Investing in semiconductor stocks can be quite challenging. Many of them languish for a long time -- even as operations clearly improve -- until suddenly, investors begin singing the company's praises.
That patience has been rewarded, as Micron is now on the top of many "buy" lists and making a run for the $12 mark, after having more than doubled over the past year.
Although Micron may have a bit more upside, I prefer to focus on chipmakers that still suffer from very low expectations, even as their business starts to get stronger. Right now, that's the backdrop for ON Semiconductor (Nasdaq: ONNN), which has integrated a series of recent acquisitions and is poised to generate robust free cash flow in the years ahead.
While companies like Intel (Nasdaq: INTC) dominate the world of microprocessors, Qualcomm (Nasdaq: QCOM) is a leader in communications chips and Micron owns a big slice of the memory market, ON is niche player in a wide variety of markets, including:
- Automotive electronics
- Medical devices
- Power supplies
- Military equipment
- Industrial process controls
Although ON has its roots and headquarters in Phoenix, the company derives the bulk of its sales in Asia. While many chipmakers supplying Asian customers must compete aggressively on price and therefore post dismal profit margins, ON's emphasis on advanced chip designs has helped keep gross margins above 30% in nine of the past 10 years.
The reason to be focusing on this company now is a long-awaited shift in chip spending. ON's revenues have been under pressure for much of the past five years, thanks to the moribund global economy, but recent design wins, coupled with a broader industry upturn, are expected to help ON generate its first year-over-year quarterly sales gain (in the quarter that starts next month) for the first time in more than two years.
Analysts expect that strength to continue into next year, when sales growth should approach 10% (yielding roughly $3.1 billion in sales). And thanks to operating leverage, per-share profits are expected to rise roughly 40% to around 80 cents. Indeed, sales and profit forecasts for 2013 and 2014 have been steadily rising for the past few months as analysts note improving order trends. A key area of growing demand is automotive electronics (roughly 30% of sales), as automakers pack their vehicles with more technology.
Another reason this stock is timely: Management has just completed a multiyear spending program to lower costs and boost plant efficiency, and free cash flow is expected to move from just above break-even in 2012 to more than $300 million this year. By 2015, that figure should exceed $450 million, according to Merrill Lynch.
And much of that cash flow is expected to pump up the balance sheet. ON had $540 million in net debt at the end of 2012 but is expected to have net cash of $250 million by 2015. That nearly $800 million swing in cash is expected to open the door to stock buybacks and dividends.
Risks to Consider: ON's considerable exposure to Asian markets could prove troublesome if China, South Korea and Japan stumble in the quarters ahead.
Action to Take --> Don't think of this stock as a potential home run pick. Its broad diversification means it will only grow at a good -- but not great -- clip as some divisions grow faster than others. Instead, think of that revenue diversity as providing consistency, compared with companies like Intel and Micron that may be more susceptible to booms and busts.