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Integrated circuits on a circuit board. The semiconductor industry has been in focus during the U.S.-China trade war.
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Company: ON Semiconductor Corp (ON)
Business: A premier semiconductor company that focuses on power and sensor products. ON Semi’s segments include (i) Power Solutions Group, which offers a range of discrete, module and integrated semiconductor products; (ii) Analog Solutions Group, which designs and develops analog, mixed-signal and logic application specific integrated circuits and application specific standard products and power solutions; and (iii) Image Sensor Group, which designs and develops complementary metal oxide semiconductor and charge-coupled device image sensors, as well as proximity sensors, image signal processors, and actuator drivers for autofocus and image stabilization for various end users in several markets.
Stock Market Value: $10.7 billion ($26.07 per share)
Activist: Starboard Value
Percentage Ownership: n/a
Average Cost: n/a
Activist Commentary: Starboard is a very successful activist investor and has extensive operational activism experience helping boards and management teams run companies more efficiently and improving margins. Starboard has had significant success in the semiconductor space with investments in Actel, Microtune, Zoran, DSP Group, MIPS Technologies, Integrated Device Technology, Tessera, TriQuint Semiconductor, Micrel, Integrated Silicon Solution, Marvell and Mellanox Technologies. In all twelve of these filings, Starboard has had a positive return on its investment and their average return on the twelve is 71.62%, versus an average of 23.23% for the S&P 500 during the same time periods.
What’s Happening:
Starboard believes that the company trades at a deep discount to peers and should take one or more of the following actions (i) improving gross margin by rationalizing its manufacturing footprint, (ii) reducing cyclicality and boosting FCF conversion by exploring a fab-lite model and (iii) continuing industry consolidation.
Behind the Scenes:
ON Semiconductor is a premier semiconductor company that focuses on power and sensor products. The company sells products across diversified, attractive end markets with the automotive and industrial markets making up almost 60% of revenue. These markets have a long runway for growth with long product life cycles. Approximately 80% of the company’s revenue has 3-plus years in product longevity and about 50% is 7-plus years, making this a very stable business. Also, because the company primarily focuses on analog and power components and sensors, it is positioned to win business regardless of end product features.
Since 2007, the company has spent approximately $6 billion buying companies to strengthen its product portfolio and improve its competitive positioning. Over the long term, the company has had slow and steady revenue growth, but has seen recent declines. In 2019, revenue declined due to broad weakness in the semiconductor industry, driven by an inventory correction and the trade war with China. In 2020, the company suffered because of the Covid-19 crisis. Specifically, the company suffered because of its fab-heavy model which includes a heavy fixed cost base. Despite strong end market exposure and product positioning, results have lagged both management’s plan and peer medians – the company has a 9.2% operating income margin, much lower than management’s target plan of 22% and even more significantly lower than its peers – 33.7%. As a result, the company is trading at the widest disparity to peers in years, with a pro forma EBITDA multiple of 7.3x versus 16.5x for its peers.
Keith Jackson has been CEO of the company for 18 years and has done a tremendous job of building the company through organic growth and acquisitions. However, now is a time not for growth but for integration and rationalizing operations to run more efficiently. This was not management’s forte and the company is now at an inflection point where they can bring in the right CEO for this point in its life cycle – Jackson has already announced that he will be retiring as of May 2021.
Starboard sees multiple ways to win at the company. The first opportunity is to rationalize the manufacturing footprint and improve utilization rates to improve gross margins. The company suffers from excess costs since it has not fully integrated its acquisitions or realized other synergies from its acquisitions. The company has 12 manufacturing facilities all over the world, and could easily operate with only 3 – 7 facilities. The company has already begun to take steps in the right direction, moving from smaller and outdated facilities to better equipped facilities with excess capacity, and Starboard believes there are even more opportunities here.
Next, Starboard believes there is an opportunity to shift to a fab-lite model which would allow for more stable gross margins, more flexibility to meet surges in demand and deal with downturns, higher free cash flow conversion and better returns on capital. Moreover, external foundries are often better at manufacturing and more efficient, so this could result in even better pricing and quality for the company’s clients. Maxim Integrated is an example of a company that moved to a fab-lite model and now does 75% of its business externally. As a result, Maxim has been able to increase gross margins by almost 500 basis points, reduce capex from 10.5% of revenue to 2.5%, and is now able to have much more stable margins during downturns. It is the fab-heavy model that the company presently employs that is likely the biggest contributor to its inferior EBITDA multiple valuation relative to its peers.
The final opportunity here is strategic. Starboard sees an opportunity for continued industry consolidation and believes that the company is uniquely positioned as a scaled asset trading at a discount. While the company has historically been an acquirer, it could make an attractive target for a number of strategic buyers. There has been significant industry consolidation and in the last five years, transactions have occurred at a median multiple of 17.2x, higher than where the company trades today at 10.6x. Moreover, in between CEOs is an ideal time to explore a sale and with an activist involved, it almost automatically puts the company in play.
With the company at an inflection point, it can benefit from adding Starboard directors to the board on many levels. First, with all of its success in the semiconductor industry and one of the largest networks in the industry, there is nobody better to help identify, evaluate and negotiate the CEO succession. Secondly, Starboard has an extensive history of improving margins from a board level, particularly in technology companies. Finally, if there is an opportunity to sell the company, it is invaluable having a hedge fund on your side who can quickly create financial models to see if the transaction is maximizing value – it is like having a free investment bank that is only concerned with shareholder value.
Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.
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