Semiconductor stocks are usually a good buy when sales are about to reach a cyclical trough.
The market is dominated by ON Semiconductor (upon -5.49%) Following its second-quarter earnings report, the company’s shares have significantly outperformed stock market darling Nvidia, rising 14.2% last month compared with a 5.4% decline (as of this writing). The question is why, and whether that can continue.
Cyclical Stocks to Buy
ON Semiconductor serves two highly cyclical end markets, automotive (electric vehicles, power management, advanced driver assistance systems, etc.) and industrial (automation, EV infrastructure, machine vision, etc.), which have been declining this year for a variety of reasons.
The chart below shows a declining sequential revenue trend established beginning in Q3 2023. Furthermore, management expects the year-over-year decline to continue in Q3, with revenue guidance of $1.7 billion to $1.8 billion, which compares unfavorably to the $2.18 billion reported in Q3 2023.
However, the midpoint of the Q3 guidance suggests sequential revenue growth from the $1.74 billion just reported in Q2, signaling signs of stabilization. This is just one of the reasons investors bought shares after the recent earnings release. In other words, investors are focusing on the forecast of sequential improvement and viewing it as a potential bottoming out process.
Data source: ON Semiconductor presentation. Graphs by authors.
It’s an interesting angle, especially since semiconductor stocks are considered highly cyclical. The best time to buy is often during the darkest moments, before signs of recovery begin to emerge. This debate is what allows ON Semiconductor to outperform Nvidia, which is already performing well given surging interest and investment in AI applications and rising demand for high-performance computing (HPC) chips.
Is ON Semiconductor on the road to recovery?
The key question here is not just whether a recovery will come, but what kind of recovery will it be? Investors typically expect a V-shaped recovery, but ON Semiconductor CEO Hassan El Khoury disagrees. He continues to predict the recovery will be an “L-shaped curve.” In simple terms, this means that revenue will bottom out and then trend along the bottom, rather than a dramatic rise in sales.
That may not be what investors want to hear, especially those buying ON Semiconductor as a quintessential semiconductor recovery stock. Still, El Khoury’s caution is entirely understandable under the circumstances.
Image source: Getty Images.
Relatively high interest rates have resulted in high monthly car loan payments, negatively impacting auto sales, including EV sales. As a result, automakers are refraining from investing in EVs, which is bad news for ON Semiconductor, which is in the market for intelligent power solutions for EVs.
Additionally, the company’s industrial end markets, such as industrial automation, are struggling to ramp up orders as customers continue to use inventory built up during a time when product lead times were much longer and need to build up stock to meet demand. I’ve discussed these trends for Rockwell Automation previously.
It’s fair to say that both of ON Semiconductor’s end markets have deteriorated through 2024.
Why ON Semiconductor is still a buy
While the near-term outlook remains uncertain, there is little doubt the company is positioned for long-term growth. Moreover, it is only a matter of time before the company’s end markets recover. History suggests that interest rate cycles will turn, and there is no retreat from a future where EV sales surpass internal combustion engine (ICE) sales. ON Semiconductor has much more content in intelligent power and sensor chips for EVs than ICE.
Image source: Getty Images.
In fact, as a sign of the business’ potential, the company announced that “Volkswagen Group has selected ON Semiconductor as the primary supplier of a complete Power Box solution as part of its next-generation traction inverter for its scalable system platform.”
Moreover, for countries with relatively high labour costs, industrial automation is the future and a solution to cost-effectively reshoring production. Investment in automation is likely to increase as final demand recovers, and the more distributors reduce inventory now, the stronger the recovery will be when it arrives.
Finally, whether we see an L-shaped, V-shaped, or L-shaped to hockey stick recovery, ON Semiconductor’s valuation, trading at 18.6 times Wall Street’s 2024 earnings estimates, is very attractive and could well continue to outperform Nvidia.
