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Wedbush Morgan analyst Craig Berger recently sent a note to clients on ON Semiconductor (ONNN) in which he affirmed his belief that shares continue to be cheap as TPG shareholder overhang lessens and margin expansion continues to drive EPS gains. As a result, Berger maintained his BUY rating. Excerpts follow:

Investment Summary

Field checks indicate that ON Semi is tracking towards the mid-point of its Q3 revenue guidance range. Various field checks indicate that ON Semi is indeed tracking towards the mid-point of its Q3 revenue guidance range of $405-415 million, a positive given that investors seem to ‘not believe the numbers’ forecast by analysts for 2H'06 and 2007. We expect wireless to be sequentially flattish in Q3 but up in Q4. The PC sector seems to be ramping up, and should grow more materially in September. Overall business seems to be tracking, but is not as hot as earlier in the year.

Chip prices are stable so far in Q3; lead times have contracted slightly recently to about 10 weeks, but do not indicate an imminent shortfall in demand. Our contacts indicate that ON Semi’s chip prices are stable so far in Q3, not a surprise given the crosscurrents of some small pockets of channel inventory and an imminent seasonal build. It seems that leadtimes have declined about one week or so to 10 weeks, on average, reflecting greater supply availability as compared to the February through May time frame. None of our channel checks indicate that a significant demand shortfall or component inventory adjustment is imminent for ON Semi products.

TPG shareholder overhang is thinning as it reduces its ownership stake from 52% to 39% in August, a positive. Major shareholder Texas Pacific Group reduced its ownership stake in ON Semi from 52% to 39% in August. TPG reduced its stake from 165 million shares to 126 million shares during the month of August, via both open market selling and secondary placement of shares. ONNN has held firm in the $6 range during this time and we believe it could work higher once TPG has reduced its ownership stake. The TPG overhang has thinned, to some degree, but still represents a significant overhang on the stock, as evidence by ONNN’s industry low P/E multiple.

We believe ONNN is one of the more compelling lower tier analog/discrete firms given continued management execution, still solid channel dynamics, stronger than expected margins, and a very low 8x forward P/E multiple.

No change to our 2006 and 2007 EPS estimates of $0.75 and $0.85, respectively, our $10 price target, or our BUY rating. We believe investors should give ON Semi more credit for management’s strong execution. The company's outlook is solid, in our view, and we believe the company is capable of maintaining 40% gross margins in its core business. Our $10 price target is based on a 12x multiple of our 2007 EPS estimate, towards the low end of normalized P/E ratios for chip firms. We believe this valuation multiple is modest given the firm’s recent gross margin expansion, solid management execution, and track record of beating consensus EPS estimates.

Risks to attainment of our share price target include: capacity shortages, excess inventory reductions in the distributor channel, greater than expected internal inventory builds, greater than expected chip pricing pressure in discrete or analog components, weaker than expected demand in 2006, or weaker than expected margins.

Q2 Recap (From 7/28/06): Margin Expansion Drive EPS Estimate Upside in 2006

Q2 revenue and EPS both materially beat consensus estimates (even when backing out the $0.02 benefit from change in depreciation). ON Semiconductor reported Q2 revenues of $375 million (+12% QoQ, +24% YoY), ahead of consensus of $371 million (normalized for Gresham foundry business) and our own estimate of $370 million. Pro forma EPS was $0.20, $0.07 better than consensus and our own estimate of $0.13 ($0.02 of upside driven by change in depreciation methodology). Gross margins reached 41.0% for the quarter, +610bps ahead of our estimate, of which 200bps was driven by management’s decision to extend the depreciable life of their equipment. Also contributing to higher gross margin was improved pricing (up 1% QoQ) and better product mix. Inventory grew by +6 days QoQ to 80 days, largely due to the acquisition of LSI’s fab.

Q3 revenue and EPS guidance both meaningfully ahead of consensus, a strong positive. Q3 revenues were guided to grow to $405-415 million, significantly better than consensus revenues. The firm expects Q3 margin to decline –200bps to 38% as it ramps up more lower margin LSI foundry business. This gross margin target is significantly ahead of our 36% forecast. The firm expects strong results in its computing and consumer segments, driven by seasonal unit growth, stable ASPs and higher dollar content per device. The firm reported that backlog covered about 90% of revenue guidance for the current quarter.

Business dynamics remain healthy with channel inventory at normal levels of 11 weeks on hand, Q3 chip pricing expected to be about flat sequentially, and Q3 backlog up over Q2; these are not the type of business trends that signal an imminent industry downturn, in our view. ON Semi’s channel dynamics remain healthy with the firm seeing flat pricing in Q3 after seeing up pricing in Q2, generally stable lead times, still robust factory utilizations above 90%, greater backlog in Q3 than in Q2, and still lean distributor channel inventory of about 11 weeks, all positive signs that the industry is not headed into an imminent downturn.

Positives:

• Revenue and (normalized) EPS were materially ahead of consensus estimates in Q2, with Q3 also guided materially ahead of consensus estimates

• Gross margin was 41% in Q2 and is expected to be at 38% in Q3. Both Q2 performance and Q3 guidance beat the street consensus (somewhat expected)

• Chip ASP is up by 1% in Q2 and expected to remain stable in Q3. Unit dollar content is on the rise (expected)

• Inventory is expected to be flat in Q3. Positive operating cash generation help pay down debts and strengthen the firm’s cash position

Negatives:

• Assembly/test capacity (> 90% utilization) constraining revenues and increasing lead times (expected)

• Using 10-year depreciation method, a change from previously used 5-10 years, on manufacturing equipments, may result in a somewhat unfair comparison of QoQ gross margins.

• Increased foundry service revenues may put constraint on gross margin while having little impact on future EPS (expected).

ONNN 1-yr chart:

ONNN 1-yr chart

Source: ON Semiconductor: Margin Expansion Continues to Drive EPS Upside