The semiconductor industry is pivoting to address new growth trends: automobiles and industrial equipment. After two decades of focus on smartphones and cloud computing, all the work that's gone into advancing mobile technology for relatively safe applications (an errant smartphone update won't hurt anyone much) is now being applied to more mission-critical operations. After all, mobile software and supporting chips have to work with a high degree of certainty before being put on the road where they could seriously hurt people.
Enter ON Semi (ON 0.93%), once a commoditized integrated device manufacturer (IDM) company that was often overlooked in favor of bigger names like Texas Instruments and NXP Semiconductors. ON has done a great job positioning itself the last few years as a top option in the chip space for automotive and industrial technology. However, with shares already up over 240% in the last five-year stretch, is it worth buying right now?
ON knew this was coming, and the growth will be substantial
For a number of years, ON has been preparing its lineup of power module and power management, sensor, and motor control chips for the coming explosion in industrial semiconductor adoption. The chip design and manufacturing industry has to plan for customer orders many years in advance. To accommodate more demand, multibillion-dollar chip manufacturing facilities (called fabs) need to be planned and built. Thus, IDMs like ON have a high level of visibility into future demand trends and can plan to profit accordingly.
The company brought on CEO Hassane El-Khoury and CFO Thad Trent in late 2020 and early 2021. The duo successfully navigated another chip company called Cypress Semiconductor to more robust profitability, and eventually a merger with Germany's top IDM Infineon. That acquisition closed in early 2020 right as the pandemic was getting started.
By the time they were hired at ON, the ball was already rolling downhill for El-Khoury and Trent. But since they took over, ON has been selling off more commoditized chip fabs and reinvesting into more advanced design and manufacturing. The silicon carbide chips used in electric vehicles (EVs) have recently been one area of focus. Another is high-end sensors used in robotics, like those used in robotic machinery and heavy equipment in the industrial manufacturing sector.
The results have been impressive. Trailing 12-month revenue has increased just 37% over the last five years, but free cash flow and net income have jumped 76% and 112%, respectively, over that same period. The new ON is more profitable and ready to assume a leadership role as the EV and industrial robotics industries take off in the next decade.
By 2028, ON and other analyst predictions point toward EVs accounting for over half of all new vehicle sales. Paired with industrial technology adoption, ON thinks its overall market will grow at an average rate of 7% to 9% through 2025. Other companies like chip fab equipment maker ASML Holding agree with forecasts that the once-sleepy auto and industrial space will fuel at least 6% average annual growth for chips and related sensors for the duration of the 2020s.
Time to buy ON stock now, right?
Before going out and loading up on ON, consider a couple of risks here. Given how massive the market is for autos and industrial tech, I don't think Texas Instruments, NXP, and other competitors are the primary concerns. There will be plenty of growth to go around.
Rather, the main worry I have is a looming slowdown. Indeed, ON already announced slowing growth for its sales during the third-quarter update. After rising 26% year over year in the summer and early autumn quarter, revenue is expected to cool to just a 12% year-over-year increase for the fourth quarter. With a possible recession looming in 2023 and consumers already shifting their spending away from higher-priced items, the auto market is showing signs it could take a step back next year.
Something similar is showing up in industrial companies as well. Faced with an economic slowdown and higher interest rates, capital expenditures on some industrial equipment is also slowing.
There's also the matter of valuation. Shares trade for 26 times trailing 12-month free cash flow and 19 times trailing 12-month earnings. ON isn't exactly a "cheap" chip stock.
Nevertheless, while this uncertainty headed into the new year gives me pause, I might start slowly buying a few shares of this company anyway on the way to building up a larger position over time. If EVs keep gobbling up market share of new cars sold, demand for ON's automotive chips will rise. And the company has been slowly exiting legacy industrial products to focus on higher-order tech for things like robotics and sustainable energy production. Even in a recession, the moves the company has made should at the very least help keep a floor under the company's differentiated and highly profitable suite of solutions.
The longer-term outlook is certainly worth getting excited about too. If you believe EVs and industrial tech have a strong decade of growth ahead of them, ON Semi stock is worth a serious look.
