As Bitcoin (BTC 2.44%) hovers around $50,000 and news stories circulate about the millionaires it has created, it's hard not to experience the fear of missing out. As investors try to catch up, it can be hard to understand the difference between the digital currency and some of the companies that seemingly benefit every time it rises. That's why I set out to answer a fundamental question about one of those companies, Riot Blockchain (RIOT 0.64%). Why would an investor buy shares of this volatile cryptocurrency mining company instead of just buying Bitcoin itself?
What is Riot Blockchain?
Through the years, the company has transformed from its 2002 IPO as AspenBio Pharma, when management expected to market an antigen pregnancy test for bovines, to human diagnostics, calling the company Venaxis, and then Bioptix, after an acquisition. In late 2017, the company would pivot to crypotocurrency, changing the name to Riot Blockchain. Riot now aims to be one of the largest and lowest-cost producers of Bitcoin in North America. Management made the decision to focus exclusively on Bitcoin mining early last year and promoted former professional poker player and early Bitcoin miner Jason Les from the board of directors to the CEO office this February.
Image source: Getty Images.
Its cryptocurrency journey began in 2017 with a series of acquisitions that netted it 8,000 miners, hardware specially designed for acquiring the digital currency. By the end of 2018, the price of Bitcoin had fallen and the company was forced to take a $27 million impairment charge for the machines. By the end of 2019, shares of Riot were down 96% from the all-time high. As Bitcoin has surged over the past year, so has Riot. And the company is doubling down by purchasing a new batch of Bitcoin mining hardware.
How does Riot make money?
Like any other miner, the company turns a profit by proverbially digging up something valuable for a lower cost than it can sell it on the open market. For cryptocurrency mining, getting coins is a function of computing power measured in hash rate. A hash is just a fixed-length alphanumeric code that represents information. For instance, The Motley Fool is represented as: F077a993efeced647f83e9dee3aa75618dc7e7cdd97a0872e675290c9f7ab8e3. As the computers solve complex mathematical problems, they generate hashes and the first one that guesses the hash correctly gets the reward, or block. To win the block requires incredible computing power. Recently, Riot exceeded one exahash per second. For context, that is a quintillion, or a one with 18 zeroes behind it.
To that end, Riot has been buying up the latest hardware for mining Bitcoin, called Antminers. Management plans to have more than 37,000 of these machines deployed by the end of the year. With all that power, you would expect a drastic increase in the number of Bitcoins mined, but the creator of Bitcoin had a plan for that. The rate of Bitcoins mined continues to slow over time. For every 210,000 coins that are minted, the rate of newly minted coins gets cut in half. That last happened in May, when the reward for miners was cut from 12.5 Bitcoins to 6.25 for each block.
That means the company is trapped in an arms race of computing power to gather something at a perpetually decreasing rate. As an example, Riot only mined 730 Bitcoin through the first nine months of 2020 compared to 803 during the same period of 2019, despite increased mining power. The company's data also shows the hash rate increases linearly with the number of Antminers deployed.
| Month | Antminers | Hash Rate | Antminer Increase | Hash Rate Increase |
|---|---|---|---|---|
| October 2021* | 37,642 | 3.8 EH/s | 226% | 258% |
| February 2021 | 11,542 | 1.06 EH/s | 21% | 26% |
| January 2021 | 9,540 | 842 PH/s | N/A | N/A |
Data source: Riot Blockchain, author's calculations. *Projected
This means that as Bitcoin gets harder to mine, management will be forced to purchase the next generation of hardware to keep gathering fewer Bitcoins, and the rate of accumulation won't increase if it buys 10,000 Antminers instead of 1,000. All of these issues work themselves out as long as the price of Bitcoin continues to rise, but that's a big variable.
What's in it for investors?
That brings us to the question of why someone might buy shares of Riot Blockchain instead of just logging on to Robinhood or Square's Cash App and purchasing Bitcoin. The answer seems to be leverage. Above a certain price, every dollar increase in Bitcoin's price will flow directly to Riot's bottom line.
This is evident in the company's margin -- what it defines as revenue from cryptocurrency mining in excess of mining costs. Through the first three quarters of 2020, the margin was 38.2%, compared to 18.5% for the same period in 2019. It is notable that this metric excludes depreciation of purchased hardware, a cost that history might show is closer to an operating expense than a fixed asset. Setting that aside, and adjusting for one-time events, we can see how the company climbed toward profitability last year as the price of mined Bitcoins increased.
| Metric | First Nine Months of 2020 | First Nine Months of 2019 |
|---|---|---|
| Bitcoins mined | 730 | 803 |
| Average Bitcoin value | $9,064 | $6,434 |
| Revenue | $6.7 million | $5.6 million |
| Mining margin | 38.2% | 18.5% |
| Adjusted net loss | ($8.5 million) | ($16.6 million) |
| Adjusted net margin | (127%) | (296%) |
Data source: Riot Blockchain.
Adjusting revenue for the average price of Bitcoin during the fourth quarter (around $19,000), we can calculate that Riot would have had breakeven operations, a net profit close to $0. Since Bitcoin has averaged about $40,000 so far during the first quarter, and more Antiminers were deployed, it isn't hard to imagine a windfall of profits.
It's an extra $21,000 per Bitcoin that flows straight to the bottom line. Of course, since Bitcoin gets harder to mine over time, the math only works when the price of Bitcoin is rising. If it stagnates or drops, the company quickly becomes unprofitable and shares will collapse, as they did in 2018.
A few caveats
Aside from the price of Bitcoin, there are several risks to consider before buying shares. First, since the beginning of 2018, insider ownership has dropped from 40% of shares to less than 8%. One of the reasons for this is share issuance. Over that same period, the company has funded itself by issuing equity. In fact, there are nearly five times more shares now than there were at the beginning of 2018. Shares outstanding have more than doubled in the past year, meaning each share of stock is entitled to less than half of the share of Bitcoins mined than it was last year.
Shareholders aren't concerned with the dilution because the average holding period -- calculated by dividing the shares outstanding by the average daily volume -- is two days. You read that correctly. The average Riot Blockchain share is held for two days after purchase. Behavior like that is the hallmark of speculation and illustrates a disregard for any future stream of profits or cash flow.
Finally, the company identified three material weaknesses in its internal financial reporting related to access and accuracy of data. I wouldn't call these red flags, but it's something to keep an eye on since the company is only followed by one analyst and doesn't hold earnings conference calls.
Despite how entertaining the company's story is, and despite the allure of a leveraged way to profit from Bitcoin, I won't be buying shares of Riot Blockchain. My belief that the company is trapped in a never-ending arms race for an asset that is programmed to become more difficult to obtain leads me to believe that long-term success relies on the price of Bitcoin to continue rising in a straight line. Even if that happens, shareholders will continue to get diluted as management upgrades hardware. With an average holding period of two days, I can see why others aren't worried about that.
