Analog chips maker ON Semiconductor (NASDAQ: ON) announced better-than-expected results in Q2 FY2023, with revenue flat year on year at $2.09 billion. On top of that, next quarter's revenue guidance ($2.15 billion at the midpoint) was surprisingly good and 3.91% above what analysts were expecting. ON Semiconductor made a GAAP profit of $577.1 million, improving from its profit of $456.6 million in the same quarter last year.
ON Semiconductor (ON) Q2 FY2023 Highlights:
- Revenue: $2.09 billion vs analyst estimates of $2.02 billion (3.66% beat)
- EPS (non-GAAP): $1.33 vs analyst estimates of $1.21 (9.82% beat)
- Revenue guidance for Q3 2023 is $2.15 billion at the midpoint, above analyst estimates of $2.06 billion
- Free cash flow was -$39.8 million, down from $87.4 million in the previous quarter
- Inventory Days Outstanding: 162, up from 158 in the previous quarter
- Gross Margin (GAAP): 47.4%, down from 49.7% in the same quarter last year
Spun out of Motorola in 1999, and built through a series of acquisitions, ON Semiconductor (NASDAQ: ON) is a global provider of analog chips with specialization in autos, industrial applications, and power management in cloud data centers.ON Semiconductor’s peers and competitors include Analog Devices (NASDAQ:ADI), Texas Instruments (NASDAQ:TXN), Skyworks (NASDAQ:SWKS), Infineon (XTRA:IFX), NXP Semiconductors NV (NASDAQ:NXPI), Monolithic Power Systems (NASDAQ:MPWR), Marvell Technology (NASDAQ:MRVL), and Microchip (NASDAQ:MCHP).
Longer manufacturing duration allows analog chip makers to generate greater efficiencies, leading to structurally higher gross margins than their fabless digital peers. The downside of vertical integration is that cyclicality can be more pronounced for analog chipmakers, as capacity utilization upsides work in reverse during down periods.
ON Semiconductor's revenue growth over the last three years has been mediocre, averaging 17.4% annually. But as you can see below, this quarter wasn't particularly strong, with revenue growing from $2.09 billion in the same quarter last year to $2.09 billion. Semiconductors are a cyclical industry, and long-term investors should be prepared for periods of high growth followed by periods of revenue contractions (which can sometimes offer opportune times to buy).
While ON Semiconductor beat analysts' revenue estimates, this was a sluggish quarter for the company as its revenue only grew 0.45% year on year. This was its third consecutive quarter of decelerating growth, indicating a potential cycle downturn.
ON Semiconductor's revenue growth has slowed over the last three quarters and its management team projects growth to turn negative next quarter. As such, the company is guiding for a 2.17% year-on-year revenue decline, but Wall Street thinks there will be a recovery next year. Consensus estimates call for 0.91% growth over the next 12 months.
Product Demand & Outstanding Inventory
Days Inventory Outstanding (DIO) is an important metric for chipmakers, as it reflects a business' capital intensity and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise, the company may have to downsize production.
This quarter, ON Semiconductor's DIO came in at 162, which is 32 days above its five-year average, suggesting that the company's inventory has grown to higher levels than we've seen in the past.
In the semiconductor industry, a company's gross profit margin is a critical metric to track because it sheds light on its pricing power, complexity of products, and ability to procure raw materials, equipment, and labor. ON Semiconductor's gross profit margin, which shows how much money the company gets to keep after paying key materials, input, and manufacturing costs, came in at 47.4% in Q2, down 2.3 percentage points year on year.
ON Semiconductor's gross margins have been trending up over the last 12 months, averaging 47.8%. This is a welcome development, as ON Semiconductor's margins are slightly below the peer group average and rising margins could suggest improved demand and pricing power.
ON Semiconductor reported an operating margin of 32.8% in Q2, down 1.7 percentage points year on year. Operating margins are one of the best measures of profitability because they tell us how much money a company takes home after manufacturing its products, marketing and selling them, and, importantly, keeping them relevant through research and development.
ON Semiconductor's operating margins have been trending up over the last year, averaging 33.6%. Additionally, the company's margins remain above average, driven by its operating model and well-managed cost structure.
Earnings, Cash & Competitive Moat
Analysts covering ON Semiconductor expect earnings per share to be relatively flat over the next 12 months, although estimates will likely change after earnings.
Although earnings are important, we believe cash is king because you can't use accounting profits to pay the bills. ON Semiconductor's free cash flow came in at -$39.8 million in Q2, down 120% year on year.
As you can see above, ON Semiconductor produced free cash flow of $1.17 billion in the last year, which is 13.6% of revenue. It's good to see ON Semiconductor generate positive free cash flow since it allows the company to strengthen its balance street, but we'd be uncomfortable if its FCF margin dropped any lower.
ON Semiconductor's average return on invested capital (ROIC) of just 19.8% over the last 5 years is fairly low compared to other semiconductor companies. This underperformance suggests that the company tied up a lot of capital to achieve grow or maintain profits.
Key Takeaways from ON Semiconductor's Q2 Results
Sporting a market capitalization of $45.4 billion, more than $2.62 billion in cash on hand, and positive free cash flow over the last 12 months, we believe that ON Semiconductor is attractively positioned to invest in growth.
We were impressed by how significantly ON Semiconductor blew past analysts' revenue and earnings per share (EPS) expectations this quarter. We were also glad that next quarter's revenue and EPS guidance came in higher than Wall Street's expectations. On the other hand, its deteriorating gross margin and slight increase in inventory levels wasn't great. Overall, though, we think this was still a really good quarter that should please shareholders. The stock is up 5.56% after reporting and currently trades at $110.87 per share.
Is Now The Time?
When considering an investment in ON Semiconductor, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter. Although ON Semiconductor is't a bad business, it probably wouldn't be one of our picks. Its revenue growth has been solid, though we don't expect it to maintain historical growth rates.
ON Semiconductor's price to earnings ratio based on the next 12 months is 20.9x. In the end, beauty is in the eye of the beholder. While ON Semiconductor wouldn't be our first pick, if you like the business, the shares are trading at a pretty interesting price point right now.
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