MicroStrategy: Part 1 of answering questions about crypto accounting, cashflow, CAMT, convertibles

This is a team effort between The Dig and Deep Quarry to go deeper into the questions behind the headlines.

The Dig and Deep Quarry are teaming up today and Thursday to bring you some answers to questions that go beyond the complex trading talk and deeper than most mainstream journalists can go.

Part 1 is today. Part 2 will be published Thursday.

In both cases this detailed work is for our paid subscribers. Won’t you consider a paid subscription to both publications?

A lot of people are talking about MicroStrategy, in particular about how to trade on the fact that MicroStrategy has essentially become, under Michael Saylor's leadership, one big giant "pot of Bitcoin". Yep, that's how Bloomberg's Matt Levine describes it, once or twice a week, updating the various strategies for those who understand the lingo.

This was Levine on Wednesday of last week:

Roughly speaking the two big MicroStrategy Inc. trades are:

1. MicroStrategy is a pot of Bitcoin, and its stock trades at a large premium to the value of its Bitcoin, so you can go long Bitcoin and short MicroStrategy stock to bet on convergence. This trade is pretty tricky for most investors (what if the premium gets bigger?), but it is a great trade for MicroStrategy (it can print as much stock as it wants, and buy more Bitcoin), so MicroStrategy has done it in enormous size.

2. MicroStrategy is a very volatile stock, and you can buy its volatility at a discount to fair value, so a lot of volatility investors do. This mostly takes the form of convertible arbitrage funds buying MicroStrategy’s convertible bonds in large size: MicroStrategy gets more money to buy Bitcoin by selling its volatility to people who can use it. The arbitrageurs buy the bonds, short the stock, and profit by adjusting their hedge as the stock moves around.

And Levine wrote again last Thursday, talking about MicroStrategy copycat FartStrategy.

Convergence. Convertible arbitrage. Volatility. Arbitrageurs. Short/Hedge. Farts.

Have fun, you guys!

One of our favorite journalists, Jon Weil at The Wall Street Journal, took a different approach. He actually took the huge risk of most general business reporters of tackling MicroStrategy's accounting and tax issues in one article!

If you think MicroStrategy’s business model is wild, wait until you see its tax issues.

After years of raising money through stock and debt offerings to buy bitcoin, MicroStrategy owns a stash worth about $47 billion, which includes $18 billion of unrealized gains. In an unusual twist, it could have to pay federal income taxes on those paper gains—even if it never sold a single bitcoin. The tax bill could total billions of dollars starting next year, according to a new disclosure this month by MicroStrategy that has received little attention.

What is this all about? Weil continues:

Before this year, companies that owned crypto assets didn’t report them at fair market values on their GAAP financial statements. The accounting rules instead treated cryptocurrencies as intangible assets that could be written down in value, but not up. Thus, MicroStrategy didn’t include the unrealized gains from its bitcoin holdings in its GAAP earnings.

All of that is changing this year under new rules passed by the Financial Accounting Standards Board, which sets U.S. GAAP. Starting this year, MicroStrategy will show the fair value of its bitcoins on its balance sheet, and the fluctuations in value will be included in earnings.

Why is it now a big problem for MicroStrategy to start reporting billions in earnings? Most companies would be thrilled. We wrote in April:

MicroStrategy is concerned that unrealized gains on bitcoin holdings following the adoption of ASU 2023-08 may cause its GAAP income to exceed $1 billion for three consecutive years. If that happens MicroStrategy is expected to be subject to a corporate alternative minimum tax of 15% (“CAMT”).

MicroStrategy’s Net Income (Loss) before Income Taxes from US Operations was ($157.8) million and ($1,362.2) million for the years 2023 and 2022, respectively. MicroStrategy held 132,500 and 189,150 bitcoins as of December 31, 2022, and December 31, 2023, respectively.

While it is difficult to estimate the tax impact, it would be safe to say that, given a sharp increase in bitcoin prices from roughly $16,500 to $44,000 in 2023, adopting the new fair value standard as of January 1, 2023, would have added several billions in unrealized gains to MicroStrategy’s 2023 bottom line. It is important to note that even though unrealized gains do not affect cash flow and liquidity, additional tax liabilities do have a negative cash flow and liquidity impact.

Subscribers to The Dig and Deep Quarry would have known last April that this significant accounting change, and a resulting huge potential tax liability, was coming. You would have been waiting, as we were, for MicroStrategy's year-end reporting, in particular its 10-K, and for finalization of the CAMT rules.

The MicroStrategy 10-K is expected to be filed by Feb 15, if last year is a guide. But, as Weil writes, you did not have to wait until the 10-K to get most of the details of the impact of recent accounting and tax changes on MicroStrategy. MicroStrategy spelled it out in a filing to the SEC earlier this month.

MicroStrategy in a Jan. 6 filing disclosed numbers for the first time quantifying the impact of the tax and accounting changes. The company said it would add as much as $12.8 billion to its GAAP retained earnings, effective Jan. 1. That figure, which is a component of shareholder equity, would be part of the calculation when determining its financial-statement income for purposes of the corporate alternative minimum tax.

The company also said it would increase its GAAP deferred tax liabilities by as much as $4 billion. That figure could be seen as a rough guide for the total tax bill MicroStrategy might face if one assumed that bitcoin’s price stayed where it was at the end of 2024.

The 8-K filed on January 6 is intended to be an earnings release and, at ~30,000 words, it is incredibly detailed, especially about the risk factors of its bitcoin buying strategy. And, yet, it is too early to be able to review the auditor KPMG's opinion and MicroStrategy does not yet provide its financial statements, even unaudited ones. The 10-K in February will have more information about MicroStrategy's accounting, its legacy software business, and its taxes. That may include more detailed tax information that companies can't provide during the year until annual earnings and tax provisions are finalized.

Here at The Dig and at Deep Quarry we'll dig even deeper and answer more questions about MicroStrategy, answers which are only hinted at by Levine and Weil.

After the paywall today we answer the questions about the impact of crypto asset fair value accounting, its impact on MicroStrategy’s tax liabilities, and why MicroStrategy didn’t early adopt the fair value accounting standard that would add billions to its bottom line.

Thursday, in Part 2, we’ll answer more detailed questions about the complexity and politics of MicroStrategy’s tax situation, what its legacy software business can contribute to the MicroStrategy’s plans, the challenges of MicroStrategy’s convertible debt strategy, and what comes next.