By Rohit Kulkarni, Managing Director of Private Investment Research at SharesPost
The price of a Bitcoin has declined more than 50% over the past nine months, but that hasn’t dampened the enthusiasm for an IPO by the two biggest Bitcoin miners in the space – Canaan Creative and Ebang.
Despite the near-term headwinds, Canaan and Ebang have filed to go public in Hong Kong. Last week, Bitmain closed a $1 billion pre-IPO round, further adding to the optimism about Bitcoin mining firms. Investors will closely watch these IPOs, which can be a rare and unique opportunity to buy into in a cryptocurrency supply company. All of this reminds us of the saying about who really made money when miners struck gold in the California in 1849. “ If you couldn’t go West during the Gold Rush, you could have made money by investing in mining equipment companies.”
From a valuation standpoint, in particular, Canaan could reach unicorn status in public markets, IF institutional public equity investors believe in the long-term story of miners and apply a premium valuation multiple (>10x-12x Revenue) warranted by exponential revenue growth reported recently.
Canaan’s 400-page filing is a treasure trove of information about the trends shaping Bitcoin mining industry, as well as its outlook and risks facing Miners. Below are top 10 observations from Canaan’s filing. Stay tuned as we learn more about the company’s IPO plans via subsequent filings.
1. Bitcoin miners provide an entry point to cryptocurrency ecosystem: All major cryptocurrencies run on blockchain, a public, decentralized, and distributed ledger. Miners invest the most time and energy in adding a new group of transactions, called a block, to the blockchain. As such, these firms are essential to the entire crypto ecosystem and help build demand for any crypto currency. To understand why firms such as Canaan or Ebang can become so valuable, it’s important to understand the value they create.
Miners rapidly run a series of inputs through the Bitcoin network’s algorithm, seeking to produce an acceptable output, called a hash. This laborious process makes it easy for miners adding additional blocks, or non-mining nodes, to go back and verify these transactions again quickly because the original miner has already provided the proof of work. Mining is also the only way to put new Bitcoin into circulation, as miners are rewarded with newly minted coins when they process a block.
A Bitcoin mining machine contains chips called ICs, and each chip has over 100 cores that work to run the Bitcoin network algorithm independently of one another. This graphic in Canaan’s filing provides an interesting perspective on the value chain in the crypto ecosystem.
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2.Bitcoin mining industry trends highlight underlying drivers: As more computing power around the world is dedicated to mining, the difficulty of mining a single block continues to increase at a faster rate. When the difficulty set by the network increases, it means that the probability of finding an acceptable hash decreases. As a result, more computing power and electricity is consumed in the processing of a single block. Since only the first miner to find the right input receives the reward of 12.5 BTC plus transaction fees , miners seek to gain the upper hand by amassing more computing power at a lower cost.
Cryptocurrency mining is becoming very popular in China, where energy costs are cheap. Strong demand, especially from mining farms, has made China the home of the majority crypto mining machine companies.
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3. Large and fast-growing market opportunity: Application specific integrated circuits, or ASICs, are a type of integrated circuit (IC) used in electronics. ASICs have become the backbone of most Bitcoin mining hardware because they can be built to perform a single function, thus increasing speed and efficiency. The ASICs in Canaan’s AvalonMiner machines are designed to be compatible with the algorithm the Bitcoin network uses to validate coin transactions. The blockchain hardware market dedicated to mining is expected to have Revenue CAGR of 72% between 2017 and 2020, eventually exceeding $14 billion USD in annual revenues.
4. Business models predominantly focus on hardware design: Leading Bitcoin mining companies such as Bitmain, Bitfury, and Canaan, have focused on designing and manufacturing dedicated hardware for mining. Per Canaan’s filing, the company is a fabless IC designer that designs and distributes Bitcoin mining machines, called AvalonMiners, which run on ASICs. As a fabless company, Canaan outsources the majority of its manufacturing so it can focus on design. The company claims that, compared to the industry standard, its A841 machine is faster, has a lower malfunction rate, consumes power more efficiently, and has a superior cooling system.
5. Bitcoin miners can extend business models to Big Data/AI problems: Canaan anticipates an increase in demand for the high-performance ICs that provide the computing power needed in blockchain, crypto mining, edge computing, machine learning, AI, and other industries. The company has been developing an ASIC for edge computing, called a KPU. This solution will specialize in providing voice and image recognition for smart homes and various IoT applications. The KPU will also provide a "single" chip solution, in contrast to the industry standard in edge computing of using multiple chips.
Canaan’s KPU is expected to enter mass production in the fourth quarter of 2018. In an interview with Bloomberg published May 17, 2018, Bitmain’s CEO announced that the company will also be developing ASICs for AI. Canaan and Bitmain’s decisions to diversify their products has been viewed as a protective measure against a future decline in blockchain usage or industry crackdown by the Chinese government.
6. Bitcoin miners face a lot of fundamental risks, including exposure to Bitcoin price volatility: Apart from intense price competition among peers, Bitcoin mining hardware companies, such as Bitmain and Canaan, are exposed to price volatility of cryptocurrencies. With less than 20% of Bitcoins remaining to be mined, continued viability for the mining market assumes transaction fees will provide sufficient compensation as Bitcoin rewards eventually go away.
As highlighted in the chart above, the number of Bitcoins mined per year have declined over the past four years, along with the average number of Bitcoins miner block. We believe Bitcoin miners would face headwinds the law of diminishing returns affects mining operations. Thus, hardware focused companies could face increased pressure to both significantly improve the efficiency of their machines and provide those machines at lower price points.
7. Bitcoin miners have experienced exponential revenue growth rate: The potential upside for investors is in the category’s explosive growth. Canaan’s 2017 revenue was $1.31 billion RMB ($190 million USD) in 2017, a 4x increase from its 2016 revenue of $316 million RMB ($46 million USD). Further, the company has increased revenue by 27x since 2015, its first year of sales, when revenue was $48 million RMB ($7 million USD).
Ebang is a rival mining hardware company that also recently filed with the CCASS. The filing noted that Ebang had $925 million RMB ($135 million USD) in revenue in 2017, a 17x increase from its 2016 revenue. Ebang has grown revenue by about 32x since 2015, when revenue was $29.2 million RMB ($4.3 million USD).
8. Gross margins have improved with scale: Canaan’s gross margin was 29.1% for 2015, 41.7% for 2016, and 46.2% for 2017. Nearly all of Canaan’s revenue (99.1%) comes from its sale of AvalonMiner machines. In 2017, the company shipped 295,523 units, accounting for 20.9% of all sales in the Bitcoin mining hardware market. The company began selling internationally in 2017, and these sales accounted for 8.5% of revenue in 2017. As demand for mining hardware grows, Canaan further expands sales internationally, and the company continues to scale its operations, we can expect the company’s gross margin to continue to improve.
9. Competitive environment already consolidating among top five players: Bitmain is a Beijing-based company that produces approximately 70% of the mining hardware on the market. The company is also involved in establishing mining farms and pools, representing a significant and growing proportion of total hashes. Other companies currently producing Bitcoin mining machines that use ASICs include Ebang, Halong Mining, Bitfury, and GMO group. In June 2018, Japan’s GMO group launched the B2, the world’s first 7nm ASIC miner, ahead of Canaan.
10. Improving profitability and cash flows along with scale-driven economics: For 2017, Canaan reported an operating profit of $386 million RMB ($56 million USD), 29.5% of total revenue. This was up from $57 million RMB ($8.3 million USD), 17.9% of revenue, in 2016, and $1.8 million RMB ($263k USD), 3.8% of revenue, in 2015. The company became operating cash flow positive in 2017, bringing in $88 million RMB (12.8 million USD). This comes as an improvement since 2016, when the company had an operating cash outflow of $69 million RMB ($10.1 million USD).