Coinbase Stock: Will Make Billions in Profit (NASDAQ:COIN)

N Rottevel

The following segment is taken from this fund letter.


Coinbase (NASDAQ: CURRENCY)

The crypto ecosystem is changing extremely rapidly, and there have been many new developments since we first invested in Coinbase a year ago.

More specifically, crypto market capitalization has declined from a high of ~$3 trillion last fall to ~$1.1 trillion today (a -63% decline and -72% peak to trough). Crypto is a volatile asset class and has seen many declines of similar magnitude in the past. For example, Bitcoin was down -93% in 2011, -85% from 2013 to 2015 and -84% from 2017 to 2018. In this context, the latest decline is a fairly normal result for this emerging asset class.

A big reason for this volatility is simply that there are no major “real use cases” for the asset yet. In our letter describing the investment last year, we wrote that crypto is still “crossing the chasm” in mainstream adoption and use cases, which will force millions of mainstream users to perform crypto transactions in one form or another”

This adoption is growing, and there are a variety of apps that have shown real utility over the past year. However, since it is still in its infancy, most crypto trading is still conducted for speculative purposes, rather than utility. This will no doubt change over time as the crypto ecosystem continues to develop more utility over the coming years.

But in the meantime, this means that when bear markets hit, retail interest in crypto trading dies out, as there is no day-to-day use case for crypto yet. The only source of demand for crypto (i.e. speculation) is drying up, causing prices to plummet.

Until crypto “crosses the chasm” into mainstream adoption and everyday utility, Coinbase’s business model will remain volatile – and even more so than its competitors.

Lately there has been securities speculating on the demise of Coinbase, most of which cite Coinbase’s declining market share relative to other exchanges. However, this is a hugely inaccurate comparison, as we would say that Coinbase is in a very different end market than global exchanges that cater primarily to institutions, and is also outside of US (or regulations of any country, for that matter).

Competitors such as FTX or Binance derive most of their business from cryptocurrency institutions/”whales”, while Coinbase derives ~77% of its revenue from retail users who only trade a few hundred dollars at a time .[1] These institutions are in the crypto business, so they will continue to trade regardless of the market environment. Meanwhile, retail users are much more finicky and will trade/speculate when prices go up and lose interest when prices go down.

“We have about four times [Coinbase’s] daily trading volume [on a global level] and about 3% of their user base.

It is therefore a factor of 100 volume difference per user. They [Coinbase] have done dramatically for the long-tail retail consumer, and we have done much better for the more sophisticated and committed users who each trade greater volume.” – Sam Bankman-Fried, Founder of FTX

These institutions and whales tend to trade on offshore exchanges away from US regulations because they can access a wider variety of products and leverage. So, as a benchmark of Coinbase’s competitive position, it’s much fairer to judge against other US-based exchanges, such as Kraken, FTX US, Binance US, or Gemini.[2]. For more information on this misperception, we discussed this dynamic in our original Coinbase memo last year[3].

On this metric, we can see that Coinbase is still the top exchange by far. For example, according to CoinGecko, Coinbase currently makes ~$2.4B in daily volume, compared to Kraken at only ~$600M, Binance US at ~$500M, and FTX US at ~$260M.

table: US Crypto Exchange Market Share

US crypto exchange market share (Source: CoinGecko (LINK); screenshot as of August 15, 2022)

We also showed a similar snapshot last year. If you compare this to September 20, 2021 instantaneous to the one above (see p. 29), you will see that Coinbase has actually done a great job of maintaining market share during this bear market.

It is still ~4x larger than the next competitor, and also ~1.6x larger than the next 4 competitors combined. So even though the total “pie” (i.e. crypto trading volumes) has shrunk, Coinbase has actually maintained its relative size of that pie. It certainly doesn’t lose its competitive position, as the media headlines would have you believe.

Meanwhile, Coinbase has used this time to improve its products and simplify the user experience, in preparation for the next phase of mainstream adoption. For example, Coinbase Wallet was just redesigned this quarter and now supports seven different blockchains, so more crypto assets can be held in a single account. Compare this to its main competitor – Metamask – which still does not support Solana, and users still need to have a separate wallet for these assets.

We invested in Coinbase, based on the thesis that crypto will eventually be used for everyday transactions – and it’s hard for us to imagine a world where everyday consumers want to switch between multiple wallets, when they will be able to use Coinbase as a one-stop-shop.

Considering that historical adoption of the technology has shown that mainstream users care most about simplicity and ease of use, this development puts Coinbase on the right path to eventually becoming the de facto crypto wallet used for daily transactions.

On top of that, we were encouraged to see that Coinbase managed to avoid the whole debacle around the explosion of Three Arrows Capital. Three Arrows (or “3AC” as it is known) was one of the biggest hedge funds in the crypto space.

In June, the company began to face liquidity problems, as crypto prices fell and he found himself overextended on leverage. With over $10 billion in assets at its peak, the company’s collapse managed to bring down several notable brokers and lenders who provided loans to 3AC, including the bankruptcy of Voyager Digital and Celsius, resulting in a “mini-Lehman Brothers” type event for space. Coinbase has in the meantime avoided this debacle, which we believe is another indication of its conservative culture (whether in new product launches, lending, relations with regulators, etc.).

We believe that in the long term, this type of behavior will only build trust with customers and stakeholders, which is vitally important for a company seeking to protect the assets of hundreds of millions of individuals. and institutions.

While all of this was happening, Coinbase’s stock price reached an astonishing valuation of around $8 billion ($11 billion market cap – $3 billion net cash). The company earned $3.6 billion in net revenue last year, therefore, the stock price was only around 2.2x P/E (2021), for a company that is just getting started in this emerging field[4].

Clearly, Coinbase’s financial results will be volatile, as transactions are still primarily used for speculation. We view the company as essentially a tax on the crypto ecosystem, based on its dominant market position as a fiat-on ramp and American exchange. The size of this ecosystem comes and goes, and is largely beyond Coinbase’s control. In good years the company will make multi-billion profits, and in bear markets (like today) the company is heading for a loss of -500 million dollars.

At the start of the quarter, it became clear that the crypto market would soon follow the broader equity markets into a bear market. And given the reflexivity of Coinbase’s business model, we felt it was prudent to reduce a significant portion of the position. We sold those shares for ~$150. During the ensuing decline, we began to rebuild this position as the aforementioned valuation became too cheap to ignore. Although we missed the all-time lows, we managed to rebuild the position at a >50% discount to where we had previously sold it.

This is still a relatively small position in our portfolio given the nascent stage and inherent risk of the industry. However, we are excited to see this business grow over the next decade. If we are correct in the trajectory of the crypto industry and Coinbase’s position within it, they could very well become one of the most important companies of the next decade.


Footnotes

[1] “Whales” refer to wealthy individual traders, who trade in large sums.

[2] FTX US and Binance US are subsidiaries of FTX and Binance respectively. Since these entities operate under US regulations, they are not able to offer the same variety of crypto assets or products as their parent companies.

[3] Please see page 27, under the section “Explore Coinbase’s market share (and why we differ from the street)”.

[4] While it is true that last year was a very good year for the crypto markets, so investors should not expect these earnings on a normal basis.


Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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