Notice on rectangular yellow board announcing about toxic and dangerous area against dirty river


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Stronghold Digital Mining (NASDAQ:SDIG) has been through the wringer. The bitcoin miner’s October IPO was priced at $19 a share, and it rose to over $35 at the height of last year’s tech enthusiasm before an epic decline – to just $2 a share!

A series of headwinds blew, and the stock was put in its place. However, at this point, I believe the company is oversold and deep in value territory, being at a ~50% discount to net asset value (NAV). From here, the company represents a powerful option on bitcoin mining with multibagger potential.

An environmentally beneficial bitcoin miner

The company’s purpose is to remove coal refuse piles in Pennsylvania that are polluting the environment. William Spence, the Co-Chairman, has made it his life’s work to clean up this pollution after he and several members of his family suffered from cancer that he attributes to carcinogens from the coal refuse piles in the community in which he grew up.

Coal mining at a large scale in Pennsylvania dates back to the 19th century where it fuelled America’s industrial revolution and built the country with its steel. It was not until 1977 that coal refuse became more strictly regulated, so, today, there still exist many decades’ worth of polluting coal piles in and around the state: it is estimated that, in Pennsylvania, there are 840 coal refuse sites, covering 9,000 acres, filled by 220 million tons of coal refuse.

These coal piles cause severe environmental harm, including polluting waterways with iron oxide, aluminium, manganese and sulfate residues. The contamination causes streams and lakes to be devoid of aquatic life. They emit particulates that pose risks to human health. The piles can also ignite, posing immediate danger to local communities.

In order to properly dispose of the coal piles, the material must be burnt, which produces the usual coal emissions including carbon dioxide, nitrogen oxide, sulfur dioxide and particulates. However, the piles are gradually decomposing and leaking into the atmosphere in any case – burning the material in a controlled way is preferable to the metals contaminating the groundwater and the fire risks to local communities. Coal refuse is therefore classified as a Tier II Alternative Energy Source in Pennsylvania.

Operations

The company’s main operating segments are power generation and bitcoin mining.

Stronghold Digital Mining owns and operates two low-cost coal refuse power generation facilities in Pennsylvania, Scrubgrass and Panther Creek, with a combined capacity of 165 megawatts of electricity. The power generation revenue breaks down into capacity revenue, where the company receives a regular payment for committing to supply the grid at times of peak need (typically a few days per year), and general energy revenue where Stronghold opts to sell power into the grid.

The most economic use of the power at current prices, however, in order to fund the clean-up project and generate a profit, is to use it to mine bitcoin. The company has built out its own datacentres, equipped with 32,800 miners in total, split between its two power plants. Stronghold claims, by virtue of having its own power source, to be able to produce bitcoin at one of the lowest prices among its peers (for less than 2 cents/KWh according to CEO Greg Beard on the Around The Coin podcast).

The vertical integration benefits of the company are underappreciated by the market. Since forward grid power prices have recently appreciated, Stronghold’s average price for selling power into the grid for the next 12 months is $100 per megawatt (MW). This power price implies the same revenue as mining bitcoin at $22,000. So the company effectively has a floor on bitcoin price of $22,000 over the next year.

In addition to this downside protection, even if bitcoin stays above $22,000, Stronghold is able to increase its revenue by switching power to the grid at certain times when the grid price is higher than $100/MW. This operation, along with its capacity contract, also has the effect of stabilising the grid.

The company’s total mining hash rate capacity has grown from 1.3 exahash per second (EH/s) at the end of 2021 to 3.0 EH/s by 12 May 2022. It is guiding to 4.3 EH/s by the end of this year. The actual installed capacity is 2.3 EH/s as of 12 May, which is about 1% of the global bitcoin hashrate.

Headwinds

Since the bitcoin price has come down, along with a broad technology selloff this year, bitcoin miners have significantly underperformed bitcoin. However, what brought SDIG down from $10 to $5 at the end of March / early April was the company’s announcement that one of its suppliers, MinerVa, had failed to deliver 11,700 miners of the 15,000 that were expected from the supplier by the end of 2021. This caused an estimated $30-35m loss in revenue through to March 2022 and a downward revision in expected growth of hashrate for the year. The missing miners represent ~11% of Stronghold’s current hashrate capacity and are forecast to make up under 6% by year end. Stronghold says it is evaluating all available options under its purchase agreement with MinerVa.

Following on from this and the crash of the stock as a result, some investors then launched a class action lawsuit against the company, alleging that “the IPO Registration Statement was materially false and misleading”, as it omitted that “contracted suppliers… were reasonably likely to miss delivery deadlines” and that, therefore, shareholders could experience significant losses.

This, the general tech selloff and the fall in bitcoin price in April and May then brought the stock all the way down to $2 a share.

Market cap

The market cap of the company is $102m at the close on 16 May.

The share count and market cap are often misreported, including on Yahoo Finance and even in a Seeking Alpha article. The Q1 earnings presentation quotes the correct share count of 48.2 million. The misreporting is due to there being two classes of shares: Class A and Class V. Class A common stock is listed on the Nasdaq as SDIG and there are 20 million A shares. The 28.2 million Class V shares are voting shares owned by insiders and are not listed on an exchange; they do not have economic rights. However, what can be missed is that, for every Class V share, there is a corresponding Class A share. I confirmed this with investor relations by email.

The 48.2m shares multiplied by the share price of $2.11 results in a market cap of $102m.

Net assets

We see on the balance sheet that the net asset value, as reported, is $213m, which makes the market cap 48% of the company’s net asset value. The assets total $372 million, including $25m cash, $5m bitcoin, $100 million equipment deposits, and $220 million property, plant and equipment. Total liabilities are $158m including $108m of debt.

The equipment deposits alone are worth the market cap of the company! In addition, the two power generation assets could be worth more than their reported value on the balance sheet. In the 2021 annual report, the company states:

“Due to the specialized nature of coal refuse power generation facilities that utilize CFB technology, we estimate the replacement cost for an electricity generation facility utilizing this technology that operates on the scale of our Scrubgrass Plant would be approximately $500 million.”

Earnings & growth

In terms of the expected earnings, there is a slide in the Q1 2022 investor presentation which illustrates the calculation:

Stronghold Digital Mining Earnings drivers

Stronghold Digital Mining

For the first quarter 2022, total operating revenues were $28.7m, which breaks down to: energy ($8.4m), capacity ($2.0m), bitcoin mining ($18.2m), and $89,000 for hosting and “other”.

During this quarter, Stronghold only averaged a hashrate of 0.9 EH/s. After rapidly building out their datacentres so far this year, they now have an installed capacity of 2.3 EH/s out of a total capacity of 3.0.

The global hashrate is 225 EH/s as of 15 May 2022, giving Stronghold approximately 1% of the global hashrate.

Revenue at 2.3 EH/s and $30,000 bitcoin

The annual revenue calculation for 2.3 EH/s and $30,000 bitcoin is as follows (please refer to the infographic above):

2.3 / 225 x 30,000 x 6.25 x 52560 = $100.7m revenue from bitcoin mining.

In addition, we can add the energy and capacity revenue: $8.4m + 2.0m = $10.4m/ quarter = $41.6m/ year.

Total revenue then = $142m.

Revenue at 3.3 EH/s and $60,000 bitcoin

The same calculation, replacing the exahash and bitcoin price with 3.3 and $60,000, we get $289m revenue from bitcoin mining alone.

Expenses

In Q1 2022, we saw $58.3m of operating expenses – of which, for the purpose of projections, we can remove the $12.2m impairment on equipment deposits as this is a one-time impairment of the undelivered MinerVa miners. Therefore, we’ll use $46.1m for operating expenses (which includes depreciation and amortization) and add the $2.7m “other” expenses on the income statement (including interest expense). This comes to $48.8m a quarter, or $195m/ year of expenses.

Free cash flow

This means, therefore, on the 2.3 EH/s and $30,000 bitcoin, we’d be looking at a loss of around $53m on an annualised basis. However, this is roughly the amount of depreciation and amortization, so we would be basically breaking even – without covering the mining equipment already paid for.

2023 is potentially a different story. At numbers of 1.5% of the global hashrate (3.3 EH/s today) and ~$60,000 average bitcoin price, we can see how it’s possible for the company to make today’s entire market cap in free cash flow in one year.

Price targets

Comparing Stronghold to competitors of a similar hashrate, including Riot Blockchain (RIOT), Bitfarms (BITF) and Hut 8 (HUT), we see they are valued at several times SDIG per EH/s.

Further, it’s interesting to see the six Wall Street analysts covering the stock all rate it a strong buy – with a low price target of $10 and a high of $26.

A $10 price target seems more realistic in today’s depressed market as a multiple of 2023 earnings (~5x a strong year’s free cash flow). My low target would be the NAV of ~$5 a share.

Risks

Decline in bitcoin price, short term

The most obvious risk is the price of bitcoin. A sustained decline in the bitcoin price below $22,000 over the next year would mean the company would opt to sell energy into the grid instead of mining bitcoin. While this is a big advantage over peers and offers some downside protection, the company would still be likely to make a loss.

Prolonged decline in bitcoin price

A prolonged slump in the price of bitcoin will curb the company’s growth ambitions for longer – indeed, this has already happened. As explained on the Q1 earnings call, the company is not now in the market for miners beyond what is already on order and does not expect an acquisition of a third plant will occur in the short term (although this is the plan longer term). As for the impact on the share price, the company is already being valued, in terms of NAV and cash flow multiples, below how an average power generation business is valued. This should provide some protection from here on the share price over the medium term.

Missing capacity guidance

The company missing its guidance for 4.1 EH/s of total capacity at year end could reduce the upside in the case of strong bitcoin pricing next year, although I’ve made my assumptions based on 3.3 EH/s of installed capacity.

Rising rate environment

The macro environment of rising interest rates could affect the company’s access to future funding. However, the company has just raised a further $33.8m (on 15 May) from issuing notes with a 10% coupon which convert to preferred equity if the company’s market cap exceeds $400m by 30 September. Management stated in the Q1 earnings call that the company does not need additional financing to fund operations. They intend to grow from here using free cash flow.

Class action lawsuit

The class action lawsuit in connection to perceived investor losses suffered from the MinerVa missed deliveries could present further risks – if the company loses or has to pay extensive legal bills.

Please see the extensive Risk Factors section in the annual report for further information on risks.

Conclusion

While an investment in SDIG presents risks, I believe at this point the upside far outweighs the downside. Buying the company at ~50% of NAV gives us a margin of safety on the assets. If the company were to liquidate, in theory the proceeds should be worth significantly more than today’s market cap. Of course, it is quite possible for the company to destroy value by uneconomic operations in the case of a low bitcoin price.

However, what we see is a business with a mission and a strong management team absolutely committed to ensuring its success. They are clearly dedicated to the long-term, environmentally beneficial purpose of the company, which means they will do everything they can to ensure it survives a downturn in bitcoin price. Having the option to sell electricity into the grid is a huge plus that gives them an advantage over peers, increases revenue and offers downside protection for the business.

On the upside, we can easily see how the stock can be worth $5-$10 a share. From here, the company is a power generation business with a massive option on bitcoin. If bitcoin were to go to $70,000-$100,000, it could be a $20 stock.



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