Story Stocks^®

In search of a much-needed topline spark following six consecutive quarters of yr/yr revenue declines, ON Semiconductor (ON) is reportedly turning to the M&A market to help turn the tide. According to Bloomberg, ON, a manufacturer of semiconductors for power and sensing applications, is considering an acquisition of competitor Allegro Microsystems (ALGM), sending shares of ALGM rocketing higher.

• The timing of this potential deal is interesting as it comes just one week after ON announced a substantial restructuring initiative that includes a global workforce reduction of approximately 2,400 employees. With ON looking to cut costs and right size the company for current business conditions, making a big M&A splash through a multi-billion-dollar acquisition seems like an unlikely move.
• When ON announced the restructuring plan on February 25, CEO Hassane El-Khoury explained that the company is reducing or eliminating projects that are non-core to the business and that the cuts aren't aimed at R&D. Therefore, the focus isn't so much on cost-cutting as it is on restructuring and prioritizing areas of the business with stronger growth potential.
• On that note, an acquisition of ALGM would substantially expand ON's exposure to the EV and data center markets. Similar to ON, the company produces chips that are used in power, sensing, and motion control systems. At approximately 70% of total revenue, the Automotive end market is by far the largest market for ALGM, which has been slumping amid the high-interest rate environment and the more cost-conscious consumer. Last quarter, ALGM's revenue in the Auto market dove by 33% to $130.1 mln.
• With about half of its revenue coming from the Automotive market, ON is facing the same headwinds as ALGM, as illustrated by its downside Q4 results and soft Q1 EPS and revenue guidance from February 10. Given the current weakness in the EV and auto market, and the looming tariffs that may create another headwind for the industry, it seems fair to question why ON would want to double-down on this business right now.
• We believe that the answer to that question may center on valuation. Shares of ALGM are down by nearly 50% since mid-2023 and are trading with a more reasonable Forward P/E of about 39x. In comparison, ALGM had a forward P/E north of 70x in June of 2024. Furthermore, ALGM's margins are a little higher than ON's at 49.1% versus 45.3%, based on Q4 results. So, while the Bloomberg article didn't mention a potential price tag for a deal, ON is likely looking at the weakness in ALGM's stock as an opportunity to purchase the company at a relative discount.

Overall, we have mixed feelings about this potential deal. On the positive side, ON would become a clear leader in the power and sensing niche within the chip industry, especially in the automotive market. Also, ON may be able to scoop up ALGM at a reasonable price right now. However, doubling down on an automotive end market that seems poised for another tough year, and possibly beyond, could exacerbate ON's current growth slump.