Summary In October, we recommended a 'long Bitcoin, short MicroStrategy' trade due to MSTR's high NAV premium and reduced borrowing capacity. Since then, Bitcoin is up 21%, while MSTR is mostly flat, validating the trade idea. That said, MSTR's NAV premium has now shrunk significantly, and the company's recent convertible issuance shows an insatiable appetite for zero cost convertible bonds. Thus, it's time to close the trade and move on to greener pastures. In October of last year, we highlighted a trade idea that got a LOT of flak at the time - going long Bitcoin ( BTC-USD ) and short Strategy ( MSTR )(formerly MicroStrategy ), the leveraged bitcoin holding company. In an article titled " MicroStrategy Is Tapped Out, Short Shares And Buy Bitcoin Instead ", we discussed the idea and explained that MSTR's borrowing capacity was reaching an upper limit, which meant that investors shouldn't pay up for the stock. With a significant premium to NAV, we didn't see the value in acquiring shares simply for CEO Michael Saylor's active treasury management strategy. At the time, MSTR was on a blisteringly hot run, and so our idea was met with a considerable amount of skepticism here on Seeking Alpha. Despite that, if you fast forward to today, the performance of MSTR since our 'Strong Sell' rating is basically flat. In contrast, Bitcoin is up more than 21%, which has led to a nice gain on the spread in less than half a year: Seeking Alpha Now, 4-5 months on, the picture has changed considerably. MSTR has continued to issue debt and buy bitcoin, striking deals for convertibles paying 0% coupon rates, showing just how much investor demand there is for long term 'call options' on MSTR's stock. At the same time, MSTR's NAV premium has shrunk considerably, which has significantly reduced the attractiveness of trying to squeeze more gains out of the trade idea. Altogether, it seems as though the time has come to call it a day with a 21% total net gain, start to finish, in this position. Today , we'll examine MSTR's current financial position, explore the stock's balance sheet dynamics, and explain why we think now is the right time to exit the 'long Bitcoin, short MSTR' trade. Sound good? Let's dive in. MSTR's Financials As always, let's begin with a quick look into MSTR's financials. Before getting into the numbers, however, it's probably worth laying out MSTR's treasury management strategy for those who are new to the stock (if there are any of those left). Assume that you could go back to 2013, and that you had $100,000 in your bank account in that year. What would you do with it? If you were smart, you'd invest it into Bitcoin, which was trading around $100 bucks per coin. This gets you out of a 'losing' currency and into a 'winning' currency. Monetarily, a $100k purchase in 2013 gets you 1,000 Bitcoins. In today's day and age, that would be worth roughly $85 million. Inflation adjusted, that's still $63 million in 2013 dollars. Not bad. If you held the cash in your account and didn't touch it, then you'd be down more than 37% in terms of buying power for key U.S. goods and services, as measured by the CPI: TradingView The lesson here is simple - USDs tend to lose value over time, and with a fixed supply and increasing utility, Bitcoins - so far - have mostly gained value over time. But what if you wanted to make the most amount of money that you could? If you were placed back in 2013, then you'd actually borrow as much USD as you could get your hands on to buy Bitcoin. The borrowed funds would cost you less to pay back in the future, and those funds would also grow into a much larger balance over time. This is how to make the 'most' from this dynamic, and it's exactly what Saylor has done with MSTR's treasury. On the asset side, most of MSTR's assets are invested into Bitcoins, which totaled 499,096 at last count. In today's USD terms, these are worth roughly $48.7 billion. With a cost basis of ~$33 billion and an average price of $66k, the strategy has worked out well so far, netting gains for the company. But to maximize earnings, MSTR has also issued convertible debt to get 'short' exposure to USD while boosting Bitcoin holdings even further. In essence, this is why the stock is so volatile - the huge BTC position that's partially purchased with borrowed money, and the inherent 'short' position in USD via convertible bonds: Saylorcharts.com The whole balance sheet is basically one big leveraged bet on BTC-USD prices moving higher. Let's quickly map out the value exchanges here because they're not immediately obvious. First , let's look at the convertible bondholders. Institutional investors who buy convertible bonds essentially give cash to MSTR. From there, MSTR invests that cash into Bitcoin. Recently, MSTR issued $2 billion in bonds for this purpose. In this case, investors aren't getting interest payments, they're getting a payout diagram similar to OTM call options. This essentially equates to MSTR getting cash now, investing it, and then potentially needing to pay out shares or cash in the future: If Bitcoin has increased in price, shares are issued and everyone is happy (minus some dilution). If Bitcoin has remained mostly flat or gone up in price, but not up to the conversion price, then MSTR has basically gotten a free loan to hold Bitcoin exposure long, and USD exposure short, over that period of time. The spread here could be significant enough to realize profits to MSTR shareholders. Finally, if Bitcoin goes down in price, then MSTR needs to sell more Bitcoin than they bought to pay back the loan. Again, bondholders essentially get long-dated call options on Bitcoin, even though they're paying through the nose for it. For stockholders, you'll likely suffer some dilution. However, given the exposure to both sides of BTC-USD, you get exposure to MSTR's underlying balance sheet positioning. Over the long run, this has proven to be a winning strategy. The risk here materializes if Bitcoin goes down in price precipitously and stays there. In this event, then MSTR may need to sell more Bitcoin than they bought to pay back the loan, which would lead to falling Bitcoin holdings and realized losses. Taken together, essentially, Saylor is betting that Bitcoin won't go down and remain down for a period of ~5 years or more on a rolling basis, based on where he's issuing convertible debt. If that happens, then shareholders might be in trouble, if the company begins realizing losses to pay back the leverage. This seems unlikely given the relatively conservative leverage profile, but this is how the whole MSTR machine operates. MSTR's Valuation Now - this is all good to know, but how does it relate to getting out of the short MSTR, long Bitcoin trade? Here's why. In the past, there were basically two reasons we thought the trade looked enticing: Borrowing capacity is capped out The NAV premium was getting extended Now that both of these conditions have relaxed, it's worth explaining why a pair trade no longer makes as much sense. First, the debt. In our initial article, we mentioned that MSTR's borrowing capacity was likely capped out, given that the legacy company cashflows were barely covering interest costs. However, since then, MSTR has issued $5 billion more in 0% coupon convertible bonds, with $3 billion in December and $2 billion recently . This is in addition to continued share dilution. We can't comment on how that bet will work out for bond buyers, but the core idea remains that there's considerable investor interest in buying MSTR bonds, even if they aren't interest paying. This means that MSTR can leverage as much as they would like in the coming years, and that they're no longer fundamentally constrained by underlying business cash flows. This means that the momentum the stock saw up to that point, and the leveraged Bitcoin exposure, can very well continue on into the future. The company may not have to sell off Bitcoins at a loss. Secondly, and more importantly, the NAV gap between MSTR's market cap and the underlying treasury assets has shrunk considerably, which was the core of where this long Bitcoin short MSTR trade would have made money. When we issued the trade idea, MSTR was trading at roughly 2.7 - 3.1x NAV, depending on whether you include the normal share count or the diluted share count: mstr-tracker.com Either way, it was an incredible premium for the stock. Now, with the ratio coming back in much closer to 1x, we'd argue that the 'juice' in this mean reversion spread trade has largely been squeezed. It just doesn't look as attractive now, with less 'upside' to 'Fair Value'. Plus, there's also the risk that the stock could come become permanently valued at a premium to book, which further shrinks the profit window. Summary All told, we think the time has come to call it quits on our earlier pair trade call, given how the market has changed over the last few months. We'll take the short-term, 21% win. Now, it's time to issue the ratings adjustments to get 'back to flat'. Hence, our upgrade of MSTR to a 'Hold' rating. Stay safe out there!
