AMZN - Quantum Computing: Speculative At Best

Summary

• QCI has made bold statements about its technology but has insufficient proof of concept at this point.
• This is an unprofitable company in a nascent industry, so this is a speculative asset.
• QCI needs to generate consistent and meaningful cash flow in 2023, or insolvency becomes a looming threat.
• If you are a risk-lover who dreams of finding that big winner, this stock has that potential.

Valuation and Alternative Options:

Valuing a company like Quantum Computing, Inc. (QUBT), also referred to as (QCI), is hard. Our preferred method of valuation is taking a look at free cash flow to equity, but that is mostly pointless in the absence of any meaningful cash flow. For that reason, we will be estimating future cash flows with ambitious growth estimates. Assuming our bull case discussion below is accurate, we predict QCI will benefit from inflows of government money. Therefore, if we broke down our valuation of QCI given the current market conditions. Naturally, this is subject to change as market conditions continue to change, however, this is the guide we will use to monitor the fair value of QCI.

We make the following assumptions, which may be incorrect in the future, in our valuation model:

10% growth of free cash flow

3.61% risk-free rate

5.02% market risk premium

Under these assumptions, we believe the value of QCI at various levels of hypothetical free cash flow is:

Clearly, QCI's current market cap far exceeds its intrinsic value. This exercise illustrates the risk any investment in QCI carries. This is a highly speculative bet, but one which could payoff if our predictions about the near-term future of the quantum industry are correct.

For more risk-averse investors that still want exposure to this industry, some solid options are ( IWM ), ( QTUM ), and ( LOUP ).

Overview:

Quantum Computing, Inc focuses on providing software tools and applications for quantum computers. The company offers Qatalyst, a quantum application accelerator that enables developers to create and execute quantum-ready applications on conventional computers (similar to an application program interface), while being ready to run on quantum computers. QCI faces competition from companies such as D-Wave ( QBTS ), Rigetti ( RGTI ), and IonQ ( IONQ ).

2022 Notable achievements:

• Released QAmplify, includes enhancements to the Qatalyst platform that now amplifies the quantum effects of existing quantum computers by 5x - 20x of their qubit count
• Successfully completed the acquisition of QPhoton.
  • Founder Dr. Yuping Huang | Quantum Computing Inc. is now Chief Quantum Officer
• Successful real-world implementation of [EQC] - Entropy Quantum Computing - at the (BMW) Vehicle Sensor Placement challenge.

The Business and the Financials:

QCI classifies itself as a 'full stack' company - meaning they have product or service offerings across the whole scope of the Quantum Computing Ecosystem. QCI defines this ecosystem as Quantum Computing, Quantum Intelligence, Quantum Remote Sensing, Quantum Cyber Security, Quantum Imaging, and Quantum Optical Chips.

An eyebrow-raising partnership that QCI has landed is with the AMZN cloud platform (AWS), which is one of the largest cloud computing platforms by revenue and market share. The availability of Qatalyst on AWS Braket positions QCI directly in the middle of a global value chain for AWS users. It will be worth monitoring the productivity of this relationship and how it converts into cash flow for QCI. AWS drives massive revenue and has a growing volume of users, alongside organic industry-wide growth in Cloud usage. QCI positioning itself within the AWS ecosystem is a good strategic move, but the proof will be in the pudding - and we've yet to see any pudding. QCI as it exists today was founded in 2018 and has operated at a loss every quarter. This shouldn't necessarily scare investors since there are significant R&D costs involved in commercializing a profitable product in an infant industry.

Some good news is they've managed to produce some revenue from services for the first time, generating $134,370 at a cost of revenue of $41,692. This is a 69% gross margin. However, expenses were $18,443,966 (48% YoY increase). When factoring interest and dividends, QCI lost $19,807,546 (61% YoY increase). The aforementioned numbers are all representative of the 9 months ending September 30th, 2022. QCI also noted (in the November '22 10-Q filing) "We have approximately $94,772 in monthly lease and other mandatory payments, not including payroll, employee benefits and ordinary expenses which are due monthly." With cash on hand of ~$8,556,768, this means QCI has at most 7.5 years of solvency at current levels. Considering this also does not include payroll or benefits, the true solvency window is shorter than 7.5 years. QCI was -55.01% YTD and -28.45% the past month at the time of writing. On November 14th, 2022 QCI announced a $0.06 miss on EPS estimates, totaling -$0.22, and a downside revenue surprise of -$162.35k.

A Revolutionary Offering?

To get an idea of the competitive advantage posed by QCI's EQC offering, let's compare it to the current standard - Noisy Intermediate Scale Quantum (NISQ). NISQ systems are designed to produce closed quantum systems in pristine quantum states that are isolated from the environment. The goal of this design is to minimize the interaction between the quantum system and the surrounding environment, which can cause significant processing challenges. This design also introduces several limitations including high cost, complex maintenance requirements, and ongoing stability issues. NISQ systems also have a limited qubit scale, which restricts the size and complexity of the problems they can process. Many people have questioned the feasibility of NISQ systems and whether they will ever be able to deliver on the promises of quantum computing. QCI believes it's EQC offering addresses these limitations. In their 2022 shareholder letter, they say:

We all see the hype and concerns about the value of quantum computing, arising from limited scale, high cost, lack of stability, overall complexity, and a significant error correction challenge. The EQC is designed to address the significant challenges that current NISQ computers are facing. QCI has successfully demonstrated a scalable, error-free and cost-effective computing prototype using quantum photonics. The future systems are designed to be deployable anywhere, require no special environments, and be readily usable by non-quantum experts.

That sounds great but doesn't provide much technical detail about the functional capabilities or underlying technology that powers EQC. See this article for much deeper insight into what the underlying tech may (or may not) be - Investors In Quantum Computing Should Be Very Cautious. Management talks of a world that has EQC-based computers being sold to individuals and companies. The realization of this ambition would solidify QCI as the key player in this breakthrough industry.

Cryptography and Government Contracts

Cryptography is the process of developing ciphers. A cipher is an algorithm for performing encryption or decryption-a series of well-defined steps that can be followed as a procedure. Cryptanalysis is the process of analyzing ciphers with the goal of finding the key to decipher messages that are encrypted with a specified cipher. The history of encryption is rich with intense competition between rival governments attempting to communicate with key allies during times of international conflict. The art of encryption, or scrambling a message to hide its true meaning, dates back as far as Ancient Egypt. As long as there have been secrets to hide, encryption has existed in some form. One of the first developments in the science of cryptography was in 1586 when Mary Queen of Scots was on trial for conspiring to kill Queen Elizabeth. The only thing standing between Mary and a guilty verdict was a handful of encrypted letters. The Queen deployed a team of analysts to decode the letters, and upon successful decoding, they found sufficient evidence to sentence Mary Queen of Scots to death. The science of cryptography has evolved immensely since that time, with cryptographers developing new, seemingly unbreakable ciphers and cryptanalysts finding ways to break those ciphers and decode messages. Naturally, innovation in cipher technology is shrouded in secrecy. For example, during WWII cryptanalysts for Allied forces found a way to consistently break the cipher used by German forces. They did this by stealing books full of German encryption keys, which could be used for roughly a month to break all encrypted messages for that month. In other words, if encrypting a message is akin to putting the true message in a locked box, then the encryption key is simply the key needed to unlock that box and find the true message. Allied forces were able to systematically steal books of German keys and cover their tracks, which gave Allied forces an immense information advantage. Germany believed it was impossible and inconceivable to break their Enigma cipher. Additionally, Allied Forces were able to break Italian and Japanese messages, and the bundle of intelligence gathered from the deciphered German, Italian, and Japanese messages was given the codename 'Ultra'. Ultra played a major role in D-Day by allowing Allied forces to learn of German encampments throughout France. Clearly, it was not only key for Allied forces to break the German Enigma cipher, but also to keep it secret that they had broken it.

The current king of encryption is the first-ever asymmetric key cipher, known as RSA. There are some notable challengers, specifically Elliptic Curve Cryptography and Quantum-resistant algorithms, but these are currently only being tested as possible replacements. RSA is still the most widely used form of encryption. Symmetry refers to the characteristics of the process of decoding an encoded message. A symmetric key means that the unscrambling process is the exact opposite of the scrambling process. Returning to the lockbox metaphor, asymmetric encryption involves locking a message with key A and unlocking the message with key B. Each individual has a public key and a private key. The public key is based on a one-way function, which has the important characteristic of invertibility (or lack thereof). A one-way function can be used to convert inputs into outputs, but cannot be used to easily invert outputs back to inputs. Therefore, a public key that is based on a one-way function makes it prohibitively difficult for modern computers to invert the function and find the decryption key. For illustration, let's say persons X and Y want to send an RSA encrypted message. The process may look something like this:

Person X computer their public key with a one-way function and posts this key online. Person Y encrypts a message with this public key and sends it back to person X. Person X uses their private key to decrypt the message. In this way, Person Y can openly send the encrypted message with the encryption key publicly known, but the message is protected because it can only be decrypted using the private key held by Person X.

These keys would take an inordinate amount of time to break. From the perspective of a third party trying to break the cipher between Persons X and Y, they would need a few key bits of information: namely, the N-value (public key), and the p and q values (private keys). The N value is the output of the one-way function of prime numbers p and q and is not easily invertible. As of 1999, the standard practice in encryption was to choose an N value sufficiently large such that all computers on the planet combined would need longer than the age of the universe to find the p and q factors of N. Barring any significant discoveries in the mathematics field of factoring, RSA ciphers are effectively unbreakable. Unbreakable by modern computers, that is.

As with many other historical periods, progress in cryptography has stalled with RSA encryption. There is no publicly known and widely used decryption process for RSA encryption (although there may be government secrets). Throughout the history of cryptography, innovation has been a series of code-makers developing new ciphers that modern technology cannot break, and code-breakers innovating technology to find ways to break ciphers. This constant push-pull relationship has stalled at RSA encryption, but the next big step is in Quantum cryptography. Predictably, quantum cryptography is dependent on the principles of quantum mechanics and requires the use of quantum computers. You can visualize the issue like this: a modern computer has two switches, each representing 'true' or 'false' values of 1 and 0. If the '1' switch is 'true', then the computer identifies the '1' value and vice versa. In this way, all modern computing is binary - based on 0 and 1 values. Quantum computers do not have two switches, instead, imagine a series of dials. Each dial can be turned independently of the others and represents a different set of possible variations. Quantum computing effectively breaks the current binary limitations of modern computers and will cause an explosion in computing power. In terms of RSA encryption, if a binary computer needs to find factors p and q of the encryption key N, it would need to sift through all possible factors individually. Even if it can run each computation in fractions of a second, the sheer number of possible computations makes it impossible for RSA decryption. Quantum computers essentially allow all p and q variations to be tested simultaneously, which will drastically reduce the time it takes for the one-way function of N to be inverted.

Given the major step forward in cryptography that Quantum computing presents, we strongly believe there will be significant government spending in this space in the foreseeable future. Quantum computing looks set to offer the next revolution in cryptography. All major governments will not hesitate to offer major contracts to companies that can offer quantum cryptography services, so a company with cutting-edge quantum computing technology is perfectly positioned to benefit from this. The CEO of QCI, Robert Liscouski, has public sector experience which includes time in the U.S. Department of Homeland Security and the U.S. Department of State, and he served on the Intelligence Science Board supporting the CIA and NIA. This prior experience may help QCI earn major government contracts, which provide the safest and surest streams of revenue imaginable for a company in its infancy. QCI and the whole quantum industry also stand to benefit from the recent government semiconductor bill, which plans to invest billions into US innovation in chips and computing technology.

It's important to note that the field of quantum-resistant cryptography is still in its infancy and the research is ongoing. The security of these algorithms has not been fully proven yet. This is another real-world use case for Quantum computers - code-breaking. The code-making and code-breaking use cases of Quantum computing may have seemed much more speculative if we viewed them a year ago. However, after the start of the Ukraine-Russia war, we believe it is much more likely that major governments worldwide will invest heavily in cutting-edge cryptography solutions. This investment will cause an explosion in the Quantum industry, and likely sooner than many expect. From this macroeconomic position, quantum companies look poised to benefit greatly from both the code-making and code-breaking possibilities offered by quantum computing.

Note: for those interested in the discussion of cryptography specifically, much of the material written here was gleaned from Simon Singh's book The Code Book .

Conclusion:

Despite the numerous risks listed above, QCI has had some key accomplishments in 2022, with talented individuals joining the company and earning revenue from services for the first time. Further, positioning themselves within the AWS ecosystem will drive a lot of organic interaction with potential customers, and should lead to revenue growth.

Despite the expected revenue growth, I don't foresee profitability in the near future for QCI. An investment in QCI is highly risky and speculative. However, successful companies all have their share of troubling times, and the key to investing in big winners is believing in them while they are in their infancy. For that reason, I'm rating QCI as a Buy for any risk-loving investor out there. The market is heavily penalizing this company and for good reason. They have massive expenses and minimal revenue. However, for an investor that is able to stomach the risk and believes in the management and product/service offerings that QCI has - you may look back at this as the beginning of the bull run. The key to QCI's success will be its ability to generate a consistent and meaningful cash flow. This upcoming year may be the make-or-break year for this company and provides huge upside potential to compensate for the major risk. Further, the likelihood (or hope) for government contracts may provide a major upside shock to this stock and others in the Quantum industry.

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