Applied Digital: Examining The Big Cryptocurrency Discount (APLD)

The desire for security is opposed to all great and noble undertakings..”― Unspoken

Today, we take our first look at a small cap'Busted IPO' with a somewhat unique niche. The stock has given its shareholders a wild ride. during the last two years. There are some potential catalysts on the horizon. An analysis follows below.

company overview

Applied Digital Corporation (NASDAQ:APLD) is a Dallas-based operator of "next-generation" data centers, designing and building to provide substantial high-performance computing [HPC] power to customers, mainly cryptocurrency miners. The company has an operating facility with 100 megawatts (MW) of capacity in North Dakota, as well as a 200MW data center in Texas and a second facility (180MW) in North Dakota, both of which are due to come online by the end of February. 2023. Aplicado Digital was originally a Bitcoin miner (USD-BTC) and Ethereum (ETH-USD), hosting their hardware in China. When the Chinese government cracked down on mining facilities located within its borders, the company sought hosting facilities elsewhere, eventually resulting in the construction of its first data center and the exit of its mining operations. Able to sell its vision of predictable recurring revenue, it went public as Applied Blockchain in April 2022, raking in net earnings of $36 million at $5 per share. Applied Digital shares are trading around $2.50 a share now, which translates to a market capitalization of roughly $250 million.

The company operates in the fiscal year (FY) ending May 31.

Data centers and cryptomining

For those not involved in cryptocurrency, Bitcoin transactions are posted to the network's public ledger (the block chain) using the secure hash algorithm, which is designed for digital signatures. The network pays Bitcoin miners to group recent transactions using the cryptocurrency into "blocks", which are then validated when the miner solves the cryptographic problems. Solving these problems requires the high-performance computing power of mining servers housed in data centers. The greater the computational power to validate the transactions, the greater the portion of compensation received by the miner. As an added economic wrinkle, due to the fact that only a fixed number of Bitcoins are issued (21 million), as time goes by, miners receive decreasing wages for their services. To illustrate, in 2009 when Bitcoin was launched, each block created was worth 50 Bitcoins. By design, this compensation is halved every four years, meaning that by 2024 each block created will be worth 3,125 Bitcoins. When a miner's revenue is halved, power consumption must decrease commensurately or block building activity becomes increasingly wasteful. That's where Applied Digital's ultra-low-cost digital infrastructure is crucial.

Getting closer

The company provides a powered space to customers, who place their hardware within its shared hosting facilities. Its next-generation data centers consume vast amounts of energy to keep servers powered and cool. As such, its facilities are best suited for remote geographies with low energy costs. Because of this distinction, it is difficult to convert legacy data centers, which are typically located near metropolitan areas for low-latency Web 2.0 functions such as streaming, into next-generation properties.

Obviously, maintaining the blockchain isn't the only function of HPC's data centers, but it has been for the company's 100MW facility in North Dakota, which is home to five cryptocurrency miners. In addition, the two facilities scheduled to be energized very soon (the Administration reported at the end of February in the last communication) are fully contracted by agreements with cryptominers. The nearly 500MW of operating capacity from the three data centers is anticipated to generate annual EBITDA of $100 million.

That being said, Applied Digital is looking to expand its customer base, breaking ground in 2QFY23 by signing its first two non-crypto customers, one of which will house its equipment in a 5MW processing center currently under construction purpose-built for graphics processing units located next to their 100MW facility. In preparation for this expansion into other HPC use cases, including artificial intelligence, machine learning, natural language processing, drug discovery, graphics rendering, and other Web 3.0 functions, the company switched to its current name as of November 2022. According to Verified Market Research, Web 3.0 applications will comprise a $65 billion market by 2030.

In addition to its ongoing development, Applied Digital entered into a 50/50 joint venture (called Highland Digital) with GMR Limited to target acquisitions of distressed mining hardware and digital infrastructure assets up to $100 million by September 2022. Funding will be provided by outside investors, which means that the company will not provide capital directly to the JV.

Stock Price Performance

Although Applied Digital's initial public offering was priced at $5 per share, its extremely volatile shares touched that level just once (June 2, 2022), only to trade below $1 per share eight trading sessions later. . The only news during that time was the recovery of 4.97 million shares (5% of the total outstanding) of a provider that could no longer provide services and the end of the period of blocking of 36.4 million shares. The shares then doubled in value (to $2.12) on volume of more than 131 million shares after news broke that Applied Digital had signed a five-year hosting contract with crypto miner Marathon Digital (MARY) for 270 MW of Bitcoin mining capacity on July 29, 2022. That positive story was tempered by a simultaneous bulletin that their facility was partially (~50%) offline due to unexpected equipment failure at the substation feeding the facility with full service not restored until mid-August. After the dust settled on those developments, APLD shares traded in a 'relatively tight' range of $1.45 to $2.62 from late July until a breakout in January, before recently falling back into that trading range. .

2QFY23 Earnings and Outlook

With its only facility operating at over 90% capacity through all of 2QFY23, and fully contracted on multi-year contracts, Applied Digital reported financial results on January 9, 2023, posting a loss of $0.04 per share (non-GAAP) and negative adj. EBITDA of $2.1 million on income of $12.3 million. There are no comparators from prior years as the company was not generating revenue at the time. The bottom line was two cents better than the Street consensus, while the bottom line was $140,000 better.

Applied Digital provided an operational update that (as noted above) it expects its Texas and second North Dakota facilities to be energized by the end of February 2023, but has not yet announced if they are online. Substantially all of the latter's capacity and 90MW of the former will fulfill the Marathon contract, which should produce ~$100M annual revenue.

Balance Sheet and Analyst Commentary

As of November 30, 2022, the company had $18.1 million in cash and cash equivalents and $20.5 million in debt.

With prospects for performance in calendar 2023, Applied Digital is a favorite of Street analysts, with an Outperform rating and six Buy ratings and a $3.85 median price target. It should be noted that targets were lowered by three companies from October 2022 to reflect a delay (compared to previous expectations) in the ramp schedule for the company's Texas facility.

Chairman and CEO Wes Cummins is also optimistic. Representing the interests of B Riley Asset Management, he has purchased 300,000 shares since the company's 2QFY23 earnings report. It should be noted that he also has great personal responsibility, as his account reflects more than 3.7 million shares and his family trust holds an additional 17.6 million shares.

Verdict

The irony of Applied Digital's stock volatility is that the company will most likely transform its capital structure into a real estate investment trust, like traditional data center REITs Digital Realty Trust (DLR) and Equinix (Balance) – once it reaches critical mass. Comparisons are obviously challenging when Digital Realty operates in over 300 locations and Applied Digital expects to have three active by the end of February 2023. That being said, Digital Realty is trading at an EV/Adj. EBITDA of just under 20 and returns of 4.7%. Equinix, with its 249 cloud-enabled data centers, is trading at an EV/Adj. EBITDA of just under 22 and returns of 2%. A back-of-the-envelope calculation would suggest that if Applied Digital can execute on its $100 million annual EBITDA forecast once its three data centers are fully operational, it is currently trading at a forecast EV/Adj. EBITDA significantly below 4.

This busted IPO looks worthy of a little 'watch item' holding with several caveats. First, despite the talk of diversification, Applied Digital has massive exposure to cryptominers, and effectively all of its revenue generated in this sector. Second, its 200MW facility in Texas is being powered by a wind farm, which may be an intermittent power source or, as was the case during the winter of 2022, non-existent. Although it supports battery storage, this setup is worth some scrutiny. That being said, this is a stable business model in an uncertain industry. With diversification just beginning, Applied Digital is worth a small investment at current business levels.

As day is to a sword, night is to a shield.”-Anthony Liccione