Description

Buy ON Semiconductor Corp (ticker ON) 

Summary 

ON has favorable end-market exposure in automotive, industrial and communication, which should drive above-industry revenue growth of 3% (industry is growing 1.5-2%). Better margin mix and M&A synergies should drive EPS growth of mid-teens % over the next few years. In addition, ON’s valuation is compelling vs. other semi peers, trading at 10x 2018 P/E and 7.4x 2018 EV/EBITDA versus peer group average of 17.0x 2018 P/E and 12.0x 2018 EV/EBITDA.   

ON is a cheaper way to get long the secular growth of semi content rather than chasing other semi companies.   Admittedly, it's a lower quality semi,  but it already trades as such, and has plenty of room for multiple expansion as they execute on the recent Fairchild merger, paydown debt, and further grow the secular segments and products (ADAS, electric vehicles,  image sensors, fast charging)

Like many other diversified semi companies it's a hodgepodge of products, end markets, and exposures. 

 Company Overview

 ON Semiconductor was founded in 1999 and is headquartered in Phoenix, AZ. The company designs a wide range of energy efficient electronics such as sensors, power management, connectivity, custom and System-on-a-Chip (SoC), analog, logic, timing, and discrete devices. ON serves a broad base of end-user markets, including automotive, communications, computing, consumer, medical, industrial, networking, telecom and aerospace/defense.

-          Examples of ON’s product applications:

o    Power management semiconductor components control, convert, protect and monitor the supply of power to variety of electronic devices

o    Custom ASICs (application-specific integrated circuit) use analog, multipoint control unit (MCU), digital signal processing (DSP), mixed-signal and advanced logic capabilities to act as the brain behind many of the Company’s products such as machine vision for industrial automation

o    Signal management semiconductor components provide high-performance clock management and data flow management for precision computing, communications and industrial systems

o    Large portfolio of sensors (including image sensors, optical image stabilization and auto focused devices) provide solutions such as advanced driver assistance systems (ADAS) and active safety

Over the last 10 years, ON has evolved its business to focus more on analog, power and sensors. The management team (through M&A and organic growth) expanded products and revenue towards growth oriented end-markets such as automotive, industrials and communications.  

End Market Exposure

-           Automotive (31% of rev, rev CAGR of 7-9%)

o    This is probably the most attractive market for ON, due to the secular trend of continued content increase in autos

§  About a quarter of ON’s auto content is from image sensors. ON has a leading position in automotive cameras, with ~70% market share. Currently, the majority of vehicle cameras are used for rear vehicle applications, but the use of cameras is expected to grow sharply as ADAS applications proliferate.  ADAS is about 7-8% of revenue

§  LED lighting represents another area of potential growth in automotive, where ON has a leading position. The current penetration rate of LED lighting is only 5%, which provides substantial room for growth

o    In addition, ON’s core power portfolio and interface products have numerous areas of content within auto applications, including motor control, infotainment, safety systems and in-vehicle networking

o  The ADAS opportunity is possible another 25-50 cents in EPS over the next 5 years ( compared to $1.28 in consensus 2017 EPS).  That's assuming around 6 cameras per vehicle at a $5 ASP.  If they keep their 70% market share in the 100mm global light vehicle market and ADAS expands to 40% penetration

o    Sensata has 65% exposure to autos, NXP & Infineon 40%, CY 30%, STM 20%, 

-          Industrial (29% of rev, rev CAGR of 3-5%)

o    Industrial applications include higher performance power conversion, industrial motors/automation, traffic cameras, aerial surveillance, intelligent traffic systems, smart home/cities, and IoT

o    The acquisition of Fairchild Communications increased ON’s exposure to the broad industrial market, and increased ON’s exposure to high-voltage applications

-          Communications (19% of rev, rev CAGR of 2-4%)

o    ON’s wireless customers include major OEMs such as AAPL, Samsung and the Chinese OEMs

o    ON’s wireless product portfolio includes protection circuits, fast charging (which is increasingly hot and could be a modest growth driver), wireless charging, CMOS sensors/driver actuators that enable superior image quality, fast frame rates, high definition, and low light sensitivity.  

-           Computing (13% of rev, rev CAGR of (-6%)-(-4%))

o    ON has historically been a leader in PC power management, and despite the poor growth outlook for PC growth, content and share gains should help offset slow market growth

§  Content gains will result from the fact that INTC has decided to de-integrate certain power management components from its Skylake platform, allowing for increased ON content. ON expects power management ASPs for INTC processors to increase from $0.75 for legacy systems to more than $2.00 on Skylake

-          Consumer: (8% of rev, rev CAGR of (-7%)-(-5%))

o    Provides power controllers/converters/regulators, analog switches for consumer products such as AC units, washer/dryer, game console, induction cooker, microwave oven, power tools, vacuum cleaners…etc.

o    This segment is expected to decline MSD%+ with below company average margins

 Investment Thesis

 -          Favorable end-market exposure driving above-industry revenue growth

o    The semiconductor cycle continues on an uptrend based on strong demand in automotive, industrial, and communication markets

o    Within automotive (Serviceable Available Market (SAM) of up to $200-400 content per car), ON Semi has seen steady growth across multiple segments such as advanced driver-assistance systems (ADAS), body electronics, and in-vehicle networking. The Company has a robust product pipeline with increasing design wins for ADAS

§  ON Semi has 70% market share in ADAS for new platforms

·         It wins 60%+ of new designs. Total safety now represents ~25% of auto rev

·         Auto GMs are in the mid-high 40% range

§  ADAS is expected to be the fastest growth driver (20%+ CAGR), followed by LED lighting, then various power applications

§  Content in EV/HEV (electric vehicles/hybrid electric vehicles) are expected exceed $300 per car, but will not gain significant adoption until late 2018 or 2019

o    Within industrials, ON Semi is well positioned with its image sensors to benefit from industrial automation and machine vision applications

§  For 2017, the company expects industrial growth to be driven by power applications, new wireless standards for building and factory automation, and defense-related applications

o    Within smartphones, the Company can increase content per phone from $1.00-2.50 to $9.00 through additional charging functions (rapid charging, wireless charging), USB type-C (40 Gbps vs. 20 Gbps in UBS Mini DisplayPort), additional power management, protection chips, and RF tuning

-          Potential synergies upside from the Fairchild acquisition

o    ON is tracking significantly ahead of schedule in realizing synergies from the Fairchild acquisition it raised FCS synergies targets twice since the deal was announced 

§  During its last analyst day in March, ON increased its synergy expectations by $20mm. The company now expects total synergies of $180mm by end of 2017, with an additional $40mm in 2018 and additional $25mm in 2019

o    ON is still being punished its disaster of an acquisition of Sanyo, which they paid $660mm for back in 2010.  Sanyo is a Japanese semi company which was also hit by earthquake issues soon after the deal closed, both of which made integration very difficult.  They also had high Japan exposure (at 50%) and suffered from a weak Japanese economy and electronics industry).  Sanyo had near 0 EBIT margins out of the gate, and was a tough turnaround story in a country that makes it difficult to do any turnaround.  Fairchild will be and is a much easier acquisition.  ON remains a show me story  

o    ON has many synergies opportunities from cross selling, increased share in the distribution channel, fab consolidation, 

-          Compelling self-help story driving EPS growth of ~15% over the next three years

o    Target financial model for 2020:

§  $5.6bn of rev, 40% gross margin and 19% operating margin

·         GM expansion from ~35% to 40% will be driven by: Manufacturing efficacies 80bps improving end-market mix 90 bps

·         operating leverage (50% fall through on incremental rev): 150bps, manufacturing consolidation: 120bps, divestiture of non-core assets: 40bps

·         OPM expansion from 13% to 19% will be driven by: GM expansion of 480bps, OpEx leverage of 60bps, and OpEx synergies of 70 bps  

§  FCF target of $900mm, CAGR of 16%,  14.3% FCF yield 

§  Non-GAAP EPS of $2.00, CAGR of 15%,  7.5x P/E

o    Leverage target of 2x net leverage before end of 2018

§  Then will return 80% of FCF to shareholders

 Valuation & Comps

ON trades cheap on an absolute basis and very cheap vs. the broad semi landscape,  however that's partly because they have exposure to more commoditized, lower ASP, lower margin semis.   It's one of the cheapest semi companies out there

Many of the 'better' semi companies have 50-70% gross margins,  while ON has 30-40% gross margins like other lower end peers (e.g. DIOD, VSH)

ON has lagged semi peers by quite a bit as well over basically any time frame over the last 5 years.  Its multiple has basically been flat over the last 5 years 

It's sort of like an NXPI - which is being acquired by QCOM in a diversification play.  ON could also be a takeout target if another semi company wants to get more exposure to autos and industrials.  

At a 9.5% FCF yield on 2017 #s is also pretty attractive for many value investors.  It'll get above 10% in 2018 and beyond 

Revenue by Geography:

-          US: 15.1%

-          UK: 13.8%

-          Hong Kong: 27.8% (they had R&D and distribution centers in HK).  They sell to ZTE and Chinese smartphone OEMs

-          Japan: 8.6%

-          Singapore: 28.4%

-          Other: 6.3%

Revenue by End Markets:

-          Power Solutions Group (44% of rev):

o    Offers a wide array of discrete, module and integrated semiconductor products that perform multiple application functions, including power switching, power conversion, signal conditioning, circuit protection, signal amplification and voltage reference functions

o    The trends driving growth within end-user markets are primarily higher power efficiency and power density in power applications, the demand for greater functionality in small handheld devices, and faster data transmission rates in all communications

o    Competitors include Broadcom, Diodes, Infineon, KEC, NXP, Semtech, Texas Instrument, Toshiba and Vishay

-          Analog Solutions Group (38% of rev):

o    Designs and develops analog, mixed-signal, and advanced logic ASICs and application-specific standard products, and power solutions

o    Competitors include Infineon, Maxim, NXP, Renesas, STMicroelectronics, and Texas Instruments

-          Image Sensor Group (18%): 

o    Designs and develops CMOS and CCD image sensors, as well as proximity sensors, image signal processors, and actuator drivers for autofocus and image stabilization

o    Competitors include Omnivision, Samsung, STMicroelectronics, Toshiba, Renesas, and Rohm

Risks

-          Potential integration issues with recent acquisitions  

-          Higher debt ratio than peers at 3x net debt/LTM EBITDA,  but heading down towards 2x by the end of 2017

-          Downturn in the semis cycle: there's some concern about increased inventory in the channel,  but that seems fairly well known now

      Auto concerns / topping:  You can hedge the auto exposure by shorting an auto supplier with no secular content growth (e.g. AXL),  or an OEM 

 Competition from China after they buy NXPI's standard products business (which makes low-end discrete semis) 

Drag from declining computing and consumer segments offset the growth in communications, industrial, and auto 

Catalyst

Continuing to execute on FCS merger synergies

Continuing to paydown debt, which will expand the multiple and grow EPS and FCF

More content per device in autos, industrial, and other applications (ADAS, image sensors, power solutions, factory automation)

Divesting lower margin and non-core segments that are a drag on margins and the multiple (compute and consumer)