Why ON Semiconductor is a strong buy despite recent market challenges

ON Semiconductor, the $31 billion chip manufacturer based in Scottsdale, Arizona, has faced significant challenges lately.

Despite the broader market momentum, with the S&P 500 index climbing 29% from July 2023, ON Semi’s stock has plummeted 31%, reaching $72 from its record high.

The chipmaker’s primary customers, auto manufacturers, and industrial firms, have struggled amid a slowing market, impacting ON’s financial performance.

The company’s dependence on automotive semiconductors, which make up over half of its revenue, has been a double-edged sword.

Sales in this segment fell 21% to $907 million in the second quarter of 2024 from a high of $1.16 billion in the third quarter of 2023.

This slump came as automakers, previously concerned about supply shortages post-pandemic, overstocked chips during stagnating car production.

The pullback in purchases, combined with a subdued industrial market, squeezed ON Semi’s profit margins, pushing them down to 45% from 47.3% in the prior year and contributing to a 31% drop in earnings.

ON Semiconductor on the cusp of a resurgence?

Despite these challenges, analysts believe ON Semiconductor is on the cusp of a resurgence, according to a Barron's report.

The company’s automotive sales have already shown a 4.9% recovery in the third quarter, climbing to $951 million from the second-quarter trough.

Margins also improved slightly to 45.5%, hinting that the worst might be behind the firm.

Economic factors could further catalyze this rebound.

With the Federal Reserve and other central banks expected to reduce interest rates, there is potential for economic growth, which could boost consumer spending and auto sales.

Moreover, Donald Trump’s recent election victory might create favorable conditions for traditional auto markets, although it could temper the growth of electric vehicle (EV) sales, an essential area for ON.

Piper Sandler’s Harsh Kumar reassures in a report that automakers remain committed to EVs in the long term, suggesting that ON’s EV-focused product lines may not suffer as much as some fear.

Auto makers ramp up production: good news for ON

As auto manufacturers ramp up production to meet rising demand, their need for semiconductors will naturally increase.

This could result in a positive cycle for ON, where chip sales and prices gain momentum.

B. Riley Securities analyst Craig Ellis likens the potential surge in chip orders to “flipping a light switch,” emphasizing the rapidity with which recovery could take hold.

The industrial market, another vital revenue stream for ON, is also expected to see a gradual uptick.

With automation and advanced manufacturing processes becoming more integral to the industry, the company’s industrial chip sales are projected to grow at an annual rate of 6% over the next three years.

To bolster its production capabilities, ON Semiconductor acquired GlobalFoundries’ East Fishkill, New York, plant.

This facility provides additional chip production capacity at similar costs to existing plants, improving ON’s efficiency without proportionately increasing expenditure.

This strategic move supports the company’s goal of reaching 53% gross margins, a target it reiterated during its third-quarter earnings presentation.

Why to buy ON stock

ON Semi’s management continues to generate robust free cash flow, topping $1 billion annually.

The company has committed to using half of each quarter’s cash flow for share repurchases, which is expected to enhance shareholder value.

Analysts anticipate annual earnings per share (EPS) growth of 21%, projecting EPS to reach $7.11 by 2027, up from $4.01 this year.

If the auto market recovers faster than expected, these estimates could be conservative, with Charter Equity’s Jack Egan pointing out “more risk to the upside.”

Valuation-wise, ON Semiconductor’s current trading multiple of 17 times forward earnings is notably lower than the S&P 500’s 22 and the chip sector’s average of 23.8.

Holding this multiple would imply a stock price of around $112 by the end of 2026, representing an impressive 25% annualized gain.

While ON Semiconductor may not boast the AI-focused allure of industry giants like Nvidia, it has the makings of a strong investment as demand recovers.

With the right economic tailwinds and strategic execution, ON Semi stock could offer significant returns for long-term investors.