Canaan Is A Buy (NASDAQ:CAN)

Canaan (NASDAQ:CAN) emerges as a promising computer hardware/cryptocurrency mining stock. The company’s expertise in the integrated circuit field and its fast time-to-market has given the company an early market advantage vs. its competitors. In addition, the computer hardware industry and cryptocurrency mining industry are here to stay with high growth prospects. This gives Canaan opportunities to expand its business and increase its operations, indicating a buy opportunity for this undervalued computer hardware stock.

Business Overview

Headquartered in Beijing, China, Canaan is a tech company that designs and develops application-specific integrated circuit, ASIC, chips. The company uses the chips for their Bitcoin mining machines and Artificial Intelligence applications as Canaan is one of the leading producers of Bitcoin mining machines in the world.

Bitcoin Mining Machines

A majority of the ASIC chip applications is dedicated to the development and production of the company’s ASIC-based Bitcoin mining machine which are sold under the AvalonMiner brand. These machines are sold to customers in the United States, Germany, South Korea, and many other countries around the world. With constant technological advancement and research, Canaan usually introduces a new series of Bitcoin mining machines each year and incorporates the latest ASIC chip designs and processing technology. These machines accounted for 64.4% of Canaan’s total revenues in 2021.

AI Applications

Through its experience with the developments of the ASIC chips for Bitcoin mining, Canaan has been able to develop its AI chips which are smaller in size, have increased power efficiency, and have higher computing power. These chips provide AI solutions in the field of Internet of Things, IoT, with its machine vision and hearing abilities which include image classification, face detection, and speech recognition.

Industry Analysis

Computer Hardware Industry

The computer hardware industry is a huge global market with constant high demand. It consists of sales of personal computers, laptops, computer storage devices, and peripheral equipment like computer chips. As of 2021, it is valued at around $1,129.39 billion and it is predicted to reach $1,568.25 billion by 2026 with a compound annual growth rate, CAGR, of 6.6%. As the world becomes more and more digital, there will be a growth in investments in new technologies such as smart cities, smart cars, and artificial intelligence. These technologies are enabled through IoT. This growth in new tech investments is going to be one of the main drivers for the computer hardware market in the coming years. Large companies in this space such as Apple (AAPL), Dell Technologies (DELL), and Intel (INTC) have already begun to invest in the development of these smart technologies.

Cryptocurrency Mining Industry

The cryptocurrency mining market is a new and emerging market that has reached a size of $4050.5 million in 2020 and it is expected to reach a size of $4502.4 million by the end of 2026, with a CAGR of 2.7%. The main driver of this growth is the huge increase in demand for cryptocurrencies, especially with the boom of non-fungible tokens, or NFTs.

To understand more about this market, we first need to know what cryptocurrency mining is. Cryptocurrency mining is basically the verification of transactions on the respective blockchain, depending on the cryptocurrency. The people who verify these transactions are called miners and in order to verify the transactions, these miners need to complete some task. The method by which Bitcoin and other big cryptocurrencies use is that the miners need to solve a complex cryptographic puzzle to be able to verify transactions. The only way to solve the puzzle is to try all possible combinations and permutations which takes a lot of computing power, but once the puzzle is solved, the miners can verify transactions and earn some crypto in return for their work. This system has become a vital part for the cryptocurrency ecosystem.

As mentioned before, cryptocurrency mining can take up a lot of computing power and with costs such as electricity going up, it doesn’t help with the already high operational costs for cryptocurrency mining. This is a major barrier to entry for new crypto mining startups as many of the large companies in the space such as Bitfarms (BITF), Hive Blockchain Technologies (HIVE), and Hut 8 Mining (HUT) have already made big investments into new facilities/warehouses and technologies to increase the efficiency of the mining process and lower the computing costs.

Competitive Advantage

Despite the tough competition in both the computer hardware industry and the cryptocurrency mining industry, Canaan’s mastery of the integrated circuit design as well as its fast time-to-market with its products gives the company a competitive edge against its competitors. The Canaan team is very experienced in circuit and electronic device designs with Nangen Zhang leading the team as CEO. Mr. Zhang himself has over 11 years of experience in electronic device design, manufacturing, and research and development.

Under Zhang’s leadership, Canaan has made some technological breakthroughs in their ASIC chips such as low voltage power efficiency and higher computing density which are very important for crypto mining. The company’s fast time-to-market with its products has led to the early monetization of its ASIC chip designs for the Bitcoin mining machines giving Canaan an early market advantage. In addition, Canaan has secured multiple long-term partnerships with different leading global suppliers, allowing them to deliver high-quality products in a timely manner.

Financials

When looking at its financials, we can see that Canaan was one of those companies that was hit pretty hard by the COVID-19 pandemic. With lots of supply chain disruptions and delays, the company just could not deliver on time and meet consumer demands with its ASIC chips, leading to a decline in revenues and a loss of its profitability between 2019-2020. However, once the pandemic started to abate and production started to increase, Canaan’s sales started to increase. This, along with the recent boom of the NFT market and hype, has led to a revenue increase of over 1000% percent between 2020 and 2021.

The company’s asset trend is very similar to its revenue trend with dips between 2018 and 2020 and huge growth between 2020 and 2021, but its total debt has been constantly decreasing over the past 4 years which is very healthy. Its current D/E ratio is 0.90. This makes it easier for Canaan to get loans to put towards R&D to continue developing its ASIC chips for both Bitcoin mining machines and AI applications.

Future Growth Opportunities

Bitcoin Mining Business

Having mastered the ASIC chip design as well as being one of the main producers of Bitcoin mining machines, Canaan has the opportunity to enter the Bitcoin mining business rather than just selling the machines. Entering the Bitcoin mining business can be tough and costly, but Canaan has already secured collaborations with different cryptocurrency mining farms. In addition, their low voltage and high computing density chip helps Canaan to mine much more efficiently.

Increase Production Capacity

Another opportunity that I see for Canaan would be to increase its production capacity. As the cryptocurrency mining market continues to grow at high rates, the demand for machines will likely follow that growth. As the company increases production capacity, it is able to keep up with the demand for its products, mitigating the risk of underproducing and increasing costs/losing sales.

Valuation

When compared to its competitors, we can see that Canaan Inc is undervalued on almost all the valuation metrics.

In addition, I have performed discounted cash flow analysis of the stock. For the growth rate, I have used a CAGR of Canaan’s revenues for the past 4 years. The perpetual growth rate is chosen between historic inflation rates of 2-3% to match the economy growth and as for the discount rate, I used the company’s weighted average cost of capital. I have decided to use the company’s free cash flow in 2020 instead of 2021 because the growth in FCF between these two years was unnaturally high. By using the FCF from 2020 instead of 2021, it allows for a more natural growth and helps make the DCF analysis more accurate.

Risks

High Dependence on Bitcoin

A large portion of Canaan’s sales are from its Bitcoin mining machines. The purchasing behavior of Bitcoin miners is mainly driven by the economic returns of Bitcoin mining which usually depends on Bitcoin’s price. An increase in the price of Bitcoin would provide a bigger incentive for mining and vice versa. With Bitcoin being as volatile as it is, Canaan’s pricing strategy and sales may be unpredictable. In addition, other factors including electricity costs and the cost efficiency of mining machines can affect the Bitcoin mining business. If there was a shortage of power supply or increase in energy costs, that would raise costs of Bitcoin mining, decreasing demand for the machines.

Bitcoin’s current price is around $22,000, which is one-third of its all-time high of $68,000 back in November 2021. This huge price drop already puts a toll on Canaan’s business model and its demand for its Bitcoin mining machines as well as its future Bitcoin mining business. This makes it very important for Canaan to diversify its revenue streams to stabilize its revenue flow since a big portion of the company’s revenue comes from selling these Bitcoin mining machines. What the company could do is to tap into different industries and markets.

Due to its custom programming, compact size, and high reliability, the ASIC chip is very popular among intelligence agencies, space programs, and defense systems. Canaan could capitalize on this opportunity to develop ASIC chips that are not solely directed towards the Bitcoin mining machines. I believe that the price of Bitcoin and other cryptocurrencies will bounce back in the next year or so but still, amidst the uncertainty of the whole cryptocurrency market, this new opportunity provides a way to make consistent and stable revenue.

International Trade Policies

Since China has banned cryptocurrencies, Canaan has to export their products to many different countries around the world. Changes in trade barriers and trade policies would negatively affect the company’s operations. Recently, the United States, which has a big customer base for Canaan’s products, has advocated for greater trade restrictions and increases in tariffs, especially on goods from China. This puts risk on the company’s sales and revenues.

Government Regulation

In order for Canaan to operate effectively, it needs to obtain different approvals and certificates. These may include intellectual property, to keep the uniqueness of their ASIC chip designs, or government licenses. Complying with these regulations requires substantial expense, increasing operating costs. In addition, failure to obtain all necessary licenses and approvals would lead to further fines or even suspension of operations.

Conclusion

I would rate Canaan as a buy with a price target of $19.53 Despite tough competition in its respective markets, Canaan has shown that it is able to deliver high quality ASIC chips for both Bitcoin mining and AI applications in a timely manner. We could eventually see Canaan rise back even higher than its price target to its all-time high of $34.60.