HIVE Blockchain Technologies Ltd (HIVE) — The base case for 268% upside.
Current Price: $3.94
Target Price: $10.52 (6 months)
HIVE is a poorly understood, cash flow positive, blockchain infrastructure company — and one of the only public investment vehicles available which bridges crypto assets to traditional capital markets. The company is already a dominant player in the new and also poorly understood blockchain technology sector, and has significant cash flow generating capabilities which will be outlined in the body of this article. As such, the basis for HIVE’s target price is well justified using standard valuation metrics.
This article will lay out the valuation thesis for HIVE as a publicly traded entity, rationalizing the base case for 268% upside from current levels. HIVE’s story begins with Genesis Mining (“GENESIS”).
GENESIS is the world’s leading cryptocurrency mining hashrate provider, and following the completion of a private placement financing and mining facility acquisition, GENESIS also became 30% shareholder of HIVE. As the current crypto mining environment has become unprofitable for retail miners, professional-grade and scalable infrastructure is necessary to support growing blockchain ecosystems. Therefore, few companies have created large scale crypto mining operations in low energy cost jurisdictions to adapt to the new environment. Contrary to retail mining, industrial-scale mining has been, and continues to be, extremely profitable, and increasingly so as the value of crypto assets continues to rise. GENESIS has capitalized on this profitability, and now HIVE is positioned to do so.
On September 13, 2017, HIVE and GENESIS entered into a mutually beneficial Master Services Agreement (“MSA”), pursuant to the acquisition of a mining facility by HIVE from GENESIS. Under the MSA, GENESIS agreed to operate HIVE’s acquired mining facility, and the initial purchase agreement between the parties included an option for HIVE to acquire at least four additional data centers from GENESIS. As a result, HIVE’s first acquisition allowed it to test this new sector without risking substantial capital, and the company structured the deal such that it would allow it to quickly scale and expand should it find its new venture worthwhile/profitable. GENESIS, on the other hand, to protect itself from dilution, structured the deal such that an anti-dilutive provision gave it the option to retain 30% ownership should it find the new venture worthwhile/profitable.
To date it appears that the venture has been a success, as HIVE continues to acquire data centers, and GENESIS continues to exercise its anti-dilutive provision to purchase new common shares. The actions of these two parties signify that there may be more room for this stock to run. HIVE’s recent decision to move up its lockup provision from November 15 to November 8 sent the stock plummeting from a high of $6.75 to below $2.83 (November 24 close). This inexplicable decision does not change the underlying fundamentals of the company. In fact, we believe that it offers a unique buying opportunity for those who missed the initial run-up. Below we outline the numbers behind the operation:
Crypto mining entails the use of graphics cards (“GPUs”) to solve complex algorithms for the purpose of validating transactions on a particular blockchain. Throughout 2017, the most profitable cryptocurrency to mine has been Ether (“ETH”). HIVE predominantly mines ETH. Once a miner successfully mines the next block on the Ethereum blockchain (that is validates the group of transactions to be included in the blockchain), he/she currently receives a reward of 3 ETH and the transaction fees associated with that block (approximately $0.007-$0.1 per transaction, or $0.03 on average) for his/her efforts. As specified, in the current environment, mining a block is not easy and requires the use of significant resources (discussed below), but once a mining operation is successful, the rewards can add up.
HIVE’s share of the network hashrate
Mining difficulty is a measure of how difficult it is to find a hash below a given target. The network hashrate is the measure for a global block difficulty. The greater your hash capacity relative to the network, the greater your chances of solving the subsequent block, and as such receiving the reward. To approximate a particular miner’s success of solving the subsequent block, one can compare the miner’s hash capacity to the network hashrate. As at November 25, 2017, the network hashrate was 115,650 GH/s (Etherscan). Although mining difficulty has increased exponentially through 2017 (5,746 GH/s as at January 1, 2017), since HIVE initiated mining operations, it has essentially leveled off (100,308 GH/s as at September 18, 2017). The future network hashrate is anybody’s guess — but a more moderate growth rate would be the plausible scenario rather than a continued exponential one given the last 2 months of data. The rationale being that retail mining is no longer profitable and it has taken a significant number of miners out of the market. We have considered a base case of a 10% increase in the network hash rate over the next six months for which our target price is based.
Now to solve for HIVE’s hash capacity. Once HIVE’s four facilities are up and operational (within six months), HIVE will be operating approximately 17,211 rigs with 6 GPUs per rig, with each GPU likely having a hashrate of 30–35 MH/s. Further, under the MSA, GENESIS guarantees a 93% uptime to HIVE. We have considered a 93% to 97% uptime. Solving for the assumptions below, we determine HIVE’s proportionate hashrate to be 2.5% (base case). In other words, HIVE can expect to receive each subsequent block award (3 ETH + transaction fees) 2.5% of the time.
Having estimated HIVE’s proportionate hashrate, one can now reasonably estimate HIVE’s revenue generating ability. Mining revenue is generated via transaction fees and issuance of ETH.
Transaction Fees: Cryptocurrency miners earn revenue through the issuance of coins by the blockchain, and the transactions fees paid by users of the blockchain. The Ethereum blockchain, although amongst best of breed, is still painstakingly slow in comparison to traditional transaction systems, and currently processes a paltry~500,000 transactions / day). At a fee of $0.03/transaction on average, this results in $5.475 million/year to be split amongst all miners (validators of the blockchain). With 1.7% of the total network hashrate, HIVE can expect to generate approx. $186K in transaction fees, a relatively insignificant amount given the planned scope of their operations.
However, looking forward, Ethereum’s brainchild Vitalik Buterin has stated that he believes the Ethereum blockchain will achieve Visa level scalability within a few years. In 2016, VisaNet processed on average 150 million transactions per day, which if matched by Ethereum would result in $1.643 billion/year in transaction fees. If Ethereum is able to achieve this, HIVE could then expect to generate ~$49.8 million/year in transaction fees. Future uncertainties (what proof protocols will be adopted on the Ethereum blockchain, HIVE’s ability to retain/increase its network hashrate, Ethereum’s ability to execute its planned scale, etc.) make HIVE’s revenue generating capabilities from transaction fees difficult to estimate at this scale — and as such have not been considered in the scope of this exercise. Nonetheless, it is important to understand the potential of the Ethereum’s blockchain, and HIVE’s unique positioning and first-mover advantage as a validator of the transactions on that blockchain. It is worth mention as it gives a longer run view of HIVE’s potential revenue generating ability.
In summation, our base case valuation considers only the current value of transaction fees (~$186K). As will be seen in the subsequent section, the majority of HIVE’s value stems from the reward of ETH.
ETH Issuance: The Ethereum protocol limits 1,500,000 ETH to be issued each month. There is currently just under 97M ETH issued in total. From this amount, approximately 24.5M ETH were issued from mining. The ICO date was July 30, 2015 (28 months ago), which yields an average issued ETH per month of 842,809 ETH, below the Ethereum limit. The Ethereum network is structured such that a new block is issued every 15 seconds, so that the supply of ETH remains relatively constant. The rate of ETH issuance may be viewed in the Block Rewards Chart Below. Our best estimate of ETH issuance on a go forward basis is based on the November 2017 average of approx ~20K ETH / day, which is slightly below the historical average of ~25K ETH/day, and in our view a conservative assumption.
Given the uncertainty of ETH price ($8 at beginning of the year, $475 last price as at publishing), the value of the crypto mining operations is anybody’s guess. Throw in the uncertainty re: the rate of issuance and number of transactions that the Ethereum blockchain can support, and the range of potential revenues becomes ridiculously wide. The excitement / growth potential of HIVE is undeniable, so below we present the realistic bear to bull possibilities. At existing capacity, we would anticipate a base case that HIVE could generate $140.0 million annual revenue, with the overwhelming majority coming from ETH mining.
Crypto mining is a relatively straightforward business from a cost standpoint. The main cost is electricity, as it takes a significant amount of power to run all the mining rigs. Therefore, the most profitable mining operations are those in regions with cheap electricity (lowers the cost of running the rigs) and cool climates (lowers the cost of cooling the rigs). Iceland and Sweden (where HIVE’s current and future facilities will be located) are ideal destinations as they have relatively cool year round climates and an abundance of cheap electricity. In addition, they are superior to places such as China, the most dominant mining destination, as they provide a far more predictable political climate. Currently, under the MSA, HIVE pays GENESIS $144,650/month to operate the initial facility (2,301 rigs). As HIVE expands, it will incur greater costs in order to be able to run its planned 17,211 mining rigs. Therefore, the key to understanding HIVE’s costs lies in estimating the cost to operate its 17,211 mining rigs.
After adjustment for cheaper electricity in Iceland — the cost of powering a comparable single rig (of 6 GPUs) for one day is approximately $2.08. This is the cost to operate rigs at a retail level. To estimate HIVE’s cost, we considered the current contracted rate to operate 2,301 rigs under the MSA for $144K.
Under the MSA, GENESIS covers the cost of power and all ancillary services related to powering the rigs. Therefore, to fully power and service 2,301 mining rigs is approximately $2.09 per rig ($144K/2,301), which is comparable to the power cost of operating a retail rig. In modelling out our costs for 17,211 rigs, we considered savings from economies of scale
The argument for economies for scale is that GENESIS would not operate the rigs without a profit element. That being said, we believe the cost of operating mining rigs at commercial scale is closer to $1.80/day per rig, and no more than $2.00/day (meaning GENESIS’ profit is between $0.10-$0.20/day per rig). To this we added a routine profit markup of 10% to account for the profit.
The reasonability of our cost estimates is corroborated two-fold:
- We expect costs to rise from current $144K/month to $1.3M/month (a 9x increase) compared to a 7.5x increase in number of mining rigs (2,301 to 17,211). This is reasonable, and likely conservative as it assumes declining economies of scale, whereas the opposite is likely true.
- The cost of operating a rig in the base case scenario is $1.98, compared to $2.08 for a retail miner with a comparable cost structure, and under a similar network hashrate.
Sustaining Capital Reinvestment
Having estimated the revenues and costs, we present our net cash flows, capital structure and conclude on a share price. To be able to calculate our free cash flows, we need to estimate the replacement cost for mining rigs and frequency of replacement, that is to calculate our level of sustaining capital reinvestment.
Mining rigs (and retail prices for products) are essentially comprised of:
- A motherboard ($200)
- 6 GPUs ($300x6 = $1,800 — average life span of 2.5 years)
- 120GB Hard drive ($100)
- 4 GB RAM ($80)
- Power Supply Unit (~$200)
- A case (~$20)
The total estimate for a mining rig (to be built from scratch) is therefore $2400, with the main cost being the GPU. These are prices available to retail investors, and we would expect that HIVE/GENESIS would have the ability to purchase these at least for a 25% volume discount. Therefore, we have modeled $1,800 per rig every 2.5 years. We have not considered re-usability of any parts, or any resale value, which would be accretive to our analysis.
The table below summarizes the number of common shares outstanding.
FCF per Share and Target Price
Applying this to our FCF calculation, we derive our target share price. We use a multiple range of 20–30x, which in an emerging technology sector, with significant upside is reasonable.
Therefore, under the base case scenario demonstrated above, the 6 month target for HIVE is $10.52 (currently $3.94).
HIVE was trading at $6.75 prior to Management’s decision to accelerate the lockup of 1/3 of its voluntary pooling arrangement from November 15 to November 8. While it is understandable that certain insiders were looking to monetize a significant gain related to their portion of their shareholdings ($0.30 cost base from the private placement), we find it inexplicable in the manner in which it was handled.
That being said, we believe that this has created a unique buying opportunity to buy a cash flow positive crypto mining infrastructure company at a steep discount to its intrinsic value. We believe HIVE’s current share price approximates its bear case, and in the uncertain realm of emerging blockchain technology, HIVE presents a significant upside bet with downside protection.
Invest with caution and at your own discretion.
I/we are long HIVE.