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If you're looking for that miracle of miracles, a "safe" tech play, you might consider ON Semiconductor (ONNN) -- formerly known as SCG Holding. It's a spin-off from Motorola's semiconductor business, which went independent with a $1.6 billion leveraged buyout last August. The stock debuted at 16 in April, shot up to 27 in the first day or two of trading, and is now at 21 1/4. But some analysts think it's worth more.
Given that ON's specialty is the commodity end of the chip business, it might seem an odd choice for a tech play: It isn't in the highly visible microprocessor business that sustains Intel and Motorola. But what makes ON an interesting investment are the revenue growth and margin improvements it can achieve now that it's separate from Motorola. On the basis of top-line growth and cost-cutting, at least three of the four analysts who follow the stock believe it'll be worth $30 to $33 in the next 6 to 12 months. That's 36% to 50% capital appreciation potential, not bad considering Nasdaq's performance these days.
With $1.6 billion in 1999 sales, ON is one of the largest chipmakers in the world. Its 16,000 products include analog integrated circuits, logic integrated circuits, and discrete semiconductors -- devices with only one function used in all kinds of digital electronic appliances. Last year, about half of ON's sales were in the discrete business, a somewhat slower-growth business with a lower profit margin than the integrated circuits business.
ANALOG KICK.
That might not sound like the key to financial success, but President and CEO Steve Hanson has good use for it. "The discrete business functions as a good cash generator and supports our other businesses," he says. ON has a 7.4% market share, behind Toshiba, Hitachi, and Rohm, in the $19 billion discrete market. That market could grow to $24 billion by yearend, according to ICE, a technology consulting firm based in Scottsdale, Ariz.
ON should enjoy even better results from its analog business. The Semiconductor Industry Assn. estimates the global analog integrated circuits business will grow by 35% this year, to about $30 billion. Hanson expects ON to keep pace with the industry. ON's analog business focuses on power management -- the devices that control the flow of electricity in everything from mobile phones to hair dryers to cars. With a 9.6% market share, ON estimates that it's No. 2 in analog power management, behind TI/Unitrode.
ON's other businesses, broadband and logic, are also fast growers. With an 8.9% and 7% market share, respectively, in these markets, the company ranks itself No. 5 in both. The top four players in logic are TI, Fairchild, Philips, and Toshiba. In broadband, they are Lucent, Vitesse, PMC Sierra, and AMCC.
RIVALS NO MORE.
While it may sound as though ON faces plenty of competition, its business is situated in the middle of some evergreen markets. Devices used in power management account for about 60% of its total revenue. And as long as there are electrical devices, the need for the parts that manage the power flow inside them will continue.
Since splitting from Motorola, which still owns 6.5% of the company and accounts for 7.5% of its revenue, ON has been making deals with its former parent's rivals. "Nokia always viewed us as a competitor," says Hanson. "Now they come to us for the power-management component of the Nokia 6300 series cellular phone" -- a custom part created for Nokia. Other clients who are waking up to ON's independence include Samsung, Qualcomm, and Covic, Hanson says.
To listen to Hanson tell it, ON's growth was stifled by Motorola, which siphoned off profits to help fund its microprocessor business. All that is now changing. In addition to turning old competitors into new clients, ON is participating in the chip businesses' growth. Analysts who follow the stock predict that ON's revenues will reach $2 billion this year, up 25%. Sales could increase an additional 12% in 2001, predicts Lucas Ward, an analyst at Chase H&Q.
HEALTHY GROSS.
What has analysts most excited, however, are ON's profit prospects. "There's a lot of value in the spinout from Motorola in terms of earnings growth," says Ward. "Their higher-margin businesses will be allowed to grow faster." A small change in gross margins -- revenues less cost of goods sold -- can produce a big change on the bottom line. ON's gross margins improved from 27% in the first quarter of 1999 to 36% in the first quarter of 2000. Ward estimates that a two-point increase in ON's gross margin translates into 15% to 30% higher earnings. His projections for earnings per share over the next two years are 52 cents for 2000, vs. 22 cents in 1999, and $1.04 in 2001.
To achieve its margins, the company has to tightly control manufacturing costs. "ON's business is based on making these devices inexpensively," says Walt Lahti, a vice-president for market research at ICE. "In the manufacturing of [commodity] semiconductors, it's incredibly important to shave a tenth of a cent off production costs."
A key element of this effort is a global manufacturing strategy that keeps labor costs low. ON has plants in New England, Mexico, the Czech Republic, Slovakia, China, Malaysia, the Philippines, and Japan. "Capital equipment is not the dominant cost for ON, as it is with Intel's microprocessor business," says Lahti. "ON's products are labor-intensive. That's why they built factories in [the former] Czechoslovakia."
Controlling costs will remain critical as ON's revenues grow, and analysts like the management team's penny-pincher mentality. In a June 14 report, Morgan Stanley Dean Witter analyst Mark Edelstone wrote: "We believe that ON Semi's management team will be viewed as the best team serving the multi-market product categories." Strong management, steady growth, cash-generating businesses, and improving margins -- all of those could make ON an attractive stock for long-term tech investors.
Margaret Popper covers the markets for BW Online
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