A Diversified Semiconductor Investment

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The global semiconductor industry is a highly competitive space, characterized by rapidly changing technologies and evolving market dynamics. In this industry, the players that rely on a handful of buyers consequently reduce their bargaining power and gross margins. A better strategy is to keep a diversified consumer base to shield revenue from the changing fortunes of customers, while minimizing their bargaining power. 

ON Semiconductor (UNKNOWN: ONNN.DL  ) has avoided this predicament by maintaining a large and diverse customer base. This is the reason it enjoys an above-industry-average gross margin and cheap valuations. 

The Business 
ON Semiconductor is an Arizona-based American semiconductor company that manufactures and supplies power devices and signal management devices, as well as discrete and logic devices to OEMs involved in the automotive, communications, computing, medical, and LED industries. Semiconductor devices supplied by ON Semiconductors are also used in power, industrial, military, and aerospace applications. ON Semiconductors' manufacturing facilities and design centers are located in North America, Europe, and Asia Pacific.

The stock is currently trading at 9.2 times forward earnings, which is below the industry average of 15.4 times. The P/S is also pretty low at 1.1 times, below the industry average of 1.67 times. The PEG ratio is under 1 at 0.78 times, which is an indicator of high future growth potential. These valuation ratios suggest that ON Semiconductor is undervalued. The sell side also shares this opinion because the mean target price for ON is $9.25, a 25% upside to current valuations.

ON Semiconductor has seen its revenue decline from $744 million in the second quarter of fiscal 2012 to $688 million in the second quarter of fiscal 2013, a 7.58% year-over year decline. This was still above the expectations of both the Street and management itself. Additionally, EPS has increased by 450% year-over-year, rising from $0.02 in the second quarter of FY2012 to $0.11 in the second quarter of 2013, the most recent quarter of the current fiscal year. The company's operating income has also increased to $50.9 million in the recent quarter, up from $26.9 million in the same quarter last year.

ON Semiconductor's customer base
In the fast-paced technology vendor industry, the preferences of customers are rapidly evolving. Therefore, companies with a diverse and large customer base, rather than only a handful of large customers, have lower business risk. ON Semiconductors has a strong customer base in the market. According to the company, it has 440 direct customers, as well as 300 indirect customers, worldwide. Of the 50 largest customers, 49 have been the company's customers for more than five years, which illustrates that the company aims to establish long-standing relationships with its customers.

The semiconductor industry
The semiconductor industry is a sizable, complex space with a large number of players producing and selling different types of chips to OEMs and other device manufacturers. The biggest player in the industry (with respect to market share) is Intel, with a 15.6% market share, followed by Samsung, with a market share of 10.3%. A number of companies follow Samsung with a market share of less than 5%, The top 25 companies in the industry make up 69.3% of the market share with respect to revenue generated.

ON Semiconductor ranks 22nd in the industry in terms of market share, coming down from its 18th position the previous year. Market share declined from 1.1% in 2011 to 0.9% in 2012, according to a report on the semiconductor sector by iSuppli. Chief competitors, Advanced Micro Devices  (NASDAQ: AMD  ) , Broadcom  (UNKNOWN: BRCM.DL  ) , and Micron have market shares of 1.7%, 2.6%, and 2.2%, respectively. AMD and Micron have lost market share in the industry, but Broadcom has been able to increase its market share from 2.3% to 2.6%. Out of the top 25 market share holders in the industry, the companies that have gained share and revenues over the year are Samsung, Qualcomm, Broadcom, Sony, NXP, Nvidia, MediaTek, and LSI, whereas ON Semiconductor is one of the top 25 companies whose revenue declined by double-digit percentages from 2011 to the fiscal year ending 2012.

Quarterly Revenue Growth
ON Semiconductors has seen a year-over-year decline in revenue in the recent quarter, after seeing a decline in annual revenue and market share in recently ended fiscal year 2012. Similarly, AMD has suffered declining quarterly revenue year-over-year in the same quarter, as well as declining annual revenue. Broadcom and Micron, however, have seen quarterly revenue growth of 6.04% and 6.72%, respectively.

Earnings per share growth
Among the discussed competitors, ON Semiconductors has witnessed the highest year-over-year growth (450%) in earnings per share in the recent quarter, followed by Micron with a 112.5% year-over-year growth in the same quarter. AMD and Broadcom, on the other hand, have witnessed declining earnings per share over the same period, with a 300%, 253.57%, and year-over-year decline in revenue in the quarter ending in June.

Share price growth in three months
Shares of ON, AMD, and Broadcom have declined during the last three months. However, during the same period, Micron has seen healthy valuation growth. This growth is partially a delayed response to the acquisition of Elpida and the resultant industry consolidation.

Bottom line
ON has shown significant improvement in its bottom-line, even if the top line has suffered. The company's diverse customer base ensures lower business risk, as compared to players that rely on only a handful of larger customers. A large customer base also increases the bargaining power of the supplier. The price multiple valuation approach also shows that this company is undervalued at these valuations and offers an interesting investment opportunity.

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