The semiconductor industry is turning to address a new growth trend: automotive and industrial equipment. After 20 years of focusing on smartphones and cloud computing, all the work that went into advancing mobile technology for relatively safe apps (a buggy update to a smartphone can’t do anyone much harm) is now being applied to more mission-critical applications operate. After all, mobile software and companion chips must work with a high degree of certainty before being dropped onto roads where they could seriously harm people.
Enter ON Semiconductor (on Monday -0.81%)Once a commoditized integrated device manufacturer (IDM) company, often overlooked in favor of larger companies like Texas Instruments and NXP Semiconductors. Over the past few years, ON has done a good job of positioning itself as the top choice in automotive and industrial technology chips. However, is it worth buying now, given that shares have risen more than 240% over the past five years?
ON KNEW THIS IS COMING AND THE GROWTH WILL BE MAGNIFICENT
For years, ON has been preparing its family of power modules and power management, sensor and motor control chips for the coming explosion of industrial semiconductor applications. The chip design and manufacturing industry must plan for customer orders many years in advance. To meet more demand, multibillion-dollar chip manufacturing facilities, known as fabs, need to be planned and built. Therefore, an IDM like ON has high visibility into future demand trends and can make profit plans accordingly.
The company named CEO Hassane El-Khoury and CFO Thad Trent in late 2020 and early 2021. The pair managed to lead another chip company called Cypress Semiconductor to stronger profitability and eventually merged with top German IDM Infineon. The acquisition closed at the onset of the pandemic in early 2020.
By the time they were hired by ON, El-Khoury and Trent’s fortunes had already begun to decline. But since they took over, ON has been selling off more commoditized chip factories and reinvesting in more advanced design and manufacturing. Silicon carbide chips for electric vehicles (EVs) have recently been one of the areas of focus. Another is high-end sensors for robotics, such as those used in robotic machinery and heavy equipment in industrial manufacturing.
The results are impressive. Trailing 12-month revenue has grown only 37% over the past five years, but free cash flow and net income have grown 76% and 112%, respectively, over the same period. The new ON is more profitable and poised to take on a leadership role as the electric vehicle and industrial robot industries take off over the next decade.
By 2028, ON and other analysts predict electric vehicles will account for more than half of all new car sales. Combined with industrial technology adoption, ON sees its overall market growing at an average rate of 7% to 9% through 2025.Other companies such as chip manufacturing equipment manufacturers ASML Holdings Agree with the forecast that the once-dormant automotive and industrial sectors will drive chip and related sensor growth of at least 6% a year in the 2020s.
Now’s the time to buy ON stock, right?
Before going out and loading ON, consider a couple of risks here. Given how big the automotive and industrial technology markets are, I don’t think Texas Instruments, NXP, and other competitors are a major concern. There will be a lot of growth.
Instead, my main concern is the looming slowdown. In fact, ON already announced a slowdown in its sales growth in its third-quarter update. Fourth-quarter revenue is expected to cool to just 12% year-over-year growth after a 26% year-over-year increase in the summer and early fall quarters. With a recession looming in 2023 and consumers already shifting spending away from big-ticket items, the auto market is showing signs it could back off next year.
A similar situation occurs in industrial companies. Capital spending on some industrial equipment is also slowing in the face of a slowing economy and rising interest rates.
There is also the issue of valuation. The stock trades at 26 times 12-month free cash flow and 19 times 12-month earnings. ON isn’t exactly a “cheap” chip stock.
Still, while this uncertainty heading into the new year makes me hesitant, I might start slowly buying some shares of this company, building a larger position over time. Demand for ON Semiconductor’s automotive chips will rise if electric vehicles continue to eat up market share or sell new cars. The company has been slowly exiting legacy industrial products to focus on advanced technologies such as robotics and sustainable energy production. Even in a recession, the company’s moves should at least help maintain the bottom line in the company’s differentiated and highly profitable solutions suite.
The long-term outlook is certainly something to be excited about too. If you believe in strong growth in electric vehicles and industrial technology over the next decade, ON Semiconductor stock is worth serious study.
Nicholas Rossolillo and his clients at ASML Holding. The Motley Fool has positions in and recommends ASML Holding and Texas Instruments. The Motley Fool recommends NXP Semiconductors. The Motley Fool has a disclosure policy.