Canaan: Well-Positioned For Long Term Growth

Summary CAN’s main business focuses on the design and development of ASIC chips for Bitcoin mining machines. The company has diversified geographically, de-risking its China exposure. The global Bitcoin mining machine market size will grow at a CAGR of 12.6% from 2022 to 2031. My end-of-year price target of $15.20 on the stock is based on a forward PE assumption of 8x applied to the CY2024 earning estimate of $1.90. Thesis Canaan Inc. ( CAN ) designs supercomputing solutions for the Bitcoin mining industry and AI chips. Established in 2013, CAN is the second-largest company globally, in terms of computing power sold, for designing and producing Bitcoin mining machines after its competitor Bitmain. CAN is also a leading company in the Chinese AI market, offering AI edge-computing solutions and chips. The global Bitcoin mining machine market size will grow at a CAGR of 12.6% from 2022 to 2031 to reach $1.7 billion by 2031, which presents an opportunity for CAN to develop new-generation Bitcoin mining machines and expand revenues. I remain bullish on the stock with an end-of-year price target of $15.20 based on a forward PE assumption of 8x applied to the CY2024 earning estimate of $1.90. Business Model: Blockchain And AI Canaan Inc. has built extensive expertise in manufacturing Bitcoin mining machines and designing ASIC chips, which forms a strong foundation for AI chip design in terms of technology and capital resources. The company generates revenue through two main channels: firstly, by developing ASIC design technology for both blockchain and AI segments, and secondly, by leveraging its leadership in the ASIC Bitcoin mining business to provide technical support and R&D resources for its AI business. In 2022, the blockchain segment accounted for 99% of CAN's revenue, while the AI segment contributed only 0.2%. Blockchain Business CAN sells mining rigs and related parts globally to Bitcoin mining companies and has also started booking sales from its own Bitcoin mining business since Q2 2021. The company's competitive pricing strategy allows it to strengthen its position in blockchain supercomputing solutions. In April 2022, CAN launched its latest mining rig, A1366, under the AvalonMiner brand. In 2022, CAN generated $633 million in revenue from its blockchain products, accounting for 99% of its total revenue. AI Business CAN's AI business, established in 2018, focuses on supplying edge AI chips to customers in China's AIOT industry. The company launched its newest mid- to high-end edge inference chip, Kendryte K510, with RISC-V architecture and a self-developed neural network accelerator in July 2021. CAN has developed an AI ecosystem that encompasses front-end design, product development, and service solutions since releasing its first 28nm edge AI chip K210 in 2018. In 2022, the AI business generated $1.4 million, accounting for 0.2% of total revenue. Canaan investor presentation The cryptocurrency mining ban introduced by China in 2021 led some mining machine manufacturers and miners to exit the domestic market. As a result, CAN shifted its resources overseas to reduce its China exposure through geographical diversification. In 2021, the company's overseas revenues accounted for 63% of its total revenue, indicating a successful move. However, CAN's revenue and net income are significantly impacted by the cyclical volatility of Bitcoin's price, which has been falling over the past 15 months. As the Bitcoin price is expected to remain weak throughout 2023, CAN's mining rig demand may also weaken. To diversify its revenue and use its inventory effectively in this market, CAN run its mining business, contributing approximately $31.7 million to total revenue in 2022 (about 5% of total revenue). ASIC Design Increasing Processing Power With the wider use of Bitcoin in various applications and markets, mining machine manufacturers have been investing in advanced node capabilities as ASIC chips improve product performance and decrease power consumption. In 2013, CAN introduced its first ASIC-based mining chip and has since launched several more under the AvalonMiner brand to enhance chip performance and reduce costs. CAN was the first company to achieve 7nm ASIC-based mining chip mass production with its A921 chip in 2018. The company has launched 15 ASIC-based mining machines, and the machines' power consumption has significantly decreased every year. Canaan Geographical Diversification Reducing China Risk In 2021, China imposed a ban on cryptocurrency mining, causing some miners and mining machine manufacturers to leave the domestic market. CAN, like other companies in the China cryptocurrency industry, responded by reallocating resources overseas. In 2019 and 2020, China accounted for a significant portion of CAN's revenue at 75% and 85%, respectively. However, before the ban was introduced, CAN had already begun exploring international markets and generating sales outside mainland China. In 2021, the company's sales contribution from mainland China decreased to 36% , while its overseas revenues increased to 63% of total revenue. To diversify its revenue streams, CAN operates its own Bitcoin mining business in Kazakhstan and plans to accelerate its blockchain segment sales in North America, Central and Southeast Asia, and Australia. The company has also established a new overseas headquarters and warehouse for mining rigs logistics management in Singapore and established new partnerships and customer service centers in North America. Outside China, there is a growing trend of regulating the cryptocurrency market. In Central Asia, for example, the Kazakhstan government has required cryptocurrency miners to register their operations and business data with authorities since May 4, 2022, and file the required information every quarter. New York is the first state in the US to ban blockchain technology infrastructure after the New York Senate set forth a two-year moratorium on PoW cryptocurrency mining operations run on a carbon-based power source on June 2, 2022. In May 2022, a Cyprus government official indicated that authorities in Nicosia have prepared legislation to regulate crypto assets, and it is likely to adopt legislation before Europe finalizes a common regulatory framework. In 2023, Australia also presented a bill to regulate digital assets. Despite the increased regulation worldwide, I believe complete restrictions on the cryptocurrency industry are unlikely to be enacted. As for CAN, the management is likely to retain a flexible approach to adjust its operating policies in response to market developments. Canaan Competitive Landscape CAN primarily operates in designing and developing ASIC chips for Bitcoin mining machines, which a few Chinese companies, including Bitmain, MicroBT, and CAN, dominate . The industry is highly concentrated due to significant entry barriers, such as high fixed costs, lengthy development time, and expertise in ASIC chip design. Intel Corporation ( INTC ) recently entered the market by launching its first ASIC-based mining machine in February 2022. In the edge AI chip segment, CAN faces competition from established fabless chip companies such as NVIDIA Corporation (NVDA), Horizon Robotics, Bitmain, Rockchip, and Cambricon Technologies. Valuation The market has been overly pessimistic on CAN, in my view, as the regulatory environment surrounding crypto remains uncertain, and BTC prices experiencing a significant downtrend over the past one year. At current levels, the stock is trading significantly lower than its tangible book value (market cap of $453 million and a tangible book value of $639 million), which I believe provides a significant margin of safety and a good opportunity for long-term investors. CAN’s financial performance remains overwhelmingly geared to the blockchain mining business on the top and bottom lines. While the current backdrop is challenging, I see the segment well positioned for a cyclical rebound in cryptocurrency mining. Moreover, I believe CAN’s edge AI and mining businesses are gaining traction, supported by its solid technical ASIC know-how, effective go-to-market, and geographical diversification strategies. Mining companies’ profitability is affected by many factors, including BTC price, electricity cost, hash rate, and investment in mining machines. Mining machine manufacturers, however, have a greater focus on R&D investment into mining chip capabilities. CAN is diversifying its revenue sources; I believe it is better positioned than its cryptocurrency mining peers based on profitability. As mentioned earlier, I see market conditions and an end to US rate hikes as key to driving a recovery in BTC and, thus CAN’s valuation. The company is trading at a significant discount to the sector median, so I remain bullish on the stock despite the macro and industry-related risks. My end-of-year price target of $15.2 on the stock is based on a forward PE assumption of 8x applied to the CY2024 earning estimate of $1.90. Seeking Alpha Risks CAN's blockchain business is heavily dependent on the trends in the Bitcoin market, and a significant decline in the price of Bitcoin could result in a significant loss of revenue. In addition, as the regulatory environment around cryptocurrencies is constantly evolving, CAN must closely monitor and adapt to changes in the markets and countries where it operates to ensure that its products and services comply with local rules. The ASIC-based mining machine manufacturing market has attracted many new entrants in recent years, which could pose a challenge to established players such as CAN, potentially leading to a loss of market share and financial forecast misses. Final Thoughts Canaan is well positioned for a cyclical rebound in Bitcoin prices in 2023 and aims to achieve a more balanced revenue mix. The company is set to benefit from the growth of the global Bitcoin mining machine market, and the company has diversified geographically, de-risking its China exposure. Although there are some risks associated with the company, including regulatory risks and the uncertainty in bitcoin prices, I believe they are reflected in the stock’s valuation, and a rebound in bitcoin prices would certainly create more upside. Moreover, as cryptocurrency regulation increases worldwide, Canaan's management retains a flexible approach to adjust its operating policies in response to market developments. I remain bullish on the stock with an end-of-year price target of $15.20 based on a forward PE assumption of 8x applied to the CY2024 earning estimate of $1.90.