2024-01-05 20:11:23 ET
Summary
- Riot Platforms is one of the largest bitcoin miners and has developed one of the most cost-effective systems for mining it.
- Despite this, operating results have consistently been a loss, given the capital-intensive nature of this business.
- Bitcoin's design to resist effects of inflation makes the business difficult to scale profitably.
An acquaintance of mine asked for my opinion on Riot Platforms ( RIOT ), a company whose primary operation is mining Bitcoin ( BTC-USD ) for sale. I've avoided dabbling in cryptocurrencies and anything related to it so far. In short, I've yet to see the appeal to an investor with a long-term horizon. One of the advantages of owning a business instead of the crypto itself, however, is that a business has the potential for cash flow and adaptability. This means it gives more room for safety of principal and for the effect of compounding over time.
In looking at Riot, I see a business that lacks these usual advantages, and I will break down the various reasons for why I believe its shares are a SELL and unlikely to be worth buying.
Operations
The company has three operating segments: Bitcoin Mining, Data Center Processing, and Engineering.
2022 Form 10K
As we can see, Bitcoin Mining segment is responsible for the majority of revenues. It's also the segment that enjoys the best gross margins. Data Center Hosting is currently losing money, while Engineering makes a modest gross profit. YTD data for 2023 showed similar trends.
Q3 2023 Form 10Q
The Mining segment employs the use of "miners" to create Bitcoin, computers designed for such. As of Q3 2023 , the company had over 98K miners employed for this purpose and increased that to about 113K by year-end. They currently host these miners at a facility in Rockdale, TX and are developing a second facility in Corsicana, TX for larger-scale production. For those unfamiliar wi th how Bitcoin is mined, the process requires having enough computing power to increase their "hash rate" which allows them to find new crytographic hashes on the blockchain and allows them to "solve a block." Doing so earns them block rewards, which translates into new Bitcoin for them to sell. The hope is that scaling this allows them to realize as much profit as possible from this process.
Rockdale Facility (riotplatforms.com)
The Data Center segment is operated at the Rockdale facility, and they collect revenue from institutional-scale miners who use their facilities to deploy and operate their own miners.
The Engineering segment involves the development of power distribution equipment and other products that they apply vertically to their own model but also sell to customers in the private and public sectors for a variety of uses beyond crypto and mining.
Brief History
The company, while much older, is effectively a young business, after it suddenly shifted its focus from medical devices to blockchain in 2017, as noted here on Seeking Alpha by Hindenburg at the time. Let's see how the financial results have been since then, including reported YTD 2023 data.
Author's display of 10K data
Revenues ballooned starting in 2021, showing a radical change for the company. What was the catalyst to this? Management noted in its 2021 Form 10K :
The increase was due to higher Bitcoin values in the 2021 period, averaging $45,744 per coin as compared to $11,461 per coin in the 2020 period and an increase in the number of miners deployed from 7,043 as of December 31, 2020 to 30,907 as of December 31, 2021
This roughly tracks with the movement of the price of Bitcoin at the time, rising between 4x and 5x in market value from 2020 levels to 2021 levels.
Seeking Alpha
Since then, it has declined, which reduced their Bitcoin Mining revenues, but total revenues remained stable as they launched their newer segments. Despite that outwardly positive appearance, let's review their free cash flow for the same period.
Author's display of 10K/10Q data
Cash flows have been consistently negative. The cash flow statement sheds more light on why this is.
2022 Form 10K
The table above indicates that operating cash flows have typically been negative, while capex remains substantial. 2023's YTD data shows this trend has not changed.
Q3 2023 Form 10Q
To finance this without taking on debt, the company has been heavily diluting its shareholders to raise capital, raising over $1.2 billion from 2020 - 2022.
2022 Form 10K
This has resulted in total shares outstanding growing by more than a factor of 10.
Seeking Alpha
Recently, the company announced the Dec. 2023 results for their mining segment. They reported a 9% decline in Bitcoin produced YoY but an increase in net proceeds of 147%, benefiting from recent increases in Bitcoin's price. Nothing about this suggests to me that the decline in production is a sign of a bigger trend, but upcoming months will make that clearer.
A Look To the Future
Given these unappealing results, it's interesting to see that, despite the dilution, the market cap of the company has actually tripled in the last year.
Seeking Alpha
What kind of hopes are reflected in the market lately that makes investors more optimistic about the enterprise?
Corsicana Facility
The Corsicana facility is still largely under development and is where the company shows a great deal of its ambition.
Corsicana Facility (riotplatforms.com)
The company expects Building A1 to be completed by the end of Q1 2024, which means Corsicana can start contributing to operations as the rest of the site is developed further. A newer, larger site will allow it to scale its operations further and hopefully at lower costs, providing substantial new revenue.
Immersion-Cooling
Presumably, if you are reading this, you are on a computer. You've probably noticed that your computer heats up when you run more applications and that the fan inside becomes louder as it tries to circulate more air to cool it down.
Immersion-cooling is an alternate method in which a computer is submerged in a non-conductive liquid that helps dissipate the heat more effectively, rather than relying on a fan. Combined with the fixed contracts they sign to contain their electric costs, it's allowed them to mine Bitcoin at a cost well beneath even its market lows.
Company Presentation
So far it sounds like the company is scaling and maturing successfully, and maybe the market is responding to these developments. Yet, I've headlined this company as something that I don't think will ever be a buy. Let's get into that.
The Hash Rate Problem
As I mentioned earlier, the company continues to purchase more miners in order to increasing its computing power and thus raise its hash rate. The tricky part here is that increasing production and thus increasing hash rates reduces the return of a miner. As Onkar Singh, writing for CoinTelegraph , explains:
The number of miners in the network, mining difficulty and, ultimately, miner profitability are all impacted by changes in hashing power. In addition, the mining challenge rises when more miners join the network because it takes more guesses per second to solve the complex mathematical equation and get the block reward. As a result, the hash rate rises as the difficulty of the Bitcoin network does.
This function says a lot about the financial potential of the mining operations. The hash rate is necessarily influenced by how many people get into it, and currently Bitcoin is popular and in demand. While normally a rise in Bitcoin's market value would be good for a company trying to sell it, this is telling us that, even in the short term, it can create a feedback loop that reduces the return on investment for these miners.
To give you an idea of how much this plays into it, look at the growth of the hash rate since 2020:
Ycharts.com
It's up from about 40 TH/s to over 600, a fifteen-fold increase. Considering how much capex the company currently contributes to acquiring miners for their facilities, this continually growing problem is going to keep the need for capex high, instead of allowing it to decrease.
Halving
Now, a lot of people are more familiar with the "halving" aspect of Bitcoin. Just in case some readers aren't familiar, I'll quote Investopedia :
After the network mines 210,000 blocks—roughly every four years—the block reward given to Bitcoin miners for processing transactions is cut in half. This event is called halving because it cuts the rate at which new Bitcoins are released into circulation in half.
As they go on to say, rewards were initially 50 Bitcoins per block. With three halvings, we are now at 6.25. The next halving is expected to occur this year, and will reduce the reward to 3.125. This means that the future possible return on these miners is going to be cut in half very soon and that this will continue to occur .
We have a hash rate problem in the short term creating a costly arms race of Bitcoin miners, and then there is the factor of halving that will reduce possible revenues in the long-term. These things are not accidents. Bitcoin is designed to retain value and be inflation-proof.
Miners in the actual sense, those who dig up gold, silver, copper, or another mineral, are not encumbered in this way. As long the ores aren't too deep underground and the concentration is good enough, it's economically feasible to mine them, and scaling such an operation necessarily increases margins. These minerals have actual uses and functions that keep them in demand.
Most importantly, minerals don't have a mathematical property built into them that makes them more costly, whatever the miner does. Bitcoin does have this feature, and I believe the long-term investor should be concerned about this inherent pressure this creates on operating margins, especially since Riot's results aren't even positive yet.
Inflexible Business Model
The last thing that really seals it for me is this how this tremendous amount they are spending on capex for something that will have diminished returns over time is unlikely to be helpful for anything else. I'll quote their Risk Factors from their 2022 Form 10K :
Therefore, our Mining operations focus exclusively on mining Bitcoin, and our Mining revenue is based on the value of Bitcoin we mine. Accordingly, if the value of Bitcoin declines and fails to recover, for example, because of the development and acceptance of competing blockchain platforms or technologies, including competing cryptocurrencies which our miners may not be able to mine , the revenue we generate from our mining operations will likewise decline. Moreover, because our miners use these highly specialized ASIC chips, we may not be able to successfully repurpose them in a timely manner, if at all , if we decide to switch to mining a different cryptocurrency (or to another purpose altogether) following a sustained decline in Bitcoin’s value or if Bitcoin is replaced by another cryptocurrency not using the SHA-256 algorithm.
I think this is a very particular risk factor that should concern folks because not every company will say this about itself. Pfizer didn't know it would be making COVID vaccines, but it was able to leverage its existing assets to make that happen. Hanes, known for its socks and underwear, was able to make medical masks for sale.
It would be one thing if Riot could opportunistically produce different cryptocurrencies with the same infrastructure based on the best return available, but that doesn't seem to be the case. The company doesn't currently have positive cash flows, is facing headwinds artificially placed to protect Bitcoin from inflation, and the hundreds of millions of dollars spent on capex for these facilities and miners may not have any secondary use.
What happened to this stock when it had a business model that couldn't adapt before? I'll just show you another chart.
Seeking Alpha
Recent price fluctuations are barely even visible. Even in the lows of the Aughts, shares of this company were over $100, and it is much lower today.
For all these reasons, I cannot give a valuation for this company. Lacking positive cash flows, combined with the long-term outlook, I doubt there will ever be earnings to value.
What Will Make RIOT A Winner?
Folks looking to sell RIOT but who are worried that they may miss an opportunity should know that everything I said will probably not matter if the price of Bitcoin takes off from where it currently is and stays up. This would not only raise the margins for their mining segment, but it would also allow them to set higher prices for the data center segment and probably make that profitable too, especially since their electrical costs are largely fixed. In short, if the price of Bitcoin rises enough, eventually that would outweigh the other negative forces that make the company's cash flows negative. The sooner this occurs, before more halvings, the better.
The question you need to consider is: What will make Bitcoin do that? What will increase demand to hike the price? For example, if China wants to urbanize more, they have to import more iron to build things, and so the revenues for all iron miners go up. I myself don't know of any particular thing that would trigger this for Bitcoin in a similar manner, but I don't rule out that it could happen.
Conclusion
Riot Platforms has worked diligently on developing a cost-efficient method of mining Bitcoin at a massive scale. Yet, these efforts may ultimately prove more useful to people who believe in the cryptocurrency as a philosophical project than those who invest in shares of the company. Riot has not generated positive cash flows since the shift to Bitcoin mining in 2017, and the nature of Bitcoin indicates that it will likely be harder for them to be profitable over time.
I believe long-term investors should own a company that can organically generate cash flows and whose business models give them the adaptable traits to continue succeeding. Neither of these seem to be the case for Riot. That means shareholders must either face continued dilution of their equity or will eventually get wiped out. Because of this, I think RIOT is a SELL, and as long as it's in the business of Bitcoin mining, I doubt it will ever be a buy.
For further details see:
Riot Platforms: I Doubt It Will Ever Be A Buy