand, you also mentioned the number of pull copper design will go down. So can you help me understand, like, how should I think about the 23, the outlook, I mean, relative to maybe the semiconductor industry performance? Let's say is the semi down something, single digit percent, and then how should we think about our growth for next year?

Yeah, Hans, this is Mike. You think you've parsed it accurately, right? There's two components to this business. One is the new design activity. So this is customers releasing a new mass set, a new chip. And as I said, that activity remains very robust. Our design team fully loaded. We haven't seen any cancellations of any significant designs. But the thing that drives revenue is the number of probe cards you ship for each of those designs. You know, often this can number in the hundreds of probe cards. And given end markets for our customers, those volumes are down. Again, especially in consumer driven segments like client PC and mobile. You know, if I return to the broader question on 2023, current industry forecasts have advanced probe cards growing somewhere between a percent and two percent. You know, there is an expectation going back to Krish's statement that we are going to see some stabilization here in customers investing in new designs that will, you know, help that market be a little bit more robust than it has here in the second half.

Got it. Okay. And then, so the next question is about your largest customer with Intel and then let's say if the customer outsource more the tile to the foundry like tsmc and is there any implication on either positively or negatively incremental revenue opportunity given you have different market share at two customers right and so i guess i guess it's probably related to whether the entails the astrology in terms of the wafer testing, whether they will outsource that as well. So I just want to hear your thoughts.

Yeah. And, you know, it's always an interesting question for this business. Where are customers, you know, if they're producing wafers at the foundry, whether they're also doing tests at the foundry. And that depends for, you know, different customers have different strategies. Both major microprocessor customers, actually own their own test processes. So they purchase wafers from the foundry and then manage either internally inside their facilities or contracting out to the OSAP, like an ASC, still an AMCOR to do the test, but they own their own test processes. So I think in the microprocessor space, the shift between foundry front end and IDM front end We don't feel like there's a really big swing there for us. Having said that, clearly, we want to be in a position where we're qualified and competing for business and supporting all of the major customers in the industry, irrespective of their test model.

Fantastic. Thank you.

Thank you. Again, to ask a question, please press star 11 on your telephone. Again, that's star 11 on your telephone to ask a question. Our next question comes from the line of David Silver of CL King. Your line is open, David Silver.

Yeah, hi. Thank you very much. I apologize if I make you repeat yourself here, gentlemen. I did have to step away for just a minute or two. Regarding the cost actions that you're taking here, I'm just wondering if you provided any detail on kind of maybe the geographic spread of them. In other words, you know, I'm just wondering how much might be in North America versus in particular Asia, you know, as you align the cost actions with the anticipated costs. softer revenues. Thank you.

Yeah, most of the labor that we reduced was in North America, in our factories in California and Oregon, and some was in Asia, more on the SG&A side, but the vast majority is in North America.

Very good. And then my next question would just be maybe If you could share kind of the thinking of some of your major customers, but there is the wave of very large, you know, multi-billion dollar new fab investments that are due to come on mainly in the U.S. beginning maybe late 2023 or so. So maybe just beginning maybe a year or slightly more from now. As you think about their kind of anticipated timelines or roadmaps, from your perspective, are there going to be any major changes? In other words, is the demand declines that we're experiencing right now, does that change your major customers thinking about completing those major investments? on the original timetables. Thank you.

I think there's always a question in this industry of when you bring capacity online. You know, I think our customers are facing the same set of decisions we are in the very long lead time items, things like facilities, clean rooms, in some cases, you know, enabling tool sets for our customers, things like lithography. are multi-year, have multi-year lead times. And so, you know, I think there's a collective belief among the supply chain and the customer base that this is a cyclical downturn in the industry. Clearly, there's some other factors associated with it, whether they be US-China trade restrictions or, you know, the potential for a recession in 2023. But fundamentally, if you look at the long-term content growth and growth of the industry, we're all in the same position where we're confident in that growth, the things that underpin it, like advanced packaging. And then we all want to be sure we have the fundamental capacity footprint in place to capitalize on that demand when it comes.

That's great. Thank you very much. Thank you.

Thank you. At this time, I'd like to turn the call back over to Mike Slessor for closing remarks. Sir?

Yep. Thank you, everyone, for joining us today. We'll talk to you again either in January, or I think we're doing a couple of conferences as we end the year. If we see you there, have a great end of the year. Otherwise, we'll see you in January. Take care.

this concludes today's conference call thank you for participating you may now disconnect