Understanding the math behind MicroStrategy

  • MicroStrategy’s big bet on Bitcoin now drives the value of MSTR shares
  • Value in the operating business seems low unless a change is made
  • The case of MSTR is simple: it is a game with leverage on the underlying cryptocurrency

Overall, MicroStrategy Incorporated (NASDAQ 🙂 is one of four ways that investors can play. Each has its advantages and disadvantages.

Of course, investors from all over the world can own Bitcoin directly. But the fees and network fees remain quite high on most regulated exchanges. Simply buying and (possibly) selling the coin can consume a medium to medium percentage of the capital invested. Ownership of bitcoin generally also requires some level of security.

There are also a couple of liquid funds. Grayscale Bitcoin Trust (OTC 🙂 owns Bitcoin directly. But management fees are 2% per year, and those fees can erode returns, particularly if Bitcoin rises over a period of years. The ProShares Bitcoin Strategy (NYSE 🙂 ETF has just 0.95% lower fees per annum, but invests in Bitcoin futures rather than offering direct ownership.

And then there are the MSTR stocks. To be sure, MicroStrategy isn’t purely a Bitcoin game. The company’s software business, founded in 1989, has generated $ 500 million in revenue over the past four quarters. But with a stash of Bitcoin now worth nearly $ 2.5 billion, it is the cryptocurrency that drives the value of the entire company, and therefore of MicroStrategy shares.

How Bitcoin can drive that value is something every investor, and potential investor, in MSTR stocks needs to understand.

Basic math

At the end of the second quarter, MicroStrategy had $ 69 million in cash on its balance sheet. The company also owned 129,699 Bitcoin (this week it rounded up to 130,000 in a small transaction). At the current price ($ 18,886.30 at the time of this writing), at the end of the second quarter, the stock was worth $ 2.45 billion.

But those purchases were financed by loans. As of June 30, 2020, MicroStrategy had $ 421 million in cash and zero debt on its balance sheet. Since then, the company has borrowed $ 2.375 billion, all for the purchase of bitcoin. Earlier this year, the company even secured a bitcoin-backed $ 205 million term loan it had purchased with other borrowed funds.

So far, the strategy hasn’t necessarily been successful. MicroStrategy on average paid just over $ 30,000 for Bitcoin which is now trading below $ 19,000. On paper, the company has a loss of approximately $ 1.4 billion.

Bitcoin and MSTR from here

Given this paper loss, an investor might expect MSTR stock to have been a loser since it started buying the cryptocurrency. In reality this was not the case. Here’s how MSTR has traded against Bitcoin since August 10, 2020, the day before the software company made its initial $ 250 million investment:

In these two and more years, Bitcoin has increased by 66%; with a gain of 59%, MSTR only modestly underperformed. There is a reason for this, and it is the same reason that the math here doesn’t seem to work entirely.

MicroStrategy has a market capitalization of just over $ 2 billion. Net of debt, its cash value and Bitcoin it is around $ 200 million.

This leaves, in theory, a $ 1.8 billion valuation on operations. But there is little, if any, chance that the market will appreciate that activity near that level.

Again, the final 12-month revenue is around $ 500 million. EBITDA (earnings before interest, taxes, depreciation and amortization) over that period is approximately $ 35 million excluding the impairment of Bitcoin holdings. Excluding share-based netting, free cash flow is essentially zero.

Given that revenue has actually declined over the past decade, operating activity is probably not worth more than $ 1 billion, or double the revenue. In fact, MicroStrategy had a business value of just over $ 1 billion at the end of 2019, and it’s hard to argue that two and a half years later the business is in better shape. Revenues have stagnated and operating profit remains essentially zero.

The simple math here would suggest that MSTR is overrated. With $ 1 billion in operating activity plus $ 200 million in cash and Bitcoin net of debt it suggests a market cap of $ 1.2 billion. This, in turn, suggests a share price of around $ 110, about 45% lower.

A leveraged bet

So why aren’t investors just buying Bitcoin, GBTC or BITO?

One of the reasons is the disadvantages mentioned above. But another fundamental reason is the debt in MicroStrategy’s balance sheet. MSTR is a leveraged bet on Bitcoin.

That leverage has intrinsic value. It’s part of the reason why MSTR, despite paying $ 30,000 for Bitcoin which is now worth $ 20,000, has kept pace with the underlying cryptocurrency for the past 23 months.

In other words, what MSTR represents is an in-the-money call option on Bitcoin prices. If Bitcoin rises, the stock should outperform.

The problem, however, is that outperformance has to be significant. Imagine, for example, that Bitcoin bounces to $ 40,000. MicroStrategy’s holdings are now worth $ 5.2 billion. Operating activity is still worth $ 1 billion; cash debt remains the same at around $ 2.3 billion.

In theory, MicroStrategy is now expected to have a market capitalization of $ 3.9 billion. The problem is that in this scenario, BTC / USD has more than doubled; basically speaking, MSTR shouldn’t.

Maybe there’s more optionality value from that point that makes a difference, but the general point holds true. There is some logic as to why MSTR should trade at a premium relative to the value of its assets, but there is a real question as to whether the premium has to be that big.

Disclaimer: As of this writing, Vince Martin has no positions in any of the titles mentioned.

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