The Curious Case of Microstrategy

MicroStrategy (NASDAQ:MSTR) is perhaps the most controversial stock these days. Bulls claim the share price is a steal in spite of the 466% rise year-to-date while bears claim the valuation premium to Bitcoin holdings makes no sense, so who is right?

The Bitcoin Business Model of MicroStrategy

For simplicity, we’ll focus here just on the bitcoin business model of Microstrategy, which begins with capital raising via dilution.

CEO Michael Saylor engages in two primary strategies to raise capital for the purpose of buying bitcoin. The first is he issues new shares via at-the-market (ATM) equity offerings, selling shares directly into the market to raise funds.

This process dilutes the ownership percentage of existing shareholders by increasing the number of outstanding shares. Typically, shareholders don’t love this but, hang tight, there’s more to come on this in a moment.

Secondly, MicroStrategy issues convertible bonds with favorable terms to institutional investors, allowing them convert debt to equity at a later date, and so enabling the company to secure capital without immediately affecting the stock price.

Why dilute shareholders and issue convertible bonds? The simple answer is to raise funds in order to buy Bitcoin.

Enter The MicroStrategy Treasury Operations

MicroStrategy currently owns 386,700 Bitcoin, making it one of the largest institutional holders of the cryptocurrency alongside Blackrock.

The result of buying so much Bitcoin is that MicroStrategy’s balance sheet is transformed so that Bitcoin becomes the primary treasury reserve asset, and so reduces the reliance on traditional cash reserves. It also means that MicroStrategy’s balance sheet acts as a leveraged bet on Bitcoin’s long-term value appreciation.

But that’s not all, and here’s where things get really interesting. The bears will point to the value of the Bitcoin on the balance sheet and wonder how the company’s valuation can exceed it. For simple math, if we assume a $100,000 price per Bitcoin the value of MicroStrategy’s Bitcoin reserves is $38.67 billion. How then can the stock be trading at $76 billion?

That brings us to the yield-generating treasury operation.

Yield-Generating Treasury

Saylor’s big idea was to convert Bitcoin holdings into a yield-generating asset base.

The company lends Bitcoin to institutional borrowers who pay interest in Bitcoin to create a passive income stream.

Furthermore, Bitcoin holdings can be used as collateral to secure loans, enabling MicroStrategy to access liquidity without selling its Bitcoin and so preserving upside potential while generating funds for operational purposes.

Future optionality exists too, because if Bitcoin’s ecosystem evolves to include staking or layer-2 solutions that offer rewards, MicroStrategy is likely to earn a yield on idle assets.

As a result, bulls claim that these strategies collectively transform Bitcoin into a productive asset generating returns that help offset the cost of holding a non-yielding reserve asset. Moreover, they are a hedge against volatility in Bitcoin’s price, stabilizing MicroStrategy’s financials.

Virtuous Cycle?

Saylor’s approach results in a loop where dilution facilitates Bitcoin purchases, which then support yield-generating treasury operations.

As MicroStrategy borrows against Bitcoin or issues convertible debt, the company increases its exposure to Bitcoin’s price movements and creates leverage risk but also enhances upside potential.

Most recently, CEO Michael Saylor has claimed that MicroStrategy’s treasury operations delivered a BTC yield of 12.3%, providing a net benefit of 40,738 BTC to shareholders. Further he went on to state that “at $93,500 per BTC that would equate to $3.8 billion for the week, or $544 million each day”

It’s for this reason that Max Keiser has claimed MicroStrategy is “trading at 2 times its Bitcoin earnings, a 93% equivalent discount to the Nasdaq.”

What Could Go Wrong?

Clearly, a major risk associated with the MicroStrategy approach is that such heavy reliance on Bitcoin exposes the company to extreme price swings, which is likely to shake out a lot of investors.

Another less obvious torpedo on the horizon may stem from emerging regulations on cryptocurrency and treasury operations that could limit MicroStrategy’s flexibility or profitability in these ventures.

Perhaps there’s also a headwind up ahead from debt servicing costs that arise from issuing convertible bonds that in turn increase financial liabilities.

Is MicroStrategy a Buy?

For those like Max Keiser, who were very early to see the potential for Bitcoin, MicroStrategy is very much on sale, even after rising more than 5x this year.

He and Saylor agree that a company is not valued by its asset base alone. In fact, that’s a primary argument against the bears, who claim the company is trading at a high premium to its Bitcoin holdings.

Saylor points to Microsoft in this regard and says the technology giant isn’t valued at the $523 billion of assets it has on its balance sheet but rather its future cash flows that produce a market capitalization closer to $3.1 trillion. Similarly, he points to MicroStrategy’s treasury operations as a better way to think about how to value MicroStrategy.

Ultimately, the bulls and bears agree on one thing. MicroStrategy is a levered Bitcoin play and if the cryptocurrency rises, expect MicroStrategy to rise even more. Equally, if Bitcoin falls, expect MicroStrategy to sink by higher percentages too.

And for those wondering if MicroStrategy is indeed trading at 2x earnings and a buy or at a massive premium to its Bitcoin assets and a sell, the answer may lie in how well you understand Saylor’s financial engineering.