Hi Investors! This newsletter is a long one as we dive into the curious investment case for Microstrategy after their Q3 earnings call last week

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Chaz (RiskOnInvestor.com)

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Disclaimer - The opinions of the author in this newsletter should not be taken as financial advice. Any mention of investment products is not a recommendation to buy.

If you are looking for financial advice, please seek the services of an industry professional and do your own research.

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The Curious Case of Microstrategy

If you have been a subscriber for a while or watched some of my early YouTube videos, then you will likely be aware that I have a large position in the US company Microstrategy.

The primary reason for this position was for exposure to the cryptocurrency market in a tax advantaged account.

Despite the UK being a market leader in many areas of modern finance (and then promptly selling all our fintech startups to US giants - but that's another story!) - we seem to have been very slow in adopting crypto as an asset class and holding crypto directly in a tax beneficial way is currently impossible.

This is where Microstrategy steps in.

Shares in individual companies are easy to hold in tax advantaged accounts, namely private pensions and individual savings accounts (ISAs) - although the tax treatment changes of the former in last week's budget announcements have muddied the water a little with pensions.

So why Microstrategy?

Simply put, Microstrategy (MSTR) holds an outsized position in Bitcoin after deciding to hold it's balance sheet cash in Bitcoin in 2020.

The reasoning for Microstragey to do this was to put it's cash on hand to better use, rather than sitting and generating very little yield for the company.

As Microstrategy purchased more and more bitcoin it's valuation did something interesting, it started to trend towards parity with it's book value.

For the uninitiated, book value is effectively a measure of the 'value' of everything the company owns, this can be office premises, equipment and in our case of interest, financial assets.

I used to track many of the MSTR measures myself in excel sheets, manually inputting everything once per quarter when the latest results came out, but fortunately people have started doing this publicly and whilst I get marginally slightly different numbers they aren't different enough to warrant me updating my own data.

This chart below shows the evolution of the company valuation against it's book value.

So 2 would indicate the company being worth twice the sum of its assets.

We can see that when the markets weren't interested in Bitcoin the valuation of Microstrategy against its book value hovered around 1 from late 2021 to the start of 2024.

But then something interesting started to happen.

This premium expanded, initially to 2, where it has hovered for around 6 months before a recent leg up towards the 2.5-3x range.

Why is this curious? Because Microstrategy had its earnings call last week and I was able to listen in live while sitting on a sun lounger on holiday (I have wild holidays it seems!)

Usually I listen into these calls while out for a walk because the slides presented often add very little beyond what you can gleam from the quarterly/yearly results and I'm more interested in the sentiment from management on these calls. But in this instance the slides were very helpful because the leadership team laid out a plan for the company structure going forward that I haven't encountered before.

A Bitcoin Bank.

This has piqued my interest and I thought it was about time to run you through my thoughts

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The current playbook

The current playbook that MSTR follows has evolved from the early days of just investing spare cash on the balance sheet into a leveraged acquisition strategy spending almost $10b in the process

The debt portion has typically been undertaken with a convertible note structure

Convertible notes

Convertible notes are a loan/investment from the markets. Usually an investor will pay money to the issuer up front, in agreement for an interest rate to be paid out. MSTR was servicing this debt with the income from it's software business and I have always seen the software business as the cap on it's maximum bitcoin expansion because it can only issue as much debt as it can afford to service.

These loans will have a maturity date. Alternatively the lender can convert their loan into equity, either at a pre-agreed price or a fixed percentage discount during the next raise.

In MSTR's case these bonds have been very profitable as the price of Bitcoin has risen and the price of MSTR has risen faster (see earlier chart about expansion of NAV), converting back to equity has generated ~90% returns, almost twice that of Bitcoin in the same time period.

Equity offerings

The other primary method MSTR has used to raise capital has been through equity offerings.

This process has been undertaken via at the market offerings (ATM). In other words just selling more shares at the current market price. No further explanation needed there.

Bitcoin

Every time MSTR reports it becomes more apparent that they are a Bitcoin investment company - or as they have shifted to calling themselves, a Bitcoin Treasury Company - abbreviated to BTC

The software side of the business is currently transitioning from one which sells one-off licenses to a recurring subscription model. This is resulting in falling revenues as the large one-off payments decrease and the smaller recurring payments increase (but not yet offsetting the falls in headline revenue)

So the company is almost entirely a Bitcoin proxy at this point.

I view Bitcoin as a hedge against debasement, simply because I think people will value a peer to peer system for transferring value and the fixed supply provides the debasement hedge.

I've spoken about global liquidity in prior newsletters, but broadly speaking there appears to be a cyclical nature to it, often estimated at 65 months (5-6 years) and broadly aligns with the business cycle.

Below are 2 plots, one indicating the cyclical nature of liquidity which suggests that through to the end of 2025(ish) we can expect loosening conditions if the cycle holds and the second chart shows that as liquidity expands global equities have tended to follow a similar trajectory.

In other words, monetary supply is expanding and as such Bitcoin should perform well, as it has done since the apparent bottom of the cycle last year.

Future plans

I spoke about a Bitcoin bank earlier in this newsletter so I wanted to touch on the MSTR plan going forward.

Firstly, a bank needs capital and MSTR isn't exactly cash rich so it has a massive plan to raise money.

This extract from the earnings presentation outlines how MSTR plans to raise $42b in the next 3 years which they have said will primarily be put to use buying Bitcoin (to capitalise the bank?)

I will circle back around to this and Bitcoin soon, but first just appreciate how large this raise is.

At the time of writing MSTR has a market capitalisation of ~$47b - so the company is effectively issuing new debt and shares to the same value as the entire companies valuation which is HUGE.

When it acquires all this Bitcoin what is it planning to do with it?

To be honest this is where the water gets a bit murky and details weren't quick to appear - partially because I don't know if MSTR management know the details themselves yet

This slide from the presentation best illustrates it in my opinion.

The right hand side lists the financial instrument suite that could be available as part of the 'bank' and the left hand side shows that it is all supposed to be based on Bitcoin

So how will this work, let's walk through the product side from top to bottom.

Options

The options market is a derivative market of the underlying company, effectively 2 parties can agree a price to buy or sell shares at, time plays out, one is right and the other has to cough up the shares or money.

This gives potential for very large leveraged returns with little impact on the underlying until the option needs to be settled.

MSTR could play as a part market makers here, but I think they will likely leave this to others to build out.

MSTX and MSTU

These are leveraged products which seek to replicate the performance of the MSTR equity price on a daily basis to the tune of 2x (one bullish and one bearish)

Leveraged products like this can be beneficial as they can amplify gains and losses (I like the daily resetting ones as they have the ability to compound VERY quickly if you can catch a sustained move)

Again - I don't think MSTR will offer products like this directly, instead leaving it to others to build these products.

If MSTR trades at a premium (currently 2.7x) and you invest in a 2x leveraged product, you are effectively buying a product that will perform 5.4x the underlying Bitcoin price movement. I have dabbled in these and it's not unusual to see 20% swings in a day or even higher!

MSTR equity

This is the primary vehicle for MSTR board to generate returns for shareholders - directly with share price changes.

This is where the multiple of valuation to holdings comes in I mentioned earlier.

If MSTR is trading at 2x NAV, then the board can issue shares and buy 2x what theoretically the holdings are worth which helps keep the 'bank' capitalised with their Bitcoin reserves

Spot BTC ETFs

Nothing really to mention here, the ETF products simply hold a 1:1 ratio of depositors money with Bitcoin. Not a product MSTR is offering

MSTR Convertible notes

This is where things get interesting.

MSTR can issue new debt with interest payments. MSTR then uses the money to buy Bitcoin and just continues to service the debt either through share issuance or cash flows from other operations.

MSTR dividend

It's not clear here if MSTR would look to issue a dividend in the form of Bitcoin or cash. I assume cash as the Bitcoin would be too valuable (and difficult) to distribute directly to shareholders.

So a small yield.

The list indicates 0.5x volatility of Bitcoin, which I find surprising. Potentially that would mean a fairly large dividend, unless this 0.5x is based on something else. Unfortunately this wasn't discussed in the earnings call

MSTR fixed

Again, no details provided here, but presumably similar to a more traditional deposit account - customers can either deposit direct with MSTR or buy a fixed income product which MSTR will use the cash to buy Bitcoin as a backing for the product.

Back to Bitcoin

So, you might have realised that this all comes back to Bitcoin.

So long as Bitcoin can maintain it's value or grow the future looks bright for MSTR, but if Bitcoin collapses due to a black swan event then suddenly the house of cards would come down.

So what is the likelihood of that happening?

I think slim. Here's why:

Constant bid pressure

If we take MSTR's projected numbers and assume they use all the new capital they are raising to buy Bitcoin (as they have indicated) we can establish what the floor bid price may be for Bitcoin. If we assume MSTR only buys Bitcoin on trading days (and assume 250 per year) we can establish the buying power they will exert per day on Bitcoin from these raises.

From the table above, we can see that based on Bitcoin's issuance of 3.125BTC per block (assuming 10 minute blocks) I have highlighted roughly where the constant bid pressure from MSTR would leave Bitcoin.

Now obviously there are more market dynamics here, any buying from others will put more pressure upwards on Bitcoin and selling by others will put downwards pressure, but don't be mistaken, this is a large constant bid coming in and by year 3 significantly dwarfs the amount of new Bitcoin issued per day at current prices.

By year 4 when the next halving comes around that could lead to a significant supply crunch.

Liquidity

I have also shown how we can expect global liquidity to continue to expand over the next couple of years, this has traditionally provided strong tailwinds for assets as we've seen over the last year or so, so barring economic trouble we should see an expansion of assets again, including Bitcoin.

What NAV should BTC MSTR trade at?

All of this information is well and good, but if we are valuing MSTR based on it's Bitcoin holdings what should we base that valuation on?

At the time of writing MSTR is trading (according to MSTR tracker) at about 2.7x NAV.

But why 2.7 and not 1, or 10?

This is the biggest piece of the puzzle to me. I was starting to become more convinced that 2x was what the market was settling on but the recent move seems to have disproved that assumption.

Historically MSTR has traded at valuations in excess of 6, however I would argue that is unlikely to return soon, purely because that was when Bitcoin was a smaller component of the company than it is now.

In other words, I currently have no idea what premium to put on MSTR to cover it's leverage potential, but I do believe it should be significantly in excess of 1.5

Upcoming catalysts

FASB accounting

The way that US firms can undertaken their accounting changes in January.

Assets held on the balance sheet need to be marked down if their value decreases, but as a quirk, cannot be uplifted in value for the increase in value.

What does this mean for MSTR?

The chart below shows that MSTR are listing their Bitcoin holdings at $6.9b because of this rule, but the market value of them is $18.3b

In other words, when MSTR reports in January they are going to show a monumental 'revenue' in excess of $10b which, if you aren't following MSTR, might come as a huge shock when you see a tiny company report massive numbers.

I think this will bring a lot of attention to MSTR

Index inclusions

As MSTR has exploded in value over the last year or so, there is a growing chance that MSTR will be added to the S&P 500 and the NASDAQ 100.

MSTR meets the market capitalisation requirements for both, but there are additional thoughts a board will review and make a decision on before they permit MSTR to enter.

These are not certain, and this isn't the place to discuss in detail, but being included in the index creates a constant bid pressure for a company as passive investors just keep buying month after month which should help stabilise the floor price for shares and as such BTC as MSTR issues new shares to buy BTC.

US Elections

Whilst I'm writing we are 1 day away from the US elections.

I personally think we will see a lot of volatility, but nothing decisive either way in market movements.

Why?

The race has been broadly 50/50 according to most commentators, although Trump seems to have pulled ahead marginally according to polls in many of the swing states over the last week or so I think it is more likely we see a Trump win than a Kamala win.

Having said that, because the race is tight, I think the markets have not priced for one way or the other, and certainty may in fact end up being the best outcome for assets.

From what I've seen, when Trump starts to perform well in polls prices seem to appreciate, so whilst certainty of an outcome would be welcomed, I think a Trump win would see a more positive market than a Kamala win in the short term.

Risks

Saylor dilution

Michael Saylor currently controls over 50% of voting shares in MSTR. If voting rights shares are issued there is a risk he becomes more diluted.

As Saylor is currently the driving force behind the Bitcoin strategy the company could face resistance to it's plans.

I think this is low likelihood - in that people investing in MSTR at this point understand the game plan - there is still the risk that a hostile group of shareholders could force a change of direction.

Bitcoin price

On top of the usual company risks around control and financing, MSTR also takes on the risk of Bitcoin.

Bitcoin is currently not fully quantum resistant and getting changes made to the Bitcoin codebase is very hard, so theoretically there could be a scenario as quantum computers become more readily available that the Bitcoin blockchain becomes worthless.

I personally also hold reservations about the longer term (>10 years) issuance schedule of Bitcoin and if it will be enough to support the blockchain, but this is a future issue which shouldn't impact the next few years.

We also have the risk of Satoshi Nakamoto. I personally think that the 1 million or so Bitcoin held by the Satoshi Wallet will not come back online, but if it did the markets would get very spooked and this would likely lead to a massive sell off in Bitcoin.

If any of these, or an unforeseen event were to happen and the value of MSTR's treasury collapsed, it would have the same effect as a bank run to a traditional institution and collapse the entire company.

Black swan event

Finally, and perhaps, despite the name, the most likely in my opinion is a black swan type event.

By their very nature they are supposed to be rare, but it certainly feels like we are loosing stability in many corners of the world.

I've said before that I am concerned that Pax America is coming to an end, and the current tensions in the middle east have me concerned. A large conflict there and we could see a return to the 1970's style energy shortage, which in turn would make most Bitcoin mining unviable and collapse the price as the value in the blockchain is it's security.

It could also just result in a general asset sell off, which Bitcoin is far from immune to.

Final thoughts

I've covered a fair amount of ground here.

There is more depth if you want to go completely down the rabbit hole, but MSTR has proven to be one of the best investments you could have made of the last few years and they have ambitious plans for the next 3. I was initially basing my MSTR target prices based on a ~$120k Bitcoin and 2x NAV but an considering extending that target with the recent announcements and elevated NAV premium, time will tell and I need to see continual liquidity increase and a good business environment in the US before committing to letting it run beyond the 8x I've already banked.

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Have a great weekend!

Chaz

P.S - Want to work with me? Reach out by replying to this email and lets chat