2023-09-12 16:16:24 ET
Summary
- ON Semiconductor's stock has recently hit its all-time high and the current price is close to my fair value estimations.
- The company's recent earnings release showed flat revenue and EPS, and the upcoming quarter is expected to see a YoY decline in revenue.
- The current environment of economic challenges and geopolitical tensions pose risks to ON Semiconductor's near-term performance.
Investment thesis
M y first thesis about ON Semiconductor ( ON ) aged really well, with a 14% rally since the article went live on June 6, significantly outperforming the broader U.S. market.
Seeking Alpha
The stock price rapidly climbed and is currently trading much closer to fair value. My updated valuation analysis suggests that the stock is still undervalued, but the upside potential is 9%, and is not worth the risks to me. I think a single-digit upside potential does not outweigh the massive uncertainties we see in the current environment. While Onsemi is still a high-quality business with bright long-term prospects, I think that the current unfavorable environment will substantially weigh on the stock price in the next quarter. All in all, I downgraded my rating from "Buy" to "Hold".
Recent developments
Onsemi released its latest quarter's earnings on July 31, when the company topped consensus estimates. Revenue was almost flat YoY with a below one percent growth. The adjusted EPS was also flat, with a mere one-cent decrease.
The upcoming quarter's earnings release is scheduled for October 31. Expected by consensus quarterly revenue of $2.15 billion indicates a slight 2% YoY decrease. The adjusted EPS is forecasted to follow the top line and shrink from $1.45 to $1.35.
While I still have a firm conviction that the company's long-term prospects are bright due to the favorable secular shift to greater digitalization, I am not very optimistic regarding the near term. Revenue dynamics already demonstrate that substantial headwinds are in place since revenue growth has decelerated sharply over the past two quarters, and the upcoming quarter's revenue is expected to decline YoY.
Significant reasons for revenue growth deceleration are on the surface: the high-inflationary environment of 2022 drained consumers' pockets, and the current environment of tightening credit does not strengthen end markets. Interest rates are at their highest in the U.S. , Canada , and the Eurozone over multiple decades. It is not reasonable to expect that end markets will suddenly start demonstrating massive momentum amid this challenging environment. Many of the largest European economies are already in recession, and Jamie Dimon recently warned that risks are also ahead for the U.S. economy.
Another bearish near-term sign to me is the fact that Brent crude oil prices are above $90 per barrel despite the current weak macro environment. And I see more positive near-term catalysts for crude oil than negative. First, the U.S. strategic oil reserve is at its lowest over the last 40 years and it will be replenished sooner or later, which will notably boost demand for oil. Second, we have all seen in recent months that OPEC members are ready to implement aggressive production cuts to support the price. Third, the war between Russia and Ukraine seems to be far from ending meaning that the economic isolation of Russia will also help oil prices to stay high. All these favorable factors for crude oil prices are likely to support it at levels close to or even above $100 per barrel. With oil prices at triple digits, it will be difficult for developed economies to sustain low inflation without long-lasting tight monetary policies. That said, high-interest rates are likely to pressure end markets' demand over multiple quarters.
The good part for ON investors is that the company is profitable with the operating margin consistently above 30% over recent quarters. The balance sheet is strong with more than $2.6 billion in cash as of the latest reporting date. Debt might also look high, but the major part of it is long-term, and the leverage ratio looks prudent as well. Solid short-term liquidity metrics also suggest that the company is well-positioned to stomach the bumpy road ahead.
Seeking Alpha
My long-term outlook for the company is still positive and bullish. While we see harsh temporary headwinds, secular trends are still favorable. Trends for greater digitalization of both households and businesses make semiconductor companies beneficiaries of these shifts. Among semiconductor companies, I like the ones that have diversified offerings to different end-markets which makes them well-positioned to absorb secular tailwinds. An ON is definitely a well-diversified company that targets multiple end markets and applications. The company's solid profitability metrics also enable ON to invest heavily in innovation and continue improving and expanding its offerings to the market.
Valuation update
This year, the stock significantly outperforms the broader U.S. market with a 58% year-to-date rally. Seeking Alpha Quant assigns the stock an average "C" valuation grade, meaning the stock is approximately fairly valued. However, most part of the valuation ratios are substantially higher than the sector median as well as historical averages.
To proceed, I would like to simulate the discounted cash flow [DCF] model. I use a 10% WACC for discounting. I have revenue consensus estimates available up to 2027 and project a 12.2% CAGR for the years beyond. I use a 6.7% TTM FCF margin ex-SBC and expect a yearly one percentage point expansion.
According to my calculations, the current market cap is close to the business's fair value with a single-digit upside potential. That said, the target price is about $105 per share.
Risks update
I think that this year's massive rally makes it very risky to buy the stock now. On July 31 the stock hit its all-time high at about $102, which is very close to my fair value calculations. This is fair, but to me, it is highly unlikely that the stock will move above its all-time high amid decelerating revenue growth and all the unfavorable factors that I have described in the "Recent developments" section.
I would also like to remind readers that ON generates only about 20% of its sales within the U.S., meaning the company faces substantial international trade risks. The current environment of tensioning geopolitical situation between the developed and the developing worlds looks like a significant risk to me. Foreign exchange risk also remains substantial in my opinion.
Bottom line
To conclude, I downgrade my rating for ON Semiconductor to "Hold". While I still believe that Onsemi is a high-quality business well-positioned to absorb multiple secular tailwinds, several unfavorable factors suggest that the near term will be quite a bumpy road. At the same time, the stock price has recently hit its all-time high and is very close to the fair value with a limited upside potential. I think that the current harsh environment is highly likely to pressure the stock price in the near term, which will provide better buying opportunities for investors.
For further details see:
ON Semiconductor: Bumpy Road Ahead (Downgrade)