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Is ON’s Leveraged Balance Sheet a Cause for Concern?

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Feb. 24 2017, Updated 10:35 a.m. ET

Analysts concerned about ON’s leveraged balance sheet

In this series, we’ve seen that the Fairchild Semiconductor acquisition has had a positive impact on ON Semiconductor’s (ON) earnings. Prior to the earnings release, Zacks Investment Research downgraded its rating for ON from “hold” to “sell,” citing a leveraged balance sheet and strong competition as weak points which could overshadow the company’s strong points of a broad product portfolio, improving end markets, and restructuring benefits.

Let’s see how the Fairchild Semiconductor merger impacted ON’s balance sheet.

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Cash and debt position

At the end of fiscal 2016, ON Semiconductor’s cash reserves stood at ~$1.0 billion compared with long-term debt of $3.1 billion. This equates to net debt of ~$2 billion or a net debt-to-EBITDA[1. earnings before interest, tax, depreciation, and amortization] ratio of 3x.

ON’s leverage ratio of 3x is almost equivalent to the leverage ratio of NXP Semiconductors (NXPI) and Broadcom (AVGO). The difference between these companies and ON is the size. The huge debt encouraged NXP to be acquired by Qualcomm (QCOM) to attain financial flexibility. Hence, huge leverage is a cause of concern for ON.

Prior to Fairchild Semiconductor’s acquisition, the two companies had combined cash reserves of $892.1 million and long-term debt of $1.2 billion. ON took a new term loan of $2.4 billion to fund the Fairchild Semiconductor merger. In January 2017, ON repaid approximately $445 million of its convertible note with a coupon of 2.6%. Now, the company’s major debt bears an interest rate of ~4%.

ON’s debt repayment strategy 

At the conference call announcing the merger completion, ON’s chief financial officer, Bernard Gutmann, explained the company’s strategy to repay its debt. The company would resort to aggressive delevering activities in the first two years.

  • Firstly, ON would stop its share buyback program and channelize a major portion of its FCF (free cash flow) toward debt repayment. This strategy has been adopted by Analog Devices (ADI).
  • Secondly, ON would look to divest its non-core assets and use the sales proceeds to repay debt. NXP sold its Standards Product Division and Broadcom sold its Wireless IoT (Internet of Things) divisions to repay some debt.

Once ON Semiconductor (ON) achieves the net debt-to-EBITDA ratio of 2x, it plans to resume its share buyback program. To achieve this ratio, the company needs to reduce its long-term debt to $2 billion while maintaining a cash reserve of $1 billion.

ON’s current financial position makes it vulnerable to short-term headwinds and limits its financial flexibility. Next, we’ll look at other balance sheet items and see whether the company has sufficient flexibility to take up short-term investments.

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