20 Apr Quick Thoughts on Coinbase
Coinbase is the talk of Wallstreet. It will begin trading on the NASDAQ through a direct listing tonight. Coinbase allows users to buy and sell crypto assets such as Bitcoin and Ethereum and its business has been on a tear of late. Revenue doubled in 2020 and then surged over 900% in the first quarter of 2021.
Its shares have recently traded privately at a company-valuation of close to US$100 billion, making it even more valuable than traditional stock exchanges like NASDAQ Inc (NASDAQ: NDAQ) and Intercontinental Exchange Inc (NYSE: ICE), which is the parent company of the New York Stock Exchange.
Coinbase’s high valuation and strong business performance come as interest in cryptocurrencies spiked in 2020 and early 2021.
With the hype around Coinbase, I decided to take a quick look at its prospectus and note down some reasons for and against investing in it. Here’s my list.
Reasons to invest
Rocketing recent growth: Coinbase’s business has catapulted recently with the surge in demand and interest in crypto assets. Investors use recent growth as a proxy for what is to come in the future.
Profitable business: Unlike most tech companies seeking to go public, Coinbase is already a profitable business. In fact, it is very profitable. In 2020, Coinbase generated US$322.3 million in net income from US$1.3 billion in revenue, giving it an impressive net income margin of 24.8%. In the first quarter of 2021, Coinbase announced that it made between US$730 million to US$800 million in net income from US$1.8 billion in revenue.
Operating leverage: Coinbase can improve its margins further with operating leverage. As demonstrated in the first quarter of 2021, its net income margin improved to around 41%, compared to 24.8% for the whole of 2020. If Coinbase’s take rates remain steady, its margin can improve due to the low marginal cost for servicing each additional transaction.
Big addressable market(?): Crypto bulls will argue that Bitcoin and other crypto assets will become must-own financial instruments. Coinbase has gone as far as to say: “Our objective is to bring crypto-based financial services to anyone with a smartphone, a population of approximately 3.5 billion people today.” For perspective, Coinbase had 56 million users at the end of March 2021.
Secure platform and trusted brand: With a crypto exchange playing the role of custodian of crypto-assets, users need to trust that the platform is secure and reliable. Coinbase CEO, Brian Armstrong explained in his Founder letter: “Trust is critical when it comes to storing money. From the early days, we decided to focus on compliance, reaching out to regulators proactively to be an educational resource, and pursuing licenses even before they were needed. We invested heavily in cybersecurity, built novel key storage mechanisms, and obtained a cybercrime insurance policy. We even developed ways for customers to custody their own cryptocurrency safely, so they didn’t need to trust us at all. Most importantly, we built a culture that doesn’t take shortcuts or try to make a quick buck.” While building security is expensive and a gruelling task, it should put Coinbase in a good position to win customers looking to start their crypto journey.
Network effect and scale provide liquidity: As one of the biggest crypto exchanges in the world, Coinbase boasts scale and can hence provide better liquidity which gives users better prices on their trades.
Reasons not to invest
Revenue impacted by prices of crypto assets: Coinbase acknowledges on its prospectus that the prices of crypto assets can impact demand for buying, selling, and trading them. There was a steep decline in crypto asset prices in 2018 which Coinbase said adversely affected its net revenue and operating results. Should similar price declines in crypto assets occur in the future, Coinbase’s revenue may again fall sharply.
Highly dependent on Bitcoin and Ethereum: Although Coinbase supports the exchange of other crypto assets, the bulk of its transaction volume and revenue comes from Bitcoin and Ethereum. In 2020, these two cryptocurrencies drove over 56% of Coinbase’s total trading volume on its platform. As such, a sudden fall in transaction volume in these two crypto assets can have a big impact on Coinbase’s revenue.
Competition: Unlike stock exchanges, the barriers to entry to become a crypto exchange is much smaller. Although Coinbase has built up a solid reputation, margins can be easily eroded if more aggressive brokers come up with innovative ways to eat market share. In an article for Fortune, Shaun Tully argues that Coinbase’s high transaction fees will not last. At the moment, Coinbase charges an average fee of around 0.46%. In comparison, stock exchanges such as ICE and NASDAQ each make 0.01% on each dollar of securities traded. Tully writes:
“It can’t last, says Trainer. He predicts that fees for trading cryptocurrencies will follow a similar downward trajectory as those in stocks, possibly all the way to zero. Coinbase’s slice of each transaction is so big, and its profits so gigantic, that rivals can slash what they’re charging and still mint huge profits. “Competitors such as Gemini, Bitstamp, Kraken, Binance, and others will likely lower or zero trading fees to take market share,” he says. “If margins are that good, you invite competition.” That will start a “race to the bottom” similar to the contest for market share that triggered the collapse, then virtual elimination, of stock commissions in 2019. Trainer also expects traditional brokerages to soon offer trading in cryptocurrencies, further pressuring Coinbase’s rich fees.”
High valuation: As mentioned earlier, Coinbase could start trading at a valuation of around US$100 billion. This translates to around 14 and 32 times its annualised first-quarter revenue and net profit, respectively. Although those numbers may not seem that high (compared to other tech firms) at first glance, the possibly volatile nature of Coinbase’s business, and possible impending margin compression, might suggest otherwise.
If Coinbase’s US$100 billion valuation comes to fruition, it can begin life as a public company as one of the 100 biggest companies in the world, even ahead of established names such as Postal Savings Bank of China (SHA: 601658), Softbank Group Corp (TYO: 9984), and Starbucks (NASDAQ: SBUX).
This is a staggering achievement for a company that was founded only around 10 years ago. This does not mean Coinbase is a good investment going forward though. Investors need to consider the host of factors that could impact its eventual return for shareholders. Hopefully, this list provides a good starting point for investors who are thinking of investing in Coinbase.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia owns shares in Starbucks.