This Semiconductor Maker Isn’t a Big AI Chip Player. Why It’s Time to Buy Its Stock

In recent times, chip stocks have surged in popularity, driven largely by the increasing demand for artificial intelligence (AI) technologies. However, amidst this chip market boom, ON Semiconductor has faced headwinds. The $31 billion Scottsdale, Arizona-based company primarily caters to auto manufacturers and other industries that have been grappling with sluggish demand.

Since reaching a record high of $72 on July 28, 2023, ON Semiconductor’s stock has plummeted by 31%, while the S&P 500 has enjoyed a gain of 29%. Despite these setbacks, analysts believe that ON Semiconductor’s fortunes are poised to improve as the automotive sector rebounds.

A Shift in Demand

Automakers are expected to see a resurgence in vehicle sales after a prolonged period of lackluster performance. Analysts predict that the upcoming Federal Reserve interest rate cuts will provide a much-needed boost to economic growth, and the potential political landscape shifts could further enhance demand for automobiles. Charter Equity Research analyst Jack Egan sees ON Semiconductor as “a strong candidate for outperformance once demand rebounds.”

A significant portion of ON Semiconductor’s revenue — over half — stems from its automotive chip sales. However, the company’s auto chip sales dropped to $907 million in the second quarter of the current fiscal year, a 21% decline from the peak of $1.16 billion in the third quarter of the previous year. The initial rush by automakers to secure chips post-COVID lockdowns led to an oversupply that, coupled with stagnant car production, has resulted in lower chip orders from giants like Ford and General Motors, according to Morningstar analyst William Kerwin.

Signs of Recovery

Despite the challenges faced in recent quarters, encouraging signs are beginning to surface. In the third quarter, ON Semiconductor experienced a 4.9% increase in automotive sales, rising to $951 million from the disappointing previous quarter. This uptick in sales was accompanied by a slight increase in profit margins, indicating that the company has likely weathered the worst of the storm. B. Riley Securities analyst Craig Ellis points out that the automotive market’s recovery could happen rapidly, akin to “flipping a light switch” in terms of chip ordering dynamics.

Growth Opportunities Ahead

Should an automotive recovery coincide with a rebound in ON Semiconductor’s industrial sector, the company could be positioned for robust growth. Additionally, ON Semiconductor is projected to benefit from a 6% annual increase in its industrial revenue over the next three years, largely due to heightened automation in manufacturing processes. Overall, analysts forecast a total revenue growth of about 10%, aiming for approximately $9 billion by 2027—a significant milestone given the unique focus on silicon-carbide automotive chips that ON Semiconductor specializes in.

With few competitors in the silicon-carbide chip space, ON Semiconductor’s closest rival, STMicroelectronics, only generates just over $1 billion in annual sales from similar chip products. Ensuring production efficiency, ON Semiconductor has acquired GlobalFoundries’ East Fishkill plant, allowing it to increase chip production without dramatically raising costs. This operational improvement is expected to drive down costs even further, supporting the company’s target of achieving gross margins of 53%.

The Financial Landscape

ON Semiconductor’s management has revealed it possesses more than $1 billion in free cash flow, planning to allocate half of its cash flow each quarter towards share repurchases. This strategic approach, combined with anticipated sales growth and enhanced profitability, suggests a potential annual earnings per share increase of 21% by 2027, climbing to $7.11 from $4.01 this year. If the recovery in the automotive sector occurs sooner than expected, these earnings estimates could be conservative, leading to significant upside potential, as indicated by analyst Egan.

Investment Outlook

Currently, ON Semiconductor’s stock trades at 17 times its 12-month forward earnings—a valuation considerably lower than the S&P 500’s average of 22 and the broader chip industry’s average of 23.8. If the stock maintains its current multiple, it may reach around $112 by the end of 2026, suggesting a 25% annualized gain from current levels. This positions ON Semiconductor as an attractive option for long-term investors looking to capitalize on potential industry recovery.

In conclusion, while ON Semiconductor may not be a front-runner in the AI chip space, its well-established presence in the automotive chip sector, coupled with promising market dynamics, gives it a legitimate pathway for growth. Investors looking for both stability and growth prospects should consider adding ON Semiconductor to their portfolios.