Coinbase the next FAANG
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I will be explaining my investment thesis on the company Coinbase (COIN). I recently added the name to my portfolio as I find it to be one of the most interesting companies for my long-term growth portfolio.
So let’s start.
What does Coinbase do?
I am not going too much into the basics of what Coinbase does, as I believe most of my readers already understand the basics of a well-known company like Coinbase but are looking for more views/investment angles and data that is new to them. The article is intended for people who know what cryptocurrencies are, so I will not explain the basics of cryptocurrencies.
To put it as short as possible, Coinbase is a cryptocurrency platform. Their primary business is operating a cryptocurrency exchange platform. So think of it as a broker for cryptocurrencies. But as I will further elaborate in this article, it has become far more than just a cryptocurrency exchange.
Business lines & revenue
There are two primary business segments from which Coinbase derives its revenue. One is Transaction revenue, and the other is subscription and service revenue.
The transaction revenue represents the fees they earn on cryptocurrency trading. The subscription and service revenue comes from the payment of custodial fees, blockchain, earn campaigns, interest income, and other subscriptions and services.
Diving more deeply into transaction revenue, here is a breakdown based on trading volume for different cryptocurrencies.
We can see that the main currencies being traded on Coinbase are Bitcoin and Ethereum. However, other cryptocurrencies already represent 50% of the trading volume. When diving more into the earnings, management explained that no other individual cryptocurrency besides Bitcoin and Ethereum represented more than 10% of trading volume for the last quarter (Q2 2021).
Looking into the volume based on the type of clients, the breakdown is the following:
What is clear is that while both Retail and Institutional revenues have picked up significantly in 2021, because of the hype in the crypto space, institutions are starting to come to Coinbase at a fast pace.
A year ago, almost no institutional investors were on their platform; now, 10% of the top 100 largest hedge funds based on AUM are their clients. Many of them are even selecting them as their exclusive partner.
This institutional adoption is one of the key signals I want to point out as I believe this adoption will continue to increase. Coinbase has some advantages compared to competitors that make it more appealing for institutional clients.
Coinbase is perceived through its actions, licenses, public company, and brand as the most legal/compliant platform player in the crypto space. You still have to understand that crypto is still perceived as a possible gray area for many institutional investors because of its lack of regulation and, in some cases, rightfully so. But Coinbase has positioned itself as the one who welcomes regulation.
The other reason is the product offering. Coinbase is basically an integrated Prime broker with custodian and other services in one platform. And because crypto is such a volatile environment with big gains and big losses, the clients find it more valuable from a platform to have everything you need in one place from an operational perspective than having multiple solutions scatter around the place.
When it comes to fees, Coinbase’s basic offering is not among the cheapest, but its institutional offering, called Coinbase PRO, has competitive fees if you have assets over $100M.
Profitable retail base
Institutional revenue is good for building long-term stability in your business, but the retail base is where the profit is right now.
Out of $452B in trading volume in Q2 2021, retail clients represented 31.4% of that. But at the same time, out of $1.93B revenue from transactions, retail represented 94.7% of it. So retail is where Coinbase makes most of its money so far. Looking at the income statement for the last quarter, the business is wildly profitable.
Total revenue for the last quarter was $2.2B, up 1097% YoY and Operating income was $0.87B up 1980% YoY (yes, these numbers are not a typo). If we look at the last six months, the picture is similar—$ 1.86B in operating income on $4B in revenue. So, the business is generating serious profits.
While transaction revenue is mainly driven by volatility in the crypto space, subscription and other service revenue gets me excited.
It has grown from almost zero revenue a year ago to $102M revenue in the last quarter. To put that in perspective, if the revenue from this segment stayed the same for all four quarters, it would be the same as Cloudflare's 2020 yearly revenue.
From the earnings call, we could hear that one of these services is staking. And this service almost didn't even exist one year ago.
“ The first one, is that we're continuing to see this trend of people using crypto for more and more things beyond trading. So for example, we shared in the letter that we now have 1.7 million users doing staking in crypto, which is a way to earn yield on your assets. And this is up from -- basically, that number was probably zero a year ago. I think if you go back to 2019, late 2019, we had less than 1 million MTUs on our retail side for Coinbase in total. And now we have 1.7 million just doing one type of activity that is staking. So we're seeing people do more and more things with crypto, whether that's earning money with 1 crypto, borrowing and lending, staking, using Coinbase card and then, of course, trading. And so I think we'll continue to see that percentage go up over time, which is great. That tells us that a truly a cryptoeconomy is forming, it's not just the trading platform.”
And this segment, especially the blockchain revenue, is expected to grow as customers use more products besides trading.
“Blockchain rewards were $39 million in Q2. Blockchain rewards are generated through our interactions with various blockchain protocols where the underlying blockchain is providing rewards to the user. Historically, these revenues were generated exclusively through Staking. However, we are now including inflationary rewards, or community rewards, into Blockchain rewards which were previously included in Other subscription and services revenues.”
This segment will be a significant contributor in the following years as I expect the % of total revenue to lean more and more towards this segment away from the trading segment. With crypto being such a fast-developing environment, new services will constantly be needed.
Market share
Coinbase reported in their Q2 2021 earnings that they had 8.8 million retail Monthly Transacting Users (MTUs), up 44% from Q1 2021, and that total verified users were 68 million. Again interesting perspective Cash App from Square has around 70 million active users, and PayPal's Venmo is reported to have 75 million. Coinbase also reported 9.000 institutions that are using them.
Their main competitors are crypto exchanges such as Binance, Gemini, OKex & many others, but also fintech players like Robinhood.
Since most crypto exchanges such as Gemini, Binance, and Gemini are not public companies, it is tough to find credible data on the number of their userbase. Since estimates are all over the place and with no credible source, I won't provide them.
But we can look at the total trading volume from the exchanges and see how much of the volume is done through which. I calculated the monthly trading volume of three exchanges, Coinbase, Binance, and Gemini, for the last 30 days and the results are the following:
Binance- $25.5B
Coinbase – $4.85B
Gemini – $0.225B
We can see that Binance, in terms of trading volume, is the clear leader, followed by Coinbase. But what differentiates Binance and Coinbase the most is that Binance is perceived as a less compliant or, should I say, regulated exchange than Coinbase. My hunch is that users who want to stay more anonymous for different reasons rather use Binance than Coinbase. Binance is also a cheaper alternative when it comes to fees, and because of the anonymity factor and lower fees, it attracts users with higher assets that generate more volume.
But being a more regulated and compliant crypto exchange will be a big competitive advantage down the line, as many institutions and corporations want to enter the market. They want to choose a compliant and regulated partner in their jurisdiction, and given the history, I think Binance will have a lot of trouble on this front, which gives Coinbase the upper hand.
Regulation
As already mentioned, Coinbase is the exchange that is most compliant in the crypto space. They are also the only public crypto exchange company so far. They are proactive with regulators, and they even welcome them. A few days ago, Coinbase said the US should create a new cryptocurrency regulator and laid out a policy paper with suggestions. They know that the more the market is regulated, the bigger their competitive advantage is. Being active with regulators is also good for the long-term stability of the business, as this is a concern for many investors looking at the crypto space.
But not just US regulation they are expanding international but want to comply with the new rules and laws in each country, as we can see from these remarks in the last earnings call:
“In Germany, our subsidiary Coinbase Germany GmbH was awarded a license for crypto custody and trading from the German Federal Financial Authority (BaFin). The BaFin licensing framework is the first of its kind in the European Union, and Coinbase Germany is the first company to be issued such a license.”
“In Japan, we have successfully registered with the local regulator JFSA (Financial Services Agency of Japan) as a crypto asset exchange service provider. This registration will enable us to actively solicit customers in Japan and provide them a range of crypto services. We see huge long-term potential in Japan, the third largest economy in the world, with an active and mature crypto customer base.”
In my view, cryptocurrency exchanges are entering a new era where regulation will play an important role, and many exchanges will fail because of it. Coinbase is in the right driver seat when it comes to these exchanges and the regulation.
Investment thesis
Now above, we discussed their core business, and from the core business, two things stood out to me. Institutional adoption will be growing in the future, and the subscription and other service segments will speed up and help the transaction revenue as more and more features are added to the platform and investors start using them.
But here are the topics that got me really excited and made me pull the trigger and add Coinbase to my portfolio:
- Coinbase building an App store
- AWS of Crypto
- NFT marketplace
- Facebook digital wallet Novi custodian deal
- Valuation
Coinbase building an App store
Coinbase mentioned on their last earnings call that they want to be focused on providing as much third-party integration as possible. This makes perfect sense as the crypto space is a fast-paced and rapidly changing environment where new things pop up every year, and if you want to keep your userbase loyal and happy, you have to give them access to these things and the convenience of being a one-stop-shop. And after digging deeper, you can see they intend to build an Apple-like App store:
“And so, we're doing that with a kind of crypto app store, if you will, that can be built right into the app”
This is key, as it increases the chance that Coinbase base stays relevant and always “up to date” even in a fast-evolving landscape like crypto is. Having an app store where developers can contribute their apps that are integrated with Coinbase and offer those services to the massive user base is a win-win for both the third-party developer and Coinbase as their users won’t be looking for other platforms that can fulfill their changing needs. This is also important in future light when you can expect more and more companies, especially from the traditional financial service industry, to enter this space and try to compete. But having a robust developer ecosystem can be essential.
AWS of Crypto
When we talk about the risks and competitive pressures, we often come to the fact that at some point down the line, traditional financial service companies will want to enter the space and compete with Coinbase and other crypto platforms. While this is a risk to consider, what is also expected is that most non-tech-based companies in the financial space have trouble building the technology infrastructure to compete. And this is where Coinbase is making another smart move. Instead of being hostile to the traditional financial service competition, it welcomes it and even offers its services to them.
“We want every single financial services company out there to enter the crypto space because we believe this is going to be a huge part of the economy in the future, a substantial portion of global GDP. And so we want every bank and financial service company and fintech out there to integrate crypto, if they haven't started already, and many of them have. So I think this is partially a competition for us, but it's also partially an opportunity because one of the things we're building is called Coinbase Cloud, and this is kind of our AWS for crypto product. It's taking all those difficult things that we've had to build that I mentioned, integrating with blockchains and transaction monitoring and custody and everything and exposing those through APIs in a way that any third party can actually build on top of those services, those APIs to get to market faster. And we're seeing interest from a number of those financial service players, for instance. And so I think that we may have an opportunity to actually create a big business out of that as more and more people enter the space and not have it just be purely competitive”
A very similar phenomenon can be seen in the Fin-tech space, where traditional banks partner with Fin-tech companies to help them with the technology infrastructure aspect. This move by Coinbase is genius in my view and adds another possible revenue stream down the road that could become very significant.
NFT marketplace
Coinbase announced that it would launch an NFT peer-to-peer marketplace this year. Non-fungible tokens (NFTs) is another rapidly growing field in the crypto space that has been growing lately. I won’t go into details about what NFTs are, as this is not the point of this article. The fact is that there is a market for NFTs right now, and this market is growing. Similar to cryptocurrencies, people are buying and selling NFTs, and the volumes are not small. For a better understanding, currently, the market-leading NFT exchange is OpenSea. Their monthly trading volume in August was $3.4B and in September $3B. They charge a 2.5% fee each time you sell an NFT. This means they earned $85M in revenue in August and $75M in September. They also have around 500k total wallets registered right now.
Coinbase opened a waiting list for their NFT marketplace, where people can sign up if they are interested. In 6 days after the waitlist was announced, more than 2.3 million accounts had already signed up.
So the NFT marketplace news is a big deal because it expands its product offering and will add significant new revenue in the coming months and years.
Facebook digital wallet Novi custodian deal
A few days ago, Coinbase announced that Facebook had chosen Coinbase to handle custody services for their pilot digital wallet Novi. Novi is a digital wallet that will enable people to send and receive money instantly and with no fees.
This news is the biggest of them all for Coinbase. Facebook’s plan for a digital wallet that will enable people to transfer money is one of the most important future projects for Coinbase. Given Facebook’s plans to offer this down the line to their more than 2 billion user base, this means a lot of assets for Coinbase to have in custody and a lot of new fees with it. Suppose Facebook launches this product and offers it in its flagship products like Instagram, Messenger, Whatsapp. In that case, it could become the leading way for people to conduct P2P transactions and C2B transactions, as many businesses already use Whatsapp and Facebook Shops to operate and communicate with their clients. The most significant risk for this project is legislation and the senate, as regulators already fear Facebook.
Valuation
Now let's look at the valuation. Because it is complicated to value some new business opportunities, I will leave some out to make the valuation more conservative. I will leave out the value of the FB custodian deal, AWS for the crypto initiative, and App Store because, at this point, the value of all these initiatives would be pure guessing. In the valuation, I will only include Coinbase’s current business: the crypto trading platform together with other services and the NFT marketplace.
Given the nature of the crypto industry, the figures can be very volatile and hard to predict but let’s start with the things that management guided for this year.
“Q3 2021 In July, retail MTUs and total Trading Volume were 6.3 million and $57.0 billion, respectively, as crypto asset prices and crypto asset volatility declined significantly relative to Q2 levels. August month-to-date, retail MTUs, and Trading Volume levels have slightly improved compared to July levels but remain lower than earlier in the year. As a result, we believe retail MTUs and total Trading Volume will be lower in Q3 as compared to Q2.”
With that trading volume in mind, here are the calculations:
For Q3 and Q4, I took managements Q3 July trading volume and extrapolated them till the end of the year, even though they said that August was higher in terms of trading volume than July (so again, taking the conservative side).
If we take these numbers, we get to the full year 2021 revenue number of $5.13B.
Now let’s look at the NFT marketplace potential quantified for next year for Coinbase. I took the number of potential wallets for Coinbase NFT marketplace based on the number of people that registered to their waiting list.
Now, of course, this is just an estimation; we also don’t know what the fee for the trading will be, so I assumed that the fee would be the same as with NFT marketplace leader OpenSea at 2.5%. The potential on the waiting list suggests Coinbase could rake in $4.4B a year from the NFT marketplace alone. Still, to be conservative since we do not know how many of those signed up white-list users are actually going to use it, I took a very conservative assumption that only 250k wallets will be using it and with it that the volume at the start will be half of what the market leader OpenSea is having. With that conservative assumption, we get to annual revenue from this segment for Coinbase at $480M.
The current market cap of Coinbase is $82.4B, so it is trading at an estimated forward P/S for this year of 16.
Before we get into estimations and my scenarios, we need to understand that Coinbase’s revenue is also very dependent on the price moves of cryptocurrencies and the volatility. In the past, the main driver was mostly Bitcoin prices. Now, since the distribution between Bitcoin & Ethereum vs. other cryptocurrencies at Coinbase is 50/50, the prices of the whole crypto market matter. But in the past five years the price & volatility of Bitcoin was the main determining factor so let’s see how Coinbase’s revenue moved and how Bitcoin prices moved in those years.
We can see that we can’t extrapolate the company's future revenue growth in a straight upward line, as Coinbase already had almost $1B in revenue in the year 2017 when Bitcoin prices went from $900 to $13k. Later, Bitcoin prices fell from $13k to $3.7k, and Coinbase revenue dropped almost 50% to $0.52B.
But what we can see from this past data is that even in a scenario where crypto prices would drop significantly, we can reasonably assume that Coinbase revenue will not drop more than 50%. We can also see another interesting pattern emerging from the past, and that is in the year 2019. Bitcoin price nearly doubled from $3.7k to $7k, but revenue stayed the same.
So for my Base scenario, I will assume that crypto prices in 2022 won’t move up more than 100% and down more than 20%. That is why I will model a modest 10% increase in revenue for their transaction and service revenue segment. For my negative scenario, I will take the case of a severe drop in crypto prices which results in an almost 50% loss of revenue compared to the previous year (based on the year 2018, where a severe drop in crypto prices didn’t result in a more than 50% revenue drop).
Again this is not a prediction, and only my base case scenario assumption as I think nobody can predict any price let alone prices of cryptocurrencies. I want to present both scenarios so that you can get a feeling of Coinbases valuation in each of these scenarios.
Here are the scenarios and estimates for the year 2022.
These projections have the following estimates:
- Base case: Revenue increase of 10% vs. the year 2021 of the current business (trading and services), revenue from NFT marketplace conservative estimation, EBITDA margin at 44% of Revenue (similar to what was reported Q2 2021).
- Negative case: Revenue decrease of the current business by 47% (extrapolation of expected July 2021 revenue on a yearly basis for the whole year 2022), revenue from NFT marketplace conservative estimation, EBITDA margin at 44% of Revenue.
With my base case estimation, we get to a forward P/S multiple of 13.5 and a forward EV/EBITDA of 30.5. In my negative scenario, we get to a 23.7 forward P/S and 54 EV/EBITDA.
Now in both of these cases, Coinbase doesn’t seem to overvalued to me. My fair value for the company in the stage where Coinbase is at a forward P/S of around 15-20 seems appropriate, given the high EBITDA margin. That is also considering new initiatives that they have going on that we mentioned in the article (FB custodian, AWS for crypto, App store…), and we didn’t include them in our calculations of the valuation.
Summary
I think Coinbase is making all the right moves right now in the crypto space. It is positioning itself as the most regulated, compliant exchange and platform. This is a crucial moment as many, not just retail but also institutional investors, seek partners in the crypto space. They are also innovating and opening new sources of potential revenue, which will benefit them in the long run. I opened a position in the company a few days ago, before this big run-up in recent days, but I also added to my position right after the Facebook custody news was announced.
Disclaimer:
I own COIN in my portfolio.
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Great writeup Richard. I stumbled upon this article recently, and a lot has changed in the markets since you wrote this article. In your view, has anything changed materially between where Coinbase is now (in terms of business aspects rather than just the stock price) verses when you wrote this article in Oct last year? Has your thinking and thesis about Coinbase changed since then?