During the week since I first wrote about BitGold (XAU.V) the stock price has been on a wild ride. It went from C$4.14 up to C$8.00, down to C$4.50, up to C$6.50, and ended the 25th May trading session at C$5.60. At C$5.60/share and with a new (post-acquisition) share count of around 50M, the company has a market cap of roughly C$280M (US$230M). The product appears to be excellent from the perspective of customers, but is the business really worth US$230M?

Let me ask the above question in a different way. With its current fee structure and likely user base it’s possible that BitGold will never be consistently profitable and cash-flow positive. If a business does not have a good chance of ever being consistently profitable or cash-flow positive, what’s it worth?

As a standalone enterprise it is worth very little, especially considering that the company in question could run into regulatory problems after it puts its debit card into operation (this is the point at which governments will start taking a keener interest). However, it could be worth a lot to another company if the money-losing business is complementary to the acquirer’s existing business. For example, companies such as Google and Facebook have paid huge sums (billions of dollars) for businesses that would likely never be consistently profitable as standalone enterprises. They’ve done so because of the value that these businesses would potentially add to the existing Google and Facebook operations.

In any case, I doubt that anyone who has bought BitGold shares at prices above C$4 has done a realistic calculation of the business’s value as either a standalone enterprise or as an add-on to a larger financial services company. Actually, very few of the buyers would have done any calculation of value whatsoever. Instead, they would have bought because they like the idea of BitGold, oblivious to the fact that a good business can be a bad investment at the wrong price, or because they think that someone else will be dumb enough to pay an even higher price in the future.

Moving on, I’m impressed by the company’s senior managers. They did a terrific job of setting up an electronic gold-trading/payment platform, because the system, although simple from a customer’s perspective, is complex. In addition, they have done a fine job to date of whipping up enthusiasm for the stock and they demonstrated financial acumen by using the over-valued shares to make a big acquisition.

The big acquisition I’m referring to is the purchase of GoldMoney.com (GM), a company founded by James Turk, for about C$50M in XAU shares. GM was originally designed to do what BitGold is now planning to do, although it has since turned into a precious-metals dealing and storage service (it provides a cost-effective way for people to buy, hold and sell gold and other PMs without the hassle of taking delivery).

The first press release announcing the acquisition of GM was issued prior to the start of North American trading last Friday and was very misleading. Almost no financial details of the GM business were provided and the information that was provided created a false impression. Canada’s stock-market regulators obviously picked up on this, as the company’s plan to have its shares re-open for trading last Friday morning (the stock had been halted pending the news) had to be abandoned while it put together a new press release containing more details of what it was buying. This second attempt also appears to have been deemed unacceptable by the regulators, however, so the stock remained halted and a third press release announcing the GM acquisition was put out on Monday morning. The third time was the charm and the stock resumed trading around mid-day on Monday 25th May.

The financial details provided in the final press release revealed that GM’s business was shrinking at a rapid pace, that GM had generated only $5M of cash flow in its best year (2011), and that it was cash-flow negative over the past two years.

It’s unlikely that GM’s 135,000 current users will be significantly more profitable as part of BitGold than they were as part of GM.

I’m yet to read a proper valuation analysis (one that uses realistic assumptions) that demonstrates why BitGold deserves a multi-hundred-million-dollar market cap. Actually, I’m yet to read any proper valuation analysis from the bulls. According to the bullish articles I’ve read, you should simply buy the stock because the product is a great idea and the company’s founder is very smart. It’s as if there is no limit to what you should pay for an investment as long as there is a good story behind it. The bulls on the stock also point out that some big-name investors have taken significant BitGold positions. This is true, but the big-name investors generally paid C$0.90/share or less for their stakes. I could be wrong, but I doubt that they are interested in buying near the current price.

I don’t want it to seem as if I’m on some sort of crusade against BitGold. I very much want the business to succeed, because I like the product and want it to remain available. My only issue is with the stock’s valuation.

Even if the product makes great strides in popularity, with its current fee structure the underlying company will always be a low-margin business and therefore deserving of a low valuation. This, of course, doesn’t guarantee that the stock’s valuation won’t go a lot higher than its current elevated level, given the public’s proven ability to ignore valuation for long periods. There is also a chance that if BitGold can grow its customer base into the millions then it will be worth a lot to another electronic payment company such as PayPal or Mastercard, even if the BitGold business is a consistent money-loser. That’s one reason I definitely wouldn’t want to be short the stock and why, in terms of practical stock-market speculation (my primary source of income), I have no desire to get involved. Instead, I’ll continue to watch from the sidelines with detached amusement.

Summing up, my concern is that at some unknowable future time the “it’s a great product with smart management therefore the stock should be bought at any price” bubble of enthusiasm will collide with the “it will always be a low-margin business and therefore deserves a low valuation” brick wall of reality.

Although the evidence is far from conclusive, when taken together a number of price-related developments since the beginning of this year suggest that the cyclical commodity bear market has ended. I’m are referring to the extent to which prices fell during the second half of last year (the decline has the look of a final, bear-market-ending capitulation), the fact that oil is trading in line with a pattern that has marked multi-year bottoms in the past, the upward reversal in the Canadian Dollar, the turn from relative weakness to relative strength in emerging-market equities, and the strong rebounds in Russia’s stock market and currency. I’ll now zoom in on the last two of these developments.

The first of the following weekly charts compares the EEM/SPY ratio (the Emerging Markets ETF relative to the S&P500) with the CRB Index (an index comprising the prices of 17 commodities). The blue line on the top section of the chart is EEM/SPY’s 70-week MA. The EEM/SPY ratio trends in the same direction as the CRB Index and generally leads the CRB Index at major turning points, with trend reversals confirmed by EEM/SPY breaking above/below its 70-week MA.

The EEM/SPY ratio has turned upward. It hasn’t yet broken above its 70-week MA, but the reasons to expect that a reversal will be confirmed within the next few months are the extremely depressed level from which the CRB Index is rebounding and the second of the following charts.

The second chart compares the RSX/EEM ratio (Russian equities relative to Emerging-Market equities) with the CRB Index. When commodity prices are in an upward trend, Emerging-Market equities are generally strong relative to US equities and Russian equities are generally strong relative to Emerging-Market equities. In other words, Russian equities (in US$ terms) tend to be very strong on a relative basis. It works this way almost regardless of what’s happening in Russia.

The RSX/EEM ratio just had its strongest rally in more than 4 years and the rally happened in parallel with widespread pessimism about Russia’s economic prospects. This is a sign that the commodity bear market is over.

This post is a modified excerpt from a recent TSI commentary.

The following table shows the amount of monetary inflation in a number of different countries/regions. Specifically, the table shows the amount by which the money supplies of Australia, China, the Euro-Zone (EZ), Hong Kong, Japan, the UK and the US have grown over the past year, the past 2 years and the past 4 years. In those cases where it was easy for me to do the calculation I’ve used TMS (True Money Supply) as the monetary aggregate, but in other cases I’ve used M1 or M2. In China’s case I show results for both M1 and M2, because due to the lack of detail provided by the People’s Bank of China I’m not sure which of these measures is closest to TMS.

Here’s some information that can be gleaned from the above table:

1) Japan continues to have a relatively slow rate of monetary inflation, despite popular opinion to the contrary. In particular, although it has now been 2 years since the BOJ began to implement the greatest QE program in world history, over the past 2 years Japan’s money supply has only increased by 7.1%. This compares to 2-year increases of 16.4% for the US, 18.2% for Europe and 26.9% for Australia. How much longer will the general perception of what’s happening in Japan diverge from the reality of what’s happening in Japan?

2) The rate of monetary inflation in the EZ is accelerating relative to the rates of monetary inflation elsewhere. That’s why the table reveals that the 12-month rate of inflation in the EZ is now second-only to that of Australia. Furthermore, if the table showed growth figures for the past 6 months it would reveal that the EZ is now leading by a wide margin in the race to inflate (a.k.a. the race to the bottom).

3) Although its M2 money supply is still growing at close to 10%/year, there has been a significant tightening of China’s monetary conditions over the past 18 months. This is — at least in part — both a cause and an effect of the deflation of the country’s property bubble. It seems that in a command economy where non-performing loans never have to be recognised as such, it is possible for a massive credit-fueled investment bubble to deflate gradually.

4) The supply of Hong Kong dollars has increased by 54% over the past 4 years. This monetary inflation and the mimicking of US interest-rate policy, both of which are required to maintain the HK$-US$ peg, explain Hong Kong’s real estate bubble and high cost of living. The HK$-US$ peg hasn’t made sense for a long time and has become the main cause of a huge inflation problem in Hong Kong.

5) Considering the relatively fast pace of Australia’s money-supply growth and the A$’s resulting over-valuation, it’s remarkable that the A$’s exchange rate stayed so high for so long. The reason it didn’t buckle sooner is that the commodity price trend tends to overwhelm all other influences on the A$’s trend. This is illustrated by the following chart of the A$ and the Continuous Commodity Index Fund (GCC). An implication is that almost regardless of its inflation rate, the A$ will turn higher at around the same time as the general commodity price trend turns higher, which, by the way, probably just happened or will happen within the next few months.

A popular view is that gold has no monetary role to play in a modern, technologically-advanced economy. This view is wrong in many ways, including that, thanks to technological advances, gold is now better suited to being money than it has ever been. This is because technology has eliminated the inconveniences that would otherwise limit gold’s usefulness as money, with BitGold being the latest evidence.

In a TSI commentary back in 2010, here’s how I summarised the reason that gold is better suited to being money today than it ever has been in the past: “[The key is that] technology [now] allows gold ownership to simply and instantly be transferred without the need to physically move bullion. Almost all the monetary gold could remain locked in vaults, with ownership to a quantity of gold — anywhere from a tiny fraction of a gram to many kilograms, depending on what is being purchased — being effected electronically.” Previous attempts have been made to create platforms that enable gold to be a convenient medium of exchange, with ownership instantly transferred electronically when a transaction is done, but BitGold is the first attempt that stands a good chance of being successful.

The choice of the name “BitGold” was obviously influenced by the growing popularity (and notoriety) of Bitcoin, but BitGold and Bitcoin have almost nothing in common aside from being ways to store purchasing power and make electronic payments outside the banking system. Importantly, BitGold doesn’t have Bitcoin’s flaws, the most serious of which is that a Bitcoin, like a dollar or a Yen or a Ruble, has no use outside of its role as a medium of exchange.

Rather than being an electronic medium of exchange itself, BitGold is a platform for trading a substance (gold) that has historically been the world’s premier medium of exchange. Putting it another way, users of the BitGold system are not trading computer ‘bits’, they are trading ownership to specific pieces of physical gold stored in a vault.

To be fair, Bitcoin has one significant advantage over BitGold. The beauty of Bitcoin is total decentralisation. There are no intermediaries. There is also no need to jump through the personal ID (Know Your Customer) hoops established by the banking system at the behest of government. With BitGold there are intermediaries (vaults and insurance companies), and all the usual banking-system requirements apply.

As far as I can tell, there is no way to use technology to quickly/efficiently transfer ownership of gold without using intermediaries responsible for storing the gold and keeping it safe. On the plus side, with BitGold the storage is outside the banking system and there are several options regarding geographical location.

I’m not going to explain all the benefits of BitGold and how it works, because that’s already been done in a number of places on the internet. For example, Bob Moriarty provides a good overview HERE. I like BitGold, the product, a lot, and will probably open an account in a couple of months if it operates smoothly during the intervening period. But BitGold, the stock, is a different kettle of fish.

BitGold shares (TSXV: XAU) listed at the same time as the company opened its virtual doors to customers. This is strange. Normally, a company will have operating history before it lists on a stock exchange. Was it a deliberate ploy to float the company on the stock market before there were any hard data that could be used to value the shares? If so it worked, because the shares immediately attained what appears to be a very high valuation. I say “appears to be” in the previous sentence because, with no operating history to go by, it is impossible to even guesstimate what the company is worth. What I can do, however, is roughly determine the amount of success built into the current stock price.

At last Friday’s closing price of C$4.14 and with around 37M shares outstanding, XAU’s market cap is C$153M. This equates to US$126M at the current exchange rate. How many users would BitGold need to justify this market cap?

BitGold makes money on transaction volume — on the purchase/sale of gold. Specifically, it takes 1% of every purchase and every sale of gold made through the BitGold system. Users of the BitGold system are not charged anything for gold storage and insurance, meaning that all costs of running the system must come out of the aforementioned 1% and that whatever is left becomes BitGold’s gross profit. For the purposes of this exercise I’m going to ignore these costs and make the assumption that due to its strong growth potential the company is worth 10-times its annual sales revenue. Based on this assumption, the current market cap of US$126M would be justified by annual sales of roughly US$13M. To get $13M of sales, BitGold would need annual transaction volume of US$1.3B.

Now, the company guesses that its average annual transaction volume per user will be $1000-$2000. If I divide this range into the $1.3B implied by the current market cap, I get a range of 650K-1.3M. In other words, this method of valuation suggests that the current share price is discounting a customer base in the 650K-1.3M range.

As an aside, it is clear that BitGold will need a fairly high average transaction volume per user to be meaningfully profitable. However, it’s a good bet that many of the users will initially be ‘goldbugs’ who will use the service to make long-term investments in physical gold. Based on its current fee structure, BitGold would be more likely to lose money than make money from this type of customer.

Taking another valuation approach, BitGold has been likened to PayPal so perhaps it would make sense to compare BitGold’s valuation to PayPal’s valuation. PayPal is apparently being valued at $84 per user, but there are three reasons — not even taking into account the fact that PayPal is a major success while BitGold’s success is not yet assured — that BitGold’s valuation should be significantly lower than PayPal’s. The first is that PayPal has no storage and inventory costs to absorb. The second is that PayPal is solely a vehicle for transferring a medium of exchange whereas many of BitGold’s customers will use the service for store-of-value purposes*. The third is that the BitGold service is not available to US citizens. I’ll therefore assume that BitGold’s per-user value is a little lower than PayPal’s.

Assuming $70/user, BitGold’s current market cap implies a user base of 1.8M.

Based on the valuation methods outlined above and the company’s own growth projections, it seems to me that if all goes well then BitGold could grow into its CURRENT market cap in 2-3 years. This means that great success has already been priced in, leaving plenty of risk and no valuation-related upside for new buyers of the shares. Of course, there will always be upside potential due to the pool of greater fools, especially considering that the supply of XAU shares is small at this time.

The bottom line is that BitGold, to me, is like Amazon.com: I love the product, but hate the stock’s current valuation.

*Gresham’s Law is an obstacle to BitGold’s profitability, in that the sort of people who would want to own physical gold would be more likely to spend their fiat currency than their gold. That is, they would tend to hoard their gold and spend their dollars, euros, etc., thus reducing BitGold’s revenue per user.