Hut 8: Energy Crisis, Ethereum Merge Slam Production By 25% (NASDAQ:HUT)

It’s really all about mining costs and production. Hut 8’s (NASDAQ:HUT) adjusted operating costs per coin, excluding depreciation, went from about $13,100 in the first quarter this year, to $18,900 in the second quarter. The company’s Bitcoin (BTC-USD) equivalent production for the first quarter was 942, with the second quarter coming in flat at 946. These two trends of lower margins and no growth look to continue or worsen in coming quarters as Hut 8 struggles with heightened energy prices and falling production levels resulting from its cautious view of mining economics.

Offsetting these larger concerns, the company’s high performance computer business is operationally profitable and growing. However, it is small in absolute dollar amounts, representing about 11% of revenues in Q2. Hut 8 has also maintained a strong balance sheet with low debt and a best in industry Bitcoin retention policy with substantial holdings. Even so, as discussed below, investors may be somewhat overvaluing these positives.

Note, Canadian dollars were converted to US dollars at the rate of CAD 1.37 to USD 1.

Hut 8’s Low Growth: Ethereum End and Energy Prices

Hut 8 produced 375 Bitcoin equivalents in August and 277 in September. The company’s ASIC hash rate went from 2.98 EH/s to 3.07 EH/s, a 3% rise in the Bitcoin specific capacity. But Ethereum (ETH-USD) mining ended by midmonth with The Merge on the Ethereum platform coming September 15th, switching the blockchain’s consensus mechanics away from mining. As a rough estimate, about a fourth of the month-over-month decline in Bitcoin equivalents likely came from the suspension of Ethereum mining. And recall that Hut 8 settled its Ethereum mining rewards in Bitcoins. Expect a larger absolute hit in October as the company was likely mining Ethereum in the first two weeks last month.

Approximate Monthly Bitcoin Equivalent Production

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Author complied from hut8mining.com/media-room.

Again, as a rough estimate, a single digit percentage of the September decline may be attributable to increased network competition. Though the total Bitcoin network hash rate started and ended the month just over 220 EH/s, there were spikes up to 230 EH/s during the month. However, competition will be a substantially larger drag on October’s figures as total network hash rate has quickly jumped to and maintained 255 EH/s.

Finally, though there was notable facility improvement downtime, it seems the largest portion of the month-over-month production decline came from energy pricing related scale backs.

Unseasonably warm weather and global energy supply chain challenges caused power prices to fluctuate throughout September, and our operations team curtailed operations accordingly

Operations Update for September 2022, hut8mining.com, 10/4/22

…we actively manage power at our sites in Alberta on a kind of a 15-minute increment cycle. Meaning we’re always watching where power prices are, and when power prices get too high, we adjust operations accordingly.

Jaime Leverton on Q2 2022 Results, seekingalpha.com, 8/11/22

It is hard to speculate on where Canadian natural gas prices are headed. But it is important to bear in mind some of Hut 8’s equipment is unprofitable to operate near current Bitcoin prices and network difficulty during power price fluctuations. Note that Hut 8 is using a similar range of the latest generation MicroBT miner models at each location, but has different power pricing agreements across these sites.

Looking forward, Hut 8 plans to raise installed hash rate capacity to 3.5 EH/s by yearend. This growth rate is about equal to the growth in the total network hash rate over the past year, but meaningfully lower than what has been seen over the past four months. So Hut 8 won’t be capturing share even though they expand possible capacity.

To summarize the production dynamics above, Hut 8’s share will be pressured by relatively fast growth in the total network rate relative to their own expansion plans. And any renewed stress in energy prices from the European crisis could force a profitability based curtailment of a portion of the mining fleet, especially if Bitcoin prices remain depressed going into 2023. Lastly, compared to the prior twelve months, Hut 8’s Bitcoin equivalent production will be 10-15% lower due to the end of mining on the Ethereum platform.

Hut 8’s Spiking Costs Per Mined Coin

Hut 8’s adjusted operating costs per coin, which excludes depreciation, rose from about $13,100 in the first quarter this year, to $18,900 in the second quarter. This metric captures electricity and site operations, but is excluding non-cash depreciation.

The average cost of mining each Bitcoin for Q2 2022 was approximately $25,900 [see note], compared to approximately $24,700 per Bitcoin in Q2 2021. The increase in average cost of mining Bitcoin was primarily due to higher power prices, partially offset by the deployment of a more efficient mining fleet

Financial Results for Q2 2022, hut8mining.com, 8/11/2022 – *note: data in quote is in Canadian dollars.

In the table below, compare Hut 8’s costs to three close in size mining peers. Note that, unlike these peers, Hut 8 is largely dependent on natural gas pricing, which has been elevated and volatile. Bitfarms (BITF) is expanding its sourcing from hydropower to include natural gas in Argentina. However, this source is in the Southern Hemisphere and less connected to the Northern Hemisphere winter supply dynamics.

Calendar Q2 Costs Per Mined Coin

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Author calculated from: Hut 8 Q2’22 MDA, – CleanSpark Calendar Q2’22 FORM 10-Q,- Bitfarms Q2’22 MDA, – Hive Q2’22 MDA – Operating Costs include mining electricity and mining site operations, but exclude depreciation and secondary businesses’ electricity and site operations. Expenses include general and administrative costs, but exclude share-based compensation and general costs directly attributable to secondary businesses.

Hut 8’s Rating: HODL Strategy and Cap to Hash Comparison

I don’t think it makes sense to sell Bitcoin and then reinvest in equipment that’s going to have a payback period that extends post having. And so ultimately, the math would suggest if you sell Bitcoin now, it’s going to cost you more to mine it later.

CEO Jaime Leverton on Q2 2022 Results, seekingalpha.com, 8/11/22 (link above)

Based just on the company’s production outlook and pressured margins, Hut 8 shares would not be expected to outperform other names in the sector. This is especially true as the company is trading at a premium market cap compared to these peers. However, Hut 8 has maintained a strong balance sheet, having been able to expand their business without taking on substantial debt, or importantly, selling their mined Bitcoin.

The charts below compare Hut 8 to similarly situated Bitcoin miner CleanSpark. Both have somewhat comparable and relatively small net cash/debt positions.

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CleanSpark Capital Structure – Hut 8 Capital Structure

However, CleanSpark has an opposite Bitcoin retention strategy. And if one includes Bitcoin holdings as cash, the enterprise values more closely align. While imperfect, the purpose of this exercise and backing out the value of the Bitcoin holdings is to approximate how much one is paying per EH/s of capacity when investing.

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Author Computed/Complied from Hut 8 Q2’22 MDA, – CleanSpark Calendar Q2’22 FORM 10-Q (links above)

*Note that for fairness, Hut 8’s adjusted EV above has been further reduced by 20% to account for the high margin, high-performance computing business which is 11% of revenues, and any possible revenues and earnings the Bitcoin holdings may generate if redeployed for yield.

So in the above exercise, a potential purchaser is paying ~75% more for Hut 8’s near-future hash capacity when compared to CleanSpark.

I like Hut 8’s strong HODL strategy, how they have successfully strengthened their balance sheet relative to peers, and the positive sentiment the Bitcoin holdings generate. But at the current market cap, one appears to be overpaying for the mining portion of the business that is increasingly pressured by the growing network hash rate and the company’s particular power costs. Hut 8 is no longer a preferred Bitcoin mining play, and I am assigning a hold rating indicative of an expectation that the stock will market and industry perform.

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