ON Semiconductor Looking At Another Off Year

By Stephen D. Simpson, CFA | January 04, 2012 AAA

Short of locusts, just about everything that could have gone wrong for ON Semiconductor (Nasdaq:ONNN) did, in 2011. Not only did the company have to deal with a pair of natural disasters, but the company saw a widespread erosion in the chip market throughout the year. While the chip industry looks to have likely bottomed in the fourth quarter of 2011, ON Semiconductor is going to have a longer road back than most and investors need to understand that today's value-pricing comes at a cost.

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Twin Disasters Delay Sanyo Benefits
When ON Semiconductor bought the Sanyo chip business, it was a bold and somewhat risky move to expand the business and vault the company in the top echelon of analog chip companies. Although the promise and potential of the deal is intact, the timing has been blasted by events completely beyond management's control.

While the Japanese earthquake and tsunami early in 2011 was disruptive, ONNN management did a laudable job of neutralizing the impact. Unfortunately, the severe flooding in Thailand was another story. Not only did that flooding impact the consumer electronics market in general (hard drive manufacturers saw a lot of damage, for instance), but it did real damage to ONNN's physical infrastructure in the country. Now it looks like it will take about a year for the company to recover and margin improvement will be delayed. (For related reading, see World's Most Expensive Disasters.)

Looking for Better End-Use Demand
Like every other analog company, ONNN saw significant end-market erosion throughout 2011. Similar to management at Altera (Nasdaq:ALTR) (not an analog comparable) and Texas Instruments (NYSE:TXN), ONNN management is of the opinion that order rates are too low, inventories are running thin and the industry likely bottomed out in the fourth quarter of 2011.

Beyond a general secular recovery, there are reasons for long-term optimism at ONNN. The company has made good progress in getting itself designed into notebooks, smartphones, tablets, and LED and LCD displays. It's pretty clear from reports from companies like Dell (Nasdaq:DELL) and Corning (NYSE:GLW) that these markets are not especially strong right now, but business seems to be bottoming out here too. If ONNN can match recovery with share gains, that will leave the company in good shape exiting 2012.

Still Plenty of Challenges
ONNN's core business is a very competitive industry and the company frequently has to battle with the likes of Fairchild (NYSE:FCS), International Rectifier (NYSE:IRF) and STMicroelectronics (NYSE:STM) in competitive bake-offs, where price is often an overwhelming consideration. Making matters worse, Texas Instruments seems poised to lever its shiny new capacity to expand and go down-market into products like power MOSFETS; a market that the company has traditionally avoided due to its low margins. This puts even more pressure on ONNN management to deliver those synergies and margin improvements promised in the Sanyo deal.

The Bottom Line
Although I like ON Semiconductor and think the stock could do alright long term, it is hard to pound the table for this when there are so many cheap chip stocks out there, most of which don't have the additional operational challenges that ON Semi will have in 2012. Are these shares undervalued? Almost certainly. Names like Broadcom (Nasdaq:BRCM), Qualcomm (Nasdaq:QCOM), Altera and Atmel (Nasdaq:ATML) are also undervalued today, though, and look like better risk-reward trade-offs. (For related reading, see Finding Undervalued Stocks.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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