There's a wide, fuzzy line between "early" and "wrong" when it comes to investing. It's all well and good to buy quality undervalued names before the Street catches on, but it can take a lot of patience to see these stories through to their happy ending. Those are all points to consider for investors looking at analog chip company ON Semiconductor (Nasdaq:ONNN). ONNN is a quality broad-based company with diversified end-market exposure and strong leverage potential. But current business trends are not helpful, and while there does appear to be real value here, it may take some time for that value to make it into the stock price.
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Any Good News in 2012?
This hasn't exactly been a banner year for leading analog chip companies like Linear Technology (Nasdaq:LLTC), Analog Devices (Nasdaq:ADI) or Texas Instruments (Nasdaq:TXN), and it hasn't been any different for ONNN. Second quarter performance was sluggish, with flat sequential revenue performance despite ongoing wins in categories like hard drives, gaming and autos. Aggressive pricing from rivals like Diodes (Nasdaq:DIOD) wasn't helping, but customers in a variety of end markets were pulling back on normal ordering patterns. ONNN's guidance for the third quarter wasn't spectacular, and it doesn't seem as though the market is improving significantly. Although there hasn't been as many warnings (yet), industry-wide lead times are still pretty short and key markets like autos, communications and computers haven't rebounded much (if at all).
The Story Still Revolves Around Leverage
The key reason to own ONNN has been, and will continue to be, the company's margin leverage potential. The company made a good deal (the acquisition of Sanyo's semiconductor business) at the worst possible time, and has yet to really show the full potential of this expansion. It's not just about the ongoing Sanyo integration, though. With pricing and capacity utilization less than optimal, ONNN is not in a position to drive the sort of profits that it may be fully capable of in better times. Moreover, I can understand how bears may be a little more skeptical of the leverage story since CFO Colvin announced that he would be leaving the company - although I believe ONNN can replace him (and that there's nothing especially untoward about his departure), it's yet another challenge for a company that had plenty on its plate already.
Still a Work in Progress
ONNN has been a pretty aggressive acquirer over the years, basically buying its way into becoming a top 10 analog company. I still wonder what the ultimate story on the company will be. Is it going to build itself into another superior cash flow generator like Linear? Is it going to develop any particular areas or niches of specialization?
The Bottom Line
Investors have some challenging questions in the semiconductor space right now. Quality names like Broadcom (Nasdaq:BRCM) and Mellanox (Nasdaq:MLNX) offer good near-term growth stories, but not tremendous value. Companies like Atmel (Nasdaq:ATML), OmniVision (Nasdaq:OVTI) and ON Semiconductor seem to offer a great deal more value, but a lot more questions about near-term growth and long-term free cash flow generation.
I'm still willing to model free cash flow margins well into the teens as time goes on for ON Semiconductor, along with mid-single digit revenue growth. That creates the possibility of substantial free cash flow growth between today and 2017, as well as the risk that margin leverage fails to materialize and the stock languishes. While I think this stock could be worth more than $10 today, a lot of that value is predicated on improvements that have been slow to come, and investors need to appreciate the above-average risks with this name.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.