ON Semiconductor May Have The Leverage, But It Needs Growth

By Stephen D. Simpson, CFA | May 07, 2012 AAA

Veteran analog chip companies like Analog Devices (Nasdaq:ADI) and Linear Technology (Nasdaq:LLTC) are often praised and prized for their strong gross margins, and the new kid on the block ON Semiconductor (Nasdaq:ONNN) would certainly like to join their ranks. While ON has made solid progress in integrating its Sanyo acquisition, the fact remains that the chip sector recovering is proving to be a slow and uncertain one. Although I think ON has a good chance of eventually delivering the goods, and valuation is not terribly demanding, investors are going to need to have some patience with this one.
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Signs of Progress in First Quarter
ON Semiconductor didn't report an especially powerful first quarter, but given the results reported by companies like Texas Instruments (Nasdaq:TXN) there was no reason to believe they would.

Revenue fell more than 14% from the year-ago quarter and about 3% sequentially, with Sanyo sales down about 6%. Industrial chip sales were surprisingly weak (down 8% sequentially), and consumer and communications sales were likewise down by high single-digit percentages. Computing was down a bit (3% sequentially), while chip sales to the auto vertical jumped nearly 10% as new product wins start producing real revenue.

I was pretty impressed with the margins ON Semiconductor saw this quarter. Gross margin improved nearly two points from the fourth quarter, despite ongoing price erosion in the low single digits. While reported operating income overstates the growth a bit (up 33% annually and 43% sequentially) due to restructuring and other charges, adjusted 8% sequential growth is not bad at all for this market.

SEE: How To Decode A Company's Earnings Reports

Lower Guidance Isn't Always Bad
ON Semiconductor did break a cardinal rule of tech stocks by lowering its revenue guidance for the second quarter. There's an important "but" here, though - that cut in revenue is largely due to abandoning lower-margin business. Clearly there's a balancing act between revenue, margin and absolute gross profit dollars, but jettisoning insufficiently profitable business is a logical move.

Along similar lines, I'm impressed at how hard ON management is pushing on integrating the Sanyo acquisition and bringing down its costs. With companies like Texas Instruments looking to leverage its new capacity to go down-market and ample low-cost Asian rivals, delivering this margin leverage is going to be critical for the company in the future.

Will the Market Help ON Along?
So far, the much-heralded 2012 chip recovery is looking to be pretty unspectacular. Plenty of companies are still carrying the line that conditions are improving and revenue growth should start showing up in the second half. Perhaps they're right, but investors would do well to approach with a little caution and skepticism.

As it pertains to ONN, though, there are legitimate reasons for optimism. The auto business seems to be picking up nicely, and it's hard to imagine how the communications market will get much worse. Consumer is still a risky spot (given ON's exposure to Chinese white goods demand), but management is confident that they'll gain notebook share with the migration to Ivy Bridge. We'll see what, if anything, Maxim (Nasdaq:MXIM) and Marvel (Nasdaq:MRVL) have to say about that.

The Bottom Line
I've been cautious on ON all year, mostly as I have been concerned about the company's ambitious plans to lower costs, not to mention the risk that the chip recovery would fail to develop and make ON's balance sheet more of a talking point.

I'm starting to feel a little more confident about this stock. Although ON Semiconductor lacks a strong top line growth story for 2012, that margin leverage is a tasty morsel for patient value-oriented investors. Even if ON Semiconductor can only reach half of the free cash flow margin of larger analog companies like Analog or Linear, this stock could be in place to do well over the next couple of years.

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

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