Shares of ON Semiconductor (NASDAQ:ON) were down 14% following the fourth quarter 2019 earnings report. On one hand, the steep decline is simply a breather after the stock rallied over 30% in the final months of 2019. However, business continues to show signs of disruption from the U.S.-China trade war, and global demand for chips has been rebounding at only a modest pace since a truce was called. 

Management isn't waiting around for external factors to help, though, as it is beginning to make structural changes to boost profits in the years ahead. Expect the ride to be bumpy, but this chipmaker is a solid bet as the industry rebounds from the recent slump.

A digital board displaying stock prices in green and red.

Image source: Getty Images.

2019 sputters to a close

Fourth-quarter revenue at ON fell 7% from a year ago to $1.40 billion. Gross profit margin on product sold was 34.6% (37.9% a year ago), adjusted operating margin was 12.3% (versus 16.8%), and adjusted earnings per share fell 43% to $0.30. Trade wars dominated the headlines in 2019 for chipmakers, as China is an important market for sales and manufacturing, and the disruption was a key factor in this most recent business decline at ON. 

That isn't the whole story, though. Semiconductor manufacturing is a cyclical business, and general demand for ON's power management and sensor products was down in 2019, even when excluding the trade war's effects. Weakness in the large auto and industrial segments led the way south, leading to full-year revenue and adjusted earnings declines of 6% and 24%, respectively. 

ON Business Segment

Q4 2019 Revenue

Sequential Change

YOY Change

Automotive

$462 million

3%

(3%)

Industrial/Medical/Military

$344 million

(3%)

(12%)

Communications

$289 million

5%

(3%)

Computing

$153 million

1%

(8%)

Consumer

$153 million

(1%)

(10%)

Data source: ON Semiconductor. YOY = year over year.  

Structural changes in the works

Also of note was that free cash flow (what's left after basic operating and capital expenses are paid) was at negative $21 million in the fourth quarter, affected by a one-time litigation settlement of $175 million outlined in the last quarter. Full-year free cash flow ended at positive $160 million compared with $759 million the year prior.

Management disclosed it sees demand slowly coming back, especially in the automotive and computing segments (which includes sales for data center power management products). The first quarter 2020 outlook for revenue of $1.355 to $1.405 billion is flat with the year-ago results at the midpoint. However, gross margin projection of 33.7% to 34.7% (compared with 37% in Q1 2019) would imply another earnings decrease is in the cards.

Given the situation, ON is making some changes to cut expenses. It is still working to get its new fabrication facility in East Fishkill, New York up and running by the middle of 2020. In tandem with the opening of that new facility, management is still in the process of closing down its Rochester, New York facility and now also looking for a partner to take over its manufacturing operation in Belgium -- with both moves seen as improving profit margins on product sold. As a reminder, improving gross margin has been laid out as a top priority and was, in part, one of the reasons ON purchased WiFi chipmaker Quantenna in the spring of 2019.  

On top of structural changes, it is at least promising that ON's end markets like automotive (including power management for electric vehicles and sensors for driver assist systems), cloud computing (via data center chips), and 5G mobile networks will be in growth mode for years to come. 2019 was painful, but sales should eventually rebound and resume their gradual rise. In the meantime, shares aren't cheap -- currently trading at 51 times 2019 free cash flow -- but bear in mind the numbers are skewed after substantial spending in the last year. Valuations should moderate as ON starts to lap an ugly 2019.