The New Onsemi Is Worth Turning Back On

The chip maker more commonly known as Onsemi ON -2.44%decrease; red down pointing triangle has taken a hard hit this year. Its shares have fallen 7% against a 26% gain for the PHLX Semiconductor Index. Most of that is due to a sharp downturn in sales of chips designed for cars and various industrial applications. Automakers, which over-ordered components coming out of the pandemic, have been working through that inventory instead of buying new stuff. 

The automotive sector now makes up more than half of Onsemi’s revenue. But other chip makers have been hurt by the same cyclical downturn—without their multiple’s suffering much. Texas Instruments TXN 0.94%increase; green up pointing triangle, Analog Devices ADI -1.09%decrease; red down pointing triangle and Microchip also specialize in so-called analog chips designed for industrial and automotive markets, and all trade at multiples of 29 to 34 times forward earnings, according to FactSet. Despite a recent uptick over the past month, Onsemi shares closed Monday a little over 17 times forward earnings.

The weak multiple puts Onsemi in an ideal position for upside once customer orders pick back up. When exactly that happens is a matter of much debate. Recent weakness in consumer spending and auto sales has affected demand and likely stretched out the inventory cycle. 

Onsemi has avoided trying to call any bottom. “I’ll be calling the bottom when I’m standing on the top on the other side,” joked Chief Executive Officer Hassane El-Khoury at a KeyBanc investment conference earlier this month. But the company cited “stabilizing” demand in its industrial chip market in its latest quarterly report on July 29, and also believes it is undershipping demand in autos, which means orders should pick back up quickly as inventory clears. 

Having been in business for a quarter of a century, Onsemi has seen plenty of the chip industry’s brutal downcycles. But some smart changes have eased the pain this time. Since joining the company as CEO in 2020, El-Khoury has led an effort to exit less profitable businesses and pare down the company’s manufacturing footprint. 

That has cost the company some top line. Chief Financial Officer Thad Trent says Onsemi has exited about $475 million worth of business in total. But it has also made what remains much more cost effective, which helps when sales downturns result in costly underutilization of chip-making facilities also known as fabs. Onsemi’s gross margins have stayed in the 45%-47% range for the past four quarters as revenue has declined; previous sales downturns of a similar magnitude have taken gross margins as low as 31%, according to data from S&P Global Market Intelligence. 

Expanding gross margins is particularly notable given Onsemi’s entry into silicon-carbide chip manufacturing. The material is better than regular silicon for applications that involve large amounts of power conversion, such as drivetrains in electric vehicles. Onsemi has become a major supplier to EVs; the company noted in its latest earnings call that its components have been designed into nearly 60% of the new EVs that were introduced at the Auto China exhibition in Beijing in April. Silicon carbide is also expected to play a growing role in data centers, given the high energy demands of the latest artificial-intelligence systems being deployed there. 

But silicon carbide is also very challenging to manufacture, especially at a scale necessary to serve the growing EV market. Wolfspeed WOLF 4.19%increase; green up pointing triangle—a competitor to Onsemi in silicon-carbide manufacturing—saw its gross margin fall to 12% for the nine-month period ended March compared with 33% for the same period a year prior, in part due to execution and manufacturing yield issues at one of its silicon-carbide facilities.  

Onsemi is stepping up its own silicon-carbide manufacturing footprint, with plans announced in mid-June to build a new $2 billion facility in the Czech Republic. That caused some concern among investors worried about oversupply during a period of weaker demand for autos. But in a July 29 report upgrading the stock to a ‘buy’ rating, Jack Egan of Charter Equity noted that Onsemi’s more moderate expansion relative to rivals “should reduce the chance it runs into a supply glut” if industry growth falls below expectations. 

Another big plus is a recently announced deal to supply silicon-carbide chips to Volkswagen, the world’s second-largest automaker by annual sales. Blayne Curtis of Jefferies says that deal should highlight the strength of Onsemi’s role as a vertically integrated silicon-carbide player. He also noted in a July 29 report that “the name remains very cheap relative to the long-term GM/earnings leverage we expect to see over recovery.” 

The time is right to take Onsemi out of the garage. 

Write to Dan Gallagher at dan.gallagher@wsj.com