FormFactor Inc (FORM) 2005 Q3 法說會逐字稿

Good day everyone. Welcome to the FormFactor third-quarter 2005 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would now like to turn the call over to any Annie Lecshin. Please go ahead.

Good afternoon. Thank you for joining FormFactor's third quarter 2005 earnings conference call. With me on today's call are Igor Khandros, Chief Executive Officer; Joe Bronson, President and Ron Foster, Chief Financial Officer. Joe will provide a summary of our third quarter performance, including a review of the marketplace, an update on the new factory, new product announcements and a review of our strategic focus going forward. Ron will then go through our financials in more detail and provide guidance. Please note that the details of the Company's revenue and bookings by market segment as well as the regional breakdown of its revenues can be found in the investor section of FormFactor's Web site at www.formfactor.com.

We would like to take a moment to mention that the Company will be presented at the Lehman Brothers 2005 Global Technology Conference on December 7. As other events occur, we will make additional announcements.

Finally, before I hand the call over to Joe, I will review our Safe Harbor. During the course of this conference call, we may make projections or forward-looking statements within the meaning of the federal securities laws, including statements regarding FormFactor's growth and financial performance, as well as our strategic and operational plans. These forward-looking statements are based on current information and expectations and are inherently subject to change. Actual results may differ materially and adversely to those in our forward-looking statements, due to various factors including but not limited to, the rate at which customers adopt the Company's newly released architectures; the technologies and products; the expense in which chip manufactures modify; announced capital equipment expenditures and device roadmaps and the Company's ability to efficiently complete the transition to its new facility. Please refer to the Company's recent filings on Form 10-K and 10-Q for more detailed discussions of the relevant risks and uncertainties. FormFactor undertakes no obligation to review or update any forward-looking statements or update the reasons actual results could differ materially from those anticipated in forward-looking statements.

Now I would like to turn the call over to Joe Bronson.

Good afternoon and thank you for joining us today. We are pleased to report that FormFactor had a very strong third quarter, posting record revenues and bookings, improving profitability and continuing to successfully transition and ramp the new factory.

Revenues increased 19% sequentially to 62.4 million, exceeding our target range of 54 to 59 million. Gross margins continued to show improvement, achieving 45% versus 41.6% last quarter and our profitability also increased to $0.23 from $0.12 last quarter.

Excluding onetime adjustments that Ron will discuss in detail, our earnings per share was $0.17 compared to our guidance of $0.11 to $0.14. We continue to focus our attention on execution to meet our customers' needs by completing the new factory production ramp to further increase capacity and introduce new products and technologies.

Demand continued strong during the third quarter with the 300 millimeter and 90 nanometer capacity buys continuing and the consumer mobile applications market propelling other segments such, as mobile RAM.

Three key messages we want to emphasize today are -- the new factory transition is going well as we move into the ramp phase. Our market opportunity is large and expanding with multiple growth drivers due to the evolving requirements of the industry as final package test is moving to the wafer. And finally, margins will continue to improve sequentially as revenue increases favorably leverage our operating model.

With respect to the new factory, I would like to start providing a status report. This is the only MEMS facility of its kind in the world and when fully ramped, will provide the Company with the most advanced technoLogical capabilities (technical difficulty) RAM segment. We expect the continuing diversification and growth of DRAM architectures to be a very strong contributor to our overall growth over the next few years.

The transition at DDR2 (ph) continued. Through (ph) the transition has been slower than anticipated a year ago the outlook for DDR2 remains positive. Customers continue to utilize (technical difficulty) options as DDR pricing held strong and most customers are moving to 90 nanometer at DDR before moving to DDR2. We believe there is a growing trend towards longer coexistence of between next-generation and previous generation architectures in part due to the next generation of chipsets not forcing southern (ph) transitions. In the future, we believe transitions will no longer be uniform as they are not driven by memory performance, but by shrinks for cost reduction and chipset changes. Thus, customers could eventually have multiple generations of certain technologies running simultaneously, such as DDR3, DDR2 and DDR. FormFactor benefits in this environment of architectural diversity as customers tool multiple designs with multiple sets of probe cards.

The technology transition to 90 nanometer continued in Q3 as we derived 60% of our DRAM revenue from 90 nanometer or below and virtually all, 98%, from 110 nanometer or below. With this move well underway, we believe 2006 will be a significant year for 90 nanometer.

We believe the technology evolution of 70 nanometer has begun and we're currently working on designs for NVU (ph) and memory companies. Customers are also making an interim step to 80 nanometer designs as well.

From a capacity standpoint, FormFactor continued to benefit from 300 millimeter buildout by major memory manufacturers. Several new facilities remain on track to be completed by late 2005, early 2006. Our Q3 300 millimeter revenues and bookings increased once again, outpacing those of 200 millimeter. With nearly three-quarters of our DRAM revenue now coming from 300 millimeter, FormFactor is clearly benefiting from the retooling as some test equipment has already been ordered.

Flash was down slightly this quarter due largely to weakness in NAND (ph). Now that we have additional capacity, we are now focused on capturing a larger portion of the Flash market. We believe the need for higher parallelism and growth in consumer applications such as digital still cameras, 3G, phones, MP3 players and U.S. Flash drives will drive strong long-term growth in the overall NAND market. The current state of this market is similar to the DRAM market we entered (technical difficulty) where a highly fragmented set of small competitors offered marginal solutions with lower reliability and uptime performance and had difficulty ramping production. In 1997, we entered the DRAM market with higher-performance, industry-redefining products that lowered our customers' overall cost of test and enabled their technology roadmap changes. Since that time, we have become the supplier of choice to the DRAM market. We believe we will provide key differentiation and unparalleled value to our Flash customers with high parallelism (technical difficulty) Touchdown 300 millimeter products. We are on track with development of these products and we have already shipped one Touchdown 200 millimeter NOR (ph) product to one of our major customers this quarter. This product is capable of testing an industry-leading 600 DUTS, or device under test, simultaneously.

As NOR technical requirements are significantly more stringent than NAND, we believe we are well positioned for NAND product ramps in 2006. As with all of our products, we expect that NAND Flash margins will be at benchmark levels as the product elements will be optimized for Flash. We anticipate customer evaluation of our one Touchdown products over the next few quarters.

Going forward, we expect Harmony-based products to be the industry standard in the overall Flash market. We continued to make significant progress in Logic during the third quarter. Now that capacity is ramping at the new factory (technical difficulty) at the digital consumer DSP and game applications at major IDM and fabless foundry customers. The memory market will continue to be a very large area of opportunity where the proliferation and coexistence of architectures and the move towards finer process nodes will ensure sustainable growth and resilience of our business.

Additionally, growth for bare packaged chip applications and our customers' continually strive for cost reduction will propel new products such as wafer-level burn-ins and high frequency testing at the probe. These products enable our customers to identify defects earlier in the manufacturing process, reduce packaging costs, improve performance and increase yields. FormFactor is the only supplier in the industry with a comprehensive suite of wafer test solutions required to address KGD from wafer-level burn-in to wafer sort and final test on the wafer HF tab (ph).

In some instances where we once sold one sort card, we will soon sell as many as three probe cards. The migration of final packaged test under the wafer represents the most significant market opportunity for FormFactor over the next several years as the transition to multichip package applications explodes.

Wafer-level burn-in had a strong quarter as customers are increasingly trying to lower their cost of test and increase final test yields. During the quarter, we announced our wafer level burn-in upstream product which accelerates reliability testing for our customers. This product is based on our proven MicroSpring contact technology and allows for very high-temperature testing which increases throughput, performance and yields for our customers. We anticipate exiting 2005 having quadrupled our wafer level burn-in 2004 revenue. Based on the continuing design wins during the quarter, we expect demand for wafer-level burn-in probe cards to continue to grow in Q4 and more than double again in 2006.

An emerging technology for moving test to the wafer is HF tab, a technology that was developed over the last several years and recently introduced to the market. Our HF tab products help customers get closer to KGD by providing wafer testing to high-speed electrical specifications testing, otherwise known as final test on the wafer. FormFactor is currently the only company that can provide this type of product. We had a number of significant to design wins for volume production in the first half of '06 for key customers.

Growth in HF tab will be driven by two factors. First, the market continues to move to higher frequency nodes. We are currently seeing our customers move to 133 MHz and 166 MHz in mobile SDRAM and to 266 MHz in mobile DDR. Second, the test infrastructure capable of utilizing our at-speed probe cards with frequencies up to 266 MHz is expected to be introduced this quarter. This will also enable customers to use HF tab probe cards to speed up conventional wafer sort test and further improve throughput, thus reducing cost of test. To provide some perspective on these markets, we believe the size of the HF tab and wafer level burn-in markets will exceed the size of the NAND Flash market in 2007.

There is considerable discussion by the investment community about our competitive position, so we would like to offer the following perspective. We believe that our competitive position in 2005 has strengthened as competitors have been unable to meet our customers' advanced requirements. The competition in the probe card market is fragmented, made up of small players or small portions of companies typically deriving the majority of their revenues from selling older technologies. Several companies are trying MEMS probe card applications. We believe that these companies typically do not possess the resources needed to invest in R&D and enable customers demanding technology roadmaps across various applications, and therefore, typically focus on a single customer. It's a very long road from development of a new contact technology to a shipment of our very few probe cards. It's an even longer road from delivery of a few probe cards to reliable high-volume shipments. Customers who attempt to use these products often need multiple suppliers to minimize the risk of these unproven products and we have seen several examples of suppliers being changed from one product generation to the next without any one of them as of yet achieving substantial manufacturing learning.

Today FormFactor alone has committed the necessary resources to invest in R&D to develop and keep pace with customers' technology roadmaps. We are the clear leader in MEMS probe cards and have the lion's share of learning at the customers' test floors, solving their most advanced problems, using our established R&D, engineering and worldwide applications and support resources. Our R&D products and learnings are protected by a global IP portfolio of over 650 patents and pending applications, including several key technologies that we believe are cornerstones of MEMS probe cards that are needed to meet today's test requirements. And we are on track with our transition to a new factory which will provide us with the leading-edge, high-volume capability that has orders of magnitude beyond any other current or potential competitor. With our new facility, we are now able to quickly ramp multiple products simultaneously with the consistent product performance and provide low-risk turnkey high-volume manufactured solutions for customers.

In short our future success is in our own hands. Our main objectives for the next two quarters will be to successfully ramp at the new facility, excel at timeliness and delivery and commitments to resources; second, to continue to develop new market-leading products to address large and expanding markets as final test moves to the wafer, and three, achieve targeted margin performance. Now that we are ramping capacity, we will now further expand our product portfolio. We will capitalize on our Harmony architecture and multi-DUT products in order to further penetrate markets, such as NAND, Flash and Logic. The R&D pipeline is full of products for advanced memory application. We will maintain and extend our leadership as we work to deliver the highest performance, lowest cost and highest quality testing solutions across all of our markets.

Finally, I would like to thank our employees for their hard work and dedication in making this a very successful quarter.

Now I'm going to turn the call over to Ron Foster, our CFO, who will provide third quarter results and our guidance for the fourth quarter of 2005. Ron?

Thanks, Joe. I would like to highlight the financials for the quarter and provide a few more details.

Revenue in the quarter climbed by 10 million to a record $62.4 million, a 19% sequential growth and 21% growth year-over-year. Both Logic and DRAM grew strongly while Flash was down 4% quarter-to-quarter. Third-quarter bookings increased to record level (technical difficulty) 62.9 million. This was an increase of 9% over Q2 and 40% over the same period last year.

From a geographic perspective, we saw revenue strength across most regions, especially North America, Europe and Japan. Business from Korea, including North American subsidiaries, also grew. Revenue from Taiwan fell slightly in the quarter as we transitioned to a direct sales model in this region. As we mentioned last quarter, this is an important step as the Company becomes more globally focused. However, bookings from Taiwan increased significantly in the quarter and we expect Q4 revenues and bookings to be strong as we begin to reap the benefits from our direct sales model.

Typically, revenue from Taiwan accounts for approximately 15 to 30% of our total revenue in any given quarter and is grouped in the Asia-Pacific category. A breakdown of revenues by market segment and geography is available on our website.

DRAM revenues rose 22% from last quarter, driven by mobile RAM, which more than doubled, and DDR2, which climbed 5%. Mobile RAM was the fastest-growing and largest volume category in DRAM. In fact, it exceeded DDR2 revenue. We continue to see solid demand for DDR2 probe cards as well. As Joe mentioned, we are seeing the shift towards the coexistence of the multiple architectures with both DDR and DDR2 in production at the same time. Our strength in DRAM continued as bookings rose 20% sequentially, driven by a substantial increase in DDR2. We anticipate the mobile RAM business to scale with the adoption of 2.5G and 3G phones, amplified by the fact that most of these devices go into KGD -- known good die sales -- and, therefore, will drive incremental wafer-level burn-in and HF tab product sales as well.

Flash revenues fell 4% sequentially with NOR showing continued strength. Bookings declined 28% due mostly to weaken business in NAND. As Joe discussed, we expect to see our NAND business ramp through 2006 with volume shipments of our One Touchdown 300 millimeter Harmony product in the second half. We also anticipate continuing growth in our in NOR business.

Logic revenues grew 39% while bookings were down slightly as the timing of some orders from design win customers were pushed out. This market segment continues to be an area focus for the Company. Revenues from wafer-level burn-in products increased significantly in the quarter, up 50% sequentially and bookings up nearly 60%. Wafer-level burn-in revenues were nearly six times greater than the same quarter last year. This business is expected to grow from the low single-digits last year to double-digits in 2005 and we expect it to more than double again in 2006.

We anticipate that annualized revenue growth rates can exceed 25% over the next several years, driven by robust growth in our core markets and strong development of new markets, such as consumer, mobile, wafer-level burn-in and HF tab related to known good die.

Our turns ratio based on customer demand was 43% for the quarter, compared to last quarter's 49%. This decline was expected as we entered the third quarter with higher than normal backlog. Going forward, we do not believe that turns will be a useful measurement of our business as we shorten lead times on customer orders. On-time delivery and leadtime reduction will be our focus.

GAAP gross margins for the third quarter improved sequentially from 41.6% to 45.3%. The $10 million ramp in revenue enabled by the new factory, coupled with continuing yield improvements, contributed to the increase. As anticipated, new factory startup costs began to decline this quarter to 2.3 million compared to 4.7 million in the second quarter. The costs this quarter represent only the labor and material related to equipment and process start-up. Other costs, including all depreciation, facility costs and other previously reported redundancy costs, have been incorporated in the normal operating numbers as the factory is now ramping and virtually all of the process centers are in production and shipping products.

Gross margins net of direct start-up costs were 49.1%, down from 50.7% in the second quarter. The second quarter, however, excluded 3.3 percentage points of redundancy costs that are now included in our third quarter factory gross margin.

As mentioned last quarter, we have accelerated investments in factory capital equipment and resources to scale to higher revenue levels sooner. This is evidenced in the strong revenue performance this quarter, our expectations for the fourth quarter and the current factory installed capacity of greater than $80 million per quarter. With current gross margin at 49.1% excluding only the nonrecurring start-up costs, we anticipate achieving our target gross margin range of 53 to 55% once the ramp is complete and we are operating in the $75 million revenue range. Subsequent increments of capacity to free up manufacturing bottlenecks are contemplated in our general capital outlook. Capital spending will moderate at 20 to $25 million next year, depending somewhat on revenue levels.

We are planning to exit the old factory by the end of Q1 2006. Currently, a portion of the wafer line and brick line (ph) and in interposers are still operating in the old site. By the end of the fourth quarter, only a portion of the wafer line will still be operating from the old site.

Operating expenses for the quarter were $19.8 million, up 4.2 million from Q2. Operating expenses, excluding stock-based compensation of $1.4 million, were 29.4% of revenue in the quarter, up from 28.4 in the second quarter. R&D costs grew 2.2 million to 12.3% of revenue due largely to the rollout of new technologies concurrent with the new factory ramp. We are also making investments in new technologies and products as we focus on the new market opportunities that Joe described. As previously mentioned, we expect R&D expenses to scale with revenue growth in the 12 to 14% of revenue range. This funding and our unique manufacturing capabilities are the key drivers to our significant product differentiation and unique value proposition.

Sales and marketing expense increased sequentially with the start-up of our new Taiwan direct sales and service operations. G&A expenditures increased primarily due to severance costs related to our COO departure and an increase of 700K in legal and compliance costs as we continued with our ongoing litigation and Sarbanes-Oxley compliance work. Stock-based compensation expense increased by 800K, resulting primarily from option acceleration related to our COO departure.

One item to note is that we will have an additional week in our fourth quarter to align our year end with the calendar year end. This 14th week occurs during the holiday season at the end of December in that we will have a December 31st fiscal year end. We anticipate this additional week will add proportionately more costs than revenue to our income statement.

Operating income for the quarter of 8.5 million, or 13.7% of revenue, was up from 6.3 million, or 12% of revenue, in the second quarter. Adjusting for the 1.4 million severance package which was excluded from our guidance, operating income would have been 9.9 million and 15.9% of revenue, compared to our target of 11 to 14%.

Other expense for the quarter of 486,000 -- other income and expense for the quarter of 486,000 was down as a result of foreign exchange losses on currency translation due to the weakening of the Japanese yen. We recorded a net tax benefit in the quarter of $759,000. The tax rate for the quarter was impacted by two significant onetime adjustments; one, adjustments related to a recently concluded R&D tax credit study documenting our eligibility for such credits and, two, the release of previously accrued prior-year tax contingencies which are no longer necessary. These two items accounted for $3 million of tax benefit in the quarter and added $0.08 to our EPS. The annualized tax rate for the year normalized for these onetime adjustments is 29.2% compared to 32.4% used in the second quarter.

We anticipate some incremental future benefit from the R&D tax credit study which is expected to impact future quarters. We expect the tax rate for 2006 to increase to the 33 to 35% range as earnings increase. Net the income for the quarter was $9.8 million, or $0.23 per fully diluted share versus $5 million or $0.12 per fully diluted share during the second quarter and 7.5 million or $0.19 per fully diluted share during the same period of 2004. EPS in the quarter was reduced $0.04 by news factory start-up costs versus $0.08 in the second quarter. $0.08 of the EPS improvement relates to onetime tax adjustments mentioned earlier. The previously announced severance agreement reduced EPS by $0.02 in the quarter. Normalized for these two items, EPS was $0.17 in the quarter compared to our target of $0.12 to $0.14.

Cash and short-term investments increased $8 million in the quarter to 204 million from 195.5 million last quarter as the cash generating potential of our new factory began to accelerate. Cash flow generated from operations during the third quarter was 11.3 million. Capital expenditures were 9.2 million on a cash basis, down 300K from the second quarter. Proceeds from the issuance of stock were 6.1 million in the quarter primarily relating to option exercises and stock purchased under the employee stock purchase plan. DSOs were 43 days during the third quarter versus 46 days in the second quarter, largely due to more linear shipments in the quarter. Net inventories increased by 1.6 million during the quarter to 14.4 million. Headcount continued to increase, reaching 801, up from 704 in the second quarter. Three-quarters of the headcount increase related incremental manufacturing resources, mostly direct labor.

Let me now provide you our guidance for the fourth quarter of 2005. We continued to experience demand across a broad range of product areas and our outlook for Q4 remains strong. We expect revenues for the fourth quarter to be 63 million to $67 million. GAAP operating income is expected to be approximately 16% to 18%, including about 1% of new factory startup costs. We expect stock-based compensation of $700,000 for the fourth quarter. We target GAAP earnings-per-share of $0.20 to $0.22 per fully diluted share. New factory start-up costs are projected to decline to less than $1 million, reflecting only non-recurring costs, such as move costs, qualification materials and start-up labor.

Now let us open the call for questions. Operator?

(Operator Instructions). Bill Lu, Piper Jaffray.

Hi, good quarter. Just a quick question. I want to be absolutely clear on the start-up costs. It looks like for the next -- for (indiscernible) and 4Q, it's actually lower than what you forecasted previously, but it looks like also you're going to keep your old factory open for one quarter longer. Can you just explain why that is so? Is it demand, or what's driving that?

Bill, referring to the start-up costs, we came in at about $2.3 million in the third quarter. We had given an estimate of $3 million. Given the fact that all of our equipment centers are ramping in the new factory, we did not include any redundancy costs in our numbers in the third quarter at all and some of that actually was in our original estimate.

Going forward in the fourth quarter, we expect less than $1 million in start-up costs, again, including only non-recurring start-up costs. All of the other costs are in our operating numbers. Does that address your question, Bill?

Yes, and then why is the old factory kept open for another quarter?

We, as we communicated last quarter, have consciously focused on ramping to a higher level of revenue sooner and also satisfying customer needs and demands. And in so doing, we elected to keep certain process centers open longer in order to ensure a smooth transition and to get to higher revenue levels, which we have already achieved this quarter and in our guidance for next quarter compared to the prior planning.

Can I ask you a quick follow-up question? If you look at the KGD and the final test at probe, is it fair to say that that's mostly with sort of non-generic DRAM right now with some mobile and things like that, and then the ramp with -- you know, typical DRAM is still yet to come?

Yes. KGD actually, the ramp of KGD right now in our business is driven by mobile RAM and the demand there is for stacked packages. Therefore, all of mobile RAM that goes into stacked packages has to be fully validated on a wafer, and that includes both performance testing which we do with our HF tab product as Joe mentioned and wafer-level burn-in, which is reliability testing.

There are other applications where customers are beginning to use elements of known good die testing, including other DRAM applications. We also see emerging need for known good die testing in Flash and we will be addressing that need next year. And we also see a longer-term need in SOC. For example, DSPs, or digital signal processor chips, also go into stacked packages. And actually, there is a very big challenge there, how to validate those chips to a level of validation to the percentage of validation that that does not drag the overall yield of this stacked system in a package or multi-chip packages as people call them down. And that is a major, major evolving issue. We will be taking advantage of that opportunity longer-term. So KGD trend is actually; for us, it's beyond the trend now. It's sort of an explosion. It's something we worked very, very hard for 5 years and we have a leading products not only for high-speed testing in DRAM, but you will see in the future our leading products in Flash and also in Logic and SOCs. So this is just something as we communicated to everybody during the IPO was going to be, had a potential of being a major growth driver, but now it is here and you can see by mobile RAM revenues this quarter that it's happening and it is a major, major growth driver.

I wanted to add that when Joe mentioned that the way we see it, the known good guide testing, including mobile RAM just memory alone in 2007, will be a large market for us than NAND Flash probe cards. But as I mentioned, there will be also Logic market evolving. So this is a major trend of moving more and more testing from final test onto a wafer and you can see reallocation of money in the industry.

Thanks very much.

Mark Bachman, Pacific Crest Securities.

Hi, guys. Ron, can you walk through the redundancy costs, explain to us why did you not break them out this time and include them in your operating expenses, and how should we think about these going forward? It was my impression that redundancy costs are that and that they are redundant and that they're supposed to be going away. I assume that you have a lot of those people that were hired there under time-limited contracts, and so I want to understand how the margin progression is going to work going forward now that you have rolled them into your operating costs.

Let me characterize redundancy a little more specifically. Redundancy costs as they were previously defined were costs of duplicate infrastructure, if you will, old site and new site, part of which was not operational. And so what we have characterized here is that we have got virtually all of our new site operational in that every part of it is producing production so that it's not proper to characterize redundancy costs, which are for example, facilities, depreciation and resources associated with starting up operations and machine centers that are not fully in production. So it's a better characterization for us to count all of that in our operating results. We are in production at some level and ramping up in each one of the process centers.

So going forward, as I mentioned, we're only including non-recurring start-up costs which are the costs I enumerated, such as move costs continuing qual costs, equipment factory start-up costs, machine start-up, et cetera, that will all away once we are fully in production. Does that address your question?

I guess it does. I was hoping for a little bit clearer answer. Exactly how do we know for sure that those costs are going away?

We specifically identified these categories as ones that are only related to start-up. They are qual materials, as an example, that are being used simply to qual machinery and to get it functioning. Labor associated with actually installing and starting up equipment and move costs -- specifically moving and installing equipment in the factory -- they will not continue in any of the categories I described.

And just finally, with the closure of the factory in Q1, can you give us an estimate of the close-down costs to close that old facility down, and will it hit in Q1, or will it hit in Q2?

Mark, we're going to be taking a look at those close-down costs here in the fourth quarter. We don't have a view of that right now. There's an evaluation that needs to go on. And once we have ascertained that both the number and we will also pin down the timing in terms of taking the -- any charges that are appropriate. Once those numbers are known, we will take them as an accrual or a liability.

Mark, I want to make one point that I hope sticks. In my remarks, I said that margins are going to go up sequentially. And I think in Ron's remarks, he said that margins were going to achieve 53 to 55 when the Company achieves 75 million in revenue. So I think that's a way of looking at the fact that margin progression as we stated is happening exactly the way we forecasted it. So I think you need to see that you will see margin progression next quarter. We should see margin progression after that as well.

Thank you, Joe.

And the characterization I made, Mark, of 49.1% gross margin excluding only non-recurring start-up costs by ramping to the 75 million revenue range and getting the factory through the transition we believe will be in our target operating range of 53 to 55% gross margin. And we expect to march sequentially here quarter by quarter through improving margins.

Thank you.

Mehdi Hosseini, Friedman, Billings Ramsey.

Thank you. When I look at (technical difficulty)

Medhi, are you there? Medhi, you blanked out on us.

Murali Abburi, J.P. Morgan.

Congratulations, guys, on a strong quarter. First a point of clarification. At this point, does your revenue guidance represent actual demand, and we do we assume that exists in no longer capacity constraint?

The revenue capability of the factory as I characterized is greater than $80 million. We have substantially all of that capability in place as we ramp the factory. Obviously, we need to go through the steps to get there. So the key point being made is that we have no longer a constraint of our factory making us unable to take more business and we're actually in the demand generation mode now of identifying new business opportunities, and that is why Joe enumerated them in detail in his comments. And we see very strong design flow, order pipeline and business engagement with customers, including the numerous new areas that were enumerated that are all going to fill that pipe going forward. And we believe that we're going to have the factory capability to deliver that sequentially here as we go forward quarter-by-quarter. And also as we described, that will lift our margin because we have significant margin leverage as the revenue increases.

Alright. Then real quick, are you guys still in that (ph) distribution agreement with Spirox (ph) last quarter, right? I was curious as if you guys had any sort of non-compete agreement with Spirox, or are they free to distribute probe cards from other companies down the road?

We have exclusive rights to our products in the areas where we operate, including Taiwan, that are non-compete arrangements.

No, I meant do you have a non-compete that stops Spirox from distributing other peoples' cards for the next year or so, or anything like that?

Yes, we do.

Alright, thanks.

Mehdi Hosseini.

Thank you, this is Medhi. Going back to your booking mix in Q2, you had about $11 million of Flash booking, but your revenues this quarter was 9, and bookings declined significantly. So is there a backlog building, or was there any cancellation? And my second (question) has to do with the DDR2. You had about 17 million off DDR2 booking in Q1. And back then, the mix -- or the magnitude of DDR2 unit shipment was significantly lower than Q3, but your DDR2 booking went down in Q3. If you could just provide some color as to how we should think about this. Thank you.

In terms of the Flash business, as we characterized, we are putting the capabilities in place and engaging with customers now and engaging in designs as well as new technology roll-out here in the Company to deliver increasing Flash. I would not try to infer too much in terms of the bookings trends. And there were no cancellations per se in the business, if that's what you're looking for. In terms of DDR2, I wasn't sure what exactly what question you were asking in terms of the trend line of DDR2 growth. Can you reiterate that?

Sure. My question has to do with the trend line in DDR2 in reference to the actual DDR2 wafer shipment. In Q1, you had $70 million of DDR2 booking and I would guess that the wafer shipment, DDR2 wafer shipment at your customers, was significantly lower than Q3.

It's a very, very hard relation to make because customers buy probe cards and then customers, as I think Joe and Ron mentioned, have coexistence of several architectures at the same time. And then when one of the architectures has higher spot market price or there is higher demand, they will run more of that. But they basically own suites of our probe cards that coexist in some cases. So trying to look at our bookings numbers in the quarter and relate them to actually wafer shipments is probably a very difficult exercise, Mehdi. But DDR2 is happening. It looks like for us, it looks like this parity is around Q1. But what is happening is that there are enormous amount of other drivers in DRAM, and that is the real story for FormFactor. People are ramping 90 millimeter for DDR2. Once that is completed, they are beginning to ramp 90 millimeter for mobile RAM, which is a completely distinct tooling event (ph) for FormFactor. Once they do that, companies are ramping 80 nanometer now, taking an intermediate node. Instead of waiting for 40% chip strength, they're taking 20% where they can get it. So all of these things are happening, densities are changing, architectures are changing. Graphics, DRAMs will be a big thing next year. So you have this coexistence of designs and you have companies managing this kind of suite of product and deciding what to run.

If I may, just one follow-up for Ron. Should we think about a tax credit in Q4?

Mehdi, that's why I characterized the tax rate at 29.2%. That was an annualized tax rate. That would be the rate for Q4.

Okay, thank you.

Timm Schulze-Melander, Morgan Stanley.

Good afternoon, guys, and congratulations on the quarter. Two very quick questions. The first is, Ron, on the $34 million of cost of sales, could you give us some indication of what proportion of those would be fixed costs? And secondly, on average -- I know there's going to be some variation -- but on average, can you compare the gross margins you earn on a DDR2 probe card compared to a DDR1 card? Thank you.

In terms of the COGS numbers, what we've characterized is that the new factory has a higher dollar level of fixed cost associated with it, but significantly more revenue leverage. So if you look at it as we scale, we will leverage that fixed cost over much higher volumes and our variable costs will actually be lower as we ramp. I don't specifically call out the mix, but you will see that leverage as we ramp up against revenue as we just characterized. In terms of comparison of margins --.

Timm, let me take that question. I do not believe that there is a significant variance in FormFactor margins across different memory architectures. And the reason is the only way we sell is based on total cost of ownership. We go, we identify where we can add value that nobody else can and we share in this value we had with customers. Our margins really don't vary accruals DRAM, Flash or across architectures, very significantly.

Great, thanks very much.

Mark Fitzgerald, Banc of America Securities.

I was curious on the SG&A and R&D expense for next quarter, will those go down, given some of the charges that you had this quarter?

Down as a percent?

No, down in absolute. I'd assume the COO's option package of the $1 million plus was in the SG&A line.

Yes, it was, and the stock comp. 1.1 million in the stock comp and the rest in the SG&A line. So, yes, that does go away, but in terms of absolute trend lines, as I commented, we expect our R&D to continue to scale with revenue as an example. And we are approaching our model line for operating expense structure already.

So total expenses on a dollar basis, are we looking flat to down or up?

On a dollar basis as we grow revenue, we will expect some dollar increases. We also have the 14th week I commented on, which adds some incremental cost structure in the fourth quarter.

Okay. And just to follow onto that, will gross margins be up next quarter? When you said margins going higher next quarter, can we assume gross margins are higher?

We don't give gross margin guidance, but you can certainly infer appropriate conclusions from the income guidance.

I mean, it has a big swing, whether the expenses are flat or down, whether gross margins are up or down. You must have in your model here with the revenue base that you gave us some assumption as to --.

Mark, we expect continuing gross margin improvement quarter-by-quarter.

Let me reiterate what I said before. Margins will improve sequentially.

Gross margins?

Those are gross margins?

Gross margins, yes.

Okay. And then just a bigger macro question. With the complexity of your product increases here, I assume the number of assembly steps go up. Do you offset that by higher ASP's?

I'm not sure what you mean, Mark, by assembly steps going up. I do not believe that that is changing. And this new factory, one of the reasons we did it was that it offers us far more advanced capability that will enable us now to go to finer node in complexity of products for many, many years ahead. So now, it is in general true when the products are more complex or customer applications require more complex products or require more engineering that we can derive more value and share in this value again with customers.

So with the -- I understand the complexity of when you manufacture the springs, but I assume when you assemble those springs into the board that there's quite a few assemblies steps associated with that.

Mark, no. FormFactor is a true MEMS technology probe card. It is a batch-fabricated process that distinguishes FormFactor for all kind of MEMS probe card wannabees. We have a batch fabrication process that assembles -- that doesn't assemble, that fabricates these things in precise spatial relationships. So next time you visit us, I will be happy to go through these things with you.

Patrick Ho, Legg Mason.

Thanks a lot, guys. And actually, thanks for the additional information on the facility transition costs. It's quite helpful in modeling going forward. Just a quick I guess follow-up on the facility transition question. Based on what you said following the June quarter earnings and what you are saying now, it sounded like there was quite a dramatic improvement. What was the I guess turnaround in 3Q? Was it just improving yields? Did you guys get your equipment in a lot better? What was I guess your most incremental improvement on that front?

I would like to say good management, but that would be rather self-serving. I think the organization has really coalesced around this building. It's a very remarkable facility. It has been a lot of hard work. Igor just demonstrated in the test and assembly process what a good process it can be. So I think we have added a few very good people to the organization, but also the entire organization is pulling together to make this happen. If you look on our Web site, it's the number one priority and it has really been a team effort and I really have to thank all of the employees that been working their tails off to make it happen. It's a 7-by-24 operation and we had quite a lot of training to do. If I think of one of the major things -- we insisted on operator certification to work in the new facility. That meant people had to pass an examination. Things of that type. A lot of little things that are coming together to make this a really first class operation and fulfill the promise that we believe we have from a spectacular R&D portfolio. That's coming and that's also very critical because our introduction of products from R&D and the manufacturing is going to be very critical and we believe this facility is going to be an enabling function with all the modern equipment and capability we have in it. So it's going to be extremely important and I think it's going to be -- give us the ability to make this factory a competitive advantage. We already have a significant technical advantage, but this gives us an operating advantage once we get in done right. So we are getting to the point we're about done and starting to ramp this thing.

Okay, great. And just I guess a final question, maybe Ron can answer this. You said that the facility has now about over $80 million of revenue capability right now. As you're looking forward into 2006, what's the incremental growth potential for capacity additions from that level?

Patrick, we view that we can incrementally expand the capacity of the facility by breaking the specific bottlenecks in the factory operations and scaling up various process centers. That's why I made the characterization that we believe we can do the additional scaling within our normal range of capital budgeting, and I gave you that range number of 20 to $25 million next year. The wafer fab part of the facility has tremendous capacity to scale well into the future. Other parts of the operations, such as back-end test, et cetera, we may evolve over time to a more distributed kind of model and we will figure that out as we go. But we have certainly got capacity where we are to move in the 120 to $125 million range, and then up from there.

Edward White, Lehman Brothers.

Thanks; a two-part question. First on the factory, can you talk maybe qualitatively about the economies of scale and production cost advantages, yield advantages, that you expect that we get there in addition to the ability to build probe card with better complexity? And then second, Joe, I think you talked about the fact that there will be some instances in the future where you might have sold one probe card in the past and you can now sell three. Can you talk about some examples of where that might occur?

I'm going to let Igor answer the second one on the known good die. With respect to the new factory, I think there's two major factors. First of all, the Company is changing. It's a much larger company than it was a year ago. So the professionalism and business processes are getting -- they need to get more robust, they are getting more robust. There's a lot of things that are going to improve productivity. We have put together a very serious quality program that emanates from the top of the company where we're trying to get all 801 people involved. And that actually has very significant leverage when you really get to do that before the company gets big and starts to decide that these things aren't important.

The other thing that's very critical, and we're right in the middle of doing this, is we need to figure out how to get productivity out of the equipment that we installed. You know, we spent in excess of 65 million on the facility, so we're trying to figure out what is the revenue capability out of the various equipment configurations, and how do we get that maximized through just like we would any other -- like a wafer fab would, et cetera?

Finally I think the important thing is really the work force and the training and disciplines, cleanroom protocol; all of the details that make for productive capability. We're going to be watching things like revenue per headcount, the type of -- getting our fixed overhead as a percentage of revenue to scale, and that's what this is all about. So those are the things we are really focused on as we enter the final phase of ramping the factory. Igor?

Let me answer the second question. So traditionally, what has been done in the industry is that wafer test would be used at probing, and then you would go into classical package assembly and test. So there was very significant test contain (ph), and still is, at package where people do wafer level burn-in -- sorry -- burn-in of packages, which is reliability test, and then they do final test at the package.

Now, the big story here is that there is increasing demand for multi-chip packages and it's now proliferating. It started in cellphones, it is now going into all consumer electronics, it's also going into games. It's just really an exploding trend right now. And in that case, when you put four chips together in one package, all of these chips, which are bare, unpackaged chips, they must be validated at the wafer. Otherwise, if three chips are okay but the fourth one fails, you throw out entire assembly. So that's the problem.

So what happens now is, when you, for example, ship a mobile RAM into stacked package, you must do sort and sometimes you do more than one, which is what we traditionally sold probe card into. But then you must do wafer level burn-in, which is now an incremental probe card. It's a different probe card, it's a new incremental business for us. And then, you need to sell high-frequency probe cards capable of high-frequency final test on a wafer. So in some of these cases, in many of them, you'll sell up to three probe cards where you used to sell one. We have worked on this.

We are well-recognized in the industry and by the customers as the undisputed leader in this area in terms of being able to do, for example, high-frequency test on a wafer. I don't know whether you saw, Ed, but I think a day or two ago, we had an announcement from Tera Probe. And Tera Probe is the largest testing company for mobile RAM today in the world and they did select FormFactor to do that. So it started in mobile RAM. As I mentioned in my answer to one of the previous questions, it is now going to be a trend in Flash because for example in the cell phones, two of the chips that go into these packages are MEMS and (indiscernible) Flash. So both would have to be validated at the wafer. And SOC, or including chips like DSPs, that trend also is going to be in the future. So this is a tremendous potential for us and we're very well positioned to do this.

Great, thank you very much.

Jim Covello, Goldman, Sachs.

Thanks very much, good afternoon, congratulations. A couple of quick questions. There's been so many people that have been so negative on your stock this quarter because of execution issues. It just seems like the execution has been much better than expected. What do you think the difference between the expectations and the reality really were? And then are you confident that we have kind of turned the corner? Because it looked like we had turned the corner earlier in the year, then things were a little choppier, now this quarter was very, very strong in the execution. Are you confident that going forward, this is sustainably good execution from here on in?

I would explain this in the following way. We lost 2.5 months with the metal contamination at the beginning of the year. That took a lot of people to go fix that. We stabilized all of the wafer fab operations, but I think that took some focus away from the new site start-up. We had a decent revenue quarter in the second quarter and then woke up and found we had a whole bunch of other things to do in the new site. And I think the organization is very now very well focused on execution. A lot of these large start-up costs that really that were incurred to start up the factory are way behind us. We're down to the dribbles and the drabs and that's actually costs you don't have to manage any more and that helps out quite a bit with the execution and the details.

So I think it enabled us to get really well focused on the new site and also a lot more focused on customers. And so we're doing a much better job with customers and I think you're seeing significant customer pull for our products all over the place and this is very significant. Customers want us to be able to execute for them as quickly as possible because they know it's going to reduce their cost of test. They are very unhappy when we cannot get stuff to them on time.

So I think the whole company is coalesced and focused on this matter and we are going to get it done. I think we are going to continue to get it done. We've made some comments here today that we expect sequential margin improvement and we're going to stand by that. And a lot of people doubted and said our 53 to 55% goals were not achievable, aggressive, and that we were smoking something. So I would tell you that we absolutely have a roadmap to get there and we're going to do it.

I think I wanted to add to that. One other factory, Jim, has been that there has been quite a bit of comments about competitive situation where as we look at it very, very carefully, the way we see it, our competitive situation this year strengthened. For example, our number two competitor, Gem (ph) in Japan, has tried now for many years -- I think three or four years -- to get into and get traction in MEMS probe cards. And this year actually had (indiscernible) and it looks like it's going back to the drawing board.

But some of these comments for some reasons, right, this additional negative reaction. So all in all, I would like to second what Joe said. This is a very unusual time for us. We're both companies very focused on execution and there is quality mindset improvement and focus on quality from COO all the way to the operator. And at the same time, I have never seen a time in the company history where so many new products, so many new applications were being worked on. And things are coming together, it looks like.

Operator, we'll take one last all.

Kevin Vassily, Susquehanna Group.

Good afternoon. Maybe a question for you, Igor. Can you talk a little bit about some of the technology you are working on with regard to doing some extension of research capability on the probe card to kind of help extend the useful life of some of the testers that are in the field, kind of where our customers with regard to this, what kind of interest level et cetera?

As you know, FormFactor has very strong background in what we call TRE technology, which is technology resource extension technology. And we took it to a level where we could actually provide a complete solution to some customers in that area. And that has been behind the unparalleled value on cost reduction and test that we have provided.

We don't like to comment about things that we haven't researched because we don't like to do strategic plans for our competitors. So -- but I can tell you that there is a very, very important trend in the industry where for example, we do have products today or we have technology today to enable very high frequency test. But when you start doing 500 MHz or above frequency test on a wafer, some of what resides on a test and some of what resides on probe card has to work very, very well together. So we have worked on it very hard and we understand this area very well. And of course when rated this very high frequency product, we will be (indiscernible) operating with tester companies to make sure it all works. And there will be a some very, very interesting opportunities beyond that, starting with wafer-level burn-in and in the future in test.

Thank you. And with that, I thank you all for joining the call and I look forward to seeing you in the future events and conferences. Thank you.

That does include today's conference call. Again, thank you all for your participation and have a great day.