Opportunities and Risks of MicroStrategy: Profit and Loss from the Same Source

Last week we discussed the potential benefits that Lido could gain from changes in the regulatory environment. This week, we turn our attention to the popularity of MicroStrategy, as many industry insiders have commented on the operational model of this company. After digesting and researching in depth, I have some of my own views to share with everyone.

I believe the reason for the rise in MicroStrategy's stock price is due to the "Davis Double-Play". By designing a business model that finances the purchase of BTC, it ties the appreciation of BTC to the company's profits, and obtains financial leverage through innovative designs that combine traditional financial market financing channels. This gives the company the ability to achieve profit growth that surpasses the appreciation of its own BTC holdings. At the same time, as the holding volume expands, the company gains a certain 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. Meanwhile, affected by the company's operating expenses and debt pressures, MicroStrategy's financing ability will be significantly reduced, which will further impact profit growth expectations. At that time, unless there is new support to further drive up the BTC price, the positive premium of MSTR stock relative to BTC holdings will quickly converge, a process known as "Davis Double Kill."

What are the Davis Double Hit and Double Kill

"Davis Double-Click" is a term proposed by investment master Clifton Davis, usually used to describe the phenomenon where a company's stock price skyrockets due to two factors in a favorable economic environment.

1. Company profit growth: The company has achieved strong profit growth, or its business model, management, and other aspects have been optimized, leading to an increase in profits.

2. Valuation Expansion: As the market becomes more optimistic about the company's prospects, investors are willing to pay a higher price for it, thus driving up the stock valuation.

"Davis double kill" is the opposite, usually used to describe a rapid decline in stock prices due to the combined effects of two negative factors:

1. Decline in company profits: The company's profitability has decreased, which may be due to factors such as reduced revenue, rising costs, or management errors, resulting in profits falling below market expectations.

2. Valuation contraction: Due to declining profits or a deteriorating market outlook, investors' confidence in the company's future decreases, leading to a decline in its valuation multiples and a drop in the stock price.

This resonance effect usually occurs in high-growth stocks, especially evident in many technology stocks.

How the High Premium of MSTR is Caused

MicroStrategy has shifted its business from traditional software operations to financing the purchase of BTC. This means that the company's profit source comes from the capital gains of BTC purchased with funds obtained through equity dilution and bond issuance. With the appreciation of BTC, the equity of all investors will correspondingly increase.

The difference lies in its financing ability, which brings about a leverage effect. The expectations of MSTR investors for the company's future profit growth come from the leverage gains obtained through the increase in its financing capability. Considering that MSTR's total market value of shares is in a state of premium relative to the total value of its held BTC, as long as it remains in this state of premium, both equity financing and its convertible bond financing, accompanied by the funds obtained to purchase BTC, will further increase the equity per share.

For Michael Saylor, the positive premium of MSTR's market value over the value of its held BTC is a core factor in the viability of his business model. Therefore, his optimal choice is how to maintain this premium while continually financing, increasing his market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will also boost investor confidence in future growth even in the face of high price-to-earnings ratios, enabling him to complete fundraising.

Risks Brought by MicroStrategy to the Industry

The core 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 for this is the "Davis double kill," and the period when BTC enters a high-level oscillation phase marks the beginning of the entire domino effect.

As the growth of BTC slows down and enters a consolidation phase, MicroStrategy's profits will continuously decline, potentially even reaching zero. At this time, fixed operating costs and financing costs will further shrink the company's profits, possibly putting it in a loss situation. This consolidation will erode market confidence in the future price development of BTC. This will translate into doubts about MicroStrategy's financing capabilities, further undermining expectations for its profit growth. Under the resonance of these two factors, the positive premium of MSTR will quickly converge.

In order to maintain the establishment of its business model, Michael Saylor must maintain a status of positive premium. Therefore, selling BTC to raise funds to repurchase stocks is a necessary operation, and this is the moment MicroStrategy began to sell its first BTC.

Considering Michael Saylor's current position, and the fact that liquidity is usually tightening during periods of volatility or downturn, when he starts to sell, the price of BTC will drop faster. This accelerated decline will further worsen investors' expectations for MicroStrategy's profit growth, causing the premium rate to drop further, which could force him to sell BTC to repurchase MSTR, at which point the "Davis Double Kill" begins.

Risks of MicroStrategy's Convertible Bonds

The convertible bonds issued by MicroStrategy are essentially bonds with free call options layered on top. Upon maturity, creditors can request MicroStrategy to redeem them at a predetermined conversion rate equivalent to shares, but MicroStrategy can actively choose the redemption method, using cash, stock, or a combination of both. This convertible bond is unsecured, so the risk associated with debt repayment is not significant.

Convertible bond investors are primarily hedge funds that use them for Delta hedging to earn volatility returns. The specific operation involves purchasing MSTR convertible bonds while simultaneously shorting an equivalent amount of MSTR stock to hedge against the risk brought by stock price fluctuations. As the price develops subsequently, hedge funds need to continuously adjust their positions for dynamic hedging.

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