An In-Depth Look at MicroStrategy's Opportunities and Risks: Davis' Double Click and Double Kill
author:@Web3_Mario
Summary:Last week we discussedLido's potential to benefit from changes in the regulatory environmentI hope to help everyone seize this wave of Buy the Rumor trading opportunities. A very interesting topic this week was the popularity of MicroStrategy's microstrategy. Many seniors commented on the company's operating model. After digesting and thoroughly researching, I have some opinions of my own, which I hope to share with you. I think the reason for the rise in MicroStrategy's stock price is due to “Davis's double click”, the business design of purchasing BTC through financing, binding the value-added value of BTC to the company's profit, and the capital leverage obtained by combining innovative design of traditional financial market financing channels has enabled the company to surpass the profit growth brought about by the appreciation of BTC held by itself. At the same time, as its holdings expand, the company has a certain BTC pricing power, further strengthening this profit growth expectation. The risk also lies in this. When the BTC market fluctuates or is at risk of reversal, BTC's profit growth will stagnate. At the same time, MicroStrategy's financing capacity will be greatly reduced due to the company's operating expenses and debt pressure, which in turn will affect profit growth expectations. At that time, unless new help can take over and further boost the BTC price, the positive premium of MSTR's stock price over BTC holdings will quickly subside. This process is also known as the “Davis Double Kill.”
What is Davis' double click and double kill
Friends familiar with me should know that the author is committed to helping more non-financial professionals understand these developments, so I will replay my own logic of thought. So first, let's add some basic knowledge about what “Davis double click” and “double kill” are.
The so-called “Davis Double Play” (Davis Double Play) was proposed by investment guru Clifford Davis (Clifford Davis), and is commonly used to describe the phenomenon of a company experiencing a sharp rise in stock prices due to two factors in a favorable economic environment. These two factors are:
l Company profit growth: The company achieved strong profit growth, or optimization of its business model, management, etc., which led to an increase in profits.
l Valuation expansion: As the market is more optimistic about the company's prospects, investors are willing to pay a higher price for it, thereby boosting stock valuations. In other words, valuation multiples such as the price-earnings ratio (P/E ratio) of stocks expand.
The specific logic driving “Davis Double Click” is as follows. First, the company's performance has exceeded expectations, and both revenue and profits are growing. For example, good product sales, increased market share, or successful cost control will directly lead to the company's profit growth. At the same time, this growth will also increase the market's confidence in the company's future prospects, leading investors to accept a higher P/E ratio, pay higher prices for stocks, and begin to expand in valuations. This positive feedback effect of a combination of linearity and index usually causes stock prices to rise at an accelerated pace, the so-called “Davis double hit.”
To illustrate this process, let's say a company's current price-earnings ratio is 15 times, and its future profit is expected to increase by 30%. If investors are willing to pay 18 times the price-earnings ratio due to an increase in the company's profits and changes in market sentiment, then even if the profit growth rate does not change, an increase in valuation will drive the stock price to rise sharply, such as:
l Current stock price: $100
l Earnings increased by 30%, which meant that earnings per share (EPS) increased from $5 to $6.5.
l The price-earnings ratio increased from 15 to 18.
l New share price: $6.5 × 18 = $117
The share price rose from $100 to $117, reflecting the dual effects of increased earnings and increased valuation.
“Davis Double Kill”, on the other hand, is the opposite. It is commonly used to describe the rapid decline in stock prices due to the combined effects of two negative factors. The two negative factors are:
l Decline in the company's profit: The decline in the company's profitability may be due to factors such as reduced revenue, rising costs, and management errors, resulting in lower profits than market expectations.
l Valuation contraction: Due to declining profits or poor market prospects, investors' confidence in the future of the company declined, leading to a decline in its valuation multiples (such as price-earnings ratio) and a decline in stock prices.
The whole logic is as follows. First, the company failed to achieve the expected profit target or faced operational difficulties, leading to poor performance and declining profits. However, this will further worsen the market's expectations for the future. Investors have insufficient confidence, are unwilling to accept the current overestimated price-earnings ratio, and are only willing to pay a lower price for the stock, leading to a drop in valuation multiples and a further drop in stock prices.
Another example to illustrate this process. Assuming that a company's current price-earnings ratio is 15 times, its future profit is expected to drop 20%. As earnings declined, the market began to have doubts about the company's prospects, and investors began to reduce its price-earnings ratio. For example, reduce the price-earnings ratio from 15 to 12. Stock prices may drop significantly as a result, for example:
l Current stock price: $100
l Earnings fell 20%, which meant that earnings per share (EPS) fell from $5 to $4.
l The price-earnings ratio was reduced from 15 to 12.
l New share price: $4 × 12 = $48
The stock price fell from $100 to $48, reflecting the dual effects of declining profits and shrinking valuations.
This resonance effect usually occurs in high-growth stocks, especially in many technology stocks, because investors are usually willing to give high expectations for the future growth of these companies' business, yet this kind of expectation is usually supported by large subjective factors, so the corresponding volatility is also high.
How did MSTR's high premium come about, and why is it the core of its business model
After adding this background knowledge, I think everyone should be able to roughly understand how MSTR's high premium compared to its BTC holdings came about. First, MicroStrategy switched its business from a traditional software business to financing the purchase of BTC. Of course, it is not ruled out that there will be corresponding asset management revenue in the future. This means that the company's profit comes from capital gains added to the value of BTC purchased through capital gains obtained by diluting shares and issuing bonds. As BTC increases in value, all investors' shareholders' equity will increase accordingly, and investors will benefit as a result. MSTR is no different from other BTC ETFs in this respect.
The difference is that its financing capacity has a leverage effect, because MSTR investors' expectations for the company's future profit growth are leveraged gains obtained from an increase in its financing capacity, considering that the total market value of MSTR's stock is in a positive premium state compared to the total value of BTC it holds, which means that the total market value of MSTR is higher than the total value of BTC it holds. As long as it is in this positive premium state, regardless of equity financing and its convertible bond financing, the equity per share will be further increased as the capital obtained is purchased in BTC. This gives MSTR the ability to increase earnings unlike BTC ETFs.
As an example, let's say MSTR currently holds $40 billion in BTC, with total tradable shares X, and its total market value is Y. At this point, the equity per share is 40 billion/X. If financing is carried out using the most unfavorable equity dilution, assuming that the ratio of new shares issued is a, this means that the total tradable shares become X* (a+1), and the financing is completed at the current valuation, and a total of A* Y billion US dollars has been raised. Converting all of these funds to BTC changes from BTC holdings to 40 billion + A*Y billion, which means that the equity per share becomes:
We subtract it from the original equity per share to calculate the growth of diluted equity in equity per share, as follows:
This means that when Y is greater than 40 billion dollars, that is, the value of BTC held, that is, when there is a positive premium, the equity growth per share brought about by completing the financing purchase of BTC is always greater than 0, and the larger the positive premium, the higher the equity growth rate. The two are called a linear relationship, and the effect of the dilution ratio a shows an inversely proportional characteristic in the first quadrant. This means that the fewer additional shares are issued, the higher the equity growth rate.
Therefore, for Michael Saylor, the positive premium on the value of MSTR's market value and the BTC value it holds is a core factor in the establishment of its business model, so his best choice is how to maintain this premium while continuing to finance, increase his market share, and gain more pricing power over BTC. Meanwhile, increasing pricing power will also enhance investors' confidence in future growth in the face of high price-earnings ratios, so that they can complete fund-raising.
To sum up, the mystery of MicroStrategy's business model is that the appreciation of BTC drives up the company's profits, and a positive BTC growth trend means that the corporate profit growth trend is improving. With the support of such a “double hit by Davis,” MSTR's positive premium began to expand, so what the market is at is how high a positive premium valuation can be used to complete subsequent financing.
What risks does MicroStrategy pose to the industry
Next, let's talk about the risks MicroStrategy poses to the industry. I think the core of this is that this business model will significantly increase the volatility of BTC prices and act as an amplifier of fluctuations. The reason for this is the “Davis double kill,” and BTC entering a period of high volatility is the beginning of the entire domino game.
Let's imagine that when BTC's growth slows down and enters a period of turbulence, MicroStrategy's profit inevitably begins to decline. I would like to expand on the following. I see that some friends value its holding costs and floating profit scale very much. This is meaningless. The reason is that in MicroStrategy's business model, profits are transparent and are equivalent to real-time settlement. In the traditional stock market, we know that the real factor that causes stock price fluctuations is financial reports. Only when quarterly earnings are announced can their actual profit level be confirmed by the market. In the meantime, investors only estimate changes in financial conditions based on some external information. In other words, most of the time, the stock price reaction lags behind the actual changes in the company's earnings, and this lag relationship is corrected when the quarterly earnings report is released. However, in MicroStrategy's business model, since the size of its holdings and the price of BTC are public information, investors can understand its actual profit level in real time, and there is no lag effect, because the equity per share changes dynamically, which is equivalent to real-time profit settlement. Since this is the case, the stock price already reflects all of its profits, and there is no lag effect, so there is no point in focusing on its holding costs.
Bringing back to the topic, let's take a look at how the “Davis Double Kill” unfolded. As BTC growth slows down and enters the oscillation phase, MicroStrategy's profit will continue to decline or even return to zero. At this time, fixed operating costs and financing costs will further reduce corporate profits, or even lose money. At this point, this kind of shock will continue to wear down the market's confidence in the subsequent development of BTC prices. This will translate into questions about MicroStrategy's ability to finance, further dampening expectations of its profit growth. Under the resonance of the two, MSTR's positive premium will quickly subside. And in order to maintain the establishment of its business model, Michael Saylor must maintain a positive premium. Therefore, buying back shares by selling BTC in exchange for funds is a necessary operation, and this is when MicroStrategy began selling its first BTC.
If some friends want to ask, why don't you just hold BTC and let the stock fall naturally. My answer is no. More accurately, no when the BTC price reverses; it can be tolerated properly when the price of BTC fluctuates. The reason is MicroStrategy's current shareholding structure and what is the best solution for Michael Saylor.
According to MicroStrategy's current shareholding ratio, there is no shortage of top financial groups, such as Jane Street and BlackRock, and the founder, Michael Saylor only accounts for less than 10%. Of course, through the two-tier shareholding design, Michael Saylor has an absolute advantage in voting power because it holds more Class B common shares, and the voting rights for Class B common shares are in a 10:1 relationship. Therefore, the company is still under the strong control of Michael Saylor, but its share of shares is not high.
This means that for Michael Saylor, the company's long-term value is far greater than the value of the BTC it holds, because assuming the company faces bankruptcy and liquidation, it won't be able to obtain much BTC.
So what are the benefits of selling BTC during the volatile phase and buying back stocks to maintain the premium. The answer is also obvious. When premiums converge, assuming Michael Saylor determines that MSTR's price-earnings ratio is undervalued due to panic at this time, then selling BTC in exchange for funds and buying back MSTR from the market is a cost-effective operation. Therefore, the effect of repurchases at this time on reducing circulation and increasing equity per share will be higher than the effect of reducing BTC reserves and reducing equity per share. When the panic is over, the share price pulls back, and the equity per share will become higher as a result, which is conducive to subsequent development. This effect is easier to understand in extreme situations where the BTC trend reverses and when MSTR has a negative premium.
However, considering Michael Saylor's current holdings, and when there is a fluctuation or downward cycle, liquidity is usually tightened, then when it starts to sell off, the decline in the price of BTC will accelerate. However, the acceleration of the decline will further worsen investors' expectations for MicroStrategy's profit growth, and the premium rate will drop further, and this will force it to sell BTC to buy back MSTR. At this point, the “Davis Double Kill” begins.
Of course, another reason that forced it to sell BTC to maintain its share price is that the investors behind it are a group of deep states with full control. It is impossible to watch the stock price return to zero and remain indifferent, which will inevitably put pressure on Michael Saylor to assume responsibility for managing its market value. Furthermore, recent information shows that with the continuous dilution of shares, Michael Saylor's voting power is already less than 50%. Of course, no specific sources have been found. But this trend seems inevitable.
Are MicroStrategy's convertible bonds really risk-free before maturity
After the discussion above, I think I've fully explained my logic. Also, I would like to discuss the topic of whether MicroStrategy has no debt risk in the short term. A senior already introduced the nature of MicroStrategy's convertible bonds, so I'm not going to discuss it here. It is true that its debt has been around for quite a long time. There is really no risk of payment until the due date. However, my opinion is that its debt risk may still be fed back in advance through stock prices.
A convertible bond issued by MicroStrategy is essentially a bond with free call options. At maturity, creditors can request MicroStrategy to redeem at the same value as a previously agreed conversion rate stock, but there is also protection for MicroStrategy. That is, MicroStrategy can actively choose the redemption method and use cash, stocks, or a combination of the two, which is relatively flexible. If you have sufficient funds, you can repay more cash to avoid stock dilution. If you don't have enough capital, then you can buy more stocks, and this convertible bond is unsecured, so it's true that the risk of debt repayment is not too great. Moreover, there is another protection for MicroStrategy, that is, the premium rate exceeds 130%, and MicroStrategy can also choose to redeem the original value directly in cash, which creates conditions for loan renewal negotiations.
Therefore, creditors of this bond will only have capital gains if the stock price is higher than the conversion price and 130% below the conversion price. Other than that, only the principal amount plus lower interest. Of course, after being reminded by Mr. Mindao, investors in this bond mainly use hedge funds to do delta hedging and earn returns on volatility. So I thought about the logic behind it in detail.
The specific operation of delta hedging through convertible bonds is mainly by purchasing MSTR convertible bonds and shorting an equal amount of MSTR shares to hedge the risks caused by stock price fluctuations. Moreover, along with subsequent price developments, hedge funds need to continuously adjust positions for dynamic hedging. Dynamic hedging, on the other hand, usually has the following two scenarios:
l When MSTR shares fall, the delta value of convertible bonds decreases because the bond's conversion rights become less valuable (closer to “false value”). At this point, more MSTR shares need to be shorted to match the new Delta value.
l When the MSTR stock price rises, the Delta value of convertible bonds increases because the conversion power of the bond becomes more valuable (closer to the “real value”). Then, at this point, the hedging nature of the combination is maintained by buying back some of the previously shorted MSTR shares to match the new Delta value.
Dynamic hedging requires frequent adjustments in the following situations:
l Significant fluctuations in the underlying stock price: for example, a drastic change in the price of Bitcoin causes MSTR's stock price to fluctuate sharply.
l Changes in market conditions: such as volatility, interest rates, or other external factors influence the convertible bond pricing model.
l Normally, the hedging foundation triggers operations based on the magnitude of the change in Delta (such as 0.01 per change) to maintain accurate hedging of the combination.
Let's take a specific scenario to illustrate. Assuming the initial position of a hedge fund is as follows
l Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).
l Shorted $6 million worth of MSTR shares.
When the stock price rises from $100 to $110, the delta value of convertible bonds changes to 0.65, then the stock position needs to be adjusted at this time.
The calculation is the number of shares to be recovered (0.65−0.6) x 10 million = 500,000. The specific operation was to buy back 500,000 US dollars of shares.
However, when the stock price falls back from $100 to $95, the new delta value of convertible bonds changes to 0.55, and the stock position needs to be adjusted.
The calculation requires additional short stocks (0.6−0.55) x 10 million = 500,000. The specific operation was to short sell the stock for $500,000.
This means that when the price of MSTR falls, the hedge fund behind its convertible bonds will short more MSTR shares in order to dynamically hedge Delta, thereby further impacting MSTR's stock price, and this will have a negative impact on the positive premium, which in turn affects the entire business model. Therefore, the risk on the bond side is that it will feed back early through the stock price. Of course, in the upward trend of MSTR, hedge funds are buying more MSTR, so it is also a double-edged sword.
