2023-10-16 17:00:38 ET
Summary
- ON Semiconductor is well-positioned to profit from the growing electrification transition in the automotive market, with a focus on silicon carbide (SiC) power circuits.
- The SiC segment is expected to grow at 2x the pace of the overall market, and ON aims to capture 40% market share by 2027.
- A growing chunk of SiC based LTSAs (Long-term Strategic Agreements) offer added benefits.
- Despite the enticing SiC narrative, we remain conflicted about kick-starting a long position in the stock at this juncture.
The SiC Impetus
We particularly like ON Semiconductor ( ON ) because it is well-positioned to profit from the growing electrification transition in the automotive market, which incidentally is its top focus market, besides the industrial market.
To be more specific, we like ON's ongoing thrust in deepening its silicon carbide (SiC) power circuit expertise (in, a market which is poised to witness around mid-teens CAGR demand, through the end of the decade. Because of the relative efficiency that they offer at high voltages, one could see SiC semiconductors come to the fore, as EVs increasingly transition from 400V to 800-V battery systems over time. Basically, Yole Group believes that the SiC segment will likely grow at twice the pace of the overall market through FY27.
ON is basically looking to garner 40% market share in this segment by 2027 and has been making a series of brownfield investments that will help attain their targets at a quicker pace. Management is also keen to reiterate that by going down this route, rather than the greenfield route they could potentially generate savings of 40%.
All in all, as things stand, the SiC portfolio has already proven to be a highflyer of sorts, with this segment growing at 400% YoY, and hardly a breath away from hitting $1bn of sales.
What we also like here is how the SiC-oriented sales mix is also leaving a mark on the overall texture of the group topline. From being a transactional-based entity, whose sales are largely oriented towards distributors ( 58% as of last year's sales mix), ON is now increasingly getting into SiC-based long-term strategic agreements ((LTSA)) which certainly helps de-risk the business model (in Q2 alone, the company signed $3bn of new silicon carbide based LTSAs, taking the lifetime total to $11bn) by way of better revenue visibility. Going forward, through the next 12 months, management expects over $6bn of revenue to come through just from these LTSAs alone.
Other benefits of these LTSAs are that they generally involve minimum purchase commitments, so ON can also make better budgeting and planning decisions over time. The company is also abetted by certain co-investments made by the partner over specified periods which means the CAPEX committed will likely be lower than what ON would normally have to incur under the traditional transactional model. All in all, as LTSAs take up a greater chunk of the sales mix, one can be reasonably hopeful that ON's return on invested capital ((ROIC)) which has plateaued in recent years could start tending higher again.
Closing Thoughts - Is ON A Good Buy Now?
Even though there's a lot to appreciate about ON's strategic positioning, we feel a bit ambivalent about kick-starting a long position in the stock. Here are a few things influencing our mixed stance.
ON's standalone weekly price imprints over the last 20 months tell us that what we have is an ascending channel, with the price largely respecting the two boundaries across this duration, except during late July, when it looked a tad overextended, trading above the upper boundary. That didn't last for too long, and now we've seen a pullback to the lower boundary of the channel, offering an attractive reward-to-risk equation, for those looking to trade within the channel boundaries.
However, if one widens their perspective beyond the channel alone, it is worth considering that we currently have an intermediate downtrend in place with a series of lower lows, and lower highs, since August. Given this ongoing weakness, the share price could certainly do with a step-up in share buybacks (note that ON currently has a $3bn sized buyback program underway, which translates to ~7-8% of the market cap), the pace of which has been sliding over the past year (down by 35% over the past year).
This is largely driven by the fact that FCF generation has come off in recent quarters (down by 105% over the past year). Whilst weakness on the FCF front may abate in H2, it is difficult to imagine a marked improvement, given that ON's capital intensity is likely to be quite elevated for a while, particularly as they step up capital investments in the Silicon Carbide field. For context, in Q2, the capital intensity was 21% , whereas in FY22 it was 12% and their long-term goal is to get it to 11%. On the Q2 call, management stated that they believe the ratio will likely come in at the mid-to-high-teens for "the next several quarters", so don't expect any bumper FCF numbers any time soon.
Nonetheless, one encouraging development for the share price is that the ferocity of insider selling that we saw at the turn of H2 seems to have stopped. August and September saw a markedly lower cadence of aggregate insider sales (relative to July), whilst there hasn't been any selling whatsoever in October.
Besides that, also note that after some pretty strong exits from the smart money segment between June and August 2023, there appears to be some stability in the net shares owned by them, over the last couple of months. Yes, they are not yet emboldened enough to buy, and without the purchasing support of this cohort, it may be difficult for ON to generate strong bullish momentum.
This, in some part, could be dictated by the fact that ON still appears to be a very pricey proposition, even if one accounts for the solid earnings growth that will likely come through over the next few years.
Based on consensus estimates for FY24, ON is currently priced at a forward P/E of 15.6x, which translates to an exorbitant premium of 50% over the stock's 5-year average multiple. Yes, we can appreciate that there could be a degree of re-rating in the multiple given the recent impetus by ON to deepen its positioning in high-growth avenues, but still, a 50% premium still comes across as too elevated for our liking.
One could perhaps also have been more enthused if one was getting a forward PEG (Price to earnings growth) ratio of less than 1x, but that is not quite the case. YCharts estimates point to a CAGR of 14% through FY24, resulting in a PEG ratio of 1.11x.
Finally, it's also worth pondering if ON could benefit from some rotation momentum within the semiconductor universe. Well, the chart below suggests ON wouldn't be the most optimal bet as its relative strength as a function of the wider semi-universe is still trading well above the mid-point of the two-decade-old range.
To close, we believe a HOLD rating on ON Semiconductor feels more fitting at this juncture.
For further details see:
ON Semiconductor: Enticing SiC Story, But Ambivalent About The Stock