Applied Digital Corporation

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Applied Digital Corporation is a technology company that specializes in designing, developing, and operating digital infrastructure, including data centers, with an emphasis on high-performance computing (HPC) and artificial intelligence (AI) applications.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Applied Digital (APLD) is primarily a builder and operator of data centers, with a shift towards high-performance computing (HPC), and particularly AI-related infrastructure. Historically, APLD has focused on digital infrastructure, mostly used by Bitcoin mining companies, with a recent strategic shift towards HPC. The company’s revenue is largely driven by contracts with colocation clients, where clients utilize APLD’s infrastructure to power their own operations.

  • Revenue Distribution:
    • APLD’s revenue primarily comes from two segments: data center hosting and cloud services. The data center segment is primarily driven by HPC customers, while the cloud segment is more targeted towards AI and machine learning applications. The company’s clients utilize its facilities, power, and cooling resources.
  • Industry Trends:
    • The data center industry is experiencing massive growth, which is primarily being driven by a need for increased computing power, for things such as AI and Machine Learning.
    • HPC and AI related infrastructure is expanding at a rapid pace.
    • The demand for data centers with specific attributes, like low cost/high power is growing faster than the traditional data center infrastructure.
  • Competitive Landscape:
    • The data center industry, particularly the HPC segment, is becoming increasingly competitive. There are more and more established players, and newer players in the industry.
    • The industry is very fragmented.
    • Given low barriers to entry (high upfront cost, does not equal high entry barriers), differentiation is crucial to long-term success.
  • What Makes APLD Different?:
    • APLD focuses on being a low cost data center provider that is optimized for high power applications like crypto mining and AI.
    • They have been implementing AI in-house to optimize performance and efficiency.
    • They claim expertise in designing, developing, and operating customized high-density facilities for HPC and AI, which they believe they can do cheaper and more efficiently than the competition.
  • They are trying to transition into a broader digital infrastructure play, instead of just bitcoin mining infrastructure.
  • Other relevant information: * The management has emphasized its intent to prioritize higher-margin segments and grow capacity to facilitate HPC and AI customers. * The company is trying to expand into new geographic locations. The company stated in an earnings call they are seeing a lot of demand in the North Dakota market. * The current market situation has been affecting the price of bitcoin, which may have a secondary effect on their financials. The management has stated in earnings calls that the increase in their revenues does not directly reflect any increase in the bitcoin price. The reason for this is that their contracts are based on pricing rather than the price of Bitcoin. * APLD’s core business, HPC Hosting, is expected to grow exponentially in the coming years. * APLD is expected to become cash flow positive in 2024.

Financial Analysis

  • Revenue: APLD has shown strong revenue growth YoY, indicating an increase in demand for its HPC infrastructure.
    • However, the transition from the legacy crypto hosting side to the HPC/AI infrastructure is still in progress.
    • It is important to take a note that the bulk of revenue is coming from operations that were previously in the crypto business which is why we don’t see a strong profitability in those operations, even when they are growing. The profitability on new HPC focused data centers are expected to be higher.
  • Profit Margins: Gross and operating margins have improved recently, but the high depreciation and share based compensation costs have kept profit margins weak.
    • As management stated in the earnings call, they are trying to increase their EBITDA margin, which comes from selling higher margin services.
    • Net loss is still substantial, but management is promising an improvement in coming years.

  • Balance Sheet: While their overall debt is high, a high percentage of it is long term. Short term debt is also high, which does expose them to risks from interest rates. Current assets are far lower than the total liabilities. This makes them seem risky in short-term liquidity, which the next points should shed some light on.

  • APLD did a large private placement of stock in Q2, which significantly helped the cash balance. This helps the short-term liquidity.

  • The long-term debt was taken at low fixed rates, this protects the company from high interest rates in the future.

  • Cash Flow: APLD is not consistently generating positive free cash flow, but has been generating operating cash flow. They need to continue improving their cash flow.

Moat Rating

  • Rating: 2 / 5 * APLD has some level of advantage, but is currently vulnerable to the competition. * Positive Aspects: APLD does provide some unique features for its clients, such as low-cost high-power facilities. They do have some existing contracts with key partners. But this alone is not enough to completely deter competitors from trying to compete. * Negative Aspects: APLD has very little or no brand recognition and no real IP. They don’t own a proprietary process or anything that would give them a strong sustainable competitive advantage. Their advantage of low cost can be easily replicated as it comes from access to electricity and tax rates. * There isn’t a network effect or any other thing making it difficult for customers to switch to a competitor. They do have a good relationships with existing clients. * It is unlikely that APLD can create strong pricing power with their customers.

Legitimate Risks to the Moat & Business Resilience

  • Competitive Pressure: The increasing competition could decrease their profitability if they are unable to differentiate themselves on something other than low-cost. There are other firms operating with similar low cost models.
  • Technological obsolescence: Any rapid change in technology can render the current setup obsolete, forcing major reinvestment and infrastructure change.
  • Dependence on Energy and Power Costs: Since they rely on the availability and low cost of power, any drastic rise in that cost could make them less competitive.
  • Customer Concentration: Their revenue is heavily dependent on a handful of large customers. Losing them could create a huge negative impact.
  • Acquisition/Partnership Risks: Any future acquisitions or partnerships may fail to integrate effectively, or may lead to an increase in debt and decrease in the cash flow available.
  • Regulatory Risks: Given how new the HPC industry is, future regulatory and legal decisions might affect the business negatively.

Understandability Rating:

  • Rating: 3/5 * While APLD’s shift to HPC and AI is understandable and fairly straightforward, some parts of their operations are not that simple to assess. It requires an understanding of the data center industry, as well as the emerging trends in artificial intelligence (and blockchain on their older business). * Their financial statements are very detailed and may be hard to follow for inexperienced investors.

Balance Sheet Health Rating:

  • Rating: 3 / 5
    • APLD’s cash position is good right now, but is propped up by the latest private placement. Without it, it’s unlikely that the business can maintain all operations.
    • Their current ratio is less than one which is not ideal, given current liabilities exceed their current assets. They would need to rely on cash flow generation, which is not consistent as of now.
    • Most of their debt is long term, but their interest expense is still fairly high, so this will put pressure on profitability until new contracts begin generating positive free cash flows.
    • Given these factors, APLD is at an average range in terms of balance sheet health.

Recent Concerns, Controversies, and Problems

  • Auditor Change: The company recently fired its audit company and chose a new one. In the 10K report, the company stated, “We were dismissed on December 19, 2022 as a result of the conclusion of our Audit Committee that a change in the independent registered public accounting firm was warranted.” This has raised a lot of concerns in the financial community.
  • Share Dilution: The private placement of common stock was done at an extremely low price ($1.90, more than 60% below market price), which heavily diluted existing shareholders. The company has more shares available for the executives and the insiders. This also raises conflict of interest issues.
  • Lawsuits: The company is dealing with multiple lawsuits from shareholders for fraud and insider malfeasance. These have created considerable uncertainty on the future of the company.
  • High cash burn: Despite promising an improvement, they are still burning through cash, they need to become cash flow positive in order to become a viable business in long term.
  • High Debt: APLD has taken a large amount of debt for its expansion purposes, and some of it is short term debt, creating an increased level of risk given the rise in interest rates and the volatility in the crypto market.
  • Missed revenue expectations: They have been missing revenue expectations for the last two quarters. These has resulted in a lot of uncertainty.
  • Shift from crypto to AI: The shift from crypto to AI and HPC is not finalized, creating further uncertainty. They still depend a lot on the old business, and they have not proved that their new AI focused business segment is viable, and will generate profit.