Stock Analysis: On Semiconductor (ON)

Stock Ratings: 1 = buy at current stock prices, 2 = buy on a 5-10% dip in stock price, 3 = sell on a 5-10% increase in stock price, 4 = sell at current stock prices to raise cash.  Ratings are based upon 12-18 month outlook on stock direction and not necessarily related to moves I make due to financial positioning.

The events over the course of this week is forcing me to go back and perform a review of this stock.  As of this writing, the stock has fallen almost 14.3% in the course of 4 trading days.  What's going on?  What are my risks?  Is this a buying opportunity or do I need to get out of Dodge?  I'm going to put my best effort forth to answer that.

First, let's figure out what's put us in this position.  The first thing to note is that the stock closed at $9.68 on Tuesday.  It's now down about 10.7% since then ($1.04).  So while the primary market indicators are down to begin with, this stock had a particularly strong selloff the last two days.  I see 2 factors.  First, we have the competing offers to buy out Fairchild Semiconductor.  On Semi originally provided a $20 per share all cash buyout which was later challenged by a Chinese semiconductor company with an offer of $21.70 which was then sweetened when they said all layoff costs would also be covered.  All of this brought the stock down coming into the new year.  On Wednesday, On Semi released a statement saying that they have extended the decision window out to January 20.  However, they did not increase the offer of $20 per share, as most analysts and pundits expected them to.  Without the acquisition, the company doesn't grow as much as they may have been projecting to happen.  Then the other shoe dropped.  This shoe came in the combination between the China stock market taking a cliff dive - triggering circuit breakers and closing the market early - coupled with reports that suppliers to Apple have been indicating a significant slowdown - especially in China.  Pull a James Harden, mix this stuff up, and you have yourself a chef's recipe for a scared investors to run for the hills. 

But is that the right thing to do?  Am I foolish for not following suit?  Do I need to change my position as the facts change?  Let's put this together against some numbers.  First, let's assume the Fairchild deal doesn't go through (entirely possible at this point).  Ok, so the company doesn't pay 1/2 of their market cap as of 12/31/2015 to buy another semiconductor space.  Surely this is a loss of potential customers, synergies, and markets they wanted to go after, so future growth won't be as strong as it could've been.  That said, ever since this deal started happening, the stock has gone down.  That's right, acquire company, suddenly the acquirer is worth less.  Don't get the win and the losing acquirer loses again.  Thanks for playin' Sal!  I have to say this lacks logic to me.  Best case scenario, you have a larger company that is expected to bring immediate gains to the bottom line and one less competitor in your industry.  Worst case scenario, you lose the deal and you don't pay up in a price war, and your earnings and growth propositions are exactly what they were prior to this deal (not accounting any other factors.  We'll get into those other factors in a minute).  I was worried we'd get into a bidding war.  So far that hasn't happened and I'm relieved!  Right now, I feel all is well in regards to the offer.

Next takes us to China and overall business.  There are a couple things here worthy of noting.  First, while US auto sales have been strong and are predicted to be strong in 2016, the concept of more rate hikes honestly puts pressure on the automotive industry.  On is making a lot of great products to help automate our automobile, but if automotive sales are peaking, that's likely to mean sales will be peaking as well.  Only new technologies that haven't been made as standard in a vehicle will have an opportunity to grow or create new revenues.  The Apple supplier news puts pressure on the cell phone industry that the company also supplies to.  That said, they don't provide chips for Apple, but they do for Samsung and other device makers - like Xiaomi, the Chinese low-cost maker.  Samsung showed signs of slowing and in all honesty I see and feel consumer interest waning in both the cell phone and tablet markets.  Cell phones are more likely to be replaced every couple years instead of every year.  Tablets probably last 3-4 years now (this is all what I see/feel, no real facts).  As we approach market saturation and a slowdown in replacement cycles due to lack of new technology, this space is going to continue to slow down, though remain fairly strong, I believe.  You take those market conditions, and combine that with a China stock market that is plunging while people believe there is less and less growth and add in the fact that On Semi's revenues in Asia (excluding Japan) were 62% of total revenues in Q3 of 2015, and now you start to see some impact (Note: China/Hong Kong have been sited to be about 31% of On's overall business via this article).  Automotive and communications industries are about 50% of revenues that won't be growing much past 2016, from what I can tell.  

Let's play with what could happen with revenues if the freak-out over China is real.  Let's say China is as bad as it seems.  Growth is slowing, demand is slowing, inventories are rising (something that was refuted in the Q3 report) - let's say that growth will be 20% less than we expected because of it.  That means my estimate of earnings growing ten cents in 2016 becomes growth of 8 cents, or 9.5%.  With slowing growth, let's say a fair multiple is down to 12 times earnings.  My $0.94 earnings estimate becomes $0.92 and my price target goes from around $13 to $11.04.  Let's get more dramatic and say earnings growth slows 60%.  Now the earnings estimate is $0.90.  the target is $10.80 at a 12x multiple and $9 at a 10x multiple.  The stock's price at the close of today's trade was $8.64.  Yes, the price is well under some of the worst case scenarios that I think could play out, given what I know right now.  Say ON can pull off the Fairchild deal - even if it decides to pay a couple more per share - the company would have to be worth more yet at that point.

I focused on the consumer electronics and automotive categories, but the company also plays in industrial and IoT (Internet of Things) spaces as well.  The latter, in particular is getting really hot and could become a growing space for the company.  The industrial uses are doing well too.  And even while I see automotive sales decreasing, the tech that is going into them is still reasonably new and strong.  More automation is coming into play and On has the cameras and sensors to make help make that happen.  All these things make it hard to believe the worst case scenario is in play.  Is it reasonable, for now, to lower my guidance and expectations?  Sure, that can be feasible.  Is a stock at $8.64 worth picking up if it seems like it's already below most downside risks and has $2 plus upside?  Darn tootin' it is.  However, this market isn't favorable and hasn't shown signs that everything is over with yet.  I haven't decided if I'll pick more up as I'm below my cost basis, but I certainly don't feel like selling it, unless I'm in a position that I must raise cash.  If that becomes the case, this may be one of the first to go despite how it seems under valued.  The stock, as a whole, is tied too closely to too many items that are at the heart of selling to just hold blindly when needing cash.  I don't anticipate the stock taking out lows of 2014 (about $7.44).  The stock shows technical signs that there is still room for more down side, but it seems limited as we're starting to push to oversold areas.  I could see the stock losing as much as 7%-8% more, putting us down around the $8 mark or it then breaks a longer term trend line, as shown by the longer and shallower of the 2 lines in the below graph.

So for now, I lower expectations of 2016 earnings to $0.92 at 12x earnings for the multiple.  My price target is $11 until I learn/hear more from the fourth quarter report or see something that changes these facts.  If my thesis is correct, I'm looking at 7% downside risk and 27% upside potential, given worse conditions, much less things not being as bleak as they seem.  As such, the stock is ranked a 1.