ON Semiconductor (ONNN) reported second quarter earnings that beat the Zacks Consensus Estimate by a penny. Shares have been range bound since ON reported, mainly due to the in-line results and disappointing guidance.
Revenue
Revenue of $583.3 million was up 6.0% sequentially and 38.9% year over year. This was much better than management’s revenue expectations of $565-580 million, or an increase of 4-7% sequentially. The industrial end market continued to drive results, while TVs showed signs of weakness in the last quarter.
The Asia/Pacific region witnessed the strongest growth, increasing 8.4% sequentially. In comparison, the Americas region was up 4.5% and Europe down 0.7%. The largest chunk of ON’s revenue continues to come from Asia (particularly China and Singapore).
Revenue by End Market
The Medical end market was the softest in the last quarter, declining both sequentially and year over year. The communications market was also down slightly on a sequential basis, although it grew from the year-ago period. All other segments grew both sequentially and year over year.
Computing was the largest end market with a 26% revenue share. The segment was up 6.0% sequentially and 33.8% year over year. Second quarter contribution from this market was at historic highs. The significant increase from the year-ago quarter was driven by both desktop and notebook computers (power management, audio amplifiers, protection devices, thermal management and standard products). The corporate refresh cycle, resultant production ramps at several key customers and the success of Windows 7 drove the increase in demand.
Automotive was the second largest end market in the last quarter with a 20% contribution, increasing 11.6% sequentially and 63.5% year over year. Components sold into this market continued to benefit from distributors building inventory to more normal levels. Increasing electronic content per vehicle remains a longer-term driver of segment results.
Industrial brought in 19% of revenue, up 6.0% sequentially and 46.7% from the year-ago quarter. This was another record performance by the company. The company saw particular strength in some pockets, such as custom analog, mixed signal and ASIC. The convergence of connected building automation systems with energy efficient initiatives should drive growth in the segment over the next few years, increasing demand for wired communications over IP, embedded control, motor control, sensors, and lighting and imaging equipment.
Consumer was 17% of total revenue (up 12.6% sequentially and 81.7% year over year). Despite the strong performance in the last quarter, management stated that the TV market had seen a post-World Cup slump, although there were signs of a fourth quarter rebound. ON Semiconductor also saw strength in the gaming market and management stated there were some builds in the area.
Communications generated 15% of revenue, down 0.6% sequentially and up 4.2% year over year. Medical, representing 3% of revenue, declined 20.5% sequentially and 16.6% year over year.
Revenue by Segment
The largest segment is Standard Products, which generated 33% of revenue in the last quarter. Segment revenue was up 8.9% sequentially and 46.2% from the year-ago quarter. Automotive & Power generated 24%, up 10.6% sequentially and 49.7% year over year. Computing & Consumer brought in another 23%, increasing 8.0% sequentially and 41.9% from the year-ago quarter. Digital & Mixed Signal, which generated 20%, was the smallest segment in the last quarter, declining 4.8% sequentially and increasing 16.4% from the year-ago quarter.
Margins
Gross margin for the quarter was 42.5%, up 34 basis points (bps) from the previous quarter’s 42.1%. Mix improvement was the primary driver of the gross margin in the last quarter. Management stated that utilization rates were relatively stable during the quarter, indicating no major volume impact.
The operating expenses of $131.9 million were down 0.3% sequentially. The operating margin jumped 177 bps sequentially and expanded 1,483 bps year over year to 19.9% of revenue. While all expenses except G&A declined sequentially as a percentage of sales, the decline in R&D was the most significant. G&A expenses were up 33 bps as a percentage of sales. Compared with the year-ago period, all expenses declined significantly as a percentage of sales.
Net Profit
On a pro forma basis, ON Semiconductor reported a net income of $93.2 million, or a 16.0% net income margin compared with $77.3 million, or 14.0% in the previous quarter and $6.1 million or 1.5% in the second quarter of last year.
Our pro forma estimate excludes inventory adjustments, restructuring charges, amortization of intangibles and tax adjustments in the last quarter but includes stock based compensation. Our pro forma estimate may not match management’s presentation due to the addition/exclusion of some items not considered by management.
On a fully diluted GAAP basis, the company recorded a net income of $78.7 million ($0.18 per share) compared with $63.0 million ($0.14 per share) in the previous quarter and a net loss of $3 million (-$0.01 per share) in the prior-year quarter.
Balance Sheet
Inventories were up 8.0% sequentially, with inventory turns down slightly from around 4.3X to around $4.2X. Days sales outstanding (DSOs) were around 50, similar to the last quarter.
The cash and short term investments balance were $467.1 million at quarter-end, with the company generating $158.9 million from operations. ON Semiconsuctor spent around $52.5 million on capex, $23.4 million on acquisitions (excluding cash acquired), $3.2 million on share repurchases and $195.1 million on debt repayment.
At quarter-end, ON Semiconductor had $632.9 million of debt on its balance sheet, or a net debt position of $165.8 million, down from a net debt position of $262.8 million at the end of the Mar 2010 quarter.
Guidance
The guidance for the third quarter was disappointing. Revenue expectations of $585-610 million, representing a sequential increase of 0-5%, appear to be less than normal seasonality.
The GAAP gross margin is expected to be 42.2%-42.7%. Excluding special items of approximately $2 million, the non GAAP gross margin is expected to be 42.5-43.0%. GAAP operating expenses are expected to be $141-145 million. Excluding special items of approximately $10 million, the non GAAP operating expenses are expected to range between $131million and $135 million. Stock based compensation, which is included in management’s pro forma expectations, is expected to be $13–14 million.
Interest and other expenses are expected to be $10 million and non-cash interest expense approximately $8 million. GAAP and non-GAAP taxes are expected to total $4 million and $3 million, respectively. The diluted share count is expected to be 445 million.
Management also expects to spend around $130-160 million on equipment purchases in 2010 and another $30 million on buildings to consolidate offices in the Bay area, as well as the consolidation of assembly and test operations in the Philippines.
Recent Acquisitions
ON Semiconductor completed two acquisitions in the last few months. One was a tuck-in affair, which ON nabbed for around $22 million. The ostensible reason for the deal was position in the ultra-low power DSP market, primarily used in hearing aids and consumer audio processing applications. Management expects the business to generate $30 million in quarterly pre-tax income, approximately 18 months from the date the transaction closes.
The more significant acquisition was that of SANYO Semiconductor in a cash-and-stock transaction valued at $366 million. Sanyo Semiconductor generates around $300 million a quarter and ON Semiconductor expects the acquisition to generate pre-tax income of around $30 million a quarter after around 1.5 years from the date the transaction closes. Immediate gains include increased capacity, a stronger manufacturing and sales presence in Asia, portfolio enhancement (power management products, microcontrollers, customized application specific integrated circuits and motor control devices), cross-selling opportunities and increased exposure to automotive, industrial and consumer verticals.
Our Recommendation
We are Neutral on ON Semiconductor shares in the 3-6 month time horizon, as management appears cautious regarding near-term demand. We also view negatively management’s statements regarding inventory accumulation at distributors, particularly because most semiconductor companies continue to report lean inventories at distribution. This seems to indicate weaker sell-through for ON. Additionally, management stated that the company did not see increase in utilization rates and did not expect increases in the fiscal third quarter either, indicating that there was no reason for increased production. We are, however, positive about increased cash flow and the debt reduction in the last quarter. Our short-term recommendation, represented by the Zacks Rank of #3 is Hold, indicates that we also do not expect any notable appreciation in share prices in the 1-3 month timeframe.
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