Summary MicroStrategy's pivot towards Bitcoin investment has turned its stock into a BTC proxy for investors. The company's inclusion in the S&P 500 will attract capital from passive funds, enhancing its BTC acquisition strategy. The stock's value is largely based on the growth of BTC per share, making it a leveraged bet on Bitcoin. Reflexivity from index inclusion can be a catalyst for an aggressive surge in the stock price. Adjacent to these points is the potential for short and gamma squeezes as the market dynamics become more clear to people. MicroStrategy Incorporated (MSTR), a provider of business intelligence and AI-based enterprise software solutions. In recent years, it has garnered significant attention from investors for its aggressive Bitcoin (BTC-USD) acquisition strategy. This pivot towards Bitcoin investment has put MSTR under the spotlight, transforming its stock into a BTC proxy for investors. Even with the advent of the spot ETFs, I believe this stock still holds tremendous potential for value creation. Overall I am incredibly bullish on MSTR, and especially for the next 18 months. The thesis that I am outlining here depends heavily on MSTR being included in the S&P 500 index, and thus is highly speculative as this event hasn't materialized yet . For one, MSTR's inclusion in the S&P 500 will reduce its cost of equity financing. Inclusion in the index would attract a vast pool of capital from passive funds tracking the S&P 500. This would enhance MicroStrategy's BTC acquisition strategy, allowing it to buy even more BTC by effectively absorbing capital from the index funds. Such an outcome is largely the result of financial engineering, and less of actual value creation via astute business decisions. That said, it could mean wonderful things for the share price. Bitcoin Strategy Let's first go over how the BTC acquisition strategy works, and then talk through how index inclusion changes the game in a big way. The company uses both equity and debt issuance to purchase BTC. As of 11 March 2024, it has 205,000 BTC . This has a market value of $14 billion. MSTR's total liabilities is about $2.5 billion. And the market value of equity (market cap) is $24 billion. The $24 billion includes the BTC and the software business, but it also means being on the hook for the liabilities. Assuming MSTR sold off $2.5 billion of BTC to pay off all liabilities, shareholders are left with about $11.5 billion worth of BTC and the software business. Assuming MSTR is not trading at any premium to the value of the underlying BTC, this means the software business is worth $12.5 billion (24 total value minus 11.5 BTC value). I am skeptical of this. MSTR TTM revenues are about $500 million. Are we to believe that the software business on its own is worth 25x sales? The picture gets even worse when you consider that annual revenue hasn't grown at all for many years. The simplest answer to explain this is that the market is pricing MSTR at a premium to the BTC it holds. On what is this premium based? The software business is quite mediocre if sales haven't grown. In fact, they've decreased in real terms. I believe the premium comes from the fact that BTC per share is growing over time. (Note: I'm not estimating what the exact premium is. That depends on the value of the software business, which I won't cover in depth here.) MSTR had 91,064 BTC in March 2021, with 11,300,000 shares outstanding. This is about 0.008059 BTC per share. By December 2022, MSTR had 132,500 BTC and 11,500,000 shares outstanding. This is about 0.011522 BTC per share. As of March 2024, it has 205,000 BTC and 17,000,000 shares outstanding. This is about 0.012059 BTC per share. The BTC per share has increased about 50% in the last three years. I believe this fact is key to understanding the premium. If you expect BTC per share to grow over time, and you believe in the long term value of BTC, then it makes sense to pay a premium for a company that is dedicated to using financial engineering and free cash flow to acquire more BTC. If you're really that bullish on BTC, it makes sense because this is a leveraged bet on BTC. There are traditionally three ways of dealing with a company's excess cash: dividends, buybacks, or reinvestment in the company (ie. capex). Generally speaking, issuing shares means that you are doing capex. MSTR shareholders have voted with their money (by not dumping the stock after all these dilutions) that they prefer a fourth way: buy BTC . So how exactly is BTC acquired? MicroStrategy is almost utilizing its shares as a printable currency to purchase BTC. As long as people will price the equity at a premium to the underlying BTC, MicroStrategy can issue shares and buy BTC until the premium closes. As long as investors believe it will continue to increase its BTC per share, they will price the equity at a premium. And as long as BTC keeps going up, this premium is unlikely to disappear. What is the effect of diluting the shareholder in the long term? So far, the effect has been that BTC per share goes up. This will be the most meaningful long term effect as long as a premium exists. Another effect is that metrics like earnings per share and cash flow per share will decrease over time. This might make the stock look less attractive on a quantitative basis. However, MSTR's main investor base doesn't seem to worry about that much. Also, this is not a deterrence to the index funds. The system is interrupted if the price of BTC falls . This will absolutely cause value destruction, but not necessarily ruin for the shareholders. As long as debt can be serviced via the cash flows from the software business, MSTR does not need to liquidate its BTC. (This is also why MSTR is a better bet on BTC than Bitcoin miners. If BTC goes to 0, miners are done because the cash flow part of their business will go to 0 and they will need to liquidate all their assets.) Impact of S&P 500 Inclusion At the current market cap, MSTR can definitely join the S&P 500. It meets all the requirements for earnings and liquidity. Inclusion will open MSTR to a pool of forced equity buyers in the form of passive S&P 500 index funds. There's a few things to remember here. First of all, equity indices tend to rebalance quarterly and they rebalance based on the relative market caps of the components. This means that if new shares are issued, the next quarter will probably see buying from the passive funds so that they can faithfully track the cap-weighted index (assuming all else is held equal). Second, equity offerings that meet a certain materiality threshold can get intra-quarter treatment too. This means there is a forced buyer even between quarterly rebalancing events. If the share issuance is big enough (at least $150 million), indices will be adjusted immediately to accommodate this, meaning index funds that are trying to track the index must also divulge funds into purchasing the share issuance. Equity Indices Policies & Practices Methodology (Page 14) (spglobal.com) It is a known fact that index inclusion tends to decrease the cost of equity . The impact this will have on MSTR is to be determined. I think we can expect that MSTR will take full advantage of this lower cost of equity and issue shares like never before to acquire BTC. This will undoubtedly help drive up the price of BTC. And, based on what we covered before, as long as the price of BTC goes up, the premium priced into MSTR shares is expected to remain positive, which allows MSTR to issue more shares to buy more BTC. Index inclusion simply means that there is now a pool of forced buyers to help subsidize this process of issuing shares to purchase BTC. Whereas before MSTR sold shares to the market where there may or may not be a buyer of shares, index inclusion means that there is always a buyer. If we just add the AUMs of the three biggest S&P 500 ETFs (SPY, IVV, VOO), we get about $1.4 trillion of assets. This of course does not include mutual funds and other retirement options which track the S&P 500. Some quick math: MSTR's $25 billion market cap is about 1/123 of Microsoft's market cap. Microsoft is about 7% of the S&P 500. 1/123 of 7% is about 5.7 bps. This is the portion of index fund AUM that would be allocated to MSTR if it were added to the index. 0.00057 x $1.4 trillion is about $800 million. That is roughly 3.2% of the supply of shares purchased by the top three S&P 500 ETFs alone. Also, because the index is weighted by market cap, the higher MSTR's market cap goes, the more MSTR the index funds must buy - think of this as the 5.7 basis points figure growing to be larger. Put differently, the higher BTC's price goes, the more index funds will channel money into buying MSTR shares, which will ultimately be used to push up BTC's price. This cycle breaks down if investors decide to close the premium by selling their shares or of BTC begins to decrease. Otherwise, the tables are seemingly set for a reflexive rally in the price of MSTR, as long as sell pressure for BTC remains unable to satiate demand . Given the materiality threshold, MSTR can continue to issue shares and its burgeoning market cap will absorb value from other stocks in the S&P 500. If a fund was forced to rebalance its portfolio such that the MSTR allocation needs to be greater (presumably because MSTR's market cap has significantly grown), then the only way the fund can do this is to sell some other stocks in the S&P 500 to buy MSTR. This has the marginal effect of pushing down the price of the other stocks and pushing up the value of MSTR - another contributing factor to the reflexive feedback loop. I should also add that you wouldn't see this dilution strategy done by other index constituents. Shareholders of most companies are not okay with their shares being diluted. But we've already established that MSTR shareholders think differently about this. As long as BTC per share increases, MSTR shareholders seem to be happy. When combined with the fact that a chunk of the shares will be sold to forced buyers, the strategy of dilution to fund BTC acquisition becomes much more effective. Short Squeeze MSTR currently has around a 17% short interest . Some traders are probably betting that the premium between MSTR and the underlying BTC will begin to close. Thus, I think it is likely that much of this short interest is the short leg of a BTC and MSTR pairs trade. With the new spot ETFs, it would be trivial to go long iShares Bitcoin Trust ETF ( IBIT ) and short MSTR (doing so would allow the ETF position to be cross-margined with the rest of the portfolio). If this pairs trade is the case, then the potential for a short squeeze is lessened because the traders can stay in their short positions for much longer. If this is not the case, and there are a lot of "unpaired" MSTR shorts, I believe there is potential for a parabolic short squeeze. What makes this scenario possible is that it isn't unreasonable at all to bet on a BTC collapse by shorting MSTR. Assuming this is the case, then index inclusion and subsequent reflexivity between MSTR, BTC, share issuance, and having forced buyers in the form of passive index fund capital is ripe to seriously hurt the shorts. Gamma Squeeze A lesser known form of reflexive market behavior is called the gamma squeeze. Gamma is the convexity offered by an option contract. It measures how much delta changes with respect to the price of the underlying stock. Gamma squeezes happen when traders buy a lot of call options from market makers. Market makers generally try to maintain a directionally neutral portfolio. If they sell a lot of call options to traders, this means they are inherently short the upside. The instantaneous amount they are short is seen in the total delta of the call options they sold. To get back to directionally neutral, they must buy delta units of the underlying stock. What's remarkable is that options deliver a lot of delta for a very low amount of capital. Thus, a relatively small amount of capital can be used to force real market participants (market makers) to buy a huge amount of underlying stock. And it gets even better. As the stock rises, the calls become closer to being in-the-money and this increases the delta of the calls, which increases how much stock the market makers have to buy, which increases the stock price. A reflexive loop is thus created. And this was where the name "gamma squeeze" comes from. Gamma dictates how much additional shares market makers must buy, since it is the change in delta (ie. how much market makers need to be long to hedge out the option) with respect to the underlying price. More gamma means more shares must be purchased. More calls purchased by traders means more gamma the market maker has to hedge out. This is what happened to GameStop (GME) back in January 2021. It started as a short squeeze but also turned into a gamma squeeze as retail traders piled into call options. I believe that something very similar can happen to MSTR, once the reflexive dynamics inherent to index inclusion becomes more clear to people. Risk The biggest risk by far to this thesis is a Bitcoin collapse. If this were to happen, we can assume that MSTR would be hit even worse than BTC. It might even lose out on being included in the index and everything mentioned here would have no chance of happening. I am personally pretty bullish on BTC in both the long-term and the next 18-months. My most recent article about Bitcoin is here . I view this risk as very unlikely in the near or long-term. Another very related and big risk is if the MSTR's premium closes. This could happen for a number of reasons, and they need not be fundamental in any way. Investors may want to just cash out, and that alone could cut short the reflexive loop. It's important to remember that any decrease of the premium would generally mean a material decline in the share price. That could have some reflexivity to it too, but in the downward direction. Also, if MSTR does not get included in the S&P 500, then it is business as usual. It will continue to purchase BTC with its issuance, and its share price will continue to move with BTC. We can consider this a risk to the thesis because everything I have covered here is somewhat predicated on index inclusion. However, given its quantitative metrics, there really is no reason for MSTR to remain outside of the S&P 500 by the end of 2024. Besides that, MSTR's software business could see material declines in sales. This could become a liability to the company if the trend of negative free cash flow continues. MSTR Free Cash Flow (Seeking Alpha) I will emphasize that I believe MSTR's software business is mediocre at best. Its outperformance over enterprise software competitors and most other tech stocks is nearly entirely due to its BTC strategy. If it weren't for that, this isn't really a business worth my personal investment consideration. That is to say, if I ran the normal quantitative screens to filter for equities I would like to own, negative free cash flow and no sales growth will automatically ensure that MSTR doesn't even show up in my list of investable companies. If MSTR has no ability to generate free cash flow, I can't see a long term path forward for it as a business. This scenario would reduce MSTR to a near or medium term macro trade: a leveraged bet on BTC that makes use of inherent financial engineering, while BTC is in the middle of its bull market. I am optimistic that MicroStrategy's recent rebranding as the world's first Bitcoin development company is an interesting avenue which could make use of its BTC assets. As someone who studies the Bitcoin ecosystem in depth, I can see many different technical possibilities for this. MSTR and its co-founder Michael Saylor also enjoy a cult-like following in the Bitcoin community. These are both financial and social capital which can be deployed to the tremendous advantage of MSTR shareholders. That said, it is very early and we have yet to see what this realignment of company image actually entails. I will watch it closely. Until then, it's just talk, and talk is cheap. There is a risk that the "business" side of MSTR becomes a liability that forces the company to sell some of its BTC. I think this would be bad for the company and could even cause a sentiment shift where investors exit en masse and promptly close the premium. Such an event would collapse the share price. Summary and Price Target I have introduced what I view as one of the most compelling equity investment theses in 2024. I believe that inclusion into the major equity index will be a game changer for MSTR because it can basically abuse the system of passive forced buyers to buy more BTC and increase the BTC per share. As long as BTC increases, MSTR should continue to increase. Since my price target for BTC is about $175,000 for this bull cycle , I expect MSTR to at least match this growth. Thus, my base case would be 143% growth from here. At the current price of about $1,500 per share, this puts my price target at about $3,645 (this and everything henceforth is split-adjusted). However, given the inherent leverage in the MSTR balance sheet, I would not be surprised at a price of $5,000 or even more. For reference, here is the 3 year performance comparison with BTC. Leverage matters. BTC and MSTR (Seeking Alpha) Index inclusion, depending on how MicroStrategy takes advantage of it, is the bull case. I can feasibly see this stock topping $8,000 given a short squeeze and a gamma squeeze. The bear case is that the premium starts to narrow and we see MSTR underperforming BTC going forward. There is of course the chance that BTC collapses and the biggest risk I covered in the previous section becomes realized. MSTR could fall back to $500 per share (-67% from here) or worse. The high variance in scenarios is why I give the stock a Buy Rating, even though the risk-reward I am laying out seems pretty attractively asymmetric. I would consider a Strong Buy Rating if the software business could show strong growth and free cash flow was positive and growing.
