2023-09-14 10:05:13 ET
Summary
- ON Semiconductor has already seen a significant increase in its stock price, with shares moving from $60 to $96 in 2023.
- Technical analysis suggests that the stock may continue to rise in the coming months, particularly given the time of year.
- ON Semiconductor has strong growth prospects, driven by the increasing demand for semiconductors in various industries, and has a reasonable valuation.
The semiconductors have been one of the biggest beneficiaries of 2023’s epic equity rally. The group was decimated in 2022, and the combination of low valuations, torrid growth rates, and increase risk appetite from investors has led to some truly eye-popping returns. One such beneficiary is ON Semiconductor (ON), which has seen its shares move from about $60 at the beginning of the year to $96 today.
The stock made a high of $111 back in July, and I think we’re poised to see a run right back to that high, and potentially more in the coming months. ON’s valuation has suffered during the bull run, but it’s still plenty attractive. With powerful seasonal tailwinds coming, ON looks like a great buy candidate for those that can stomach a little volatility.
End of the bull, or pause that refreshes?
That is, of course, the key question. However, I think the weight of the evidence suggests we’re likely to see ON higher in the coming months than it is now. But the beautiful thing about using technical analysis is that you can limit your risk by intelligently setting stops. Let’s dig in.
We can see on the price chart that the rally that took the stock to $111 was quickly unraveled in August as stocks in general sold off. ON was an easy profit-taking target given the run it had prior to that, so no big surprise there. However, we need to see bullish follow through to confirm this bull run isn’t done yet.
I marked a blue horizontal line where the 20-week exponential moving average is today, which is the first potential support should ON continue to pull back. Under that, we have the double bottom that was set in August at roughly $89. Both are potential areas for stops, and both are potential areas for taking long positions, depending upon your own personal risk preferences.
Now, the accumulation/distribution line is flying and is very near its highs. That simply means that there’s much more buying during the day than selling – thus, “accumulation” – which is no guarantee but is a great indicator of a stock the Street thinks is going higher.
The momentum indicators both reached oversold territory during August but have since made big bounces. The key here is that we see some follow through, or that we get a higher low when this pullback ends. It would take a large, protracted move down from here to create lower lows on the momentum indicators, and at that point, we’d be way past the support levels I identified above anyway.
Finally, I love relative strength, and ON is part of perhaps the hottest group in the market this year, with the semis outperforming the S&P 500 by 45% . Sign me up.
One final note is on seasonality, which we can see below for 2018 to 2022.
September is a weak month for ON, but my goodness, look at November. October averages 3.5% gains, while November has averaged 16.6% gains in the past five years. That’s an average gain over this five-year period of about 20% in the next two months. To be very clear, this guarantees absolutely nothing, but odds are odds, and it’s hard to find anything more bullish than this.
Long growth runways and massive profitability
Let’s turn our attention to the fundamentals of ON, which show a company that has multiple levers to pull to grow in the coming years. Part of the reason why investors have flocked to the semis as a group is because the products they produce are in an ever-growing roster of products, and volumes are soaring. There’s no end in sight when it comes to this expansion, including the ramping of EV production across the globe, as well as the countless consumer and industrial applications of chips.
ON sees its total growth target through 2027 at 10% to 12%, with automotive driving most of that through EV adoption, largely. Its legacy businesses, like 5G and cloud, are cash cows, but are likely to be a drag on growth. However, that’s okay because the cash they generate helps ON invest in growth areas. ON reckons it can grow at 3X the market rate, and if it gets anywhere near that sort of growth, there are a lot of good things that will happen.
One of those things would be margin expansion, which has been a huge source of profit growth in recent years. The company has worked to build gross margin, which has come through product mix, lower input costs, and strategic actions like fab divestitures. Management reckons there's more meat on the bone, and that ON can add another ~400bps of gross margin in the next four years.
With operating expenses set to decline as a percentage of revenue (if only slightly), all of that would flow to operating margins, which the company thinks can be a mighty 40% of the top line by 2027. That sounds ambitious, but have a look at the progress from the past three years (data is trailing-twelve-months).
As revenue has ramped higher, gross margin has risen, and operating expenses have been under control, operating margin has exploded higher. For 2020, operating margin was about 8% of revenue. In the past four quarters, it was four times higher than that. This management team has delivered.
Small wonder, then, that estimates look the way they do.
All 27 EPS revisions and all 28 revenue revisions in the past three months have been higher. That’s incredible, and it speaks to the initiatives ON has in place that are growing revenue, controlling expenses, and boosting margins.
One final note on the capital structure is that ON has reinvested in its business without undue leverage. Below we have TTM free cash flow and net debt, both in millions, for the past three years.
The company has reduced net debt by more than half in this period, and net debt is now less than TTM FCF, meaning ON has a very manageable amount of leverage. With cash flow ramping through higher revenue and higher margins, I have little doubt this chart will continue to improve in the coming quarters, allowing flexibility with leverage, but also investments in new products to drive the next leg of growth.
But what of the valuation?
The valuation has risen significantly in 2023, which you’d expect given the size of the rally we’ve seen. However, keep in mind that estimates have risen as well, meaning the damage is less than perhaps one would think.
Shares trade for under 18X forward earnings today, which is average for ON in the past three years. I’d argue with the EPS revision schedule we looked at, the company deserves a higher valuation than it has seen in recent years, but even if you disagree with that, it’s fairly valued. In my view, the days of 30X earnings and 10X earnings were equally as unreasonable, and both resolved with reversion to the mean. Today, as I said, I don’t think the valuation will play a huge part in shareholder returns given it’s about where it’s been historically.
So what do we make of all of this? You can be the judge of that but for me, we have a company with strong, diversified top line growth, proven and sustained margin expansion, robust FCF growth, and a reasonable valuation. When we add in the unbelievable seasonal tailwinds and the fact that the semis continue to rule the roost in the equity market, I’m slapping a buy rating on the stock.
For further details see:
ON Semiconductor Is Ready For Liftoff Into Year-End