"Mining" the Future: Canaan Technology's Mining Business Differentiation and Financial Analysis Report

Canaan Technology was founded in 2013 and went public on November 21, 2019. It is a technology company focusing on ASIC high-performance computing chip design, chip research and development, computing equipment production and software services. With the vision of "Supercomputing is what we do, social enrichment is why we do it", Canaan has extensive experience in chip design and streamlined production in the ASIC field. In 2013, under the leadership of founder and CEO Zhang Nangeng, the founding team of Canaan delivered the world's first batch of ASIC-powered Bitcoin mining machines to its customers, branded as Avalon. In 2019, Canaan completed its initial public offering on the NASDAQ global market. Canaan not only provides customers with a full range of artificial intelligence (AI) solutions globally, including AI chips, algorithm development and optimization, hardware modules, end products and software services, but also provides supercomputing solutions through its proprietary high-performance computing ASICs (application-specific integrated circuits). As of 2022, Canaan has 541 employees, covering bitcoin mining machines, mining and artificial intelligence products, with major markets in Indonesia, Malaysia, the United States, Australia, Kazakhstan and other countries and regions.

This report provides a comprehensive analysis of the financial position of Canaan's mining business since 2021, with the aim of assessing the impact of this business decision on the company's financial position. By combing through the company's financial data since the start of the mining business, and comparing the performance of the mining business in the last two quarters, this report reveals the profitability and cost control of Canaan in the mining field, and discusses the impact of the mining business on the company's overall financial health and strategic development direction. This analysis not only reflects the company's competitive position in the mining hardware market, but also considers the impact of industry trends, changes in market demand, and the relevant policy environment on Canaan's business expansion decisions.

2 Analysis of Canaan's strategy to expand its mining business

2.1 Canaan Mining Activity Revenue Report

2.1.1 Income from mining activities

Canaan's Q2 2023 quarterly report disclosed that its mining revenue for the second quarter of 2023 was US$15.9 million, an increase of 43.3% from US$11.1 million in the first quarter of 2023 and an increase of 105.1% from US$7.8 million in the same period of 2022. The quarter-over-quarter growth was primarily driven by the recovery in the price of Bitcoin and the increase in Bitcoin rewards on the network during the quarter. The year-over-year increase was mainly due to the increase in computing power injected into mining.

Canaan's Q3 2023 quarterly report disclosed that its mining revenue in the third quarter of 2023 was US$3.3 million, a decrease of 79.5% from US$15.9 million in the second quarter of 2023 and a decrease of 64.6% from US$9.2 million in the same period of 2022. The quarter-on-quarter and year-over-year decreases in this quarter were mainly due to a decrease in mining computing power, which led to longer transaction confirmation times due to the decline in Bitcoin hashrate, as well as lower mining costs. The reason for this decline in computing power is that in July 2023, the Rules for the Licensing of Digital Mining Activities came into force in Kazakhstan, which requires those engaged in cryptocurrency mining to first obtain a professional license. Subsequently, the company decided to temporarily shut down its mining computing capacity of approximately 2.0 Exahash/s in Kazakhstan to ensure legal compliance, and has been actively working to obtain a Class II license for mining hardware owners since early July, with its mining operations in Kazakhstan suspending until the third quarter of 2023.

2.1.2 Revenue from sales activities

Canaan Technology's quarterly report for the second quarter of 2023 disclosed that the product revenue in the second quarter of 2023 was US$57.9 million, of which the sales revenue of mining machines increased from US$43.7 million in the first quarter to US$57.8 million. This compares to $44.1 million in the first quarter of 2023 and $238.1 million in the same period in 2022. The increase compared to the first quarter of 2023 was primarily due to an increase in sales of total computing power, although lower selling prices resulted from weaker overall purchasing power on the market demand side. The decrease compared to the second quarter of 2022 was mainly due to a decrease in the selling price due to the decline in the price of Bitcoin. Revenue from AI products was $1 million in the second quarter of 2023, compared to $4 million in the first quarter of 2023 and $2 million for the same period in 2022.

Canaan Technology's quarterly report for the third quarter of 2023 disclosed that the product revenue in the third quarter of 2023 was US$29.9 million, of which the company's mining machine sales revenue in the third quarter of 2023 was US$29.755 million. This compares to $57.9 million in the second quarter of 2023 and $136.3 million in the same period in 2022. The decrease compared to the second quarter of 2023 was primarily due to lower total computing power sales and lower selling prices, which were driven by an overall slowdown in market demand. The decrease compared to Q3 2022 was mainly due to a decrease in selling prices, with an overall slowdown in market demand despite a gradual recovery in Bitcoin prices and an increase in total computing power sales. Revenue from AI products was $2 million in the third quarter of 2023, compared to $1 million in the second quarter of 2023 and $4 million for the same period in 2022.

2.1.3 Proportion of revenue from mining activities

Canaan's total revenue for the second quarter of 2023 was US$73.85 million, with mining revenue accounting for approximately 21.5% of total revenue.

Canaan's total revenue for the third quarter of 2023 was US$33.32 million, with mining revenue accounting for approximately 9.8% of total revenue.

At present, Canaan's mining business revenue accounts for a relatively small amount, and the computing power has decreased under the requirements of legal compliance, resulting in higher mining costs and lower mining revenues. However, the company will implement a destocking strategy for a longer period of time to reduce risk and improve operational efficiency. The balance of the mining business and the mining machine business needs to be further adjusted according to the later market performance and the company's strategy.

2.2 2023Q2-Q3 Mining Costs and Profits

2.2.1 Direct costs of mining activities

Canaan's mining costs for the second quarter of 2023 were US$30.6 million, an increase from US$27.3 million in the first quarter of 2023 and US$11.5 million for the same period in 2022. Mining costs here include the direct costs of mining production (including electricity and hosting fees, etc.), as well as depreciation and amortization expenses. Depreciation expense for deployed miners was $16.2 million in the quarter, compared to $16.3 million in the first quarter of 2023 and $10.1 million for the same period in 2022. The year-on-year increase was mainly due to the increase in mining capacity. As a result, the direct cost of mining activities in the second quarter of 2023 was $14.4 million. Direct costs accounted for 47.1% of total costs.

Canaan's mining costs in the third quarter of 2023 were US$18.7 million, down from US$30.6 million in the second quarter of 2023 and US$15.8 million in the same period in 2022. Mining costs here include the direct costs of mining production, including electricity and hosting fees, as well as depreciation. Depreciation expense for deployed mining rigs was $15.8 million in the quarter, compared to $16.2 million in the second quarter of 2023 and $7.7 million for the same period in 2022. The year-over-year increase was mainly due to the increase in computing power deployed in the company's mining business. As a result, the direct cost of mining activities in the third quarter of 2023 was $2.9 million. Direct costs accounted for 15.5% of total costs. The proportion of direct costs is reduced.

Canaan's product costs were $83.7 million in the third quarter of 2023, compared to $113.3 million in the second quarter of 2023 and $97.1 million for the same period in 2022. The continuous, year-over-year decline coincides with a decline in computing power sold. Accrued inventory write-downs, advance payment write-downs and provisions for inventory purchase commitments were $53.9 million in the quarter, compared to $45.9 million in the second quarter of 2023 and $33.1 million for the same period in 2022. Product costs include direct production costs and production-related indirect costs for mining rigs and AI products, as well as inventory write-downs, prepayment write-downs, and inventory purchase commitment provisions.

According to the above data related to the mining business and mining machine sales business, the gross profit margin of the mining business in the second quarter of 2023 is: -0.92%, and the gross profit margin of the mining business in the third quarter is: -68.47%. At this stage, Canaan's mining business has not brought significant profits to the company.

2.2.2 Profit Analysis

Net loss for the second quarter of 2023 was $110.7 million, compared to a net profit of $6.3 million for the same period in 2022. Net loss for the third quarter was $80.1 million, which includes inventory write-downs, advance write-downs and provisions for inventory purchase commitments accrued during the quarter. These actions are in line with the Company's proactive destocking strategy in response to challenging market conditions and should be treated as non-cash items. To improve its financial position, Canaan has implemented strict expenditure control measures, including layoffs to improve operational efficiency. For some time to come, Canaan remains committed to maintaining cash reserves through diversified sales efforts and prudent expense management, ensuring continuity of operations, and positioning itself to capture future opportunities.

2.3 The impact of the expansion of mining business on Canaan's asset-liability ratio

2.3.1 The number and value of Canaan's existing mining machines

Canaan's inventory in the second quarter of 2023 was US$272 million, while its fixed assets, including software equipment, were US$50.48 million and right-of-use assets were US$289,600. Canaan's inventory in the third quarter was US$217 million, with fixed assets including software equipment of US$34.002 million and right-to-use assets of US$230,000. It can be seen that Canaan Technology has focused its business on the more profitable sales of mining machines, with a median price of 140 million yuan (about 1,946 US dollars) and a stable number of mining machines (for sales and mining) of about 140,000 units.

2.3.2 The impact of the previous expansion of the mining business

Canaan Technology has previously been in the mining business.Since the second quarter of 2021, Canaan has expanded the global market, and the relationship between the company and its customers has developed from simple mining machine sales to joint mining, and the interests are more closely bound. At the same time, mining is also listed as a separate financial account in the financial statements. Therefore, the main indicators of the first quarter of 2021 and the second quarter of 2021 are selected to compare and analyze the impact of mining activities on the company's asset ratio, and the following table can be made to visually show the difference in Canaan's financial performance before and after the start of the business.

Key indicators | Q1 2021 | Q2 2021

Total Asset Turnover | 0.24 | 0.69

Return on equity | 0.24 ％ | 21.50 ％

Net profit margin on sales | 16.58 ％ | 25.46 ％

Quick ratio | 1.10 | 1.96

Debt-to-asset ratio | 75 ． 52 ％ | 43.34 ％

liquidity ratio | 1.31 | 2.40

Current Assets/Total Assets | 98.42 ％ | 98.47 ％

From the data, it can be seen that Canaan Technology's total asset turnover rate and return on net assets have significantly improved after expanding its mining business, and its financial performance as a company expanding its business downward from the traditional upstream industry chain is better. The increase in the current ratio and quick ratio and the decrease in the gearing ratio reflect the improvement of the company's financial position, while the increase in return on equity shows the company's increased profitability and efficient use of capital. The specific analysis is as follows:

(1) Increase in current ratio and quick ratio: The current ratio refers to the ratio of the company's current assets to current liabilities, while the quick ratio excludes inventory, which is a relatively difficult asset to realize. The increased current ratio and quick ratio mean that the company is better able to repay short-term debt and respond to sudden liabilities. The introduction of mining operations may have increased the company's cash inflow and reduced the amount of money tied up in inventory, thus increasing both ratios.

(2) Smaller asset-liability ratio: The asset-liability ratio refers to the ratio of the company's assets to liabilities, and a reduced asset-liability ratio indicates that the company's assets are healthier than its liabilities. This could mean that the company is getting more money through mining operations to pay off debt or invest in more profitable projects, or it is reducing debt through more efficient asset management.

(3) Return on equity increases: Return on equity refers to the ratio of the company's net profit to net assets, and the increased return on equity shows the increase in profits created by the company's net assets per unit. This may be due to the additional revenue brought by the introduction of mining operations, or the company's cost management has been optimized, resulting in higher profit levels. It may also reflect the company's more efficient use of capital and increased profitability.

In summary, the improvement of these financial indicators shows that Canaan has achieved an improvement in its financial position, optimization of assets and liabilities, enhancement of profitability and better meeting the expectations of investors through the introduction of mining business.

According to past experience, the mining machine business is linked to the currency price, and the performance of the currency price is good, and the performance of the currency price is poor. In 2021, the lowest price of the currency fell to around $30,000 per piece, and the highest exceeded $60,000 per piece, and the price trend fluctuated greatly; At the same time, there are many challenges from all sides, but Canaan's performance trend in 2021 has risen for 4 consecutive quarters, and the final annual performance has increased by more than 10 times year-on-year, far outperforming the currency price trend. It proved that the pioneering and flexible business strategy, stable supply chain capacity supply, expansion of mining business, continuous R&D investment and team building, and increasingly perfect management level were helpful to Canaan at that time.

In the fourth quarter of 2021, despite the relatively large fluctuations in currency prices, Canaan further expanded overseas markets, such as Southeast Asia and South America, and established contacts and cooperation with customers in emerging markets such as Malaysia, the United Arab Emirates, Argentina and Peru. The proportion of new customers purchasing computing power reached 41%; At the same time, the demand of several traditional overseas markets such as Central Asia, North America, and Europe is still strong, and the proportion of computing power purchased by repeat customers has reached 59%. The strong market demand drove the company to sell 7.74 million tons of computing power in the fourth quarter, an increase of 15% from the third quarter, and once again set the best historical single-quarter record.

2.4 The impact of the expansion of mining business on Canaan's inventory

In the first quarter of 2021, Canaan's inventory was US$376 million, and in the second quarter of 2021, it was US$587 million, a year-on-year increase of 56.12%. The following table can be made to visualize the impact of Canaan's inventory ratio before and after the start of the business.

Key indicators | Q1 2021 | Q2 2021

Business cycle | 228.59 days | 190.57 days

Inventory turnover | 0.39 times | 1.02 times

Number of days of inventory turnover | 228.59 days | 176.49 days

After the implementation of Canaan's business decision, the shortening of the business cycle and the increase in inventory turnover reflect the following factors: First, the addition of the mining business may bring additional revenue streams and increase the company's total revenue. Second, because mining operations typically take less time to convert into cash or other liquid assets, the company's cash flow has improved and its business cycle has been shortened. In addition, the increased inventory turnover means that the company is able to convert inventory into sales revenue more quickly, reducing the risk of inventory overstocking and improving the efficiency of capital utilization.

Taken together, the improvement in these metrics indicates that the company has improved operational efficiency, increased profitability, and better met market demand.

In general, on the basis of the main business of mining machine production and sales, Canaan Technology extends its coverage to the downstream of the industrial chain by expanding its self-operated mining business, so as to improve competitive barriers, increase revenue sources, and gradually reduce the risk of a single business model. Although the mining business is growing rapidly, it still accounts for a low percentage of the company's total revenue. According to the company's plan, a certain percentage of production capacity will be deployed for self-operated mining every month, and the specific number of deployments will be flexibly adjusted according to the situation of cooperative mines and market demand, and these mines are mainly located in overseas regions such as Kazakhstan, but the mining market in Kazakhstan is being further adjusted due to compliance needs, which may increase the company's mining costs.

Although proprietary mining operations can reduce risks on the surface, they may be scaled up due to their high correlation with the main business and the greater regulatory risks faced by mining operations. If the mining business is invested as an important asset, it may pose a serious challenge to Canaan's revenue and cash flow when the market is poor or regulatory policies are tightened. While the mining business provides a certain source of revenue for the company, its risk factors also need to be carefully considered to ensure that the company can maintain a healthy operation in different market environments.

3 Synthesis conclusions

Canaan's strategic decisions and financial performance since expanding its mining business in 2021 reveal the company's efforts to seek growth and competitive advantage in the global mining hardware market. By vertically integrating the upstream and downstream businesses of the industrial chain, Canaan not only strengthened its control in the Bitcoin ecosystem, but also diversified certain market risks and further strengthened its market position. However, since the growth of mining machine production and sales business and mining business are heavily dependent on the cyclical and volatile nature of Bitcoin, this decision has a limited effect on the diversification of market risk.

Despite negative gross margins in the second and third quarters of 2023, short-term financial challenges have not fully offset the long-term value of the strategic decision to expand the mining business. Considering the growth potential of Bitcoin as a long-term investment target, Canaan's Bitcoin holdings may realize capital appreciation in the future, thereby compensating for short-term operating losses. Therefore, the mining business can not only serve as an immediate source of income for Canaan, but also may pave the way for long-term asset appreciation. Therefore, despite the challenge of negative gross margin in the short term, Canaan's mining business expansion remains strategic and forward-looking, which is expected to bring the company opportunities for continuous growth and profit maximization in the ever-changing digital currency market.

In conclusion, Canaan's mining business expansion strategy is a strategic decision that comprehensively considers market trends, technological advantages, and long-term investment value. By continuously optimizing its business model, strengthening cost control and risk management, and flexibly adapting to market changes, Canaan is poised to find opportunities in the midst of challenges and achieve long-term success and growth in the mining hardware and mining business segments.