Summary The article discusses the difficulty in mining Bitcoins, which has reached a record-breaking 60T together with the halving event to occur in April 2024. This increase is attributed to the growing number of miners like Bit Digital and the use of more advanced mining equipment. This makes it imperative for the miner to adjust its operating model while taking into consideration its scale of operations and the quantity of Bitcoins in the treasury. A comparison with gold extraction helps especially for those who find Bitcoin mining to be too complex a topic. First, when you think of mining, images of miners using sieves along riverbanks to retrieve precious metals during the 1848 gold rush may come to mind. As this thesis will show, there are some similarities with Bitcoin mining. As for Bit Digital (BTBT), the miner's shares are at the $2.15 level, or well below its July high of $4.59 as shown in the blue chart below. Tellingly, the price action also indicates that as of August, the stock is no longer moving in tandem with Bitcoin's ( BTC-USD ) orange chart. Data by YCharts This is mostly because of reduced crypto output due to mining difficulty and the upcoming Bitcoin halving event in April 2024 which will significantly reduce the rewards obtained when contributing a block to the blockchain network. Thus, the objective of this thesis is to assess how BTBT is adapting its operating model accordingly and whether it is a buy. The company's third quarter 2023 financial results are expected to be announced around November 15 and I start by elaborating on the mining difficulty using the gold analogy. Network or Mining Difficulty First mining cryptocurrency consists of systematically verifying transactions on the blockchain and creating new coins through dedicated hardware and blockchain software. Just like gold diggers in the last century rushing to look for deposits along river banks before others got to the spot, creating Bitcoins is highly competitive as it also involves a multitude of miners, but this time racing to solve complex mathematical puzzles requiring considerable computing power. Now, the larger the concentration of miners at a location competing for scarce resources, the greater the difficulty in mining. This is the same with Bitcoin as new capacity or computing power measured in exahash per second (EH/s) is constantly added to the blockchain network. As for BTBT, its active hash rate was about 2.0 EH/s as of October 31. Moreover, mining difficulty is increasing and reached a new high of 62.46T (or trillion units) on October 30. To obtain an idea of how fast this is increasing, this figure was only around 20T at the end of 2021, meaning that difficulty has increased by more than 200% within two years. This results in a fall in production, unless additional capacity is added rapidly. Thus, BTBT produced 111.6 BTC in October, or a 7% month-over-month decline from the 130.2 BTC produced in September mostly due to network difficulty. Now, looking at the total number of BTC held, this was 1,394.4 at the end of October as summarized below. For this matter, BTBT produces both Bitcoins and Ethereum and the figure of 1,394.4 is the Bitcoin equivalent of its digital asset holdings. Interestingly, this is less than the 1,881.6 BTC it held in its treasury at the end of September signifying that it has been selling some or 487.2 (1,881.6 - 1,394.4) of its produce on the open market to take advantage of the appreciation in Bitcoin prices since the beginning of this year. The rest of the Bitcoins (which are not sold) are kept in the miner's treasury as part of a strategy called HODLing, or holding on to most of their produce. The Halving Event and Bitcoin's Volatility Now , keeping Bitcoin as opposed to selling it on the open market makes sense because of the impending halving event. This will de facto reduce block rewards or miners' main income sources. Tellingly, after April 2024 they will obtain only 3.125 BTC for each block added to the blockchain compared to 6.25 BTC currently. An analogy with gold mining is a scarcity of gold fields resulting in two miners having to work together on the same concession (portion of allocated land) and dividing any quantity of gold extracted into half. With rewards dropping by 50% because of halving, miners must adapt their strategies, and, one solution is to accumulate the excess BTC mined during favorable times. This reserve can serve as a buffer against the impact of reducing block rewards after April next year. The reason is that halving also aims to reduce the pace of Bitcoin creation thereby indirectly cutting its supply. However, there is another key factor at play here, or demand which may not necessarily follow since this is an industry where there is a lot of volatility and where simple demand-supply economics may not apply. One example is investors dumping the cryptocurrency in the aftermath of the collapse of the FTX crypto exchange led by Sam Bankman-Fried back in November last year. At that time, BTC fell beyond the $20K level as charted below. Data by YCharts Currently, a lot of the enthusiasm that is propping up the crypto market is the potential approval of a spot Bitcoin ETF by the Security and Exchange Commission. In these circumstances, instead of only focusing on the quantity of Bitcoin held by miners, it makes more sense to look at efficiency. This is about making use of power-efficient equipment, tapping into lower-cost electricity like renewables, as well as improving labor productivity. For this purpose, while some miners will upgrade to the latest and highest-efficiency mining equipment, others look for the lowest energy costs. Now, one financial metric that can provide an idea of efficiency is the gross margins, which is 31.74%. However, looking deeper into the income statement, there are also Depreciation and Amortization expenses of $3,725,152.00 for the second quarter of 2023 ending in June 2023. This amounts to 41% of the revenues of $9,037,602.00 obtained for the same period. This is significant and is caused mainly by older-generation mining equipment getting depreciated as suppliers like Bitmain continually release newer and more power-efficient versions of its Antminers. The Diversification Strategy Implies Considerable Changes Furthermore, given the pace at which new releases are affected, mining equipment depreciates rapidly, signifying that it is unproductive to spend capital on these, especially amid rising mining difficulty and with the halving event looming. In this respect, as seen with its hosting agreement with Soluna Computing involving the redeployment of existing equipment from its fleet, BTBT is not spending money to boost production capacity at the expense of seeing the underlying equipment depreciating rapidly. Instead, it is spending Capex on acquiring 132 FusionOne HPC (High-Performance Computing) servers for approximately $35 million. This is within its current spending capacity given that it had cash of $24.4 million on its balance sheet as of October 31 plus digital asset holdings amounting to approximately $48.3 million . These servers will contain 1,056 H100 GPUs supplied by Nvidia ( NVDA ) and be used to support the AI applications (or GPU-accelerated workloads) of a customer with whom BTBT has signed an agreement to supply rental-based hosting services. Noteworthily, the contract is for a three-year term that should exceed $250 million worth of revenue with the equipment to be housed at a third-party data center by the end of this year. bit-digital.com The related income is expected as of January 2024, but, since this is just the initial stage, BTBT will still need additional financing to set up the whole AI infrastructure. It plans to use a mix of cash, selling digital assets, new equity issuance, and equipment-linked debt. For this matter, Nvidia's H100 comes with a hefty price tag of above $40K each, and data centers are now charging more for hosting amid higher demand by hyperscalers like Microsoft ( MSFT ) and other enterprises setting up AI-specific infrastructures. Therefore, it is important to consider factors like profitability and the amount to be raised through equity funding and debt. Now, the company had zero debt on its balance sheet at the end of June. Moreover, as I elaborated in a previous article , the data center environment hosting AI servers differs considerably from that required by Antminers mining digital coins. This means that this timely diversification away from Bitcoin mining into AI-specific infrastructure makes sense, but it means that the company is entering a new business line, implying changes at the operational level. Therefore, it is important to look for more details when the financial results for the third quarter of 2023 (ending in September) are released around November 15 . More of A Hold In the meanwhile, with a valuation grade of D+ , BTBT still remains a richly valued stock despite the downside. In this respect, the Price-to-sales multiples remain higher than the median for the IT sector by over 90% as illustrated below. Valuation Metrics (seekingalpha.com) In conclusion, and again performing a comparison with gold extraction, Bitcoin mining is more energy-intensive, and, given the two pain points facing miners, namely network difficulty and halving, it is imperative that they rapidly adapt. In this case, BTBT's strategy emphasizes diversification instead of accumulating coins which is justified firstly, given the volatility inherent in the crypto asset class may simply sap demand after April 2024, thereby devaluing the Bitcoin reserves being held. Finally, given that the company is venturing into a new business, investors may prefer to wait for concrete profitability metrics like expected margins to be obtained by hosting AI-specific infrastructure in the next week's financial results before investing. Also, it would be useful to obtain an update as to whether the company is recruiting someone experienced in colocation hosting in Tier 3 data centers.
