As posted on the forum here on Saturday, I/O Fund has plans to initiate a position in Riot Blockchain. Below is a quick summary.
Despite Bitcoin miners’ troubled past with China throughout the years, China’s Central Bank is getting serious about its intent to shutdown cryptocurrencies in the country. In May, China banned financial institutions and payment companies from crypto-related services. In June, there were mass arrests in China of people suspected of using crypto in so-called illegal ways. In July, the Weibo, the Twitter of China, shutdown crypto-related accounts. There are many theories as to why China is moving quickly to shutdown Bitcoin mining, including to meet its climate goals. The more likely reason is to launch a digital Yuan stable coin
The result from these measures is that half the crypto mining world went offline in July. Notably, we are seeing a recovery in terms of TH/s.
Riot Blockchain is a company that offers an interesting hedge with Chinese tensions as the company facilitates bringing Bitcoin mining to the United States. During the crypto boom of 2018, China supplied 74% of the world’s bitcoin production. The crackdown creates a new market for locations like Texas, the only state in the continental United States that owns their own power grid.
In April, Riot signed an agreement to buy Whinstone’s Texas operations, the largest mining organization in North America, for $80 million in cash and 11.8 million shares of Riot stock for a total value of $651 million. The high-performance mining facility is based in Rockdale, Texas, with up to 750-megawatt of capacity after expansion in 2022. In the same month, Riot agreed to buy 42,000 mining machines from Bitmain Technologies, increasing Riot’s mining hash rate by 97%. From December 2019 to December 2020, Riot increased its hash rate by 461%.
RIOT Financials
By Bradley Cipriano
RIOT has yet to report Q2 results (it filed a late filing notice) so our financial analysis is based on Q1 figures which were released in May 2021. Q1 sales increased 872% YoY to $23 million, which missed topline estimates by 5% ($1 million). Gross margin increased 2,650 bps YOY to 68%, which was also above the prior quarter (Q4 2020) gross margin of 60%. Further down the income statement, Q1 EPS was positive at $0.09, but came in well below estimates of $0.20/share.
We are not too concerned with RIOT’s Q1 top and bottom-line misses because the firm is investing heavily right now for an anticipated acceleration in growth in the future. This is happening at an opportune time, as China recently banned bitcoin mining. This is a favorable trend for Riot, as bitcoin’s network hash rate has decreased in recent months, meaning it is relatively easier for RIOT to mine bitcoins. As a quick overview, if RIOT’s hash rate increases as a percentage of bitcoin’s total network hash rate, then RIOT will earn relatively more bitcoins going forward. This will also increase sales and earnings going forward.
Looking forward, analysts are expecting an acceleration in Riot’s sales. This is likely due to two main trends: 1) result of bitcoin’s decreased network hash rate and 2) Riot’s investments in capex. We believe that the robust forward growth rate is more of a function of capex (more bitcoin miners), as Riot has invested heavily in new bitcoin miners in recent months.
Riot is forecasting a material increase in its hash rate going forward. This is because Riot acquired Whinstone in May 2021. Whinstone is a 100-acre site in Rockdale Texas with 190k sq ft. of bitcoin mining hosting space, with another 60k sq ft of hosting space being built right now. This acquisition followed large investments in new bitcoin miners, and Riot will need a place to host them. Importantly, the scale of the new facility also significantly lowers Riot’s costs of electricity. Riot disclosed that its expected costs per kWh will be ~$0.025, which is nearly half of MARA’s costs of $0.045 per kWh at its new facility. This should be a significant advantage in the long run as Riot can operate more efficiently than its peers.
A risk going forward is that Bitcoin’s network hash rate increases going forward. Luckily, Riot invested early in new bitcoin miners and will start receiving the new equipment before the competition. This will allow Riot to reap the benefits of a subdued network hash rate before the competition. RIOT has spent $100 million in capex in the last twelve months, mostly on new mining equipment. Since manufacturers (i.e. Bitmain) require down payments ahead of deliveries, RIOT’s $100 million of capex (which are mostly prepayments on btc miners) will allow the company to receive its equipment faster than the competition.
As of Q1, Riot had 13,750 BTC miners deployed, but this number is expected to 4x by Q4 2022. For example, RIOT has the following outstanding purchase orders for new bitcoin miners:
· 25,400 btc miners (s19) to be delivered in monthly batches between Q1 2021 and October 2021
· 43,500 btc miners (s19) to be delivered in monthly batches between November 2021 and October 2022
This delivery schedule appears favorable to the competition, as MARA has purchase orders for 30,000 machines to be delivered in January 2022 through June 2022. Since bitcoin’s network hash rate is currently subdued due to the purge in Chinese miners, being first to market with new machines will be a significant advantage. This is because RIOT will be able to earn relatively more bitcoins with its new machines since the network hash rate will likely be lower in 2021 than in 2022. It should be noted, however, that MARA has order s19pro bitcoin miners. The pro version of s19 has a higher hash rate but is more expensive.
Given the scheduled deliveries of new bitcoin miners, we estimate that RIOT will have ~24,000 BTC miners deployed as of Q2. This is above the competition, as MARA had 20,000 miners deployed as of Q2. RIOT will also start receiving its next batch of orders in November 2021, or three-months before MARA starts receiving its orders. Furthermore, Riot is getting to market sooner, which we believe is a significant advantage given Bitcoin’s relatively low network hash rate.
Concerns:
While we believe that Riot is positioned well to benefit from bitcoin’s subdued hash rate, the company is not without issues. As mentioned above, RIOT has yet to report Q2 results and had to issue a late filling notice (NT10Q) as a result. The firm also reported a material weakness in its internal controls in its most 10K, which stated that the company had improper controls and a lack of segregation of duties. There has also been some management reshuffling recently, as the old CEO is now the CFO and the new CEO (as of February 2021) is just 35 years old. There is also a new COO as of April 2021. Generally, a late filing, a material weakness and management turnover can be signals that a company has low quality accounting.
We also note that RIOT is a significantly capital-intensive business, meaning that it needs to spend money on capex in order to grow sales. The company is also at the mercy of Bitmain, the Chinese bitcoin mining designer & manufacturer juggernaut. Given Bitmain’s market dominance, buyers of its miners must pay well in advance and received orders in batches. This places miners such as Riot at a disadvantage as they must pay upfront and wait months to receive their equipment, which negatively impacts ROI.
However, we do not believe that these concerns are significant at the moment. Riot made a material acquisition in Q1 which helps explain why it needs more time to file its Q2 results. The firm’s material weakness and management reshuffling are issues to watch going forward, but do not appear to be headwinds to future growth. While Riot is capital intensive, so are its competitors. This also provides a “moat” as it takes significant investments and time to build out industrial grade mining facilities.
Conclusion:
Riot is well positioned to benefit from two market trends: an increased bitcoin price and a decreased network hash rate. Riot had invested early in ordering new bitcoin miners and the company will be rewarded as it will receive the orders earlier than the competition. Given bitcoin’s subdued network hash rate, Riot will be able to mine more bitcoins as its hash rate grows faster than the competition. Riot’s costs of electricity is also half of MARA’s, which should helps further support Riot’s premium position over the competition. If Riot can continue to scale and report lower unit costs, it will likely outperform in the future.
*Updated 8/23/21