Investor Letter #007

MicroStrategy's relentless Bitcoin buying campaign continued on Monday with the completion of their $500 million secured debt raise, and the announcement of an "at the market" stock offering for up to $1 billion.

The proceeds of both raises will go towards buying Bitcoin, which could soak up 0.2% of all circulating Bitcoin supply at today's prices of $40,000.

These purchases will add a significant amount of Bitcoin to MicroStrategy's stash, reinforcing the narrative that MicroStrategy is merely a Bitcoin holding company.

However, the truth isn't quite that simple. Investors need to recognize that MicroStrategy's approach to debt and equity issuance changes the valuation of the business under different circumstances, as does their future plans to buy more Bitcoin.

Let's take a look at MicroStrategy's business metrics and the trade-offs investors must consider when choosing between buying Bitcoin and buying MicroStrategy stock.

Valuing MicroStrategy

MicroStrategy in Q2 2020

MicroStrategy made their first Bitcoin announcement in their Q2 2020 earnings release. In it, they mentioned changing their capital allocation strategy to buy assets like stocks, bonds, gold, bitcoin, or other asset types.

On that day, MicroStrategy closed at $117.81 per share, or a $1.15 billion valuation.

This is what MicroStrategy's business metrics looked like back then:

  • $530M of cash and short-term investments
  • $130M of long-term liabilities ($100M associated with their operating lease)
  • $475M in TTM revenue
  • $38M in TTM cash flow from operations
  • Annual revenue decreasing at ~1% per year

MicroStrategy was trading for 30x their cash flows from operations, which is a reasonable valuation for a mature software business in a low interest rate environment.

Let's use that as our base case. How have MicroStrategy's business metrics changed since then?

MicroStrategy in Q1 2021

As of Q1 2021, this is what MicroStrategy's business metrics look like:

  • $82M of cash and short-term investments
  • $115M of long-term liabilities ($82M associated with their operating lease)
  • $1.66B of convertible senior notes outstanding
  • $492M in TTM revenue
  • $87M in TTM cash flow from operations

In just one year, MicroStrategy has transformed their shrinking business into a growing one, while more than doubling their cash flow from operations. Ignoring the $1.66 billion of convertible debt used to buy Bitcoin, it's hard to deny that MicroStrategy's core business has meaningfully improved since last year.

Revenues are up, possibly due to MicroStrategy's increasing relevance in the tech community, and margins have improved, possibly due to decreased travel and office expenses associated with remote work.

A similar 30x multiple on TTM cash flow from operations would value MicroStrategy's core business at $2.62 billion today.

Why is this important?

MicroStrategy trades for $5.68B today ($600 per share), and is about to complete a $500M Bitcoin purchase that will raise their overall Bitcoin stake to roughly $4.18B at a Bitcoin price of $40,000 per coin.

Using the $2.62B core business valuation above, MicroStrategy should be worth the sum of $4.18B and $2.62B, or $6.8B before considering the cost of their debt issuance.

The question investors must ask is whether or not MicroStrategy's three debt raises are enough of a burden to justify the difference between their expected valuation ($6.8B) and their current valuation ($5.68B).

MicroStrategy has raised three rounds of debt this year, each with different terms and maturity dates. Let's examine each debt raise and figure out how each one impacts the future value of MicroStrategy's business.

MicroStrategy has a total of $2.2 billion of debt to pay off as of today, along with annual interest payments of $30-$35M for the next 4 to 7 years.

However, $1.7 billion of the $2.2 billion outstanding debt can be converted into MicroStrategy equity if certain conditions are met. Let's explore those conditions.

Debt Issue #1

Since MicroStrategy stock has traded more than 30% above the conversion price of $398 for 20 days within a 30 day time period during Q1 2021, these debt holders can now choose to convert their debt into MicroStrategy equity.

On or after Dec 20, 2023, MicroStrategy can also choose to convert any outstanding debt from their first issuance into equity, assuming the same conditions as above are met.

On or after June 15, 2025, debt holders can convert their debt into equity at any time.

Debt Issue #2

This debt issue can only be converted into equity after June 30, 2021 by debt holders if certain conditions are met.

The most likely condition is if MicroStrategy's stock trades more than 30% above the conversion price of $1,432 for 20 days within a 30 day time period. Right now, MicroStrategy stock is trading for $600.

On or after Feb 20, 2024, MicroStrategy can choose to convert the debt into equity as well, assuming the same conditions as above are met.

On or after Aug 15, 2026, debt holders can convert their debt into equity at any time.

Debt Issue #3

This debt is not convertible into MicroStrategy equity, so MicroStrategy will be required to pay the full $500M principal in 2028, along with regular interest payments of $30,625,000 per year.

MicroStrategy vs. Bitcoin

MicroStrategy is making a big bet on Bitcoin. With roughly 70% of MicroStrategy's current market cap attributable to their Bitcoin position, the stock will be heavily influenced by the price of Bitcoin moving forward. However, while MicroStrategy's stock will move in the same direction as Bitcoin, it's still uncertain whether Bitcoin or MicroStrategy will be the better investment.

To understand the intricacies involved, let's examine MicroStrategy's business under different scenarios to see the effects of high, low, and stable Bitcoin prices on their business.

What If Bitcoin Prices Drop?

Let's imagine Bitcoin prices fall 90% to $4,000 and remain there until 2028, when all MicroStrategy debt has matured. In this scenario, it's likely that no debt will be converted into equity and MicroStrategy will be forced to pay off all their debt in cash or through additional financing.

MicroStrategy's $4.18B of Bitcoin would drop to $418M, while their outstanding debt would remain at $2.2B + $230M of interest payments.

Assuming their core business remains unchanged, MicroStrategy's expected lifetime cash flows of $2.62B must be discounted to reflect the $2.43B of added liabilities, and the new $418M value of their Bitcoin holdings.

All together, $2.62B - $2.43B + $418M = a rough valuation estimate of $608M.

In this case, MicroStrategy investors would get a slightly better return than if they had invested in Bitcoin directly under the same price conditions.

What If Bitcoin Prices Rise?

Let's imagine Bitcoin prices rise 10x to $400,000 instead. Assuming no further debt issuance, MicroStrategy will have $41.8 billion of Bitcoin on their balance sheet.

That will easily push their stock price above $2,000 per share, at which point all MicroStrategy convertible debt will be turned into equity.

This would dilute existing stock holders by creating 2.36 million new shares, bringing total MicroStrategy shares outstanding to 11,836,000.

With a core business worth $2.6B, $41.8B of Bitcoin holdings, and only $500M of debt to be repaid along with $210M of interest, that gives MicroStrategy a valuation estimate of $43.7B.

However, due to the new share issuance, that only implies a price per share of $3,692, or a 6.15x gain from $600 per share. Compared to the 10x gain for Bitcoin holders, MicroStrategy investors would be worse off.

What If Bitcoin Prices Stay Flat?

Let's imagine Bitcoin prices stay flat at $40,000 until 2028. Assuming no other changes, MicroStrategy's overall business metrics would be the same as they are today.

The only difference is that MicroStrategy's first debt issuance would be completely converted into MicroStrategy equity, while the second convertible bond wouldn't be. That means 11,103,000 shares will be outstanding after the conversion of MicroStrategy's first debt issuance.

With a $2.62B core business, $4.18B of Bitcoin, and $1.76B of debt and interest to pay off, MicroStrategy will be worth $5.04B, or $454 per share.  This is a slight decline from where the stock currently trades, so MicroStrategy investors would be slightly worse off than Bitcoin investors in this case.

What If MicroStrategy Keeps Buying Bitcoin?

Finally, there is one more important outcome to consider.

What happens if MicroStrategy continues using debt and equity to buy more Bitcoin? There was over $1.6 billion of demand for today's $500 million raise, and if Bitcoin prices continue to rise I suspect the appetite for MicroStrategy's secured debt will continue to grow.

Furthermore, MicroStrategy's $1 billion "at the market" securities offering today was another indication that the company isn't slowing down their Bitcoin buying.

MicroStrategy has been buying Bitcoin relentlessly for almost a full year, and it has actually become one of the company's core business strategies.

MicroStrategy pursues two corporate strategies in the operation of its business. One strategy is to acquire and hold bitcoin and the other strategy is to grow our enterprise analytics software business.

Therefore, when analyzing MicroStrategy's business, investors should expect MicroStrategy to continue buying more Bitcoin with fiat denominated debt or equity issuance. Rather than comparing MicroStrategy's business to a Bitcoin ETF, it may be more accurate to think of their business as a levered Bitcoin ETF.

The key difference between MicroStrategy's approach to leverage and a retail trader's approach, is that MicroStrategy has access to some of the least expensive capital in the world and has billions of dollars in collateral that can support their purchasing plans.

MicroStrategy's levered approach obviously has higher risks if Bitcoin prices drop, but it also has the potential to significantly out-pace Bitcoin returns if Bitcoin prices rise.

Using the example above, let's imagine that Bitcoin rises 10x by 2028. But this time, let's assume MicroStrategy is able to double their Bitcoin holdings in the next 7 years through debt and equity issuance and free cash flow purchases.

Instead of holding $41.8 billion of Bitcoin in 2028, MicroStrategy will have $83.6 billion of Bitcoin.

This would put MicroStrategy's valuation at over $85 billion before considering additional debt and equity issuance.

Even if we discount MicroStrategy's $85 billion valuation by $10 billion to account for debt and equity issuance, the value of their business would still significantly outpace the value of Bitcoin due to MicroStrategy's leveraged purchases.

Final Thoughts

MicroStrategy is accumulating Bitcoin at an unprecedented pace. However, the Bitcoin added to their balance sheet only represents one component of the company's valuation.

Investors must also realize that each Bitcoin purchase comes with a future obligation to either issue new shares, repay debt, or sometimes both.

As MicroStrategy accumulates Bitcoin, the value of their core software business becomes less relevant to the company's valuation, and the price of Bitcoin plays a more influential role in determining the success of MicroStrategy.

That being said, MicroStrategy's stock price may not always move in lockstep with the price of Bitcoin. Bitcoin purchases made with cheap debt or equity issuance could help MicroStrategy's business act like a leveraged Bitcoin bet.

My Writing Last Week

Last week I wrote about the changes to institutional Bitcoin holdings in the month of May.

Institutional Bitcoin Adoption in May 2021
Institutional Bitcoin adoption continued to rise in May, albeit at a slower rate than in prior months. MicroStrategy and many public Bitcoin mining companies continue to add to their Bitcoin holdings, but these additions have been offset in part by sales from companies like Tesla and Ruffer. Declini…

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