Canaan Inc. Q1 FY2021 Earnings Call

Ladies and gentlemen, thank you for joining us and welcome to the Canaan Inc. First Quarter 2021 Earnings Conference Call. At this moment, all participants are in a listen-only mode. Following the speakers' presentations and management’s prepared remarks, we will have a question-and-answer session. Please be aware that this event is being recorded. Now, I would like to turn the conference over to our speaker host today, Mr. Shaoke Li, Board Secretary of the Company. Please go ahead, Mr. Li.

Thank you very much. Hello, everyone, and welcome to our earnings conference call. The Company's financial and operating results were released by our news source services earlier today and are currently available online. Joining us today are our Chairman and CEO, Mr. Nangeng Zhang; and our CFO, Mr. Tong He; Mr. Maso Lee from ICR, our IR consulting firm, will conduct the English translation throughout the call. In addition, Mr. Xiaoming Lu, our SVP, will also be available during the question-and-answer session. Mr. Zhang will start the call by providing an overview of the Company and the performance highlights for the quarter. Mr. He will then provide the details on the Company's operating and financial results for the period before we open the call up for your questions. Before we continue, I would like to refer you to our Safe Harbor Statement in our earnings press release, which also applies to today’s call as we will be making forward-looking statements. Please also note that we will discuss non-GAAP measures today, which are more thoroughly explained and reconciled to the most comparable measures reported under Generally Accepted Accounting Principles in our earnings release and the filings with the SEC. With that, I will now turn the call over to our Chairman and CEO, Mr. Nangeng Zhang. Please go ahead, sir.

Hello, everyone. This is Nangeng Zhang, Chairman and CEO of Canaan Inc. I will now provide a brief overview of our progress in the first quarter of 2021. During the quarter, we significantly improved our financial performance as a result of the Bitcoin price rally, increasing customer demand, and the substantial ramp-up of our mining production and delivery. As such, we reported total net revenues of $61.5 million and a non-GAAP adjusted net income of $21.9 million in the first quarter of 2021, a significant improvement from a non-GAAP adjusted net loss of $31.4 million in the full year of 2020. With the mass production of the new generation mining machines, our product yield continues to improve. Through close collaboration with our foundry partners, we have further enhanced our chip manufacturing process. As of today, such advances have led to industry-leading performances in our chip speed and yield. In the second quarter-to-date, in addition to our delivery of mining machines, we have also secured a number of large purchase orders of future contracts. Furthermore, we have locked in the fab capacities of our foundry partners for the next 12 months to fulfill these future contracts. Although the Bitcoin price volatility in Q1 created some challenges in sales of mining machines, we expect our Q2 total shipments to either maintain or surpass our current growth rate. Due to the Bitcoin price volatility caused by recent policy and market uncertainties, we are not able to project total net revenues for the second quarter in a precise manner. Hence, we expect our total net revenue for the second quarter to be in a range of $150 million to $200 million. In terms of mining machine sales strategy, we have reprioritized our sales focus to our long-term and large-scale customers. As of May 31, 2021, we have total order volume of over 149,000 mining machines with over $190 million of total customer transactions. Regarding our future contracts, we have signed purchase orders of more than 10,000 mining machines with both Mawson, the U.S. ASIC company and Genesis, an international Bitcoin mining giant. In aggregate, we have had 29 different customers, each with purchase orders of more than 1,000 mining machines accounted for 94% of our total orders this quarter. Our partnerships with such large-scale customers generally involve multi-batch mining machine purchases over a long period of time. These characteristics have helped us to reduce the impact of short-term fluctuations in cryptocurrency prices and ensure the stability of our production and delivery schedules. Since the second half of 2020, we have had our focus on overseas customers. As of May 31, 2021, our overseas revenues accounted for more than 70% of our total net revenues, with purchase orders from overseas markets accounting for more than 70% of our total outstanding purchase orders. Since the second half of last year, capacity shortages in the global semiconductor supply chain have become a common challenge for chip makers around the world. To secure the production and supply of our products, we have initiated negotiations with our suppliers, opting to provide them with a higher unit price and longer upfront payments. As of now, we have paid our suppliers a total of approximately $200 million in upfront payment. In April of this year, we completed a direct offering of 13,492,055 of our ADS at $12.6 per ADS for a total amount raised of $170 million. The financial impact through our latest series and our recent large purchase orders will considerably enhance our cash position, aid us in supply chain improvements and enable us to secure sufficient production capacity for future deliveries. Going forward, we will continue to invest in our R&D capabilities to improve the quality and performance of our mining machines. We will also utilize our cash reserves to enhance our customer service capacity and expand our business segment and models. In anticipation of self-operated Bitcoin mining, we have already set up a wholly-owned subsidiary in Singapore and deployed an operational team in Kazakhstan. In late May of this year, we also deployed the first batch of mining machines in Kazakhstan for our Bitcoin mining-related operations. We believe that our self-operated Bitcoin mining business will help improve our financial performance and expand our business growth and customer base. As we integrate more industry resources into our operations, we believe this business segment will enable us to revitalize our mining machine inventory, shield us from Bitcoin volatility, and ensure our inventory efficiency during a market upturn. As a technology company, we have always prioritized our investments in R&D as the driver of our core competitiveness. As such, our total R&D investments reached $8.9 million in the first quarter of 2021, with the majority allocated to developing new products, improving capacity and yield, expanding the product lines and supply chains, and investing in our R&D team. Beyond our core mining machine business, we also achieved steady progress in advancing our other business initiatives during the period. The AI industry is still in the early stages of market cultivation. Since launching our first-generation AI chip, K210 series, in 2018, we have made outstanding progress and continue to gain traction in the markets for robotics, education, and smart homes. We have cumulatively delivered 479,000 of the K210 series AI chips to our customers to date. In March 2021, we finished the chip process for our second-generation AI chip, the K510 series. We have also completed the main function testing for all functional modules of this series and expect to launch it in the second half of this year. As such, we plan to expand our K510 series into multiple application scenarios with a promising outlook that includes high-end cameras, edge computing, video conferencing, and more. Furthermore, we maintain and emphasize education sponsorship with the establishment of a developer ecosystem. We recently became the sole technical support provider for the 2021 National Student OS Design Competition, an event organized by China's Ministry of Education. Using development boards equipped with our K210 chip, students from over 120 colleges and universities across China participated in the competition. Currently, our Kendryte K210 chip has also become the chip of choice for developers in many interesting application scenarios such as smart meters, eye-tracking VR applications, programmable robot docks, etc. In summary, we have established in-depth partnerships across various segments of the semiconductor industry value chain. These relationships will play an essential role in supporting our steady business expansion in the future. As we continue to accelerate our growth, we will generate increasing returns for our customers and investors going forward. Now I will turn the call over to Mr. Tong He, our Chief Financial Officer, to go through the financial details.

Hello, everyone. This is Maso Lee with ICR. I will now speak in English on behalf of Mr. Tong He.

Thank you, Nangeng. Now I will provide an overview of our first quarter financial results. Before I start, please note that all numbers are in RMB terms unless otherwise noted. Total net revenues increased to RMB402.8 million from RMB68.3 million in the same period of 2020 and RMB38.2 million in the previous quarter. The increases were due to the rise in our total computing power sold as we delivered more Bitcoin mining machines in the period. Cost of revenues increased to RMB208.6 million from RMB65.9 million in the same period of 2020 and RMB29.2 million in the previous quarter. The increase in our cost of revenues was in line with the changes in our sales volume of Thash and the cost of our Thash. As a result, we reported a gross profit of RMB194.2 million in the first quarter of 2021 compared to RMB2.4 million in the same period of 2020 and RMB9.1 million in the previous quarter. Gross margin further expanded to 48.2% from 3.5% in the same period of 2020 and 23.8% in the previous quarter. Research and development expenses were RMB58.2 million compared to RMB41.8 million in the same period of 2020 and RMB40.1 million in the previous quarter. The increases were mainly due to higher share-based compensation expenses, which increased to RMB24.1 million in the first quarter of 2021 as part of our amended 2018 Shares Incentive Plan. The increases were partially offset by the decrease in contracted expenses and other expenses related to our R&D activities during the first quarter of 2021. Let's now take a look at our other operating expenses in the first quarter. Selling and marketing expenses were RMB6.3 million compared to RMB4.1 million in the same period of 2020 and RMB6.1 million in the previous quarter. The increases were mainly driven by higher share-based compensation expenses in the first quarter of 2021, partially offset by lower advertising expenses. Our selling and marketing expenses in the quarter included RMB3.0 million in share-based compensation expenses. General and administrative expenses increased to RMB143.4 million from RMB27.6 million in the same period of 2020 and RMB33.9 million in the previous quarter. General and administrative expenses in the quarter included RMB114.8 million in share-based compensation expenses. Consequently, our loss from operations in the first quarter of 2021 narrowed to RMB13.7 million from RMB71.1 million in the same period of 2020 and RMB71.0 million in the previous quarter. Net income attributable to ordinary shareholders was RMB1.2 million compared to a loss of RMB39.9 million in the same period of 2020 and RMB72.0 million in the previous quarter. Non-GAAP adjusted net income, which excluded share-based compensation expenses, was RMB143.2 million. In comparison, non-GAAP adjusted net loss was RMB38.2 million in the same period of 2020 and RMB73.1 million in the previous quarter. Diluted net earnings per ADS was RMB0.01 compared to a loss of RMB0.25 in the same period of 2020 and a loss of RMB0.46 in the previous quarter. Turning to our balance sheet. Contract liabilities as of March 31, 2021, increased to RMB1,210.6 million from RMB430.4 million as of December 31, 2020. The increase was driven by the increased down payment for the sales order of our Bitcoin mining machines, which are scheduled for delivery in the following quarter of 2021. As of March 31, 2021, we had cash and cash equivalents of RMB1,337.8 million compared to RMB391.3 million as of December 31, 2020. Short-term investments as of March 31, 2021, decreased to RMB8.5 million from RMB62.4 million as of December 31, 2020, as we redeemed a portion of our short-term financial products during the period. We purchased the short-term financial products to receive higher returns, but at the same time can withdraw at any time. Looking ahead into the second quarter of 2021, as we have begun mass producing our new generation of Bitcoin mining machines, we believe that our product yields and deliveries will substantially increase on a year-over-year basis. However, the volatility in Bitcoin pricing in late May of this year has made it difficult to reduce the future trends in Bitcoin prices. As a result, we will not provide financial guidance for the coming quarter. This concludes our prepared remarks for today. Operator, we're now ready to take questions.

Thank you. We will now start the question-and-answer session. We have our first question from Akida Erkin from Chinese Securities. Please go ahead.

I'm going to translate myself quickly. My first question is about. How do you consider the impact of financial regulation on the Bitcoin mining industry in companies like Canaan? Thank you.

In terms of the policy environment, I believe every new and emerging industry is subject to the testing of market evolution and regulatory compliance. In 2020, cryptocurrency represented by Bitcoin became increasingly accepted by the market. Bitcoin has gone through a long process to be valued and recognized by the market. Similarly, in terms of regulatory supervision, I believe the Bitcoin and the mining industry also need to navigate the process of regulatory compliance. The peculiar nature of the cryptocurrency mining industry combines technology-driven aspects with a strong financial future. As the Vice President of the PBOC, Mr. Li Bo expressed at the Boao Forum for Asia recently, if we consider Bitcoin as an investment instrument, we need to develop regulatory policies to efficiently manage potential financial risks, which mainly refer to: one, activities that cause market disorders, such as financial fraud; and two, preventing individual investment risks from extending into the overall financial system. As such, we believe regulatory supervision is constructive to the development of the Bitcoin mining industry, not destructive. In the long run, regulatory provisions are positive for the healthy and early development of the industry. From the market perspective, currently, the majority of our customers are overseas companies, including public companies, well-established mining companies, and professional financial institutions. Policy changes in China might cause some domestic mining companies or vendors to undersell Bitcoin mining machines to medium and small miners abroad, which will cause price volatility of mining machines in international markets. The majority of our customers are large-scale institutions and professional mining companies. The large amount of upfront payments received from these customers will enable us to smooth out the price volatility caused by the underselling of mining machines.

My second question is, what is the attribute of overseas governments towards cryptocurrency currently? Will they be pointing to commodities-based positive regulation globally?

The supervision of Bitcoin from major economies worldwide has been consistent. Most economies from a developmental perspective, according to Statistics of various economies, over 52% or 132 economies currently recognize Bitcoin as legal currency and do not impose restrictions on it. Only 14 economies consider Bitcoin illegal and restrict it. In terms of the nature of Bitcoin, more than 60% of the economies believe it has monetary properties, which means it could be used as a means of payment. Nearly 30% of the economies regard it as a commodity, while more than 10% treat it as property. Recently, many countries, such as Turkey and India, have indicated they may join the list of economies that will prohibit or strip Bitcoin control since the pandemic has worsened their economic growth and domestic inflation has clearly risen. The attitude towards Bitcoin regulation among these economies varies over time.

My third question is, recently some local leaders, both domestically and internationally, have expressed concerns about the high energy consumption of Bitcoin mining. So, what do you think of this concern? Will the closing down of Bitcoin mining firms in Inner Mongolia cause a chain reaction in other places in China?

The establishment of a reserve with the global platform for digital currency mining companies in Inner Mongolia is not a new move. Sudan has issued similar policies before. Currently, the development of the Bitcoin mining industry relies on low-cost power resources. There are two main types of resources: thermal power and hydro power. The Northern Western region is dominated by thermal power, which contradicts the inherent environmental protection principles of carbon neutrality. This is one of the fundamental reasons for the withdrawal of local mining in Inner Mongolia. Additionally, many mining companies engage in mining activities pertaining to data centers in joining policy subsidies branded by the country, but fail to fulfill their corresponding social responsibilities. Therefore, withdrawal from these companies will help standardize the operations of domestic mining companies. Although the mining industry consumes electricity, it utilizes waste electricity to a large extent. Miners prefer to choose areas with lower electricity prices to engage in mining activities for profit-making purposes. Low electricity prices indicate that local power supply exceeds actual demand, resulting in energy waste. Before effective means emerge to displace waste electricity, Bitcoin mining serves as a solution to transform and store value with electricity. Currently, some degree of power abandonment exists in many mining areas in China, notably in the Northwest and Southwest regions. Bitcoin mining has significantly contributed to the finances, employment, and income of residents in rural areas. It also enables new energy facilities to generate income and further expand their scale. I hope that answers your question.

Thank you. We have the next question from Martin Shen. Please go ahead.

We still see good revenue growth in the second quarter. Maybe you can give us some color on the second quarter mining machine output and the price compared to the first quarter of 2021?

As we discussed last quarter, we still expect 70% to 80% of our Q2 orders to the future contracts, driven by our optimizing supply chain, continuous ramp-up of our capacity, and improvement of product yield. Our throughput has been considerably elevated. As a result, we expect shipments of mining machines in Q2 to be more than tripled compared to Q1.

Do we see any impact on the Bitcoin price fluctuation in the second quarter or second half of 2021?

Recently, we have observed considerable fluctuations and corrections in the Bitcoin price and also heard different voices from the market. The overall returns for Bitcoin miners remain at a relatively high level. Under most circumstances, the cost of mining machines does not exceed one-third of miners' income. Additionally, total computing power of the Bitcoin network declined recently due to policy changes in China and the transitions between dry and wet seasons. There is a minor decline of overall returns for miners, but the change is significantly less than the replacement of 3.5 million. The price of mining machines depends on multiple factors. Without considering the impact of policy changes, we see a strong correlation between the price of mining machines and the returns of mining. However, recent policy uncertainties and Bitcoin price volatility have cultivated an overwhelming waiting atmosphere in our domestic market. As domestic miners consider going abroad, overseas demand for secondhand mining machines booms, which has caused short-term turbulence in market supply and demand. Based on our experience and current market situation, we believe major impacts from policy uncertainty and fluctuating Bitcoin prices do not greatly affect the price of mining machines themselves, but rather the timing of placing purchase orders. While domestic customers wait for a clearer policy environment, overseas customers tend to prefer a more stable Bitcoin price. Currently, most of our overseas customers have resumed ordering for spot sales or futures contracts. The impact on overall price is not material, especially for miners not under futures contracts. Depending largely on the Bitcoin price, current prices of mining machines for spot sales are 20% to 30% lower compared to when Bitcoin prices were $60,000.

Regarding our shipment, we already discussed our shipment in the second quarter compared to the first quarter. Can we continue to increase shipments in the second half?

In terms of our total shipments this year, we currently expect to deliver around 300,000 Bitcoin mining machines to our customers. However, regarding revenue and profit, we are not able to provide clearer guidance at this point. We believe these figures are entirely related to the Bitcoin price.

I also want to know, do we have any strategy to get rid of the Bitcoin cycle and maintain profitability for a long time?

Yes, this is a very good question. Firstly, as we are in a fast-developing, emerging new industry, we believe stable profitability is not the top priority of our business operation. We are working on maximizing our profit and managing the risks of losses at the same time. Our operating performance used to be significantly affected by changes in Bitcoin price. The impact was sometimes even magnified on our operating performance. This is natural due to the simplicity of our business model and product line. As a result, we have carried out the following initiatives to increase and stabilize our profitability. The first initiative is the selection of customers and models. We enter into long-term supply agreements with select customers and suppliers to stabilize our supply chain sales and profits, and we also reserve a small portion of the mining machines for spot sales in the market to enhance our profitability. Our second initiative is to expand into new business segments, such as self-operated mining, to diversify our business model. This is a critical segment for a hardware manufacturer to share the development dividend of the blockchain industry. Furthermore, as a directive business model of the blockchain industry, it is fundamental for computing power easing, cloud computing sales, and even computing power contracts. As the industry evolves, the entry barriers for cryptocurrency mining have become too high for most participants on our call today to build and operate large-scale mining facilities. This entry barrier has essentially discouraged investment in this field. The business model of pure hardware manufacturing is outdated. We should promote the hardware plus service model or even pure service model, Mining as a Service (MaaS), to become the mainstream model. The third point is diversification. Essentially, we are a chip company. Our core competency is the capability of defining chips and massive production of them. It would be too narrow if we limit our technological advantages and strong balance sheet only to the development of mining chips. Therefore, we are developing homologous technologies to be applied to entirely different AI devices and edge AI chips. Although this new business segment is still in the early stages of market cultivation, it is generally acknowledged that AI chips represent an important industry in the future with vast market potential. We hope to be prepared for potential business opportunities as they arise. Thank you. Hope this helps.

We would like to know about the next-generation machine progress. Which current partners are we cooperating with, and what is the rough status for publication?

To avoid causing confusion in the market, we normally don't separately launch a single new chip due to the simultaneous generation of technologies and massive production by multiple foundry partners. Uncertainty is always associated with any R&D project. As such, there might be changes to our following discussions and expectations. The next-generation chip is the second iteration of our existing technology. We expect to gradually adopt the next-generation chip in the second half of this year. Compared with current products, we expect an overall improvement of 10% to 15% in terms of performance, cost, and power consumption. In terms of the R&D process of the next-generation chip by our foundry partners, the full function testing of the chips has been put into production, and mass production is aligned with our foundry partner's testing. We expect the overall improvement to be in the range of 20% to 30%. Additionally, we are also in the process of developing a 5-nanometer chip, and we expect to launch the M5 products next year. Instead of the challenges of R&D itself, the long process and capacity constraints are the major obstacles for its launch. Regarding our cooperation with Samsung, the manufacturing of mining chips requires large volume wafers. Under the current supply shortages of wafers, we can only utilize foundries' surplus capacity from time to time. As such, our demand is not prioritized by the foundry partners. Foundries that have multiple cutting-edge fabrication production lines are important potential partners for us. The performance and cost of our 8-nanometer chip produced by Samsung was very good. However, limited by Samsung's capacity constraints, we suspended our cooperation for several months earlier this year. We plan to resume our cooperation with Samsung for the production of our new chip later this year or next year. Our first strategic plan for developing our mining machines currently includes Bitcoin, Ethereum, and Litecoin. In addition to our existing Bitcoin mining machines, we are developing mining machines for Ethereum, and we hope to improve the performance of the new machine by one to two orders of magnitude compared with current mainstream GPUs. As a result, the R&D of new ETH mining machines is complicated and difficult, so we expect to launch our ETH mining machines next year. Given the current supply shortages in the market, we believe it's tough for anyone in the industry to mass-produce ETH mining machines this year due to the severe shortage of supply for logic wafers, TREM wafers, and packaging.

We have the next question. This is coming from the line of Daniel Weiskopf from Toroso Investments.

Unfortunately, I don't speak Chinese. So I'm going to just thank you for trying to give the transparency on this call and to all the great questions. Congratulations on a good quarter.

Thank you.

Let me translate for the management.

That was my only question. Thank you.

We have the next question. This is coming from the line of Craig Ellis from B. Riley Securities. Please go ahead.

Thanks for taking the question. I will ask for help in translating the following. First, regarding the order intake that the Company is seeing, I believe that's leading to the Company believing it can ship 300,000 units this year. But the question is really on 2022, are you taking orders currently for 2022 shipments? And can you quantify the magnitude of orders that you might have taken year-to-date for next year?

Thank you for your question.

Yes, we have taken orders for 2022, quarter one. Does this answer help you?

It does. But I was hoping you could also quantify the degree of orders that you've taken for 2022 in addition to whether you're taking them or not?

Yes. We have taken orders for impact, and as mentioned by Nangeng Zhang, the Chairman and CEO, we have preorders for 2021. Additionally, we have preorders for quarter one for 2021, organized by monthly pacing, which helps us a lot in the allocation of production capacity and stabilizes our business pipeline.

That's helpful. I have a second question, if I could. In the press release, the Company disclosed there was a RMB56 million order cancellation in the calendar second quarter. The question is related to that order cancellation, can those systems be redeployed to other customers or would those systems be redeployed to the Company's internal mining operation? Can you just confirm what happened with the systems associated with that cancellation?

The cancellation was from one of our customers in North America. Customers have the right to decide to purchase or to cancel. This cancellation doesn't impact our business. As for miners' sales and demand, you can see from the report that the situation remains stable and healthy. Thank you.

In light of the current supply situation in the market, we view the cancellation from this particular customer as a positive impact on our full year performance since we have already signed a contract with a new customer at a higher price. Thank you.

That's very helpful and kind of opportunistic. Finally, I just wanted to get some further color on some of the supply dynamics in the market. The Company indicated that its pre-booked capacity with foundry suppliers in the back half of the year. If demand continues to grow through the year, can you get upside to your current capacity for this year and exceed the unit shipment target of 300,000 rigs? Thank you.

Let me take a second to translate for the management.

Yes, we don't see further potential for increasing manufacturing capacity this year given the supply and demand situation in the market. What we can do is increase and improve the performance and yield of our products, which will enable us to deliver more terahash to our customers. In terms of manufacturing capacity, we hope to lock in more capacity to address the increasing market demand next year. Thank you.

There are no further questions at this moment. I will hand the call back to the management for any closing remarks. Take it over.

Thank you, everyone, for joining us today. If you have any further questions, please do not hesitate to contact us. Thank you. Bye-bye.

Bye-bye.