ON Semiconductor has been hit by falling sales to auto makers and sluggish sales of its industrial chips. That's about to change -- and its earnings picture looks bright. By Jacob Sonenshine
Chip stocks have been hot, but ON Semiconductor has not. That may be about to change.
The $31 billion Scottsdale, Ariz.--based chip maker hasn't had an easy time lately. Its customers are mainly auto makers and manufacturers, which have been struggling even as demand for artificial-intelligence chips has increased. ON Semi stock has dropped 31% to $72 from its record high on July 28, 2023, while the S&P 500 index has gained 29% over the same period.
But ON's moment may finally have arrived. Car makers could see a pickup in demand following a couple of years of lackluster sales. Demand should be helped by Federal Reserve interest-rate cuts, which provide a tailwind for economic growth, while Donald Trump's election could provide a boost as well. ON Semi may not be Nvidia or even an AI play, but the stock now looks like a buy.
"ON Semi [is] a strong candidate for outperformance once demand rebounds, " writes Charter Equity Research analyst Jack Egan.
For ON, the problem starts with its semiconductors for cars, which make up a little more than half of its total revenue. Sales of auto chips fell to $907 million in the second quarter of this year, down 21% from a peak of $1.16 billion in the third quarter of last year. Following Covid-19 lockdowns, auto makers, fearing a shortage, rushed to buy semiconductors. Now they have too many, especially with car production stagnant, and companies like Ford Motor and General Motors are buying fewer chips, says Morningstar analyst William Kerwin. The weakness, combined with a sluggish market for industrial chips, pushed ON's gross profit margins down to 45% from 47.3% in the third quarter of 2023, causing earnings to fall 31%.
The good news is that those pressures appear to be in the past -- and they should stay there. The economic backdrop should get a boost from the Fed and other central banks cutting interest rates, while Trump's victory could help the economy and the car business overall, though it could slow electric-vehicle sales, an important business for ON. But even that might be less of a worry than investors fear. "The world is going to come to EVs, and none of the car makers are abandoning EV plans, " says Piper Sandler analyst Harsh Kumar.
As auto makers see strengthening demand, they'll order more chips to produce more vehicles. That could lead to year-over-year growth in the number of chips ON sells, and lift semi prices because it takes time for semiconductor makers to ramp up their supply. There are early signs of improvement. In the third quarter, ON Semi's auto sales rose 4.9% to $951 million from that awful second quarter, while margins increased half a percentage point to 45.5%. That suggests that ON has gotten through the worst. "There is an element of chip ordering that's like flipping a light switch," says B. Riley Securities analyst Craig Ellis.
An auto recovery would go a long way toward fixing what ails ON, especially if the growth is matched with a rebound in other sectors. Its industrial revenue is expected to grow by 6% annually over the next three years as manufacturers increasingly use automation to make equipment, driving demand for more chips.
All told, analysts expect total revenue to grow by 10% to about $9 billion by 2027, a record that is achievable, given that there are only a few companies focused on the silicon-carbide auto chips ON sells. The company's only larger competitor is STMicroelectronics, which generates just over $1 billion in silicon-carbide chip sales each year.
That sales growth should be matched with improvements in efficiency. Last year, ON purchased GlobalFoundries' East Fishkill, N.Y., plant. This facility can produce more chips but at a similar cost to ON's other plants, which will help drive costs down. Other costs -- such as research and employee pay -- are expected to rise more slowly than sales, as the company doesn't need to go on a hiring binge. That should help it reach its target of 53% gross margins, which it reiterated on its third-quarter earnings presentation, though it didn't specify for which year.
Management also has more than $1 billion in free cash flow, and it plans to use half of each quarter's cash flow to repurchase shares. Together with its likely sales growth and improving profitability, analysts expect earnings per share to grow by 21% annually to $7.11 by 2027, according to FactSet, from $4.01 this year. Those estimates could be low if the auto business recovers more quickly than expected. "At this point, there's more risk to the upside," says Charter's Egan.
Nor does the stock look expensive. It currently trades at 17 times 12-month forward earnings, well below the S&P 500's 22 and the average chip stock's 23.8. Even holding the multiple steady would bring the stock to about $112 by the end of 2026, for a 25% annualized gain from today.
That makes ON Semi stock one to jump on for long-term investors.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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November 08, 2024 21:30 ET (02:30 GMT)
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