MicroAlgo: Be Cautious Of This Hot Stock (NASDAQ:MLGO)

On Monday, October 30, 2023, the shares of MicroAlgo (NASDAQ:MLGO) shot up nearly 20%, in the wake of a new technological development. With that increase, the stock price had nearly tripled since mid-December 2022 – after falling from more than $10 earlier that month.

MicroAlgo Inc. is a relative newcomer to American public markets; it began trading on NASDAQ on April 13, 2021. As the name suggests, it is a tech company, one that specializes in central processing algorithms.

Thesis

I believe a lack of organizational and operational focus makes the company’s structure and operations hard to understand. A secondary concern is that the company does not have enough financial history to provide information in which we might have confidence.

About MicroAlgo

It is a central processing algorithms company, and it explains its business this way in its 10-K for 2022:

“In sum, we provide effective advertising solutions for digital marketers by optimizing advertising content and precisely matching content with suitable consumers by processing a massive amount of data through efficient automation. Eligible consumers are selected in accordance with their demographics and personal preferences, which our central processing algorithm service is able to analyze for the purpose of maximizing the internet advertisement effect.”

It focuses on three vertical markets: internet advertising, gaming, and intelligent chips.

As of Wednesday, November 1, 2023, it had a market cap of $143.85 million, based on a closing price of $3.17.

This muddy org chart tells a story

The company provides this chart in its most recent 10-K:

Offshore refers to companies outside the People’s Republic of China, and onshore refers to companies based within China. Whatever the location, there are subsidiaries within subsidiaries. All of this to provide just $18.5 million in revenue during the second quarter of 2023.

With all these seemingly interdependent enterprises, what are its transfer pricing policies? The company does not disclose them, so we’re left trying to figure out what’s happening within a black box.

MicroAlgo did disclose in its 10-K that it intends to selectively seek strategic acquisitions. It also wants to expand to even more markets, including government, finance, and healthcare. Presumably, this will lead to an even bigger org chart, which will further reduce clarity about its operations. It also suggests even more dilution of its focus on advertising and gaming.

Limited financial data

As noted, the company began trading publicly in April 2021, which means investors have just two annual reports and fewer than eight quarterly reports. Here are excerpts from the last five quarterlies, based on data compiled by Seeking Alpha (all data in millions of U.S. dollars, except for earnings per share):

A couple of issues to note:

• Revenues have varied significantly as has the cost of revenue. However, the gross profit has improved over the past three quarters.
• Research and development spending is growing (more in the Risks & Opportunities section).
• Net income has been negative over the past three quarters, although its severity was dampened by a minority interest gain in the second quarter of 2023 (the full second quarter report apparently has not yet been released).
• Basic earnings per share is in negative territory, although the company has reduced the number of shares outstanding.

As to what’s behind these inconsistent numbers, the 10-Q for the first quarter offers a couple of indications. First, gross margins for central processing algorithm services in the first quarter slipped from 34.3% in Q1-2022 to 30.2% in the same quarter of 2023. The company attributed the slippage to its increase in the cost of revenue in its short-form video advertising.

MicroAlgo’s gross margin for intelligent chips and services fell from 4.1% in Q1-2022 to 0.4% in Q1-2023. It reported the market for intelligent chips was ‘sluggish’ and chip costs increased significantly.

Turning to the cash flow statements, second-quarter net income was negative, so it was unable to use that for financing. Cash from financing in Q2 saw the firm issue $1.4 million in new debt, repay $19.2 million in previous debt, and take in $20.3 million in ‘Other Financing’. No new shares were issued in conjunction with this other financing.

The balance sheet showed $19.1 million available in cash and short-term equivalents at the end of June 2023. At the same time, it had accounts receivable of $5.2 million and other receivables of $24.9 million. Total assets totaled $71.5 million, which includes $14.6 million of goodwill resulting from its merger with WiMi Hologram Cloud Inc.

Competition

MicroAlgo does not name competitors in its annual or quarterly reports, however, in its 10-K it does acknowledge, “There are other companies addressing various aspects/verticals of the central processing algorithm service market in the PRC (People’s Republic of China). The central processing algorithm service market is highly fragmented and evolving.”

A bigger competitive threat may come from internet giants such as Google/Alphabet (GOOG, GOOGL) and Meta Platforms/Facebook (META). As Brenda Kanana summarized in an October 27, 2023 article for Cryptopolitan:

“Google, Meta, and Snap have harnessed the capabilities of artificial intelligence to thrive in the evolving advertising landscape. As AI redefines the digital advertising landscape, these tech giants are well-positioned to maintain their dominance and adapt to emerging challenges, setting the stage for a dynamic and competitive future in digital marketing.”

Risks

October 30th’s big swing has not been MicroAlgo’s only quick change in price. One year ago, on October 31, 2022, it closed at $10.29 and remained around that price for the next six weeks. Then, on December 13th, it dropped from $10.47 to $4.10 – in one day. It fell to $1.25 in late December before picking itself up to $3.69 at the close on October 30, 2023.

The big uptick on October 30 came in the wake of an announcement that the company had developed new backtracking search algorithm software. Some investors liked the news and bid the price up from $3.09 to $3.69, an increase of 19.5%. The key is to remember MicroAlgo stock can fall as quickly as it can rise.

Risks also include its dependence on a limited number of customers. According to 2022’s 10-K, it had 173 customers at year-end, compared with 248 at the end of 2021. Just one of those companies accounted for 18.5% of its total revenue last year, and its three largest customers accounted for 45.2%.

With its headquarters in China, a couple of other risks exist. First, the PRC government may exert a significant influence over the company. Second, almost all of its operations, as well as senior management and directors, are based in China, so legal judgments against the company or its officers may not be enforced.

Opportunities

MicroAlgo is part of the online advertising industry and may share in its rapid growth. Statista has reported that ad media owners’ revenue worldwide is expected to grow from an estimated $856 billion this year to more than one trillion by 2026. It added, “That comes with the unceasing rise of the internet, whose maximum share in the world’s ad spending is yet to be seen.”

In its annual filing, the company also claimed to be among the first movers among central processing algorithm services in China, thus having a competitive advantage. It also claims to have strategic alliances with many customers.

Also, to its credit, the company owns a significant amount of intellectual property. In the 10-K, it noted, “We are the market leader in terms of the quantity of intellectual property. As of December 31, 2022, we own 548 proprietary intellectual property rights, which include 400 copyrights of which 396 are software copyrights, 83 patents, 27 registered trademarks, 20 exclusive rights for the layout design of integrated circuit and 18 domain names. The large quantity of intellectual property at our disposal as compared to our competitors exemplifies our commitment to research and development and long-term development.”

If nothing else, that intellectual property may make it a takeover candidate in the future.

Valuation

Since the company is not profitable yet, some standard valuations familiar to investors are unavailable. That includes anything to do with earnings, including price/earnings (P/E) and price/earnings-to-growth (PEG).

Based on two years of reported history, it does have price/sales (P/S) and price/book (P/B) ratios. P/S is 1.90, which is nearly 20% below the industry (Technology) median. Similarly, the enterprise value-to-sales ratio is 1.66, which is 32.53% below the sector median (all data in this section is on a TTM or trailing twelve-month basis).

Shifting our focus to the balance sheet, the P/B ratio comes in at 2.39, which is 5.29% below the sector median. However, I don’t like to place too much weight on the P/B because tech company assets are mostly intangible and hard to quantify.

Based on the P/S and EV/S, MicroAlgo is modestly underpriced, which seems appropriate for a relatively new security. Still, I expect the company to survive and grow on the strength of its intellectual property and be worth more than its current valuation in the next couple of years.

Conclusion

Charlie Munger, who, along with Warren Buffett, has led Berkshire Hathaway Inc. (BRK.A, BRK.B) to success, has emphasized the importance of simplicity. He wrote, “We have three baskets for investing: yes, no and too tough to understand.”

As an investor who’s taken some risks with microcaps, for better and for worse, there’s much about MicroAlgo that’s too complicated for me (and probably for Munger, too). That starts with its corporate structure. In addition, I won’t be able to understand its financials until I see more history; this company currently doesn’t have enough quarters or years to give us stable financials or ratios.

On the plus side, it’s part of a dynamically growing industry, and given its portfolio of intellectual property, it may even become a buyout target by one of the larger players.

Overall, though, I believe the risks outweigh the potential rewards at this point, so I would not recommend MicroAlgo at this time.