Canaan Inc. Q2 FY2021 Earnings Call

Thank you. Hello everyone, and welcome to our earnings conference call. The company's financial and operating results were released by our newswire services earlier today, and are currently available online. Joining us today are our Chairman and CEO, Mr. Nangeng Zhang; and our CFO, Mr. Jim Cheng. In addition, Mr. Jingjie Wu, our SVP; and Mr. Shaoke Li, our Secretary of the Board, will also be available during the question-and-answer session. Mr. Zhang will start the call by providing an overview of the company and performance highlights for the quarter. Mr. Cheng will then provide the detail 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 statements in our earnings press release, which also applies to this 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 the generally accepted accounting principles in our earnings press release and 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. I will now provide a brief overview of our progress in the second quarter of 2021. Since May of this year, promulgation of a few regulatory policies on Bitcoin mining has had a certain impact on the total computing power of the Bitcoin network and Bitcoin prices. Nevertheless, we have developed our overseas business in advance and secured purchase contracts with multiple large-scale mining companies. As such, we were able to reach record high revenues of RMB1,081.8 million, which is $167.5 million during the second quarter. Meanwhile, our gross profit reached RMB427.1 million, which is $66.2 million, and our non-GAAP net income reached RMB320.1 million, which is $49.6 million, marking a historical high since our IPO. In the second quarter, we continued to strengthen our collaborations with foundry partners to stabilize our production capabilities to further upgrade our technology and improve our product yields. These improvements have been well recognized by our customers who have placed more new and renewal orders as a result. We closed the registered direct offering of $117 million in the second quarter. As of June 30, 2021, we had $161.2 million in advances from customers, which has allowed us to secure wafer supply from our foundry partners and better support our chip production. At the same time, our strong cash position has enabled us to accelerate our R&D team expansion and the development of new products. During the second quarter of 2021, we attracted 45 new technology talents for joining our team, representing 28% of our total R&D team by the quarter-end. In terms of our mining machines sales, we delivered a robust 5.9 million terahash of computing power to our clients in the second quarter of 2021, marking a historical new high for sales performance. Large orders included tens of thousands of high-performance mining machines from monitoring infrastructure groups and the Genesis digital assets. Meanwhile, our presale computing power has continued to increase significantly. As of September 10, 2021, our presale computing power reached 9.11 million terahash. Our pre-orders are now scheduled to June 2022. The significant increase in our presale computing power has led to a substantial increase in our advances from customers. As of June 30, 2021, our advances from customers have reached $161.2 million, representing an increase of 141.8% at the end of 2020. Throughout our client collaborations, we will adjust the volume of presale orders and the proportion of advances from customers according to the market conditions and our expectations. This helps us partially offset the impact of market volatility and better secure our supply chain. Regarding our self-operated mining, we have been adhering to the business philosophy of operating in compliance with the law and regulations. The first batch of mining machines deployed for Kazakhstan by our fully owned subsidiary in Singapore assumed operations in early June and Bitcoin production is stable. We expect to ship out the second batch of mining machines with the computing power of 0.85 million terahash per second soon as our self-operated mining business continues to be one of our strategic focuses in the future. We will continue to expand the scale of our self-operated mining business while also adhering to the law and regulations. Our R&D expenses reached about RMB64 million, which is $9.9 million in the second quarter, increasing by 145.4% year-over-year. With the increased investments in R&D, we have also steadily expanded our R&D team by attracting more talent to join us. As previously mentioned, we have newly hired 45 new technology talents, who are mainly responsible for technology management, IC front-end design, IC back-end design, and other risk development. We also expect to tape-out the next-generation chip in the fourth quarter and anticipate an overall performance improvement of 15% to 20%. In terms of AI business, we released Kendryte K510 in July to address the demand of high-end application scenarios, specifically in terms of visual workload processing. The Kendryte K510's computing power is approximately three times higher than that of its previous chip generations. We have also started our R&D efforts for the K230. This is the next-generation AI chip that will outperform our current K210 product. We have seen exponential growth in our overall AI chip sales, which increased by 335% in the first half of 2021 from the same period of last year. Between September 22, 2020, and September 12, 2021, the company has cumulatively deployed approximately $9.3 million to repurchase approximately 2.51 million ADS under the company's share repurchase program, further demonstrating our confidence in Canaan's growth potential. Despite the impact on our business operations from industry-wide chip supply instability in the second quarter, we still achieved the best quarterly revenue since our IPO. On behalf of Canaan, I would like to take this opportunity to express our sincere gratitude to our partners, customers, and investors for their support and trust. In the meantime, we have further strengthened our senior management team by inviting professionals with global vision, profound experience, and extensive resources to join Canaan. Such efforts have enabled us to optimize our management and operations while also achieving more efficient process management and collaborations among different departments. Going forward, we will continue to build on our successes in the first half of this year to create increasing value for all of our shareholders. We expect that our revenues in the first quarter of 2021 will increase by 10% to 30% on a sequential basis. Please note that this forecast reflects our current and preliminary review of the market and operational conditions, which are subject to change. This concludes my prepared remarks. I will now turn the call over to our CFO, James.

Thank you, Mr. Zhang. Hello, everyone. This is James. I joined Canaan in early August as CFO, and I'm happy to communicate with you on our earnings call. We delivered a remarkable second quarter. I wish I was here to witness the progress of reaching these achievements. We realized record highs in multiple financial metrics for the quarter. We generated a robust revenue of RMB1,081.8 million, which means $167.5 million, the highest sales record in our history to-date. The impressive top line performance for the quarter sets a solid foundation for our profitability. As such, we achieved a non-GAAP net profit of RMB245.0 million, which is $49.6 million, demonstrating a historical new height since our IPO. Additionally, our larger amount of pre-orders have brought substantial advances from customers, which further generated strong and continuous cash inflow. This enabled us to secure future wafer supply, grow our research and development team, and carry out strategic investments. On top of our encouraging performance, we are also fully aware of some industry-wide challenges, including Bitcoin price fluctuations, wafer supply instability, and regulatory uncertainties in different countries, etc. Despite these dynamics, we remain confident in the long-term prospects of the industry. With our technologically advanced precise management of cash flows, solid business operating capability, and efficient execution of strategies, we are ready to accelerate along our growth trajectory. Total net revenue increased by 507.3% year-over-year and increased by 168.6% quarter-on-quarter to RMB1,081.8 million, mainly due to the substantial increase in total computing power sold. The cost of revenues increased to RMB654.6 million. The year-over-year and sequential increases were in line with the increases in the company's terahash sales volume and the costs for terahash. Gross profit was RMB427.1 million, up 887% year-over-year and up 119.9% quarter-over-quarter. Total operating expenses were RMB261.6 million compared to RMB62.2 million in the same period of 2020 and RMB207.9 million in the first quarter of 2021, as the company enhanced its investments in R&D efforts and sales bonus spending during the quarter. Research and development expenses were RMB64.0 million, increasing by 145.4% year-over-year and increasing by 10% quarter-over-quarter. The increase was primarily attributable to the increased headcount in technology-related departments. Income from operations was RMB165.5 million compared to operating loss in the same period of 2020 and in the first quarter of 2021. Net income attributable to ordinary shareholders reached a new high since the company's IPO at RMB245.0 million compared to a net loss of RMB16.8 million in the same period of 2020 and our net income of RMB1.2 million in the first quarter of 2021. Non-GAAP adjusted net income was RMB320.1 million compared to a non-GAAP adjusted net loss of RMB16.0 million in the same period of 2020 and our non-GAAP adjusted net income of RMB143.2 million in the first quarter of 2021. Non-GAAP adjusted net income excludes share-based compensation expenses and the change in fair value of warrant liability. Basic and diluted net earnings per ADS for the quarter were RMB1.46 and RMB1.40, respectively. As of June 30, 2021, the company had cash and cash equivalents of RMB1,220.2 million, up 211.8% compared to RMB391.3 million as of December 31, 2020. This concludes our prepared remarks. We are now open for questions.

We have seen that Canaan has signed a long-term sales order with a customer. Is it because of any changes in the market condition? Do you apply a fixed price of mining machines for long-term orders? Is the average price of this order lower than the mining machine for a one-time purchase?

Since 2021, we have observed the increased recognition of cryptocurrency's growth potential by overseas professional institutions and a substantial increase in the number of institutional players in the cryptocurrency mining business. In general, these institutional players usually set up special funds for their operational funding for a period of three years or longer. They arrange construction and operation of their mining farms stage-by-stage on a quarterly or monthly basis. As such, these mining companies are more inclined to cooperate with mining machines players and suppliers, such as Canaan, who can assure a longer-term and steady supply. This is the primary reason for the increase in our long-term orders for mining machines. According to the latest situation, we set the prices for our spot sales and pre-orders referencing market trends. Generally, the price gap is between 10% to 20%. We will also extend some discounts to our clients. From the company's perspective, we need to try our best to avoid the negative impact of market uncertainties on the company's operations and supply chain. At the same time, we would like to grasp the upside momentum when the market is prospering. As such, we have been dynamically adjusting our mining machine allocations among future contract sales, spot sales, and self-operated mining according to market situations, production capabilities, and client demand.

Did we enhance our capacity to secure wafers from our foundry partner because we have bigger orders on hand?

So we are under negotiation with our foundry partners regarding wafer production for the next 9 to 18 months, mainly until the second half of next year. Especially, we are also taking measures to secure factory capabilities for the packaging and testing phases of IC manufacturing, which investors typically pay less attention to. In light of the overall instability of production capabilities throughout the entire IC industrial chain, we believe our production capability and supply chain are well-managed. Our production capability allocated for wafer packaging and testing is also reasonable, which has enabled us to keep the high production cycle from wafer through mining machines available for sales to be around 120 days on average. So this has not been prolonged. So far, our wafer supply is also relatively stable.

We have heard about order cancellations from demand. Do we have a chance to get demand order transfers from TSMC? The CEO have discussed about a multi-foundry partnership before. Could you elaborate on your demand and the current valuation of the foundry capacity from TSMC, Samsung, and SMIC?

So, TSMC is a foundry partner with large manufacturing capability and also a large number of customers. So there will be excess capacity from time to time caused by occasionally unexpected changes to its capacity allocations. This will be an opportunity for us to leverage its excess capacity if we have prepared properly in our business planning. Here I would like to reiterate what I previously mentioned. We need to be well prepared to grasp the outburst of supply capability from foundry partners. This holds true for the entire industry for a long period because we rely on the excess capacity of foundry partners' cutting-edge fabrication production lines. In the meantime, this long-term market situation requires a substantial allocation of personal resources to do a large amount of product design work. It consequently requires substantial investments in R&D. As a result, we have to evaluate the pros and cons and do trade-offs to form our operational hand. We have sustained our efforts on this over the past several years. Although we haven't received any verbal or written guarantees from our upstream partners, we are trying our best to secure additional capacity from foundry partners in 2022.

Fine. My next question is about the gross margin. Model 1246 has been in mass production for half a year. Have you seen the yield rate continue to climb? Do you see any room for further improvement of Canaan in the 1246 gross margin?

Currently, our yield rate has increased to over 90%. With the improving yield rate, our product cost has been reduced. However, the overall material price increase across the industry has partially offset the gross profit increase; so that's the current situation.

Can you update on new product development? When do you expect to launch the next generation of machines? What is the expected manufacturing capacity? Who would you work with to produce it? Will you partner up with the same foundries as Model 1 to work with?

We generally have a product iteration every nine months. According to this pace, we anticipate releasing 1 to 2 new products in the next year. We expect to tape-out our new iteration of chip in the fourth quarter, which is estimated to improve our overall performance by 15% to 20%. We now define a product model according to its computing performance instead of nodes and fab factories. Additionally, we will speak to our foundry partnership strategy.

Can you update on the development of self-operated mining business? In this COVID environment, have you entered into any challenges for operations?

The first batch of mining machines deployed to Kazakhstan by our Singapore subsidiary has been in operations since early June, and the Bitcoin production is very stable. The second batch of mining machines with computing power of 850,000 terahash is expected to be shipped out from the factory very soon. The challenge for the first half of this year mainly resulted from the large sales volume of our machines. We needed to prioritize and fulfill our customers' orders first, and there is not much left over for our self-operated mining. As we just mentioned in our prepared remarks, the self-operated mining business is becoming one of our strategic business units. We will continue to expand the scale of our self-operated computing power while also adhering to relevant laws and regulations.

Can you elaborate more on Canaan's investments in Pixelworks? What are your expectations for product synergies for Asia, collaboration, and revenue contribution?

We believe Pixelworks is an outstanding company that is currently undervalued. They have very strong technology accumulation and extensive experience in the areas of visual processing. We believe with Canaan's advance knowledge and experience in the IC field, there are quick collaboration opportunities in the technology products.

You made some changes to Canaan's management team. Could you discuss your incentive plan, such as stock options, to ensure a stable management team?

Yes, we have. Apart from our endeavor to secure production capability, the most important thing in my current job is to attract more talent to the company and improve our internal synergies. I firmly believe that the current strategy, the correct strategy, high-level talent, and sufficient R&D investments are the necessary conditions for the success of our products. Therefore, we have set up an equity-incentive plan for the selection and retention of talent and will continue to implement it firmly in the future.

And the last question, I have a question for Jingjie Wu. When do you expect Canaan to gain its number one market position in terms of mining machines output, performance, and value for money?

Achieving and sustaining the number one market share position in the mining machines industry is absolutely one of our important strategic goals in the short and medium term. To achieve this strategic goal, we have set sub-goals internally in terms of industry-leading performance of mining machines, competitive manufacturing costs, and more. Consequently, we continue to invest significantly in our R&D and the supply chain, and we have made encouraging progress on this front. Ultimately, we believe it's really important for us to adhere to our pace and strengthen ourselves, and we believe we will achieve more over time.

Thank you once again for joining us today. If you have further questions, please feel free to reach us through the contact information provided on our website.

Thank you. That concludes the conference for today. Thank you for your participation. You may now disconnect. Thank you.