Coinbase (NASDAQ: COIN) | Riding On The Crypto Adoption Wave

Key Points

  • Coinbase is the leading crypto exchange platform in the United States

  • It is well-positioned to benefit from the increasing adoption of crypto

  • Its regulatory-first approach has built a strong moat

  • Significant optionality from its ventures arm and potential of becoming a super-app

  • Launch of its NFT marketplace could be a strong catalyst

  • DCF-backed fair value of $358.10 represents a possible upside of 39.5%

 

Company Overview


Founded in 2012, Coinbase is the leading crypto exchange platform in the United States. It is the first major crypto-based company to go public in US history, with trading commencing on April 14 2021. The leading crypto exchange in the United States by volume, the company provides its users with the ability to buy, sell, transfer, and store crypto assets in a user-friendly web platform and mobile application.

Business Segments

Coinbase has 3 main revenue streams – transactions, subscriptions and services, and others.

1. Transactions

Transaction revenue, comprising retail and institutional transaction revenue, makes up the bulk of Coinbase’s total revenue (83% in 3Q21).

Despite retail trading volume being much smaller than that of institutional, retail transaction revenues are significantly higher. This is due to the vastly higher fees that retail traders are being charged compared to institutional – in 3Q21, it was 1.1% and 0.03% respectively. Even though institutional transaction revenue is relatively small, we portend that serving institutions is still important as they can be tapped upon for more revenue as Coinbase monetises more services. 2. Subscriptions and Services

Subscriptions and services make up a comparatively smaller proportion of total revenue (11% in 3Q21). It is made up of custodial fees, staking fees, campaign revenue, interest income and others.


3. Others

Other revenue includes the sale of crypto assets when Coinbase is the principal in the transaction. This occurs periodically when it fulfils customer transactions using its own crypto assets for orders that do not meet the minimum trade size or during unanticipated system disruptions. In addition, it earns interest income on its cash and cash equivalents.


Management


Coinbase was co-founded by Brian Armstrong (CEO) and Fred Ehrsam (Board Director) in 2012. Prior to Coinbase, Brian Armstrong was an engineer in Airbnb while Fred Ehrsam was a trader at Goldman Sachs. In 2017, Fred Ehrsam left Coinbase to start cryptocurrency investment firm Paradigm and now serves on the board of directors. As of 3Q21, Coinbase insiders own a combined 16.5% stake which ensures that both the company and shareholders’ interests are aligned.

 

Industry Overview

Crypto's overall market capitalisation has increased from $22B to $2.2T in the last 5 years, signalling rapid adoption.


As it hit the mainstream in 2021, we saw many breakthroughs in the space. For example, the first Bitcoin ETF made its debut on the New York Stock Exchange in October, allowing investors to have direct access to the crypto market from traditional brokerage accounts that they may already own. Furthermore, this also indicated a significant interest from household brands across industries, some of whom (such as Paypal, Square and Tesla) have allowed customers to make payments through Bitcoin. As more use cases of the crypto industry surface and gain traction, adoption will continue to increase, spurring the overall growth of the crypto economy.

Crypto exchanges are made up of centralised exchanges (CEXs) and decentralised exchanges (DEXs). Among CEXs in the US, Coinbase is the leading exchange in terms of trading volume, followed by FTX, Kraken and Gemini. On the other hand, among DEXs, dYdx leads trading volume, followed by Uniswap and Pancakeswap. We will further explore DEXs and how they may pose a threat to CEXs later in the article.

 

Investment Theses


Thesis 1: Increase in adoption of crypto will benefit Coinbase

The cryptocurrency adoption curve has been deemed to be the fastest in human history. In fact, blockchain technology and cryptocurrency are seeing a faster growth trajectory than the growth of the Internet in the late 1990s.

In terms of an absolute number of users, Bitcoin's adoption is approximately where the Internet was in 1997. What is different, however, is that Bitcoin’s adoption rate is much higher as compared to the Internet. At current growth rates in adoption, Bitcoin will have around 1 billion users in the next 3-4 years.

While adoption has been exponential, it must be determined if this level of adoption will continue. We refer to Metcalfe’s Law, which states that the value of a network like Bitcoin should be proportional to the number of users of the network. Said plainly, each time a user joins an app with a network behind it, the value of the app is increased to n^2. The model has been validated with user data from companies such as Facebook and Tencent, and it has even been used for Bitcoin.


As such, all stakeholders of the Bitcoin network are economically incentivised to help to increase the adoption of the network. These include developers, miners, users, investors, exchanges, and other infrastructure solutions that support the network. This creates a strong network effect for the continued adoption of Bitcoin.


On top of this, we are beginning to see a reversal in institutions' stance on crypto with large financial institutions deploying significant resources into this space. This can be seen from the year-to-date inflow of $9.5b in digital asset investment products compared to $6.7b in 2020.

In addition, there has been a 445% increase in venture capital investments into the crypto industry in 2021, indicating that there are sufficient funds within the system to fund the next stage of growth of crypto applications.


We believe the overall growth of the cryptocurrency industry will benefit Coinbase as it would mean more investors deploy capital into this space, possibly leading to higher trading volumes and thus, transaction revenues as well as a larger user base to tap upon for premium services.

Thesis 2: Strong moat created by its regulatory-first approach


Since its founding, Coinbase has constantly leaned into regulation and compliance.

This is evident from the slide above which shows that Coinbase has the most complete set of licenses. In addition, Coinbase is known to have sought money transmission licenses as early as 2013 and is well known for its regulatory-first approach.


We believe this is a more sustainable strategy in the long run compared to other exchanges which have adopted a ‘do first, seek forgiveness later’ approach (ie Binance, Huobi) that has resulted in bans in several countries. This has enabled Coinbase to build a relationship of trust with regulators and thus, could be subject to fewer crackdowns than its competitors.


As a result, Coinbase has built a strong reputation of trustworthiness amongst the retail public. This has resulted in strong mindshare with the public which could lead to greater adoption of the Coinbase platform as crypto’s serviceable addressable market grows exponentially.


In addition, its stellar reputation has attracted many institutional clients as seen from the fact that it has onboarded 10,000 institutions and that 10 of the top 100 hedge funds by AUM are its clients. Given that Coinbase will be the custodian for their digital assets, we believe that they will stick to Coinbase for the long term, thus, creating a moat for Coinbase.


Thesis 3: Significant optionality


a) Potential to become a super-app

As outlined in the company overview, Coinbase offers many crypto-related products and services. Given the wide range of use cases for crypto, we believe that Coinbase could roll out more of them, potentially becoming a super-app, similar to WeChat.

For instance, Coinbase is planning to release an NFT marketplace for minting, purchasing, showcasing, and discovering NFTs. With NFTs exploding in popularity, Coinbase NFT could capture the rising demand and be a one-stop solution for consumers.


In addition to targeting consumers, Coinbase is reaching out to developers through Coinbase Cloud. Developers can build their crypto projects with Coinbase Cloud’s API and blockchain infrastructure. With more users utilizing Coinbase’s services, this attracts developers to build crypto projects with Coinbase and expand Coinbase’s service offerings, which then further attract and retain users within the ecosystem.


b) Coinbase Ventures


Since its founding, Coinbase has backed over 150 startups such as OpenSea (NFT marketplace), Dapper Labs (digital collectables maker) and TaxBit (Crypto Tax Software).


According to Crunchbase, Coinbase Ventures has made more than 100 investments in 2021. Furthermore, it was the most active crypto VC in 3Q21 with 24 deals secured.

As of 3Q21, the carrying value of its investment portfolio is approximately $270m. In our opinion, this understates the actual size of its portfolio and we could see significant appreciation should Coinbase mark-to-market its investments or exit them.


This can be seen from the significant valuation gains of some of its VC investments:

As of 3Q21, Coinbase Ventures made a record 49 investments and its portfolio size stands at over 200+ companies and projects. As such, Coinbase Venture is likely to benefit from the growing crypto economy as its investments appreciate in value.

 

Financial Highlights


1. Revenue

From 1Q19 to 3Q21, Coinbase grew its revenue at a CQGR of c. 35% driven mainly by a sharp increase in transaction revenue. This was a result of greater retail and institutional crypto adoption which led to higher trading volumes.

However, we note that 3Q21 revenue declined by c. 41% Q/q which was attributed to weaker trading volume as crypto asset volatility declined.

As seen from the chart above, trading volume is correlated to crypto asset volatility, thus, any drop in crypto asset volatility could hamper transaction revenues in the short term. However, we believe that as crypto adoption grows, there will be less of a correlation between the 2 and the correlation between trading volume and the number of active users will be more prominent.


2. Profitability

From 1Q19 to 3Q21, Coinbase’s gross margin was relatively stable, ranging between 70% to 89%.


From 1Q20 to 1Q21, Coinbase's EBIT and net income improved by 35 and 26 ppts respectively. This was a result of a steep decline in technology & development and general & administrative expenses as a percentage of total revenue as these were largely fixed costs.


However, from 1Q21 to 3Q21, Coinbase's EBIT and net income declined by 33 and 12 ppts respectively as total revenue fell due to lower trading volume while absolute technology & development and general administrative expenses increased as Coinbase grew their headcount in a bid to expand operations.

 

Valuation

Given the uncertainty over the projection of Coinbase's revenue, we used a range of possible revenue estimates which gave us a band of possible valuations.

Based on our base case, we derived a fair value/share of $358.10 for Coinbase using a 5-year DCF. This represents an upside of 39.5% from the last closing price of $256.79.


As seen from the financial highlights, Coinbase's revenues fluctuate significantly, thus, it is difficult to project their short-term revenues with high precision. Hence, we adopted a probable 5-year scenario to model Coinbase.


Key Assumptions

  • Verified users reach 145.8m by 4Q26, representing a ~2x from 3Q21

  • Monthly transacting users to hit 20.9m by 4Q26, representing 14.3% of total verified users (up from 10.1% in 3Q21)

  • Quarterly trading volume to reach $1.5t by 4Q26, representing a 374% increase from 3Q21

  • Retail take rate progressively declines YoY until 0.9% in 4Q26, from 1.1% in 3Q21

  • Institutional take rate to progressively decline YoY until 0.02% in 4Q26, from 0.03% in 3Q21

  • Tax rate of 21%

  • Applied WACC of 8.7%, which is more conservative than the Capital Asset Pricing Model which yielded a WACC of 7.7%.

  • Terminal growth rate of 2.5%

 

Risks


1. Fee compression


As mentioned above, there are many new platforms vying for market share, such Square’s Cash App and Robinhood in the US, and Revolut in Europe - all of which offer cryptocurrency trading. This heightened level of competition could result in a fee compression in the long-term, as mentioned by Coinbase’s CEO, Brian Armstrong.


2. Stricter monetary authority regulation

Central banks and regulators pose the risk of delegitimizing digital currencies, as the crypto market may pose a risk to the validity of fiat currencies. This is largely due to the reduction in control that central banks may have over their monetary policies. Furthermore, governments are launching their own digital currencies. China has introduced the digital yuan, and other governments may follow suit, which will lead to headwinds in the cryptocurrency market. Should the clampdown be enforced in the US, Coinbase's trading volume will be affected.


3. Lower volatility during a possible crypto winter

Should we enter a crypto winter, we could see lower volatility and thus, lower trading volumes, similar to 2Q18 to 4Q19. This would affect Coinbase's transaction revenue, however, we believe that Coinbase's increasing emphasis on its subscription services, which are recurring in nature, will help to dampen any decline in transaction revenue.

 

Catalysts


1. Launch of NFT marketplace


Coinbase is planning to launch its NFT marketplace in 1Q22 to 2Q22. This represents a significant opportunity for growth as NFT transaction volume stands at a c. $43b annual run-rate and could grow much larger as use applications for NFTs increase.


Currently, the NFT marketplace leader Opensea holds a c. 95% market share, however, we believe that Coinbase could challenge it as it is beginner-friendly (ie allowing customers to purchase NFTs with a credit/debit card). This demand for a frictionless experience can be seen from the over 2.6m long waitlist for Coinbase's NFT marketplace compared to the over 500k registered users on OpenSea.


2. Strategic acquisitions to bolster revenues

Coinbase’s streak of acquisitions, where it acquired more than 13 firms in FY21, is likely to accelerate in FY22. This is mainly underpinned by Coinbase’s announcement on Sept 21 to raise $1.5b debt to invest in product developments & strategic acquisitions moving forward.

Specifically, Coinbase’s future acquisitions may centre on:

a. Growing its international businesses


This can be seen from management’s Q1 announcement that international growth was a top priority and would undergo a multi-year process moving forward. Coinbase’s most recent acquisitions of Unbound and Agara, as well as its partnership with MUFG, were also aimed to tap into the Israel, India and Japanese markets respectively. This string of international-based acquisitions further highlights management’s commitment to accelerating its overseas strategy, which would further bolster revenues beyond its domestic US market.

b. Improving customer service & ease of use for professional investors


This is evident from its acquisitions of Skew, Tagomi and Ransomware in FY21 to offer professional traders a more sophisticated trading & visualisation experience. This is further supported by management’s Q3 announcement that it was seeking to diversify its target audience (beyond US retail users) to sustain revenue growth, given its c. 19% Q/q dip in monthly retail transacting users in Q3 due to higher volatility in the crypto markets.

 

Conclusion


In conclusion, we believe that Coinbase is well-positioned to benefit from the growing crypto economy as the leading crypto exchange in the US. In addition, its strong competitive moat built through its regulatory-first approach should allow it to sustain its dominant market share. Furthermore, we see significant optionality in its Coinbase Ventures arm and potential to become a super-app.


Thanks for reading,

Asaad, Vanessa, Wei Jun, Joseph


Disclaimer: This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/Snowball Labs do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such. Cover Photo by Jason Briscoe on Unsplash

 

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