onsemi: Shrinking Lead-Times Deserve Attention, But The Long-Term Story Matters More

These are tricky times in the semiconductor industry. Lead-times continue to fall, at an accelerating rate in some cases, and some companies have mismanaged their channel inventories relative to sluggish demand in many end-markets. It’s not so surprising, then, that the SOX has continued to fall, but I’m a little surprised that onsemi (NASDAQ:ON) has underperformed a bit since my last update.

To be sure, there are some near-term trends that are not favorable for the company, including accelerating shrinkage in lead-times and some potential pressure on margins from utilization. On the other hand, shrinking lead-times are also an opportunity to clear out less desirable business and improve the long-term margin outlook. Moreover, onsemi continues to execute exceptionally well on its silicon carbide (or SiC) expansion plans and there may be some upside in the model due to superior inventory management.

Between the company’s analyst day earlier this year, Q2’23 earnings, my expectations for the second half of 2023, and the longer-term outlook, I’m still bullish on onsemi’s stock. I appreciate the “falling knife” risk that the stock presents today, but if this is a stock you want to own, I wouldn’t advise getting too cute about timing the bottom.

Looking To Next Week’s Earnings Report

It’s been quite a while since onsemi has missed Street expectations for revenue in a quarter, and it certainly doesn’t hurt that a lot of critical auto products are still in short supply. That should underpin these upcoming results, but I want to note a few risk factors.

First, lead times are shrinking. As per Christopher Rolland at Susquehanna, lead times continued to shrink in September (the 15th straight month of declines), with a 5-day drop to 18.7 weeks after a 2-day drop in August. onsemi appeared to have a much greater decline, on the order of 47 days (to 16.1 weeks), though there have been some ongoing shortages in certain power management chips and IGBTs for EVs.

Given that both MOSFETs and power management chips are decelerating at above-average rates (34 days and 12 days, respectively), it’s not so surprising that onsemi would be seeing higher declines. Likewise, while SiC lead-times are still very elevated compared to the rest of the industry, availability has been improving pretty rapidly as new capacity comes online.

I also see some risk from the company’s ongoing strategic business exits. Management was targeting $350M to $400M in strategic business exits this year, but had only accomplished about $100M as of the second quarter. As lead-times ease, it’s easier for onsemi to exit business (you don’t anger customers as much, as they can source from others more readily), and so there could be a bigger headwind from exits than is contemplated in the numbers. Whether this shows up in Q3 or Q4 (or management pushes the exits in 2024), I don’t know, but it’s worth watching.

I also see some modest risk on the margin side. Management’s guidance called for a 40bp qoq decline at the midpoint, but with lead-times falling more rapidly, it is at least possible that utilization could fall more than management expected with that guidance, and that would create some pressure on margin.

Last and not least, I want to hear about the how ongoing SiC ramp is going. Management has executed very well here – certainly better than Wolfspeed (WOLF) and arguably better than Infineon (OTCQX:IFNNY), Rohm (OTCPK:ROHCY), and STMicroelectronics (STM), but let’s see how this next phase goes as the company has to ramp more internal wafers from its GTAT facility.

Healthy Auto, Still-Healthy Individual Industrial Markets, And Self-Help

The main driver for onsemi, the auto industry, remains a relatively healthy opportunity. I do have concerns about the UAW strike impacting auto builds, but those vehicles are unlikely to have a lot of onsemi content onboard (some ADAS for sure, but not much EV-related content).

The S&P recently upgraded its outlook for auto builds in ’23 (from 6.3% to 7.7%), largely due to China EVs, and that should serve onsemi well. It may actually end up being the case that the UAW strike inadvertently helps onsemi – it’s at least plausible to me that some EV/ADAS customers could still be supply-constrained on components like MCUs; if those are diverted away from UAW-struck facilities, it could drive more onsemi content elsewhere. Beyond this, I also see opportunities for competitive share gains, with the company having introduced a new inverter that seems consistent with Tesla’s (TSLA) comment about pursuing a design that requires SiC like content.

I’m not exceptionally bullish on industrial markets in general, but areas like electrification, medical, and renewable power are holding relatively well. ABB (OTCPK:ABBNY), the only major electrification player to report so far, reported growth in both revenue and orders, and while I expect weaker factory automation demand in the near term, solar and other renewable installations continue to grow.

Last and not least is potential self-help. It doesn’t always get the attention it should from investors, but onsemi is quite good at managing inventories, and the company has been running its channel inventories lean while building up internal inventories. Although channel inventory did tick up in Q2’23 (from 7 weeks to 7.7 weeks), it’s still running below the 10-11-week target. Not only is that prudent in a period of declining lead-times (not stuffing the channel), normalizing the channel inventories could offer a few hundred million of revenue upside at some point.

The Outlook

I’m not fully onboard with the longer-term guidance that management laid out at its May analyst day. I do think the company will outgrow the overall semiconductor industry on the back of its strength in advanced power and sensing, and I do think the company will outgrow its rivals in SiC. Where I depart is the 35% to 40% share – I think that’s a big ask against Infineon, Rohm, and STMicro, even with the move toward trench architecture and other capabilities like internally-developed advanced packaging (good for managing temps and extending EV range) and a new exciter module that doesn’t require magnets.

To be clear, this is only a disagreement of degree, and $9B in secured long-term supply agreements for auto and industrial customers is impressive. I have little question that onsemi will see significant growth on the back of growing demand for EVs, charging, electrification infrastructure, and automation, as well as “oh yeah, and that too” markets like data center and 5G cloud.

I’ve upgraded my revenue growth expectations, taking my 2027 number about 6% higher and my 2032 number almost 9% higher. At a little over 8%, my long-term revenue growth rate is higher than my numbers for both Infineon and STMicro. I’ve also upgraded my margin estimates; management has done a very good job of improving margins through this restructuring or turnaround, and I think mid-20%’s adjusted long-term FCF margins are possible. Management’s target of 40% operating margin in 2027 is aggressive and ambitious, but doable.

Translating that all back into fair values, I think the shares are undervalued below $100 just on discounted cash flow (and it’s not uncommon for growth semi stocks to trade above, even well above, discounted FCF-based value). My margin-driven EV/revenue and EV/EBITDA approaches get me to about $105, and another $10/share would be relatively easy to unlock as market sentiment moves from contraction (shrinking lead-times) to expansion/growth again. While I value onsemi with a roughly 5.1x revenue multiple today, achieving that 40% op margin target could take the multiple to 6.5x down the road.

The Bottom Line

The worst I can say about onsemi now is what I’ve said about other chip stocks – buying into shrinking lead-times can be painful, and I don’t think the correction is over yet. I still think it will take several more months for lead-times to normalize, and while these stocks often move a quarter or two in advance of the turn, a weaker global economy could delay that turn.

I think onsemi will be fine for the long term; the trouble is that the shares could definitely see the $70’s again, maybe even the $60’s, before the $90’s. If you can’t abide the idea that you didn’t buy in at the absolute best price, maybe this isn’t the right time or the right stock, but I’d be careful about getting too cute about picking a bottom if this is a stock you want to own.

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