As investors open the books on 2013, there was widespread hope that this will be the year in which the semiconductor industry turns around. While a better demand environment would certainly help ON Semiconductor (Nasdaq:ONNN), internal operating leverage is even more important to the company's financial results. This stock is not tremendously compelling on a long-term basis, but if ON Semiconductor starts delivering better margins, better earnings and a revaluation of those earnings could make this a winning stock.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

Sanyo - Will the News Ever Be Good Again?
ON Semiconductor thought it was making a transformational acquisition when it acquired Sanyo's chip business, and the company was right - though not at all in the way it had hoped. Sanyo's operations were socked by the devastating floods in Thailand shortly after the deal closed, and the company's margins have languished since. Now the squabbles between China and Japan over some disputed territories are spilling over into business, with Chinese customers and businesses boycotting Japanese products.

Management has worked hard to pull expenses out of the Sanyo operations, and has recently talked about driving break-even results on $200 million in quarterly revenue in 2013. If that all works out, Sanyo could finally start to make some positive contributions later in this year - a welcome addition given the debt that the company took on in the deal. Looking even further out, Sanyo could have higher incremental margins than ON's base business, so success here is critical to the bull thesis.

SEE: The Industry Handbook: The Semiconductor Industry

Can the Company Carve its Own Niche?
Whether or not ON Semiconductor fixes Sanyo, I do still have some concerns about the company's base business.

While it is a top 10 analog chip company (though still quite a bit smaller than Texas Instruments (Nasdaq:TXN), Analog Devices (Nasdaq:ADI) and Maxim Integrated (Nasdaq:MXIM)), the company has not really established a niche for itself like Analog Devices or Linear Technology (Nasdaq:LLTC).

That's concerning to me, as analog chip companies are under fairly continual price pressure and more commodity-type chip companies don't enjoy the same premiums. Equally to the point, the analog chip industry on the whole tends to broadly track nominal U.S. GDP, and that essentially means that ON Semiconductor is a leveraged play on basic U.S. economic growth.

The Path to a Better Valuation
I do believe that ON Semiconductor could generate mid-teens operating margins in a couple of years, provided that the Sanyo improvements bear fruit and that U.S. economic growth stays positive. If that happens, ONNN's multiple could be 30%, 40% or even 50% higher than it is today. Couple that with the better earnings and revenue that go with that growth and margin leverage and you can see how this stock could be a winner.

SEE: A Look At Corporate Profit Margins

Several things have to happen between now and then, however. First, those Sanyo improvements simply have to come through - I suspect Wall Street is sick of hearing about this topic, and the company needs to deliver to improve sentiment. The company's new product wins in automotive, industrial and consumer goods have to ramp up and ramp up profitability. Last but not least, beaten-down chip end markets like computers, consumer electronics and telecom equipment have to start showing some signs of life.

The Bottom Line
ON Semiconductor is not all that exciting from a free cash flow (FCF) perspective. I don't project the company outgrowing the analog chip industry, so the revenue growth prospects over the long-term are in the low single digits. While I do believe that the company can lift its margins and produce solid free cash flows, even 10% compound free cash flow growth doesn't point to a compelling fair value (in the high single digits).

That said, chip stocks don't really trade in response to cash flow-derived fair values, probably in large part because the businesses are so volatile that accurate free cash flow models are well-nigh impossible. Instead, these stocks tend to trade on price/sales and price/earnings multiples. While peer analysis suggests a fair value around $8 (based on the company's weaker margins), I wouldn't rule out a double-digit share price if ON Semiconductors shows convincing signs of delivering on its margin potential.

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

Related Articles
  1. Economics

    The 9 Industries Driving Texas' Economy

    Find out which industries are driving the Texas economy. Learn about the largest and fastest growing employers and producers in Texas.
  2. Stock Analysis

    The Biggest Risks of Investing in Facebook Stock

    Find out what risks Facebook shareholders face in coming years, and why the social media giant may struggle to find new markets in the future.
  3. Stock Analysis

    The Biggest Risks of Investing in Apple Stock

    Read about the biggest risks facing Apple, Inc., and why AAPL investors should always be prepared for the day when the tech giant starts to struggle.
  4. Stock Analysis

    Will WYNN Continue to Rally?

    Wynn Resorts has experienced a rally recently. Will it remain a good bet?
  5. Stock Analysis

    Don't Be Fooled by the Market's Recent Rally

    The bulls won for a bit in early October, but will bears have the last laugh?
  6. Stock Analysis

    Will Twitter's Stock Find its Wings Soon?

    Twitter is an enigma to many investors, but its story is pretty straightforward.
  7. Investing Basics

    How to Think About Seasonality Trends

    Investors benefit when company research incorporates seasonality trends that predict relative strength and weakness throughout the calendar year.
  8. Stock Analysis

    8 Solid Utility Stocks for a Bear Market

    If you're seeking modest appreciation, generous dividend payments and resiliency, consider these eight utility stocks.
  9. Stock Analysis

    Why Phillips 66 (PSX) is a Solid Long-Term Bet

    Here's why Phillips 66 will likely remain one of the world’s largest and most profitable companies for a long time to come.
  10. Investing

    This New Trend Makes Robotics an Industry to Watch

    Robots created to work with humans, instead of taking their place, have the possibility to change the face of manufacturing across the globe.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!