Canaan Inc.: Is The Hibernation Finally Over? (NASDAQ:CAN)

Investment Thesis

In theory, Canaan Inc. (NASDAQ:CAN) should be a great trading stock to play Bitcoin’s bull cycle because the company is one of the top three manufacturers of bitcoin mining machines in the world (the other two are Bitmain and MicroBT) and its stock should correlate closely with the Bitcoin price. However, the reality was unfortunately quite the opposite: Canaan had significantly underperformed and essentially decoupled from the entire Bitcoin related stock universe in 2023. Ironically, its much smaller and weaker industry peer, Ebang International Holdings Inc. (EBON), had an unbelievably stellar year with its stock up 425% in 2023, handily beating not only Canaan but Bitcoin, Valkyrie Bitcoin Miners ETF (WGMI), the crypto exchange Coinbase (COIN) and the Bitcoin hodler MicroStrategy (MSTR) (see chart below).

Given the imminent tailwind in 2024 and the ongoing recovery of the industry fundamentals, this disconnection between Canaan and Bitcoin price could be reversed in full force likely as early as January 2024. Actually, we have already seen some encouraging signs of the recoupling momentum between the two in December 2023, during which Canaan stock finally woke up and rose 44%.

Our base case scenario for Canaan in 2024 is that the correlation between its stock price and Bitcoin is reestablished with the current wide performance gap finally closed. During 2023, Canaan lagged Bitcoin by approximately 135 percentage points and an eventual price convergence of the two would imply a target price of Canaan at $4.95, i.e. 2.6x of the close price of $1.94 on January 12, 2024.

We also compared Canaan’s valuation with its Bitcoin-related peers by using Price to Sales ratio. The table below summarizes the market capitalization, 2024 sales forecast, and P/S multiples of its peers with a market capitalization of less than $1 billion. Not surprisingly, Canaan has the lowest P/S ratio of 1.5x while the ratio of its peers was in a range of 2.5x to 6.0x. If Canaan were to trade in that range, the price should be between $3.24 and $7.76. If Bitcoin continues its bull run in 2024, Canaan stock could have further upsides assuming it tracks closely with the Bitcoin price during the year. It is worth noting that Canaan once traded above $36 per share back in March 2021 when its correlation with Bitcoin was still on.

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*Market capitalization as of January 12, 2024.

**Based on Seeking Alpha estimates.

Source: Seeking Alpha.

For those who missed the Bitcoin rally in 2023, Canaan, at the current level, could be a good catchup play during 2024. However, please be aware that the trade of being long Canaan is very speculative and its stock price could be extremely volatile despite all the positive industry catalysts. In terms of risk-reward profile, with the upside target at $4.95, Canaan’s downside floor could be $1.13 which is its all-time low since its IPO in November 2019.

Canaan Hibernation

Theoretically the stock price of Canaan, one of the largest crypto mining rig manufacturers in the world, should track closely with Bitcoin price because the higher the Bitcoin price, the higher the average selling price of the Bitcoin mining rigs, and the higher the stock price of Canaan. Also, Canaan should benefit from some scarcity value as among the world’s top three Bitcoin mining rig manufacturers, it is the only publicly listed one. The reality, however, couldn’t be further away from the theory over the past four years (see chart below).

Canaan was tracking closely with Bitcoin in early 2020 but that correlation broke down in the middle of May 2020 primarily due to the expiration of its IPO lockup period and a negative online research report. During the first wave of a strong Bitcoin price rally in early 2021, the correlation was somewhat re-established and Canaan stock price hit a historic high in late March 2021. Since then, a persistent decoupling kicked in and Canaan stock price essentially flatlined into a deep hibernation, no longer reacting to any Bitcoin price movement at all.

One possible explanation for this long hibernation is the China factor. The background was that the US Congress passed the

Holding Foreign Companies Accountable Act (HFCA) in December 2020, and the SEC issued implementing regulations in March 2021. Under the new law, if the Public Company Accounting Oversight Board (PCAOB) certifies it has not been able to review a company’s audits for three consecutive years, the SEC must delist it. All of a sudden, all the US-listed Chinese ADRs could be potentially delisted three years from March 2021. Invesco Golden Dragon China ETF (PGJ) declined 42% during 2021 and Canaan was also dragged down 23% despite the fact that it generated historically high revenue with Bitcoin up 48% that year (see chart below).

Fast forward to 2023, Bitcoin ended the year up 155% while WGMI rallied 295% (see chart below). Per this media article, the outperformance of WGMI could be due to the interplay of rising prices and high short interest of the underlying stocks, or a likely short squeeze.

Canaan, on the other hand, was up only 19% during 2023, even lower than the 25% return of S&P 500 Index (SPY). That said, we did see some silver lining – Canaan seemed to suddenly wake up from its long hibernation in December and bounced 44% during that month alone while Bitcoin was only up 12%. At one point in December, Canaan even outperformed WGMI before giving back part of the gain at the year’s end (see chart below). If this re-coupling momentum continues into 2024, Canaan could be well positioned not only to close the performance gap with Bitcoin but also to further benefit from the likely start of a new Bitcoin bull cycle.

Canaan Fundamentals

Given the highly cyclical nature of Bitcoin mining business, Canaan’s management has done a reasonably good job navigating the company through the industry down cycles and ongoing regulatory changes. Below are our key observations.

1) Canaan’s top line and profit margin have been dictated by the Bitcoin price.

Canaan’s revenue was mostly determined by the total computing power sold and their average selling price (ASP). ASP was driven by three factors, the Bitcoin price, expected mining returns, and the performance of the mining rigs. Higher Bitcoin prices and expected mining returns typically will lead to higher demand for mining rigs and in turn, drive up the ASP. In a down cycle, those two factors will depress the demand and ASP of mining rigs. The performance of the mining rigs is an important factor, but not as decisive as the other two, because a mining rig with better features could sometimes have a lower ASP than an older version if it was launched in less optimal time during a downcycle or right after a sharp Bitcoin price correction.

Since it employs a fabless model, Canaan’s cost of revenues is primarily driven by the raw materials and the cost of contract manufacturing. Typically, a newly launched mining machine model tends to have higher production costs per Thash early in its product life due to initial setup costs which will level down as the production process becomes mature and more optimized over the following years. Given this, Canaan’s gross margin is therefore more dictated by ASP (ultimately by Bitcoin price) than the production costs per Thash. As long as ASP holds constant or trends higher, the gross margin will increase over time. However, if ASP falls significantly in a downturn, gross margin will suffer severely as both the production costs and inventory write-down can add up to be higher than ASP.

Canaan went public in 2019, so we only have its annual financials up until 2017. Between 2017 and 2023, Canaan experienced two Bitcoin cycles and Bitcoin hit its peak price of each cycle in 2017 and 2021 respectively (see chart below). 2024 is likely year 2 of the third cycle Canaan is navigating through.

Bitcoin Price Cycles

In the following chart, we compared Canaan’s ASP, average selling cost per Thash (ASC) and average gross profit per Thash (AGP) with yearly return of Bitcoin price so as to assess the connection between the Bitcoin cycle and the company’s profit cycle. It is very clear that the Bitcoin price had a direct and significant impact on Canaan’s gross margin. Also, Bitcoin cycle led Canaan’s profit cycle by approximately one year, most likely due to the production and delivery process for the mining rigs. For example, Bitcoin price tanked 74% in 2018 but Canaan still generated 166 Yuan gross profit per Thash with a 45% gross margin per Thash that year. In 2019 the company started to feel the delayed negative impact of Bitcoin selloff and reported 34 Yuan gross loss per Thash. Ironically, Bitcoin was already on its way up during the period. Canaan also reported a gross loss per Thash in 2020, but that was mainly due to COVID 19 disruption and should not be counted as part of the cycle.

Canaan’s Gross Margin vs Bitcoin Return

During the second cycle, Bitcoin price nosedived 64% in 2022, but Canaan did not receive the shockwave until 2023 and reported a gross loss of $167 million and net loss of $242 million respectively in the first 9 months, the highest in past six years (see charts below). However, with Bitcoin price up 155% in 2023 and likely more rally in 2024. Given where we are in this cycle, we would expect Canaan to swing to a gross profit and net profit again over the next two years.

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One positive development in the current cycle is that Canaan’s core products, including Avalon A1346, A1366 and A1466 mining rigs have all been able to generate profit at the current Bitcoin price ($42,313 as of January 14, 2024) based on the estimates of whattomine.com (see table below). Those three models should be the main sources of Canaan’s revenues in 2024 before a new model is launched during the year.

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*https://www.whattomine.com/

**https://www.cryptominerbros.com/

This profit trend was further verified by two recent product orders. Per the company press release on January 3, 2024, Canaan had secured two major purchase orders late December 2023, include 16,700 A1466 mining rigs from Cipher’s JV entities and 1,100 A1346 mining rigs from Stronghold who also had the option to purchase an additional 2,500 A1466 mining rigs. Based on the selling price in the above table, these orders are worth approximately $59 million or $67 million, if including Stronghold’s purchase option. To keep these orders in perspective, Canaan’s revenue in 3Q 2023 was only $33 million.

2) The balance sheet had been prudently managed.

Canaan’s balance sheet was debt free as of 3Q 2023. Since the company incurred net loss in each of the first three quarters in 2023, its cash on the balance sheet had been depleted to only $41 million. Canaan management had preemptively addressed the issue during 3Q 2023 with a $125 million convertible preferred share deal. Additionally, the Company entered into an At Market Issuance Sales Agreement with B. Riley Securities as the sales agent, under which Canaan could raise up to $68 million by selling its ordinary shares. These two deals certainly bolstered the liquidity position of the company during the industry downturn.

Canaan’s balance sheet was also supported by its Bitcoin holdings which had increased steadily over the past two years since the company started its self-mining business. By the end of 3Q 2023, the company held 860 Bitcoins (excluding 378 customers’ deposits) on its balance sheet which at the current Bitcoin market price are worth over $36 million (see charts below).

3) R&D commitment remained intact.

Canaan’s R&D team has close to 300 members, or over 50% of the company’s total employees. The team is divided into two groups, one for developing the mining machines and the other for its AI products. Despite the industry downtown, the company had committed to its R&D investment. During the first nine months of 2023, the company spent over $54 million in R&D, on par with the level of full year 2021 when the industry was at its peak of the last Bitcoin cycle.

This consistent R&D strategy through the industry cycles certainly paid off for Canaan as evidenced by its mining rig’s hash rate and energy efficiency improvements over the last 10 years (see chart below).

Over the past six year, Canaan typically released three new models per year (see table below) except in 2020/2021 (COVID disruption) and 2023 (industry downtown). This pace of new product launch, supported by R&D investment, is critical for the company to remain competitive against the other two major industry players and to also stay well prepared for the next industry upcycle which most likely will be around corner in 2024.

Key Favorable Catalysts

In 2024, Canaan could potentially benefit from several industry and company specific catalysts that are setting up Bitcoin for a continued upward trajectory. The key industry catalysts will most likely happen during the first four months of 2024, i.e. SEC approval of spot Bitcoin ETFs and Bitcoin halving.

1) January 10, 2024 – the SEC approval deadline of spot Bitcoin ETFs.

As expected, SEC approved the spot Bitcoin ETFs by the January deadline. The general market consensus is that the launch of these ETFs would have long-ranging positive impact for Bitcoin price for two reasons. Firstly, the buying power of these new ETFs will create incremental and persistent demand for Bitcoin. Secondly, the new ETFs will fundamentally change the structure of Bitcoin investors base as they make the Bitcoin, as an asset class, immediately more accessible to the institutional investors. In a post on The Pomp Letter, Matt Hougan, CIO of Bitwise Investments, analyzed the potential price impact of the new Bitcoin ETFs by looking at the gold ETF launched back in November 2004:

The price of gold rose for nine straight calendar years after the first gold ETF launched in the U.S. on November 18, 2004. It is the longest streak of consecutive positive years in gold’s recorded history.

There were many reasons for this historic run apart from the ETF launch. But the ETF played a big role. Over this time period, gold ETFs attracted $89 billion in inflows worldwide, vacuuming up 2,667 metric tons of gold. That’s 86 million ounces-more gold than the countries of China, Switzerland, and Russia hold combined.

This fundamentally altered the demand balance for gold. According to the World Gold Council, investment-related demand for gold rose from 4% of total demand in 2000 to 45% in 2009, “driven mainly by an increase in demand for ETF and related products.” Given gold’s inflexible supply, this likely contributed to rising prices.”

If history repeats itself, the price impacts of the new Bitcoin ETFs will play out surely but gradually as it will take time for those ETFs to build up their AUM and to slowly push up Bitcoin price. Actually, the prices for both Bitcoin and related stocks all traded down right after the ETFs’ launch as the traders took profit by “selling the news”, however, this short-term volatility shall not alter the long-term tailwind created by these new ETFs.

2) April 2024 – Bitcoin Halving.

The next halving event will likely happen in April 2024 which is expected to reduce the Bitcoin mining reward from 6.25 BTC to 3.125 BTC per block. The halving essentially will lead to a reduced supply of Bitcoin and historically has driven up the Bitcoin price as the demand remained constant or higher.

Current market expectation is that the halving and other positive catalysts could make 2024 a year of Bitcoin bull run. One of the research newsletters we closely follow is from Blockware Solutions, a leading mining rigs marketplace. In its 2024 outlook, the base case target for the Bitcoin price is $100,000 while the bear case is $65,000 (see screenshot below). Even in its bear case, the Bitcoin price will still be up more than 50% from year-end 2023 which certainly bodes well for Canaan.

Besides these two industry developments, Canaan will potentially benefit from three company specific catalysts:

1) March 2024 – Earnings release.

Canaan will report its 4Q 2023 earnings likely in March 2024, in which the management should update their outlook on the company’s order book based on their observation in 1Q 2024. If Bitcoin indeed started a bull run in early 2024, both the average selling price of the mining rigs and the forward orders for Canaan’s products would rise significantly.

2) Independent funding of Canaan’s AI business.

In its 3Q 2023 earnings call, Canaan mentioned that it was going through an internal restructuring with the goal to clearly separate the mining machine business from its AI business. The two businesses will operate independently and potentially AI business will raise financing separately. This is exciting progress that the market might have totally missed. Just like in the US, AI frenzy swept China in 2023 as the institutional investors were rushing into the space and pushing up the valuation of AI projects. Per a Reuters report, one recent example is 01.AI, an AI startup launched by Lee Kai-fu (ex-Google China Chief and a venture capitalist) in July 2023 after a three-month incubation period, already hit a valuation of $1 billion early in November 2023. If Canaan’s AI business chose to raise fund independently, it would certainly benefit from this market trend and command a market valuation (hopefully higher) without being “tainted” by the highly cyclical Bitcoin mining business. If that is the case, the intrinsic value of Canaan could also be elevated based on the sum of parts valuation.

3) More ETF inclusion.

Per stock ETF exposure tool of etfdb.com, Canaan is currently included in 31 ETFs, of which only 8 have Canaan within their top 15 holdings (see table below). It is also worth noting that the AUM of those ETFs is quite small with the largest one being $152 million.

By comparison, Riot Platforms (RIOT) is currently in 70 ETFs of which 12 have it within their top 15 holdings. Marathon Digital Holdings (MARA) is currently included 71 ETFs, of which 17 have it within their top 15 holdings. Besides the fact that they are included in more ETFs, they are also included in the ETFs with much larger AUM, e.g. Amplify Transformational Data Sharing ETF (BLOK) with $1.1 billion AUM and SPDR S&P Kensho New Economies Composite ETF (KOMP) with $1.9 billion AUM.

ETF inclusion will be a positive technical catalyst for Canaan and will most likely happen when the stock price of Canaan is on a rising trajectory in 2024. The marginal purchase from the Bitcoin themed ETFs could further amplify the upward momentum. As a catalyst, this one could be a long shot, but we do not want to rule out the odds of it happening in an industry upcycle in 2024.

Key Risks

1) Lack of investors’ interest in the approved spot Bitcoin ETFs. If the investors are not enthusiastic about the spot Bitcoin ETFs, there will not be sufficient support for Bitcoin price for a sustainable rally in 2024. Both Canaan’s stock price and business will suffer in this case.

2) Continued decoupling between Canaan stock and Bitcoin price. Investors could continue to shy away from Chinese ADRs, including Canaan. Under this scenario, Canaan stock could remain flatlined despite all the positive catalysts in 2024, e.g. approval of spot Bitcoin ETF, post halving Bitcoin price rally or improved financials of Canaan.

Conclusion

As one of the top three Bitcoin mining machine manufacturers in the world, Canaan is a great trading stock to play the potential bitcoin upcycle. Despite being visibly absent from the strong industry recovery in 2023, the company is currently well poised for a bull run in 2024 given the strong lineup of positive industry catalysts, such as the launch of multiple spot Bitcoin ETFs and imminent halving event. At the current price, Canaan stock provides an asymmetric risk-reward profile that could be achieved by simply closing the valuation gap with Bitcoin and other industry peers. The key risk of being long Canaan is the persistent decoupling between its stock and the Bitcoin price.