I’m Still Not Sure On Coinbase (NASDAQ:COIN)

I have recently covered other investments in the crypto space, one of them being Bitwise’s ETF (BITQ). While I was generally pessimistic about the fund and its constituent companies, I had a better summary of Coinbase (NASDAQ:COIN):

Coinbase Global, Inc. strikes me as probably the best business of the bunch. It is a crypto exchange, and it’s not exclusive to BTC transactions. It enjoys high cash flow from operations most years, with outflow from capex.

I did think, however, that COIN was worth its own analysis, particularly as we can see it’s performed quite well over the past year.

While a lot of talk lately around crypto has been in relation to the upcoming halving, I’m going to focus more on the long-term here and explain why I think COIN is just a Hold for now.

Brief History

Founded in 2012 and with its IPO in 2020, we have a few years of operating history to see how Coinbase has evolved in its role as a crypto exchange (and adjacent services).

While much smaller just a few years ago, the bull market of 2021 brought a windfall of activity to the company. We can also see just how sharply this changed once 2022’s changes (War in Ukraine, rate hikes) took hold. Still, it’s ahead of where it was pre-2021.

Expressed as free cash flow, the impact to the bottom line is clearer. 2022 saw significant cash outflow.

Following the IPO, however, we have seen a significant amount of stock-based compensation, comparable to their cash generation and therefore risking the long-term returns. Thus, we need to consider what opportunities management thinks they can unlock, what kind of growth will justify this level of SBC.

Initial Valuation

Before we go into that, let’s consider what the current valuation on the market says about the company, with a market cap of $59.5 billion, that comes to ~$245 per share. I’ve visualized that valuation below with a Discounted Cash Flow model.

I used $1,125M as baseline FCF because that is the average of the last three years. From there, it’s a matter of tweaking inputs until we get a valuation close to the current one on the market. As such, we can say that the market is valuing COIN for FCF growth ranging from 17% to 20% over the next decade and still priced for some growth on its terminal multiple toward the end of that period.

So this is an optimistic valuation. We need to consider what has informed the market’s opinion. Much of this is due to a rally after Q4 2023 results were announced.

Management’s Vision

During Q4 2023 earnings, CEO Brian Armstrong relayed the following about the three phases for crypto:

I’ve always said that crypto adoption will happen in three phases, and I want to touch on what we did in 2023 to help drive each of those. In Phase one, crypto is a new asset class that people want to trade. Crypto trading has been a major revenue driver for the industry, and Coinbase is the leader in spot trading in the U.S. But in 2018, derivatives trading became the majority of crypto trading volume.

Phase Two:

The second…it’s also powering new financial services. And in 2023, Stablecoin began to be used in Global Payments. We launched the ability to send free instant global payments on USD Coin using base. We are now in the process of integrating this into our products to make payments of first-class experience.

And finally:

In the third phase and final phase, we believe crypto will also be a new application platform for the Internet. Over time, the Internet has become more and more centralized with big companies. The Internet also didn’t start with a native form of money or payments or value built in. So we got credit cards bolted on as an afterthought. And the number of associated issues like fees, fraud, chargebacks, limited ability to send microtransactions or do cross-border commerce and that led to the rise of ad-based business models. Crypto is redecentralizing the Internet with a new set of protocols for money, identity, messaging, social media, content, governance and even voting.

The reason I laid this out is because the first two phases, it seems to me, have already happened or are currently happening. We can see it in Coinbase’s current operations.

Above, we can see total revenues. Below, we can see how they are broken down.

In essence, the first table (transaction revenue) entails Phase One, and the second (subscriptions/services) entail Phase Two. There was a windfall of cash from the bull market of 2021 for transactions, which was short-lived. Phase Two, meanwhile, has become a growing part of the revenue, particularly the Stablecoin service.

So I do believe there’s some tailwinds here, some organic evolution of the business that gives it more sources of the cash flow since the IPO. These two phases, as they are currently reflected in the business, are pretty simple ones. The real question is the third one occurring. The move from One to Two is a gentle slope, while Two to Three is a sheer cliff. Armstrong is betting on a paradigm shift of global financial services.

In Coinbase’s Morgan Stanley conference call in March, Armstrong elaborated his thoughts on what can lead to this:

So if you look at a number of emerging markets around the world, people — especially where people have high inflation, they’ve started to use dollar-backed stablecoins. And so we made a big effort to get USDC, which is one of the largest stablecoins out there….So we’re already starting to see people adopt that in places around the world. And I think like it kind of makes sense. None of us really think it makes sense to pay 2% to Visa every time you swipe your credit card. It’s just sending bits of data… I think payments are going to flow to the path of least resistance over time.

There is some basis to this then, but it’s still a grandiose assumption to think it will take over to the level that he believes. There are some security threats to crypto that aren’t quite as severe for fiat currency. Crucially, if we’re talking about the USD, this is an asset that’s FDIC-insured. Crypto is not.

In that same conference call, when asked on what gave Coinbase such a lead in the crypto space, Armstrong explained:

Well, the big one is trust. Every few years, there’s a run-up in crypto, and we see some companies rush in and they cut corners to try to get big fast. And what we found is that, that doesn’t really work. This is regulated financial services. It does take longer to do things in a compliant way, but that’s what creates value long term and makes sure that we stand the test of time.

Of course, we could say this about Visa (V). They, along with companies like PayPal (PYPL), were a big part of the growth the Internet, and they did so with a similar reputation built on trust. That might be why people will accept something like a 2% fee, along with the trust that comes with dollar-cash accounts being FDIC-insured. We don’t know that the trust game is one they will win or if it will be soon enough that this valuation makes sense. I think this warrants caution about growth assumptions for Coinbase, the company.

Debt and Dilution

Then there’s concerns for shares of COIN, namely about how they could be diluted going forward.

There’s $1.2 billion in convertible notes. So this will either be a drag on the cash flow (which is barely $1 billion as it is), or it’s going to dilute shareholders more. According to their Form 10K (pg. 163), these are convertible at an approximately $370.45 per share, so if price stays in its current range, that may not happen. While this alone wouldn’t account for significant dilution, there is also the matter of stock-based compensation that I mentioned before.

I showed how much SBC is, but let’s take look at how the stock rewards being issued started stepping up in 2023 and the hundreds of millions in taxes paid on equity awards.

Now, the Senior Notes are due farther into the future, so I am less worried about those, but considering how shaky the crypto markets can be (again, look at 2021’s results versus 2022’s), one bad year can really spoil things for this company, forcing default or refinancing on unpleasant terms.

Debt and dilution are a drag on the per-share return of COIN, whatever else is true of Coinbase as a whole, and I wonder if the market is fully appreciating how little things like this can add up and whittle down a long-term return.

Conclusion

Out of the crypto-focused investments out there, COIN stands as one of the sounder ones, with some history of positive cash flow and proof of concept. It goes beyond crypto miners in this regard. I believe the current valuation has some grounding in reality, but it’s a sunny view of the future, one that assumes a basic level of cash flow and growth, much of which is dependent on the rest of the world doing something that will be good for Coinbase, not the other way around.

I don’t find $245 particularly disagreeable, but I also don’t think there’s enough clarity to run with it. Given the volatility of the crypto markets and that’s COIN’s best case relies on the ambitious Phase Three (along with the ongoing dilution), I don’t think $245 presents a margin of safety. Those who got in earlier in the year seemed to be getting good value. In the meantime, I’d prefer to wait for a similar price, and it’s a Hold until I see it.