It’s a new year with new investment challenges, but Brainchip (ASX:BRN) is back on the ramp (some things never change).

To at least get some context around the ASX’s hottest, (largely) pre-revenue AI chip manufacturer, Stockhead put the word out to our investor network to see what the pros think.

Luke Winchester at Merewether Capital answered the call.

Brainchip — the latest

BRN isn’t a holding in the Merewether Portfolio, and Winchester takes a more sceptical view of the stock at current prices.

He also hasn’t been afraid to air his BRN views in the treacherous waters of Aussie fintwit, sometimes resulting in ‘robust’ Twitter discussions with Brainchip bulls.

Right now, they (the bulls) are in control. Brainchip surged by another 26% yesterday to close at $1.86, giving the stock a market capitalisation of $2.537bn.

To contextualise the BRN price action, Winchester delved into concepts such as market structure, industry consolidation and narrative investing.

But first, a brief historical timeline.

– After surging from 3c a share in 2020, BRN consolidates in a steady range between 40c-60c from January 2021 to October 2021.
– October 21: BRN releases three updates;

  • a US patent for granted a US patent for “spontaneous machine learning and feature extraction” in connection with its core product – the Akida 1000 neuromorphic AI chip;
  • Flagged that it would start taking orders for Akida development kits, to allow research partners and commence internal testing of the chip; and
  • Its 4C filing; operating cash outflow of US$3.96m on receipts of US$112k, with ~US$23m in the bank.

– November 15: R&D specialist Sean Hehir is appointed as new CEO to “lead (BRN’s) shift into commercialisation”, after previous leader Louis DiNardo stepped down suddenly bank in March.
– November 25: Enters into a licensing agreement with Tokyo-listed Megachips granting it an exclusive, worldwide intellectual property licence which BRN said is expected to generate ~$2m in revenue over the next two financial years.
– January 14: US investor LDA Capital, which first provided equity financing to Brainchip in August 2020, re-ups to subscribe for a further $15m worth of shares.

BRN – first take

Appraising that timeline, Winchester says Brainchip isn’t so different from a lot of stocks in Merewether’s investment sphere.

“I see a dozen Brainchips a day across the microcaps space,” he said.

“A lot of those updates are what you’d expect to see from a sub-$20m market cap company that has a speculative business or product.”

The difference is that following its parabolic Christmas rally, BRN now trades with a market cap north of $2bn.

Let’s write that out – TWO BILLION.

When it comes to that speculative technology, Winchester clarifies that he doesn’t think Brainchip is making it up.

“It all looks real to me. It’s not a fraud in that sense – there’s something there that they’re working on,” he said.

But in the risk/reward paradigm that’s applied to early-stage technology companies, Winchester doesn’t have conviction Brainchip can be in the “1% that make it” to production scale, profits and re-ratings.

So how does a pre-revenue semiconductor company trade with a higher market cap than plenty of established, profitable ASX stocks?

“The thing with BRN is that first of all, the valuation as it stands assumes all of that (tech) is coming through,” Winchester says.

“Look, it may do — I don’t claim to have the expertise to comment definitively on the product itself.

“But I think it’s also worth taking a step back and asking how did we get to where we are?”

Narrative investing

The idea of narrative strength around a given stock has arguably become more prevalent in the post-COVID bull run.

In that sense, BRN has a neat one-sentence pitch: an AI chip that mimics the neural networks of the human brain.

That may help grab the attention of the influx of retail investors – now accepted as a feature of the current market – who may be less interested in drilling down into company fundamentals.

“If I’m someone with $5-$10k in a Commsec account, that’s probably much more exciting than other stocks we could talk about,” Winchester says.

Small caps are also proving adept at building a narrative through off-market channels such as social media and press releases.

‘…from my vantage point, if you’ve got tech that’s genuine and head-and-shoulders best in class, you get bought out’

BRN plays the game, but it’s not the only one.

Last week, the company answered an ASX price query in response to its mooning stock price.

BRN said there was no material information that would prompt the surge, but it did refer to a press release which flagged a customer, Information Systems Laboratories, had joined its Early Access Program.

Because there was no commercial arrangement, the company said it didn’t fit Listing Rules criteria for an ‘announceable event’.

“If the ASX asks questions they can say it wasn’t material. But at the same time you can pander to your shareholder base through off-market announcements,” Winchester says.

It’s a savvy new theme – building a narrative without having to deal with ASX regulations.

“I think the ASX has clamped down quite a bit in that area. They’ve learnt their lesson from companies like GetSwift,” Winchester says.

“But if you’re not announcing to the ASX you can do it through other channels. And that kind of feeds on itself.

“Everyone is happy to be making money. But once the fundamentals aren’t supported by the share price, it does create the risk of that ‘greater fool’ theory where the stampede can retreat as quickly as it came in.”

To Brainchip’s credit, they have “well and truly kicked ahead” of their peers in the space, he added – companies such as Archer Materials (ASX:AXE) and Weebit Nano (ASX:WBT) which shot higher on steady news flow before seeing some price weakness.

However, the heat in early-stage semiconductor plays also reminds him of the 2018 cannabis boom, or the original lithium bubble (in 2017).

Is BRN the odd one out? “Maybe, but I think a lot of people right now are there for the share price, not the fundamentals,” Winchester said.

“For me as an investor if I have conviction in a stock and it falls 20%, that’s not fun but I’ve done the research to have conviction in the business behind it. And I do wonder how many new buyers in BRN would actually have that.”

Market structure

When it comes to eyebrow-raising moves in small cap stocks, market structure can also play a role.

Going back to his earlier point, Winchester says that when he looks at BRN’s capital markets activity, he sees a company “not too dissimilar to a lot of microcaps”.

Brainchip joined the ASX in March 2015 through a reverse listing via Aziana Ltd (a former mining stock), with 580m shares on issue. It now has around double that.

“When I see a company with a billion-plus shares on issue it means they’ve carried out dilutive capital raises to fund via equity,” Winchester explained.

“That’s fairly common at this end of the market. Except that business is usually worth 1-2c (per share).”

Instead, BRN is worth almost $2. And when you multiply that by its shares on issue you get some “ridiculous multiples”.

“I think most people that have come to story — particularly recently — don’t understand that dynamic,” Winchester said.

“They see a share price – a number on a screen that can go up or down based on money flowing into it.”

Is BRN tightly held? A small free-float where investors can drive the price higher at the margins?

Actually, far from it.

“Looking at the register, you’ve got to give them credit,” Winchester says.

The founder (Peter Van Der Made) still has a 10-11% holding. After that there’s a couple of nominee banks, which hold shares on behalf of different institutional investors.

One of them is well-known Australian firm Regal Funds Management.

Regal became a substantial investor when it bought 82.65m BRN shares on April 2020 at just 3c (BRN has gained ~6,000% since then).

Two weeks later, it sold 10.84m of them between 4.6c to 5.2c — a handy short-term gain, although it’s fair to say Regal may have left some $$$ on the table.

(That sale brought Regal’s holding back below 5% of total BRN shares outstanding and because the fund isn’t a substantial holder anymore, its activity in the stock isn’t reported).

“Beyond that, there’s not a holder above 1%,” Winchester says. Former CEO Louis DiNardo holds around 0.7%.

And while it has the option to buy more under its equity financing arrangement, Brainchip’s US investor LDA Capital only holds around 1% of the total stock on issue, Winchester said.

So what ultimately stands out about Brainchip’s register is that it’s wide open. It’s also not much of a short target.

“There’s not much borrow on the stock because it’s not institutionally held, which means there’s less borrow available to short,” Winchester explained.

With a register constructed like that, retail can play a key role in volumes and trading activity.

In that context, Winchester returned to his greater fool theory.

He’s loathe to dusting off tired investing clichés, but when a pre-revenue company has +1bn shares on issue and a market cap of +$2.5bn “over the long term markets are a weighing machine, rather than voting machine”.

In other words, eventually the business metrics will have to catch up to support that valuation.

“Maybe it can – that’s the caveat to it all; they’re doing really interesting stuff in a really interesting market,” Winchester said.

“Whoever carves out big piece of the edge/AI market will be big – I agree. But when I look at space already and the dollars being thrown at it, I struggle to think BRN is one of them.”

Consolidation

Tying that through to his last point, Winchester concluded that one way he assesses the outlook for semiconductor chip technology is through what’s happening at the big end of the market.

“I looked at this area a while back. (US giant) Intel is investing in neuromorphic chips and made some acquisitions in the US$200m—US$300m range,” Winchester said.

“Apple acquired one, Nvidia is developing technology internally. So it’s a space that has lots of eyeballs on it with well-capitalised companies behind it.”

Is Brainchip a possible takeover target? At a $2.5bn valuation?

Looking at BRN’s R&D spend to the June half-year, Winchester said it came in around $4.4m, but around half of that gets paid to the partners that manufacture the chips.

“So your actual R&D budget to develop this concept is a bit over $2m – let’s call it $5m for the full-year,” Winchester said.

“That’s Intel’s coffee budget.”

“Fair play to the investors that got on BRN early,” he says. “But from my vantage point, if you’ve got tech that’s genuine and head-and-shoulders best in class, you get bought out.”

“And that’s where I get a bit sceptical because if Brainchip had a market-leading solution, we already know Intel’s acquisitive. Apple, Nvidia etc – they don’t miss you.”

“You don’t go under the radar of these businesses because they know where cutting-edge technology is and they’ll go and find it.”