July 10, 2021
Coinbase: A “tollbooth business” in the Growth of Cryptocurrencies
Pynk community coinbase investment research banner

When it comes to Crypto investing through the stock market, last time I told you about KR1, which in my opinion is one of the most attractive ways of gaining exposure to Cryptocurrencies and the seismic growth potential of new blockchain technology. Today, I would like to tell you about another newly listed stock which provides investors with a “tollbooth” exposure to this exciting space: Coinbase Global, the parent company of the popular cryptocurrency exchange Coinbase, which went public via direct listing recently. Skeptics regard Coinbase as a poster child for the 2020-2021 speculative frenzy. I must admit I hadn’t looked at the IPO closely for this very reason. However, after digging into the numbers, I disagree. Coinbase is a real business with real profits, a strong brand and a well-executed business plan.

Coinbase vs. Bitcoin

As regular readers know, I often look for a somewhat safer way to invest in an explosive trend. So, if you’re bullish on Cryptocurrency and Blockchain, why choose Coinbase over Bitcoin? Well, compared to Bitcoin, in my opinion Coinbase has clear fundamental and value advantages. Yes, its business now is heavily dependent on Bitcoin, but at least analysts can value Coinbase based on the revenues and profits it generates. This in my mind makes Coinbase a much safer and potentially less volatile play. And this has been shown to be true in the recent market rout: although bitcoin is down 44% since Coinbase’s IPO date (14th April), even if you’d bought Coinbase after the first day’s rise (at $328), you would only be down 22%.

Additionally, betting on Coinbase is a bet on the role of Cryptocurrencies as a whole, rather than just one type of Cryptocurrency. If interest in Ethereum increases, the price of Bitcoin could be negatively impacted, but Coinbase would reap the benefits of Ethereum transactions on its platform in the same way it does with Bitcoin.

Pynk community coinbase investment research performance graph


Source: Stockopedia
Past performance is not indicative of future results.
Returns may increase or decrease as a result of currency fluctuations.

Company Description

Coinbase is a leading cryptocurrency exchange and serves as a platform for users to easily buy and store cryptocurrency. The company makes most of its money from charging transaction fees to customers to buy and sell cryptocurrencies like Bitcoin and Ethereum. Despite being around for over a decade, Bitcoin was largely inaccessible and deemed too risky to touch due to the ‘no-regulation’ intricate structure of blockchain.

Even if the average person wanted to buy Bitcoin or other cryptocurrencies, it was hard to determine which platforms were trustworthy. Furthermore, encrypted Crypto banks forced users to jump through hoops to even access their accounts. Consequently, stories of users being locked out of their multi-million dollar worth accounts began plaguing the internet, further deterring people from jumping aboard the Crypto-train. Coinbase’s user-friendly interface helped to eliminate that uncertainty and pessimism in the Crypto market. Much like Robinhood appeals to young, first-time investors, Coinbase is newbie-friendly. Coinbase typically charges a spread of 0.50% for Cryptocurrency purchases and cryptocurrency sales. The more transactions made on the platform means more revenue for the company.

Pynk community coinbase investment research graphic B


Source: Business of Apps 1

Ownership Structure

Below is a list of the top shareholders in Coinbase. The IPO made CEO Brian Armstrong one of the world’s richest men on paper and it is reassuring that his continued substantial shareholding means his interests are still very much aligned with those of the company. Coinbase also is notable for its dual-class share structure, meaning insiders will retain full control of the company. Typically this isn’t a setup favoured by equity markets, but Google is an example of a company that made it work well for investors.

Brian Armstrong
The CEO and co-founder of Coinbase, who launched the company in 2012, will, not surprisingly, be the biggest breadwinner. The company’s 8-K filing with the Securities and Exchange Commission, filed eight days ago, listed him as holding 2,753,924 Class A shares and 36,851,833 Class B shares of the company. That makes him the largest individual shareholder.

Marc Andreessen
Andreessen was one of the first investors in Coinbase. Individually and through Andreessen Horowitz, he owns 5,516,037 Class A shares and 23,961,498 Class B shares. Prior to investing in Coinbase, he was a backer of Netscape and Facebook.

Fred Ehrsam
The Coinbase co-founder and managing partner of the crypto investment firm Paradigm owns 2,570,459 Class A shares and 15,114,503 Class B shares.

Fred Wilson
The Union Square Ventures partner joined the Coinbase board in 2017 and led the Series A funding round. He currently holds 13,902,324 Class B shares.

Nas
A rap icon might seem an unlikely name amongst the financial titans, but Nasir Jones (better known by his stage name) also runs the investment firm QueensBridge Venture Partners and was part of the Series B round in 2013. Coinbase didn’t list his investment in the 8-K, but a story posted on Coindesk estimated his holdings between 99,329 shares on the low end or 496,642 on the high end.

Ribbit Capital
The firm behind the Robinhood trading app, got in early on a Coinbase funding round. It currently owns 11,995,949 Class B shares.

Tiger Global Management
The group, which led the Series E round of funding at Coinbase, owns 2,624,880 Series A shares.

Source: Forbes Magazine

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Investment Case

I think Coinbase represents a high risk but compelling long-term investment proposition with meaningful valuation upside for a variety of reasons. This is especially the case if you believe that the Bitcoin price will continue to rise over the medium term and that greater adoption of Cryptocurrencies generally will take place both amongst institutions as well as the wider public.

One of the Leading Exchanges
Coinbase is the only pure-play Crypto exchange that is publicly traded. Coinbase has plenty of competitors, mainly other Crypto exchanges like Kraken and BlockFi. PayPal has also entered the Crypto space, and they certainly represent a worthy competitor but could also do much to lend credibility to the whole space, benefitting all parties. Everyone charges similar fees to retail customers but competes on price for larger buyers and sellers. The point is that if you believe in the underlying growth, then Coinbase is one of the key players that stands to benefit.

Correlation to Bitcoin Price
Coinbase’s revenue is clearly correlated to the price of Bitcoin, inferring from historical revenue figures. Therefore, I would think there would be a strong positive correlation in the future as well. Therefore, if an investor is bullish on the future of Bitcoin, Coinbase shares represent a somewhat lower risk exposure given the installed base of customers and fee (and potentially in the future card loyalty scheme) structures.

Cyclicality of Revenues - Should Reduce Going Forward
Sceptics say this level of profitability isn’t sustainable, that competition will quickly erode Coinbase’s margins, and that therefore the valuation is unsustainable. After hearing that Coinbase was going public, I was fully expecting to see an extreme IPO valuation. After looking at the numbers in detail though, I have changed my mind.

Undeniably, the weakness of the business is that it is very cyclical. If you look at Coinbase’s revenue and profit history, you can see how the 2017 boom and 2018 bust affected their business. I would counter that there are many businesses in equally cyclical sectors (commodities, oil, etc) and this alone cannot be an argument against an investment, especially as Coinbase is also benefiting from massively rising adoption within the Cryptocurrency ecosystem…

Pynk community coinbase investment research graphic C


Past performance is not indicative of future results.

But another reason for Coinbase’s weaker performance in 2018 and 2019 was that institutional investor interest in Cryptocurrency was low during that time. Just $11 billion of institutional investor money was being spent compared to $45 billion retail. This sank to $3 billion and $4 billion respectively in Q1 2019. Fast forward to Q4 2020, institutional investors spent $57 billion on transactions compared to $32 billion retail. Institutional investors have now overtaken retail investors in cryptocurrency interest. This is promising looking ahead in terms of reduced volatility of transaction volumes and therefore a smoother business performance.

Pynk community coinbase investment research graphic D

Growth Through Reward Cards
Many cyclical industries – notably airlines - have sought to help smooth the cyclicality in their revenues through loyalty and reward programmes.

Here’s how the programs typically work. Let’s say I get a nice meal and a couple of glasses of wine somewhere tonight and run up a $100 tab, which I pay with my credit card. Behind the scenes, 2-4 percent of this amount typically goes to credit card companies. Visa/Mastercard take a little bit, the credit card processor takes a bit, but the issuing bank takes most of it (70+ percent of the fee). If you use an American Airlines card, for example, the issuing bank splits this money with the airline. As a result, the airline gets immediate cash and only has to put up a promise to fly someone in the future as a corresponding liability. Importantly, this results in upfront cash flow, recurring revenue, and no fixed costs to the airline. It doesn’t sound like a lot, but volume is the key, and airlines make billions of dollars per year off these programs because they’re able to split up a $500 plane ticket into 200 different credit card transactions someone does anyway and then give it to them as a reward.

So Coinbase is working on a rewards card that pays in Bitcoin. There’s a well-defined market of Crypto enthusiasts who would gladly put expenses on their card to earn Bitcoin or other Cryptocurrency. This would make Coinbase money from their split of the interchange fees and it would help stimulate volume on their exchange when people buy and sell Crypto with their reward money, not to mention that it helps solidify the value of the brand. This is a win/win/win, and I expect it to be a hit.

There’s a waitlist for the debit card right now, and my hope is that they will be able to launch a credit card soon as well. Unlike airlines, Coinbase is starting from the point where they have a hugely profitable business. I don’t think it’s a stretch that they could pull in similar income numbers to airline rewards cards by 2025, which make $5 billion-plus in annual profit. Their Crypto exchange would therefore be even less exposed to Crypto price movements. If you think about it, this is a classic “tollbooth business”: in business speak, the tollbooth analogy is used to describe very attractive businesses that charge a fee just for giving customers access to a network or sector and this is exactly what Coinbase does. Going forward, Coinbase simply has to keep a user-friendly exchange where people can easily buy and sell Crypto and grow the business further by developing the rewards cards as a revenue source for even greater upside.

Declining Margins?
The worry for bears is that a similar race to the bottom will happen for Crypto exchanges that happened to online stockbrokers. There are a couple of differences here though. I don’t think the best proxy for Coinbase is stock trading. I think the foreign exchange market is a better proxy, and foreign exchange still has higher transaction fees for retail customers than the stock market does. I attribute the higher fees for FX in general to the lack of a centralised exchange to trade them. Nevertheless, I would anticipate in the long run that Coinbase will have to charge less in fees due to competition. However, I don’t think this will happen as quickly as the bears expect given the ‘trust’ factor counting for a lot in such a new space, and also I think the reward card business may well somewhat protect margins. I also expect Bitcoin trading volume to grow over time, meaning a lower margin on a higher volume could still mean higher profits.

Recent Results: Explosive Growth Metrics

Business is booming and the underlying picture is extremely exciting. First-quarter revenue climbed nine-fold from last year, jumping from $190.6 million to $1.8 billion. Net income also skyrocketed from $32 million to between $730 million and $800 million over the same period. Simply put, these YoY numbers are insanely good. In just one quarter, Coinbase earned more than in the entirety of 2020.

Pynk community coinbase investment research graphic E

Image Source: Business of Apps
Past performance is not indicative of future results.

This monumental growth was not just restricted to the most recent years. Revenue in 2016 was just $16 million but in 2017, revenue shot up to $927 million. Yes, revenue dipped in 2018 to $520 million and $483 million in 2019, but these numbers are still incredibly impressive.

Pynk community coinbase investment research graphic F


Image Source: Business of Apps
Past performance is not indicative of future results.

Profitability reflected a similar pattern over the years, with 2018 and 2019 dipping into the red. Nevertheless, 2020 saw profits of $322 million and $765 million by Q1 in 2021.

Pynk community coinbase investment research graphic G

Image Source: Business of Apps
Past performance is not indicative of future results.

Some may regard these numbers as volatile, but Coinbase’s growth in users has been headed in only one direction: stratospherically upwards. In 2018, monthly active users sat at 0.7 million. Users then climbed to 1 million in the next year, 2.8 in 2020 and to 6.1 million by 2021.

Pynk community coinbase investment research graphic H

Image Source: Business of Apps
Past performance is not indicative of future results.

Other areas of consistent growth are Coinbase’s AUM and transaction volumes. Assets under management increased from $25 billion in 2019 to $90 billion in 2021. Transaction volume also rose from $135 billion in 2017 to $335 billion in 2021. To put this into perspective, leading competitor Binance’s $35 billion AUM is only a fraction of Coinbase’s $223 billion AUM.

Pynk community coinbase investment research graphic I

Past performance is not indicative of future results.

Market Rout & Margins

The significant Crypto market sell off will impact Coinbase’s second quarter and estimates have been revised down accordingly. Clearly an investment in Coinbase today depends on your view on the recovery and price growth potential of Bitcoin and Cryptocurrencies in general in the period ahead.

Interestingly, Coinbase is far less reliant upon Bitcoin than it used to be. Bitcoin accounted for 57% of its trading volume in last year’s Q2 while in the most recent quarter, it was 39%. Other Cryptos besides Bitcoin and Ethereum are now 40% of trading volumes, and while that percentage has moved around, it shows that Coinbase is more than just a way to trade Bitcoin, which should help its long-term appeal in the space as a Crypto go-to for traders.

If you have a look at the operating margin numbers, Coinbase is exhibiting enormous operating leverage as revenues have risen:

Pynk community coinbase investment research graphic J

Source: Q1 shareholder letter

We can see that, on the whole, margins are undoubtedly moving in the right direction. Technology and development costs were 12% of revenue in Q1, which is less than half their relative level a year ago. G&A costs plummeted from 33% to 8% of revenue. Keep in mind that Coinbase doubled its employee count during this period, and its tech and development spending 4X’d during the past year, so it isn’t like Coinbase is in some period of austerity; it is investing for future growth, and seeing massive operating leverage. If/when the investments slow down, the margin profile should stabilise at very high levels.

Again, operating margins are likely to moderate this quarter, but if you zoom out and look longer-term at higher rates of Crypto adoption and trading volumes, Coinbase’s operating model looks to benefit massively over the long-term. Each dollar of incremental revenue is producing higher rates of operating profits, and that’s very good news for the value of Coinbase.

For comparison, see the operating margin percentages for Nasdaq (NDAQ) and CBOE (CBOE), exchanges that - while not exactly the same as Coinbase’s model - are quite comparable to Coinbase.

Pynk community coinbase investment research graphic K


Source: TIKR.com

To be clear, there is no doubt that revenue estimates have come down in recent weeks, no doubt due to weak price action in Bitcoin, Ethereum, and other coins. Indeed, they’ve been halved (or more), so analysts fully expect revenue to be weak for the June quarter. However, keep in mind that estimates are materially higher than they were when Coinbase came public earlier this year, and that was when cryptos were flying. Margins may well be affected but if you believe in the longer term revenue growth picture, then there is every prospect that the business’ huge operating leverage will continue to help margins.

The “App Store” of Crypto

“Build the crypto app store: Apple didn’t attempt to build every app for the iPhone, it empowered developers and gave mobile users an easy way to access new innovative apps. We need to do the same in crypto. There is now 10s of billions of dollars of economic activity running on dApps, and a new trend coming out every three months. We’ll work to give our users easy access to all of this from the main Coinbase product.”
Brian Armstrong, CEO & Founder Coinbase

Part of the reason I feel Coinbase has excellent prospects is because its offerings are immense. Its list of supported coins is massive and growing all the time, having added another three coins just last week. Coinbase is angling to be the premier destination for all things Crypto, and it certainly appears to be well on its way to achieving that. This breadth is supportive of Coinbase’s future success whether Bitcoin maintains its dominance, or Ethereum, or any other coin. In addition, I feel the recent banning of leading Crypto exchange Binance has only benefited Coinbase’s business prospects so far.

Coinbase is also thinking long-term, recently issuing a convertible note that has rock-bottom costs and minimal maximum dilution for shareholders if the share price flies in the coming years. This is an intelligently designed capital raise, and it will allow Coinbase to continue to invest in the user experience, supporting more coins, and lowering its operating costs in the years to come. The Crypto world is full of companies with no revenue or chronically unprofitable models that appear to be led by people that don’t know what they’re doing. Coinbase is the grown up in the room, methodically working its way towards dominance in a still-burgeoning market.

Valuation Upside

We can use comparable listed exchanges as a guide to help value Coinbase. Nasdaq is priced at 26x this year’s earnings and 8.9x this year’s sales. CBOE is on a 23x PE and 9.3x Price to Sales. Coinbase is currently valued at 25x this year’s earnings, and 7.3x this year’s sales. In other words, Coinbase could be seen as fairly valued based upon earnings, or slightly cheap based upon sales. However, if you think of Nasdaq and CBOE competing in markets that are literally hundreds of years old in some cases, and Coinbase being still at the very beginning, valuing them the same way seems to make a bit less sense. In other words, the growth in cryptos doesn’t appear to be priced into Coinbase as it is being priced like much more mature alternatives.

Contrary to popular opinion therefore, I actually think Coinbase’s IPO valuation makes the most sense in terms of valuation compared to any new issue that I’ve seen recently. We have all seen truly eye watering valuations on some recent SPACs and IPOs for businesses that are really at very early stages of their development so without meaningful revenues or profits.

On the other hand, Coinbase is an established profitable business which looks attractive on normal valuation metrics like Revenue multiples and PE multiples. For me, it is not difficult to see substantial upside from the current share price of Coinbase over the medium term. As I said, Coinbase is being valued in line with other mature exchanges. Caution is in fact surprisingly widespread: Wall Street analysts so far predict that Coinbase’s earnings will fall in 2022 compared with 2021. If you think they’re wrong as I do, the valuation is very compelling. It’s also attractive that the price has drifted back to the IPO level after the initial surge (down c.50% from its post IPO peak). I see significant share price growth if Coinbase sustains their growth going forward.

However, it is important to note that volatility is likely to be high as sentiment towards the company very much tracks the price of Bitcoin (and is very likely to be the reason the Coinbase shares pulled back in the past couple of months).

Key Risks

Volatility of Bitcoin

Coinbase’s numbers are certainly impressive but what accounts for its volatility in 2018 and 2019? This directly links to interest in Cryptocurrency. More interest in Bitcoin and other Cryptocurrencies means more interest in Coinbase. Looking at the price volatility of Bitcoin, it’s clear just how correlated the cryptocurrency is to Coinbase’s revenue. In 2018 Bitcoin peaked at around $15,000 before plunging closer to below $4000 in 2019.

Pynk community coinbase investment research graphic L

Image Source: Coindesk
Past performance is not indicative of future results.
Returns may increase or decrease as a result of currency fluctuations.

Less Protection for Depositors

The main attraction of Coinbase is its immersion in decentralisation. This requires users to fully trust Coinbase’s system but their accountability is questionable. Unlike traditional banks which are required by governments to have a reserve if things go pear-shaped, Coinbase is playing somewhat in the Wild West. It’s believed that Coinbase would give users time to withdraw their money and assets if things were to go south for the company, but the legalities of the Crypto world are still being discussed.

Risk of Hacking

A greater risk is if Coinbase gets hacked. Due to its decentralised nature, if a significant hack were to occur, its users’ assets would be at risk more so than a traditional bank. In order to mitigate such risk, Coinbase stores 98% of its customers’ funds offline. The company is also innovating various methods including verification mechanisms to secure access to their customers’ funds.

Conclusion

At a time when Cryptocurrencies are gaining immense traction and interest, Coinbase is positioned perfectly. It plays into the strong belief that Cryptocurrencies are not just a fad, but a revolutionary form of money structures. Through its simple UI and noob-friendly approach, Coinbase opens the door for newcomers to enter the ever-expanding world of digital currency.

In the future, Coinbase can bring aboard other digital assets, offering its customers a wide breadth of opportunities to diversify their wealth digitally. After the recent price falls, the shares are compelling value. Bitcoin may well see higher returns but those whose risk appetite is lower should seriously consider Coinbase.

Blockchain’s decentralising capabilities and the disruption of traditional transaction systems is truly remarkable. Throughout the pandemic, physical cash transactions have been discouraged and dependence on digital payments has given the world a glimpse into what a digital monetary universe would look like. Cryptocurrencies push this further and are aimed at offering a viable and more transparent structure that would strip power from traditional banks. Coinbase not only facilitates this transition from traditional to digital payments, but also offers a “tollbooth” into an entire alternative digital economy.

In a similar fashion to banks, Coinbase could offer interest payments, and other investment lending programs. It could even expand its base beyond Crypto and into new blockchain-based assets such as NFTs. Coinbase would play an integral part in this new digital world. Coinbase has already grown at an immense pace, but it seems like it has much further to grow.

I like the fundamentals of Coinbase’s business and think the valuation actually isn’t stretched at all. I see growth opportunities from increased trading in not just Bitcoin but other Crypto assets as well as their new card rewards program, which I think can be a big winner. This is a speculative stock, and as such has much more inherent volatility than the typical stock in my portfolio. But this higher risk has to be set against their strong market position, high profitability and the likelihood that their incredible recent top line growth continues into the medium term.

Coinbase is all set to keep building their customer base and increasing trust among them. As this increases, Coinbase is also expanding the assets available on their platform, which in turn leads to further innovation in bringing new products for their customers. Coinbase’s full potential remains untapped.

NOW IT’S YOUR TURN:

As most of our Pynk community are fairly familiar with cryptocurrencies in general, many of you will be quite familiar with Coinbase, but do you think it represents good value as a way of investing into cryptocurrencies via the stock market?

Would this kind of exposure to cryptocurrency make you reevaluate your current cryptocurrency positions?

This material is not investment research in accordance with the legal requirements designed to promote investment research independence and is also not subject to any prohibition on dealing ahead of the dissemination of investment research; and as such is considered to be a marketing communication.

All investments have the potential for profit and loss and your capital may be at risk. Past performance is not indicative of future results.

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Written by
Pouneh Bligaard
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