Riot Platforms: The 3 NOs And The Defiance Of Limited Supply

Summary 3 NOs: No end to dilution, No guidance beyond 2023, No strong catalysts until Bitcoin halving 2024. RIOT Blockchain's recent doubling of authorized shares suggests no end of dilution in sight, such policy looked counter-intuitive to Bitcoin's limited supply. Shrinking prepaid suggests another round of massive dilution incoming. RIOT's 2023 Q1 all-in mining cost per Bitcoin came in at $46,200, while Bitcoin has to trade above $67,915 to justify its $1.86bn market cap. Introduction: RIOT's 'Debt-Ceiling'-Equivalent Crisis In our previous article , we established that different miners adopted different capital structures to stay afloat amid Bitcoin's pessimistic performance. Some Bitcoin miners like CleanSpark ( CLSK ) aggressively sell Bitcoins mined to cover expenses; miners like Marathon Digital Holdings ( MARA ) take on debt; other miners like Riot Platforms ( RIOT ) and Hut 8 Mining ( HUT ) finance operations through equity (dilution). Because of this, we think it is very important that investors pay attention to the implication of RIOT's recent doubling of the number of Authorized Shares. This is pretty much equivalent to " increasing the debt ceiling " (although the former is equity, the latter is a liability). Should dilution continue, this will cause a major headwind to RIOT's upside potential. On the 11th of July 2022, RIOT announced the increase in the number of shares authorized for issuance: ... recommended that the Company's stockholders vote FOR Proposal No. 4, to increase the number of authorized shares of Riot Blockchain, Inc. common stock, authorized for issuance... The Board of Directors of Riot Blockchain UNANIMOUSLY recommends that Riot Blockchain stockholders vote FOR all proposals. As a result, RIOT's authorized shares have doubled from 170mil to 340mil . Given RIOT's policy to dilute shareholders instead of taking on liability, we do not think that the terminal authorized shares will only be 340mil in the future, even though a Bitcoin price rebound might slow the rate of dilution. From the perspective of business strategy, this move indeed secured RIOT some flexibility to expand mining capacity to survive this capital-intensive business. On the flip side, we felt that this move is more beneficial to the talents and executives of RIOT rather than the shareholder. Let us explain. RIOT's 3 NOs No End to Dilution: The Defiance of Limited Supply The Bitcoin mining business is a very capital-intensive business. Depreciation of the Property, plant, and equipment (PP&E) remains one of the primary costs of mining Bitcoin. Moreover, The average mining rig lifespan is 3-5 years. After which the mining rigs are worn out or become obsolete (not profitable). Table 1. RIOT's Depreciation Cost QR Cost of Revenue (Self Mining, $mil) Depreciation ($mil) Administrative (including SBC, $mil) Interest Expense ($mil) Total Expense Depreciation % 2023Q1 21.9 59.34 12.7 3.8 97.74 61% 2022Q4 22.6 37.59 30.8 0 90.99 41% 2022Q3 14.7 26.56 16 0 57.26 46% 2022Q2 18 20.6 10.7 0 49.3 42% 2022Q1 19 14.25 10 0 43.25 33% 2021Q4 15.7 5.536 38.93 0 60.17 9% 2021Q3 13 12.2 40 0 65.2 19% 2021Q2 9.3 5.738 3.5 0 18.54 31% 2021Q1 7.5 2.85 5.5 0 15.85 18% Source: Author In addition, the Bitcoin mining sector is highly competitive because the potential mining reward (Bitcoin - BTC-USD ) of one Bitcoin mining company is relative to the mining capacity of its competitor. Bitcoin mining companies compete with one another to gain a larger share of the Bitcoin network. This implies that acquiring more mining rigs (increasing mining capacity) does not guarantee more Bitcoins mined. Therefore, Bitcoin mining companies have to constantly increase their mining capacity just to maintain the same level of production, including RIOT. The increase in authorized shares can help RIOT expand and maintain operations, attract talent, and reward executives: RIOT will have greater flexibility to pursue value-creative opportunities, which may include corporate transactions, public or private offerings of equity securities, and attracting and retaining top talent in a highly competitive market. However, this business mechanics is negative news for RIOT's shareholders because RIOT's prepaid to vendors to secure new mining rigs are close to being exhausted. Table 2 details RIOT's shrinking prepaid. Table 2. RIOT's Shrinking Prepaid QR PP&E ($mil) Prepaid ($mil) 2023Q1 717.3 54.4 2022Q4 692.5 75.03 2022Q3 650.2 200.5 2022Q2 411 376 2022Q1 325 351 2021Q4 263 267 2021Q3 201 95 2021Q2 129 79 2021Q1 28 71 Source: Author RIOT's shrinking prepaid implies RIOT has to raise additional capital to fund the next stage of expansion beyond the guided end-of-2023 12.5 EH/s . Based on RIOT's track record, we expect RIOT to raise capital through equity. This would result in more shareholder dilution. By referring to Table 3, notice that an increase in the sum of prepaid and cash usually coincided with an increase in shares outstanding. In 2021Q4, prepaid and cash positions increased from $95mil to $267mil and $58 to $312mil respectively. During the same period, shares outstanding also increased from 97.2mil to 116.75mil. Similar observations can be made in 2022Q3 as well. Therefore, we expect to see further dilution past 170mil shares outstanding in the near future when RIOT announces the next stage of expansion plans or if Bitcoin continues to trade below RIOT's total mining cost per Bitcoin ($46,200, computed below). Table 3. Increase in Prepaids and Cash Likely Followed By Shareholder Dilution QR PP&E ($mil) Prepaid ($mil) Cash ($mil) Shares Outstanding (mil) 2023Q1 717.3 54.4 158.3 167 2022Q4 692.5 75.03 230.3 167.75 2022Q3 650.2 200.5 255 167.3 2022Q2 411 376 270 148 2022Q1 325 351 113.5 117.3 2021Q4 263 267 312 116.75 2021Q3 201 95 58 97.2 2021Q2 129 79 147 95.95 2021Q1 28 71 241 84.12 Source: Author No Guidance Beyond 12.5 EH/s and 2023 To our knowledge, aside from the Rockdale Facility and Corsicana Facility, RIOT has not guided investors on future expansion plans beyond 12.5 EH/s. Without guidance, analysts won't be able to extrapolate future profitability. What we need to know is whether RIOT's rate of expansion can keep up with the growing Bitcoin network hash rate and the resulting mining difficulty. According to Figure 1 and Figure 2, the Bitcoin network hash rate and mining difficulty were growing at 87% CAGR in the past 2 years. If RIOT's expansion plan cannot match the Bitcoin network growth rate, RIOT's Bitcoin will likely suffer. Due to a lack of guidance, we will model RIOT's profitability and valuation based on the end-of-2023 12.5 EH/s mining capacity. Our model suggests that Bitcoin has to trade above $67,915 to justify RIOT's current market cap of $1.86bn, assuming a 5x earnings multiple (derive from equipment average lifespan), $46,200 total mining cost per Bitcoin (= ($22mil Self-Mining Cost of Revenue + $59.34mil Depreciation + $12.7mil General Admin + $3.8mil interest expense)/2,115 Bitcoin Mined in Q1), and 7,072 Bitcoin reserve. At $67,915 per Bitcoin, RIOT's mining business net of assets and liability stands at $608mil (= $1,860mil market cap - ($158.3mil cash + $717.3mil PP&E + $54.4mil prepaid + 7,072 Bitcoin reserve * $67,915 - $158.2mil total liability). On the other hand, RIOT's profit per Bitcoin mined would be $21,700. At 12.5 EH/s and 87% Bitcoin network CAGR, RIOT is expected to mine 5,600 Bitcoin annually, or $121.6mil. At 5x earnings multiple, RIOT's mining business would be worth $608mil. Even though RIOT may be overpriced now, it is more likely for RIOT to retain this premium and track the Bitcoin price than to decline simply due to fundamentals. Considering RIOT's severe shareholder dilution problem, we recommend prospective investors time their entry to trade the Beta. This is also because RIOT is more volatile than Bitcoin. Figure 1 Data by YCharts Figure 2 Data by YCharts No Strong Catalyst Until Bitcoin Halving 2024 We've previously established our investment thesis for Bitcoin following its 4-year halving cycle. Following the thesis, the current cycle began with a 1-year bull market in May 2020, followed by a 1-1.5 yrs of bear market. Currently, we're in the 2-year recovery phase, where Bitcoin should gradually recover back to its all-time high. Although Bitcoin did not arrive at our predicted $10,000 price level during the bear market, Bitcoin followed through on 4 out of the 5 predicted sequences of action. We noted the path to $10,000 will be difficult because the halving cycle dictates Bitcoin cannot fall below the previous all-time high (~$20,000). Hence, we missed our opportunity to load up at $16,000. So why isn't the recovery phase a strong catalyst for RIOT? This is because we do not know the distribution of the Bitcoin price. If Bitcoin trade mostly below RIOT's total mining cost per Bitcoin, shareholders risk severe dilution. RIOT's 2023 Q1 total mining cost per Bitcoin stands at $46,200. The average total mining cost per Bitcoin is $41,700 over the past 9 quarters. Two other headwinds that could negate upside potential during this Bitcoin recovery phase include a potential large-scale equity offering for the next stage of the expansion plan and potential selling pressure from all the previously issued shares. Table 4. RIOT's All-in Total Mining Cost per BTC QR Total Mining Cost per BTC 2023Q1 46,200 2022Q4 53,000 2022Q3 55,000 2022Q2 35,300 2022Q1 30,800 2021Q4 44,400 2021Q3 50,500 2021Q2 27,500 2021Q1 32,300 Source: Author Verdict In our opinion, RIOT's policy of continuously increasing outstanding shares and authorized shares goes against the motivation for investing in Bitcoin. Isn't Bitcoin's limited supply its key attraction? If so, why risk getting diluted by RIOT? Furthermore, RIOT's operation and business management aren't as efficient and lean as MARA's. Therefore, we couldn't recommend exposure to RIOT even though RIOT could outperform Bitcoin, given RIOT is more volatile than Bitcoin. On our end, we'll continue to maintain our existing strategy (outlined here ).