FormFactor selling for close to cash

FormFactor (FORM.Nasdaq)

Price: $6.45 (9/27/2011)

I was going through a list of net-nets by market cap and stumbled upon FormFactor, what intrigued me about FormFactor was that I noticed looking at the balance sheet that they're selling slightly more than cash value, something rare for an American company. 

What does FormFactor do?

Like many companies currently trading below net current asset value (NCAV) FormFactor is involved in the semiconductor business.  FormFactor designs and manufactures silicon wafer test probes.  The probes are used to test integrated circuits.  The company states that their technology moves wafer burn-in and sort upstream to increase chip yield.  I'm not exactly sure what that means in technical terms but in laymen terms FormFactor builds equipment that improves the chip manufacturing process.

Balance Sheet

The balance sheet is the highlight of FormFactor, they have $324m in cash and marketable securities against $44m in liabilities.  They also have $50m in receivables and inventory, my net-net worksheet is below which gives a great overview of the balance sheet position.

I show the Property Plant and Equipment account on the worksheet but don't include the value as a part of NCAV.

Profitable?

As with many net-net stocks FormFactor isn't profitable and claims to be in the midst of a turnaround plan.   FormFactor violates one of my rules for net-net investing which is that the company needs to be profitable or at least cash flow positive.  FormFactor has been losing money since 2008 and eating into their cash pile, although the cash burn as slowed down recently.

A company's plans for profitability usually consist of two factors, reduced expenses and increased margins.  Usually a good situation is one where a company only needs to focus on one factor to turn operations around, in the case of FormFactor they have problems with both factors.

Reading through a smattering of press releases it seems that management would want investors to believe a turnaround in profitability hinges on revenues, in which part it does, but that's not the whole story.  The company has a gross margin of 21% (most recent quarter) which is up being negative for most of the past two years.  The real problem though is expenses. In the latest quarter SG&A and R&D expenses were double the gross profit.

While costs have come down some since 2009 they haven't come down enough, the company is spending $10m a quarter on R&D.  To operate at break even the company would need to increase revenues by around 20% a quarter or about $40m a year to about $240m.  The company only achieved this revenue number twice in the last ten years in 2006 and 2007 the last two years they were profitable.

To get back to profitability the company either needs to double their gross margin, increase revenues to record levels or make deep cuts in expenses.  I'm not sure of the feasibility of any of these but until one or more is accomplished the company will continue to burn through their cash holdings.

I have attached an imagine of FormFactor's comon-sized income statement from Morningstar.  The graphic really highlights the problems with their margins and how out of control expenses are.

Summary

The issue for an investor considering FormFactor is they need to consider the probability of either revenue increasing rapidly, expenses being cut, or management slowly burning the cash pile trying to accomplish either item.  I don't really know what the most likely option is, but I do know from watching a lot of net-net's that most of the time management will see the cash pile as a bit too tempting and use a portion of it on an acquisition with the idea that an acquisition will turn things around.  Even with the great balance sheet the turnaround risk is real and there isn't enough of a margin of safety for me to invest in FormFactor.

Talk to Nate about FormFactor

Disclosure: No position