2024-01-09 11:42:18 ET
Summary
- ON Semiconductor Corp. has performed poorly compared to other semiconductor stocks and has a murky chart with resistance levels overhead.
- Earnings estimates for ON Semiconductor have been weak and continue to fall, indicating downside risk.
- The stock's valuation is higher than historical norms and does not adequately reflect the deteriorating fundamental outlook.
Semiconductor stocks have been an outstanding place to invest your money in recent quarters, which is a hallmark of a tech-led bull market. However, not all semi stocks are created equal, and a former buy recommendation of mine in the space - ON Semiconductor Corp. (ON) - has performed quite poorly on a relative basis. The stock fell from $111 to just $61 at the October low, having rebounded somewhat in the last couple of months. So is this a buying chance? I don't think so. The situation has changed since my buy rating, and I was wrong. ON is now just a stock to avoid, in my view, as I'll explain below.
A murky chart
Last time I covered ON, the stock was about $96, and I noted support at $92. That failed on the way to just $61, and this is why we use stops. Losing $4 per share is manageable, while losing $35 is decidedly less so. The chart deteriorated massively since then, and there are plenty of resistance levels overhead for the bulls to contend with.
There's the downtrend line from the summer high, gap resistance at about $81, and the relative high at $86/$87. These should be strong resistance levels, so I would expect more choppy action ahead. The stock in no-man's land here, with momentum having improved, but lots of resistance overhead. In short, I just don't like the look of the chart, so it's a contributing factor to me rating the stock as an avoid/hold. I like chart's with favorable risk/reward, and ON simply doesn't have that.
On the plus side, seasonality is on the side of ON, with the last five January/February periods producing average returns of 8.5%, or 51% annualized. The company posts earnings on February 2nd, so we'll see.
The thing is that earnings estimates have been extremely weak recently, and this January/February period relies upon a pre-earnings run and some follow through thereafter. Stocks that see pre-earnings runs have strong estimates, however, and ON simply doesn't. In other words, this time may be different.
Flagging estimates fueling downside risk
Estimates for semiconductor stocks tend to be volatile, so there's nothing necessarily unique about ON in that respect. But as we can see below, not only is ON now expected to see negative revenue and EPS growth for both last year and this year, but estimates continue to fall.
Estimates are rosier in fiscal 2025, but given recent momentum, it's difficult to believe those will stay as positive as they are at the moment. Semiconductor stocks tend to be high-growth vehicles, and the bottom line is that there are better picks out there at the moment if you're looking for earnings growth.
In the past three months, there have been 28 EPS revisions, and 30 revenue revisions, and out of those 58 revisions, 57 of them have been lower. It's challenging to overcome a tsunami of negative sentiment like that and it's not something I'm trying to fight.
To be fair, in the past couple of years, ON has produced very strong earnings growth. The post-COVID bull market we saw in semiconductor stocks also saw ON's EPS move from 85 cents in 2020 to more than $5.00 in 2022.
Part of that was down to robust revenue increases, but most of it was due to margin expansion. The issue is that this kind of move is very obviously unsustainable. Below we have trailing-twelve-months gross and operating margins to illustrate this point.
Gross margins moved from about 33% at the cycle low to nearly 50% in the final quarter of 2022. Operating margins, however, moved from about 8% at the cycle low to 33% at the end of 2022. That is operating leverage in action, wherein higher revenue and gross margins leverage down fixed costs, thereby producing more profit on each dollar of sales. The problem we face now is that operating leverage works in both directions, and with lower revenue is coming lower margins.
With the top in margins having occurred a few quarters ago, and revenue estimates clearly moving lower, it's difficult to argue that we'll see these margin numbers improve in the foreseeable future. With that being the case, I also cannot see cause for the bulls to bid the stock up meaningfully from here.
The valuation isn't sufficiently pricing in risks
With this negative fundamental backdrop in mind, I would want to see the stock with a below-average, cheap valuation. I see nothing of the sort here.
The stock is trading for 17X forward earnings today, which is higher than the average from the past two years of 15X, and a long way above the low of 10X. When I look at valuations relative to historical norms, it's important to consider context of growth. During much of this two-year period, ON had very strong actual and projected growth in revenue and earnings. However, we know that revenue has peaked and rolled over, and margins have as well. That's a much weaker fundamental setup, so that deserves a weaker valuation. What we have, however, is a stronger valuation, which is incongruous in my view.
Finally, we can see some of the deterioration in the stock's fundamental picture I've been on about in the Quant Rating .
The valuation hasn't really changed, but growth, momentum, and revisions are all worse, with the last two significantly so. My fundamental assessment lines up with the Quant Rating changes, which gives me confidence I'm viewing this prudently. My only difference with the Quant Rating is that I'd rate the valuation lower than C+ given the deterioration of growth prospects, as I explained above.
The fact is that the last time I covered ON, it was in a different place, and I put the wrong rating on it. Its fundamental outlook has gotten worse, and the stock is way too expensive at the moment. I don't want to short it here, but I also don't want to go anywhere near it, so it's getting a downgrade to hold/avoid.
For further details see:
ON Semiconductor's Weakness Likely Isn't Over