FormFactor Inc

NASDAQ:FORM

Earnings Call Transcript 2022-Q3

[Operator]

Welcome everyone to FormFactor’s Third Quarter 2022 Earnings Conference Call. On today’s call are Chief Executive Officer, Mike Slessor; and Chief Financial Officer, Shai Shahar. Before we begin, Stan Finkelstein, the company’s VP of Investor Relations will remind you of some important information.

[Stan Finkelstein, Vice President, Investor Relations]

Thank you. Today, the company will be discussing GAAP P&L results and some important non-GAAP results intended to supplement your understanding of the company’s financials. Reconciliations of GAAP to non-GAAP measures and other financial information are available in the press release issued today by the company and on the Investor Relations section of our website.

Today’s discussion contains forward-looking statements within the meaning of the federal securities laws. Examples of such forward-looking statements includes also 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 U.S.-China trade restrictions, the anticipated demand for products, our ability to develop, produce and sell products, and the assumptions upon which such statements are based. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed during this call. Information on risk factors and uncertainties is contained in our most recent filing on Form 10-K with the SEC for fiscal year ended 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’s CEO, Mike Slessor.

[Mike Slessor, Chief Executive Officer]

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 FormFactor’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 tenants 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 investments in engineering systems, have historically resulted in less volatile demand cycles than wafer 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 FormFactor 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 7; 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 are 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 FormFactor’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 U.S.-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 a steeper 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 bond 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 have 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 have noted in the past, whether based on conventional solder-based assembly processes or more revolutionary process 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 and 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 weakened 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 Systems 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 FormFactor in the industry overall, driven by the fundamental trends of semiconductor content growth and innovations like advanced packaging. These are trends where FormFactor is well positioned as an industry and technology leader and we are confident that our resilience and commitment to invest in R&D and capacity will position FormFactor 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.

[Shai Shahar, Chief Financial Officer]

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.

Systems 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 Probe Card 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.

GAAP 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 issued 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 Card segment, partially offset by the increase in Systems segment gross margin. Our Probe Card 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 reserves 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 Systems segment gross margin was 53.7%, 320 basis points higher than the 50.5% gross margin in the second quarter. This increase is due to higher revenue and a 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-based compensation, $1.6 million higher than in the second quarter due to the increase in fair value of the annual RICO grants as a result of the higher stock price at the time of grant, $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 the mid to high single-digits of non-GAAP pretax income until we fully utilize our remaining U.S. based R&D credits. Third quarter non-GAAP net income was $18.3 million or $0.24 per fully diluted share compared to $36.8 million or $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 million 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 2-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 cost 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 million 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 points.

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 1 additional working week. Accordingly, non-GAAP earnings per fully diluted share for Q4, is expected to be $0.03, plus or minus $0.03. A reconciliation of our GAAP to non-GAAP Q4 outlook is available on the Investor Relations section of our website and in our press release issued today.

With that, let’s open the call for questions. Operator?

[Operator]

Thank you. [Operator Instructions] Our first question comes from the line of Brian Chin of Stifel. Please go ahead, Brian Chin.

[Brian Chin, Stifel]

Thanks for taking. I will ask a few questions. Maybe just to start here, can you just clarify, I guess, in terms of the revenue step down from 3Q into 4Q, about $25 millionish 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 XRS?

[Mike Slessor, Chief Executive Officer]

Yes. So, Brian, this is Mike. Good question. As you said $25 million reduction at the midpoint sequentially, I will start with the biggest impact, which is the impact of the October 7 China regulations. This is between $10 million and $15 million sequentially. I will start with the biggest impact, which is the impact of the October 7 China regulations. This is between $10 million 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 are not part of the step down in the quarter, but one-third, a significant chunk of what’s been a $40 million 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 million to $15 million in the quarter, call it, $50 million annualized associated with these.

Moving to the next biggest component is DRAM. We’re projecting 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 and surprisingly 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 magnitude of each. But as we look forward, 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 – 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.

[Brian Chin, Stifel]

Okay. Got it. And further clarification. Within the $10 million 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 that gives you a residual $5 million 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?

[Mike Slessor, Chief Executive Officer]

Yes. So the China DRAM impact is more than $5 million. It’s more than half of the overall $10 million 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 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.

[Brian Chin, Stifel]

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 conjoin with that. How low can you lower quarterly revenue breakeven too?

[Mike Slessor, Chief Executive Officer]

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 is 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 is 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 DRAM – 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.

[Shai Shahar, Chief Financial Officer]

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 million and $145 million a quarter. That’s the breakeven point.

[Brian Chin, Stifel]

Got it. That’s helpful. And 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 discretely factoring in things like moving from pilot to volume production for 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 discretely in terms of what could get better next year?

[Mike Slessor, Chief Executive Officer]

Well, I think as we look at advanced packaging and the impact it can have on our business, there is 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 is still pretty uncertain. 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 are advanced packaging-related or a 3-nanometer ramp inside the foundry space, there is a few things that do offer some degree of hope as we work our way through mid-2023 into the back half of 2022.

[Brian Chin, Stifel]

Okay, thank you.

[Operator]

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

[Charles Shi, Needham]

Good afternoon, Mike, Shai. Certainly, when I look at your restructuring plan, you are lowering head count by approximately 13%. Obviously, this is never easy and probably quite painful. But it 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, 1, 2 months ago, what exactly have deteriorated because I remember there was a quite some rapid and abrupt inventory correction actions in late June, early July. In August, maybe a little bit while 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 3 months and to really lead you to take decisive actions like what we just announced today. Thank you.

[Mike Slessor, Chief Executive Officer]

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 in reduction in demand, but 1 that extended into the middle part of 2023. We are 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.

[Charles Shi, Needham]

Thanks. Maybe I want to – next question, I want to double click some of the comments you’ve made, Foundry and Logic, probe card, if I heard it correctly, I think you are implying roughly $10 million ish kind of reduction in the Foundry and Logic segment into next quarter. So a couple of more specific things. RF probe card, are we going to see some run rate factors like in the teens like that’s – I remember that’s the run rate when you first acquired Cascade Microtech, which is when you got the 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 and Logic, Probe Card business. Is that what’s going on into Q4?

[Mike Slessor, Chief Executive Officer]

Yes, I think that’s a pretty good summary. Let me expand on it a little. 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 our 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 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 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.

[Charles Shi, Needham]

Thank you, that’s all from me for now.

[Mike Slessor, Chief Executive Officer]

Okay, thanks, Charles.

[Operator]

Thank you. Our next question comes from Krish Sankar of Cowen. Please go ahead, Krish.

[Krish Sankar, Cowen]

Hi, thanks for taking my question. I had two of them and I have both of them upfront. Mike, the first one, and I’m kind of curious, you said there is some weakness because of – besides China, some of your memory customers slowing down. And I thought most of the CapEx is scheduled for next year. Is this like probe card 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 verticals of smartphones that you’re seeing out of probe card slowdown. That’s the first question. And then the second question is that probe card considered consumable 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 proper as a consumables on a go-forward basis? Thank you.

[Mike Slessor, Chief Executive Officer]

Yes. Thanks, Krish. So let me start with the memory and RF piece. There is 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 are 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 the 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. Sorry, the second question, can you remind me?

[Krish Sankar, Cowen]

Mike, it is about probe card consumable...

[Mike Slessor, Chief Executive Officer]

Yes, cyclicality and – yes. 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 road maps. As we talked about on the last earnings call, we had several customers react very quickly and decisively the 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 the first volume probe cards for pilot production for a China-based microprocessor driving advanced packaging forward. 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 have two quarters here of sequentially pretty significant sequential declines in probe cards.

[Krish Sankar, Cowen]

Thanks a lot, Mike. I really appreciate it.

[Mike Slessor, Chief Executive Officer]

Thanks, Krish.

[Operator]

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

[Craig Ellis, B. Riley]

Yes. Thanks for taking the question. Mike, I wanted just to start by going back to the breakdown that you’ve given us in terms of the three things that are impacting revenues you should look into the fourth quarter, and the question really is helping us understand the degree to which some of these things, I think it’s more foundry and logic and some of DRAM that’s more cyclical and just due to the sudden decrease in demand that we’re seeing in 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 cash flow at a midpoint, about $12.5 million. So is it reasonable to think that the more long-term impact more structural impacted a $25 million decline is the DIS piece and that we would just need to find in other parts of the business to offset that? Or for whatever reason, would you see that coming back at some point?

[Mike Slessor, Chief Executive Officer]

Yes. I think it’s an interesting question. And as you might imagine, Craig, a current topic of hot debate here FormFactor. I think the – we’re very, very focused right now on making sure we do whatever we can to support our customers. They have – they are 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 this – 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 have 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, sort of around the magnitude that we talked about, the $12.5 million a quarter, $50 million annualized where we are 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 Systems 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, 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 probe card space.

[Craig Ellis, B. Riley]

Got it. And 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 OpEx portion since you may be at a different cadence on those two...

[Shai Shahar, Chief Financial Officer]

Yes, 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.

[Craig Ellis, B. Riley]

Yes. And I think you said that there are some things that are going to benefit the fourth quarter’s numbers and OpEx and cost of sales. So, what was – for whatever is executed through the fourth quarter, what’s the incremental benefit you would expect to COGS and to OpEx for the first calendar quarter?

[Shai Shahar, Chief Financial Officer]

Well, we announced it today and 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. And 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 we set.

[Craig Ellis, B. Riley]

Got it. Okay. And then lastly, and this is on COGS side. 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% COGS?

[Shai Shahar, Chief Financial Officer]

Yes. We had a couple of inventory reserve 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 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 excess and obsolete inventory model. That was about $3 million in Q3.

[Craig Ellis, B. Riley]

Okay. Got it. Okay. And then lastly, Mike, can you just provide a little bit more granularity in terms of how you are 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 are progressing at perhaps slower pace. But given where revenues are, I am a little bit surprised if we are continuing to expand unless there are things that are just very long lead time since it would seem like given that if you have time to pick up pace again in 1Q or 2Q…

[Mike Slessor, Chief Executive Officer]

Yes. And that’s exactly it, Craig. It’s the long lead time items. Obviously, in reducing headcount and capacity through labor, we have 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 have got some things associated with especially facilities that are multiyear 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 have said in the prepared remarks, the strategic tenets behind this business remain firmly in place. So, it’s purely an issue of timing, where we are 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.

[Craig Ellis, B. Riley]

Got it. Okay. Thanks.

[Operator]

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

[David Duley, Steelhead]

Yes. Thanks for taking my questions. I was wondering if you could just help me understand, I think you have 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 basis points 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? And then I have a follow-up on the gross margin after you answer.

[Shai Shahar, Chief Financial Officer]

Sure. So, just to make sure we are talking about the same number. So, Q2 of 2022 was 47.4%. We guided down to 39% in Q3 and we hit 39%, and we are talking about 33% in Q4 and two main factors impacting that. One is the overall revenue going down. We have fixed costs that are – need to be observed and when revenue go 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 cards 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 gross margin. So, these are the two main factors impacting the decline in the gross margin.

[David Duley, Steelhead]

Okay. And 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 we can assume revenues flat, but just kind of 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?

[Shai Shahar, Chief Financial Officer]

So, I think in the mid-term, so I think we talked about Q4, and we are implementing the restructuring plan in 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 market to achieve this target model.

[David Duley, Steelhead]

So, if – 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 million to get to 47% or 48% with a similar mix…?

[Shai Shahar, Chief Financial Officer]

[Technical Difficulty]

[David Duley, Steelhead]

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

[Shai Shahar, Chief Financial Officer]

Yes. 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 longer long lead time, but we have 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 reduced the capacity in this restructuring. This restructuring should – we should have – we have the facilities in place. We have the tools in place and we have enough labor to get to 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 will add as the demand comes in.

[David Duley, Steelhead]

Thank you.

[Operator]

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

[Hans Chung, D.A. Davidson]

Thank you for taking my question. I have a couple. So first, so as your business is sort of design-driven and then also on the other hand, also sort of impacted by the unit as the number of the forecast 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 see you also talk about the new design tape out for 3-nanometer is more than double than 5-nanometer in the first couple of years. And things like design momentum is still very robust, right, at least on foundry side. And then we also have the new platform from a logic customer. And then – but on the other hand, you also mentioned the number of forecast per design would 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, if the semi is down something single-digit percent. And then how should we think about our growth for next year?

[Mike Slessor, Chief Executive Officer]

Yes. Hans, this is Mike. You think you have parsed it accurately, right. There is 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 is 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. 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. If I return to the broader question on 2023, current industry forecasts have advanced probe cards growing somewhere between 1% and 2%. 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 help that market be a little bit more robust than it has here in the second half.

[Hans Chung, D.A. Davidson]

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

[Mike Slessor, Chief Executive Officer]

Yes. And it’s always an interesting question for this business, where our customers – if they are producing wafers at the foundry, whether they are also doing test at the foundry. And that depends for 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 staff like an ASC still an Amkor 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 is a really big swing there for us. Having said that, clearly, we want to be in a position where we are qualified and competing for business and supporting all of the major customers in the industry, irrespective of their test model.

[Hans Chung, D.A. Davidson]

Alright. Got it. Thank you.

[Operator]

[Operator Instructions] Our next question comes from the line of David Silver of CL King. Your line is open, David Silver.

[David Silver, CL King]

Yes. 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 minutes. Regarding the cost actions that you are taking here, I am just wondering if you provide any detail on kind of maybe the geographic spread of them? In other words, I am just wondering how much it might be in North America versus in particular, Asia, as you align the cost actions with the anticipated softer revenues? Thank you.

[Shai Shahar, Chief Financial Officer]

Yes. 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.

[David Silver, CL King]

Very good. And then my next question would just be maybe your – if you could share kind of the thinking of some of your major customers, but there is the wave of very large multibillion-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 are experiencing right now? Does that change your major customers thinking about completing those major investments on the original timetables? Thank you.

[Mike Slessor, Chief Executive Officer]

I think there is always a question in this industry of when you bring capacity online. 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, enabling tool sets for our customers, things like lithography, are multiyear – have multiyear lead times. And so I think there is a collective belief among the supply chain and the customer base that this is a cyclical downturn in the industry. Clearly, there are some other factors associated with it, whether they would be U.S.-China trade restrictions or the potential for a recession in 2023. But fundamentally, if you look at the long-term content growth and growth of the industry, we are all in the same position where we are 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 the demand when it comes.

[David Silver, CL King]

That’s great. Thank you very much.

[Mike Slessor, Chief Executive Officer]

Thank you.

[Operator]

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

[Mike Slessor, Chief Executive Officer]

Yes. Thank you everyone for joining us today. We will talk to you again either in January or I think we are doing a couple of conferences as we end the year, if we see you there. Have a great end of the year. Otherwise, we will see you in January. Take care.

[Operator]

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