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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark one)

or

Commission File Number: 000-50307

FORMFACTOR, INC.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (x)  No ( )

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ( )  No (x)

The number of shares of the registrant’s common stock, par value $0.001 per share, outstanding as of July 31, 2003 was 34,255,274 shares.

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FormFactor, Inc.
Form 10-Q for the Quarterly Period Ended June 28, 2003
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PART I.     FINANCIAL INFORMATION

Item 1. Unaudited Condensed Consolidated Financial Statements

FORMFACTOR, INC.
CONDENSED CONSOLIDATED INCOME STATEMENTS
(in thousands, except per share date)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FORMFACTOR, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FORMFACTOR, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FORMFACTOR, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1 – Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements of FormFactor, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 28, 2003 are not necessarily indicative of the results that may be expected for the year ending December 27, 2003, or for any other period. The balance sheet at December 28, 2002 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements and notes should be read with the financial statements and notes thereto for the year ended December 28, 2002 included in the Company’s final prospectus dated June 11, 2003 for its initial public offering filed with the Securities and Exchange Commission.

NOTE 2 – Initial Public Offering

     The Securities and Exchange Commission declared the Company’s first registration statement, which the Company filed on Form S-1 (Registration No. 333-86738) under the Securities Act of 1933 in connection with the initial public offering of its common stock, effective on June 11, 2003. Under this registration statement, the Company registered 6,900,000 shares of its common stock, including 900,000 shares subject to the underwriters’ over-allotment option, with an aggregate public offering price of $96.6 million. The Company registered 6,505,305 of these shares on its behalf and 394,695 of these shares on behalf of certain stockholders of the Company, including a director and certain officers of the Company.

     The Company’s public offering commenced on June 12, 2003 and all of the shares of the Company’s common stock that it registered on its behalf and on behalf of the selling stockholders were sold for the aggregate public offering price of $96.6 million through an underwriting syndicate managed by Morgan Stanley & Co. Incorporated, Lehman Brothers Inc., Banc of America Securities LLC and Thomas Weisel Partners LLC. This offering terminated after the sale of all of the shares of the Company’s common stock that it registered under its registration statement on Form S-1.

     The sale of shares of common stock by the Company, including the sale of 900,000 shares pursuant to the exercise of the over-allotment option by the underwriters, resulted in aggregate gross proceeds of approximately $91.1 million, approximately $6.4 million of which the Company applied to underwriting discounts and commissions and approximately $2.5 million of which the Company applied to related costs. As a result, the Company received approximately $82.2 million of the offering proceeds.

     The sale of shares of common stock by the selling stockholders resulted in aggregate gross proceeds of approximately $5.5 million, approximately $2.7 million of which the selling stockholders paid to the Company to repay loans from the Company and approximately $387,000 of which the selling stockholders applied to underwriting discounts and commissions. As a result, the selling stockholders received approximately $2.4 million of the offering proceeds.

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FORMFACTOR, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)

NOTE 3 – Significant Accounting Policies

     The Company’s significant accounting policies are disclosed in the Company’s final prospectus dated June 11, 2003 for the year ended December 28, 2002. The Company’s significant accounting policies have not materially changed during the three and six months ended June 28, 2003.

NOTE 4 – Inventories

     Inventories are stated at the lower of cost (principally standard cost which approximates actual cost on a first-in, first-out basis) or market value. Reserves for potentially excess and obsolete inventory are made based on management’s analysis of inventory levels and future sales forecasts.

Inventories, net of reserves, consisted of the following (in thousands):

NOTE 5 – Warranty Accrual

     The Company offers warranties on certain products and records a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and the Company’s estimate of the level of future costs. Warranty costs are reflected in the income statement as a cost of revenues. A reconciliation of the changes in the Company’s warranty liability for the six months ended June 28, 2003 follows (in thousands):

NOTE 6 – Stock-Based Compensation

     In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123” (“SFAS No. 148”) which amends FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements were effective for interim periods ending after December 15, 2002.

     The Company uses the intrinsic value method of APB Opinion No. 25 (“APB No. 25”), Accounting for Stock issued to Employees,” in accounting for its employee stock options, and

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FORMFACTOR, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)

presents disclosure of pro forma information required under SFAS No. 123, as amended by SFAS No. 148.

     Had compensation costs been determined based upon the fair value at the grant date, consistent with the methodology prescribed under SFAS No. 123, the Company’s total stock-based compensation cost, pro forma net income and pro forma net income per share, basic and diluted, would have been as follows (in thousands, except per share data):

     The Company has adopted the disclosure only provisions of SFAS No. 123. The Company calculated the fair value of each option on the date of grant using the minimum value method as prescribed by SFAS No. 123. The assumptions used are as follows:

     Since June 12, 2003, the Company includes an expected volatility factor of 67% in addition to the factors described in the preceding table in determination of the fair value of all options granted. Therefore, the pro forma net income and pro forma net income per share may not be representative for future periods.

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FORMFACTOR, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)

     The weighted average estimated fair value of employee stock option grants was $1.40 per share and $1.04 per share for the three months ended June 29, 2002 and June 28, 2003, respectively, and was $1.39 per share and $1.01 per share for the six months ended June 29, 2002 and June 28, 2003, respectively.

NOTE 7 – Net Income per Share

     Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted net income per share is computed giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and redeemable convertible preferred stock.

     A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share follows (in thousands):

     The following outstanding options, common stock subject to repurchase, redeemable convertible preferred stock and warrants were excluded from the computation of diluted net income per share as they had an antidilutive effect (in thousands):

NOTE 8 – Commitments and Contingencies

     From time to time, the Company may be subject to legal proceedings and claims in the ordinary course of business. As of the date of filing this quarterly report, the Company was not involved in any material legal proceedings.

     In May 2003, the Company received a Notice of Violation from the Bay Area Air Quality Management District regarding its record keeping relating to its usage of wipe cleaning solvent. Although the Company introduced corrective action to prevent any continued or recurrent record keeping violation, the Company may still be subject to a penalty based upon the unresolved Notice of Violation. The Company believes that the final resolution of this notice will not have a material impact on the Company’s financial position or on its results of operations.

NOTE 9 – Notes Payable and Bank Line of Credit

In March 2001, the Company entered into a financing agreement with a financial institution which provided for total borrowings up to $16.0 million. The terms of the agreement provide for a revolving line of credit, up to the commitment amount of $12.0 million for working capital requirements and the issuance of letters of credit, an equipment line of credit, which provides borrowings up to $2.0 million, and a term loan of $2.0 million, to be used only to consolidate and refund other existing long-term debt. In February 2003, the agreement was amended to increase the line of credit to $16.0 million. In April 2003, the Company borrowed funds under the line of credit to pay down the amounts outstanding under the expiring term loan and equipment line of credit. On June 28, 2003, the Company had the following amounts available and amounts drawn under this amended agreement (in thousands):

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FORMFACTOR, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(unaudited)

Borrowings under the amended agreement accrue interest based on either the Comerica Bank prime rate or the LIBOR rate plus 2%. The Company has no debt obligations that has not been recorded in the condensed consolidated financial statements.

NOTE 10 – Recent Accounting Pronouncements

     In April 2003, FASB Statement No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”) was issued. SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, and amends certain other existing pronouncements. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, provisions of SFAS No. 149 should be applied prospectively. The Company does not believe that the adoption of SFAS No. 149 will have a material impact on its financial position or on its results of operations.

In May 2003, FASB Statement No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS No. 150”) was issued. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The Company does not believe that the adoption of SFAS No. 150 will have a material impact on its financial position or on its results of operations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward-Looking Statements

     This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Securities Exchange Act of 1934 and the Securities Act of 1933, which are subject to risks, uncertainties and assumptions that are difficult to predict. The forward-looking statements include statements concerning our business strategy (including anticipated trends or developments in the

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semiconductor industry in general and our business in particular), revenues, gross margin, operating expenses, research and development programs, sales and marketing initiatives, and market growth and direction, and competition. In some cases, you can identify these statements by forward-looking words such as “may,” “might,” “will,” “could,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative or plural of these words and other comparable terminology.

     The forward-looking statements are only predictions based on our current expectations and our projections about future events. All forward-looking statements included in this quarterly report are based upon information available to us as of the filing date of this quarterly report, and we assume no obligation to update any of these statements. Actual results could differ materially from those anticipated by the forward-looking statements as a result of many factors, including those identified below in the section titled “Risks That May Affect Future Results” and elsewhere in this quarterly report.

     The following discussion should be read in conjunction with our condensed consolidated financial statements and the accompanying notes contained in this quarterly report. Unless expressly stated or the context otherwise requires, the terms “we,” “our,” “us” and “FormFactor” refer to FormFactor, Inc. and its subsidiaries.

Overview

     We design, develop, manufacture, sell and support precision, high performance advanced semiconductor wafer probe cards. After the fabrication of a semiconductor wafer, the chips on the wafer are subject to wafer probe test. During wafer probe test, a wafer probe card is mounted in a prober, which is in turn connected to a semiconductor tester, and the wafer probe card is used as an interface to electrically connect with and test individual chips on a wafer. At the core of our product offering is our proprietary MicroSpring interconnect technology. Our MicroSpring interconnect technology includes a resilient contact element manufactured at our production facilities in Livermore, California. To date, we have derived our revenues primarily from the sale of wafer probe cards incorporating our MicroSpring interconnect technology. At the core of our product offering is our proprietary MicroSpring interconnect technology. Our MicroSpring interconnect technology includes a resilient contact element manufactured at our production facilities in Livermore, California. To date, we have derived our revenues primarily from the sale of wafer probe cards incorporating our MicroSpring interconnect technology.

     We work closely with our customers to design, develop and manufacture custom wafer probe cards. Each wafer probe card is a custom product that is specific to the chip and wafer designs of the customer. As a result, our revenue growth is driven by the number of new semiconductor designs, technology transitions and increased semiconductor production volumes.

     Revenues. We derive our revenues from product sales, license and development fees and royalties. To date, wafer probe card sales have comprised substantially all of our revenues. Wafer probe card sales accounted for 99.8% of our revenues in the three months ended June 28, 2003 and 99.9% of our revenues for the three months ended June 29, 2002. Revenues from license and development fees and royalties have historically not been significant. Increases in revenues have resulted from increased demand for our existing products, the introduction of new, more complex products and the penetrations of new market segments. Revenues from our customers are subject to both quarterly and annual fluctuations due to design cycles, technology adoption rates and cyclicality of the different end markets into which our customers’ products are sold. We expect that revenues from the sale of wafer probe cards will continue to account for substantially all of our revenues for the foreseeable future.

     Cost of Revenues. Cost of revenues consists primarily of manufacturing materials, payroll and manufacturing-related overhead. Our manufacturing operations rely upon a limited number of suppliers to provide key components and materials for our products, some of which are sole source.

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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 and inventory reserves or write-offs as cost of revenues. We design, manufacture and sell a fully custom product into a market that has been subject to cyclicality and significant demand fluctuations. Wafer probe cards are complex products, custom to a specific chip design and have to be delivered on lead-times shorter than most manufacturers’ cycle times. It is therefore common to start production and to acquire production materials ahead of the receipt of an actual purchase order. Wafer probe cards are manufactured in low volumes, therefore, material purchases are often subject to minimum purchase order quantities in excess of our actual demand. Inventory valuation adjustments for these factors are considered a normal component of cost of revenues.

     Research and Development. Research and development expenses include expenses related to product development, engineering and material costs. All research and development costs are expensed as incurred. We plan to invest a significant amount in research and development activities to develop new technologies for current and new markets and new applications in the future. We expect research and development expenses to increase in absolute dollars, but to decline as a percentage of revenues.

     Selling, General and Administrative. Selling, general and administrative expenses include expenses related to sales, marketing, and administrative personnel; internal and outside sales representatives’ commissions, market research and consulting; and other marketing and sales activities. We expect that selling expenses will increase as revenues increase, and we expect that general and administrative expenses will increase in absolute dollars to support future operations, as well as from the additional costs of being a publicly traded company. We expect selling, general and administrative expenses to decline as a percentage of revenues.

     Stock-Based Compensation. In connection with the grant of stock options to employees in fiscal 2001, 2002 and the six months ended June 28, 2003, we recorded an aggregate of $15.0 million in deferred stock-based compensation. These options are considered compensatory because the fair value of our stock determined for financial reporting purposes is greater than the fair value determined on the date of the grant. As of June 28, 2003, we had an aggregate of $12.5 million of deferred stock-based compensation remaining to be amortized. This deferred stock-based compensation balance will be amortized as follows: $792,000 during the remainder of fiscal 2003; $2.5 million during fiscal 2004; $4.2 million during fiscal 2005; $3.9 million during fiscal 2006 and $1.1 million during fiscal 2007. We are amortizing the deferred stock-based compensation on a straight line basis over the vesting period of the related options, which is generally four years. For options granted to employees to date, the amount of stock-based compensation amortization usually recognized in future periods could decrease if options for which deferred but unvested compensation has been recorded are forfeited.

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     Use of Estimates. Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventories, investments, intangible assets, income taxes, financing operations, warranty obligations, excess component and order cancellation costs, restructuring, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgements about the carrying values of assets and liabilities that are not readily apparent from other sources. For excess component costs, the estimates are dependent on our expected use of such components and the size of the minimum order quantity imposed by the vendor in relation to our inventory requirements. Because this can vary in each situation, actual results may differ from these estimates under different assumptions or conditions.

Results of Operations

     The following table sets forth certain operating data as a percentage of revenues for the periods indicated:

Three Months Ended June 28, 2003 and June 29, 2002

     Revenues. Revenues for the three months ended June 28, 2003 were $22.1 million compared with $18.5 million for the three months ended June 29, 2002, an increase of $3.6 million, or 19.4%. The $3.6 million increase for the quarter was due primarily to an increase of $2.7 million in revenues from sales to manufacturers of flash memory devices and an increase of $1.5 million in revenues from sales

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to DRAM manufacturers, offset in part by a reduction of $292,000 in revenues generated from sales to flipchip logic manufacturers and by a decrease of $325,000 in other revenues.

     The majority of revenues for the three months ended June 28, 2003 were generated by sales of wafer probe cards to manufacturers of DRAM devices. Sales of wafer probe cards to test DRAM devices for the three months ended June 28, 2003 accounted for $13.8 million of revenues compared to $12.4 million for the three months ended June 29, 2002, an increase of 11.3%. The increase in revenues from DRAM manufacturers was driven by an increased demand for wafer probe cards, as our customers began transitioning to 512 megabit devices, 110 nanometer technology and 300 mm wafer sizes.

     Increased design wins at manufacturers of flash memory devices increased our revenues in the market segment for the three months ended June 28, 2003 compared to the three months ended June 29, 2002. Revenues generated from sales to flash memory device manufacturers for the three months ended June 28, 2003 were $4.0 million compared with $1.2 million for the three months ended June 29, 2002.

     Revenues by geographic region for the three months ended June 28, 2003 as a percentage of revenues were 64.8% in North America, 13.1% in Europe, 14.0% in Asia Pacific and 8.1% in Japan. Revenues by geographic region for the three months ended June 29, 2002 as a percentage of revenues were 47.2% in North America, 14.3% in Europe, 32.0% in Asia Pacific and 6.5% in Japan. Revenues for North America include shipments to Asia Pacific customers through their North American subsidiaries. For the three months ended June 28, 2003 revenues for all geographic regions, except Asia Pacific, increased due to strong demand for our product. Revenues for Asia Pacific declined due to decreased demand from one distributor serving this area.

     The following customers accounted for more than 10% of our revenues for the three months ended June 29, 2002 and June 28, 2003: