Is MicroStrategy the next FTX?

Author: 100y Compiler: Luffy, Foresight News

If you can live to see tomorrow, it may mean: a) you are more likely to be immortal, or b) you are closer to death.

——Nassim Nicholas Taleb's "Black Swan"

It has been two years since FTX filed for bankruptcy in November 2022. The market seemed to have forgotten the collapse of FTX and Terra, and recovered quickly, with Bitcoin reaching the $100,000 mark.

Although the steady rise of the market is exciting, as an investor who entered the crypto market in 2020, I have witnessed too many crashes, and I can't help but worry about what the next black swan event will be.

The collapse of FTX and Terra had different causes, processes, and outcomes, but they share one clear similarity: virtuous and vicious cycles. Both are structured to achieve explosive growth in favorable market conditions, but also to fall into an endless death spiral when things go wrong.

Similar characteristics are currently being exhibited by another entity, MicroStrategy. I personally believe that MicroStrategy is less risky than FTX and Terra, but its use of debt to buy Bitcoin is not without danger. I want to discuss this briefly.

1. Current Situation

1.1 Company Overview

MicroStrategy was originally founded by Michael Saylor in 1989 as a business intelligence company. In its early days, the company focused on analytical software, eventually expanding to mobile applications and cloud services as technology advanced.

Source: companiesmarketcap.com

The company went public in 1998 with an initial valuation of approximately $1 billion. Aside from a brief surge during the dot-com bubble, MicroStrategy's market cap has hovered around $1 billion, and until 2020, it remained a relatively unremarkable stock. However, everything changed on August 11, 2020, when MicroStrategy announced its first purchase of Bitcoin as a public company. Since then, it has continued to accumulate BTC, driving its own market value to exponential growth, currently around $90 billion.

1.2 Where does the money come from?

Source: SaylorCharts

MicroStrategy purchased a total of 402,100 BTC at an average price of $58,263, accounting for about 1.9% of the total supply of 21 million Bitcoins, which is a staggering number. The company funds its Bitcoin purchases primarily in three ways:

1.2.1 Cash Reserves

Source: SEC

As a software company, MicroStrategy generates revenue through product licensing, subscription services, and product support. According to its 10-K report, the company's core business generated approximately $499 million in revenue in 2022 and approximately $496 million in 2023.

After deducting costs and operating expenses (excluding cryptocurrency price fluctuations), MicroStrategy will have a surplus of $10.5 million in 2022 and $800,000 in 2023. These funds can be used to purchase BTC or pay interest on existing debt.

1.2.2 Convertible Senior Notes and Stock Issuance

Source: MicroStrategy 2024 Third Quarter Report

MicroStrategy's main way of raising funds is to issue convertible senior notes. As of the third quarter of 2024 financial results, the company had accumulated approximately $4.26 billion in debt through such notes, with an average annual interest rate of 0.811%, and annual interest expenses of $34.6 million.

Most recently, on November 21, 2024, MicroStrategy issued another $3 billion worth of convertible senior notes. This brings its total debt to over $7 billion. It is worth noting that the newly issued $3 billion of notes has a coupon rate of 0%, which means that no interest expenses will be incurred. In return, investors can convert these notes into shares in the future at a premium of 55%.

In addition to convertible notes, MicroStrategy also conducts stock issuance. In the third quarter of 2024, the company issued $1.1 billion worth of Class A common stock.

MicroStrategy announced plans to raise a total of $42 billion in the next three years (2025-2027). Of this, $21 billion will come from equity issuance and the remaining $21 billion will be raised through fixed income issuance. The specific timeline is: $5 billion from each source of funds in 2025, $7 billion in 2026, and $9 billion in 2027.

1.3 Some interesting statistics

Here are some interesting data and facts about MicroStrategy:

Source: SaylorCharts

MicroStrategy purchased Bitcoin at an average price of $58,263, with a total market value of $38.5 billion and a book value of $23.4 billion, resulting in unrealized gains of approximately $15 billion.

Source: MSTR-tracker

MicroStrategy's market valuation is about 2.2 times its Bitcoin holdings. This valuation difference is why funds such as Citron are shorting MicroStrategy shares.

Source: MSTR-tracker

Despite the increase in the number of shares due to the stock issuance, the BTC price per basic share actually increased. This is because MicroStrategy's purchase of Bitcoin is faster than the dilution effect of the additional stock issuance.

2. Is Microstrategy the next FTX?

While structural issues played a role in the collapse of FTX and Terra, the moral hazard of their founders was also an important reason. Black swan events are inherently unpredictable by definition, so it is impossible to assess whether there is moral hazard within MicroStrategy based on public information. Therefore, the focus here will be on analyzing structural risks.

While this topic of discussion sounds grand, the structural risk involved in MicroStrategy is actually simple: investing in Bitcoin through leverage. If the company only invested its own equity in Bitcoin, the impact of the price crash would be relatively small.

Source: MicroStrategy

However, as highlighted in the third quarter report of 2024, MicroStrategy's goal is to use prudent leverage to acquire as much BTC as possible, increase shareholder value, and outperform the performance of Bitcoin itself.

As we all know, leverage is a double-edged sword. Leverage itself is accompanied by debt interest costs. If the value of BTC purchased with leverage falls, the company may be forced to sell its holdings to repay its debts.

Michael Saylor has repeatedly stated in the media that he has no intention of selling BTC, which means that any forced liquidation could seriously affect the company's value. This could lead to a decline in MSTR's stock price and difficulties in future financing. A breakdown in the leveraged strategy could also have significant knock-on effects on the market.

To assess whether MicroStrategy's leveraged strategy is sustainable, I will examine two key aspects:

• Interest Cost

• Sustainable Volatility

2.1 Can MicroStrategy Control Interest Costs?

First, let's consider interest costs. With the recent issuance of $3 billion in convertible senior notes at a 0% coupon rate, MicroStrategy's total debt is approximately $7.3 billion, with an average interest rate of 0.476%, and annual interest expenses of $34.6 million. The key question is: Can MicroStrategy continue to make these interest payments?

Source: SEC

According to the company's 2023 10-K filing, MicroStrategy holds approximately $1.13 billion in other assets in addition to digital assets. This is much higher than the annual interest expense of $34.6 million, indicating that MicroStrategy has no problem paying interest in the short term.

In addition, MicroStrategy has generated considerable revenue from its core business, business intelligence software. However, it is worrying that after deducting revenue and operating expenses, the remaining profit is relatively small and has been declining.

The size of future debt cannot be ignored either. As mentioned earlier, MicroStrategy plans to issue an additional $21 billion in convertible senior notes over the next three years. This would increase its total debt to $28.3 billion. At the current average interest rate of 0.476%, annual interest payments could rise to $134.7 million, which could be an unaffordable amount in the long run.

While MicroStrategy recently reduced its interest burden by issuing 0% coupon bonds, it remains uncertain whether the company will be able to continue to obtain such low-interest debt. The next section explores this issue further.

2.2 Is Future Fundraising Sustainable?

2.2.1 Will Investors Continue to Provide Funding?

Source: MicroStrategy

The primary issue is the sustainability of financing. Although the current positive sentiment in the cryptocurrency market makes it easy to obtain financing, historical data shows that MicroStrategy did not issue any convertible senior notes between February 2021 and March 2024. This period happens to be the period from the 2021 Bitcoin crash to the recent market recovery.

Source: Bitbo

While there is no hard evidence, Bitcoin's price cycles have historically been consistent with its 4-year halving cycle. This suggests a high probability of a bear market around 2026-2027, with the BTC long-term power law model suggesting a potential price floor of $53,000-70,000 during this period. Considering that MicroStrategy's average Bitcoin purchase price is $58,000, a bear market could make financing difficult.

2.2.2 Volatility is Crucial

Source: MicroStrategy

Beyond the price of Bitcoin, volatility also plays an important role in the sustainability of the Convertible Senior Notes financing.

Some readers may ask: Why is MSTR stock trading at more than 2x its net asset value (NAV)? Why would investors participate in the recent issuance of $3 billion of convertible senior notes with a 0% coupon?

Source: MicroStrategy

The key to these issues is volatility. Compared with other assets, Bitcoin and MSTR have shown significantly higher volatility, which is attractive to investors. MicroStrategy even highlighted the volatility of its stocks in its third quarter 2024 IR report.

High volatility makes various trading strategies possible, such as Delta hedging, Gamma trading, and volatility arbitrage.

• Delta measures the sensitivity of option prices to changes in the price of the underlying asset.

• Gamma measures the amount that delta changes as the price of the underlying asset moves.

• Gamma trading exploits these changes to profit from market fluctuations, making higher volatility profitable.

Source: MSTR-tracker

Because Bitcoin is more volatile than traditional stocks, and MSTR amplifies this volatility through leveraged purchases of Bitcoin, MSTR shares and its convertible senior notes have attracted great interest from hedge funds. These notes are not only a debt instrument, but also a call option that allows holders to convert them into shares at a specific price, further increasing their appeal.

Source: Bitbo

In order for MicroStrategy to maintain smooth financing, the volatility of BTC and MSTR must continue to exist. However, with the approval of Bitcoin ETFs and the continued entry of institutional investors, the market is becoming more stable and volatility is gradually decreasing. If Bitcoin's volatility decreases, MSTR's NAV premium may shrink, thereby affecting its stock price and reducing the financing attractiveness of its convertible senior notes.

3. Ultimately, price is the most important

Ultimately, the most critical factor is the price of Bitcoin. If the cryptocurrency market had not experienced a downturn, FTX could have become a large exchange comparable to Binance. Similarly, if Curve Finance's UST pool had not been attacked, Terra could have become the third largest network after Bitcoin and Ethereum.

If the price of BTC continues to rise steadily, MicroStrategy's current strategy could form a positive flywheel that drives explosive growth for the company and the cryptocurrency market. However, if the price of BTC plummets, the worst-case scenario is that MicroStrategy sells its Bitcoin holdings to repay its debts, triggering a vicious death spiral.

Thankfully, MicroStrategy's debt is unsecured. The company previously issued bonds collateralized by Bitcoin, but it was not fully repaid until the third quarter of 2024. If Bitcoin remains as collateral, forced liquidation in the event of difficulty in repayment could have catastrophic consequences.

Personally, I think MicroStrategy does not seem to face significant immediate risks. Its interest costs remain manageable and financing has been going smoothly so far. However, the size of the planned financing ahead is unprecedented, while the volatility of the underlying asset, Bitcoin, is expected to decline. Therefore, I expect the risk level to be high in the period 2025-2027.

Bitcoin is rapidly growing in value, becoming a challenger to gold's status. But the question remains: Will MicroStrategy continue to buy BTC in a sustainable manner and become one of the most powerful companies in the world? Or will it become another cautionary tale, caught up in the narrative of the tulip bubble? Only time will tell.