Description

Summary:

ON Semiconductor (NASDAQ: ON) has been written up twice on VIC in the past, please take a look for helpful background. ON provides an opportunity to invest in a semiconductor supplier with strong secular tailwinds and a significant margin expansion opportunity trading at a discount to peers.

Business Overview:

ON is an American semiconductor supplier based in Phoenix, Arizona. ON was founded in 1999 after Motorola spun off their Semiconductor Components Group. ON continues to produce discrete, standard analog, and standard logic devices, which it sells into key end markets such as: Automotive, Industrial Applications, Radio Frequency (5G and Cloud Communications), Aerospace and Defense, and Medical Devices. Out of these key segments, the firm has shifted its product mix towards Automotive and Industrial Applications, with these 2 key end markets making up ~73% of total revenue. Through this shift, ON has been successful in beginning their shift towards higher price mix and more specialized products. These are also the 2 fastest growing end markets for their shift into Silicon Carbide, a next-generation semiconductor material, that will drive revenue growth and free cash flow generation in the next 7-8 years.

ON is vertically integrated, with front end manufacturing sites in 10 countries and back-end design sites in 19 countries for its 3 key segments:

1. Power Solutions Group (PSG) - Semis used for power switching, conversion, signal conditioning, amplification, circuit protection and voltage regulation. This segment makes over 50% of the total revenue. This is also the segment within which the Silicon Carbide manufacturing resides. This is also the highest growth segment with long term revenue growth in 2030 of 15%
2. Analog Solutions Group (ASG) - Semis used for advanced logic capabilities, ASSPs and ASICs, RF and integrated power solutions and design solutions, along with government contracts. This makes up over 33% of revenue and is the highest margin segment at 52% gross margin.
3. Intelligent Sensing Group (ISG) - CMOS image sensors and signal processors, single photon detectors and actuator drivers. Used in automotive and industrial applications primarily (90% of revenue) and is the segment that most closely follows Moore’s law.

Thesis Overview:

1. Shift towards Silicon Carbide (an emerging market in semiconductors) creates an opportunity for above market expected growth rate, driven primarily by automotive and industrial application adoption.
2. Improving gross margins and reduction in capital investment as a result of SiC adoption and shift towards analog product mix will help ON generate higher than expected free cash flow.
3. Changing product mix towards analog, with higher margins and more differentiation in product, warrants a re-rating of multiple to narrow valuation gap with analog device manufacturing companies such as Texas Instruments and Analog Devices Inc.

From a top line standpoint, the emergence of Silicon Carbide has significant implications for the revenue growth trajectory of ON. ON has had robust revenue growth of mid-to-high 20% since COVID restrictions were eased and end markets caught up on demand. However, the question that arose is whether ON could sustain a high revenue growth rate as key end markets reached more stable growth rates. However, through the shift towards SiC and the product mix shift towards automotive and industrial applications, ON is able to successfully ramp up revenue growth in the short and long term.

Silicon Carbide is a more concentrated market due to having almost 63% of total use cases in automotive, and a further ~20% in industrial applications. This is due to it being a wider bandgap material and being able to conduct well at higher temperatures and voltages. Due to this advantage over Silicon in semiconductors in automotive, it is also expected to grow above market CAGR due to the increasing volume of EVs and the increasing content of SiC per vehicle. To believe the argument that SiC will drive revenue growth for ON, you also need to believe the argument that the SiC device market will follow the trajectory of the Silicon semiconductor device market in terms of consolidation. I expect the market to consolidate due to high startup cost of facilities, low substrate yields that drive costs for SiC products, along with the R&D required to develop a production technology in-house.

ON’s recent acquisition of GTAT to partially in-source the substrate part of the supply chain for ON, which has an advantage now in the crystal margin due to GTAT’s technology, along with in the device market due to higher power density and lower device packaging cost due to a structural technology advantage. This translates into better gross margins for the PSG segment over time as the GTAT technology is fully integrated into the revamped FAB in South Korea used specifically for SiC production. The market is also expected to ramp with better innovation due to the automotive market being slower to adopt newer technologies, but this is bolstered by the new LTSAs ON signed with legacy partners such as Volkswagen, Tesla, Jaguar Land Rover and Hyundai. You also need to believe that the relationships are a key driver with automotive companies putting out their next generation of EVs or new EV fleets are either single sourced or at most double sourced for SiC production due to having to invest in capacity early on, along with increasing SiC content per vehicle increasing the need for supply agreements.

As the business continues to change its vision strategically towards more analog type products. On a revenue basis, if you strip out cyclicality, revenues have grown at a 10% CAGR. As the business shifts towards analog devices as a larger portion of revenue mix, which are more specialized products with lower Capex needs, the business is expected to grow FCF per share in the mid teens. This is also due to structural changes in the business’ supply chain through the divestitures of Non-core FABs and product lines. This is estimated to have ~$160mm positive Gross Margin impact for the FAB divestitures along with exiting ~$700mm in non-core revenue segments with an average GM of 26%. This not only makes the business more efficient from a margin perspective, but also decreases the expense and Capex needs for ON.

Valuation:

With regards to valuation, the key driver for a re-rating is the shift towards analog products and the resulting margin expansion, which will lead to greater FCF generation and warrants a EV/ Sales multiple re-rating to approximately 5.7x (resulting in c. 35% upside), from current levels of 4.2x, which is closer to Texas Instruments and Analog Devices, which have lower capex requirements and generate more FCF than ON currently. They serve as good comps given their focus on analog products and with most of their revenues exposed to the industrial + auto end markets.

Risks:

There are 2 primary risks associated with this investment, that may play out:

1. Lower than market adoption rates of SiC by automotive manufacturers and the lower investment into semiconductor supply - this is played out through the decrease in automotive market growth, decrease in SiC TAM and the shrinking SiC content per EV (market expects growing SiC content per EV) in the bear case.
2. Overbuild of capacity and cyclicality concerns - there are significant bullwhip effects in the semiconductor supply chain, with historical overinvestment in capacity in periods where market expects high growth. The inability to clear the channel of inventory and overbuild of capacity significantly affects top line and gross margins due to lower utilization of fabs.

Catalyst

Earnings growth