The herd behaves in mysterious ways. Special purpose acquisition companies (SPACs) are a great example of how irrational investors can be. First, they were pumping shares when a planned merger was announced, never mind that the merger hadn’t completed yet. When that foolish behavior was called out, the herd then started pumping shares the day of the merger. The efficient market hypothesis tells us that no new information is being made available in 24 hours that merits a sharp price increase, yet newbie investors don’t seem to care. Today, we’re going to talk about a company that inexplicably jumped (checks Bloomberg terminal) +123% on the first day of trading following the merger – Arqit Quantum (ARQQ).
About Arqit Quantum Stock
Founded in 2016, London’s own Arqit has taken in an undisclosed amount of funding to develop a quantum encryption technology that’s just about ready to be commercialized. The company went public using a SPAC called Centricus Acquisition Corp, and the merger was just finalized today. To understand what Arqit does, we need to examine the problem they’re trying to solve.
The Quantum Encryption Problem
A great deal of money is pouring into companies trying to develop quantum computers. Once a proper quantum computer has been developed, it will be powerful enough to break current encryption methods that are largely based on mathematics. Some estimates claim such a quantum computer could arrive in four years’ time, Google’s claims to quantum supremacy be damned. Therefore, we need an encryption solution that is “quantum safe.”
It’s a problem we wrote about three years ago in our piece on Why Post-quantum Cryptography is Important Today. In that piece, we looked at a Canadian company that’s tackling the problem, Isara Corporation. At least a handful of other companies are working on the quantum encryption problem too, like QuintessenceLabs and their true random number generator.
For those of you who speak nerd, Arqit has published a fairly accessible white paper on their approach titled Facing the Quantum Threat. It starts by talking about two general approaches to solving the quantum encryption problem – building better algorithms and protocols (easier said than done), or using a method of security based on the laws of physics, not mathematics. For example, we could use a pair of entangled photons to establish a shared key between Alice and Bob. If Alice and Bob both measure the polarizations of their individual photons, they always get the same answer with 100% probability. If someone eavesdrops, the correlation no longer exists. That’s the simplest way to describe what Arqit has built – a method of allowing two parties to obtain a ground truth that ensures secure communications in an era of quantum computing.
Called QuantumCloud, it’s a new way to create and distribute unbreakable symmetric keys with 1,435 patent claims filed. Software needed at the endpoint is less than 200 lines of code, light enough to be deployed on all kinds of devices – from IoT sensors to smartphones. Customers can request keys when needed using a cloud-based application programming interface (API) which triggers billing. Throw in some smart contracts on the blockchain and they’ll be cooking with gas.
The next step to improve the platform is to make it accessible via satellite, something that makes the offering more appealing for customers for reasons we won’t get into (mainly because we don’t understand them ourselves). With just two satellites, Arqit expects to deliver 2 quadrillion keys per annum. Prior to launching its first satellite in 2023, Arqit’s quantum encryption platform, QuantumCloud, will use machines to generate a terrestrial simulation of the quantum satellite technology.
The Road to Revenues
The Company has entered into several long-term customer contracts, however those contracts are contingent upon the successful delivery of operational technology which is still in development.
Arqit has not yet begun commercial operations and currently does not generate revenue. In Fiscal 2020 (ending September 30, 2020) they received “Other Operating Income” of $2.12 million from a 2019 contract with the European Space Agency. While the SPAC deck estimates $14 million in revenues for 2021, the F-4 filing estimates the “time it is able to fully commercialize its products” to be “targeted for 2022.” The work being done with customers through the remainder of 2021 surrounds pilot projects which prove product-market fit. Says the company, “certain of its customer contracts are subject to the successful completion of pilot phases with those customers, which are due to begin in the second half of 2021.”
With the end of Arqit’s fiscal year rolling around – September 30, 2021 – it makes sense to wait and see if they manage to bring in $4 million in revenues from QuantumCloud as they say they will. That’s one way to tell the pilot phase has been successful. (The next year, that number is supposed to quadruple to $16 million.) Since they’ll now be filing quarterly reports with the SEC, we ought to see a steadily growing stream of revenues coming from QuantumCloud. Once that number becomes meaningful – $10 million per annum – we’ll come back around for another look.
A Messy SPAC Trade
When a SPAC merger happens, it’s traditionally been the case that the SPAC company trades under its own ticker until the merger completes. At that time, you’ll see the ticker change. In the case of Arqit, the old issue is just hanging out there which may confuse some. What’s even more confusing is how the old shares traded under $9 a share prior to the merger completing. At any rate, let’s look at the valuation of Arqit using our simple valuation ratio (we’ll use implied market cap at $10 a share and 2021 estimated revenues):
- Market Cap / Annualized Revenues
1,402 million / 14 million = 100
Arqit is one of the most highly valued SPACs we’ve ever come across using their offering price of $10 a share. For those shares to fall under our valuation threshold of 40, they’d need to trade at around $4 per share. Instead, they’re trading at around (checks Bloomberg terminal) $14 per share. Needless to say, we wouldn’t touch this stock with a ten-foot pole at today’s prices. No matter how great the story, there needs to be some limit on what you’re willing to pay. This dramatically reduces the likelihood you’ll end up a bag holder.
Lastly, it’s very tempting to short stocks that are ridiculously overpriced, but don’t. The Robinhood YOLO warriors sitting on the other side of that trade exhibit little rationality, and you can easily get your margin limits tested while they waffle on about ALL and diamond hands. It’s better to let the institutional investors take their stimmy checks.
We’re patient, risk averse investors who don’t suffer from FOMO. None of this “climb on the money train before it takes off” stuff. Between the time we started writing this article until the time we penned the conclusion, shares of Arqit plummeted -46% to settle at $11.30 a share. The bag holders are licking their wounds right now, while looking for the next stonk to hodl.
Robinhood’s app has done the investment world no favors. Newbie investors see a stock price surge and think that’s a good thing. We call see it for the volatile red flag it is. For the moment, Arqit Quantum is overvalued at any price above $4 a share, so we’re avoiding it.
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