Want to Bet on Bitcoin Without Owning Any? Try These Mining Stocks.

More than 11,000 computers hum 24 hours a day at the old Alcoa site, making trillions of calculations a second to help operate the Bitcoin network. Run by Riot Blockchain (ticker: RIOT), the machines contributed to “mining” 1,292 Bitcoins in the third quarter, worth $54 million in revenue to Riot. Rockdale is now one of the largest Bitcoin production sites in North America. Riot aims to add 63,000 computers, more than doubling its mining capacity, by the end of 2022.

“We plan to make it one of the largest Bitcoin mining assets in the world,” says Riot CEO Jason Les. The Alcoa site included a large electrical switching yard—ideal for a miner aiming to expand to 700 megawatts of capacity, enough to power 650,000 homes.

That kind of electricity use has elicited criticism that crypto mining is contributing to carbon emissions. But if you believe in the promise of Bitcoin, the miners offer an alternative to owning the coin—betting on the network’s high-tech plumbing and potential for tangible profits.

Riot looks appealing for its growing share of the market and efficiency gains as it expands. Another stock to consider is Core Scientific, a miner that plans to go public through a merger with a special purpose acquisition company, or SPAC, called Power & Digital Infrastructure Acquisition (XPDI).

Marathon Digital Holdings (MARA) could also be a winner. The stock sold off this week after disclosing an investigation by the Securities and Exchange Commission related to the prior issuance of restricted shares.

“There’s no accusation we’ve done anything wrong,” Marathon CEO Fred Thiel tells Barron’s. Marathon, he adds, is flying in mining “rigs” from Malaysia and expecting to more than triple its Bitcoin capacity over the next year.

Mining stocks have gained an average of 291% this year as Bitcoin has doubled, far ahead of the Nasdaq Composite’s 25% return. But they are highly sensitive to movements in Bitcoin prices and investor sentiment. Marathon, for instance, was ahead 628% this year before giving up more than a third of those gains on news of the SEC investigation, as well as an increased convertible bond offering.

Despite the volatility, large-scale miners are generating operating profits, based on adjusted earnings before interest, taxes, depreciation, and amortization, or Ebitda. Riot’s revenue should jump to $464 million next year from $220 million this year, according to consensus estimates. Ebitda is expected to increase to $324 million from $125 million.

Core, based in Bellevue, Wash., is also turning into an industry leader. The company operates in Kentucky, Georgia, and North Carolina, and is developing plants in North Dakota and Texas, scaling up to 1,000 megawatts of total capacity by the end of 2022—topping every other North American miner. Core aims to host infrastructure for other miners and produce its own coins, generating more-stable cash flows than if it were just a stand-alone miner.

Core also seeks to be net carbon neutral, using renewables and carbon credits. “They have good long-term contracts with energy providers,” says an investor with more than 5% of XPDI’s shares. He expects the stock to hit $20, up from $13.75 recently. As with any SPAC, investors can cash out at $10 when the merger comes up for a vote, expected in January.

D.A. Davidson analyst Christopher Brendler calls Core a “best in class” operator that should ramp up profits as it expands. He sees the company more than doubling revenue over the next year to $1 billion, generating $565 million in adjusted Ebitda.

Marathon, for its part, is banking on an asset-light model—contracting with hosting facilities for energy and plowing nearly every penny of capital into mining machines. The company has just 10 employees, outsourcing much of its operations. Thiel says the company is buying machines in bulk at 30% of the industry average, producing Bitcoins at a cost of roughly $6,200, well below the industry average of $10,000. Wall Street expects Marathon’s sales to more than triple from 2021 to 2022, reaching $750 million, resulting in Ebitda of $581 million.

Bitcoin mining isn’t anything like digging gold out of the ground. Rather, it involves producing Bitcoins as a byproduct, or reward, for validating transactions on the blockchain network. Miners do this by running computers continuously to try to guess a string of alphanumeric characters for each block of transactions. Guessing correctly validates the block, adding it to a chain of previous blocks (hence the term blockchain). The main prize for being first is payment in Bitcoin itself, which the network’s code allocates at a rate of 6.25 Bitcoins per block.

One big variable, along with the price of Bitcoin itself, is mining difficulty—how many guesses per second the network makes to validate, or “hash,” the next block. That hash rate is measured in exahash, or 10 to the 18th power hashes a second. It’s now nearly 170 exahash and could more than double over the next year, says Thiel, assuming miners lock in power agreements and get their machines operating.

Why does this matter? Because a higher hash rate reduces the potential rewards for each miner. The rate plummeted this summer after China banned Bitcoin mining, but it has been climbing back. Analysts expect it to rise, potentially making it harder for miners to earn Bitcoin rewards and requiring more electricity for each coin.

Higher Bitcoin prices attract more miners, which raises the network’s hash rate. Miners are thus in a perpetual arms race—continually expanding and upgrading equipment to hit production targets. They also tend to raise capital serially for more infrastructure and machines, potentially diluting equity owners or straining their balance sheets. Riot, for instance, spent $651 million to acquire mining assets in Rockdale and plans to spend $160 million on the infrastructure buildout. Marathon recently raised $650 million.

Rising hash rates have another consequence: a steeper carbon toll. Miners are consuming 0.5% of the world’s electricity, according to the Cambridge Bitcoin Electricity Energy Consumption Index. As it gets tougher to mine, companies may consume more electricity, potentially increasing carbon emissions even as many countries try to cut back.

Industry groups say that 58% of global Bitcoin production is now carbon neutral, based on renewable fuels. El Salvador, where Bitcoin has become an official currency, is harnessing geothermal energy from a volcano for mining. But plenty of Bitcoin is still produced with coal in places like Kazakhstan.

North America is also turning into a mining hub, with more than 40% of the global hash rate. A third of U.S. production is now based on renewable power, according to the industry, potentially reducing the carbon toll. One creative approach: Stronghold Digital Mining (SDIG) wants to turn toxic coal waste in Pennsylvania into Bitcoins.

“Miners don’t contribute to carbon emissions in energy markets that are properly designed,” says Peter Cramton, an economist and former energy regulator in Texas. Miners in certain markets soak up renewables that would otherwise be wasted as surplus power, he points out. That can provide demand for wind- and solar-power generators, giving them incentives to develop renewables with long-term customers. “Power companies with excess power look at Bitcoin mining as a way to create baseload consumption for renewables,” Thiel says.

Riot plans to ramp up capacity in Texas and install an “immersion cooling” system to keep circuits running at lower temperatures. Riot says the cooling baths should boost the computers’ hash rate by 25% and reduce downtime, lifting overall performance by up to 50%.

“It will result in fewer machines generating the same hash rate,” says H.C. Wainwright analyst Kevin Dede, who rates the stock a Buy with a $50 price target.

Wall Street likes the mining stocks for their capacity expansion plans and high gross margins. Multiples for the stocks are well below those in other areas of crypto; exchanges like Coinbase Global (COIN) and mining chip company Nvidia (NVDA) both trade at far higher valuations.

The miners’ discounts reflect concerns about their capital intensity as companies vie for production—betting on higher prices for a risky and controversial asset. Investors have seen this story turn to tears in other cyclical industries, notably in Texas’s century-old oil patch.

Bitcoin mining will get tougher as the hash rate rises. The Bitcoins doled out for validating blocks will halve in 2024, to 3.125 per block—forcing miners to add capacity and make up for lost revenue. Costs are still low enough that efficient, large operators can be highly profitable. But scale will matter more than ever as the margins dwindle. “We’re very focused on playing this arms race,” Thiel says. “But it will get harder going forward.”

Write to Daren Fonda at daren.fonda@barrons.com