This Cheap Chip Stock With Strong EV Exposure Stands Out From the Rest

A slew of chip stocks with high automotive and industrial exposure look attractive right now. But for a few reasons, this one might be the best of the bunch.

Following recent selloffs that I think have been driven in part by overblown macro fears, a number of quality chip companies look attractively priced. Arguably, Onsemi (ON)  has one of the strongest risk/rewards among these firms.

Onsemi, formerly known as ON Semiconductor, sells power semiconductors, image sensors, microcontrollers (MCUs), Wi-Fi chips and a slew of other products that go into everything from cars and factory equipment, to smartphones and IoT devices, to 5G base stations and cloud servers. Its rivals/peers include Texas Instruments (TXN) , Analog Devices (ADI) , NXP Semiconductors (NXPI) , STMicroelectronics (STM) , Microchip Technology (MCHP) , Renesas and Infineon.

I think there's a lot to collectively like about these companies right now. Most notably:

1. The companies have moderate valuations. Following their recent declines, forward P/Es for the group are generally in the mid-to-high teens, while gross margins (GMs) typically range from the 40s to the high 60s.
2. The companies currently have more demand than they can handle. Most of the aforementioned companies have talked about being supply constrained into 2023 and inking long-term supply agreements with major customers eager to secure capacity and move away from just-in-time inventory systems. In addition, the companies have been hiking prices for many of their offerings, as they both pass on higher costs and benefit from a favorable supply/demand balance.
3. The companies have clear long-term growth drivers. Though they operate in a cyclical industry -- one that might very well see its next down-cycle in 2023 -- their cycles should continue seeing higher highs and higher lows, thanks to the secular growth drivers they have in key end-markets. Key ones include rising semiconductor content for cars, factory automation investments, IoT device proliferation and growing cloud capex.
4. The companies generally have low exposure to softening consumer end-markets. Evidence has been piling up that demand for consumer notebooks, Chromebooks and low-end smartphones is slowing down. But companies such as Onsemi, TI and ADI have only modest exposure to these end-markets. Rather, a majority of their sales come from automotive and "industrial" end-markets. ("industrial" is in parentheses here since it's used by these companies to describe not just chips used within, say, factory equipment, but also ones used within defense/aerospace equipment, medical devices, solar farms, and other non-consumer products)

Nonetheless, if I had to pick just one of these companies to invest in, I'd probably go with Onsemi, for a few reasons:

1. Onsemi is one of the cheaper companies within its peer group. Its shares trade for just 14 times a 2022 FactSet EPS consensus figure that (considering it's based on a revenue consensus that implies just 14% sales growth) looks beatable.
2. Onsemi is led by a relatively new CEO who has been overhauling the company. During his four-year run as CEO of Cypress Semiconductor (sold to Infineon in 2020), Hassane El-Khoury oversaw a turnaround in which Cypress shed or de-emphasized low-margin product lines, made shrewd acquisitions and dialed up investments in automotive and IoT growth markets. He's been applying a fairly similar playbook to Onsemi since becoming its CEO in December 2020, and appears to be far from finished.
3. Onsemi has a strong margin-expansion story. Over its last five reported quarters, Onsemi's non-GAAP GM has risen from 34.4% to 45.2%, an increase that puts it slightly above the company's prior 2025 GM target of 45%. Higher sales and a good pricing environment have helped, but so have the efforts of El-Khoury and other execs to drive operational efficiencies -- in part by selling less-efficient manufacturing sites and moving more internal chip production to a 300mm wafer fab the company is acquiring from Globalfoundries (GFS) -- and shift Onsemi's sales mix towards higher-margin products. Onsemi now has a 2025 GM target range of 48% to 50%, and (with some peers having GMs well above 50%) it wouldn't be a shock if the company also exceeded this goal before 2025.

   
   Onsemi's margins have risen at a brisk pace over the last several quarters. Source: Onsemi.

4. Onsemi looks well-positioned to gain automotive chip share thanks to its EV and ADAS (advanced driver assistance systems)-related products. Onsemi is a major supplier of silicon carbide (SiC) power semiconductors and modules -- they can improve range, weight and charging times for electric cars relative to using silicon-based alternatives -- for EVs, EV chargers and industrial products. The company is also a top supplier of image sensors and power management chips for automotive and industrial cameras, and it supplies sensing chips for automotive LIDAR sensors. All of this leaves the company poised to take auto chip share as penetration rates for EVs and ADAS/autonomous driving features grow, as well as to see meaningful industrial growth. Also: Onsemi's recent acquisition of SiC materials maker GT Advanced Technologies should in time improve the company's SiC product margins, lower its dependence on top SiC materials supplier Wolfspeed (WOLF) and create opportunities to sell SiC materials to third-party chipmakers.

   
   Onsemi's sales mix is steadily shifting towards auto and "industrial" end-markets. Source: Onsemi.
   

5. Onsemi has some M&A optionality. El-Khoury's last company was eventually acquired by a bigger chipmaker, and it's not out of the question that Onsemi, which currently sports a $26 billion valuation, could one day see the same fate. Certainly, the company's status as a diversified U.S. chip manufacturer with strong EV, ADAS and SiC exposure doesn't hurt its attractiveness to potential suitors.

At the time of publication, Eric Jhonsa was long Onsemi, NXP and STMicroelectronics.