MicroStrategy (MSTR.US) has gone big on Bitcoin and there is no going back as most of the company's value is in the Bitcoin it owns.
Introduction
While the world was suffering from Covid, governments around the world cut interest rates to zero and pumped money into the economy. Assets of all kinds began to rise. Michael Saylor, the CEO of a marginally profitable software company called MicroStrategy (MSTR.US) had an idea: why not invest the company's extra money in Bitcoin? That fell short, so Saylor doubled and tripled, issuing convertible bonds (CoCo's), debt, and equity to finance additional purchases worth billions of dollars. For a while, it seemed like a smart bet, as Bitcoin shot up to $69,000 in 2021 from a pre-pandemic level of just $7,000. MSTR shares followed suit, rising from $140 to over $1,200.
This year, 2022, is not looking so good as the price of Bitcoin has more than halved, below the company's median acquisition price.
MicroStrategy has effectively become an example of leverage in Bitcoin, with bulls believing the company will be vindicated in the long run, while bears find it a convenient way to short Bitcoin.
The company owned 129,699 BTC at an average price of $30,664 as of June. On January 30, a total investment of $3.977 billion of funds through the company's original $500 million cash balance, its cash flow, $1 billion of new "class A" shares, and the issuance of $2.4 billion of secured and unsecured debt. Bitcoin's drop for the quarter will affect a digital decline of $918 million for the quarter, which should come as no surprise.
The surprise for the market was the resignation of CEO Michael Saylor as such. He will now be CEO. Neither the company nor Saylor linked his resignation to the loss of Bitcoin. Saylor's comment was, "I think splitting the roles of president and CEO will allow us to better pursue our two corporate strategies of acquiring and holding bitcoin and growing our business analytics software business. As CEO, I will be able to focus more on our bitcoin acquisition strategy and related bitcoin advocacy initiatives, while Phong [Le] will have the power as CEO to manage overall corporate operations."
Issues to consider
The value of the company is derived from its operating business and its Bitcoin holdings. And in such a dilemma, several questions are raised about the company's strategy and future:
- What is the fair value of MSTR shares at the current Bitcoin price? What is the advantage/disadvantage? How much of the company's intrinsic value is derived from its Bitcoin holdings? At what price would Bitcoin have to be for the company's current share price of $313 to be justified?
- How much does a $1,000 change in the price of Bitcoin affect MSTR's value per share?
- At what Bitcoin price does the value of the company's shares go to zero and bankruptcy becomes a possibility?
- Let's start with the context most appreciated by investors: Where is Bitcoin headed?
When interest rates are zero, people are grasping at straws. While there is a future for blockchain technologies, it is unclear whether they will require any particular cryptocurrency. So far there have been no legal use cases for any cryptocurrency, and there appear to be few barriers to entry for creating new ones.
There will always be a market for Bitcoin as there will always be a certain amount of excess cash in the world trying to find a niche in the oldest and most established cryptocurrency. There will also be a certain amount of demand from criminals, those looking to diversify into alternative assets, and people who are wary of fiat currencies. However, it becomes increasingly costly from an opportunity cost point of view to hold as interest rates rise.
At a short term zero rate, you are not giving up anything by owning a cryptocurrency. At 3.25-3.5% (the Fed's 2022 target), that's a significant cost. Many retail investors buy assets because they are going up. The initial shock of it going down drives them to buy more to drive down the average price. But a sustained downdraft is likely to make them throw in the towel and find something else to do. Therefore, the environment for Bitcoin going forward is likely to be challenging, until we reach a period where interest rates start to decline.
However, we are pricing MSTR shares at the current Bitcoin price without having a firm view of where it is headed.
Crypto stock?
Paying attention to the price sensitivity of MSTR to Bitcoin, at the recent price of $23,000 per BTC, the fair value of the company's shares is $150, which is a 50% drop from the current price.
75% of the calculated company's intrinsic value derives from its position in Bitcoin, assuming the operating business is valued at 2x revenue (which equates to a multiple of 25x at a normalized 10% operating margin).
Bitcoin would have to be at $37,500 for the recent stock price of $313 to be justified. At a Bitcoin price of $10,000, the company's market value would be less than its debt and bankruptcy becomes a possibility if the company does not have the ability to roll it over. While for every change of $1,000 in the price of Bitcoin, the value of MSTR shares changes by $11.50.
Therefore, in the face of such a 50% correction to the current price of Bitcoin, investors should avoid MicroStrategy stock. If you believe in Bitcoin, direct purchase of the cryptocurrency is better.
In a bull case where Bitcoin doubles in price to $46,000, the stock would be worth $410 at a 30% premium to the current price. In a bear case where Bitcoin loses an additional third of its value to $15,000, the stock would be worth $55 or 80% off the current level.
Therefore, bankruptcy advocates who wouldn't mind being paid in Bitcoin should keep an eye on the $10,000 level. The company can create value by selling shares at this level and buying back its debt at a discount. Its convertible bonds due 2027, for example, are selling for half the price at which the company issued them, according to the company's latest quarterly report (10-Q).
Last quarterly report
Its Bitcoin sensitivity aside, MicroStrategy posted another dull operating quarter. Its core operating software business saw revenue decline 3% year over year and growth 2% in constant currency. The company continues to highlight its subscription services revenue, which grew a much more exciting 40% year-over-year in constant currency. The problem is that this business has only $14 million in revenue, a miniscule 11.5% of total sales. In summary, what the company offered can be seen in the following image.
Despite highlighting the positives built into revenue, costs are an uglier picture. Operating costs, including the cost of revenue, sales and marketing, R&D and G&A, increased from $104 million to $107 million. In this case there is no adjustment in constant currency. So, even in the best of cases and adjusting for revenue to a constant currency, the company's core operations were down in profit. This fact calls into question how an independent software business is stagnant and, at best, mediocre and worth only a few hundred million in the most bullish scenario.
The market is viewing Saylor's resignation as a very positive thing. While stocks are up 14%, Bitcoin is only up 1%. Saylor's resignation raises other questions. One of the most important is what really changes in the company?
It's hard to believe that Phong Le's move from chairman to CEO will change the trajectory of the moribund software business. Michael Saylor remains as CEO, which means an active and operating role, and also owns more than 1.9 million Class B supervoting shares, or 67.7% of the voting power. Also, the Board of Directors, which signed the Bitcoin purchase, does not change at all. All of that adds up to Saylor's resignation as CEO being primarily aesthetic in nature.
Valuation
Recovering the pre-pandemic reference valuations. Two years ago, just before the Bitcoin investment, MSTR had the following valuation (as of June 30, 2020).
So the market used to see the core software business at around $600 million. Being very generous for argument's sake, 2020 was still affected by Covid and that the real valuation of the software business before Bitcoin was $1 billion.
At present, the valuation has changed:
So whichever way you look at it, the market has dramatically increased the valuation of this company simply because it bought Bitcoin and lost around $1 billion doing so. So it makes no sense that the market is paying this premium given that anyone can buy Bitcoin quite easily and the amount of debt this company now has makes the stock a hyper-leveraged bet on Bitcoin. If Bitcoin falls below $17,733, the value of your company's Bitcoin portfolio will be less than the value of your debt.
Technical analysis
From a technical perspective, MSRT is in a key resistance zone, where the relative strength shows an evident erosion in overbought levels, something that could affirm, together with the movement of Bitcoin, that we are facing an imminent correction in the value.
We cannot leave aside an analysis of Bitcoin, the main cryptocurrency shows important synergies in the sensitivity of MSTR shares to the performance of BTC.
Conclusion
MicroStrategy's current open interest (short positions) is 3.7 million MicroStrategy shares, more than 39% of the free float not owned by Saylor. Some of that short is linked to the company's convertible bonds. The covered bonds of which $500 million are outstanding are trading at $87 and offer a 9% yield. Putting that in context, the covered bonds, which have a direct claim on some of the company's Bitcoin and the rest of the company's operations, are trading at this 9% return despite being lower than the valuation of the company before Bitcoin. That indicates that the holders of this debt still see a lot of risk in this company.
The company doesn't appear to benefit much from Saylor's resignation as CEO. The stock is still a “divine” bet on Bitcoin, a highly leveraged one.
Darío García, EFA
XTB Spain
