ON - ON Semiconductor: No Demand Destruction For Silicon Carbide (Rating Upgrade)

2023-07-07 12:51:30 ET

Summary

• ON's stock has rallied very optimistically due to the supposed "Bull Run" and growing demand for Silicon Carbide, particularly in the EV and renewable energy end markets.
• Our long-term price target is at $115.76, suggesting a +24.9% upside potential from current levels.
• This is based on ON's premium valuations compared to its peers, likely attributed to the growing backlog through FY2025 and its leadership in the SiC and IGBT segments.
• ON remains a Buy due to the promising electrification cadence through 2030, significantly aided by the management's confidence in achieving controlling market share.
• Then again, there is one caveat to this investment thesis for an improved margin of safety.

ON's Growth Investment Thesis Remains Robust

We previously covered ON Semiconductor Corporation ( ON ) in December 2022, with us concluding with a Hold rating despite the impressive FQ3'22 earnings call, due to the tremendous stock rally of +49.74% rally since the June 2022 bottom and the potential reduced margin of safety at those levels.

The macroeconomic outlook was highly volatile as well, thanks to the peak recessionary fears and the Fed's sustained rate hike then.

However, the ON investment thesis has proven to be more robust than expected, with an expanding non-cancellable backlog through FY2025. Combined with the notable expansion in its gross margins and EPS thus far, we are cautiously re-rating the stock as a Buy.

Author's Rating History

With the stock market already bottoming in December 2022 (in hindsight) and recovering since then, thanks to the generative AI hype, it appears that we have missed out on the party, with the ON stock further rallying to new heights at the time of writing.

There has been no demand destruction for Silicon Carbide as well, with the semiconductor company still reporting a more than healthy inventory level of $1.81B (+12.4% QoQ/ +21.4% YoY) by the latest quarter.

The same has also been observed with other SiC players, such as STMicroelectronics ( STM ) at $2.87B (+11.2% QoQ/ +34.1% YoY), Infineon Technologies ( OTCQX:IFNNY ) at $3.79B (+8% QoQ/ +37.4% YoY), and Wolfspeed ( WOLF ) at $292.9M (+8.7% QoQ/ +31.5% YoY).

This is compared to the relative glut observed in the memory end market such as with Micron ( MU ) at $8.23B (+1.3% QoQ/ +46.4% YoY), and the PC/ gaming end market with Intel ( INTC ) at $12.99B (-1.7% QoQ/ +8.8% YoY), Advanced Micro Devices ( AMD ) at $4.23B (+12.2% QoQ/ +74% YoY), and Nvidia ( NVDA ) at $4.61B (-10.4% QoQ/ +45.8% YoY).

It appears to us that the shift towards electrification may be accelerating indeed, instead of losing momentum during these peak recessionary fears, allowing the ON management to capitalize on the growing demand for SiC, especially in the EV and renewable energy end markets.

These two end markets now comprise an annualized revenue of $6.16B (inline QoQ/ +22% YoY) or the equivalent of 79% (+6 points QoQ/ +14 YoY) by the latest quarter, with a long-term view toward 85% .

EV Adoption Projected To Accelerate Ahead

With EV adoption still at its nascency, somewhat affected by the Fed's rate hike thus far, we believe that ON's dual-pronged strategy may boost its top and bottom line in the long term. The IEA already expects EV sales to comprise ~36% of the vehicle market share by 2030, compared to the previous 2021 projection of 15%.

This is on top of the projected demand in the renewable energy , industrial , and 5G/ Cloud Power ( AI computing end markets ), providing further tailwind to the SiC adoption.

Thanks to this cadence, ON has been able to rationalize its offerings while focusing on the higher margin technologies with improved ASPs, naturally explaining the management's long-term gross margin target of 53%, compared to 2022 levels of 49% and 2019 levels of 35.8%.

While 2023 remains a transitory year, we believe its leadership in the SiC and IGBT space may pay off in the intermediate term, as a vertically integrated product solution provider.

For now, ON remains well capitalized with cash/ short-term investments of $2.72B (-7.4% QoQ/ +62.8% YoY) by the latest quarter, suggesting its excellent liquidity moving forward.

Therefore, investors need not fret about the impacted Free Cash Flow generation of $87.4M (-78.7% QoQ/ -71.3% YoY), due to its increase in its capital expenditure of $321.5M (+84.9% YoY) by the latest quarter, since these are attributed to the management's expedient production ramp in order to meet the growing SiC demand.

So, Is ON Stock A Buy , Sell, or Hold?

ON 5Y EV/ EBIT valuations

Based on ON's NTM EV/ EBIT valuations of 15.75x and the market analysts' FY2025 adj EBIT projection of $7.35 per share, we are looking at a long-term price target of $115.76, suggesting a +24.9% upside potential from current levels, despite the impressive +46.71% rally since our September 2022 buy rating.

Then again, the stock also trades at a notable premium compared to its SiC peers, such as STM at 8.77x and IFNNY at 12.62x. This is despite the former only expected to generate an EBIT expansion at a CAGR of +4.7% through FY2025, compared to STM at +5.9% and IFNNY at +16.8%.

These projections suggest that ON may be trading at a premium, compared to its historical growth at a CAGR of +54.5%, STM at +54.3%, and IFNNY at +34.8% between FY2019 and FY2022.

On the other hand, the bulls may argue that the optimism embedded in ON's valuations is partly attributed to the expanding Long-Term Service Agreements [LTSA] of $17.6B ( +6% QoQ / +104.6% YoY ), at which a "significant portion are firm commitments that are non-cancellable."

It is also important to note that this growing sum excludes the remaining performance obligations for contracts having an original duration of one year or less, with the semiconductor company expected to recognize an additional $5.8B of committed revenues over the next twelve months.

ON 5Y Stock Price

Therefore, with its LTSAs suggesting a fully booked backlog through FY2025, if not FY2026, we are not surprised by the strength of ON's rally thus far, especially aided by the long-term lead times of 42 weeks, compared to the historical 10 weeks.

Due to the "continued supply tightness but strong demand profile ," we are rating the stock as a Buy, especially aided by the management's confidence about achieving controlling market share over the next decade.

Then again, the ON buy rating comes with a caveat that investors patiently wait for a meaningful pullback to its previous support level of between $75 and $87.

While market analysts are already touting about the start of the supposed "bull run," we remain skeptical since Powell's hawkish commentary suggests prolonged inflationary and elevated interest rate pain through 2024.

In addition, ON investors must be aware that there are many players looking to tap on the great electrification cadence, such as STM, IFNNY, WOLF, and Samsung ( SSNLF ), potentially intensifying the market competition for integrated SiC offerings.

Combined with the baked-in premium, the stock may also face a steep sell-off if its backlog growth slows down and/or the management fails to deliver on its projections, triggering drastic losses for investors who add at these peaks. As a result, we believe there may be more attractive entry points for an improved margin of safety.

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