FORMFACTOR INC (FORM) FY 2022 MD&A

Item 7:    Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. In

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addition to historical consolidated financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions as described under the “Note Regarding Forward-Looking Statements” that appears earlier in this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated by these forward-looking statements as a result of many factors, including those discussed under “Item 1A: Risk Factors” and elsewhere in this Annual Report on Form 10-K.

Overview

FormFactor, Inc., headquartered in Livermore, California, is a leading provider of essential test and measurement technologies along the full semiconductor product lifecycle - from characterization, modeling, reliability, and design de-bug, to qualification and production test. We provide a broad range of high-performance probe cards, analytical probes, probe stations, metrology systems, thermal systems, and cryogenic systems to both semiconductor companies and scientific institutions. Our products provide electrical and physical information from a variety of semiconductor and electro-optical devices and integrated circuits from early research, through development, to high-volume production. Customers use our products and services to accelerate profitability by optimizing device performance and advancing yield knowledge.

We operate in two reportable segments consisting of the Probe Cards segment and the Systems segment. Sales of our probe cards and analytical probes are included in the Probe Cards segment, while sales of our probe stations, metrology systems, thermal systems and cryogenic systems are included in the Systems segment.

We generated net income of $50.7 million in fiscal 2022 compared to net income of $83.9 million in fiscal 2021 and net income of $78.5 million in fiscal 2020.

The decrease in net income in fiscal 2022 compared to fiscal 2021 was primarily due to decreased revenues, lower margins driven primarily by a less favorable product mix and lower factory utilization, and increased restructuring charges. This was partially offset by a reduction in the amortization of intangibles and in the annual effective tax rate. The first half of fiscal 2022 was strong, realizing net income of $60.1 million with $401.1 million in revenue at 47.0% gross margins. In the second half of fiscal 2022, revenues declined, mainly within the Probe Cards segment, and mix became less favorable, resulting in a net loss of $9.4 million with $346.9 million in revenue at 31.0% gross margins. Despite the decline in total revenues in the second half of fiscal 2022, the Systems segment recognized record revenue levels in the third and fourth quarters of fiscal 2022.

The increase in net income in fiscal 2021 compared to fiscal 2020 was primarily due to increased revenue in both of our reportable segments, partially offset by slightly lower margins driven primarily by a less favorable product mix and a higher effective tax rate due to significant one-time tax benefits during fiscal 2020 that did not recur.

Fiscal Year

We operate on a 52/53 week fiscal year, whereby the fiscal year ends on the last Saturday of December. The fiscal years ended December 31, 2022, December 25, 2021 and December 26, 2020 included 53 weeks (with 14 weeks in the fourth quarter), 52 weeks and 52 weeks, respectively.

Use of Estimates

Preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. Our accounting policies are fundamental to understanding our financial condition and results of operations reported in our financial statements and related disclosures. We have identified the following accounting policies as being critical because they require our management to make particularly difficult, subjective and/or complex judgments about the effect of matters that are

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inherently uncertain. Our management has discussed the development, selection, application and disclosure of these critical accounting policies with the Audit Committee of our Board of Directors.

Inventory Valuation

We state our inventories at the lower of cost (principally standard cost which approximates actual cost on a first in, first out basis) or net realizable value. We regularly assess the value of our inventory and will periodically write down its value for estimated excess inventory and product obsolescence based upon an analysis of existing inventory quantities compared to estimated future consumption. Future consumption is estimated based upon assumptions about how past consumption, recent purchases, backlog and other factors may indicate future consumption. On a quarterly basis, we review existing inventory quantities in comparison to our past consumption, recent purchases, backlog and other factors to determine what inventory quantities, if any, may not be sellable. Based on this analysis, we record an adjustment to the cost basis of inventory when evidence exists that the net realizable value of inventory is lower than its cost, which occurs when we have excess and/or obsolete inventory.

At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Market conditions are subject to change, and demand for our products can fluctuate significantly. Actual consumption of inventories could differ from forecasted demand, and this difference could have a material impact on our gross profit and inventory balances based on additional provisions for excess or obsolete inventories, or a benefit from the sale of inventories previously written down.

Revenue Recognition

Revenue is recognized upon transferring control of products and services, and the amounts recognized reflect the consideration we expect to be entitled to receive in exchange for these products and services. An arrangement may include some or all of the following products and services: probe cards, systems, accessories, engineering services, installation services, service contracts and extended warranty contracts.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. In contracts with multiple performance obligations, we identify each performance obligation and evaluate whether the performance obligation is distinct within the context of the contract at contract inception. Performance obligations that are not distinct at contract inception are combined and accounted for as one unit of account. Generally, the performance obligations in a contract are considered distinct within the context of the contract and are accounted for as separate units of account.

Our products may be customized to our customers’ specifications; however, control of our product is typically transferred to the customer at the point in time the product is either shipped or delivered, depending on the terms of the arrangement, as the criteria for over time recognition is not met. In limited circumstances, substantive acceptance by the customer exists which results in the deferral of revenue until acceptance is formally received from the customer. Judgment may be required in determining if the acceptance clause is substantive. In certain instances control of products is transferred to the customer over time based on performance and in those instances we utilize an appropriate input or output measure to determine to what extent control has transferred to the customer. Judgment may be required in determining an appropriate measure of performance.

Installation services are routinely provided to customers purchasing our systems. Installation services are a distinct performance obligation apart from the systems and are recognized in the period they are performed. Service contracts, which include repair and maintenance service contracts, and extended warranty contracts are also distinct performance obligations and are recognized over the contractual service period, which ranges from one to three years. For these service contracts recognized over time, we use the input measure of days elapsed to measure progress.

A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. In determining the transaction price, we evaluate whether the price is subject to refund or adjustment to determine the net consideration to which we expect to be entitled. We generally do not grant return privileges, except for defective products during the warranty period. Sales incentives and other programs that we may make available to our customers are considered to be a form of variable consideration, which is estimated in determining the contract’s transaction price to be allocated to the performance obligations.

For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation based on its relative stand-alone selling price. The stand-alone selling prices are determined based on observable prices, which are the prices at which we separately sell these products. For items which do not have observable prices, we use our best estimate of the stand-alone selling prices.

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We account for tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction (i.e., sales, use, value added) on a net (excluded from revenue) basis.

Results of Operations

In this section, we discuss the results of our operations for the year ended December 31, 2022 compared to the year ended December 25, 2021. For a discussion of the year ended December 25, 2021 compared to the year ended December 26, 2020, please refer to Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 25, 2021.

The following table sets forth our operating results as a percentage of revenues:

Revenues by Segment

Revenues by Market

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Foundry & Logic — The decrease in Foundry & Logic product revenue in fiscal 2022 compared to fiscal 2021 was driven by the weakening demand from the slowdown in the semiconductor industry that began in the third quarter of fiscal 2022 causing decreased unit sales.

DRAM — The decrease in DRAM product revenues in fiscal 2022 compared to fiscal 2021 was driven by decreased design wins and customer demand, a result of overall DRAM market weakness in fiscal 2022.

Flash — The increase in Flash product revenue in fiscal 2022 compared to fiscal 2021 was driven by increased demand from large multi-national customers.

Systems — The increase in Systems product revenue in fiscal 2022 compared to fiscal 2021 was driven by increased sales of probe stations, metrology systems, and cryogenic systems.

Revenues by Geographic Region

Geographic revenue information is based on the location to which we ship the product. For example, if a certain South Korean customer purchases through their U.S. subsidiary and requests the products to be shipped to an address in South Korea, this sale will be reflected in the revenue for South Korea rather than U.S.

Changes in revenue by geographic region in fiscal 2022 compared to fiscal 2021 were primarily attributable to changes in customer demand and product sales mix.

In October 2022, the United States government imposed new controls, including expanded export license requirements that significantly impacted trade with China for advanced U.S. semiconductor technology sold in China. Although the percentage of revenue to China was relatively stable when comparing fiscal 2022 to fiscal 2021, these restrictions resulted in a decline in expected revenues from shipments to China. Within the Probe Cards segment and Systems segment, respectively, approximately $7.8 million and $1.9 million of expected revenues in the fourth quarter of fiscal 2022 were not recognized as a result of these sanctions, and primarily related to China domestic customers. Although the current impact to our large multi-national customers with operations in China has been minimal, it remains to be seen whether these customers will be able to

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sustain their licenses going forward. We do not anticipate these expanded export license requirements to be relaxed, and expect these regulatory conditions to continue to negatively affect our revenues similarly going forward.

Cost of Revenues and Gross Margins

Cost of revenues consists primarily of manufacturing materials, compensation and benefits, shipping and handling costs, manufacturing-related overhead (including equipment costs, related occupancy, and computer services), warranty adjustments, inventory adjustments (including write-downs for inventory obsolescence), and amortization of certain intangible assets. Our manufacturing operations rely on a limited number of suppliers to provide key components and materials for our products, some of which are a sole source. We order materials and supplies based on backlog and forecasted customer orders. Tooling and setup costs related to changing manufacturing lots at our suppliers are also included in the cost of revenues. We expense all warranty costs, inventory provisions and amortization of certain intangible assets as cost of revenues.

Gross profit and gross margin by segment were as follows (dollars in thousands):

Probe Cards—Gross profit and gross margin in the Probe Cards segment decreased in fiscal 2022 compared to fiscal 2021, primarily due to lower revenues, greater inventory excess and obsolescence reserves, higher net manufacturing spending driven by higher labor and overhead costs, and lower standard margins related to a less favorable product mix.

Systems—Gross profit and gross margin in the Systems segment increased in fiscal 2022 compared to fiscal 2021, primarily as a result of higher revenues and a more favorable product mix, largely related to increased sales of 300mm and 200mm probe stations, and metrology systems.

Corporate and Other—Corporate and Other includes unallocated expenses relating to amortization of intangible assets, inventory, fixed asset, and deferred revenue fair value adjustments due to acquisitions, share-based compensation, and restructuring charges, net, which are not used in evaluating the results of, or in allocating resources to, our reportable segments. The reduction in Corporate and Other in fiscal 2022 compared to fiscal 2021, is primarily due to a reduction in the amortization of intangibles from significant intangibles becoming fully amortized and a reduction in stock-based compensation expense, partially offset by increased restructuring charges arising from a change in estimate of excess and obsolete inventories related to our third quarter of fiscal 2021 plan and the execution of a headcount reduction in the fourth quarter of fiscal 2022 targeted at aligning FormFactor's cost structure with reduced demand levels within the Probe Cards segment by streamlining and improving the efficiency and business effectiveness of our operations.

Overall—Gross profit and gross margin fluctuate with revenue levels, product mix, selling prices, factory loading and material costs. For fiscal 2022 compared to fiscal 2021, gross profit and gross margins have decreased on lower revenue levels, a less favorable Probe Cards segment product mix, increased labor, overhead, inventory excess and obsolescence reserves, and restructuring charges, offset by less amortization of intangible assets.

Stock-based compensation expense included in cost of revenues for fiscal 2022 and 2021 was $3.8 million and $5.2 million, respectively.

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Research and Development

The increase in research and development expenses in fiscal 2022 compared to fiscal 2021 was primarily driven by an increase in headcount which is to support our continued investment in technology leadership. Increased project material costs, general operational costs, annual salary adjustments, restructuring charges, and stock-based compensation also contributed to the increase. These increases were partially offset by lower performance-based compensation. The components of this increase were as follows (in thousands):

Stock-based compensation expense included within research and development in fiscal 2022 and 2021 was $8.2 million and $7.6 million, respectively.

Selling, General and Administrative

The increase in selling, general and administrative expenses in fiscal 2022 compared to fiscal 2021 was primarily driven by higher stock-based compensation, increased travel related costs as restrictions related to COVID-19 relaxed, restructuring charges, and annual salary increases, partially offset by lower performance-based compensation.

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The components of this overall increase were as follows (in thousands):

Stock-based compensation expense included within selling, general and administrative in fiscal 2022 and 2021 was $19.3 million, and $16.6 million, respectively. The increase of stock-based compensation in fiscal 2022 compared to fiscal 2021 was primarily driven by an increase in total awards outstanding, which has increased in recent years consistent with an overall increase in headcount.

Interest Income and Interest Expense

Interest income is earned on our cash, cash equivalents, restricted cash and marketable securities. The increase in interest income in fiscal 2022 compared to fiscal 2021 was attributable to an increase in investment yields due to the higher interest rate environment.

Interest expense primarily includes interest on our term loans, interest rate swap derivative contracts, and term loan issuance costs amortization charges. The decrease in interest expense in fiscal 2022 compared to fiscal 2021 was primarily due to lower outstanding debt balances offset by increased average rates on the outstanding debt.

Other income, net

Other income, net primarily includes the effects of foreign currency impact and various other gains and losses. The increase in other income, net, in fiscal 2022 compared to fiscal 2021 was attributable to a net increase in foreign exchange gains. Foreign exchange gains for fiscal 2022 were $1.1 million.

Provision for income taxes

Provision for income taxes reflects the tax provision on our operations in foreign and U.S. jurisdictions, offset by tax benefits from tax credits and the foreign-derived intangible income (“FDII”) deduction. Our effective tax rate may vary from period to period based on changes in estimated taxable income or loss by jurisdiction, changes to the valuation allowance, changes to U.S. federal, state or foreign tax laws, changes in ASC 718 stock-based compensation expense/benefit, future expansion into areas with varying country, state, and local income tax rates, and deductibility of certain costs and expenses by jurisdiction.

We have utilized our previous net operating loss carryforwards allowing us to benefit from the available FDII deduction, resulting in a decrease from the U.S. statutory rate and, combined with higher R&D tax credits, a decrease from fiscal 2021 of our worldwide effective tax rate for the fiscal year ended December 31, 2022.

As of January 1, 2022, the Tax Cuts and Jobs Act of 2017 eliminated the option to deduct research and experimental expenditures immediately in the year incurred and requires taxpayers to amortize such expenditures attributable to domestic and foreign research over five and fifteen years, respectively. While it is possible that Congress may defer, modify, or repeal this provision, potentially with retroactive effect, we have no assurance that this provision will be deferred, modified, or repealed. An Advanced Manufacturing Investment credit becomes available in 2023 and is a 25% credit for qualified investments in an advanced manufacturing facility. We expect to generate federal tax credits under this program that will both lower our effective

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tax rate in the future and also help to offset the additional cash taxes arising from the change to capitalize research and experimental expenditures described earlier.

Liquidity and Capital Resources

Capital Resources

Our working capital decreased to $324.9 million at December 31, 2022 compared to $375.3 million at December 25, 2021.

Cash and cash equivalents primarily consist of deposits held at banks, money market funds, commercial paper and U.S. agency securities. Marketable securities primarily consist of corporate bonds, U.S. treasuries and agency securities, and commercial paper. We typically invest in highly-rated securities with low probabilities of default. Our investment policy requires investments to be rated single A or better, and limits the types of acceptable investments, issuer concentration and duration of the investment.

Our cash, cash equivalents and marketable securities totaled approximately $238.1 million at December 31, 2022 compared to $276.1 million at December 25, 2021. Based on our historical results of operations, we expect that our cash, cash equivalents, and marketable securities on hand, and the cash we expect to generate from operations, will be sufficient to fund our short-term and long-term liquidity requirements primarily arising from: research and development, capital expenditures, working capital, outstanding commitments, and other liquidity requirements associated with existing operations. However, we cannot be certain that our cash, cash equivalents, and marketable securities on hand, and cash generated from operations, will be available in the future to fund all of our capital and operating requirements. In addition, any future strategic investments and significant acquisitions may require additional cash and capital resources. To the extent necessary, we may consider entering into short and long-term debt obligations, raising cash through a stock issuance, or obtaining new financing facilities, which may not be available on terms favorable to us. If we are unable to obtain sufficient cash or capital to meet our needs on a timely basis and on favorable terms, our business and operations could be materially and adversely affected.

If we are unsuccessful in maintaining or growing our revenues, maintaining or reducing our cost structure, or increasing our available cash through debt or equity financings, our cash, cash equivalents and marketable securities may decline.

We utilize a variety of tax planning and financing strategies in an effort to manage our worldwide cash and deploy funds to locations where they are needed. As part of these strategies, we indefinitely reinvest a portion of our foreign earnings. Should we require additional capital in the United States, we may elect to repatriate indefinitely-reinvested foreign funds or raise capital in the United States.

Cash Flows

Operating Activities

Cash provided by operating activities consists of net income for the period adjusted for certain non-cash items and changes in certain operating assets and liabilities. The $7.6 million decrease in cash provided by operating activities for fiscal 2022, as compared to fiscal 2021, was primarily related to decreased net income, partially offset by relatively less investment in working capital, due primarily to lower accounts receivable and higher accounts payable.

Net cash provided by operating activities in fiscal 2022 was primarily attributable to net income of $50.7 million and net non-cash expenses of $99.2 million, which includes depreciation, amortization, stock-based compensation, and the provision for excess and obsolete inventories. This was partially offset by an increase in net working capital of $18.2 million, primarily related to cash paid for inventories of $28.8 million, decrease in accrued liabilities of $8.0 million, and a reduction in operating lease liabilities of $8.0 million, partially offset by cash provided by a decrease in accounts receivable of $26.0 million.

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Investing Activities

Net cash used in investing activities in fiscal 2022 primarily related to $65.3 million of cash used in the acquisition of property, plant and equipment, $6.1 million used for the purchase of marketable securities, net of maturities, and $3.4 million used for the acquisition of a business.

Financing Activities

Net cash used in financing activities in fiscal 2022 primarily related to $82.3 million used to purchase common stock under our stock repurchase program, $15.7 million used to pay tax withholdings for net share settlements of employee equity awards, and $8.4 million of principal payments made towards the repayment of our term loans, partially offset by $10.5 million of proceeds received from issuances of common stock under our stock incentive plans.

Debt

FRT Term Loan

On October 25, 2019, we entered into a euro denominated $23.4 million, three-year credit facility loan agreement (the “FRT Term Loan”) with HSBC Trinkaus & Burkhardt AG, Germany, to fund the acquisition of FRT GmbH in fiscal 2019.

The FRT Term Loan bore interest at a rate equal to the Euro Interbank Offered Rate (“EURIBOR”) plus 1.75 % per annum and was repaid in quarterly installments of approximately $2.0 million plus interest. We made the final payment on the FRT Term Loan on October 25, 2022. We are no longer subject to the terms of the FRT Term Loan.

Building Term Loan

On June 22, 2020, we entered into an $18.0 million 15-year credit facility loan agreement (the “Building Term Loan”) with MUFG Union Bank, National Association (“Union Bank”). The proceeds of the Building Term Loan were used to purchase a building adjacent to our leased facilities in Livermore, California.

The Building Term Loan bears interest at a rate equal to the applicable LIBOR rate plus 1.75% per annum. Interest payments are payable in monthly installments over a fifteen-year period. The interest rate at December 31, 2022 was 5.87%.

On March 17, 2020, we entered into an interest rate swap agreement with Union Bank to hedge the interest payments on the Building Term Loan for the notional amount of $18.0 million. As future levels of LIBOR over the life of the loan are uncertain, we entered into this interest-rate swap agreement to hedge the exposure in interest rate risks associated with movement in LIBOR rates. By entering into the agreement, we convert a floating rate interest at one-month LIBOR plus 1.75% into a fixed rate interest at 2.75%. The interest rate swap included a 0% floor that was effective for one year from the date of the swap. As of December 31, 2022, the notional amount of the loan that is subject to this interest rate swap is $15.5 million.

The obligations under the Building Term Loan are guaranteed by a deed of trust covering certain real property and improvements and certain personal property used in connection therewith. The deed of trust creates a first priority lien or encumbrance on the property with only such exceptions as may be approved by Union Bank in writing.

The Building Term Loan contains covenants customary for financing of this type. As of December 31, 2022, the balance outstanding pursuant to the Building Term Loan was $15.5 million, and we were in compliance with all covenants under the agreement.

Stock Repurchase Programs

In October 2020, our Board of Directors authorized a program to repurchase up to $50 million of outstanding common stock to offset potential dilution from issuances of common stock under our stock-based compensation programs. This repurchase program replaced the previous repurchase program that expired in February 2020 to purchase up to $25.0 million of outstanding common stock. There was no stock repurchased in fiscal 2020. During fiscal 2021, we repurchased 622,400 shares of common stock for $24.0 million, and, as of December 31, 2022 we had utilized the remaining funds available for repurchase under this program after repurchasing 676,408 shares of common stock for $26.0 million during fiscal 2022.

On May 20, 2022, our Board of Directors authorized an additional program to repurchase up to $75 million of outstanding common stock, also with the primary purpose of offsetting potential dilution from issuance of common stock under our stock-based compensation programs. This share repurchase program will expire on May 20, 2024. During fiscal 2022, we repurchased 1,700,893 shares of common stock for $56.4 million, and as of December 31, 2022 $18.6 million remained available for future repurchases.

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Contractual Obligations and Commitments

The following table summarizes our significant contractual commitments to make future payments in cash under contractual obligations as of December 31, 2022 (in thousands):

(1) Represents our minimum interest payment commitments at 5.87% per annum for the Building Term Loan, excluding the interest rate swap described in Debt, above.

The table above excludes our gross liability for unrecognized tax benefits, which totaled $40.1 million as of December 31, 2022. The timing of any payments which could result from these unrecognized tax benefits will depend upon a number of factors and, accordingly, the timing of payment cannot be estimated.

Indemnification Agreements

We have entered, and may from time to time in the ordinary course of our business enter, into contractual arrangements with third parties that include indemnification obligations. Under these contractual arrangements, we have agreed to defend, indemnify and/or hold the third party harmless from and against certain liabilities. These arrangements include indemnities in favor of customers in the event that our products or services infringe a third party's intellectual property, or cause property damage or other indemnities in favor of our lessors in connection with facility leasehold liabilities that we may cause. In addition, we have entered into indemnification agreements with our directors and certain of our officers, and our bylaws contain indemnification obligations in favor of our directors, officers and agents. These indemnity arrangements may limit the type of the claim, the total amount that we can be required to pay in connection with the indemnification obligation and the time within which an indemnification claim can be made. The duration of the indemnification obligation may vary, and for most arrangements, survives the agreement term and is indefinite. We believe that substantially all of our indemnity arrangements provide either for limitations on the maximum potential future payments we could be obligated to make, or for limitations on the types of claims and damages we could be obligated to indemnify, or both. However, it is not possible to determine or reasonably estimate the maximum potential amount of future payments under these indemnification obligations due to the varying terms of such obligations, a lack of history of prior indemnification claims, the unique facts and circumstances involved in each particular contractual arrangement and in each potential future claim for indemnification, and the contingency of any potential liabilities upon the occurrence of events that are not reasonably determinable. We have not had any material requests for indemnification under these arrangements. We have not recorded any liabilities for these indemnification arrangements on our Consolidated Balance Sheets as of December 31, 2022 or December 25, 2021.

New Accounting Pronouncements

See Note 17, New Accounting Pronouncements, of Notes to Consolidated Financial Statements.