ON Semiconductor Offering An Exciting Growth And Margin Leverage Story

 Hassane El-Khoury is already having a noticeable impact on the business, with good progress already in hand on multiple short-term projects meant to improve margins. Better still, El-Khoury laid out an entirely credible longer-term strategy to “premium-ize” the company’s mix, leverage above-average growth opportunities in higher-value products, and further improve the structural margins of the business.

One of my common refrains is that successful turnarounds can go a lot further than investors initially think, and I think that’s the case here. I do see some risk when the current cycle decelerates (lead times are 2x more above long-term averages), but that would just be some short-term noise. Longer term, I see ON potentially generating $10B in annual revenue with 20%+ FCF margins and an operating margin that could support a 4x or better revenue multiple.

With a strong run in the shares since late July, they’ve now only just exceeded the performance of the SOX index since my last update, though comps like Infineon (OTCQX:IFNNY), STMicro (NYSE:STM), and Texas Instruments (NASDAQ:TXN) have done a bit worse. I see no reason why the shares shouldn’t trade above $50 in the short term, with a high single-digit long-term annualized return potential on estimates that still have room to be exceeded.

 

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ON Semiconductor Offering An Exciting Growth And Margin Leverage Story

ON Semiconductor Highlights The Importance Of Management And Margins

In only about two months, ON Semiconductor (ON) shares have appreciated another 30%, roughly doubling the return of the SOX index. A strong beat-and-raise quarter doesn’t explain the outperformance, as peers/rivals like Infineon (OTCQX:IFNNY), STMicro (STM), and Texas Instruments (TXN) had those too.

I believe the performance of ON shares is testament to just how important management and margins are to investors. While new CEO Hassane El-Khoury hasn’t had the opportunity to conduct a full review (there will be an August analyst day), his initial takes on his plans for ON are pretty much exactly what investors wanted to hear – prioritize higher-margin value-added products, get out of some lower margin businesses, rationalize the manufacturing base, and reinvest in growth.

I said before that I thought a better-run ON could see around nine points of long-term margin improvement. I’m currently modeling a bit less than that, but there’s still room for outperformance and I think ON has a credible line of sight to adjusted FCF margins of 20% or more over time. A lot of this is now in the share price, though, and while I do still believe that the combination of growth ramps (in auto and industrial, especially) and margin expansion is a powerful one, I don’t see the upside I did before.

 

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ON Semiconductor Highlights The Importance Of Management And Margins

New Leadership Enhances ON Semiconductor's Self-Help Story

Leadership matters, and I believe ON Semiconductor (ON) has made a good hire for its CEO position.

There is a lot of work ahead if the company is to deliver meaningfully better margins on a consistent basis, but the new CEO has a positive track record there, and the company’s efforts to upgrade its product/market mix should help. There are still real long-term concerns and challenges, including elevated substitution risk and fierce competition, but I believe the self-help story now has more credibility in the short term.

ON has done a little better than its semiconductor peers since my last update, and semis remain a comparatively hot sector relative to the broader market averages. I do like the cyclical tailwinds that the sector has, as well as prospects for better “value capture”, but I am still concerned about the level of overall valuation. For ON, I think the share price today is pretty fair, but with upside into the mid-$30’s if you believe that operating margins can move into the high teens in 2022/2023.

 

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New Leadership Enhances ON Semiconductor's Self-Help Story

Improving Auto Demand And Increased Likelihood Of Change Driving New Interest In ON Semiconductor

I've had an odd "relationship" with ON Semiconductor (ON) over the years, with management's inability to hit margin targets (and inability to drive margin leverage) and questionable M&A decisions factoring prominently into the negative side. On the other hand, I've always liked the potential of what ON could be under the right circumstances, and the shares have done pretty well since my last two positive write-ups (in a strong market for chip stocks, I'll note).

With the CEO on his way out, I think ON Semiconductor's capacity for change is higher now than ever before, and apparently I'm not the only one who sees upside in a differently-run ON, as Starboard has also gotten involved as an investor. On top of all that, guidance updates from companies including Sensata (ST), STMicro (STM), and NXP (NXPI) have all confirmed an improving environment for the key auto end-market.

At today's price, there's still some upside in ON, but the story is transitioning from undervalued on the basis of what it is to maybe undervalued on the basis of what it can become. Successful turnarounds can unlock a lot of value (often a lot more than seems apparent in the early stages), but I'd be careful about putting the cart too far ahead of the horse, as ON still has a host of significant issues to navigate.

 

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Improving Auto Demand And Increased Likelihood Of Change Driving New Interest In ON Semiconductor

ON Semiconductor Is A Tricky Mix Of Opportunity And Disappointment

There’s a quote I’ve long loved, apocryphally quoted to Dallas Cowboys defense lineman Randy White, that goes “Potential is a fancy French word that means you ain’t done yet!” That’s not entirely fair when it comes to ON Semiconductor (ON), but I don’t think I’m the only investor torn between the possibilities of what higher-value products like image sensors and SiC MOSFETs could do for ON and the historical realities of the company’s performance over the last few years.

Being unable to hit margin targets is a big deal with semiconductor companies, and particularly when there isn’t enough revenue out-growth to compensate. I’m likewise concerned that management is still too optimistic about its near-term prospects and may have more risk on costs and inventories. Countering that, the stock has been thumped again and appears to be trading with more reasonable expectations embedded into the price.

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ON Semiconductor Is A Tricky Mix Of Opportunity And Disappointment

ON Semiconductor's Performance Isn't Pretty, But Better Days Are Ahead

I had a mixed view on ON Semiconductor (ON) back in May, as I thought the shares had some appeal on drops below $20, but that there was also still a lot of risk in the outlook as I felt sell-side analysts were too bullish about a second half recovery. That’s all largely come to pass, as ON has continued to struggle with weaker demand in autos and industrials and high inventories, and sell-side expectations have headed down through the year.

Buying below $20 has worked and I continue to believe it will in the near term. I think the market overdid it with the post-earnings jump, as ON’s guidance wasn’t that good, but I guess Texas Instruments (TXN) reset the bar such that any good news was welcomed. While I still believe there are some potholes on the road directly ahead, I like ON’s long-term leverage to EVs, server/cloud power, factory automation/IoT, and renewable energy. Investors can also consider names like Infineon (OTCQX:IFNNY) and STMicro (STM) for those same reasons, but I believe a fair value in the low-to-mid $20’s is sufficient to warrant consideration.

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ON Semiconductor's Performance Isn't Pretty, But Better Days Are Ahead

Infineon Managing To Weaker Assumptions About The Chip Recovery Cycle

With Infineon (OTCQX:IFNNY) being one of the rare semiconductor companies to challenge the rally in chip stocks by pointing to a lower, slower recovery, it’s not surprising that these shares have lagged the SOX this year, not to mention peers like ON Semiconductor (ON) and STMicro (STM). Japan’s Renesas Electronics (OTCPK:RNECY) has been down in the doldrums with Infineon, but then there are some pretty serious margin (and possibly market share) issues at that large MCU player.

At this point, it’s just too soon to tell whether what’s going on at Infineon is an issue of company-specific end-market/customer mix, market share shifts, or a more aggressive approach to dealing with inventory and demand challenges. Given the relative valuations and recent performance trends, I’d probably list my preference order as STM, ON, Infineon, Renesas, but Renesas has a lot of upside if they get back on track, ON has more inventory risk, and Infineon may prove to be managing this downturn the best when it’s all said and done.

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Infineon Managing To Weaker Assumptions About The Chip Recovery Cycle

ON Semiconductor Not Out Of The Woods Yet

I’ve been bullish on ON Semiconductor (ON) for a while, but I thought the shares were a little ahead of themselves back in February, particularly given what I thought were risks that semiconductor companies would see a longer correction process from record high lead times and less growth in 2019. While semiconductor stocks as a whole have continued their upward march (despite some iffier reports), ON shares have underperformed since mid-February, falling slightly against a 15% increase for chip stocks in general and more modest performances from fellow power peers like Infineon (OTCQX:IFNNY), STMicro (STM), and Texas Instruments (TXN).

I’m still concerned about full year expectations for 2019, particularly with record high inventory and what I think will be a weaker second half economy than commonly expected now. Longer term, I still like ON and I think fair value is in the low-to-mid $20’s. Although I hesitate to recommend these shares without reservation because I think there could be a market correction that takes the shares back to around $20, investors who less inclined to try to time the market and/or willing to hold longer term can certainly consider this name today.

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ON Semiconductor Not Out Of The Woods Yet

STMicroelectronics Still Counting On A Big Finish To 2019

When I last wrote about STMicroelectronics (STM), I cautioned against trying to get too cute about timing a bottom for this leading chip company, particularly when the shares looked undervalued even on the assumption of a tougher 2019. The shares have since risen another 15% or so, lagging a broader chip market rally that has surprised me in its intensity.

I continue to like STM, though perhaps not quite as much as before given the rising valuation, and I like the company’s broad leadership across microcontrollers, PMICs, sensors, MEMS, silicon carbide, and so on, as well as the diverse market exposure to attractive markets like autos, industrial, IoT, and imaging. Although I am still concerned that the big second half rebound that so many chip companies are counting on may disappoint, I still think STM is a stock worth buying and owning today.

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STMicroelectronics Still Counting On A Big Finish To 2019

The Market Seems To Be Counting On A Quick Rebound At Maxim Integrated

There are a lot of meaningful positives with Maxim Integrated (MXIM). Not only has this company successfully transitioned to a more attractive end-market mix driven by auto electrification and factory automation, the company has also meaningfully upgraded its profitability by pruning lower-return businesses, bringing more distributors into the mix, and outsourcing more production. With strong margins, above-average growth potential, and a strong business anchored in power management and interface ICs, I believe Maxim can do well on its own and/or become an attractive acquisition target.

All that said, there are limits to what I’ll pay and Maxim is trading beyond those limits. Recent results and guidance should serve as a reminder that Maxim’s better mix doesn’t immunize it from macro challenges, and I am concerned that investors have gotten too cavalier about assuming a quick return to growth across the chip sector. In the $50’s, Maxim just looks too expensive to me relative to the risks of further setbacks/revisions in the sector.

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The Market Seems To Be Counting On A Quick Rebound At Maxim Integrated

Content And Share Gain Expectations Driving Outperformance At ON Semi

I really can’t complain about ON Semiconductor’s (ON) performance since my last update, as the shares have dramatically outperformed the semiconductor rally and risen by more than a third. While power management companies (including ON, Infineon (OTCQX:IFNNY), and STMicro (STM) ) have done a little better with respect to performance and guidance than others like Texas Instruments (TXN), Maxim (MXIM), and NXP (NXPI), it seems like ON in particular has regained investor interest on the back of solid wins, improving bookings, and management’s confidence that revenue will grow in 2019.

I still like ON shares, but not as much as I did back in December. The semiconductor sector as a whole has a lot riding in terms of guidance on a second half rebound and I think it may be premature to just rule out another round of guidance cuts due to weaker conditions in China (autos and manufacturing) and emerging weakness in Europe (Germany and Italy). I think ON shares should now be trading closer to the mid-$20’s, but it may make sense to let things simmer down a bit first.

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Content And Share Gain Expectations Driving Outperformance At ON Semi

Guidance From STMicroelectronics Suggests A Stronger Second Half Than Many Expected

For better or worse, short-term stock price performance is mostly a game of expectations, and expectations going into this reporting cycle were for semiconductor companies to lower guidance for the first quarter. While Xilinx (XLNX) was a notable exception, that expectation has held true conceptually, with Texas Instruments (TXN), Intel (INTC), and STMicroelectronics (STM) all guiding down, but the magnitude of the revisions seem to be less severe than feared.

Specific to STM, I’m still bullish on these shares even after a double-digit pop post-earnings. The market is still not sold that the company’s cost structure and operating philosophy have really changed such that a downturn won’t hammer margins, and I believe that there is still room for the company to surprise. Although I’m a little concerned that management’s full-year targets for 2019 are aggressive and that the sector could see a second cut to numbers in three months, I like these shares below the high teens.

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Guidance From STMicroelectronics Suggests A Stronger Second Half Than Many Expected

Infineon's Rich Content-Growth Mix Going Up Against A Tougher Chip Cycle

With high lead times leading the Street to expect serious inventory corrections and disruptions to sales and orders, leading power management semiconductor companies like Infineon (OTCQX:IFNNY), STMicroelectronics (STM), and ON Semiconductor (ON) have underperformed a weakening semiconductor sector over the past year. Although end markets like electric vehicles, wireless charging, and industrial automation continue to grow (and likely will continue to grow in 2019), lead times are still very high and Infineon is investing considerable resources to support future demand, pressuring free cash flow, and margins in the near term.

Infineon will see significant competition from STMicroelectronics and ON in key areas like auto power semiconductors, but there's likely to be significant underlying demand over the next 10 to 15 years. Infineon is, likewise, well-placed to benefit from the "inverterization" of home appliances, growth in factory automation, and growth opportunities in data centers and 5G wireless. I am worried that the semiconductor down-cycle could be worse than currently expected, but the shares are already discounting a lot and I do see upside from here.

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Infineon's Rich Content-Growth Mix Going Up Against A Tougher Chip Cycle

STMicroelectronics Discounting A Truly Scary Semiconductor Cycle

I suppose that relative to the perpetually optimistic sell-side, I’m bearish on the semiconductor sector over the next 12-24 months, but I believe the share price of STMicroelectronics (STM) (or “STM”) is now pricing in a truly frightening level of pessimism about the near-term outlook for the industry. STM will certainly face stiff competition from companies like Infineon (OTCQX:IFNNY), ON Semiconductor (ON), Renesas (OTCPK:RNECY), Cypress (CY), and NXP Semiconductors (NXPI) in the coming years, but I believe the company’s strong position in MCU, power management, and sensing is being underrated now, not to mention the possibility for future volume-driven margin gains.

I think STMicroelectronics should be more fairly valued in the range of $17.50 to $21.50, a wide range to be sure, but one reflects the consistent gap between longer-term adjusted discounted free cash flow (which tends to produce lower targets) and the short-term multiples-based approaches that are typically more commonly-used on the Street.

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STMicroelectronics Discounting A Truly Scary Semiconductor Cycle

Cypress Semiconductor's Value Obscured By A Growing Wall Of Worry

Given the roughly 15% drop in the SOX over the past six months, it’s not too hard to find chip stocks that look more reasonably-valued, if not cheap, these days. The catch, though, is how well current expectations factor in the numerous risks that seem to be mounting early in 2019 – shrinking lead-times, weakening auto and industrial markets, weakening memory pricing, and so on. Although I do like the business mix at Cypress (CY), and I believe the company is well-placed to gain share in the auto and IoT markets in the years to come, weaker near-term conditions are definitely a risk and I think it will take some time before a margin-driven mid-to-high teens fair value gains any real traction in the market.

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Cypress Semiconductor's Value Obscured By A Growing Wall Of Worry

ON Semiconductor Feeling The Heat From The Street

That companies like ON Semiconductor (ON) will survive the next phase of the semiconductor cycle is not in doubt to me, but what this corrective phase will look like is still very much up for debate. It’s not unreasonable to think that the adjustment from recent record highs in lead-times will lead to a more painful cycle than that seen in 2015, but then there are secular growth drivers helping ON Semiconductor that I’m not going to just dismiss out of hand.

When I last wrote about ON I said “…but the risk of near-term turbulence is something to consider …”, but I didn’t really think the shares would drop by roughly one-third in just a few months. Certainly the sector-wide declines in semiconductor stocks are being driven more by fear and momentum than truly horrible conditions (and/or outlooks), but that doesn’t make the losses sting any less. Moreover, with no real end in sight to the trade dispute between the U.S. and China, it’s tough to know whether the industry can manage a graceful dismount from the record lead-times as demand slows in markets like auto, handsets, data centers, and industrial.

I think the valuation is still quite interesting for long-term investors, but I also think the near-term still holds outsized risks. While the shares should be trading at least in the low $20’s, sentiment is poor now and semi stocks are likely to stay in the doghouse through at least the middle of 2019.

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ON Semiconductor Feeling The Heat From The Street

Infineon Facing Near-Term Ordering Risks, But Attractive Long-Term Growth Opportunities

These are interesting times for the semiconductor industry. End-market demand is still pretty healthy, and with many suppliers at or near capacity, lead times have lengthened and double-ordering has become more commonplace. That's a threat to companies like Infineon (OTCQX:IFNNY) (IFXGn.XE), ON Semiconductor (ON), and STMicroelectronics (STM), as the industry has struggled in the past to exit gracefully from periods of extended lead times and deal with what is often an over-capacity situation in the immediate aftermath.

I do believe the near-term outlook for Infineon has some risks to it (and I would say the same for ON, STM, and Renesas (OTCPK:RNECY)), but I like the company's long-term growth opportunities in areas like auto, factory automation, renewables, and appliances, as it leverages its very strong position in power and looks to grow share in microcontrollers (or MCUs).

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Infineon Facing Near-Term Ordering Risks, But Attractive Long-Term Growth Opportunities

Lead Times Are A Risk, But ON Semiconductor Seems Undervalued

Can I really complain about the performance of ON Semiconductor (ON) over the past three months or on year-to-date basis when the shares are up 50% over the past year and have thumped not only the SOX, but peers like Texas Instruments (TXN), Infineon (OTCQX:IFNNY), and STMicrolectronics (STM)? Even so, these shares haven’t done so well lately, and I believe that’s largely due to concerns that rising lead times are signaling some weak orders and weaker revenue in the not-so-distant future.

Maybe this time will be different and the industry will navigate back to more normal lead times without major order/revenue disruptions. I don’t like to count on “maybe it will be different”, though, and the awful performance of Renesas (OTCPK:RNECY) highlights how unforgiving the market can be when companies go through an “adjustment phase”. ON Semiconductor shares do look undervalued and I do like the company’s long-term position in markets like auto and industrial and parts of communications and computing, but the risk of near-term turbulence is something to consider if you’re the type of investor who hates short-term pain in the pursuit of long-term gain.

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Lead Times Are A Risk, But ON Semiconductor Seems Undervalued

Integrated Device Technology Managing To Stay Ahead Of Expectations

Since my first write-up on the company for Seeking Alpha in September of 2017, Integrated Device Technology (IDTI) (or "Integrated Device") has done alright. The shares are up about 30% since then, outdoing the SOX by about 10%, more or less matching ON Semiconductor (ON), beating Silicon Labs (SLAB) by a bit, and handily outperforming Broadcom (AVGO) over that time. Better still, management has delivered performance that suggests that major drivers like server memory interfaces, wireless charging, and sensors, can, in fact, lead to significantly higher revenue and margins in the year to come.

Not surprisingly given the performance, the valuation argument is more of a stretch today. Trading at around 5x forward revenue, I'd argue the price today is a pretty reasonable reflection of the growth and margin potential at IDTI, but I also happily acknowledge that IDTI offers more near-term year-over-year growth potential than many other chip names and investors will flock to (and pay for) exceptional growth opportunities.

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Integrated Device Technology Managing To Stay Ahead Of Expectations

Power Integrations' Revenue Re-Acceleration Looking More Like A 2019 Event

All you need to be a successful semiconductor loved by investors is perpetual double-digit revenue growth, 60%-plus gross margins, 30%-plus operating margins, a rich buyback, expanding end-markets, and optionality on both ends of the M&A spectrum. See? Simple.

Sarcasm aside, Power Integrations (POWI) has been in a tougher spot recently, with the company missing a few times on the top line and lowering guidance. A slowdown in smartphones and communications and delays in other programs has pushed revenue growth down from the double-digits, and the margins remain sub-optimal. Add in a relatively robust valuation, and I’m not too surprised that the shares have lagged the SOX by a significant degree since my last update, not to mention underperforming peers/rivals like ON Semiconductor (ON). With the shares already pricing in a return to double-digit revenue and a mid-20%’s operating margin, it’s tough for me to see a compelling risk-adjusted opportunity here.

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Power Integrations' Revenue Re-Acceleration Looking More Like A 2019 Event