Riot Blockchain Stock: Revisiting Our Investment Thesis (NASDAQ:RIOT)

This article was prepared by Lasan Devasirinarayana in collaboration with Dilantha De Silva.

We initiated coverage on Riot Blockchain, Inc. (NASDAQ:RIOT) in December of 2020 with a strong sell rating, and as expected, our article received a lot of criticism from many Seeking Alpha readers who were bullish on the prospects for RIOT stock at the time. In addition to the company changing its corporate name 4 times in less than 20 years, we also highlighted several other negative developments and unattractive characteristics that could push the stock price down in the long run. After shooting to new highs following our first article, Riot Blockchain stock has now given up all those gains and is down 47% from the price at the publication of our first article. We are long-term-oriented investors, and for this reason, we believe this decline in Riot’s market value is not a testament to the accuracy of our initial analysis as we believe the investment thesis surrounding cryptocurrencies has not played out fully. For this reason, we thought it best to revisit our investment thesis for Riot to determine whether more losses are likely or if we are nearing an inflection point where RIOT stock will pivot to the upside.

The new-look business model

Riot Blockchain now carries out its operations under two new segments, on top of its primary operation, Bitcoin mining, subsequent to the strategic acquisitions of Whinstone U.S. Inc. on May 26, 2021, and Ferrie Franzmann Industries, LLC on December 01, 2021. These acquisitions have paved the way for the company to tap into Data Center Hosting and Electrical Products and Engineering markets, respectively. Riot has generated a net profit of $20.2 million in the last 12 months and the revenue of $270 million achieved by the company in the same period is higher than the revenue reported by the company during the previous 10 years combined, for context.

Riot Blockchain’s new business model is centered around vertically integrating its business to own, operate, and manufacture cryptocurrencies. To this end, the company seems ready to look for inorganic growth opportunities to accelerate the progress it has made in the last 12 months on the back of increasing demand for and interest in cryptocurrencies and other digital assets.

Q1 earnings topped our initial estimates but we are being cautious

For the first quarter ended in March, Riot reported revenue of $57.9 million through Bitcoin mining, which was a growth of 150% YoY compared to the previous year’s $23.2 million. This segment’s revenue was predominantly driven by the higher number of Bitcoin mined during the quarter. Despite our predictions from December 2020 looking ambitious at a quarterly Bitcoin mining potential of 1,200 given the fundamentals at the time, the company has in fact succeeded in mining 1,405 Bitcoin in Q1 2022. This is an improvement of 186% YoY from the 491 Bitcoin mined during the same quarter in the previous year. Also, this is now the third consecutive quarter above the 1,200 Bitcoin threshold we cited for the company to accomplish sustainable profits. Riot operated with 42,919 ASIC miners during the quarter at a hash rate capacity of 4.3 exahash per second (EH/s).

The company anticipates 41,601 new S19j-Pro model miners and 30,000 new S19XP model miners to be delivered by Bitmain through December 2022, pushing the total number of miners deployed to 120,146 (the company currently owns 5,626 miners that are yet to be deployed as well). During the FY ended in December 2021, the company entered into six purchase agreements with Bitmain for a combined total price of $535 million for the delivery of the above miners, and Riot has $214.4 million remaining to be paid in monthly installments through December 2022 to Bitmain in advance of the shipments. Despite promising results on the top line, the cash position of the company at the end of Q1 does not appear healthy given these upcoming commitments, with only $113.6 million cash in hand. We believe the management will have to opt for debt financing while equity financing options remain a stretch at the moment amid gloomy market sentiment.

In Q1, Riot’s net income was inflated by non-recurring items such as fair value changes in derivative assets and gains realized through the sale of cryptocurrencies, however, partially offset by the impairment of cryptocurrencies, consequent to the decline in Bitcoin prices to $41,241 from $46,729 in the previous year. The recurring operating profit after adjustments for the above stands at approximately $9 million for the quarter against the reported $37.9 million.

Acquisitions might not end up adding value

Despite the newly acquired companies contributing 12.1% and 15.2% through Hosting and Engineering revenue, respectively, to the total revenue of the company, the direct cost of revenues of both segments – driven by direct power costs, direct material costs, direct labor costs as well as indirect manufacturing costs – amounted to $26.5 million, which is 122% of what both segments collectively contributed to the company in the form of revenue. In other words, these two new businesses ended up losing money at the gross profit level. This is highly concerning given that Riot’s vertical integration efforts ironically appear to further hurt its profitability due to the losses made at the gross profit level.

Whinstone U.S. Inc. was purchased at a price of approximately $651 million, out of which $80 million was paid in cash while the bulk of the transaction was funded with 11.8 million RIOT shares along with a couple of other modes of payments. We are not convinced whether this investment was a feasible decision whereas outsourcing the hosting services to a third party instead of acquiring Whinstone would have made more sense by creating room for margin enhancements, which is exactly what the doctor has ordered.

Looking ahead

We believe the quarter ending June 30 will not look positive amid crashing Bitcoin prices in the market. Bitcoin prices have plunged 53% from the last quarter to around $21,241, and we forecast Riot to generate only about $48 million in Mining revenue for Q2, assuming a 3.2% QoQ growth in the quantity mined at an average price of $33,385. Assuming the company maintains its gross profit margin at 32%, we can only anticipate a gross profit of roughly $15 million for the quarter from the Mining segment. We do not foresee the Hosting and Engineering businesses contributing positively at the gross profit level, therefore, leaving the company with only the gross profit made through Mining operations to account for fixed overheads. Hence, we believe the company will not be able to make a positive operating profit for the second quarter.

Despite Riot Blockchain insisting that operating efficiencies have turned around the company to achieve profitability in the last few quarters in contrast to our previous estimates, we continue to believe that Riot’s overall performance was inflated by the surge in Bitcoin prices from the beginning of FY 2021. We appreciate the fact that Riot has made some positive moves but at this point in time, market factors that were out of the company’s control seem to have done the hard yards in pushing the company toward profitability.

Takeaway

Riot Blockchain investors have been on a wild ride in the last couple of years, and it would be fair to assume that there were big winners along the way who got out of RIOT stock at the right time. Because we are investors – not traders – from a fundamentals perspective, we believe the bottom line may deteriorate amid the likelihood of higher interest expenses in the coming quarters on the back of possible debt financing to fulfill payments scheduled for the remaining three quarters of FY 2022. Hence, we remain unconvinced that the company is on track to make sustainable profits and reiterate that it is a highly volatile business that is strongly reliant on fluctuating Bitcoin prices. With some positive adjustments to our model, we conclude that Riot Blockchain will not be able to sustain profitability unless the company mines at least 1,700 Bitcoins per quarter with average Bitcoin prices hovering above $45,000.