Cipher: Don't Look Up

Summary Cipher has a fast-growing, low-cost mining operation that it believes is the best-in-class. More than 80% of its capacity is in one site that has particularly low electricity prices, which might make it the most profitable Bitcoin mining operation in the US. With only 28 employees and a small management team, it is focused and dedicated to their plans. Cipher's competitive advantage is also its biggest threat; if it loses it, it could lose everything. Cipher Mining Inc. ( CIFR ) is building mining capacity at an impressive rate; it has signed an outstanding Power Purchase Agreement ((PPA)) with Luminant that gives it a competitive advantage over all the miners I follow except Riot Platforms ( RIOT ) and guarantees a profitable Bitcoin (BTC-USD) operation at all Bitcoin prices for the last three years. The PPA has the flexibility to allow Cipher to sell the electricity purchased under the agreement back to the grid when the cost of electricity makes that more profitable than mining Bitcoin. Last quarter selling electricity, it added $150k in profits to the bottom line. Cipher has signed an equally impressive deal with Canaan (CAN) for 11,000 new miners that will be energized in Q3 and implied in the recent earnings call that this is part of an extended agreement giving Cipher preferential purchase prices and payment terms. Management is delivering growth while minimizing debt and dilution, trying to build a true industry leader. Listening to the recent earnings call, it was clear that they believe they are already industry leaders and are pursuing the right path. They do not see any hurdles and are pressing on with energy and speed. They have their heads down, working hard, following the plan. If they look up, they might see some negatives on the horizon, potentially severely disrupting their plans. This is the third article I have written on Bitcoin miners in recent weeks. They have experienced a boom in price that started in December and continues. Initially, Cipher was leading the pack, but as you can see from the dashboard below, they have more recently fallen back. This article will explain the reason for the initial growth and present an argument for the slowdown. Mining Companies Performance (May 10th) (Author Database) In the latest earnings call , I was looking for information about two things (Q1 2023, May 9th) How is the capacity build-up going? What is happening with the Luminant legal case? Cipher Capacity Build Cipher is growing fast; they are doing a great job (slide 7 of the Q1 2023 earnings call presentation ) Cipher capacity (Q1 2023 earnings) 7.2EH/s makes Cipher a real player in this market. Riot Platforms quotes a current figure of 9.8 and a target of 11. I listened with interest to hear how well the build-out was going; I heard the management say "best in class" enough times for me to start counting when they said it. I was impressed by the quoted Bitcoin mining performance, 45 in two days (May 7 th and 8 th ), and by the low-cost production and energy prices paid. The purchase of 11,000 mining rigs from Canaan was intriguing, and I liked how operations were funded by selling Bitcoin mined. However, they did not mention, nor were they asked about, a legal case that could potentially bring this particular company down. Cipher is in dispute with Luminant Luminant, a subsidiary of Vistra Energy ( VST ), provides electricity to Odessa, one of Cipher's 4 mining sites. The electricity is supplied through a Power Purchase Agreement that is an excellent deal for Cipher. It provides very low-cost energy and allows Cipher to sell energy back to the grid when the price of electricity is higher than the value of Bitcoins mined. Cipher management believes it gives them a significant competitive advantage over their competitors. From the research I have done, they are probably right. The PPA has delivered an average cost per kWh of 2.7c ( slide 3 of earnings call presentation) compared with Riot at 2.9 c and Hut 8 Mining Corp. ( HUT ) at 3.4c. Of the 16 miners I track, 9 publish their energy cost, and these are the three lowest figures. The Odessa site is crucial to the success of Cipher. They have four mines; Odessa is wholly owned, and they have a JV in which they are a minority shareholder in the other three. Cipher Mining Sites (Q1 2023 Slides) In the earnings call, we heard the Odessa site (based in Texas) has continued its build-out and reached 5.0 EH/s capacity, meaning Odessa represents 84% of Cipher's mining capacity. Cipher own 49% of their other locations as part of a JV with WindHQ. In the earnings call, we heard that Cipher ordered 11,000 more miners for Odessa and expects to have them installed by Q3. Management did not mention the legal dispute with Luminant in the Q1 earnings call. The FY 2022 report ( from P60 10K 2022 ) described the issue as not material. In my view, it is potentially very material. Luminant legal case (FY 2022 10K notes) In this case, Luminant is asking for the repayment of $6.7 million they claim was paid to Cipher in error. Cipher said in the FY 2022 report We wholly dispute the claims made by Luminant and we intend to contest the case vigorously The industry has a precedent case, which is the cause of my concern. Hut 8 encountered a similar problem with the electricity supplier to one of its sites supplied by Devon Energy ( DVN ) subsidiary Vista. (I covered the case in my recent article ( The Bitcoin Miners Are Flying, But Where Is Hut 8 Going? ). Hut also contested the claim vigorously; in the end, Vista turned off the electricity supply! The case has still not been resolved, but the entire site remains without electricity, and the nearly 8,000 mining rigs that should be running are in storage. Hut does not expect to be able to re-energize the area and is looking for new homes for the miners (and a new PPA to provide power). If Luminant cuts the power, as happened to Hut, Cipher will lose 84% of its mining capacity as well as the PPA, the source of its competitive advantage, valued on the balance sheet at $71 million ( Derivative line items slide 13 ), and it could be in going concern territory. Luminant has not paid the money due to Cipher under the PPA (page 60, item 3 10k FY 2022 ) which implies they take the dispute far more seriously and have the right to terminate this contract. (page 4 FY 2022 10K ) The agreement also provides for certain curtailment events pursuant to which Luminant has a right to curtail the electrical power delivered in each contractual year. Subject to certain early termination exceptions, the agreement provides for a subsequent automatic annual renewal, unless either party provides written notice to the other party of its intent to terminate the agreement at least six months prior to the expiration of then current term The risk seems overwhelming, and management reported it as not a material issue. Having over 80% of their mining rigs in a single site in Texas presents another issue. In December 2022, a storm in Texas damaged a building and took 17,000 Riot Platforms mining rigs offline. Riot, the market leader and operator of multiple sites, has sufficient capacity to cope with this level of disturbance; I am not sure that is true of Cipher. Cipher bought 11,000 miners from Canaan. Cipher said in the earnings call that the 11,000 miners are the lowest cost and best payment conditions they have ever had; they also said it was the best deal they have ever heard of in the industry! In the call, we heard how the CEO had taken a multiple-week trip to Asia, to build a better relationship with one of the miner manufacturers. They mentioned having discussions with Bitmain , MicroBT, and Canaan. The CEO discussed the sales pitch they presented; Cipher believes that as a market leader, it has superior finances and the ability to be a leading long-term customer. Canaan is the less well-known of the three. Its Avalon mining rig has a reputation for working well in high temperatures (useful for Texas) and is known to be reliable. It is not considered as powerful or profitable as Bitmain's Antminer or MicroBT's WhatsMiner . It is challenging to get precise information on the mining profitability of the different miners as it is a source of competitive advantage for miners and manufacturers As far as I know, the two actual market-leading miners (in terms of capex) Riot and Marathon Digital Holdings ( MARA ) are not following Cipher and buying from Canaan. They are buying from Bitmain and MicroBT. It does make me wonder if the fantastic deal that Cipher signed was not one that Bitmain and MicroBT were prepared to sign. This deal may lead to Cipher having inferior mining performance per rig relative to the market leaders they aspire to be. Executive Pay I think too many SPAC deals have padded managers' pockets at the investors' expense. I have avoided several companies on this issue alone. The CEO of Cipher, Tyler Page, previously worked for Bitfury as head of business development. Bitfury started in Holland in 2019 as a Bitcoin miner; they are now an investment company and have invested in several companies across the crypto landscape. Bitfury owns 5% of Hut 8 and 81% of Cipher. Page was at Bitfury for eight months before becoming the founding CEO of Cipher. Page received $103 million in pay and awards in the first two years of Cipher's operation. The proxy statement where this information comes from, explained it was needed to keep him at the business. (As a comparison the CEO of RIOT received a total of $43 million for the same period) Payment to officers (Proxy page 28) The amount of money is significant, but the majority is performance-related restricted stock, so shareholders should benefit if Page gets the total amount. Best in Class: Groupthink? I often listen to earnings calls live; you can get extra information from how the management answers questions and reads out their prepared statements. After this call, I came away convinced that the administration believed they were already the best-in-class mining company. They said the phrase more times than I can remember. I heard no dissent or disagreement, nobody considering they were anything but the best-in-class. The managers already believe they are the best Bitcoin mining investment and cannot understand why the market is not agreeing, and the share price is not increasing at the same rate as others. It reminded me of the Hollywood film in which the characters were so concerned about making money from the asteroid that they forgot it was heading to Earth. Cipher Finances Cipher debt and cash over time (Author Database) Cipher has zero debt but has now spent most of the cash raised in the SPAC transaction. In April, Cipher mined and sold 406 Bitcoins to fund its operations, leaving 427 Bitcoins held. During the last quarter, Cipher reported the following cash movements. Cash use (Earnings Q1 2023) It is a low-cost operation with only 28 employees (compared to 489 at RIOT). However, with a reported $3.9 million of cash and approximately $12 million of BTC its short-term assets are only $16 million, less than the spend in Q1 2023. Cipher did say that it intends to continue funding its growth and operation using the Bitcoin it produces, and even though it has a large ATM shelf prospectus in place ($250 million), it does not intend to issue new shares. It looks like a tight balancing act; I expect that any significant disruption will force Cipher to take on debt or to go to the markets. Conclusion Cipher has grown its capacity quickly and signed excellent agreements, making it a low-cost operator with a potentially sustainable cost advantage due to its PPA. It has grown its capacity with very few employees compared to its peers. Cipher is short on cash and spends the bitcoins it produces to fund operations, so I believe that any drop in production will likely mean a trip to the ATM shelf registration. The PPA with Luminant is its greatest asset and its greatest threat. At the moment, for me, it seems too risky to buy into Cipher. My next miner article will be on Riot Platforms.