Marathon Digital: Big Downside To Fair Value

Introduction

This is turning out to be a good year for Bitcoin (BTC-USD) enthusiasts. Most risk assets have done well as the Federal Reserve goes easy on interest rate increases, and provides support to banks, increasing liquidity in the market.

As investors drive up the price of Bitcoin and associated stocks like MicroStrategy (MSTR) and Coinbase (COIN), Bitcoin miners are having their day in the sun. Although still far off their highs, their stocks have had an impressive run of late. The latest positive news has been BlackRock (BLK) filing to create a Bitcoin ETF.

Marathon Digital (NASDAQ:MARA), a debt-laden Bitcoin miner, seems to be the worst positioned of the Bitcoin bunch, with 75% downside to fair value.

Company background

Marathon was incorporated in 2010 and is based in Fort Lauderdale, FL. It operates 8 Bitcoin mining facilities in the US, and is planning one in Abu Dhabi, UAE (through a joint venture). It contracts with data hosting providers to host its equipment that run to secure transactions on the Bitcoin network, in return for which the company generates Bitcoin. The mining process involves performing a large number of mathematical computations to guess the result of a cryptographic process.

Marathon Digital is listed on the Nasdaq exchange. It has a market cap of $2.5 billion and an enterprise value of $3 billion.

Marathon Digital quarterly financial overview

For the first quarter of 2023, Marathon Digital reported revenue of $51.1 million, down 1% versus the prior year. It reported cost of revenues of $51.1 million and G&A expenses of $15.3 million, for an adjusted operating loss of $15.3 million, or a -30% adjusted operating margin. The company also had $6.2 million in impairments and $17.6 million of realized gains, which I exclude in my analysis. Including these, the company reported an operating loss of $3.9 million. The share count at 159.2 million, was up a stunning 54% over the prior year.

The company produced 2,195 Bitcoin during the quarter. It cost the company $23,280 (up 11% YoY) to produce each Bitcoin before G&A expenses, and an all-in cost of $30,250. So at current prices, the company should be just about breaking even.

Cost of producing Bitcoin last quarter before G&A expenses = $51.1 million/2,195

Cost of producing Bitcoin including G&A expenses = ($51.1 million + 15.3 million)/2,195

Looking at the balance sheet, property and equipment was $715 million, up $442 million from the prior quarter, as the company took delivery of equipment it had previously ordered and paid for. The company had $125 million of cash and $733 million of debt. I would give the company credit for $146 million of investments and deposits, calculating net debt to be $462 million, The debt is 1% interest rate convertible debt due 2026. The conversion price is $76 per share, far from the current share price of $16. So it’s fair to say that it is unlikely to be converted, and the company has got a good deal at the expense of the debt holders.

The company also owns 11,466 Bitcoin, which at the current price of $30,500, is worth $350 million.

On the cash flow side, the company funded its operating deficit of $58 million by issuing $163 million of stock. The excess cash was used to repay $50 million of debt and invest $43 million in a joint venture to set up mining operations in Abu Dhabi.

The problem for the crypto mining industry as a whole, is that with easy access to capital, all of them are expanding capacity and spending big on equipment. With increased competition and difficulty, the cost to mine each Bitcoin goes up. And there are only 1.6 million (of the 21 million maximum level set) left to mine!

MARA stock valuation and recommendation

Given that it costs the company about $30,000 to mine each Bitcoin, close to the current market price, I don’t believe there is much profit potential in this business. The company would generate profits if the price went much higher, but I would expect this to be temporary and the margin to be competed away.

The clear contributor to value here is the Bitcoin held by the company as it is a liquid asset that can be easily monetized. I will be generous and assign value to the property and equipment as well at the carrying value. Most of it can be sold and repurposed, possibly for the trend du jour of AI. Adding these two elements gives us $1,065 million in value for the enterprise. To get the equity value, I will deduct net debt of $462 million to arrive at $603 million, or $3.80 per share. Thus, I see more than 75% downside from the current $17 share price.

For a bull case, I will assume that the price of Bitcoin gets a boost to a sustained price of $36,000, and the company produces 1,000 Bitcoin a month at a cost of $30,000 each. This is the current level of production, according to an update the company provided for June. Thus, it would generate an operating profit of $6 million a month, or $72 million a year. I will assign a 12x multiple to this cash flow to get a value of $864 million. In addition, the Bitcoin the company holds would now be worth $63 million more. Adding these two elements to the base case valuation would result in equity value of $1,530 million or $9.60 per share. Thus, it is hard to get to even a $10 stock price on a fundamental level. For the nit-pickers, I will admit that there is an element of double-counting here, with the value of the property and equipment being added along with the cash flow value of the business. It provides a level of conservatism were Bitcoin to reach a higher level.

In a bear case, the company will get to November 2026 with Bitcoin in a bear market. It is unlikely that the company will be able to get the kind of generous debt deal it (and to be fair, many other companies) got during the Covid bull market. The problem for Marathon is that with inconsistent revenues dependent on a volatile Bitcoin price, no profits, and assets that barely cover its debt if they can be sold, rolling over the debt at any terms may prove to be challenging. In this case, the company would have to declare bankruptcy, with the equity being rendered worthless.

I recommend that investors sell any positions in MARA stock or short it. I see little fundamental risk in a short position, with big downside to fair value.

I would caution that the short interest is moderately high at 25% of float. The stock is not easy to borrow, with a cost that will depend on what your broker will charge, in the 5 to 10% a year range. A lower risk option would be to buy puts, at the $15 strike, while a lower cost option would be to sell calls and roll them over as they expire.

It is hard to identify definite catalysts, but an interest rate increase in July, followed by quantitative tightening as the Federal Reserve sells securities, could deflate the price of Bitcoin and related securities. In the case of Marathon, I would expect continued share sales from the company as well, particularly if the price of Bitcoin goes down below the cost of production.

External ratings

Seeking Alpha’s quantitative rating system gives MARA a composite rating of 3.4, equating to a hold, with a C- for valuation, C- for growth, F for profitability, and A+ for momentum. So if you’re a momentum investor, this article is not for you! Wall Street analysts have a buy, with a rating of 3.8. Their average price target appears to be $13, lower than the current market price, so they will need to either downgrade their ratings or increase their price targets to reflect the recent price action in the stock.

Upside risks are moderate

The main risk for any mid-cap company is acquisition risk. I think it’s unlikely that any unrelated company would want to get into the Bitcoin mining business and pay a premium for a miner. It is possible that a competitor like Riot Platforms (RIOT) may want to buy the company, but it is not much bigger.

On a fundamental basis, the company could become much more profitable than I have forecast by cutting costs and/or seeing the price of Bitcoin balloon.

Due to the higher than normal level of short interest, the chances of a short-covering rally are not insignificant.

The company could pivot its business model and become an AI firm!

Conclusion

Bitcoin mining is highly capital intensive, with elevated costs and no margins. Even with generous assumptions, there is downside in MARA stock. The company faces the risk of not being able to roll over its debt in three years if the price of Bitcoin falls.