|Shares Out. (in M):||452||P/E||16.0x||10.9x|
|Market Cap (in $M):||3,833||P/FCF||19.3x||11.0x|
|Net Debt (in $M):||355||EBIT||279||407|
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ON Semiconductor (ONNN) fits the mold of a general investment thesis that has worked quite well for us over time: a decent company with one of its segments significantly underperforming and masking the earnings power of the company, longer-term. In short we think, we think ONNN can earn close to $1.00 per share in the next 1-2 years and has a fair value of $10-12.
ON is cheap because its SANYO division is depressing earnings and folks are skeptical that the company will effectively turn the segment around. The stock trades at 12x 2014 consensus EPS of 70c, but we think the company could earn closer to 75 or 80c with a run-rate approaching $1.00 towards the back-half of 2014 – which we think would lead to a higher multiple for the stock. Any industry cyclical improvement could provide upside to these forecasts (semi industry revenues are still 5-10% below the 15-year trend-line in 2013).
ON sells a combination of analog chips and standard products. In general, producing analog chips is a decent business with about 15 main global competitors. Analog chips are defined as semiconductors that integrate and regulate “real world” functions such as temperature, speed, sound and electrical current. Digital semiconductors process binary information, such as that used by computers.
The market for analog semis differs from the market for digital semiconductors. The analog industry is typically characterized by longer product life cycles than the digital industry. In addition, analog semi manufacturers tend to have lower capital investment requirements for manufacturing because their facilities tend to be less dependent than digital producers on state-of-the-art production equipment to manufacture leading edge process technologies. ON and other analog companies will typically buy fab equipment after it’s been depreciated by higher-end manufacturers like Intel or Taiwan Semi. The end- markets are more varied and more specialized than the relatively standardized digital semiconductor product markets. In general, analog has a higher barrier-to-entry – not a great business, but a decent one.
The company has a portfolio of 40k+ products and sells ~40b units per year at average price of ~$0.07. Manufactures semis, so has operating leverage, but not R&D intensive. End markets (2Q13): Computing = 16%, Consumer = 20%, Auto = 28%, Industrial = 19%, Communications = 17%. Customers: OEM's = ~55%, Distributors = ~40%, EMS = ~10%. Acquired SANYO in Jan 2011. Prior to 1999, was sub of Motorola.
SANYO Acquisition – in 1Q11, ON paid $480m for SANYO. On top of the amount paid, the company has posted $323m of operating losses. SANYO was primarily a manufacturer of simpler, commoditized, consumer chips in Japan and other parts of Asia. Following the acquisition, ON got hit with two issues: 1) a step-down in the competitiveness of Japanese consumer electronics companies and 2) floods at their Thailand manufacturing facility that caused a shift in demand to other regions of Asia. The company blames most of its problems on these issues; other industry insiders say the SANYO business has been terrible for years and that ON misjudged its ability to streamline its operations. Either way, the acquisition was bad; but, the analysis must look forward.
Earnings Walk (Street May Be Miscalculating Potential Improvement)
It seems that the street is calculating gross margins for the consolidated company, when we think you should calculate them for SANYO and Ex-SANYO separately – this leads to a different result, as our gross margin estimate is roughly 100bps+ higher than FC for 3Q/4Q14, with EPS of 45c v. FC at 39c (for the two quarters combined).
Looked at another way - ON Earned 68c annual run-rate in 3Q13 and lost 1c at SANYO. If they can get 10% margin on SANYO at 200m quarterly revs, that would add 20c. 10% increase in revenue at 20% incremental op margins could add 10c+.
More Detail on SANYO
Admittedly, the thesis assumes ON will be able to get its SANYO division back to a reasonable operating margin. But, the company is making progress and we don’t think the hurdle is that high before earnings estimates get revised upwards. By mid-2015, ON thinks the break-even for SANYO is ~$140m of revenue (vs. $157m in 3Q13). Today, ~65% of revenues are coming from outside Japan and they expect that to be closer to 75% by the end of 2014. In other words, the drag from the competitive position in Japan is diminishing.
ON is taking its medicine and buying the stock now, when the windshield is still dirty, should be rewarding.
We and our affiliates are long ON Semi (“ONNN”) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of ONNN. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusions.
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