2023-11-01 05:17:51 ET
Summary
- ON Semiconductor's stock price plunged 35% after disappointing Q4 guidance, but underlying fundamentals remain strong.
- According to my valuation analysis, the stock is now about 25% undervalued.
- Despite attractive valuation and strong fundamentals, I am not buying because it is highly likely that weak stock market sentiment will prevail in the near term.
Investment thesis
My latest rating downgrade for ON Semiconductor (ON) had good timing because the stock price plunged 35% within less than two months. Today, I want to refresh my investment thesis after the rapid stock price move after disappointing guidance shared during the latest quarter's earnings release. However, my analysis suggests that cautious guidance for the upcoming quarter and early 2024 is a temporary weakness and not secular. Profitability metrics demonstrate solid resilience despite a massively challenging environment, and ON's balance sheet is a fortress, which means the company is ready to weather the storm. On the other hand, the company's long-term prospects are bright as it serves various promising end markets and has vast financial and human capital to drive innovation and long-term revenue growth. After a recent stock sell-off, the valuation became much more attractive, with about 25% upside potential under very conservative underlying assumptions for my discounted cash flow [DCF] simulation. Despite strong fundamentals and attractive valuation, I reiterate my "Hold" rating for ON due to the current weak market sentiment and massive level of uncertainty in the current macro environment.
Recent developments
The latest quarterly earnings were released on October 30, when the company topped consensus estimates. Revenue was almost flat YoY with a slight below one percent decline. Despite shrinking, I believe that profitability metrics demonstrated solid resilience as the operating margin was almost 32% in Q3, compared to 33.6% in the same quarter last year.
Seeking Alpha
Despite quarterly solid results from the high-level perspective, the stock price nosedived by about 25% after earnings were released. The cautious Q4 guidance reflecting the harsh environment provided by the management during the earnings call was the primary reason for such a massive stock sell-off. The management expects quarterly revenue to be $2 billion at the midpoint of the forecasted range, which indicates a 5% YoY decline. The management expects the non-GAAP gross margin to be around 46.5%, which indicates a slight YoY decline, and I do not consider it dramatic. That said, I think that the Q4 guidance downgrade was not as significant as the recent stock sell-off might suggest.
The upcoming quarter's earnings are scheduled for release on February 2, 2024. Consensus estimates project the adjusted EPS in Q4 of $1.21, which means a YoY decline from $1.32.
Seeking Alpha
Current headwinds are apparent, and the list has not changed much: high-interest rates environment, softening end market demand due to substantial inflation of 2020-2022, and vast geopolitical uncertainty. The recent Fed's hawkish rhetoric and new military conflicts escalating rapidly suggest that the bumpy road is still far from being over. But these headwinds are temporary: interest rates and inflation are cyclical, and all wars end with peace. The vast uncertainty here is about the timing of positive shifts in monetary policy and geopolitical trends. That said, the stronger the company's balance sheet in the current environment, the better it is for investors.
Seeking Alpha
And onsemi's balance sheet is indeed strong. The company had $2.7 billion in cash as of the latest reporting date, and its leverage ratio is prudent, with the covered ratio looking far above enough. Current liquidity metrics are also in excellent shape. That said, I do not doubt that the company can weather the storm even if it takes multiple quarters ahead. Remembering that the company's profitability metrics are still wide, as the operating margin still flies above 30%, is crucial.
Considering all the above factors, ON is well-positioned to continue investing in innovation and build long-term shareholder value. As a long-term investor, I prefer to ignore the noise and pay attention to secular trends. ON is likely to absorb the secular shift to electric vehicles [EVs] as a company with solid exposure to the EV market. Sales of internal combustion engine [ICE] powered vehicles will be banned across the EU starting from 2035 . This is an apparent long-term bullish sign for companies serving the EV industry, like onsemi.
Apart from the promising automotive end market, onsemi is also present in several other domains, and its set of offerings is diversified, including energy and charging infrastructure, industrial automation, and 5G. All of these industries are promising, considering the secular shift toward more digitalization as we are currently amid the Fourth Industrial Revolution .
The company has a strong track record of financial success, which gives me high conviction that it can sustain its ability to absorb secular tailwinds. Despite being severe, current headwinds are apparently temporary and not secular.
Despite my high conviction in the company's strong fundamentals from the secular perspective, there are apparent reasons why buying a recent sell-off might be early. The current weak stock market sentiment is the number one reason why I prefer not to hurry up. CNN's Fear and Greed Index is already in the "Fear" zone, but this earnings season is highly likely to be soft overall, which will not add much optimism to the stock market. Another big negative factor for the ON's stock price is the ongoing weakness in EV demand due to high-interest rates. The deteriorating financial performance of Tesla (TSLA), despite implementing massive discounts across all vehicle models, is a red flag for the whole EV industry in the short term. With an undisputable EV leader having troubles due to the harsh macro environment, it is highly likely that other EV makers' earnings will also disappoint, which might pressure ON as well.
Valuation update
The stock is up less than 2% year-to-date, underperforming the broader U.S. market. Seeking Alpha Quant assigns ON a decent "B-" valuation grade because a notable portion of ratios are double-digits lower than the sector median and historical averages. On the other hand, ratios related to sales look substantially elevated. That said, valuation ratios analysis outcomes are mixed and do not give sufficient evidence to me.
As usual, I prefer to simulate the discounted cash flow [DCF] model for a growth company like onsemi. Given the recent Fed's hawkish rhetoric, I use a slightly elevated 11% WACC for discounting, a one percentage point higher than I did last time for ON's valuation. Long-term revenue consensus estimates available up to FY 2027 were downgraded, so I also incorporated this into my valuation update. At the same time, I use the same 12.2% revenue CAGR for the years beyond. Given the recent deteriorating financial performance, I use a 1.6% TTM FCF ex-SBC margin for my base year. On the other hand, I expect a notable rebound with a 150 basis points yearly expansion.
According to my DCF simulation, the business's fair value is approximately $35 billion, indicating a 25% upside potential for the stock price. That said, the target price for ON is $78.
Risks to my cautious thesis
There are several massive negative factors, which I have mentioned at the beginning of my analysis. If one of them eases, this might be a significant positive catalyst for the stock market, especially high-quality growth stocks like ON.
While the Fed has been hawkish so far, the current interest rates are at their multidecade highest, and the pivot in monetary policy rhetoric will come sooner or later. While I consider the soon pivot unlikely, given that the U.S. economy still demonstrates strength , even slightly positive signals from the Fed might become huge positive catalysts for the stock market. Any signs of easing geopolitical tensions, especially between the U.S. and China, might also add substantial optimism for investors.
Bottom line
To conclude, ON is still a "Hold". Despite being a high-quality business poised to absorb multiple secular tailwinds, I think the current weak sentiment will prevail soon. That is why I am not hurrying to buy the dip after the recent massive sell-off, although the valuation has become much more attractive.
For further details see:
ON Semiconductor: The Market Overreacted, But I Am Still Not Buying