Author:@Web3_Mario
Summary:Last week we discussed the potential forLidoto benefit from changes in the regulatory environment, hoping to help everyone seize thisBuy the rumortrading opportunity. This week we have an interesting topic, which is the heat ofMicroStrategy, and many seniors have commented on the operation mode of this company. After digesting and delving into it, I have some of my own views, which I hope to share with you. I think the reason for the rise inMicroStrategystock price is the "Davis double play", through the business design of financing to purchaseBTC, which binds the appreciation ofBTCto the company's profitability, and the innovative design of combining traditional financial market financing channels to obtain financial leverage, which gives the company the ability to grow its profits beyond the appreciation of its ownBTCholdings, and as the holding volume expands, the company also has a certain pricing power overBTC, further strengthening this profit growth expectation. However, the risk also lies in this, when theBTCmarket experiences volatility or reversal risk,BTCprofit growth will stagnate, and at the same time affected by the company's operating expenses and debt pressure,MicroStrategy's financing capacity will be greatly discounted, which will affect the profit growth expectation, at which time unless there is new support to further push up theBTCprice, the premium ofMSTRstock price relative toBTCholdings will converge rapidly, which is the so-called "Davis double kill".
What is the Davis Double Play and Double Kill
Those familiar with me should know that I am committed to helping more non-financial friends understand these dynamics, so I will replay my own thinking logic. Therefore, let's first supplement some basic knowledge, what is the "Davis Double Play" and "Double Kill".
The so-called "Davis Double Play" (Davis Double Play) was proposed by investment master Clifton Davis, and is usually used to describe the phenomenon of a significant increase in a company's stock price due to two factors in a good economic environment. These two factors are:
l Company profit growth: The company has achieved strong profit growth, or its business model, management team and other aspects have been optimized, leading to increased profits.
l Valuation expansion: Due to the market's more optimistic outlook on the company's prospects, investors are willing to pay a higher price for it, thereby driving up the stock's valuation. That is, the stock's price-to-earnings (P/E Ratio) and other valuation multiples expand.
The specific logic that drives the "Davis Double Play" is as follows. First, the company's performance exceeds expectations, with both revenue and profits growing. For example, good product sales, market share expansion or successful cost control, these will directly lead to the company's profit growth. And this growth will also strengthen the market's confidence in the company's future prospects, causing investors to be willing to accept a higher P/E ratio, paying a higher price for the stock, and the valuation begins to expand. This linear and exponential positive feedback effect often leads to an accelerated rise in the stock price, which is the so-called "Davis Double Play".
To illustrate this process, let's assume that a company's current P/E ratio is 15 times, and its future earnings are expected to grow by 30%. If, due to the company's profit growth and changes in market sentiment, investors are willing to pay a P/E ratio of 18 times, then even if the growth rate remains unchanged, the increase in valuation will drive a significant increase in the stock price, for example:
l Current stock price: $100
l Earnings growth of 30%, meaning earnings per share (EPS) increase from $5 to $6.5.
l P/E ratio increases from 15 to 18.
l New stock price: $6.5 × 18 = $117
The stock price has risen from $100 to $117, reflecting the dual effect of profit growth and valuation expansion.
The "Davis Double Kill", on the other hand, is the opposite, usually used to describe the rapid decline in stock price under the joint action of two negative factors. These two negative factors are:
l Decline in company profits: The company's profitability declines, which may be due to factors such as reduced revenue, increased costs, or management mistakes, leading to profits below market expectations.
l Valuation contraction: Due to the decline in profits or the deterioration of the market outlook, investors' confidence in the company's future declines, leading to a decline in its valuation multiples (such as P/E ratio), and the stock price declines.
The overall logic is as follows. First, the company fails to meet its expected profit targets, or faces operational difficulties, resulting in poor performance and declining profits. This will further worsen the market's expectations for its future, and investors' confidence will be insufficient, unwilling to accept the currently high P/E ratio, only willing to pay a lower price for the stock, leading to a decline in the valuation multiple and a further decline in the stock price.
Again, let's use an example to illustrate this process. Assume that a company's current P/E ratio is 15 times, and its future earnings are expected to decline by 20%. Due to the decline in earnings, the market begins to doubt the company's prospects, and investors begin to lower its P/E ratio. For example, reducing the P/E ratio from 15 to 12. The stock price may plummet significantly as a result, for example:
l Current stock price: $100
l Earnings decline by 20%, meaning earnings per share (EPS) decrease from $5 to $4.
l P/E ratio decreases from 15 to 12.
l New stock price: $4 × 12 = $48
The stock price has fallen from $100 to $48, reflecting the dual effect of declining earnings and contracting valuation.
This resonance effect often occurs in high-growth stocks, especially in many tech stocks, because investors are usually willing to give these companies a higher expected future growth, but this expectation is often supported by a lot of subjective factors, so the corresponding volatility is also very large.
How is MSTR's high premium created, and why does it become the core of its business model
After supplementing this background knowledge, I think everyone should be able to roughly understand how MSTR's high premium relative to its BTC holdings is generated. First, MicroStrategy has switched its business from the traditional software business to financing the purchase of BTC, although it does not rule out having corresponding asset management revenue in the future. This means that this company's profitability comes from the capital gains of the BTC it has purchased through equity dilution and debt financing. With the appreciation of BTC, all investors' shareholder equity will correspondingly increase, and investors will benefit from this, in this respect MSTR is no different from other BTC ETFs.
The difference arises from the leverage effect of its financing capacity, because MSTR investors' expectation of the company's future profit growth comes from the leverage gains obtained through its financing capacity growth, considering that MSTR's total market capitalization is in a positive premium state relative to the total value of the BTC it holds, that is, MSTR's total market capitalization is higher than the total value of the BTC it holds. As long as it is in this positive premium state, regardless of equity financing and its convertible bond financing, the funds obtained will be used to purchase more BTC, which will further increase the equity per share. This gives MSTR a profit growth capability different from BTC ETFs.
To illustrate with an example, assume that MSTR currently holds $40 billion in BTC, with a total outstanding shares of X, and a total market capitalization of Y. Then the current equity per share is $40 billion / X. In the worst case of equity dilution financing, assuming the issuance of new shares is a proportion of a, this means that the total outstanding shares will become X * (a + 1), and by completing the financing at the current valuation, a total of a * Y billion dollars will be raised. By converting all of these funds into BTC, the BTC holdings will change from $40 billion to $40 billion + a * Y billion, meaning that the equity per share will become:
Let's calculate the increase in equity per share due to the dilution of shares, as follows:
This means that when Y is greater than 400 billion, which is the value of the BTC it holds, that is, when there is a positive premium, the increase in equity per share brought about by the financing to purchase BTC will always be greater than 0, and the higher the positive premium, the higher the increase in equity per share, the two are in a linear relationship, and as for the impact of the dilution ratio a, it presents an inverse proportion characteristic in the first quadrant, which means that the less the shares are issued, the higher the increase in equity.
So for Michael Saylor, the positive premium between MSTR's market value and the value of the BTC it holds is the core factor for the establishment of its business model, so his optimal choice is how to maintain this premium while constantly financing and increasing his market share to gain more pricing power over BTC. And the continuous enhancement of pricing power will also enhance investors' confidence in future growth even in the case of a high P/E ratio, enabling it to complete fundraising.
In summary, the secret of MicroStrategy's business model lies in the fact that the appreciation of BTC drives the increase in the company's profits, and the good trend of BTC growth means that the trend of the company's profit growth is also good, and with the support of this "Davis double kill", the positive premium of MSTR begins to expand, so the market is betting on how high a positive premium MicroStrategy can achieve to complete subsequent financing.
What are the risks that MicroStrategy brings to the industry
Next, let's talk about the risks that MicroStrategy brings to the industry. I believe that the core is that this business model will significantly increase the volatility of BTC prices, acting as an amplifier of volatility. The reason is the "Davis double kill", and the entry of BTC into a high-volatility oscillation period is the beginning of the entire domino effect.
Let's imagine that when the growth of BTC slows down and enters a oscillation period, the profitability of MicroStrategy will inevitably start to decline. Here I want to explain that I see some partners attaching great importance to its holding cost and the scale of its floating profits. This is meaningless, because in MicroStrategy's business model, the profit is transparent and equivalent to real-time settlement, while in the traditional stock market, we know that the factors that really cause stock price fluctuations are the financial reports, and only when the quarterly financial reports are released, the market will confirm the true profit level, and in the meantime, investors can only estimate the changes in the financial situation based on some external information. That is to say, most of the time, the stock price reaction lags behind the real changes in the company's profitability, and this lag relationship will be corrected when the quarterly financial reports are released. However, in MicroStrategy's business model, since its holding scale and BTC price are public information, investors can understand its real profitability in real time, and there is no lag effect, because the equity per share changes dynamically with it, equivalent to real-time settlement of profits. Since this is the case, the stock price has already truly reflected all its profits, and there is no lag effect, so it is meaningless to pay attention to its holding cost.
Let's bring the topic back and see how the "Davis double kill" unfolds. When the growth of BTC slows down and enters a oscillation stage, the profitability of MicroStrategy will continue to decline, even to zero, and at this time the fixed operating costs and financing costs will further shrink the company's profits, even into a loss. And at this time, this oscillation will constantly erode the market's confidence in the future development of BTC prices. And this will be transformed into doubts about MicroStrategy's financing ability, further undermining expectations of its profit growth, and under the resonance of these two, the positive premium of MSTR will converge rapidly. And in order to maintain the establishment of its business model, Michael Saylor must maintain the state of positive premium. So selling BTC to buy back stocks is a necessary operation, and this is the moment when MicroStrategy starts to sell its first BTC.
Some partners may ask, why not just hold the BTC and let the stock price fall naturally. My answer is that it is not possible, or more precisely, it is not possible when the BTC price reverses, although it is possible to tolerate it appropriately during the oscillation period, because of the current shareholding structure of MicroStrategy and what is the optimal solution for Michael Saylor.
According to the current shareholding structure of MicroStrategy, there are many top-tier financial groups, such as Jane Street and BlackRock, while the founder Michael Saylor only holds less than 10%, of course, through the design of dual-class shares, Michael Saylor has absolute voting power, because he holds more Class B common shares, and the voting rights of Class B common shares are 10:1 compared to Class A. So this company is still under the strong control of Michael Saylor, but his shareholding ratio is not high.
This means that for Michael Saylor, the long-term value of the company is far higher than the value of the BTC he holds, because if the company faces bankruptcy and liquidation, he would not get much BTC.
So what are the benefits of selling BTC and buying back stocks to maintain the premium during the oscillation stage? The answer is also obvious. When the premium converges, if Michael Saylor judges that MSTR's P/E ratio is undervalued due to panic, then selling BTC to raise funds and repurchasing MSTR from the market is a profitable operation. Therefore, the effect of reducing the float and amplifying the equity per share at this time will be greater than the effect of reducing the BTC reserve and shrinking the equity per share, and when the panic is over and the stock price rebounds, the equity per share will become higher, which is beneficial for subsequent development, and this effect is easier to understand in the extreme case of BTC trend reversal and MSTR appearing at a negative premium.
And considering Michael Saylor's current holdings, and the fact that liquidity is usually tightened when there is oscillation or downward cycles, when he starts to sell, the price of BTC will accelerate its decline. And the accelerated decline will further worsen investors' expectations of MicroStrategy's profit growth, and the premium rate will further decline, which will force it to sell BTC to buy back MSTR, and then the "Davis double kill" begins.
Of course, there is another reason that forces it to sell BTC to maintain the stock price, which is that the investors behind it are a group of well-connected "Deep State", who cannot just sit and watch the stock price go to zero, and must inevitably put pressure on Michael Saylor, forcing him to take responsibility for managing its market value. And recent news shows that with the continuous dilution of shares, Michael Saylor's voting rights have fallen below 50%, although I haven't found a reliable source for this information. But this trend seems to be inevitable.
Is there really no risk for MicroStrategy's convertible bonds before maturity
After the above discussion, I think I have already stated my logic completely. I still hope to discuss another topic, whether MicroStrategy has no debt risk in the short term. Some predecessors have introduced the nature of MicroStrategy's convertible bonds, and I will not go into details here. Indeed, its debt duration is quite long. There is indeed no repayment risk before the maturity date. But my view is that its debt risk may still be reflected in advance through the stock price.
The convertible bonds issued by MicroStrategy are essentially a bond with a free call option, and at maturity, the creditors can request MicroStrategy to redeem them in stocks at the previously agreed conversion rate, but there is also protection for MicroStrategy, that is, MicroStrategy can actively choose the redemption method, using cash, stocks or a combination of the two, which is relatively flexible, if the funds are sufficient, they can repay more cash to avoid dilution of equity, if the funds are insufficient, then more stocks can be used, and moreover, this convertible bond is unsecured, so the risk of repayment is not great. And there is also a protection for MicroStrategy here, that is, if the premium rate exceeds 130%, MicroStrategy can also choose to redeem it directly in cash at par value, which creates conditions for refinancing negotiations.
So for the bondholders of this bond, they can only have capital gains when the stock price is higher than the conversion price, but lower than 130% of the conversion price, otherwise they can only get the principal plus low interest. Of course, after the reminder of Mindao, the main investors of this bond are hedge funds doing Delta hedging to earn volatility returns. Therefore, I have thought about the logic behind it in more detail.
The specific operation of Delta hedging through convertible bonds is mainly to buy MSTR convertible bonds and short an equal amount of MSTR stocks to hedge the risk brought by stock price fluctuations. And with the subsequent price development, the hedge fund needs to continuously adjust the position to dynamically hedge. There are usually two scenarios for dynamic hedging: l When the MSTR stock price falls, the Delta value of the convertible bond decreases, because the conversion right of the bond becomes less valuable (closer to "out-of-the-money"). At this time, it is necessary to short more MSTR stocks to match the new Delta value. l When the MSTR stock price rises, the Delta value of the convertible bond increases, because the conversion right of the bond becomes more valuable (closer to "in-the-money"). At this time, by buying back some of the previously shorted MSTR stocks to match the new Delta value, the hedging of the portfolio can be maintained. Dynamic hedging requires frequent adjustments in the following cases: l Significant fluctuations in the underlying stock price: such as large changes in the price of leading to violent fluctuations in the MSTR stock price. l Changes in market conditions: such as volatility, interest rates or other external factors affecting the pricing model of convertible bonds. l Hedge funds usually trigger operations based on the magnitude of Delta changes (such as every 0.01 change) to maintain the precise hedging of the portfolio. Let's take a specific scenario as an example. Suppose the initial position of a hedge fund is: l Buy $10 million worth of MSTR convertible bonds (Delta = 0.6). l Short $6 million worth of MSTR stocks. When the stock price rises from $100 to $110, the Delta value of the convertible bond changes to 0.65, then the stock position needs to be adjusted. The calculation shows that 500,000 shares need to be bought back. The specific operation is to buy back $5 million worth of stocks. When the stock price falls back from $100 to $95, the new Delta value of the convertible bond becomes 0.55, and the stock position needs to be adjusted. The calculation shows that 500,000 shares need to be shorted. The specific operation is to short $5 million worth of stocks. This means that when the MSTR price falls, the hedge fund behind its convertible bonds, in order to dynamically hedge the Delta, will short more MSTR stocks, which will further weigh on the MSTR stock price, and this will have a negative impact on the positive premium, thereby affecting the entire business model. Therefore, the risk on the bond side will be fed back in advance through the stock price. Of course, in the upward trend of MSTR, the hedge fund will buy more MSTR, so it is also a double-edged sword.
