Forget Nvidia – this semiconductor stock is much more valuable

NVIDIA is a great company and a great stock, but it currently trades at just over 50 times Wall Street’s 2024 earnings estimates. That’s fine for many investors willing to pay a premium for a high-quality growth stock, but for investors willing to take on some short-term risk, ON Semiconductor (AT 3.54%) might be a better option. Here’s why.

Cyclicity plays a role in semiconductor stocks

Semiconductors are subject to strong economic cycles; this has always been the case and will continue to be the case. This is because when their customers see increasing demand, the first thing they do is order chips in preparation for a production increase. Conversely, when they see a slowdown coming, the first thing they do is stop or cancel chip orders as they prepare for a production slowdown.

Semiconductors are therefore always early indicators of their end markets. However, not all end markets are the same, and this year the spending has been all about artificial intelligence (AI) and the high-performance computing (HPC) chips that power it. That is why Nvidia has done so well, and why Semiconductor manufacturing in Taiwan continues to outperform, led by a strong recovery in its HPC sales.

Positioning of ON Semiconductor

However, ON Semiconductor’s key end markets, industrial and automotive, remain difficult, which is why the company’s share price has fallen 21% over the past year. I’ll come back to this point in a moment, but first a few words about the company itself for those who don’t know it.

The investment decision reflects management’s repositioning of the company to target exciting, long-term growth markets. This is best seen in the company’s silicon carbide activities. Management has invested heavily in positioning itself in the silicon carbide business, not least through the recent announcement of a multi-year, $2 billion investment in a silicon carbide (SiC) manufacturing facility in Central Europe. Silicon carbide chips offer several advantages over traditional silicon chips, particularly at the higher voltages required for electric vehicles (EVs).

In addition, the chip company has positioned itself in other exciting growth markets with new technologies in which it has a relatively high market share, including factory automation, electric vehicle charging, renewable energy infrastructure, 5G and advanced driver assistance systems (ADAS).

Image source: Getty Images.

ON Semiconductor’s challenges

Unfortunately, although these end markets have great long-term growth potential, their growth will slow down in 2024. The impact of the slowdown is most evident in the company’s declining revenues and the slowdown of its silicon carbide business. Growth in electric vehicle sales has slowed as persistently high interest rates have made auto loans more expensive. As a result, automakers have scaled back their investments in electric vehicles, which has negatively impacted the company’s revenues.

For example, in October, management explained that a decline in demand from one automotive customer, an original equipment manufacturer (OEM), would result in the company reaching only $800 million in 2023, instead of the $1 billion target. In February, CEO Hassane El-Khoury told investors, “The latest EV plans from OEMs point to more moderate growth, signaling SiC market growth in the 20 to 30 percent range,” while market reports predicted “30 to 40 percent growth for silicon carbide in 2024.”

In a sign of a declining market, El-Khoury briefed investors in April, saying he still expected the overall silicon carbide market to grow in 2024, “albeit at a slower rate than previously expected.”

While he noted that there were signs of demand stabilizing, he made it clear: “I’m not going to predict the bottom. I said that very clearly last time. I’ll predict it when I’m sitting on the other side of the peak.”

Therefore, anyone considering a purchase must be aware that negative news may emerge in the short term.

Two reasons to buy ON Semiconductor

If you can afford the short-term risk, the stock is very attractive. After all, nobody disputes that electric vehicles are the future of the industry. A lower interest rate environment is enough for electric vehicle sales to pick up, and with them investments in electric vehicles. In addition, all of the other target markets mentioned have excellent long-term growth prospects.

Meanwhile, ON Semiconductor’s valuation multiples are not demanding. With a price-to-earnings ratio of 18.3, the company looks like an excellent value. While there is no guarantee that these numbers will be reached, and as El-Khoury notes, it is difficult to predict the bottom of the market, it is fairly safe to assume that ON Semiconductor’s end markets and revenues will recover in line with traditional cyclicality.

Since the company only needs to meet Wall Street estimates to be considered a great value, I would say the risk-reward calculation favors enterprising investors buying the stock.