Opportunities and Risks of MicroStrategy: Davis Double Click and Double Kill

Last week we discussed Lido's potential benefits in the changing regulatory environment. This week's topic is the heat around MicroStrategy, with many industry insiders commenting on the company's operating model. After in-depth research, I have some of my own views I would like to share with everyone.

I believe the reason for MicroStrategy's stock price increase is the "Davis Double-Trigger." Through the business design of financing to purchase BTC, the company ties the appreciation of BTC to its profits and obtains financial leverage through innovative financing channels, enabling the company to achieve profit growth beyond the appreciation of its own BTC holdings. As the holdings expand, the company also gains a certain pricing power over BTC, further reinforcing this profit growth expectation.

However, the risks also stem from this. When the BTC market experiences fluctuations or reversals, the profit growth of BTC will stagnate. At the same time, affected by the company's operating expenses and debt pressure, MicroStrategy's financing capacity will be significantly reduced, which will further impact profit growth expectations. At that time, unless there is a new driving force that can further push up the BTC price, the positive premium of MSTR's stock price relative to BTC holdings will quickly converge, a process known as "Davis Double Kill."

What are the Davis Double Knock and Double Kill

"Davis Double Click" is usually used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment.

1. Company profit growth: The company has achieved strong profit growth, or optimizations in business models, management, etc., have led to an increase in profits.

2. Valuation Expansion: The market is more optimistic about the company's prospects, and investors are willing to pay higher prices, driving an increase in stock valuations.

"Davis Double Kill" is the opposite, describing the joint effect of two negative factors leading to a rapid decline in stock prices:

1. Company profits decline: Decreased profitability may be due to factors such as reduced revenue, increased costs, or management errors, leading to profits falling below expectations.

2. Valuation contraction: Due to declining profits or worsening market prospects, investor confidence decreases, leading to a decline in valuation multiples and a drop in stock prices.

This resonance effect usually occurs in high-growth stocks, particularly evident in technology stocks. Investors are generally willing to assign high expectations for the future business growth of these companies, but such expectations often contain a considerable amount of subjective factors, leading to greater volatility.

Reasons for the High Premium of MSTR and the Core of Its Business Model

MicroStrategy has shifted its business from traditional software to financing the purchase of BTC. This means its profit source comes from capital gains on BTC acquired through dilution of equity and bond issuance. As BTC appreciates, the equity of all investors will correspondingly increase.

The difference between MSTR and other BTC ETFs lies in the leverage effect brought about by its financing capability. Investors' expectations of the company's future profit growth stem from the leverage gains obtained through its financing capabilities. As long as MSTR's total market value is higher than the total value of the BTC it holds in a premium state (, both equity financing and convertible bond financing will further increase the equity per share. This gives MSTR a profit growth potential that is different from that of BTC ETFs.

For Michael Saylor, the premium of MSTR's market value over the value of its held BTC is a core factor in the viability of the business model. Therefore, his optimal choice is to maintain this premium while continuously raising funds, increasing market share, and gaining more pricing power over BTC. The continuous enhancement of pricing power will boost investors' confidence in future growth under high price-to-earnings ratios, enabling him to complete fundraising.

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Risks Brought by MicroStrategy to the Industry

MicroStrategy's business model could significantly increase the volatility of BTC prices, acting as an amplifier of fluctuations. When BTC enters a period of high volatility, the "Davis Double Kill" may begin.

As BTC growth slows down and enters a consolidation phase, MicroStrategy's profits will continuously decrease, possibly even to zero. Fixed operating costs and financing costs will further narrow the company's profits, potentially leading to losses. This oscillation will continually erode the market's confidence in the future price development of BTC, transforming it into doubts about MicroStrategy's financing capabilities, further undermining its profit growth expectations. Under the resonance of these two factors, MSTR's positive premium will rapidly converge.

To maintain the business model, Michael Saylor must uphold a positive premium status. Selling BTC to raise funds for stock buybacks is a necessary operation, which also marks the moment MicroStrategy begins to sell its first batch of BTC.

Considering Michael Saylor's current shareholding ratio and the influence of the investors behind the company, it is not feasible to simply hold BTC and let the stock price naturally decline when the BTC price reverses. By selling BTC to regain funds and repurchasing MSTR shares from the market, the equity per share can be increased after the panic subsides, which is beneficial for future development.

However, considering the current holdings of Michael Saylor, and the fact that liquidity usually tightens during a down cycle, when MicroStrategy starts to sell, the price of BTC may drop more rapidly. This could further worsen investors' expectations for MicroStrategy's profit growth, leading to a further decline in the premium rate, thus creating a vicious cycle.

The Risks of MicroStrategy's Convertible Bonds

Although MicroStrategy's convertible bonds do not have direct repayment risks before maturity, their debt risks may still be reflected in stock prices in advance. The convertible bonds issued by MicroStrategy are essentially bonds with an overlay of free call options, allowing creditors to redeem them at maturity for shares at an agreed conversion rate.

This type of convertible bond is mainly used by hedge funds for delta hedging to earn volatility returns. The specific operation is to purchase MSTR convertible bonds while short selling an equivalent amount of MSTR stock to hedge against the risks arising from stock price fluctuations. As prices change, hedge funds need to continuously adjust their positions for dynamic hedging.

When the price of MSTR falls, the hedge funds behind the convertible bonds will short more MSTR shares to dynamically hedge Delta, further hitting the MSTR stock price. This will negatively impact the premium, affecting the entire business model. Therefore, the risk on the bond side will be reflected in the stock price in advance. Of course, in an upward trend for MSTR, hedge funds will buy more MSTR, so this is a double-edged sword.

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