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HIVE and Proof of Stake

I sold my position in HIVE.  I hate doing an about face on a position so quickly, but I came across an issue that gave me some concern.

My post the other day raised the question from someone of what the expected change in Ethereum to proof of stake consensus would mean for HIVE.  I did a bunch of reading on the matter and it makes me uncertain enough to sell.

Proof of stake is a change to the consensus method used.  If Ethereum switches to proof of stake, I’m not sure what role miners will have.

I wasn’t able to get a good feeling for when or even if Ethereum will implement proof of stake.  It sounds like it could be some time in 2018, but it also sounds like its a change that has been promised for some time and there remain to be issues to be sorted out before it can be implemented.  It may never happen.

Nevertheless based on what I’ve read, it seems likely that if it does get implemented, the need for miners for will be greatly diminished.  While miners will move to other tokens, I can’t quite see how these other tokens, with much smaller market capitalizations then Ethereum, will be able to absorb the supply.

Until I can understand this better I thought I better sell.

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HIVE Blockchain as a crypto-mining bet

When I started looking at the crypto-miners a month or so ago, I was pretty skeptical.  I thought there was a good chance that the business was a promotion to make it sound like you were a blockchain company when really you weren’t.  The company’s were all shells that had flipped the switch to blockchain overnight.  It was hard to take it too seriously.

But since then I have come around.

What made me change my mind was profitability.  This post, which is from an excellent crypto-blog, does a great job of describing the opportunity.  If you want raw data, check out this calculator and these GPU hardware stats.  A single RX 480 card has a hash rate of 28 MH/s and takes 160W of power.  Using the calculator, 28 MH/s and 160 W of power at $0.10 per kWh gives you a profit of $31.26 per month from mining 0.143 Ethereum. On Ebay you can buy a 7 GPU mining rig for $3,214.  7 GPUs should pull in $2,600 worth of Ethereum per year at $450 Ethereum.  It’s a pretty solid return and I haven’t even shopped around, tried to buy wholesale like a scaled player or moved my operation to a low cost power district.

You can run through a similar exercise with bitcoin.  You can buy the equipment at retail and still come away with a pretty solid return on investment. If you start shopping wholesale, or assembling the rigs at scale, I imagine the payback is over 100%.

With that said I’m not getting into the crypto mining business.  I have a feeling the devil is in the details, and there is a lot more to it than just buying the equipment and plugging it in.

But you get the point.  The above analysis gave me a reason to look more closely at the miners and what they are trading at.

Stepping my toes into the water, at the beginning of last week I bought a little Riot Blockchain.  I had lucky timing as the stock almost immediately started running.  I bought Riot because on an equipment basis, when I compared it to HIVE Blockchain, it seemed quite a bit cheaper.  But I was never really sold on the story, mainly because Riot hasn’t really given many details about their operation and we don’t even know if they are mining yet.  As such I sold out way too early. I began selling at $11 while the stock got as high as $22 on Friday.

Thus my Riot Blockchain experience is likely finished.  But it led me back to HIVE, which looks more interesting as I have dug deeper.  I took a position in HIVE on Friday at about $2.80 (Canadian), for the reasons I will explain below:

HIVE Blockchain

HIVE started out as a reverse merger of a gold company called Leeto Gold (yes a reverse merger; you can pull out the red flags, I’m not going to deny they aren’t there).  They got into the crypto-mining business when they acquired two data centers in Iceland from a very large private mining firm called Genesis Mining, the first in September and the second in October.  I first looked at the stock after the purchase of the second data center.  I struggled to wrap my head around the business, and the disclosure was (and still is) lacking.  So I passed.

I watched the stock shoot all the way up to $6 (Canadian).  But then it came crashing back down.  With Ethereum prices 40% higher and with HIVE securing a third much larger data center to be built in Sweden (in two phases) I decided to look again.

The short report

Ironically it was a short report that cemented my interest in the stock.  I don’t know who wrote this or where it came from.  Someone posted a link to it on Stockhouse last week.  Reading it made me reconsider my thoughts on HIVE.

The report does a really good job of weaving together the sparse disclosures from HIVE and gauging the size of their mining operation.  It was very helpful to see how you can build a model (a rough one but a model nevertheless) from the somewhat detailed disclosures HIVE gave on the first Iceland data center and the subsequent minimal disclosures of how much each additional data center would increase hash capacity.

Of course the report, being a short report, concludes that HIVE is way overvalued.  But I’m pretty sure this is because of one little mistake.

If you read the report, you will note that it references 2,301 GPU cards in the first data center.  Because of the lack of disclosure from HIVE, all of the other data center calculations are factors of the known size of the first one.  As the report explains, if there is only 2,301 GPUs in the first data center then HIVE isn’t going to make much money, either on the first data center or any of the subsequent one’s.

But here’s the thing.  When I read the report I had done enough research to know that 2,301 GPUs is not very many for a data center.  Moreover, it seemed like there was no way anyone would pay $9 million USD and 67 million shares for that many GPUs.  You’d have to be crazy.

Luckily I have a subscription to Sentieo, including their Canadian data, and that makes it really easy to search for something like “2,301” and find out the context.  As it turns out, the document is hidden in the obscurity of the annual report of the reverse merger parent Leeta Gold Corp.  And it doesn’t actually say GPUs. Here is the relevant paragraph (my underline):

The HIVE Facility consists of 2,301 graphic processing unit (‘GPU”) mining rigs. Maintenance costs, including electrical power, to be paid to Genesis, for operation of the HIVE Facility are expected to be around US$144,650 per month. The maintenance costs will be part of the Master Services Agreement

Its 2,301 rigs.  This makes much more sense and changes the calculations significantly.  Its pretty easy to google “gpus per rig”.  If you do you find that most rigs have at least 5 GPUs.  Many rigs have more than 10 GPUs.

Thus, when I looked at the short report conclusion and saw that they projected $750,000 per month in revenue, I was like, wow, its actually more like 10x that much.  And that’s at $300 Ethereum!

Time to buy.

Conflicting Disclosures

If the short report is off by a factor of 10x then HIVE is a no brainer.  To get a levered play on the direction of cryptocurrencies at a cheap price is a steal.  Unfortunately as I have done more work to make sure the details align, things have become a bit muddled again.

To reiterate what I said earlier, the tricky thing about evaluating HIVE is that:

  1. There isn’t a lot of information about each of the data centers. In fact every subsequent data center has to be based off of the known information about the first data center
  2. The company has provided two fairly different estimates of the profitability of the first data center

So what do we know about the first data center?  Well, we know there is 2,301 rigs.  But we don’t really know how many GPU’s each rig has (though I’m pretty sure its more than one).

The other information we sort of know is the profitability of the first data center.  Unfortunately, I say sort of because HIVE has given us two numbers for this and they aren’t that close to one another.

On June 14th, in this press release, HIVE said the following (my underline):

Based on the computational capacity of the first Data Centre, the historical prices, and required hash rates, and using a mine and immediately sell strategy, the trailing 12 month EBITDA would have been approximately US$7 million.

Later, in their October presentation, HIVE provided this chart on slide 18 (light blue represents the first data center only and dark blue represents two data centers in Iceland).

There is a big difference between $4 million of “gross mining margin” and $7 million of EBITDA.  Because the $4 million number is more recent, I’m going to assume it’s the correct one.

I wanted to try to get to the number independently.  With the disclosure of 2,301 rigs and a reasonable assumption of GPUs per rig its pretty straightforward to use a cryptomining calculator to come up with gross profit, which is likely the equivalent to what HIVE describes as their “gross mining margin”.

But how many GPUs per rig?  I would have expected at least 10.  From what I’ve read, a big miner like Genesis should have at least 10 GPUs per rig.  You’d think Genesis would be using the most efficient GPUs in their stack.

The problem is that the numbers don’t work out with 10 GPUs.  I’ve tabled two scenarios, one with 10 GPUs per rig and the other with only 5.  I actually also had a third scenario with 15 GPUs per rig (the “high” scenario), but given the results that one seems unlikely so I didn’t include it in the table.

Surprisingly, it’s the 5 GPUs per rig scenario that matches a data center generating $4 million of margin at a $300 Ethereum price.

One other possibility is that there are indeed 10 GPUs, but they are lower end processors.  My assumption above was based on the RX 470 card, which has processing speed of 27 MH/s.  I’m told this is one of the most efficient cards.  But maybe the Iceland data centers use R9 280s, which would have a little more than half the processing power as the RX 470s (see the table below).  That would get us closer to 10 GPUs per rig while still staying within the $4 million gross mining margin range.

Of course the other wildcard is that if the earlier $7 million EBITDA number is correct, then my mid case is likely closer to the truth.  But like I said, given the dearth of information I am forced to believe the later number is more accurate.

Once you get the first data center pegged, its easy to figure out the contribution of subsequent data centers from the increases in hash power that HIVE has disclosed for each.

The second data center is said to “increase hashpower by 70%”.  From this information, and assuming a similar power consumption agreement as the first data center, its easy to calculate its contribution.  Keep in mind that it’s the “low” number in the table below that is the one I’m assuming is most accurate.

The third data center (in Sweden) was said to increase hash power by 175%.  Note that I also added a 20% cost escalation for power and maintenance costs on top of what HIVE is paying for the Iceland assets.

For the fourth data center, the company said the following about its Swedish operations on November 14th:

The Sweden Data Centre will consist of newly constructed GPU mining rigs using the latest hardware, custom-designed by Genesis. Each phase is expected to represent approximately 6.8 MW of electricity consumption for a total of 13.6 MW in Sweden. HIVE and Genesis are evaluating expansion potential in Sweden as well as Iceland. In Iceland, HIVE’s current operating facilities represent 3.8 MW in electricity consumption. Completion of the Sweden Data Centre is subject to a number of conditions, including but not limited to, Exchange approval.

To calculate the hash power of the second phase of the Swedish data center I used the same method as the short report, which noted from the above disclosure that Iceland would be 22% of power consumption and Sweden was 78% of power consumption.  Since we already know the hash power from Iceland as well as from the first data center in Sweden It just takes a little bit of math and isolate the second phase in Sweden:

Conclusion

So where does this all leave us?  Well HIVE may not be super cheap, but neither does it appear to be outrageously expensive.  I actually think it’s a pretty interesting way of playing the rise in the Ethereum price (this is something I never would have expected to say a month ago!).  Below is the summation of the profitability of all of the 4 data centers at 3 different Ethereum prices.  Again, remember it’s the low case column that is the likely one, at least given the information that is available.

Of course the numbers above don’t include G&A and taxes so some adjustment has to be made for that.  With 280 million shares outstanding HIVE has had a market capitalization on Friday of $650 million USD.  That capitalization doesn’t seem all that out of line with the low case profitability at $450 Ethereum even adjusting for some G&A and tax.  Especially given the upside blue-sky potential for crypto-currencies and the probability that their relationship with Genesis will lead to more data center deals in the future.

With that said there are plenty of questions remaining.  How long before the profitability drops?  How quickly does the equipment need replacing?  How old are the Iceland data centers?  Is the business actually sustainable over a longer period of time, in particular if the proof of stake changes are implemented?

I don’t have firm answers to those questions yet.  I bought the stock Friday and there is still a lot of digging to be done.  But in the short term, I’m not even sure how relevant those answers are to the primary question, which is where the stock price goes from here.  Its already moved big time today (Monday) and I added a little more at the open this morning.  I suspect we are relatively early on in the speculative excesses of blockchain technologies.  If HIVE can show the above level of profitability and more investors begin to clue into that, I think there is a better chance the stock price moves higher than lower.  And that’s ultimately what we’re all in this for.

Week 332: More Churn

Portfolio Performance

See the end of the post for my full portfolio breakdown and the last four weeks of trades

Thoughts and Review

So I’ve been doing so-so with the portfolio.  I had a big bump up in September because of Helios and Matheson, and since then have mostly been treading water, a few winners and a few losers.

My online portfolio has actually done somewhat better than my actual one.  This is primarily because A. By chance I held on to a larger piece of Helios and Matheson into the high $20’s and B. I’m fully exposed to the Canadian dollar fluctuations in the online portfolio and the Canadian dollar has fallen back below 80c of late.

I’ve still failed to outperform the market for the last 6 months, and that’s been frustrating.  My outperformance in the near term is going to depend a lot on Overstock, which is my largest position right now.

I added around my oil positions as it seems more likely then not we will continue to see draws through year end.   I find the Canadian service companies particularly interesting, mainly because they really look cheap based even on backward looking metrics but stand to benefit further from the price and volume increases one would expect are coming.  I have mentioned Cathedral Energy before, and also like Essential Energy (with the recent positive decision on the outstanding lawsuit) and Aveda Transportation, which is quite levered and has a business tied closely to drilling.

I sold out of Klondex.  I had reduced my position earlier and sold the rest after a pretty so-so quarter.  On the other hand I increased my position in Gran Colombia, which is a frustrating stock for me because it raised guidance and continues to show good cash flow but has these towering asks day after day that keep the stock down.  Gold has been crummy through December in the past but I am pretty excited about gold in 2018.  I want to keep more than my usual weighting going into the new year.

I was pretty happy with the mining results of Ascendent Resources, Largo Resources and Lynas, though none have really done much since their reports.  I plan to write something up on Largo in the near future.  Vanadium seems to be catching some attention and Largo is the only way to play that.  Largo had a really good day on Friday, but its volatile so I don’t know if there will be follow-through.  Vanadium prices are firming up though.  There was a good overview of Vanadium in this blog.  I plan to write up my thoughts on Largo soon.

I was disappointed in Sherritt’s results and sold down my position for now.  Similarly I didn’t like what I saw with CUI Global, particularly that the odorizer technology is not ready for prime-time.  So I sold that one too.  Smith-Midlands was disappointing and who knows when an infrastructure bill gets passed, so I’m out of that stock.  I sold Lakeland Industries, though I might buy that one back in the short term.  I sold the rest of Identiv, a bunch ahead of earnings and the rest after their dismal report.  I sold Daseke ahead of earnings, which turned out to be fortuitous.  And I bought and sold a company called Xunlei Limited, which I quite honestly lucked into when searching for blockchain companies.  I really can’t wrap my head around what they do, so I didn’t stick around after some gains there.

So there’s more churn for sure.  I’m going to try to be quicker to the sell button going forward.  I think that I have been slow to sell for logistical reasons, and this has been a contributor to my poor performance over the last few months.

I’ve taken a few other small, new positions but nothing with enough conviction that I want to talk about them yet.

In fact that’s about all I want to say about the portfolio right now.  Here is my portfolio as of Friday.

Portfolio Composition

Click here for the last eight weeks of trades

A few more thoughts on Overstock

My biggest position right now is Overstock.  I’ve already written two posts about the stock (here and here). I actually added to the position some more today as it dipped back into the $40s.  I’ve been spending most of my time on the name.  Here are a few new thoughts on it.

What is the lending platform worth?

I am constantly re-evaluating the lending platform.  The industry is really opaque and its been a lot of work getting numbers that I have some comfort in.

I have found two sources that seem credible.  The first is this paper from Beneish, Lee and Nichols.  The second is this lawsuit from the pension funds against the prime brokers.

In what follows I am considering the US stock market only.  I believe that once this market is proved out, tZero should be able to expand the platform to other market.  But we’ll leave that for the future.  Right now the big question is whether tZero can make this work in the US.  The news on the call that there is indeed $100 billion of inventory and that they had been offered another $6 billion of hard to borrow that very day (as I’ll describe, the vast majority of revenue from stock lending comes from a few hard to borrow securities), is reassuring.

The US lending market generates $4-$4.5 billion of revenue to prime brokers.  According to the lawsuit documentation, and also described by Bryne a number of times, the prime broker cut is supposed to be around 60%.  But most assume the actual cut is higher because of inter-broker transactions that reduce the cut for the lender.  So let’s say its actually 75%.  That pegs industry revenue from US equities, including what is going to the lender, at $6 billion.

You can get to a very similar number by using the data from the Beneish paper and this article from the securities lending times, which was referenced in the lawsuit document.  The Beneish paper uses IHS Markit data on stock lending rates and volumes.  Global equities on loan are $851 billion and the US makes up 55% of the lending market.  Therefore total US equities on loan are $472 billion.  The average borrowing rate for US equities on loan is about 1.5% (its actually a bit higher but roughly).  So that gives a market size of $7 billion.  So its in the ballpark of the first number.

You often hear a much smaller average borrowing rate quoted, something around 45-50 basis points.  I believe this is because the number quoted is referring to the volume averaged borrowing rate.  In fact the number is usually is described as just that: a volume weighted average.  The reality of the stock lending business is that 80% of equities are easy to borrow and fetch a very small rate (33 basis points).  So most of the volume generates very little revenue.  The majority of revenue comes from a few hard to borrow stocks.  To give perspective, and its a rough calculation because all the data isn’t there, but I calculated that around 50% of revenue from stock lending comes from the 5% most hard to borrow stocks when I used the tables and data from the Beneish paper.

So I’m going to assume it’s a $6 billion market.  Byrne has said that they want to cut fees by 50%.  He has also said the tZero/lender split will be 20/80.  That gives a total addressable market of $600 million for tZero.  I expect that to be very high margin revenue, though Overstock hasn’t given us any numbers to put to margins yet.

One consideration that I haven’t accounted for is the impact of collateral on the prime brokers numbers.  I’m still fuzzy on how this will work.  I believe that the prime broker revenues quoted are fee only revenue.  However the prime brokers also makes some money from holding collateral of the borrower.  Some of this collateral return is passed back to the borrower as a rebate, but the rest is profit to the prime broker.  I don’t know how the collateral will be considered with tZero, but if the lenders are now going to participate directly in the interest generated, that may be included in that 20/80 split, which would make my above estimates low.

Even ignoring the collateral, the opportunity is considerable.  At 10-20% market share, which should be a reasonable objective if the platform is successful, tZero stands to generate $60-$120 million of high margin revenue.  An 8x revenue multiple on $120 million puts you at $1 billion valuation.

Of course there are plenty of folks that don’t think tZero will succeed in capturing any of the market.  I guess that’s what the next few months will prove out.  For what its worth they’ve gone from $0 to $100 billion in two months.  And they’ve brought on board Quantum Fund and Passport, who presumably aren’t making their investments in Overstock because of their desire to make a play in e-commerce.  But we’ll see.

What is e-commerce worth?

The second element I’ve spent time on is e-commerce.  To be honest, for the longest time I was scratching my head about the e-commerce numbers I was hearing.  Marc Cohodes estimated in his Grants presentation that the business could fetch $70+ in a sale.  D.A Davidson valued e-commerce at $58.

When I was stepping through the valuation, I had trouble coming up with those numbers.

Starting with the existing business, I calculated that EBITDA from e-commerce (after eliminating the losses from Medici) for 2015, 2016 and 2017 were $33 million, $31 million and around $18 million for this year.

Byrne said on the third quarter call that there would be “hundreds of basis points of synergies” if they got together with a “bricks” retailer.  I assumed 200 basis points.  Presumably there would also be sales growth from the membership base of the “bricks” acquirer being directed to Overstock to shop.  I assumed 20%.

With all these assumptions the best I could come up with was about $80 million of EBITDA including all the synergies.  That made it hard to justify where the big buy-out numbers were coming from ($70 per share is about $1.75 billion before considering the Soros and Passport dilution, or more than 20x EBITDA including all the synergies).

But then I found something I missed the first time on the conference call.  @teamonfuego, who has been working on Overstock valuations as well, pointed to this passage late in the call.  My underline:

Yes, so this synergy goes both ways. So for example, if we were combined with a large chain, these large chains have similar logistical footprint. They typically have a dozen or so mega distribution centers, each of which are feeding a couple dozen distribution centers, each of which are feeding 10 to 15 stores. If we were integrated with such a company, we could overnight I mean, you would have a system that was competitive with Amazon, fulfillment by Amazon or even nicer than fulfillment by Amazon in several ways. We built, this thing, Saum and Stormy, actually, built some years ago, SOFS. This thing we called SOFS is a software logistics system for an agile network supply chain. We’ve only had it hooked up to our 3 distribution centers, but it could be hooked up to thousands, and it was actually built to be hooked up to as many as we wanted, you don’t need thousand, you need a dozen. So just by, for example, if we were part of a large brick-and-mortar chain, that itself was like $200 million, $250 million of various logistics cost, all right to the bottom line.

I’ve actually talked to a couple of people now that acknowledge that e-commerce logistics are a problem for many of the bricks retailers, and a solution to that problem could be quite coveted.

So who has thousands of distribution centers?  Well this article from Forbes is interesting.  So I’m not at all saying that Walmart is a potential acquirer, but more generally the article talks about how Walmart specifically but also other bricks retailers are embracing what is called omni-channel commerce.  Omni-channel commerce is essentially the process of turning each store into a distribution center.   A number of the chains mentioned, along with plenty of others, would have the 1000’s of stores that would make the logistic cost reduction realized.  The concept aligns pretty well with what Byrne is talking about above.  Needless to say this can change the e-commerce valuation substantially.

Curious Transaction

One of the first things that caught my eye the day of the third quarter earnings release was this disclosure in one of the 8-K’s.

I found it very curious.  Why would Overstock terminate an existing loan and lease agreement in order to make a similar loan with Patrick Byrne’s family?

Indeed I was not surprised when I saw that this transaction was picked up by a few of the shorts on twitter a couple days later.  They pointed to it as an example of a questionable related party transaction.  I can’t disagree, it’s certainly odd. But I wonder if it’s missing the point.

I dug into exactly what the master lease agreement was for.  As it turns out, Overstock entered into the MLA on November 25th 2015.  The lease is to “finance certain software and/or software licenses(s) (“Licensed Software”), software components, including but not limited to, software maintenance and/or support“.

The lease and debt agreement occurred close to the time of the closing of the acquisition of SpeedRoute.  The purchase was initiated in August 2015 and it closed some time before the beginning of 2016.  In fact the day before, on November 24th, Overstock issued an S-3 amendment for potential selling stockholders from SpeedRoute of Overstock stock.

The timing makes me think there’s a pretty good chance these are Speedroute’s assets that Overstock is doing the MLA for.  Reading through the MLA, those assets were secured by Overstock’s land and building.  So you had tZero software secured by Overstock.com assets.

I have to wonder if Overstock cancelled the loan and MLA in order to disentangle the two entities.  Byrne decided to take on the loan and MLA himself (via his family) as a short term plug.  Keep in mind there was no reason to end the relationship with US Bank.  The agreement extended to 2020.  Also, the terms of the loan to Byrne’s family was at a higher interest rate, so this couldn’t be construed as an economic .  Obviously the optics of leasing out from your own family are unfavorable, and I can’t see doing that unless you had another motive.

I may be totally off base about this, but I just have to think you don’t make this change unless you are pretty far down the road to some sort of separation.

Bitt

While all the focus is (rightly) on tZero, Byrne did point to Bitt as his second most promising investment.  I knew Medici owned 11% of Bitt but didn’t know they could own up to 35% with warrants.

Bitt is in the business of digitizing currency to the blockchain for governments.  they are “creating digital wallets for citizens, for people, essentially frictionless payment system, including remittances, which incidentally are a $500 billion industry globally, remittances alone, on which the vig is about 15%.”

Bitt is close to completing their first use case in Barbados.  Catlin Long (from Symbiont) commented on this on her blog back in 2016:

More central banks in small countries will follow the lead of the central bank of Barbados, which green-lighted a blockchain start-up called Bitt to create a digital Barbados dollar that uses Bitcoin’s blockchain as an alternative method for settling foreign exchange. Small central banks are searching for alternatives because local banks are losing access to US financial system, owing to the retreat of American correspondent banks from small countries — a trend called “de-risking.” This is choking off trade, which is the lifeblood of most small economies.  Folks, this an unintended consequence of laws requiring U.S. banks to comply with strict anti-money laundering and know-your-customer regulations. These laws are hurting the developing world — and, ironically, boosting Bitcoin as a valuable alternative payment system. Kudos to Barbados for its creative solution!

Byrne said on the call that Bitt’s development in Barbados is undergoing 4 weeks of testing.  So its pretty close to coming to fruition.

I mean, this thing has a global application, and what I think the first to market with the kind of wallet we’re bringing to market, I just saw, I mean, it’s all in testing. It’s all done. It’s all being tested for another 4 weeks, it’s really slick. It’s really better than anything I’ve seen in the market, that’s a potential enormous business.

While I don’t really have a sense of what the addressable market is for a digital currency, I suspect if the blockchain really does snowball and become the preferred method of recording transactions, it would be pretty big.  If Bitt can be first to market with a successful launch in Barbados, I think that the company is probably worth quite a bit (pun intended).

A few other random thoughts

1. On the conference call Byrne said that “the market” wanted Overstock to get their ownership in tZero down to below 50%.  I think that makes sense for optics.  It makes me wonder if we get some sort of divestiture announcement before the ICO.  Maybe selling a 20% stake to a strategic investor, which along with the ICO would take the overall stake down to 50%?  Purely speculating here but it would seem to make sense to do that before the ICO.  I didn’t really understand the whole “bitcoin fork” reason for the 15 day delay.

2. The securities purchase agreement for the Quantum Fund is lacking the normal disclosure that no non-public information has been exchanged (h/t 20slots for this).  Note that in the Passport agreement, the statement is present (any information that constitutes or could reasonably be expected to constitute material non-public information…)

3. Who was the man in the next room?

4. There was some insider selling over the last few days.  At a glance it appears like they were selling out, but after closer inspection its clear that each of these insiders own significant amounts of restricted stock.  For example Sam Noursalehi, President of Retail, sold 5,000 shares.  He owns 48,000 shares of restricted stock in addition to the remaining 11,000 shares he owned.  I’m not too worked up about these sales.

5. The shorts have been out in full force on Overstock.  Lots of tweets and articles.  I’m actually somewhat comforted that so far, while I can see that the shorts are digging through IP addresses, looking for backdoors to tZero platforms and searching through the Linkedin connections, I haven’t really seen anything that scares me that much.  Of course that could change tomorrow. I’m sure there will be another article.

My thoughts on the Overstock/tZero ICO

This is a follow-up on my original post on Overstock and blockchain.  There are likely be more to come as I learn more (and come up with more questions).

Up until I got interested in Overstock.com I had not given a lot of thought to initial coin offerings (ICOs).  I knew they were a way of raising money, I knew a few fellow investors were making a killing on them, I knew that the details were often murky and that the holders rights were not all that clear.  But I didn’t really delve into the concept too much.

As I explained in my last post, I have yet to make a serious investment in crypto-currencies.  I was running into stumbling blocks being Canadian, and it appeared that there were going to be more stumbling blocks with ICOs.  So I didn’t look too closely.

But when I started looking at Overstock, I started thinking about ICOs.   Overstock’s subsidiary tZero is going to start the pre-sale of their ICO on November 15th (there is a countdown on their website).  tZero is 83% owned by Overstock.  This is, in essence, the first ICO for a publicly traded company.

After spending some time on it, what I’m kinda thinking now is that an ICO is a pretty neat way for a public company to raise money.  Particularly if it’s a company trying to fund a new venture that needs scale from the customer to succeed.

What are the details?

From what I can tell, we don’t know all the details.

Overstock announced some details about the upcoming t0 ICO on October 24th, so about a week ago.  As I pointed out in my last post, of these details I thought the key ones were the following:

  • The tZERO token will be tradable on tZERO’s U.S.-regulated ATS.
  • The tZERO token will incorporate profit-sharing features of a security as well as utility features of an app token, including:
    • Token holders will be able to use the tZERO token to pay for fees on the ATS and payment of such fees using tZERO tokens will grant up to a 25% discount as compared to payments made using U.S. dollars. The tZERO token is expected to have additional functionality and token holder benefits to be announced at a later to date and will be included in the offering memorandum; and
    • tZERO believes its token will be the first to offer a percentage of tZERO’s profits, distributed as a quarterly distribution paid into tZERO token holders’ digital wallets.

The benefits of token holding are: A. discounts when using the platform, B. quarterly distributions and C. additional functionality to be announced at a later date.

The one thing that I’m not clear on is whether the discount is referring to the token exchange, the share lending exchange or both?  I am assuming its referring to both, but that might be wrong.

The most important distinction is that this ICO does not convey ownership, at least not in any traditional liquidation/acquisition sort of sense.  While the strict definition of Simple Agreement for Future Token (SAFT) considers this offering a “security token”, and that is how Overstock refers to it in their press release, it is not a security in the way we usually think of it.  Byrnes himself has referred to the token as a “utility token” on other occasions.

When the ICO is complete Overstock expects tZero will get somewhere between $200 – $500 million of capital (based on comments made by Byrnes a couple of weeks ago).  This will be used to further develop their various platforms: their security lending platform, their token exchange, potentially other exchanges that have yet to be revealed.

What I think is pretty cool

The way the token is set up has some pretty interesting consequences.  Unlike a share offering or debt offering, the capital provider doesn’t just give his money and sit passively. The token holder has an active interest in seeing the platform succeed.

This is because one of the two key features of the token is a discount on usage.  This means the value of the token is best realized by a consumer of the platform.  Maybe a speculator can make some money buying a token and watching it appreciate but the token holder who is also lending stock or buying tokens on the exchanges (so using the platform) is going to be benefiting more from holding the token then the speculator.  Moreover, once a consumer of the platform is a token holder, they have an interest in making that platform succeed because the value of their token will increase based on its success.

In this scenario the consumer of the platform is the natural lender.  I think that’s the key point here.

The lynch pin to the whole process is having a platform that is valuable.  If you have that, then the token offering becomes a virtuous circle of on-boarding consumers and giving them a stake in its success, which in turn will help lead to its success.

In the case of tZero, if a pension fund decides they like the idea of the alternative security lending exchange, they can buy tokens.  This will give them a discount on transactions when using that exchange.  Furthermore, once they have tokens they can benefit from the dividend and benefit from the rise in value of their token.  So it becomes in their best interests to drive business to the exchange and get others involved.

The same reasoning can be used for the other tZero platform, with a consumer of the ICO trading platform.

As for the benefits to Overstock, I’ve already pointed out that tZero gets a capital injection they can use to facilitate the growth of the business.  If allocated properly, this presumably will lead to more value creation for the token. And I imagine, though I don’t know this for sure, haven’t seen it detailed, that Overstock will keep a significant percentage of the tokens so they participate in the increase in value of the token as the platform grows.  The less obvious benefit, but the one that I think is the most interesting and should be underestimated: in many ways Overstock acquires partners in the business with an interest in seeing it succeed but without giving away ownership.

What they are really giving up is a portion of future revenues determined by the discount on usage. But again, this benefit only accrues to consumers of the platform.  And Overstock/tZero needs those consumers to buy into the platform anyways for it to be successful.  Giving away a portion of that future value to prospective consumers in return for improving the chances that this future value is realized seems like a pretty reasonable trade-off to me.

The other way to think I was thinking about these benefits was to try to frame it as a very unique debt offering with unusual attributes.  First, the principle will never have to be repaid.  Instead of payment of principle you give payment of discount.  Second, the “interest” that is paid (I’m framing the dividend as being an interest of a sort) is a function of the platform success (in terms of lost revenue from the discounts and from dividends paid).  And third, you give some sort of stake in future developments yet to come.

I’ll be honest. I have thought about this in maybe half a dozen different ways in the last few days.  Its kinda like debt, kinda like equity, kinda like a membership, kinda like a co-operative, but not really exactly like any of those things.  None of the analogies fit perfectly.  This is different.  And It’s a pretty cool way to raise money.

One other thing…

The last thing I wanted to mention is that @teamonfuego found a great bit of due diligence.  A little over a week ago Byrnes made three announcements at the Money 20/20 conference.  One of these announcements was with respect to the digital locate receipt technology they are using in the tZero stock lending platform.

Brynes said that the platform is now live in an alpha stage and has about $8 billion of inventory.  If you remember from my last post, there was about $100 million of inventory as of the second quarter earnings call.

But even more impressive, Byrnes said that by November 1st the platform will go live with more than $120 billion of inventory.

He also said they were integrating with a couple platforms (so far unnamed), have about 8,000 users, active traders involved, and he reiterated that he thinks they can disrupt the prime broker desk which is 75% of revenue of prime brokerage industry.

When I wrote my original post on Overstock, my thought was I would add once we have confirmation of buy-in on the security lending platform.   I doubled and then tripled up on my position on hearing this news.

My bets on Blockchain

This is going to be a quick and dirty “here are my thoughts” post because I want to get the idea out there and solicit feedback.  I want to talk about what I have done with blockchain, where I think it might be going, and why I am (cautiously) optimistic that blockchain technology isn’t the bubble that many fear.

Back in May I decided that bitcoin just might be the real deal. I started to look for ways of investing in it.  It was a tough go.

I found that putting money into bitcoin in Canada was somewhat more difficult than the United States.  I cringed at the idea of providing a bunch of personal information to some exchange site, including drivers license and a credit card. I’m a dinosaur in some respects and I get nervous about transferring personal information over the internet.

I also found very few ways of playing the trend via the stock market.  There were basically zero publicly traded company’s that I could find.

I ended up taking only a small position in bitcoin and ethereum (really small).  But I also did another, much smarter thing.  I took a tiny position in Overstock.com.

The size of the position was inconsequential.  I’m not going to pretend I got in before the move or even that I understood what Overstock was doing.  I did it simply so I would have a placeholder in my portfolio and I would be aware of it if something happened.

In mid-September something happened and the stock started to go.

Now fortunately but unfortunately, I was really caught up in the Helios and Matheson story at the time, and so I didn’t pay a lot of attention to Overstock.  My mind doesn’t multitask all that well, and delving into blockchain while I was trying to decipher Moviepass just wasn’t within my capacities.  Its too bad, because if I had I am sure I would have seen what I see now and gotten in about $10-$15 earlier.

Nevertheless, I did get around to looking at both Overstock.com and at other crypto ideas over the last couple of weeks.

A few things have struck me.

Blockchain not Currencies

First, I feel like the real play here is with blockchain, not bitcoin. Getting into crypto-currencies has been a money maker, no question.  But going forward I am of the mind that the winners are going to be companies that have figured out ways to use blockchain technology to eliminate inefficiencies, in particular those associated with the middle man of particular transaction classes.

The most common description I hear of blockchain is that it is a decentralized platform.  That has never really resonated with me.  Maybe the word decentralized is too vague.  After doing much reading and listening on the subject, I have found that the definition that makes more sense to me is to say that blockchain is simply a very effective way of eliminating the middle man.

I know if I was to use that definition publicly I would get a lot of push back: its too narrow, it doesn’t describe all the functionality or possibilities that blockchain can encompass, etc.  But to me, looking for near-term disrupting investment ideas, that is the definition that sticks.

Our world is full of transactions that individuals and companies perform with each other every day.  Each transaction requires a level of trust between the buyer and seller.  In many cases the level of trust required to complete a transaction directly between buyer and seller is not possible.  Maybe its distance, logistics, complexity, could be any number of things.   Whenever we run into this “trust gap” the solution has always been to employ an intermediary that embodies a greater level of trust and through which the transaction can flow.

Of course this middle man takes a cut.  In some cases, especially if its an opaque market, they take a big cut.

The way I look at blockchain is it’s a way of dis-embodying that trust into technology.  The middle man disappears.  The skim shrinks.  Everyone (other then the middle man) benefits.

This makes so much sense to me.  It seems inevitable. It makes me want to go all in.

Overstock

Overstock is the obvious way to play this.  I finally got into Overstock in a more meaningful way in the mid-$30s.  I have added since then.  The stock is parabolic which is frightening and I can just as easily see it going to $35 as $55 in the short run.  I mean who knows when a chart looks like this and is clearly being run around by traders.

In the longer run, I think that what Overstock is doing is fascinating and if it works, the stock will go much higher.

The thing that really jump-started Overstock was their initiative, via their subsidiary tZero, to launch a trading systems for tokens.  That seems to have coincided with when the stock took off.  They also announced their own initial coin offering (ICO) for tZero, which will take place over the next couple of months.

I think these are both great initiatives and are movements in the right direction.   But the most interesting development to me is the blockchain securities lending platform that Overstock’s tZero subsidiary has developed.  Byrnes does a really good job of describing how the platform works on the second quarter conference call.  Start listening at a little after the 20 minute mark.

In this case, the middle man that Overstock is trying to eliminate is the prime broker.  The cut that the prime broker appears to be taking in security lending seems to be abnormally large.  If you want the details of how it works, just listen to the call and do a few google searches.  Its clear that A. this is a very large market and B. there is a lot of waste to be eliminated if the middle man can be removed.

What I also find so interesting about the opportunity, other than that it makes sense, is that even by taking a much smaller piece of the pie than prime brokers currently do Overstock/tZero can make a lot of money because the transaction base is so large.  IHS Markit says that security lending is a $9 billion market.  If this platform can begin by taking even a smidgeon of that, its going to be very significant to the stock.  If the platform goes viral, well then things would get silly.

On the second quarter call Byrnes noted the following about the platform (my underline):

I’ll mention we have about 700 symbols in inventory now. 100 of them are hard to borrow, we have over $100 million in inventory. Another reason I’m in New York is talking to people who have billions or tens of billions of dollars that they want to integrate, they want to provide as inventory. So, we’ll see how this goes, but I’m really quite proud of this system.

So its just starting to scale.  I think it was only 5 weeks old at the time.

I admit I am fuzzy about the economics.  Clearly the play here is to make this advantageous to funds and short sellers by lowering transaction fees and taking a smaller skim than what prime brokers take, and by performing the task with complete transparency.  Byrnes goes on in the call to define the following economics of the platform net to tZero:

This is the best use of blockchain I’ve ever seen, because it addresses exactly the issues that regulators have, that short sellers have, that prime brokers have. I don’t want to be sued if this turns out to be wrong, I think the capacity is 1% of x, if we theoretically got somebody putting in $1 billion, I think we should be generating $10 million through, essentially the bottom line of tZERO, and I think there may be possibilities well beyond that.

None of this is to say that it’s a sure thing that the security lending platform, the ICO platform or any of the other initiatives that Medici (the Overstock subsidiary that owns tZero) has a stake in, are going to pan out.  But I am of the mind that some of them will.

One last thing about Overstock that I think is worth mentioning.  The ICO seems like a really interesting way to raise money to me.  According to the press release that I linked to above, the ICO will give participants a tZero token that has the following attributes:

  • The tZERO token will be tradable on tZERO’s U.S.-regulated ATS.
  • The tZERO token will incorporate profit-sharing features of a security as well as utility features of an app token, including:
    • Token holders will be able to use the tZERO token to pay for fees on the ATS and payment of such fees using tZERO tokens will grant up to a 25% discount as compared to payments made using U.S. dollars. The tZERO token is expected to have additional functionality and token holder benefits to be announced at a later to date and will be included in the offering memorandum; and
    • tZERO believes its token will be the first to offer a percentage of tZERO’s profits, distributed as a quarterly distribution paid into tZERO token holders’ digital wallets.

My take on this (tell me if you think I am wrong) is that the value intrinsic to the token is not based on ownership.  The beauty of it is that its not really an ownership stake.  In fact I am pretty sure you can’t do a US based ICO right now that generates out right ownership in a company (the SEC hasn’t laid down any structure for this yet but again tell me if I am wrong about this).

Instead the token is more like the right to participate in the success of the platform.  I almost want to say that its like an Amazon Prime membership for blockchain technologies but maybe that’s too cheeky and a bit of a stretch.   Nevertheless, the value of the token is a function of the success of the platforms created by tZero, realized via the discounts and dividends that are derived from their success.  So the benefits are most easily realized by participants in the platforms, in this case those who participate in the ICO exchange and the securities lending exchange (maybe others?).

To use a word I hate to use, it all seems very synergistic.

Think about it.  These tokens, while not offering ownership in tZero, are going to give holders a significant discount on transactions on the platforms and are going to give a dividend based on the success of the platforms.  So the bigger the tZero platforms get, the more valuable the tokens are.  And if you are a fund that is thinking about how it would be nice to lend securities without having to have a prime broker take a big chunk of the interest, it probably makes sense to take on some token exposure so you can make your transactions even more cheaply and even get a dividend kick-back that is a function of your own volume to some degree.

Its easy to see how if this works, it could snowball.

Other ideas

Overstock is my favorite blockchain idea hands down and the only one I have a truly meaningful position in.  But I also took small positions in a few others.

I own two Canadian venture stocks, LeoNovus and Posera, which both made JV’s with the company DLT labs.  I will be the first to admit that the details on what comes of the JV’s are murky but I did some work into DLT Labs and they seemed like a legitimate blockchain development company so I figured each was worth a small stab.  LeoNovus also has a proof of concept agreement with a Canadian bank and was interviewed on Capital Ideas TV here.  Both of these stocks are actually up quite significantly today, and I’ll admit that I have questioned whether their growing market capitalizations are justified on multiple occasions today.

I also took small positions in a couple of Chinese related ideas, Xunlei Limited and Xinyuan Real Estate.

Xinjuan has somewhat of a peripheral blockchain idea.  My original impetus to buy the stock was that it appeared cheap compare to other Chinese real estate developers and we seem to be in a bit of a China bull market at the moment.  But its also had a blockchain platform for property financing live for over a year now and that gave me some added reason to take a small spec.  I came across the stock from this youtube video.

Xunlei has a blockchain based product called OneCloud and has recently had an ICO, which is not easy to do for a Chinese company.  The company also has over $5 in cash and investments per ADS, so it appears relatively cheap and thus I figured it was worth a tiny punt.

Again none of these four stocks are significant in size for me. Way less than 1%.  Overstock is the only one I have any real conviction in so far.

Conclusions

I am not going to pretend I have some amazing insights that project the success of any of these companies.  I’ll be clear about this, and I include Overstock in the statement.  This is to a large degree a speculation.  The technology makes sense to me, and in the case of Overstock the applications they have identified make sense to me, but I don’t really know if it pans out in the end.

It is a bit like Helios and Matheson in the sense that while I don’t know how it all plays out, my thinking is this:  I suspect that for foreseeable future the money wanting into blockchain technology assets is going to far exceed the number of available avenues to invest in.  This happens all the time and when it does it floats a bunch of little companies along with it.  A few of these companies turn out to be winners.  Many turn out to be flops.  But getting from here to there can make you a lot of money if you are agile.  So for the time being, picking the eventual winners kind of takes a back seat.  That’s why I was willing to take some bets on the smaller basket outside of Overstock.

And like I said, I don’t even know if Overstock will be a winner here.  Maybe no one will adopt their initiatives and tZero will crash and burn.  I’m certainly no expert in the field.  What I do know is that while Byrnes seems to be more than mildly hated by many, which I think is great, when I listen to what he has to say (for example as the 2014 key note at this Bitcoin conference) I think he makes a lot of sense.  He clearly has thought this through and made his bet after much consideration for underlying conditions.  I am of the mind that the underlying conditions he describes are accurate, and that the direction he projects is correct.

So I’m going along for the ride.  And I will tell you what I want to do.  I want to take a really big position in Overstock.  I think the upside is so big if these ideas pan out.

But its really hard to jump heavily into a stock up as much as Overstock is. My position size right now is a relatively modest, but not insignificant, 3.5%.

I am in part writing this post as a request for comment.  Please send me emails with opinions of whether you think this makes as much sense to you as it does to me.  Or not.  And whether you think Overstocks initiatives or any of the other company’s I’ve taken a spec position in, will pan out or not.

Its so new and uncertain, but also seems to make sense.  So I am open minded.

Waiting on my position in Bearing Lithium

I took a position in Bearing Lithium a little over a month ago.  It was one of a number of positions I took when I realized the significance and inevitability of the electric vehicle.  But since then it hasn’t done much. It has probably been the worst performer of the bunch.

When I compare the performance of Bearing to other lithium stocks that have risen significantly I am disappointed.  Nevertheless the stock is cheap and I think over time the valuation discount will be closed.  So I plan to wait on it a while longer.  Here is the story.

Maricunga Deposit

Bearing owns a 17.7% interest in a lithium brine deposit in Chile called Maricunga.  Maricunga is one of the highest grade deposits in the world with a measured and indicated (M&I) resource of 1,143mg/L. The Ni 43-101 report outlines a deposit contains 1,720,000 tonnes of lithium carbonate equivalent (LCE) M&I resource.

The deposit is co-owned by Lithium Power, Bearing Lithium and a Chilean JV Partner.  Lithium Power has an earn-in to 50% ownership by advancing the project to feasibility.  Because of the earn-in Bearing has their costs covered until roughly mid-2018 when a feasibility study is produced.

Here is the Australian firm Independent Investment Research, who covers Lithium Power, giving their thoughts on Maricunga (note that this was before the recent resource estimate that more than doubled the size of Maricunga):

Bearing Lithium acquired its stake in the project via a merger with a US OTC company called Li3.  Li3 had a 49% stake in the project until July 2016 when they entered into the agreement with Lithium Power and the Chilean JV Partner to create a JV to hold the assets.

As part of the JV agreement Li3 had their stake reduced (to the current 17%). In return Lithium Power agreed to contribute $27.5 million in cash to the Maricunga JV to cover exploration and development until feasibility.

Being an OTC junior strapped for cash, Li3 took the deal.

Still being short of cash and stuck in relative obscurity as a penny stock on the OTC, Li3 agreed to be merged with Bearing in January of this year.  The merger wasn’t met with universal glee by all shareholders.  As a number of posts on the investorhub board suggest, some shareholders questioned why they were diluting their stake in Maricunga.

It’s a good question.  I am guessing that it came down to a lack of options for raising capital, and the hope that a listing on the TSX Venture would lead to promotion and a re-rating of the deposit.

Unfortunately that hasn’t happened so far.

Peer Comparison

I would argue that Bearing Lithium is undervalued.  Below is a comparison with a number of other lithium explorers, some with a defined deposit and some without.  Even companies with no firm resource hold much higher valuations than Bearing.

Why the discount to peers?  There are reasons, but I don’t think any of them justifies the discount.

First, the majority of the lithium resource exists in the Litio 1-6 concessions (I provide a map that outlines the concessions below).  These concessions do not have a mining permit yet and are not grandfathered like Cocina 19-27 concessions. In their current state they can be explored, but not mined.  There may be some concern about getting a permit.

Mitigating this concern are comments from the mining minister in Chile, who came out and was in favor of maricunga (according to this interview):

If I was to choose anywhere in Latin America, one, two and three, it would be Chile, Chile, Chile. But saying this, moving forward, Aurora Williams, who is the mining minister of Chile, announced at PDAC only last week that Chile’s main goal is to find foreign capital to develop the Maricunga.

While permitting, at least with the current government, will require negotiations, when it comes time to go to the table I don’t expect that Bearing Lithium and Lithium Power will be the one’s to take the deposit to production.  I think Maricunga gets picked up by a bigger player.  The map below shows how the concessions are surrounded by neighbouring concessions owned by Codelco and SQM.

Consolidation into a single large operation makes sense.  When that occurs, I suspect that the larger company will be able to negotiate permits for the entire district.

The second reason for the discount might be that Maricunga is in Chile.  Chile has a far more left leaning government than Argentina.  The government has feuded with SQM over the company’s leases in Chile.  They have been renegotiating terms of Albemarle’s royalties where they have asked for a 60% royalty if lithium prices rise over $12,000/t USD.

There is an election in Chile in November so a change of government is possible.  Early polls suggest a change in government might occur.

The third reason is ownership structure.  The ownership was a problem before the merger because Li3 was listed on the OTC, was a penny stock (like literally a 1c stock!) and thus it received zero exposure.  It’s a bit better now that Bearing holds that stake, but I wonder how many investors are dissuaded by the relatively small minority interest Bearing has.

It doesn’t help that Lithium Power trades on the ASX.  I don’t think there are many lithium-brine plays on the Australian exchange.  Australia is all about hard rock lithium mining.  I don’t know of another that is primarily a brine-only play (please tell me if I’m wrong?).  Lithium Power is a bit of a fish out of water.

As well, Lithium Power has a huge warrant overhang of 72 million shares at 55c.  Because Bearing Lithium and Lithium Power trade to a similar valuation, the ceiling on Lithium Power impacts Bearing as well.

The fourth reason is promotion.  Whether or not you think all these tiny little lithium explorers are going to turn out golden in the end, you have to admit that their stock movements lately have had more to do with speculation than anything fundamental to the individual names.  So far there isn’t a lot of promotion around Bearing and the Maricunga deposit.  For example, if you go through the Seeking Alpha articles on lithium you will find all kinds of tiny juniors referenced, some with only some hectres of land and no resource, but there has been nothing written about any of the Maricunga players.

So there are some reasons.  None of them are particularly compelling to me.  None make me want to sell my position.

Conclusion

Its been a disappointing investment so far.  I’ve watched a couple of other tiny positions I have in lithium juniors (International Lithium and Nemaska Lithium) give me more profits than my larger position in Bearing (I’m down on my position in Bearing so far).

Nevertheless I am going to stay the course.  The Maricunga deposit is world class, its higher grade than almost all its peers, its relatively advanced and has not shown any features that would handicap it.  I think eventually the superiority of the deposit will win out and I’ll hold on for that to happen