Onto Innovations: An Interesting But Demanding Story (NYSE:ONTO)

At a time when the semiconductor market at large is showing real signs of life, with the shares of various participants hitting fresh highs, a previously smaller firm grabs its moment of fame as well. One of such under covered names is Onto Innovation (NYSE:ONTO), a semiconductor name which has seen its shares quadruple since the start of the pandemic.

Having seen great commercial traction since a pre-pandemic merger, Onto has seen interesting price action in 2023, with shares having seen a real run higher while the business was struggling a bit. Given all this, valuations have become much more demanding, with investors being upbeat about the role which Onto can play in AI, of which imminent results are expected.

Unique Perspectives Across The Semiconductor Value Chain

Onto Innovation claims to have a unique perspective across the semiconductor value chain, standing alone in process control. Onto aims to solve the most difficult yield, performance, quality and reliability issues for its clients by making the critical path of progress, faster and more efficient.

With exception to a brief move higher around the time of the dotcom bubble, shares have displayed quite some volatility. A $1 stock around the time of the economic crisis in 2009 traded in its teens all the way through 2016, before rallying further to the $40 mark pre-pandemic.

These share price advancements were disrupted by the operating performance, as the company grew sales from less than $200 million in 2023 to around half a billion in 2020, and to a billion in 2022. On top of sales growing a factor of 5 times, operating margins rose to the mid-twenties, coming from largely break-even levels a decade before.

Of course investors had to incur some dilution, all relating to the 2019 merger between its predecessors Rudolph and Nanometrics, to create what is now known as Onto Innovation.

Where Do We Stand?

With the wider semiconductor sector running on fire coming out of the pandemic, Onto posted solid results for the year 2022. In February of last year, Onto posted a 27% increase in full year sales to $1.01 billion. GAAP operating profits of $236 million worked down to net earnings of $223 million (amidst net interest income and a modest tax rate), with GAAP earnings reported at $4.49 per share. Adjusted earnings came in a dollar higher, in fact were reported at $5.52 per share, with the vast majority being the result of the amortization charges incurred, something which I am happy to adjust for.

With shares trading at $80, multiples were non-demanding at the time, but this came as the company guided for a reversal in the business, with first quarter sales in 2023 seen down to around $200 million.

This turned out to be the case as first quarter sales fell to $199 million and change, as no immediate recovery was seen, with second quarter sales seen around $203 million. In fact, second quarter sales fell further to $190 million and change, although the company issued a more upbeat third quarter outlook, with revenues seen at a midpoint of $215 million.

By November, third quarter sales were reported at $207 million, which looks soft, but included a ten million headwind from delayed shipments of two lithography systems. Despite the shortfall, which should be made up in the coming period, the fourth quarter outlook was not too convincing, with fourth quarter sales seen at a midpoint of $208 million.

The Stock Returns

Given the mixed results to date in 2023, and not so upbeat outlook for the fourth quarter, investors in Onto are really upbeat, as shares essentially doubled over the past year. From a value of $110 in October, shares have risen to effective all-time highs around $165 per share here.

With 49 million shares trading at $165, the market value of the firm has risen to $8.1 billion, including a $629 million net cash position. The resulting $7.5 billion operating asset valuation values the business at over 9 times sales, which trend just over $800 million. With adjusted earnings trending closer to $3.50-$4.00 per share, the valuations are quite demanding here as a modest valuation early in 2023 has risen substantially with the shares having doubled, and earnings having taken a beating.

Part of the momentum appeared to be related to the role which Onto could play in AI. This was evident in the summer already, as Onto announced in August that it received over $100 million in orders for the Dragonfly G3 inspection system, with deliveries seen in the first quarter of 2024.

What Now?

Right now there is real divergence between the results reported in 2023, which are down substantially from 2022, and the share price which doubled during the year. This has pushed up the valuation to a great extent, for good reasons, as the company sees a healthy order intake for its Dragonfly systems.

The other big driver behind the shares were comments made on the third quarter conference call, which took place in the first half of November. Here, management indicated that another $110 million in orders were reported in the 2.5 months before, on top of the $120 million orders of August. This combined $230 million order intake for the Dragonfly surpass the quarterly revenue run rate here, boding well for sequential improvements in the results and all of 2024, certainly as these orders are expected to be shipped (to an important extent) in the first half of 2024.

Amidst all of this, I am performing a balancing act, as it is clear that 2024 is going to be a better year. With a current net cash position of $13 per share, a repeat of $5.50 in earnings per share power (as was the case in 2022) makes that shares now trade around a 27 times forward multiple, but the risks are substantial, both to the upside and downside.

With shares having seen a huge run, now does not seem the prudent time to chase the share, but I anxiously look forward to the fourth quarter results and, moreover, comments about 2024 and the order intake, as real momentum in the business is seen here.