There have been two big winners in the semiconductor sector over the past year: those exposed in a big way to the artificial intelligence (AI) revolution, and chip companies participating in the growth of electric vehicles and infrastructure.
More specifically, silicon carbide (SiC) is set for blockbuster growth in the years ahead. A material with high heat resistance and conductivity, SiC is perfect for electric vehicles and infrastructure. Only a handful of players are investing in the novel material today in a big way, and these companies could be set for big profits a few years out.
One is On Semiconductor (ON 2.53%). While the stock is up more than 50% this year, it pulled back recently after its earnings report, and amid the general tech sector sell-off.
However, the stock has not one but three potential catalysts on the horizon that could propel results skyward in 2024.
1. Silicon Carbide is ramping up in earnest
First, while On has competitors in SiC, it has probably been the fastest to ramp up its own SiC chip output. It was able to convert its existing fabs and expand them to accommodate SiC, rather than having to build entirely new fabs from scratch, as, say, Wolfspeed is doing.
Since SiC chips are ramping up in earnest and are somewhat complex to make, SiC margins are currently lower than the company's overall gross margins. However, that will eventually change, and On's second quarter showed notable progress on that front.
In the second quarter, On's SiC revenue grew a whopping fourfold over the prior-year quarter, while SiC gross margins doubled quarter over quarter. Importantly, Q2 also marked the first profitable quarter for the SiC business, achieving a "high-teen" operating margin even with startup costs factored in. That's quickly making progress toward On's total 32.8% adjusted (non-GAAP) operating margin last quarter, which itself was dragged down because that very SiC revenue made up a larger part of the business.
However, On eventually expects SiC revenue to exceed the company average, helping On reach its longer-term goal of 53% gross margins, up from 49.2% in 2022, along with operating margins of 40% by 2027.
Investors should expect SiC revenue to grow aggressively, as On booked $3 billion of silicon carbide revenue under long-term service agreements (LTSAs) in the second quarter alone, bringing the lifetime total for SiC LTSAs to $11 billion. For reference, On made $8.3 billion in total revenue last year.
In addition, several customers have even made pre-payments under some of that LTSA total, further de-risking that future revenue. And on the conference call with analysts, CFO Thad Trent said he expects SiC margins to be at the corporate average by the end of the year.
In any case, investors should see a positive inflection in margins as SiC continues to scale and reach a more mature stage by the end of the year. But that's not all.
Getting new fab costs under control
It hasn't been all great news for On this year. In fact, On had a fairly significant setback after it acquired a 300mm fab in East Fishkill, N.Y. from Globalfoundries at the start of 2023. The acquisition gives On the only 300mm (12-inch) power and image sensor capacity in the U.S., which could be a big advantage as these chips are increasingly adopted in electric and autonomous vehicles. But as it turned out, the costs of running this fab were much higher than expected, and that's been a headwind to gross margins this year.
Management expects a 2.5-percentage-point headwind to remain for the next several quarters as the company works to bring down the costs of the fab and run it more efficiently. That will take time, but it should start happening in 2024. On the call, Trent elaborated:
We've now been spending six months really getting our arms around it and understanding what we need to get that cost structure back in line. Look, we've got a large manufacturing footprint, we know how to run fabs efficiently, we've benchmarked, we know exactly what we need to do. ... [T]his has been probably a year, maybe slightly more than a year, of headwind for us as we continue to take the cost out. But we expect by the time we exit '24, we've got that fab at parity and running efficiently.
While investors may see continued headwinds this year, it looks as though more margin expansion could be coming in 2024 if management gets the East Fishkill plant's costs under control.
Image source: Getty Images.
And, of course, don't forget AI
On hasn't positioned itself as an AI stock, rather concentrating on the attractive automotive and industrial chip markets. But power efficiency isn't just a theme for electric vehicles and infrastructure; it's also important to AI servers, which suck up huge amounts of energy.
At its March Analyst Day, management put forward the prospect of increasing content in AI servers in the future, and it provided more color on the second-quarter call. Even though it doesn't make AI processors, accelerators, or high-capacity memory that will be in high demand, On does produce controllers, power converters, and e-fuse protection devices that can also be used in data center servers.
When asked on the recent conference call, CEO Hassane El-Khoury noted:
... part of that focus on what we call driver and controllers is the server or the cloud infrastructure, which applies definitely to AI. [T]hat's the play we have there. ... We're going to -- we decided, we're doubling down, we're starting to run, and we're going to start delivering on that. That's going to be the winning formula for this new business also. So stay tuned for more updates as we get into Q4 or Q1 of '24.
On isn't thought of as a significant AI player, and it still might not be. But if it can parlay some of its power-efficient controllers and drivers into the booming AI server market, that could open up further growth possibilities for investors.
On in on the watchlist
While I don't yet own On, it's certainly on my watchlist. The company has made an impressive turnaround over the past few years under the activist investor-installed El-Khoury, and that transition continues.
Since the company's transformation is still in progress and the auto and industrial power chip segments are in relatively early stages of growth, On's stock looks attractive at around 18.5 this year's earnings estimates.
