ON Semiconductor: A Hidden Gem in the Chip Market

Understanding the Current Landscape

In the ever-evolving semiconductor industry, recent trends have ignited interest in certain stocks. Among these are ON Semiconductor, a $31 billion chip maker based in Scottsdale, Arizona. Despite the burgeoning demands in artificial intelligence (AI) chip markets and the overall heat in chip stocks, ON Semiconductor has struggled to realize the same attention and market performance. As the company navigates a difficult landscape, analysts suggest that conditions may finally be ripe for a resurgence in its stock value.

A Challenging Year for ON Semiconductor

ON Semiconductor’s stock price has declined 31%, falling from a record high of $72 on July 28, 2023. In stark contrast, the S&P 500 index has witnessed a 29% gain during the same period, indicating a notable lagging performance. The culprit behind ON’s woes can be traced to its significant reliance on the automotive sector, which contributes over half of its total revenue. During the second quarter of 2023, ON’s revenue from automotive chips plummeted to $907 million—down by 21% from its peak of $1.16 billion in the previous third quarter. The car manufacturing industry has been grappling with stagnant production rates, leading to overstocked semiconductor inventory and reduced orders from major players like Ford Motor and General Motors.

Macro Trends Favoring a Turnaround

Despite these setbacks, analysts indicate a shift in trends that could invigorate ON’s business prospects. The Federal Reserve’s potential interest rate cuts are anticipated to have a positive effect on economic growth, creating a conducive environment for increased vehicle sales. Moreover, the potential victory of Donald Trump in the upcoming elections could further stimulate both the economy and the automotive sector, although it may simultaneously impact electric vehicle (EV) sales, a market segment critical to ON’s future.

Analyst Harsh Kumar from Piper Sandler believes that the transition to EVs is unstoppable, signifying a continued commitment from automakers to place orders for new semiconductor products, including traditional and silicon-carbide chips produced by ON Semiconductor.

Signs of Recovery in the Automotive Sector

Recent data offers promising insights regarding the automotive sector’s trajectory. In the third quarter, ON Semi experienced a 4.9% increase in auto sales, rebounding to $951 million from the lows of the second quarter. This uptick indicates a gradual recovery and the possibility of a more profound turnaround as demand strengthens. Furthermore, the company’s gross profit margins expanded slightly to 45.5%, suggesting that operational efficiencies are beginning to yield positive outcomes.

Anticipated Revenue Growth

If the automotive sector continues on this upward trend, ON Semiconductor is positioned to benefit from a broader market recovery. The industrial segment, too, is projected to grow—up by 6% annually over the next three years—as manufacturing increasingly incorporates automation, thereby driving further demand for semiconductors.

A consensus among analysts anticipates that ON Semiconductor’s total revenue could rise by 10%, reaching approximately $9 billion by 2027. This estimate appears reasonable when considering ON’s competitive edge in silicon-carbide automotive chips, a niche currently dominated only by STMicroelectronics, which generates about $1 billion in chip sales annually.

Strategic Acquisitions and Future Profitability

In addition to potential revenue increases from stronger sales, ON Semiconductor’s efficiency may be bolstered by recent strategic acquisitions. The purchase of GlobalFoundries’ East Fishkill plant allows ON to increase chip production without significant cost increases. This facility is expected to optimize operational efficiency and aid in achieving the company’s target gross margins of 53%—a goal reiterated during the third-quarter earnings call.

Moreover, with over $1 billion in free cash flow, ON’s management plans to allocate half of each quarter’s cash toward share repurchases. This fiscal prudence, paired with anticipated growth and improving profit margins, aligns with projections suggesting a 21% annual growth in earnings per share, potentially reaching $7.11 by 2027.

A Value Proposition

From a valuation standpoint, ON Semiconductor currently trades at 17 times its 12-month forward earnings—a figure that falls below the broader S&P 500 average of 22 and the average chip stock valuation of 23.8. This discrepancy signals an attractive entry point for investors seeking long-term value, hinting at a potential stock price of approximately $112 by the end of 2026, translating to a favorable annualized return of 25%.

Conclusion

In summary, while ON Semiconductor may not be the flashiest name in the semiconductor industry, its fundamental strengths and positioning within the automotive recovery propose a strong investment case. With optimal conditions on the horizon, ON appears to be a prudent buy for investors looking to capitalize on the forthcoming demand for automotive chips and beyond. As macroeconomic indicators point toward improvement, ON’s relevance and value could well be poised for a significant upswing.