Author: @Web3_Mario

Source: https://mp.weixin.qq.com/s/jfJURj_OhymH12OBN8qIcQ

Abstract

This article primarily discusses the recent high topic surrounding MicroStrategy. Many industry veterans have commented on the company's operational model. After digesting and thoroughly researching the matter, I have some personal insights that I would like to share. I believe the reason for MicroStrategy's stock price increase lies in the "Davis Double-Play." Through its business design of financing to purchase BTC, MicroStrategy has linked the appreciation of BTC with the company's profitability. Additionally, the innovative design of combining traditional financial market financing channels and leveraging funds has enabled the company to achieve a level of profitability growth that surpasses the gains from its BTC holdings. As the position grows, the company gains certain pricing power over BTC, further reinforcing the expectation of profitability growth.

However, the risks lie in the same factors. When the BTC market experiences volatility or a reversal, the profitability from BTC will stagnate. At the same time, due to the company's operating expenses and debt pressure, MicroStrategy's ability to finance will be greatly reduced, which will, in turn, impact the expectations of profitability growth. Unless there is new momentum to push up the BTC price further, the premium of MSTR stock relative to its BTC holdings will quickly narrow. This process is what is referred to as the "Davis Double-Kill."

What Are the Davis Double-Play and Double-Kill?

For those who are familiar with my work, you should know that I am dedicated to helping more non-financial professionals understand these dynamics. Therefore, I will revisit my own thought process and explain it in detail. First, let's review some basic concepts: What is the "Davis Double-Play" and "Double-Kill"?

The so-called "Davis Double-Play" was proposed by investment guru Clifford Davis. It is usually used to describe the phenomenon where a company's stock price rises significantly due to two factors in a favorable economic environment. These two factors are:

1. Company profit growth: The company has achieved strong profit growth, or its business model and management optimization have led to an increase in profits.

2. Valuation expansion: Due to the market's increased optimism about the company's future, investors are willing to pay a higher price for its stock, which in turn drives up the stock's valuation.

In other words, the company's price-to-earnings ratio (P/E Ratio) or other valuation multiples expand. The logic driving the "Davis Double-Play" is as follows: First, the company's performance exceeds expectations, with both revenue and profits increasing. For example, strong product sales, market share expansion, or cost control success—all of which will directly lead to profit growth. This growth also boosts the market's confidence in the company's future prospects, which leads investors to accept a higher P/E ratio and pay a higher price for the stock, causing the valuation to expand. This linear and exponential positive feedback effect typically results in the stock price accelerating upward, known as the "Davis Double-Play."

Let's use an example to explain this process:

● Suppose a company's current P/E ratio is 15, and its expected profit growth is 30%.

● Due to the company's profit growth and changes in market sentiment, investors are willing to pay an 18x P/E ratio.

● Even if the profit growth rate remains unchanged, the increased valuation will drive the stock price up significantly. For example:

○ Current stock price: $100

○ Profit growth of 30%, meaning earnings per share (EPS) increases from $5 to $6.50.

○ The P/E ratio increases from 15 to 18.

○ New stock price: $6.50 × 18 = $117

The stock price rises from $100 to $117, reflecting the dual effects of profit growth and valuation expansion.

On the other hand, the "Davis Double-Kill" is the opposite. It is typically used to describe a situation where a stock price drops rapidly due to two negative factors. These two negative factors are:

1. Declining company profits: The company’s profitability decreases, possibly due to factors like reduced revenue, rising costs, or management mistakes, leading to profits falling short of market expectations.

2. Valuation contraction: Due to declining profits or worsening market prospects, investors lose confidence in the company’s future and are unwilling to pay a high price for the stock, causing its valuation multiple (such as P/E ratio) to decline, and the stock price to fall.

The logic behind the "Davis Double-Kill" is as follows: First, the company fails to meet the expected profit target, or it faces operational difficulties, leading to poor performance and declining profits. This in turn reduces market confidence in the company’s future, and investors are less willing to accept the current high valuation, choosing instead to pay a lower price for the stock, which causes the valuation multiple to shrink and the stock price to fall further.

Again, let's illustrate this process with an example:

● Suppose a company's current P/E ratio is 15, and its expected profit decline is 20%.

● Due to the profit decline, the market begins to doubt the company’s future prospects, and investors start lowering its P/E ratio.

● For example, the P/E ratio might drop from 15 to 12. The stock price could fall significantly:

○ Current stock price: $100

○ Profit decline of 20%, meaning EPS drops from $5 to $4.

○ The P/E ratio decreases from 15 to 12.

○ New stock price: $4 × 12 = $48

The stock price falls from $100 to $48, reflecting the dual effects of declining profits and valuation contraction.

This resonance effect typically occurs with high-growth stocks, especially in the tech sector, because investors are often willing to give these companies high future growth expectations. However, these expectations tend to be driven by subjective factors, which makes the volatility much higher.

How MSTR's High Premium Is Created and Why It Becomes the Core of Its Business Model

After supplementing this background knowledge, I believe everyone should have a basic understanding of how MSTR’s high premium relative to its BTC holdings is generated. First, MicroStrategy shifted its business from traditional software operations to financing the purchase of BTC. Of course, it is possible that future asset management revenues could also play a role. This means that the company's profits come from the capital gains of BTC purchased with funds raised through equity dilution and debt issuance. As BTC appreciates, the equity of all investors grows, and they benefit from this increase. In this sense, MSTR is no different from other BTC ETFs.

What sets MSTR apart, however, is the leverage effect brought about by its financing ability. The future profitability growth expected by MSTR investors is driven by the leverage gains from its financing capacity. Given that MSTR’s total market capitalization relative to its BTC holdings is in a state of positive premium (i.e., MSTR's market value exceeds the value of its BTC holdings), as long as this positive premium remains, both equity and convertible bond financing will allow the company to purchase more BTC, which further increases per-share equity. This gives MSTR a unique ability to generate profitability growth compared to BTC ETFs.

Let’s break this down with an example: Suppose MSTR currently holds $40 billion worth of BTC, with total circulating shares being X, and its total market value is Y.So the equity per share at this point is 40 billion over X. At the most unfavorable dilution, assume that the proportion of new shares issued is a, which means that the total outstanding shares become X * (a+1), and the financing is completed at the current valuation, raising a * Y billion dollars in total. If all these funds are converted into BTC, the BTC position will become 40 billion +a * Y billion, which means that the equity per share will become:

We subtract this from the original equity per share and calculate the increase in diluted equity per share as follows:

This means that when Y is greater than 40 billion, that is, the value of BTC held by it, that is, when there is a positive premium, the growth of equity per share brought by the completion of financing to purchase BTC is always greater than 0, and the greater the positive premium is, the higher the growth of equity per share is. The two are called linear relationship. As for the impact of dilution ratio A, it shows an inverse proportional characteristic in the first quadrant, which means that The less additional shares are issued, the higher the increase in equity is.

Therefore, for Michael Saylor, the positive premium of MSTR’s market capitalization relative to its BTC holdings is the core element of the company's business model. His optimal strategy is to maintain this premium while continuously raising funds, increasing market share, and gaining more pricing power over BTC. This increasing pricing power, in turn, boosts investor confidence in future growth even at high P/E ratios, allowing the company to continue raising capital.

To summarize, the core of MicroStrategy's business model lies in the appreciation of BTC driving profitability growth. As the trend of BTC growth continues positively, the company’s profitability trend also improves. With the support of this “Davis Double Play,” MSTR’s positive premium begins to expand, and the market is betting on how high a positive premium MSTR can achieve in future financing rounds.

The Risks MicroStrategy Brings to the Industry

Now, let's discuss the risks that MicroStrategy brings to the industry. I believe the core risk lies in the fact that this business model significantly amplifies BTC price volatility, acting as a magnifier of price fluctuations. The reason for this is "Davis Double Kill," and when BTC enters a period of high volatility, that marks the beginning of the domino effect.

Let’s imagine a scenario where the growth of BTC slows down and enters a consolidation phase. MicroStrategy’s profits will inevitably begin to decrease. Here, I want to elaborate on something I’ve seen—some people focus heavily on its cost basis and unrealized gains. However, this is irrelevant in the context of MicroStrategy's business model. The reason is that in MicroStrategy’s model, profits are transparent and essentially settled in real-time. In traditional stock markets, we know that the factors causing stock price fluctuations are the earnings reports. Only when quarterly reports are released is the true level of profitability confirmed by the market. Until then, investors only estimate financial changes based on external information.

This means that, for most of the time, stock price reactions lag behind actual earnings changes. This lag is corrected when quarterly earnings reports are released. However, in MicroStrategy’s case, because both its holdings and BTC prices are public information, investors can instantly assess its real profitability. There is no lag effect because per-share equity is dynamically adjusted, which is similar to real-time profit settlement. Therefore, the stock price already reflects all of its profits, and there is no lag effect. As a result, focusing on cost basis is pointless.

Returning to the topic, let’s now see how the "Davis Double Kill" unfolds. When BTC’s growth slows down and enters a consolidation phase, MicroStrategy's profits will continue to decline, potentially even to zero. During this time, fixed operating costs and financing costs will further erode the company’s profitability, potentially pushing it into a loss-making state. This turbulence will continue to erode market confidence in BTC's future price movements, which will translate into doubts about MicroStrategy’s financing ability. This, in turn, will further undermine expectations for its future profitability. As these two factors resonate with each other, MSTR’s positive premium will quickly shrink.

To maintain the validity of its business model, Michael Saylor must protect the positive premium. Therefore, selling BTC to raise funds to repurchase stock becomes a necessary action. This marks the moment when MicroStrategy begins to sell its first BTC.

Some may ask, "Why not just hold the BTC and let the stock price naturally fall?" My answer is: it’s not possible—more precisely, it’s not feasible when BTC prices reverse. During a consolidation phase, it might be tolerable, but when a reversal occurs, this becomes unsustainable. The reason lies in MicroStrategy’s current equity structure and what constitutes the optimal solution for Michael Saylor.

In MicroStrategy's current shareholder structure, there are top-tier financial institutions such as Jane Street and BlackRock, while Michael Saylor, the founder, owns less than 10% of the company. However, due to a dual-class share structure, Michael Saylor has absolute voting power, as the B-class shares he holds have 10 votes per share, compared to the 1 vote per share for A-class stock. Therefore, the company is still under Michael Saylor’s strong control, but his ownership stake is relatively low.

This means that for Michael Saylor, the long-term value of the company is far more important than the value of the BTC he holds, because if the company were to face bankruptcy and liquidation, he wouldn’t receive much BTC.

So what are the benefits of selling BTC during a consolidation phase and repurchasing stock to maintain the premium? The answer is clear: When the premium starts to contract, if Michael Saylor judges that MSTR’s P/E ratio is undervalued due to market panic, selling BTC to raise funds and repurchasing MSTR shares from the market is a very profitable move. In this case, the reduction in share count (via buybacks) will have a stronger impact on increasing per-share equity than the reduction in BTC reserves will have on decreasing per-share equity. Once the panic ends, the stock price will recover, and per-share equity will be higher, which is beneficial for future growth. This effect is easier to understand in extreme cases when BTC experiences a trend reversal, and MSTR even reaches a negative premium.

Considering Michael Saylor's large holdings, liquidity tends to tighten during periods of consolidation or downturn. So, when he begins to sell BTC, it accelerates the price decline. This accelerated decline will further worsen investors’ expectations for MicroStrategy’s profitability growth, causing the premium to shrink further, thus forcing the company to sell more BTC and repurchase MSTR stock. This is when the "Davis Double Kill" begins.

Of course, another reason that forces the company to sell BTC and maintain the stock price is that its investors are powerful, well-connected institutions ("Deep State") that will not passively watch the stock price collapse. They will apply pressure on Michael Saylor, forcing him to take responsibility for managing the company's market value. Moreover, recent reports suggest that with ongoing equity dilution, Michael Saylor’s voting power has fallen below 50%, though I haven’t found specific sources for this yet. However, this trend seems inevitable.

Does MicroStrategy's Convertible Bond Truly Carry No Risk Before Maturity?

After the above discussion, I believe I’ve explained my logic comprehensively. Now, I would like to touch upon another topic: Does MicroStrategy truly have no debt risk in the short term? Some predecessors have already introduced the nature of MicroStrategy's convertible bonds, so I won't delve into that here. Indeed, the bond maturity is quite far off, and there is no immediate repayment risk before the maturity date. However, my view is that its debt risk could potentially be reflected in the stock price ahead of time.

MicroStrategy's convertible bonds essentially function as bonds with a built-in, free call option. Upon maturity, bondholders can demand that MicroStrategy redeem the bonds in stocks equivalent to the conversion rate previously agreed upon. However, MicroStrategy has some protection here as well: it has the flexibility to choose how to redeem—either with cash, stocks, or a combination of both. If funds are abundant, it can pay more in cash to avoid dilution of equity; if funds are tight, it can use more stock. Additionally, the convertible bond is unsecured, so the repayment risk is indeed quite low.

Furthermore, there's another protective feature for MicroStrategy: if the bond’s premium exceeds 130%, the company can choose to redeem the bonds at their cash equivalent value. This provides the company with room for negotiations in case of refinancing. Therefore, bondholders will only make a capital gain if the stock price is above the conversion price and below 130% of the conversion price. If it is above 130%, MicroStrategy can redeem the bonds in cash, and bondholders will only receive their principal plus a low-interest return.

As pointed out by Mr. Mindao, the main investors in these bonds are hedge funds, who use them for delta hedging and to profit from volatility. After thinking it through, I realized that the delta hedging process behind these bonds works as follows: hedge funds buy MSTR convertible bonds while simultaneously short an equivalent amount of MSTR stock to hedge against the risks of stock price fluctuations.

As the price develops, hedge funds need to adjust their positions dynamically to maintain their hedge. The dynamic hedging process typically follows two scenarios:

● When MSTR’s stock price falls, the delta value of the convertible bond decreases because the conversion option becomes less valuable (closer to "out-of-the-money"). In this case, they would need to short more MSTR stock to match the new delta value.

● When MSTR’s stock price rises, the delta value of the convertible bond increases because the conversion option becomes more valuable (closer to "in-the-money"). In this case, they would buy back some of the MSTR stock they had previously shorted to match the new delta value, thus maintaining the hedge.

Dynamic hedging requires frequent adjustments under the following conditions:

● When the underlying stock price fluctuates significantly, such as when the price of Bitcoin changes drastically, causing MSTR's stock price to experience large movements.

● Changes in market conditions, such as volatility, interest rates, or other external factors that affect the pricing model of the convertible bonds.

● Hedge funds typically trigger trades based on the magnitude of delta changes (e.g., a 0.01 change in delta), ensuring their positions remain precisely hedged.

Let’s consider a specific scenario to illustrate:

Assume a hedge fund’s initial position is as follows:

● Buy $10 million worth of MSTR convertible bonds (Delta = 0.6).

● Short $6 million worth of MSTR stock.

If the stock price rises from $100 to $110, the delta of the convertible bond increases to 0.65. The hedge fund needs to adjust its stock position:

● Calculate the required stock buyback: \((0.65 - 0.6) \times 10,000,000 = 500,000\).

● So, they would buy back $500,000 worth of MSTR stock.

If the stock price falls from $100 to $95, the delta of the convertible bond decreases to 0.55. The hedge fund needs to adjust its stock position:

● Calculate the required increase in short positions: \((0.6 - 0.55) \times 10,000,000 = 500,000\).

● So, they would short an additional $500,000 worth of MSTR stock.

What this means is that when MSTR’s price declines, the hedge fund will need to short more MSTR stock in order to maintain its delta hedge. This action will put additional downward pressure on MSTR’s stock price, which negatively affects the positive premium and, in turn, impacts the entire business model. Thus, the risk associated with the bond side could indeed be reflected in the stock price ahead of time.

Of course, in an uptrend for MSTR, hedge funds would buy more MSTR stock, so it’s a double-edged sword. But the main takeaway here is that the risk from the convertible bonds can impact the stock price well before maturity, especially in volatile market conditions.

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