Bitfarms: BITF's Reduced Mining Efficiency And Our Updated Valuation Framework

Summary

• Our investment thesis was previously built on Bitfarms' green operation, the proposed 5x price target by 2022, and a $100k Bitcoin by 2025, but there are fundamental changes.
• BITF deviated from its green direction to power its 55% of its operation with natural gas to reduce mining cost, this is a fundamental change in our thesis.
• Our BITF valuation framework was updated to consider hash rate, the life span of mining rigs, and cost savings from BITF's new operation in Argentina.
• Based on our assumptions, adjustments made to the valuation framework, and the 8.5%/75% increase in BITF mining cost, BITF is 17% overvalued.
• Due to additional exposure to operational/business risks given by the increase in BITF's mining cost, we've liquidated our BITF holdings in favor of Bitcoin.

Eoneren/iStock via Getty Images

Introduction

In the previous quarter, we have covered Bitcoin mining companies, including Bitfarms (NASDAQ:BITF) and Marathon Digital Holdings (MARA), extensively with an objective valuation framework. This framework provides investors with a concise intrinsic value of Bitcoin mining companies for more effective investment decision-making.

Since our latest coverage of BITF in June 2021, several events have taken place and have prompted us to update our thesis, valuation framework, and investment value proposition. Therefore, we're going to summarize our investment thesis, provide relevant updates in this article, and improve our previous valuation framework.

Thesis Background

Our investment thesis is mainly built on 3 aspects.

Firstly, we stated that our main thesis was founded on Bitfarms' statement on being green:

Bitfarms has a diversified production platform with five industrial-scale facilities located in Québec. Each facility is 100% powered with environmentally-friendly hydropower and secured with long-term power contracts. Bitfarms is currently the only publicly traded pure-play mining company audited by a Big Four audit firm.

This is because BITF's green mining operations can capitalize on growing ESG concerns to align itself with the global trends for green and renewable energy. However, Bitfarms' 2022 expansion plan has derailed from this direction. According to Bitfarms, 55% (= 210MW / 382MW) of its mining operations will be powered by natural gas by 2022 (Figure 1). On the flip side, this move helps reduce electricity costs for mining by 45%, from $7,500 per BTC to $4,125 per BTC.

This is a double-edged sword. On the one hand, BITF's valuation improved based on our valuation framework. On the other hand, this is a fundamental shift from our initial thesis on investing in BITF.

Secondly, our valuation framework suggested an intrinsic value of $3.2b (or 5x upside) for BITF in June. Since publication, our position has increased by 20%. This finding supports BITF's claim that it is one of the most undervalued mining companies.

Thirdly, our conservative projection for Bitcoin is to reach $100,000 per BTC by 2025. This conservative project is based on Bitcoin's halving cycle that held itself for almost a decade. This projection gave BITF a significant boost in its valuation. More will be discussed in later sections. We also showed that BITF can withstand our most bearish projection of $10,000 per BTC before reaching $100,000 in 2025.

Now let's discuss several relevant updates affecting our thesis.

Figure 1: BITF's capacity distribution by region. "Argentina" represents natural gas-powered mining operations.

Source: Bitfarms

BITF's Share in Bitcoin Network Hash Rate

A crypto mining company earns rewards (cryptos) by verifying a mining block. A crypto mining company aims to increase its mining capacity (measured in hash rate) to compete with other miners for a mining block. The higher the hash rate, the higher a crypto mining company's capacity to compete for a mining block, the higher the potential reward. Conversely, the higher the Bitcoin network hash rate, the stronger the competition, the lower the potential reward.

China's crackdown on Bitcoin mining operations in China left a void to be filled (Figure 2). In other words, Bitcoin mining operations outside of China now have a larger share of the network, which translates to better reward/revenue. In addition, China's crackdown on operations will also slow the growth of the Bitcoin network hash rate. It will provide bitcoin mining operations outside of China with better long-term prospects. For these reasons, this turn of events is advantageous to Bitcoin mining operations outside of China despite the FUD.

Nevertheless, the Bitcoin network hash rate has grown significantly at a CAGR of approximately 130% over the last 5 years. At this rate, the Bitcoin network hash rate is expected to reach 324 EH/s by the end of 2022.

This estimation is important because reward calculators such as CryptoCompare and BuyBitcoinWorldwide do not consider future network hash rates and will overestimate potential mining rewards. For this reason, we've decided to improve our valuation framework by considering the future hash rates.

BITF's latest expected mining capacity remains at 8 EH/s by the end of 2022. This provides BITF with a 2.5% share of Bitcoin's entire network, up from 1% in June 2021. Bitcoin's current reward per block is 6.25 BTC, and it takes approximately 602 seconds per block. This implies there are 327k Bitcoins to be mined each year before the next halving event.

BITF's 2.5% share of the 327k Bitcoins would equate to around 8.2k Bitcoins. Therefore, BITF is expected to mine 8.2k Bitcoins per year by the end of 2022. This estimation is acceptable as BITF's annualized Q3 Bitcoins mined stands at 4,200 Bitcoins.

Figure 2: Bitcoin Network Hash Rate. Notice the steep approx. 50% Bitcoin network hash rate decline in June 2021 coincides with China's harsh crackdown.

Data by YCharts

Source: YCharts

BITF's Earnings Capacity and Valuation

Another adjustment made to our previous valuation framework is the multiples used. One way to interpret the Price-to-Earnings ratio (PER) is how long (years) it takes for investors to break even on investments. PER of 20 implies that business owners (investors) have to wait 20 years to earn back the investments made. The average life span of a mining rig is only 5 years. Hence, we should expect the company to at least earn us our investment back in 5 years. Hence, a PER of 5 is more suitable. Moreover, a PER of 5 offers investors with sufficient margin of safety considering the operational/business risks of mining companies and the volatility of cryptos.

BITF's mining cost (electricity and hosting) increased 8.4% from $8,300 in 2021Q2 to $9,000 in 2021Q3. However, BITF's total mining cost (incl management compensation, payroll, financial expense, etc.) increased 75% from $20,000 to $35,000 per BTC. This increase in cost canceled off the positive impact of the increase in Bitcoin price.

This is one of the reasons why the 45% reduction in electricity cost is crucial even though it is done at the expense of its green-energy direction. By considering the 45% electricity cost savings from natural gas, BITF's total mining cost is estimated to be $33.15k (= $35k - $3.375k*0.55).

We now have the following information:

• BITF is expected to mine 8.2k Bitcoins per year.
• BITF currently holds 2,300 Bitcoins.
• Bitcoin is valued at $48k at the time of writing.
• BITF total mining cost per BTC stands at $33,150.
• Earnings multiple of 5.

Given the information above, BITF's intrinsic value stands at $780mil. Compared to BITF's current valuation of $936mil, BITF seems overvalued. However, this valuation has several key assumptions.

Firstly, this valuation does not consider the slowdown in Bitcoin network hash rate growth caused by China's crackdown on mining operations. For instance, if Bitcoin's hash rate only grew by 50% next year, BITF's share in Bitcoin's network would increase to 3.8%. This would increase BITF's intrinsic value to $1.1bn from $780mil.

Secondly, Bitcoin's price also plays a crucial role in BITF's intrinsic value. To justify its valuation with a sufficient margin of safety for investors, Bitcoin has to be above $51k. This shouldn't be a problem as Bitcoin is expected to reach $100k by 2025 (conservatively).

Thirdly, crypto mining companies such as BITF can warrant higher multiples for valuation should the mining rig's life span improve.

Conclusion

Given the turn of events and our adjustments to our valuation framework, BITF is overvalued. This is a drastic change from our previous thesis that is well received by the community. However, we needed to update, improve, and propose our valuation framework over time to avoid providing our readership with excessive optimism.

Due to the findings presented in this article, we've sold off our holdings in BITF for Bitcoin. This is due to the increased operational risk from the increased total mining cost. If Bitcoin indeed drops to our bear case scenario of $10k, there is a risk that mining companies won't survive. On the other hand, Bitcoin holders are not exposed to such risk and can patiently wait out the bear market.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of BTC-USD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.