Can ON Semiconductor Widen Its Niche in the IoT Industry?

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ON Semiconductor (NASDAQ: ON) -- historically a maker of power management and commodity chips -- is making headway as a specialty chip maker for the Internet of Things. The IoT space has been getting a lot of attention, though, and ON is small compared to some of its peers. Widening its niche will be crucial to the company's longer-term success.

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ON making waves

Sales of devices such as smartphones, tablets, and PCs have been stagnant for the last few years. That trend took its toll on the semiconductor industry, setting off a wave of mergers and acquisitions that began in 2015. ON was no exception, and snapped up smaller rival Fairchild Semiconductor in the fall of 2016 for $2.4 billion.

Consolidating businesses against a backdrop of slowing sales of traditional devices wasn't the only option for semiconductor businesses. An area of new growth also presented itself -- the IoT in which more and more things are connected to the internet -- so ON made a pivot to capture the new market. Thus far, the IoT has provided plenty of new business to more than offset weakness elsewhere, and that trend could continue.

Metric

2016

2017

2018

2020

Estimated number of connected devices (billions)

 6.38  8.38  11.20  20.42

Estimated annual IoT spending (trillions)

 $1.38  $1.69  $2.09 $2.93

The boom in connection-enabling components for everything from smart buildings to transportation to industrial equipment has led others to enter the IoT race as well. ON finds itself elbowing for space with other newcomers like Cypress Semiconductor (NASDAQ: CY) as well as already established mobile chip makers like Skyworks Solutions (NASDAQ: SWKS). So far, the industry is new enough and growing such that each has found a niche (although ON and Cypress both directly compete on USB-C power and data transfer systems).

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ON specifically has found a home in connected autos, which made up 32% of its revenue last year. Right behind autos were industrial applications at 25%, and a new chip system aimed at medical devices and wearables was recently released as well.

With revenue up over 50% in the last few years, helped in part by the Fairchild purchase, ON has certainly found the space to stretch its legs within the industry. But is the stock worthy of investment?

To buy or not to buy...

ON's stock is having a great 2017, up 17% as of this writing, but off 10% from highs reached earlier in the year. To be fair, the whole semiconductor industry is performing well, but ON has certainly been a standout thus far.

Management reports demand growth continues to run strong, and analysts have a consensus estimate of $5.25 billion in revenue this year compared to $4.5 billion in 2016 when combining ON with Fairchild as stand-alone businesses. Profits are projected to be up 40%-plus through revenue growth and cost savings post-merger. There is no shortage of optimism on the company's prospects.

For me, the real linchpin in deciding on a company's investment-worthiness is free cash flow, or money left over after paying for basic operations and capital expenditures. Cash flow is riding high at ON, and the corresponding price-to-free cash flow ratio (same basic principle as the price-to-earnings ratio) makes the company look like a bargain. Here it is compared to some of ON's aforementioned peers:

For the time being, ON has found its place in the IoT, providing power management and sensing equipment in growing industries. The company is successfully integrating Fairchild, and its generation of ample cash could help it make more strategic purchases -- something management has said it is always on the lookout for and can also help it widen its specialty in the semiconductor world. This stock is certainly worthy of consideration.

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Nicholas Rossolillo owns shares of Cypress Semiconductor and Skyworks Solutions. The Motley Fool owns shares of and recommends Skyworks Solutions. The Motley Fool has the following options: short November 2017 $95 calls on Skyworks Solutions and short November 2017 $92 puts on Skyworks Solutions. The Motley Fool recommends Cypress Semiconductor. The Motley Fool has a disclosure policy.