Coinbase: Cryptos Gain Steam

The financial media was focused on one thing and one thing only on Wednesday – the direct listing of Coinbase. This article provides a very brief overview of why this listing has garnered so much interest amongst financial markets pundits and investors alike.

What is Coinbase?

Coinbase (NASDAQ: COIN) is a cryptocurrency brokerage where investors can buy and sell cryptocurrencies in exchange for fiat currency. Think of COIN as you would your traditional brokerage account at Fidelity, Schwab, Interactive Brokers, etc., except that COIN is focused on cryptocurrencies rather than stocks. According to the company’s website, Coinbase’s “approximately 56 million verified users, 7,000 institutions, and 115,000 ecosystem partners in over 100 countries trust Coinbase to easily and securely invest, spend, save, earn, and use crypto.” Users believe that Coinbase is one of the most secure of cryptocurrency exchanges, so it has been widely adopted and used by investors in many countries around the world. Coinbase is the largest US-based exchange for cryptocurrencies and is the second largest exchange in the world behind Asia-based Binance (see here). Coinbase is not a new company, as it was created just as the cryptocurrency market was slowly gaining visibility in 2012.

Most of Coinbase’s revenues come from transaction fees, meaning trading of 90 or so cryptocurrencies that are handled on its exchange. A small amount of revenues – less than 5% – comes from subscriptions and services (e.g. custody fees, validation fees, etc.), a much more stable (although considerably smaller) stream of revenues. The latter is apparently the fastest growing component, and it would obviously benefit Coinbase to increase its percentage of revenues coming from this more stable source. Given its reliance on trading volumes and prices of cryptocurrencies, Coinbase has been a massive beneficiary of the nearly 12x increase in Bitcoin since the beginning of the pandemic in 1Q2020.

Direct Listing

Coinbase has been preparing to go public since at least last summer, and ultimately decided to list its shares on the NASDAQ via a direct listing as opposed to a traditional IPO. This method of going public is becoming increasingly common, especially for that small subset of companies that wish to list their shares but do not need to actually sell stock to raise capital. Other companies that have done direct listings include Spotify, Slack, Uber and (high flyer) Palantir. I touched on the differences between IPOs and direct listings in an article I wrote around the time that DASH and ABNB went public in early December 2020 (here). There is also a good description of the differences between an IPO and a direct listing in an Investopedia article here. I would be remiss if I were not to point out that a third alternative for going public – a reverse merger into a SPAC – is also available to companies which wish to become listed without going down the traditional IPO route (see blog post from mid-March here re SPACs).

I believe that there is also one very large advantage of a direct listing for companies that choose to go public via a direct listing, and that is that they do not risk leaving money on the table because no new shares are issued. The price instead settles without the involvement of underwriting banks, who otherwise can stand to profit enormously from IPOs when the shares skyrocket vis-à-vis the IPO price once they start trading. In the case of Coinbase, it provided a reference price prior to its formal listing of $250/share, and it opened yesterday at $381/share, closing at $328.28/share after having reached an intraday high of $429.54/share. Had this been an IPO, the underwriters and the initial IPO investors (generally the best institutional accounts “favoured” by the underwriters) would have owned shares at $250/share and would have realised a 52% increase in share price almost instantly. Good for them perhaps, but the other side of that trade – meaning those they lost out on this almost instantaneous appreciation – would have been the existing shareholders, investors (mainly retail) that got in just after the IPO, and of course the company, which sold stock “too cheap”. In the case of COIN’s direct listing, the difference in the reference price and opening price didn’t really matter, because all of the “paper” benefits are for the existing investors in the company, meaning those that invested prior to the listing to provide funding and nurture Coinbase to its birth as a public company.

Valuation of Coinbase

One of the most amazing things is COIN’s valuation based on its share price at the close of the day of its listing. For context, let’s look at how some more established, traditional stock exchanges around the world are valued. The top 10 stock exchanges in the world are listed below, ranked by the market capitalisation (i.e. size) of their components in the middle column. I have also included the market value of the actual exchange or its owner in the rightmost column.

As the table shows, the NYSE and NASDAQ are perhaps not surprisingly the largest two exchanges in the world in terms of the market cap of their component members. The largest market value of an exchange or its owner is the Hong Kong Exchange ($75 billion), followed by the NYSE ($66.5 billion) and the LSE ($30.7 billion).

In contrast, the entire cryptocurrency market is worth around $2 trillion currently. Assuming a market share of 11.3% (covered further below) COIN has assets on it platform worth $226 billion. This is a less than 1% of the market cap of stocks that are components of the NYSE and NASDAQ. Even so, at the closing price on Wednesday, Coinbase was valued at $85.8 billion, making it more valuable than any of the top 10 global exchanges (that are listed). I realise that cryptocurrencies have momentum and their trading margins are much more attractive than stocks or bonds, but I find it very difficult to justify this sort of valuation for COIN under almost any circumstances that I can imagine other than FOMO.

Financial Results of Coinbase

The preliminary listing document (S-1) for Coinbase that was filed with the SEC can be found here. As far as the company’s capitalisation on a pro forma basis at December 31, 2020, the company had $1.06 billion of cash on hand, total assets of $5.9 billion, no debt and shareholders’ equity of $1.53 billion. The company generated $1.4 billion of revenue in its fiscal year ended December 31, 2020, an increase from $533.8 million the year before (+239%). The company was also profitable in its most recent fiscal year, generating $322 million of bottom-line net income versus a modest loss the year before. Fully-diluted earnings per share in FY2020 were $1.57. The S-1 has plenty of information in detail on Coinbase and its historical performance, but I wanted to mention several important factors that an investor that buys Coinbase should know:

• The company’s revenues are very dependent on trading volumes, and the combination of high volatility and increasing prices of cryptocurrencies obviously benefits the trajectory of the company’s revenues and earnings. As you can see from this extract from the S-1, COIN has certainly been on a roll with increasing prices and volumes traded of cryptocurrencies. But this graph also shows the growing influence of institutions in the cryptocurrency area, a key to future growth because it lends validity to the asset class.

• Although assets held on the platform is highly dependent on BTC and has remained around 70% the last two years, the trading revenues by currency have broadened quite nicely, as you can see in this graphic.

• Not only has the base of cryptocurrencies on the platform nearly doubled in only one year (from 25+ to 45+), but reliance on BTC and ETH collectively has decreased from 72% to 56% in only one year, and other cryptocurrencies have gained a higher percentage of trading revenues. This is a positive reflection on Coinbase, but perhaps more importantly, demonstrates the broadening acceptance of the asset class beyond just the big two.

• COIN has been gaining market share, as you can see in this graph from the S-1 which shows COIN’s assets versus the total size (stock) of the cryptocurrency market.

• According to the S-1, COIN has approximately 11.3% market share in 2020, an increase from 8.3% in 2019 and 4.5% in 2018.

Coinbase will be highly correlated with the evolution of the cryptocurrency market. In spite of its recent one-way move since the pandemic, history has shown that cryptocurrencies ebb and flow over time. Personally, I am yet to be convinced that today is any different, but investors must keep in mind that the general trajectory of the cryptocurrency market – in spite of its sharp and rather unpredictable gyrations – has nonetheless been up.

Investors in Coinbase

Coinbase was founded in 2012 by current CEO Brian Armstrong (age 38) and Fred Ehrsam, who left the company at the end of 2017 but still owns around 6% of the company and is on the Board of Directors. According to Crunchbase, the company has raised $847.3 million in 14 separate financing rounds since 2013. The company’s five-person executive management team owns circa 53% of the company’s class A shares. The largest VC investors include Andreessen Horowitz (24.6% class A shares), Paradigm (founded by Fred Ehrsam, 11.4% class A shares) and Tiger Global Management (11.7% class A shares).

The company’s most recent stock transaction prior to its listing on Wednesday occurred in August and September 2020, in aggregate consisting of 2,081,164 shares at $28.83/share, or circa $60 million transaction value. The reference price for the listing on Wednesday of $250/share was 8.7x the last private market transaction of COIN shares around six month ago. Based on the closing price of COIN on its first day of its listing ($328.28/share), the share price was 11.4x the last private market trade. For reference, Bitcoin increased over the same period – from September 1 to present – from $11,970 to $62,969, a 5.3x increase.

Performance of the shares on the first day of their listing

I extracted the price graph below from the New York Times, which I believe is a very good harbinger of the sort of volatility investors in COIN should expect going forward. There is also the likely risk of a super-cycle at some point that could push down heavily the price of cryptocurrencies, and therefore, would almost certainly push down COIN.

One final thing to point out is that on the first day, Cathie Wood’s ARK ETF funds (see blogpost here) was an active buyer of COIN, picking up nearly 750,000 shares across three funds – ARKF, ARKK (512,535 shares) and ARKW. Interestingly, one of stocks that ARK was selling to fund the purchase of COIN was TSLA (amongst others). With holdings like SQ, TSLA and now COIN, the ARK funds are highly dependent on the performance of cryptocurrencies in the future.

Conclusion

COIN is a solid company with excellent trends which has chosen to go public via an innovative direct listing. The company is an important player in its market and, unlike most high flyers with wildly inflated market values, is profitable. However, COIN is arguably very over-valued at these levels, even with the run in cryptocurrencies, and I suspect that its ride from this point onward will be highly volatile. In fact, it almost feels as if this sort of valuation is a curse for a company with so much promise as COIN, as I suspect the company’s operating performance will be solid even if not spectacular whilst its share price will remain highly vulnerable.

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