Marathon Digital Holdings: A Promise Keeper With A Few Cons

Summary Marathon Digital Holdings made excellent progress to achieve the guided 23 EH/s mining capacity, but this has led to a diminishing asset value due to depreciation and a decrease in prepaid. The company's adjusted net asset value has been further impacted by severe dilution since 2022Q4, with shareholders losing a 31% claim on MARA's assets and future earnings. Our model suggests that Bitcoin has to trade above $50,737 to justify MARA's current valuation, but MARA will likely tail Bitcoin's price action rather than fundamentals. MARA can be invested if prospective investors believe Bitcoin will quickly recover above $33,400 (MARA's total mining cost per Bitcoin) to avoid further dilution and Bitcoin sale. Prospective investors should also account for over-centralization risks (regulatory risks) and MARA's SBC policies. Introduction It has been a while since we last visited Marathon Digital Holdings ( MARA ). In our previous article , we discussed MARA's risk of over-centralization. We showed that 62% of MARA's operations are centralized in Texas alone. The SEC's lawsuit against crypto exchanges such as Binance (BNB-USD) and Coinbase (COIN) puts MARA under massive regulatory risk. For instance, New York recently became the first state to impose a ban (partial) on Bitcoin Mining. Should Texas impose similar policies, MARA will suffer a loss of revenue and incur massive expenses to locate and relocate to new sites with excess energy production. This article aims to examine other aspects of MARA that prospective investors should consider, especially when we've outlined a strategy that could double the return and halve potential losses, outlined here . Expansion Progress Negated With Side Effect Here, we need to give credit where it's due. MARA has guided shareholders 23 EH/s mining capacity by mid-2023 (which is now) since 2021Q4. According to the latest May production update , MARA is now nearing its guided 23 EH/s and has 20.1 EH/s capacity installed as of May 2023. Here is MARA's expansion progress since 2021Q1. Table 1. MARA's Historical Built-up Hash Rate Since 2021Q1 QR Built-up hash rate (Energized) 2023Q2 15.2 EH/s 2023Q1 11.5 EH/s 2022Q4 7.0 EH/s 2022Q3 5.7 EH/s 2022Q2 3.9 EH/s 2022Q1 3.9 EH/s 2021Q4 3.5 EH/s 2021Q3 2.7 EH/s 2021Q2 2.09 EH/s 2021Q1 1.46 EH/s Source: Author However, the side effect of this expansion is the diminishing value of MARA's asset value on paper due to depreciation. Historically, MARA supported expansion efforts by securing large amounts of equipment via large prepayments to vendors. The value of MARA's prepayment peaked at $830mil in 2022Q2 . Then, the value of MARA's prepayment ("Prepaid") gradually decreases as the prepaid equipment gets delivered. Hence, the value of Property, plant, and equipment (PP&E) increases. However, the value of the prepayment is not completely transferrable to PP&E. This is because PP&E is subjected to depreciation (both in reality and on paper) while prepayments are not. As a result, the value of MARA's total assets also decreased. Table 2 illustrates the diminishing Adjusted Net Asset Value for MARA over time, assuming Bitcoin is priced at $27,000. In this computation, we only include primary assets (Cash, Bitcoin reserves, PP&E, and Prepayments to vendors) to be conservative. Table 2. MARA's Adjusted Net Asset Value Over Time ($mil, unless stated) QR Cash Bitcoin Reserves ((BTC)) PP&E Prepaid Total Comparable Assets Total Liabilities Adj NAV Q12023 124 11466 715 69.5 1218.082 734 484.082 Q42022 104 12232 273 528.8 1235.814 809.2 426.614 Q32022 55 10670 403 735.5 1481.93 805 676.93 2022Q2 86 10055 314.2 830.2 1502.285 760 742.285 2022Q1 119 9374 334.6 635 1341.198 749.2 591.998 2021Q4 269 8133 276.2 500.5 1264.791 751.426 513.365 2021Q3 33 7035 93.9 203.3 520.045 3.9 516.145 2021Q2 171 5784 80.2 121.6 528.568 3.3 525.268 2021Q1 204 5324 42 129 519.148 3 516.148 Source: Author The diminishing Adj NAV is made worse by MARA's severe dilution since 2022Q4. The total number of outstanding shares increased by 43% (167.26mil/116.8mil, Table 3) in the past 2 quarters (2022Q4 and 2023Q1). This implies that shareholders have lost 31% claim on the MARA's assets and future earnings. Hence, Adj NAV per share has declined more rapidly than Adj NAV. Table 3. MARA's Diminishing Adj NAV per Share QR Adj NAV ($mil) Shares Outstanding (mil) Adj NAV per Share Q12023 484.082 167.26 2.89418869 Q42022 426.614 145.567 2.93070545 Q32022 676.93 116.8 5.79563356 2022Q2 742.285 113.865 6.51899179 2022Q1 591.998 103.12 5.74086501 2021Q4 513.365 102.7 4.99868549 2021Q3 516.145 102.5 5.03556098 2021Q2 525.268 99.6 5.2737751 2021Q1 516.148 99.4 5.19263581 Source: Author Unfortunately, MARA's shareholder dilution is not expected to end anytime soon. This is because Bitcoin is trading below MARA's total mining cost per Bitcoin. Hence, MARA has to cover expenses through the issuance of new shares or debt in addition to liquidating some or all of the Bitcoins mined. For instance, this year, MARA liquidated 1,500 Bitcoins in January, 650 in February, and 600 in April. As a result, MARA's Bitcoin reserves did not grow as we would like (Table 4). Table 4. MARA's Historical Bitcoin Holdings/Reserves Q Bitcoin Reserve 2023Q2 12,259 ( May) 2023Q1 11,466 2022Q4 12,232 2022Q3 10,670 2022Q2 10,055 2022Q1 9,374 2021Q4 8,133 2021Q3 7,035 2021Q2 5,784 2021Q1 5,324 Source: Author Cost Analysis: Normalizing Costs Sustainable? We computed MARA's total mining cost per Bitcoin to be around $32,000 (=$70.2mil / 2,195 Bitcoin mined). The total mining cost comprises the cost of revenue (depreciation and hosting) ($51.1mil), general administrative expenses ($15.344mil), and interest expenses ($3.76mil). Non-cash expenses such as stock-based compensations and depreciation are also included because these costs still impact the fair value of MARA's shares. $32,000 total mining cost per BTC represents a 28% decline QoQ from $44,000 in 2022Q4 and an acceptable industrial average (e.g., Riot Platforms ( RIOT ), Bitfarms ( BITF )). Moreover, the $32,000 total mining cost per BTC is also considered highly efficient by MARA's historical standard (Table 5). Table 5. MARA's Total Mining Cost Per BTC QR Total Mining Cost per BTC 2023Q1 $32,100 2022Q4 $44,400 2022Q3 $91,200 2022Q2 $81.683 2022Q1 $31,700 2021Q4 $32,240 2021Q3 $95,850 2021Q2 $20,711 Source Author However, we expect the costs to increase. One of the key reasons is stock-based compensation (SBC). According to 2023Q1 reports : The decrease in stock-based compensation is primarily related to generally lower value of the Company's stock. Following this rationale, SBC will likely increase when MARA's stock price recovers, bringing the overall total mining costs up with it. Furthermore, MARA has also increased its headcounts, which will further increase SBC when the stock price recovers. This ... increase in expense was primarily due to the increases associated with the larger scale of the business, including higher cash compensation and benefits costs ... resulting primarily from an increase in headcount from 13 employees in the prior-year period to over 30 employees in 2023... In the past, MARA was already notorious for "generous" SBC expenditures. For instance, MARA incurred $97.2mil of SBC expenses in 2021Q3 which represented 90% of the total costs . MARA also incurred $54.4mil in SBC in 2021Q1 when the cost of revenue was only $2.41mil. In 2023Q1, MARA suffered $25mil losses related to some form of stock grants. This event may not be related to SBC, but it seems MARA has troubles with compensations. Profitability and Valuations Since Bitcoin is trading well above its $15,000 (=$ 33.4mil / 2,195 BTC) hosting cost per BTC, it still makes sense to continue mining Bitcoin. That being said, MARA is currently unprofitable as Bitcoin is trading below its $32,000 total mining cost per BTC. Based on MARA's adj NAV, cost analysis, risk of SBC cost increase, and a 5x earnings multiple benchmark (which is derived from the average lifespan of the mining rigs), our valuation model suggests that Bitcoin has to trade at least above $50,737 to justify MARA's current valuation of $1.69bn. At $50,737 per Bitcoin, the adjusted Enterprise Value (EV) of MARA would be $893mil (= $1.69bn Market Cap - [$124mil Cash + 12,259 BTC * $51,000 + $715mil PP&E + $69.5mil Prepaid - $734 Total Liabilities]). On the other hand, MARA's net profit per BTC would be $17,337. Since the drop in the Bitcoin network hash rate during 2021H1, the Bitcoin network has been growing at 93% annually (Figure 1). Hence, the Bitcoin network hash rate is expected to reach 733 EH/s (Figure 2). At 23 EH/s terminal capacity, MARA would account for about 3.1% (=23 EH/s over 733 EH/s) of the total Bitcoin network. Therefore, MARA is expected to produce 10,302 Bitcoin annually until the next Bitcoin halving cycle. This would put MARA's expected annual profit at $178.6mil and valuation at $893mil at 5x earnings multiple. In summary, this implies that MARA is currently overpriced. However, we do not think that MARA's price would decline simply because it is overpriced. Based on past data, MARA is 40% more volatile than Bitcoin (Beta to Bitcoin = 1.40). Hence, MARA's price will likely follow Bitcoin rather than fundamentals. What do all these means? If you believe Bitcoin will recover above $33,400 in the near future and $50,737 in the long term, you could consider MARA investible now. Keep in mind the risk of over-centralization and MARA's SBC policy before investing. Else, you'll likely get severely diluted on top of losses from MARA's share price declines. Figure 1. Data by YCharts Figure 2. Data by YCharts Summary In this article, we discussed MARA's balance sheet is highly susceptible to the depreciation of its PP&E while shareholders risk further dilution if Bitcoin continues to trade below its total mining cost per Bitcoin. Given the additional unsystematic risk of MARA's mining business, we maintain our recommendation to invest directly in Bitcoin. We recommend giving our strategy stated above a read.