MicroStrategy's Opportunities and Risks: Davis Double-Click and Double-Kill

Last week we discussed the potential benefits of Lido due to changes in the regulatory environment. This week, there is an interesting topic regarding the popularity of MicroStrategy, with many people commenting on the company's operational model. After digesting and delving deeper into it, I have some personal insights that I would like to share with everyone.

I believe the reason for the rise in MicroStrategy's stock price lies in the "Davis Double-Down". The business design of buying BTC through financing ties the appreciation of BTC to the company's profits, and the leveraged funding obtained through innovative designs that combine traditional financial market financing channels enables the company to achieve profit growth that surpasses the appreciation brought by its holdings of BTC. At the same time, as the position size expands, the company gains a certain degree of pricing power over BTC, further strengthening this profit growth expectation.

The risk lies in this: when the BTC market experiences fluctuations or reversal risks, the profit growth of BTC will stagnate. At the same time, influenced by the company's operating expenses and debt pressure, MicroStrategy's financing capability will be significantly discounted, further affecting profit growth expectations. Unless there is new support to further boost BTC prices, the relative positive premium of MSTR stock price over BTC holdings will quickly converge, a process known as "Davis Double Kill."

What are Davis Double Hits and Double Kills

"Davis Double Click" is usually used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment:

1. Company profit growth: The company has achieved strong profit growth, or the optimization of its business model, management, and other aspects has led to an increase in profits.

2. Valuation Expansion: Due to the market's more optimistic outlook on the company's prospects, investors are willing to pay a higher price, thus driving up the stock valuation.

The "Davis Double Kill" is the opposite, used to describe a rapid decline in stock prices caused by the combined effect of two negative factors:

1. Decline in Company Profitability: The company's profitability has decreased, possibly due to factors such as reduced revenue, rising costs, and management errors, resulting in profits falling below market expectations.

2. Valuation contraction: Due to declining profits or worsening market prospects, investors' confidence in the company's future diminishes, leading to a decrease in its valuation multiples and a drop in stock prices.

This resonance effect usually occurs in high-growth stocks, especially in many technology stocks where it is particularly evident, as investors are generally willing to assign higher expectations for the future growth of these companies. However, these expectations are often supported by a considerable amount of subjective factors, which leads to significant volatility.

How the High Premium of MSTR is Created and Why It Becomes the Core of Its Business Model

MicroStrategy has switched its business from traditional software operations to financing the purchase of BTC. This means that the company's profit comes from the capital gains of BTC acquired through dilution of equity and bond issuance. With the appreciation of BTC, the shareholders' equity of all investors will increase accordingly, and investors will benefit. In this regard, MSTR is no different from other BTC ETFs.

The distinction arises from its financing capability, which brings about leverage effects, as MSTR investors' expectations for the company's future profit growth are derived from the leverage gains obtained from the growth of its financing capabilities. Considering that the total market value of MSTR's stock is in a premium state relative to the total value of its held BTC. As long as it remains in this premium state, whether through equity financing or its convertible bond financing, along with the funds acquired to purchase BTC, will further increase the equity per share. This gives MSTR a different profit growth capability compared to a BTC ETF.

Therefore, for the company's management, the positive premium of MSTR's market value over the value of its held BTC is the core factor for the establishment of its business model. Thus, the optimal choice is how to maintain this premium while continuously financing, increasing its market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will also boost investors' confidence in future growth even in the case of high price-to-earnings ratios, enabling it to complete fundraising.

To summarize, the secret of MicroStrategy's business model lies in the appreciation of BTC driving the company's profit increase, and a positive growth trend in BTC implies a positive growth trend in corporate profits. With the support of this "Davis Double Play," MSTR's premium is starting to amplify, so the market is speculating on how high of a positive premium valuation MicroStrategy can achieve for its subsequent financing.

What are the risks that MicroStrategy brings to the industry?

The risk that MicroStrategy brings to the industry lies in the fact that this business model significantly increases the volatility of BTC prices, acting as an amplifier of fluctuations. The reason is the "Davis double kill," and the period when BTC enters a high-level oscillation is the phase when the entire domino effect begins.

When the increase in BTC slows down and enters a period of volatility, MicroStrategy's profits inevitably begin to decline. At this point, fixed operating costs and financing costs will further shrink the company's profits, even leading to a state of loss. Meanwhile, this volatility will continuously erode the market's confidence in the subsequent price development of BTC. This will translate into doubts about MicroStrategy's financing capabilities, further dampening expectations for its profit growth. Under the resonance of these two factors, MSTR's positive premium will quickly converge. To maintain the viability of its business model, management must uphold the state of positive premium. Therefore, selling BTC to raise funds for stock buybacks is an essential operation, and this marks the moment when MicroStrategy began selling its first BTC.

Considering the current management's shareholding ratio, and that liquidity is usually tightened during periods of volatility or downturns, when it starts to sell off, the price of BTC will drop more quickly. This acceleration of the decline will further worsen investors' expectations for MicroStrategy's profit growth, leading to a further decrease in the premium rate, which may force it to sell BTC to repurchase MSTR, at which point the "Davis Double Kill" begins.

Does MicroStrategy's convertible bonds really have no risk before maturity?

The convertible bonds issued by MicroStrategy are essentially bonds that come with free call options. Upon maturity, creditors can request redemption in the equivalent value of stocks at a previously agreed conversion rate. However, the company can choose the redemption method, using cash, stocks, or a combination of both, which provides more flexibility. Additionally, these convertible bonds are unsecured, so the risk of repayment is relatively low. Furthermore, there is a protection for the company: if the premium rate exceeds 130%, the company can also choose to redeem at the original cash value, which creates conditions for refinancing negotiations.

The creditor of this bond will only have capital gains when the stock price is above the conversion price and below 130% of the conversion price; otherwise, there will only be the principal plus low interest. The main investors in this bond are still hedge funds used for Delta hedging, to earn volatility gains.

The specific operation of Delta hedging through convertible bonds mainly involves purchasing MSTR convertible bonds while shorting an equal amount of MSTR stock to hedge against the risks brought by stock price fluctuations. Furthermore, as the price develops subsequently, the hedge fund needs to continuously adjust positions for dynamic hedging.

This means that when the price of MSTR falls, the hedge funds behind its convertible bonds will short more MSTR shares to dynamically hedge Delta, further hitting the MSTR stock price, which will negatively impact the premium and, in turn, affect the entire business model. Therefore, the risk on the bond side will be reflected in advance through the stock price. Of course, during the upward trend of MSTR, hedge funds will buy more MSTR, so it is also a double-edged sword.