2023-10-31 16:33:59 ET
Summary
- Onsemi's share price dropped 20% after reporting lower guidance, presenting a buying opportunity for long-term investors.
- Q3 sales were slightly above estimates, with strong growth in the automotive revenue segment.
- The company's long-term outlook remains intact, and the management is focused on improving margins and streamlining operations.
Investment Thesis
Onsemi (ON) reported lower guidance than anticipated, which led to the company's 20% share price plummet as of writing this article. I covered the stock in June of this year where I said that the risk/reward is not ideal currently and a pullback would make it more attractive. Fast forward to today and the company is trading at my price target. Since the long-term is still intact, I am upgrading the company to a buy and initiated a small position as of October 30th.
Briefly on the Earnings
So, the company reported results and the guidance missed analysts' estimates. I wasn't surprised by these results, and I didn't expect anything major from them due to the fact that the semiconductor sector has been underperforming and many companies that I've covered in the past have expected soft results for the next couple of quarters more. I don't mind the overreaction that the share price experienced because I was able to open a small position and will average down further if it keeps dropping more, which I think is very likely due to the macroeconomic headwinds and the overall negative sentiment of the industry.
Q3 sales came in a tad over analysts' estimates ($2.18B vs $2.15B estimates). These results are very similar to the same quarter last year, basically flat (-.5%), and around 4% higher sequentially. Gross margins have stayed pretty much flat sequentially and 100bps down y/y while operating margins massively improved y/y in terms of GAAP. Some margin inefficiencies can still be attributed to the East Fishkill running on higher costs, as I mentioned back in June in my previous article .
GAAP EPS is flat sequentially but an 84% increase y/y, which is amazing in my opinion.
Q3 results (Investor relations)
The company's automotive revenue segment has seen tremendous growth even in this climate ( 33% growth y/y and 9% sequentially as the management mentioned in the transcript ), which I am not surprised by either, because as I mentioned in the article in June, I expected to see strong numbers coming from the EV/Automotive segment as more and more countries adopt electric vehicle initiatives and push for environmental improvements via tax breaks and other incentives.
The guidance is what brought down the company's share price by 20% as of writing the article, which I think is an overreaction. It's like people didn't know about the negative sentiment of the industry over the last year. Many companies I've covered in the past that are in the auto/EV semiconductor segment or semiconductor industry in general, have told us many times that times aren't looking good right now and expect soft results for the awhile. Many of those companies seem to see the cyclicality and negative sentiment turning positive in the next couple of quarters and we should see the demand picking back up.
Q4 Outlook (Investor Relations)
I don't think these were particularly bad results and I wasn't surprised by the softer guidance than analysts anticipated. This just allowed me to start a position in a company that still has its long-term outlook intact. The quarterly reports are very volatile and do not present a good long-term outlook and many investors are very short-term oriented, which provides long-term horizon investors with a good entry point.
Comments on Outlook
I do not doubt in my mind that the cyclicality is going to become positive for the semiconductor industry very soon. By very soon I mean sometime in the first half of '24, which means I still expect quite a bit of volatility over the coming months, which may enable me to average down even further. The semiconductor industry is estimated to see around 12% growth in '24.
Margins
The management is continuing its efforts to streamline operations. As I mentioned in my previous article, I was impressed with these initiatives, and it is good to hear that this is the case still. Although it is not apparent yet that these initiatives are working, however, with time, I expect margins to start stabilizing or even improving from the numbers seen in the recent quarter. East Fishkill is still not as efficient as expected, so until this is fixed, the company may continue to see subpar margins for a little while longer. The company's Fab Right initiative already divested 4 fabs in '22 and the management's focus on further efficiency improvements for the next couple of quarters will "generate incremental cost savings over the next few years." The management is adamant about maintaining the gross margins stable from here on out with around the mid-to-high-60% range of utilization.
I think this is very achievable because the initiative improved margins in '22 significantly as you can see below. I believe the management is competent at finding opportunities for further efficiencies, but we will have to wait and see how this all develops going forward.
The company is very different from what it was a few years ago and I believe that it will be able to achieve what the management set out for themselves, so the long-term outlook is still very good, and now that the share price plummeted so much in one day, my biggest gripe with the company is gone.
Risks
As I briefly mentioned earlier, I believe many investors are shortsighted and forgetful. I wouldn't be surprised if the company's share price tumbles some more going forward because people forgot about the macroeconomic headwinds and the negativity surrounding the semiconductor sector. When the company goes to reports Q4 numbers and potentially once again gives soft guidance, the share price could possibly plummet again because people already likely would have already forgotten what happened 3 months ago.
The management is seeing some softness in the European market, which is not great, however, I think it was expected given the high-interest rates and consumer skittishness. This could bring down sales, which the company already guided for in the press release. If it gets worse, then expect a lot of volatility in the short term and be ready to stomach such an environment for half a year or more going forward.
I've mentioned macroeconomic headwinds a lot here, as that is going to bring in a lot of volatility to the markets. The inflation is slightly stickier than anyone has expected, and the US economy is still going tremendously strong, which means that the Fed may have to continue to hike interest rates at least one more time and keep them higher for longer. This will certainly not help consumers' skittishness and if I was them, I would wait for a better interest rate environment too.
All these risks are the result of cyclicality and I believe are short-term noise. The company is still very strong financially (I covered financials in detail in my previous article), and the market provided me with an opportunity much earlier than I anticipated.
Valuation
I updated my valuation model to reflect the current climate and saw a much higher risk-free rate than it was back in June (4.9% vs 3.7% in June). For the revenue assumptions, I went with 3 different scenarios once again, and below are the base, optimistic, and conservative estimates.
The company managed to achieve around 13% CAGR over the last decade, so I think I'm on a more conservative end with my estimates.
For EPS and margins, I decided to approach with a conservative mindset also, so what I did was to leave margins as they have been at the end of FY22, which means the company is not able to improve its efficiency even with all those initiatives. This way I get a little more cushion in terms of margin of safety.
Margin and EPS assumptions (Author)
I also went with an 11.5% discount rate and 2.5% terminal growth rate for my DCF analysis, which I think is rather conservative. I usually go with around 10%, but its WACC is around 11.5% because of the high beta.
On top of these estimates, I went ahead and added another 15% margin of safety for more cushion. I used 25% in my previous valuation; however, I believe that the inputs have already beaten down the company's valuation and I think there is a little less uncertainty about the company's outlook now, coupled with a much better entry price for new investors than before. With that said the company's intrinsic value is $72.6 a share, implying the shares are trading at a slight discount right now.
Closing Comments
The biggest gripe with the company I had previously was its share price, so now that's fixed I am comfortable at starting a position right now and looking forward to where it goes in the long-run. I believe Onsemi has a lot of long-term potential and will reward its shareholders in a couple of years as long as the investors can stomach the down cycles well enough. I expect the company to trend down a little longer and will pick up more shares when that happens.
The risk/reward is very enticing here and if you are still uncomfortable with picking up some shares here, you could open a couple of cash-secured put contracts if you are comfortable with options. Sell a contract or two below the current share price and wait until it comes to you or rinse and repeat while you continue to collect premium and ultimately lower your cost basis further. I will be looking at this strategy to complement my long position.
For further details see:
ON Semiconductor: I'm In, Long-Term Thesis Still Intact (Rating Upgrade)