ON Semiconductor Shows More Signs of Industry Stabilization Despite Recession Fears

Power-management and connectivity chip maker ON Semiconductor (ON 3.27%) reported better-than-feared results during the third quarter of 2019. Revenue of $1.38 billion was near the midpoint of guidance provided a few months ago and down 10% from Q3 2018. Adjusted earnings slipped 42% year over year due to soft demand and lower selling prices on products. Nevertheless, the fourth-quarter outlook showed that the bottom is at least moderating.

The semiconductor industry has been in a rut for a year now, and it remains to be seen whether sales will rebound in an up-down-up pattern as they have in times past. As of right now, it's looking more like an up-down-flatline trend is emerging. That might not be what investors want to hear, but it was good enough news for the present in light of ongoing trade disputes and an uncertain global economy.

Further delays ahead

Paired with the first half of 2019, ON isn't having the greatest of years. Operating income is down 53% on the year, although adjustments for one-time items and the company's share repurchases have left adjusted earnings per share down just 17%. Among the big one-time line-item adjustments this quarter were restructuring and asset impairment costs ($28.1 million) and litigation expenses ($169.5 million) related to an old intellectual-property infringement case between ON's (now) subsidiary Fairchild Semiconductor and Power Integrations.

The stock is nonetheless up 29% year to date after rebounding from last year's poor showing. Though things aren't looking great by the numbers, investors are still holding on to hope that global demand for semiconductors will start picking up steam again soon.

Pp = percentage point. Data source: ON Semiconductor.

As for those hopes and dreams, management's outlook for Q4 is for $1.35 billion to $1.40 billion in sales -- down 8% at the midpoint of guidance from last year but roughly flat against the prior sequential quarter. So much for an end-of-year rebound in business. CFO Bernard Gutmann explained during the earnings call:

We saw stabilization in business trends in the third quarter. We believe that much of the stabilization was driven by normalization of inventories in supply chain as both distributors and OEMs [Original Equipment Manufacturers] have realigned their inventory in-line with lower end-market demand. While we have seen normalization in supply chain inventories, end-market demand signals remain weak. Geopolitical and macroeconomic factors still weigh on demand, and visibility into demand remains poor.

Image source: Getty Images.

Long-term trends are still intact

As semiconductor supplies are reset in keeping with a sluggish outlook, the good news is that a demand-side rebound -- whenever that might happen -- could send prices and profit margins on products soaring again. In the meantime, a floor may have been established, as Gutmann added that long-term trends are still floating ON's business.

Specifically, new technology in the auto industry (connectivity chips and electric powertrains) and cloud-computing (power management for 5G mobile networks) are helping offset weakness elsewhere. Auto industry sales fell 3% in Q3, while communications fell 8%, better than the 10% overall sales decline.

Trailing-twelve-month price to free cash flow (a proxy for basic profits; cash flow after operating and capital expenditures are paid for) now values the stock at 18.7 times. The ratio has been negatively affected by ON's acquisition of Quantenna and its purchase of a new semiconductor facility in Fishkill, New York, earlier this year. Shares trade for 12.5 times one-year forward price to earnings, though, implying that a big rebound in the bottom line could lie ahead.

Of course, much of that depends on the chip industry at least holding steady in the next 12 months. With visibility into the future still limited for ON and its semiconductor manufacturing peers, this last report card was a mixed bag for investors.