Understanding The Math Behind MicroStrategy

Broadly speaking, MicroStrategy Incorporated (NASDAQ:MSTR) is one of four ways for investors to play Bitcoin. Each has its advantages and disadvantages.

Obviously, investors worldwide can own Bitcoin directly. But network fees and commissions remain rather high on most regulated exchanges. Simply buying and (eventually) selling the coin can eat up a mid-single-digit percentage of the capital invested. Bitcoin ownership generally requires some level of security as well.

There are a pair of liquid funds as well. Grayscale Bitcoin Trust (OTC:GBTC) 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 ETF (NYSE:BITO) has lower fees of just 0.95% per annum but invests in Bitcoin futures rather than offering direct ownership.

And then there’s MSTR stock. To be sure, MicroStrategy is not purely a play on Bitcoin. 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 almost $2.5 billion, it’s the crypto that drives the value of the overall company, and thus of MicroStrategy stock.

How Bitcoin can drive that value is something every investor, and potential investor, in MSTR stock must understand.

The Basic Math

At the end of the second quarter, MicroStrategy had $69 million in cash on the balance sheet. The company also owned 129,699 Bitcoin (it rounded up to 130,000 this week in a small transaction). At the current price ($18,886.30 as of this writing), at the end of Q2, the stash was worth $2.45 billion.

But those purchases have been funded by borrowings. On June 30, 2020, MicroStrategy had $421 million in cash on its balance sheet, and zero debt. Since then, the company has borrowed $2.375 billion, all of which has gone to buying bitcoin. Earlier this year, the company even secured a $205 million term loan that was backed by the bitcoin it had purchased with other borrowed funds.

So far, the strategy hasn’t necessarily been a winner. MicroStrategy on average has paid just more than $30,000 for Bitcoin that now trades below $19,000. On paper, the company has a loss of some $1.4 billion.

Bitcoin And MSTR From Here

Given that paper loss, an investor might expect that MSTR stock has been a loser since it began buying the cryptocurrency. That actually hasn’t been the case. Here’s how MSTR has traded against Bitcoin since Aug. 10, 2020, the day before the software company made its initial investment of $250 million:

Over those two-plus years, Bitcoin has rallied 66%; with a 59% gain, MSTR has only modestly underperformed. There’s a reason for that, and it’s the same reason why the math here doesn’t quite seem to work.

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

That leaves, in theory, a $1.8 billion valuation on the operating business. But there’s little, if any, chance the market would value that business anywhere close to that level.

Again, trailing 12-month revenue is about $500 million. EBITDA (earnings before interest, taxes, depreciation, and amortization) over that period is roughly $35 million excluding impairment losses on the Bitcoin holdings. Excluding stock-based compensation, free cash flow is essentially zero.

Given that revenue actually has declined over the past decade, the operating business likely is worth no more than $1 billion, or 2x revenue. Indeed, at the end of 2019 MicroStrategy had an enterprise value just over $1 billion, and it’s difficult to argue that two and a half years later the business is in better shape. Revenue has stagnated, and operating profit remains essentially zero.

Simple math here would suggest that MSTR is overvalued. With $1 billion for the operating business plus $200 million in cash and Bitcoin net of debt suggests a market cap of $1.2 billion. That, in turn, suggests a share price of $110 or so, roughly 45% downside.

A Levered Bet

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

One reason is the disadvantages above. But another key reason is precisely the debt on MicroStrategy’s balance sheet. MSTR is a leveraged bet on Bitcoin.

That leverage has inherent value. It’s part of why MSTR, despite paying $30,000 for Bitcoin now worth $20,000 now, has kept up with the underlying cryptocurrency over the past 23 months.

Put another way, what MSTR represents is an in-the-money call option on Bitcoin prices. If Bitcoin soars, the stock should outperform.

The catch, however, is that the outperformance has to be significant. Imagine, for instance, that Bitcoin rebounds to $40,000. MicroStrategy’s holdings now are worth $5.2 billion. The operating business still is worth $1 billion; debt of cash stays the same at about $2.3 billion.

In theory, MicroStrategy now should have a market cap of $3.9 billion. The catch is that in this scenario, BTC/USD has more than doubled; fundamentally speaking, MSTR should not.

Perhaps there’s more optionality value from that point that makes up the difference, but the broad point holds. There is some logic as to why MSTR should trade at a premium to the value of its assets, but there’s a real question as to whether the premium should be quite this large.

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