20% Downside For ON Semiconductor Stock?

ON Semiconductor stock (NASDAQ: ON) is up around 1.5x since the beginning of 2020, but at the current price of around $37 per share, we believe that ON stock has around 20% potential downside.

Why is that? Our belief stems from the fact that ON stock is still up more than 4x from the low seen in March. Further, after posting weak Q3 ’20 numbers, it’s evident that demand for ON’s semiconductor raw materials has still not recovered to pre-Covid levels. Our dashboard What Factors Drove 122% Change In ON Semiconductor Stock Between 2018 And Now? provides the key numbers behind our thinking, and we explain more below.

ON stock’s rise since late 2018 came despite a 2% drop in the revenue per share, which came largely due to a 6% drop in revenues from $5.9 billion to $5.5 billion.

ON’s P/S (price-to-sales) ratio rose from 1.2x in 2018 to 1.8x in 2019, and has since risen to 2.7x, as ON stock has been riding the rally in technology stocks. However, given ON’s weak performance in Q3 ’20, there is possible downside risk for ON’s multiple.

So what’s the likely trigger and timing to this downside?

The global spread of coronavirus, has meant lower semiconductor demand from the industrial and automotive sector, which has hampered demand for ON’s semiconductor raw materials. This is evident from ON’s Q3 2020 results, where revenue came in at $1.32 billion, down from $1.38 billion for the same period last year. EPS came in at $0.39, substantially higher than the -$0.15 in Q3 2019. However, a closer look reveals that a $170 million litigation settlement cost brought down operating income in Q3 2019, and ON registered a tax benefit of $83 million for Q3 ’20, more than 3x higher than the $25 million tax benefit in Q3 ’19. The impact of the pandemic on the company’s business can be gauged from its revenue drop and the fall in gross margins (33.4% in Q3 2020 vs 34.4% in Q3 2019).

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We expect ON’s business to struggle in the near to medium term, as demand for semiconductors is still far from pre-Covid levels. If there isn’t clear evidence of containment of the virus anytime soon, we believe the stock will see its P/S multiple decline from the current level of 2.7x to around 2.2x, which combined with a reduction in revenues and margins could result in the stock price shrinking to below $30, a downside of over 20% from the current price of $37.

While ON semiconductor stock may be overvalued, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how counter-intuitive the stock valuation is for Intel vs Cisco.

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