Surprisingly, the electric vehicle (EV) revolution is drastically reshaping businesses globally, with semiconductors being one of the most influenced sectors. ON Semiconductor (ON) seems disregarded by credit rating agencies, despite its significance as a major participant in the sector. In today’s FA Alpha Daily, we will dive into ON Semiconductors’ credit risk profile through the strategic perspective of Uniform Accounting.
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The semiconductor industry is currently undergoing a dynamic transformation, fueled by the EV revolution and technological advancements.
This shift represents a significant evolution from traditional practices, as companies adapt to the increasing demands for more sophisticated and efficient technologies.
At the heart of this transformation is the adoption of the FAB LITE model by semiconductor companies.
This approach involves outsourcing certain production processes while maintaining key manufacturing capabilities in-house. It allows for greater flexibility, reduced capital expenditure, and the ability to scale production according to market demands.
One notable company leveraging this model is ON Semiconductor (ON).
By embracing the FAB LITE approach, the company has effectively streamlined its operations, leading to more efficient production processes and improved cost management. This strategic shift has played a crucial role in the company’s recent success.
ON Semiconductor’s involvement in the EV industry is particularly noteworthy. As electric vehicles gain prominence, the demand for advanced semiconductors that power these vehicles has skyrocketed.
The company has positioned itself as a crucial supplier in this sector, providing essential components that are integral to EV technology.
Despite these advancements, the company’s growth strategy and its pivotal role in the EV industry are often overlooked by credit rating agencies.
These agencies often have a narrow focus on the industry’s ups and downs, underestimating the long-term potential of companies that are aligning themselves with significant trends like the EV revolution.
ON Semiconductor has shown remarkable progress in terms of financial performance.
Specifically, the company has achieved a 20% increase in revenue over the last two years, coupled with a notable expansion in gross margin, rising from 35% to 40% in the same timeframe.
These achievements not only underscore the success of its FAB LITE model but also reinforce its solid position within the rapidly growing semiconductor industry.
However, the company’s substantial achievements in margin and revenue growth, as well as its strategic positioning in the fast-growing EV sector, are not fully reflected in its current credit rating.
Therefore, S&P gives the company a “BB+” rating, indicating a significant risk of default at nearly 11% over the next five years. It also puts the company in the risky high-yield basket.
Given its solid financial standing, we believe ON Semiconductor deserves a more secure rating.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand how the company’s obligations match against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart shows that ON Semiconductor’s cash flows are more than enough to serve all its obligations going forward.
The chart suggests that the company has a strong financial footing and should be able to meet its obligations without difficulty over the next five years.
The company has debt maturities in 2027 and 2028, yet its substantial cash flows should easily cover these obligations.
Moreover, the company’s significant role in the EV industry and recent strategic shifts are likely to boost future cash generation, in line with current market trends.
Our review of ON Semiconductor shows that the company has a low risk of default, contrary to what rating agencies indicate.
Therefore, we are assigning an “IG3+” rating to the company, which places it in the investment-grade basket, with a risk of default of only about 1%.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
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SUMMARY and ON Semiconductor (ON:USA) Tearsheet
As the Uniform Accounting tearsheet for ON Semiconductor (ON:USA) highlights, the Uniform P/E trades at 17.1x, which is below the global corporate average of 22.4x, but above its historical P/E of 15.0x.
Low P/Es require low EPS growth to sustain them. In the case of ON Semiconductor, the company has recently shown a 85% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations, that in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, ON Semiconductor’s Wall Street analyst-driven forecast is for a 3% and 4% EPS shrinkage in 2023 and 2024, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify ON Semiconductor’s $77 stock price. These are often referred to as market-embedded expectations.
Furthermore, the company’s earning power in 2022 was 4x the long-run corporate average. Moreover, cash flows and cash on hand are 3x its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 60bps above the risk-free rate.
Overall, this signals a low credit risk.
Lastly, ON Semiconductor’s Uniform earnings growth is above its peer averages and is trading below its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This analysis of ON Semiconductor (ON)’s credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.