Arcane Crypto — Gradually making progress on its agenda

Arcane Crypto (OMX: ARCANE)

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Research: TMT

Arcane Crypto — Gradually making progress on its agenda

Arcane Crypto and its early-stage portfolio companies continue to make progress (at different speeds) on developing their core products, several of which will be offered on a single platform backed by a unified, cloud-based tech framework. The company plans to enter the bitcoin (BTC) mining business (powered by renewable energy), which we see as promising given the Chinese ban on crypto mining. It raised SEK61.1m in equity in August 2021 to finance this project and management expects that it will allow the group to become cash flow positive from end-2021.

Milosz Papst

Written by

Milosz Papst

Director, Financials

TMT

Arcane Crypto

Gradually making progress on its agenda

TMT

Spotlight - Update

7 September 2021

Price

SEK0.22

Market cap

SEK1.77bn

Share price graph

Share details

Code

ARCANE

Listing

Nasdaq First North

Shares in issue following August equity issue

8.49bn

Last reported gross cash at end-Q221

SEK33.5m

Business description

Arcane Crypto is an investment company acquiring and developing early-stage businesses in the blockchain-powered digital assets sector as part of a ‘buy-and-build’ strategy. It currently has several fully owned and minority-owned businesses across payments, trading, asset management, research and media. It has been listed on the Nasdaq First North alternative market since February 2021.

Bull

Diversified exposure to the emerging digital assets theme.

Several holdings approaching commercialisation stage.

Continued high crypto trading volumes would likely benefit several of the company’s holdings.

Bear

Early-stage, loss-making businesses are inherently risky.

Dependent on continued digital assets adoption.

Several competing payment solutions to the Bitcoin Lightning Network.

Analyst

Milosz Papst

+44 (0) 20 3077 5700

Arcane Crypto is a research client of Edison Investment Research Limited

Arcane Crypto and its early-stage portfolio companies continue to make progress (at different speeds) on developing their core products, several of which will be offered on a single platform backed by a unified, cloud-based tech framework. The company plans to enter the bitcoin (BTC) mining business (powered by renewable energy), which we see as promising given the Chinese ban on crypto mining. It raised SEK61.1m in equity in August 2021 to finance this project and management expects that it will allow the group to become cash flow positive from end-2021.

Historical financials

Year
end

Revenue
(SEKm)

EBITDA
(SEKm)

PBT
(SEKm)

EPS
(SEK)

DPS
(SEK)

P/E
(x)

Yield
(%)

12/18

0.0

(1.9)

(3.0)

N/A

N/A

N/A

N/A

12/19

0.0

(7.8)

(7.3)

N/A

N/A

N/A

N/A

12/20

1.9

(17.8)

(16.9)

N/A

N/A

N/A

N/A

Source: Arcane Crypto accounts

Substantial growth from a low base

Arcane Crypto’s adjusted EBITDA loss was SEK8.3m in Q221 (vs a loss of SEK3.6m in Q121 and SEK1.5m in Q220), reflecting its 100% subsidiaries: crypto hedge fund (Arcane Assets), Arcane Research, the payment software business, Teslacoil, and the crypto broker, Kaupang Krypto. While all saw substantial year-on-year and quarter-on-quarter revenue growth from a low base (except for the pre-commercial stage Teslacoil), Arcane Crypto is yet to break even. It has also booked a SEK3.1m loss from associates due to their early development stage and the crypto markets sell-off in Q221. Arcane Crypto’s Q221 net loss was SEK7.1m (not adjusted for the reversal of social charges related to warrants).

First test trade on Pure Digital planned in September

Arcane Crypto announced a number of important developments recently. Puremarkets signed a letter of intent (LoI) with Bank of New York Mellon, which joined a consortium of tier one investment banks alongside State Street, working with the company’s interbank wholesale marketplace Pure Digital. The first test trade on the platform is due in September 2021, with Alphaplate (another of Arcane Crypto’s portfolio companies) acting as liquidity provider. Arcane Crypto acquired the remaining stake in Ijort Invest (operator of the Swedish retail crypto exchange Trijo), while Arcane Assets is exploring the issue and listing of an ETP tracking its hedge fund, which would improve distribution and help drive growth in AUM.

Valuation: Share price driven by index/ETF inclusion

Since our initiation of coverage on 3 June 2021, Arcane Crypto’s share price has increased by 22%. We believe the main positive catalyst was the share’s inclusion in the Elwood Blockchain Global Equity Index and the Melanion BTC Equities Universe UCITS ETF. Due to Arcane Crypto’s early development stage, we refrain from valuing the group. The subscription price in the recently completed directed issue was SEK0.203 per unit (consisting of one share plus one warrant).

Q221 results: Shaped by Kaupang Krypto acquisition

Arcane Crypto reported a Q221 net loss of SEK7.1m (c £0.6m, see Exhibit 1), higher than the net loss of SEK1.6m in Q220, mostly due to the full consolidation of the Norwegian spot crypto broker Kaupang Krypto which, like most of the businesses in Arcane Crypto’s group, is yet to break even. The acquisition was completed on 26 March 2021, but while Kaupang’s balance sheet was already included in Arcane Crypto’s consolidated accounts in Q121, its income statement was consolidated in the group’s P&L for the first time in Q221. This was also the main driver of the significant increase in Arcane Crypto’s revenues to SEK100.3m in Q221 (versus SEK0.2m in Q220 and SEK2.1m in Q121), which now include Kaupang’s trading volumes (c SEK97.0m), ie the value of digital assets brokered to customers, with the corresponding acquisition costs (SEK94.8m in Q221) reflected in cost of goods sold. The acquisition of the remaining 66% stake in Ijort Invest, which operates the Swedish retail crypto exchange Trijo, was completed after the reporting date (2 July 2021). Consequently, Ijort Invest’s results were still accounted for under share of profits from associates in Q221.

Arcane Crypto posted a positive SEK0.1m impact in the personal expenses line in Q221, which came from a SEK6.9m reversal of social charges associated with warrants issued to employees (in Q121, the company recognised a SEK7.5m one-off cost including an accrual of social charges related to these warrants). Their value has been adjusted to reflect the decline in Arcane Crypto’s share price during the quarter. Adjusted for the above, Arcane Crypto’s EBITDA loss stood at SEK8.3m (versus the reported EBITDA loss of SEK1.5m), which is c SEK4.8m below Q121. Excluding Kaupang’s consolidation in Q221, underlying EBITDA would be SEK3.0m below Q121. Arcane Crypto also posted a loss from participation in associated companies at SEK3.1m in Q221 (versus a profit of SEK0.5m in Q121 and a negligible result in Q220), see Exhibit 1 for details. Moreover, it booked depreciation and amortisation including write-downs on intangibles of c SEK1.0m, which we understand (based on our discussion with management) largely includes regular amortisation of Kaupang’s goodwill. Finally, the group posted net interest and other financial costs of SEK1.4m in Q221 (versus net costs of SEK0.2m in Q220).

Exhibit 1: Q221 results highlights

SEK'000s

Q221

Q220

Q121

FY20*

Revenue

100,296

190

2,094

1,941

Other operating income

76

0

63

162

Total revenue

100,372

190

2,157

2,103

Cost of goods sold

(94,835)

N/A

N/A

N/A

Personnel costs

130

(1,735)

(8,846)

(8,992)

Other external expenses

(7,151)

73

(4,354)

(10,923)

EBITDA

(1,484)

(1,472)

(11,043)

(17,812)

Adjusted EBITDA**

(8,349)

N/A

(3,568)

N/A

D&A, including write-downs on intangibles

(1,063)

(2)

(36)

(66)

EBIT

(2,547)

(1,474)

(11,079)

(17,878)

Profit from participation in associated companies

(3,138)

(8)

447

37

Interest income and other financial income

(1,581)

12

1,606

1,193

Interest expenses and other financial costs

210

(147)

(127,024)***

(228)

Profit before tax

(7,056)

(1,617)

(136,050)

(16,876)

Income taxes

0

0

0

0

Net income

(7,056)

(1,617)

(136,050)

(16,876)

Adjusted net income****

N/A

N/A

(9,097)

N/A

Source: Arcane Crypto, Edison Investment Research, Note: *Results of Arcane Crypto. **Adjusted for the accrual/reversal of accrual of social charges related to warrants in Arcane Crypto. ***Includes SEK126.9m one-time accounting effect arising from the reverse takeover. ****Adjusted for the one-time accounting effect arising from the reverse takeover.

During Q221, Arcane Crypto’s net cash outflow from investment activities stood at SEK17.2m, of which €1.5m (c SEK15.2m) was spent on acquiring an additional 9% stake in ITOAM (LN Markets), bringing Arcane Crypto’s total stake to 16%. The remaining balance represents a minor investment in IIjort Invest ahead of the acquisition of the remaining stake. The company’s cash and bank balances at end-June 2021 stood at SEK33.5m versus SEK53.9m at end-March 2021. Furthermore, on 30 August 2021, the company completed a directed equity issue to a group of qualified investors (including Morten Klein, one of its major existing shareholders) raising SEK61.1m of gross proceeds at an issue price of SEK0.203 per unit (each unit consisting of one share and one share purchase warrant), resulting in the issue of 300.9m units. The additional funds will be largely used to fund the setup of crypto mining operations (see details below). Each of the issued warrants allow the holder to subscribe to one newly issued share between 1 September 2021 and 28 February 2022 at a price of SEK0.2436 per share. The directed issue will, upon full exercise of the warrants (representing SEK73.3m of additional proceeds), translate into a total dilution of 6.85%.

Major developments in portfolio companies

Kaupang Krypto more than doubling revenues versus Q121 at an average spread of c 200bp

Kaupang’s trading volume rose to c SEK97.0m (c £8.2m) from c SEK40.0m in Q121 despite the sell-off in crypto markets in Q221. We understand that this was assisted by the broker’s increased focus on larger clients (primarily family offices and high-net-worth individuals, HNWI). The company recently launched its premium OTC offering and partnered with Fireblocks to provide custody solutions (a crucial part of the offering for institutional investors). We note that Fireblocks is one of the top players in terms of assets under custody and recently attracted a strategic investment from Bank of New York Mellon.

Kaupang’s gross profit on sales stood at c SEK2.0m, which implies an average spread achieved on its brokerage activities of slightly above 200bp. This may be viewed as quite healthy compared to, eg Voyager Digital, which recently disclosed its average spread as +100bp. While average spreads achieved by Kaupang’s local competitors (eg Safello or Goobit) are even higher, they seem difficult to sustain in the long run. We note that Kaupang’s current focus is on larger clients which, going forward, is likely to push the average spread down. At the same time, however, this should stimulate further growth in trading volumes and, in turn, gross profit. The average spread will also be determined by the mix of digital assets brokered, with cryptocurrencies other than bitcoin and ether likely offered at higher spreads.

Arcane Assets exploring the issue and listing of an ETP

Arcane Assets increased its revenue by 52% q-o-q to SEK2.7m, despite the decline in assets under management (AUM) to c SEK120m at end-June 2021 from c SEK170m at end-March 2021 (average AUM was still up in Q221 by c 25%, according to our estimates). Based on our discussion with management, we understand that the increase in revenue was assisted by performance fees and the hedge fund did not attract any meaningful new funds during the quarter. This may be somewhat disappointing given growing investor interest in crypto assets recently. The lack of new funds inflow may be largely due to the fact that the fund cannot be marketed directly (see our initiation note for details). Focus in Q321 is on distribution following the recent onboarding of a new head of business development. We note that on 16 June 2021, the company signed an LoI with Valour Structured Products to explore the issue and listing of an exchange-traded product (ETP) based on the hedge fund. Valour has so far issued four single-asset ETPs (traded on the Nordic Growth Market) tracking bitcoin, ether, Cardano and Polkadot. According to the original release, both parties are working on a definitive partnership agreement and a plan for the issue, which should be finalised later this year. We believe the launch of such an ETP would provide Arcane Assets with an important distribution channel supporting its AUM growth. However, we note that the design of such a product will likely be more complicated compared to existing digital asset ETPs (which are mostly passive products), given the active strategy of the hedge fund.

Arcane Research benefiting from new partnerships

The revenues of Arcane Research tripled versus Q121 from c SEK306k (exact Q221 figure not disclosed). This was driven by an increase in the subscription base of its existing products (which for the weekly report went up by 29% in Q221), as well as other products developed with recently added clients and partners (eg the regular report for BlockFi’s institutional investors). While some of the projects were one-off in nature (eg the industry report on the Bitcoin Trading Ecosystem published with LMAX Digital), they are likely to be used as a ‘door opener’ for attracting new customers (institutions in particular).

First test trade on Pure Digital planned for September

The result from participation in associated companies (a SEK3.1m loss in Q221) includes the share in the results of Ijort Invest (Trijo), Puremarkets, Alphaplate and ITOAM (LN Markets). Puremarkets (37.5% owned by Arcane Crypto) is gradually approaching the platform launch, with the first test trade initially planned in August 2021 (now scheduled for September 2021). On 2 July, the company announced that it had signed an LoI with Bank of New York Mellon, which joined a consortium of tier one investment banks alongside State Street (the names of the banks behind the other four LOIs have not been disclosed yet). The consortium is working with the company’s interbank wholesale marketplace Pure Digital to develop a platform to support the entire digital asset life cycle. Alphaplate reported a loss of SEK1,554k in Q221, compared to a SEK3,171k profit on market making and other trading activities in Q121. Around SEK700k of the Q221 loss is attributable to Arcane Crypto, given its 45% stake in the business. Alphaplate focused on development and third-party integrations during the quarter, including integration with the Pure Digital platform, on which it will operate as a liquidity provider. The derivatives platform LN Markets saw a 22% q-o-q decline in trading volumes to US$69m, which management believes is due to broader market sentiment amid the Q2 sell-off. At the same time, however, the number of user accounts increased by 41% versus Q121. We note that Arcane Crypto has recently increased its stake in ITOAM (operator of the platform) from 7% to 16%. Finally, Trijo’s trading volumes increased slightly in Q221 versus Q121 to c SEK40m (by c 5% according to our estimates), but the exchange is still not charging trading fees (only deposit and withdrawal fees) and is in the process of transitioning to a brokerage model based on spreads. It has recently announced a collaboration with the payment service provider Trustly (which is the latter’s first collaboration with a crypto company) and has already implemented the option to deposit funds through the latter. According to the management, this triggered an uptick in investor activity lately.

Introducing a unified, cloud-based tech stack

Arcane Crypto continues to develop a cloud-based platform that will provide access to all products offered by several of its entities, including Kaupang Krypto, Trijo, Teslacoil, Arcane Assets and Arcane Research. This is being implemented by the team behind Arcane Technology, the business unit responsible for developing Teslacoil’s payment software. We understand that Arcane Crypto continues to face difficulties in partnering with external providers of on- and off-ramp solutions for Teslacoil (we flagged this as a potential risk in our initiation note). This suggests that the project is unlikely to generate any meaningful revenues in 2021, as discussions with potential business clients and payment processors have likely been put on hold. As a result, Teslacoil is now putting more emphasis on integration with Kaupang, which will provide its users with the functionality to make payments directly to and from their regular fiat bank accounts using the Bitcoin Lightning Network (described in more detail in our initiation note). Consequently, the Arcane Technology team will serve different businesses within Arcane Crypto, rather than operating as a separate business unit.

Entering the bitcoin mining business the green way

In June 2021, Arcane Crypto signed a lease contract for hosting bitcoin miners, marking the first step into the bitcoin mining business. Total hosting capacity covered by the contract stands at 2.5MW, which will be gradually unlocked between August 2021 and Q122 (half of the hosting capacity will be available from this year and the other half from next year). The duration of the contract is 3.5 years with an option to extend it for a further two years. Meanwhile, Arcane Crypto has started the process of ordering the required mining equipment (application-specific integrated circuits, ASICs), with the first batch expected to be delivered in September 2021 and the second in December 2021. Importantly, the energy used in the mining operations will be renewable (hydropower). The business will be operated by Arcane Green Data, a fully owned subsidiary of Arcane Crypto.

Arcane Crypto is launching its mining operations in the aftermath of the Chinese ban on crypto mining introduced in recent months, which initially reduced the total computing power in the Bitcoin network (so-called hashrate) by close to 50% from its peak in May 2021 at c 200 Exahashes per second. This in turn triggered a reduction in the difficulty of mining a block (and receiving a reward in the form of newly minted BTC and transaction fees) as part of an automatic update carried out periodically by the Bitcoin network’s protocol. This, in conjunction with the recent rebound in BTC price to the current c US$51,500, has significantly improved business economics for non-Chinese miners, which continue to operate on the Bitcoin network. Moreover, we understand that the Chinese ban also resulted in a decline in the price of new ASICs and a shortening of delivery times. This all works in favour of Arcane Crypto’s new business line. We also appreciate that the company’s mining operations will be based on renewable energy, with Bitcoin’s carbon footprint recently in the spotlight again. Based on current Bitcoin network parameters (total hashrate, block reward, average block time, transaction fees, etc) and the current BTC price, we estimate that full utilisation of hosting capacity would represent mining revenue of c US$10m (c SEK86m) pa for Arcane Crypto. Having said that, this figure may change significantly depending on development of the above-mentioned factors.

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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This report has been commissioned by Arcane Crypto and prepared and issued by Edison, in consideration of a fee payable by Arcane Crypto. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

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