Onto Innovation Stock: The Divergence Continues (NYSE:ONTO)

Onto Innovation (NYSE:ONTO) is doing very well by most accounts. Sales and earnings, for instance, continue to advance at a double-digit clip, setting new records along the way. The outlook is strong with the aid of a number of secular growth drivers. However, the stock has nonetheless done poorly, especially in recent weeks, even though it has so much going for it. Why will be covered next.

The stock has sold off recently

The stock had been showing signs of strength, but the month of August turned out to be a bad month for ONTO. The low of the year was set in June, but the stock proceeded to go on a major rally in July, narrowing its losses for the year. However, the stock has turned south once again, having lost close to 25% of its value in recent weeks, bringing YTD losses back up to 33% in 2022. The chart below show how the last few weeks have been very difficult for ONTO.

Note how the rally from early July to early August came to a halt when the stock reached $90 or so. This happens to be a region where the stock struggled before earlier in the year, suggesting the presence of resistance in the $90 region. The $90 region also happens to a price level where the stock was able to find support in recent past. In other words, the $90 region has served as resistance, but also as support. This is consistent with support becoming resistance and vice versa once there is a breakthrough.

The recent highs in the $90 region can be connected to form a trendline. Another trendline can be formed by connecting the recent lows. The upper trendline is flat, but the lower trendline is sloping downwards. This price action could be interpreted as the bears gaining the upper hand over the bulls with the stock recording lower lows, but no higher highs.

Resistance looks set, but the same cannot be said of support. If the stock is to halt the recent decline, support will be needed. Knowing where support lies would help a lot. At the moment, support has yet to be established and the stock may have to go lower to find support. The stock may have to fall back to the aforementioned lower trendline. To get there, the stock would need to get past the current low and set a new low for the year.

ONTO can still count on strong growth

The weakness in the stock stands in sharp contrast to ONTO’s record-setting growth. Q2 revenue, for instance, increased by 32.5% YoY to a record $256.3M, the seventh consecutive sequential increase in quarterly revenue. GAAP EPS increased by 45% YoY to $1.03 and non-GAAP EPS increased by 39.1% YoY to $1.28. The cash balance totaled $545M at the end of Q2, up from $511M at the start of FY2022.

In terms of market segments, advanced nodes led the way with a YoY increase of 47% to $94.5M, accounting for 37% of revenue. Specialty device and advanced packaging increased by 28% YoY to $117.3M, resulting in a 46% share of revenue. Software and services increased by 19% YoY to $44.5M for a 17% share of total revenue.

ONTO reached a milestone with customer acceptance of the first JetStep X500 lithography system. The acceptance resulted in an additional $20M in revenue, which had not been factored into Q2 guidance, allowing ONTO to easily surpass Q2 guidance of $234-248M. On the other hand, this also suggests revenue would have come in at the lower end of guidance if not for the contributions from lithography systems.

These systems came with lower margins due to having gone through extensive evaluation, which resulted in gross margins that declined QoQ and YoY. As a consequence, earnings declined sequentially even though revenue went up. Margins were also negatively impacted by inflation. The table below shows the numbers for Q2 FY2022.

(GAAP)	Q2 FY2022	Q1 FY2022	Q2 FY2021	QoQ	YoY
Revenue	$256.310M	$241.350M	$193.387M	6.20%	32.54%
Gross margin	52%	54%	55%	(200bps)	(300bps)
Operating margin	22%	24%	19%	(200bps)	300bps
Operating income	$57.451M	$58.744M	$35.941M	(2.20%)	59.85%
Net income	$51.575M	$53.330M	$35.051M	(3.29%)	47.14%
EPS	$1.03	$1.07	$0.71	(3.74%)	45.07%
(Non-GAAP)
Revenue	$256.310M	$241.350M	$193.387M	6.20%	32.54%
Gross margin	52%	54%	55%	(200bps)	(300bps)
Operating margin	29%	31%	26%	(200bps)	300bps
Operating income	$73.096M	$74.264M	$49.652M	(1.57%)	47.22%
Net income	$64.001M	$65.628M	$45.879M	(2.48%)	39.50%
EPS	$1.28	$1.31	$0.92	(2.29%)	39.13%

Click to enlarge

Source: ONTO Form 8-K

Guidance calls for Q3 FY2022 revenue of $242-258M, an increase of 24.6% YoY at the midpoint. The forecast expects GAAP EPS of $0.95-1.16, an increase of 44.5% YoY at the midpoint, and non-GAAP EPS of $1.21-1.42, an increase of 34.2% YoY at the midpoint. The latest numbers suggest ONTO is getting close to reaching its financial targets of $1B in annual revenue, a gross margin of 56-57%, an operating margin of 31-32% and EPS of $5.20-5.35, the last three in terms of non-GAAP.

	Q3 FY2022 (guidance)	Q3 FY2021	YoY
Revenue	$242-258M	$200.6M	20.64-28.61%
GAAP EPS	$0.95-1.16	$0.73	30.14-58.90%
Non-GAAP EPS	$1.21-1.42	$0.98	23.47-44.90%

Click to enlarge

Guidance did not extend beyond Q3, but ONTO was confident enough to state that it expects to grow faster this year than the wafer fab equipment or WFE market. From the Q2 earnings call:

Contributing to our view of a stronger second half, bookings outpaced billings in the second quarter, adding to our backlog which is now over $700 million. Given this unprecedented visibility, we project system sales to advanced node customers to grow over 40% for the year and systems for specialty devices and advanced packaging to grow over 20%, each well ahead of fab equipment spending estimates of 9% to 10% for the industry overall.

A transcript of the Q2 FY2022 earnings call can be found here.

ONTO is on sale

The decline in the stock in combination with double-digit growth has pushed down valuations. In fact, ONTO now trades at a discount, whether in comparison to its 5-year average or the sector median. For instance, ONTO has an enterprise value of $2.8B, which is equal to 10 times EBITDA on a trailing basis and 9 times EBITDA on a forward basis. In comparison, the 5-year average is 18x and 13x respectively. The table below shows the multiples ONTO trades at.

	ONTO
Market cap	$3.36B
Enterprise value	$2.83B
Revenue (“ttm”)	$923.9M
EBITDA	$275.3M
Trailing P/E	17.92
Forward P/E	15.27
PEG ratio	0.16
P/S	3.62
P/B	2.19
EV/sales	3.06
Trailing EV/EBITDA	10.29
Forward EV/EBITDA	9.28

Click to enlarge

Source: Seeking Alpha

Why the market is looking past strong growth

The decline in the stock was not caused by poor earnings as ONTO is doing fine on that front. Neither do valuations appear to be much of a problem. However, there are other concerns out there that seem to be affecting the way ONTO is perceived. For instance, half of the recent decline or about 12% came in the wake of Micron (MU) lowering its earnings outlook on August 9. Not only did MU mention falling chip demand, but it also decided to cut back on capex spending, a negative for WFE suppliers like ONTO. Note that the news coincided with weak guidance from NVIDIA (NVDA), which also mentioned excessive inventories and weak consumer demand.

The news send shockwaves through the semiconductor industry, including ONTO as it counts MU as one of its customers. It’s worth mentioning that the news overshadowed another announcement from MU on August 9 that, unlike the previous one, should be bullish for WFE suppliers like ONTO. MU intends to invest as much as $40B by 2030 in leading-edge memory manufacturing in the U.S. after the passing of the Chips and Science Act.

We think we have the announcements baked in to our commentary. I did mention in the prepared remarks that DRAM would be down, but offset by continued strength in NAND and logic, particularly for the advanced nodes.

So barring future surprises, wheels falling off the bus kind of thing, our channel checks our discussions with the customers. We’re pretty confident the visibility we have, the fact that the book-to-bill was continued to be higher, over 1, leads us to believe we’re still in an environment where the equipment is in high demand.

ONTO for its part acknowledges weakness in the DRAM segment, but it also believes strengths in other segments like NAND will keep semiconductor equipment in high demand in the near term. Nevertheless, the fact that the stock sold off suggests the market remains concerned. The quarterly numbers from ONTO suggests all is well, but the market is not convinced it will stay that way.

Investor takeaways

In the long term, ONTO looks well placed to take advantage of a number of secular growth drivers. For instance, the amount of data generated worldwide is growing exponentially, which drives the need for high-capacity storage solutions like multi-stack 3D-NAND. The transition towards smaller process nodes requires increased process control, which can be provided by suppliers of metrology solutions like ONTO. Advanced packaging is another industry trend and the recent customer acceptance of the first sets of JetStep lithography systems show that ONTO is making headway there as well.

The most recent quarterly numbers and guidance show that ONTO is indeed benefiting from aforementioned growth drivers. However, there is no denying that demand for semiconductors is slowing down. For instance, according to the latest projections from WSTS, the semiconductor market is expected to grow by 13.9% YoY to $633B in 2022, which is less than the year before when the market grew by 26.2% YoY to $556B in 2021. Growth is expected to decelerate even more next year when the market is expected to grow by 4.6% YoY to $662B in 2023. It’s possible the market will start to contract in 2024-2025.

While demand for some types of semiconductor chips remains robust, others are not as fortunate. Numerous companies have reported falling demand for consumer goods like PCs and smartphones, which are among the most prolific users of semiconductors. In theory, declining demand for semiconductors will lead to declining demand for the equipment needed to manufacture those semiconductors, including those from ONTO. It may not happen right away, but it will as long as semiconductor demand continues to weaken.

I am neutral on ONTO as mentioned in a previous article. The fact that the stock has declined all year, especially in recent weeks after the weak outlook from industry heavyweights like MU and NVDA, says it all. The market seems convinced that the semiconductor industry is heading for a downturn, which is why it has chosen to ignore strong earnings growth and guidance from ONTO.

The backlog ensures ONTO will continue to post strong earnings in FY2022, but the divergence between the actual quarterly results and the stock are likely to continue as long as more and more semis lower their outlook due to weakening end-user demand. As long as the industry is perceived to be weakening, ONTO will remain under pressure, no matter how well the quarterly numbers look at the moment.

There may be a lag, but WFE suppliers cannot do well on a sustained basis if semiconductor demand is not there. The price action for stocks like ONTO suggests the market is pricing in weaker quarterly earnings once the downturn in semiconductor demand has trickled through to WFE suppliers like ONTO. The market is getting ready for an industry downturn and odds are the market will be proven right.