A day before its IPO on April 14, cryptocurrency exchange Coinbase Global’s reference price was US$250 ($333.97), valuing the company at a market capitalisation of US$65.3 billion. Fund managers and investors expect Coinbase to be valued (eventually) at US$100 billion. As it turns out, this benchmark was exceeded temporarily. On listing, Coinbase’s trading was volatile, rising to US$381 per share on opening, but closing at US$328.28 after climbing to a high of US$429.54. The closing price values the company at US$86 billion.
Kyle Guske II, an analyst at equity research outfit New Constructs, said: “Coinbase’s expected valuation of US$100 billion implies that its revenue will be 1.5 times the combined 2020 revenues of two of the most established exchanges in the marketplace, Nasdaq and Intercontinental Exchange (ICE), the parent company of the New York Stock Exchange. Our calculations suggest Coinbase’s valuation should be closer to US$18.9 billion — an 81% decrease from the US$100 billion expected valuation”.
In its S-1 (the initial registration document required by the US Securities and Exchange Commission for an IPO), Coinbase notes that “crypto has the potential to be as revolutionary and widely adopted as the internet”. While such a statement can lead to lofty valuations based on a “growth story”, the reality is the cryptocurrency market remains far from “mainstream”.
According to data analytics firm CivicScience, 66% of US adults are “not interested in” cryptocurrency and 18% have “never heard of it”. Similarly, CivicScience finds that while the number of people investing in cryptocurrencies is rising quickly, it still remains low at just 9% of U.S. adults. For reference, Pew Research Center estimates 90% of US adults used the internet in 2019.
High transaction fees unsustainable
As a leading cryptocurrency exchange and brokerage firm in a nascent market, Coinbase charges a large spread on each trade and a trading fee (which is the greater of a flat fee or a variable percentage fee based on region, product feature, and payment type) — both of which are unsustainably high.
Last year, Coinbase collected approximately 0.57% of every transaction in fees, which totalled US$1.1 billion in trading revenue on US$193 billion in trading volume. In total, these trading fees made up 86% of revenue in 2020. “If we assume a similar breakdown of Coinbase reported US$1.8 billion in total revenue in 1Q2021, trading fees would equal US$1.5 billion on US$335 billion in trading volume, or approximately 0.46% of every transaction,” Guske writes.
As the cryptocurrency market matures and more firms inevitably pursue Coinbase’s high margins, the firm’s competitive position will inevitably deteriorate. For example, if stock trading fees are any indicator for crypto trading fees, they could go lower.
“Competitors such as Gemini, Bitstamp, Kraken, Binance and others will likely offer lower or zero trading fees as a strategy to take market share, which would start the same ‘race to the bottom’ that we saw with stock trading fees in late 2019,” Guske says.
Similarly, if traditional brokerages begin offering the ability to trade cryptocurrencies, they will most certainly cut down on the unnaturally wide spreads in the immature cryptocurrency market. For example, if Coinbase’s revenue share of trading volume fell to 0.01%, equal to traditional stock exchanges, it is estimated 1Q2021 transaction revenue would have been just US$35 million, instead of an estimated US$1.5 billion. Coinbase’s estimated transaction revenue as a percent of trading volume in 1Q2021 is 46 times higher than ICE and Nasdaq. The likelihood of Coinbase maintaining such high fees is very low in a mature market.
Rising expenses to defend against competition
Coinbase also recognises that future profitability could fall if it has to defend its market position from rising competition. In its 1Q2021 update, the company guided for sales and marketing expenses to be between 12% to 15% of net revenue (equivalent of gross profit) in 2021, up from 5% of net revenue in 2020. Rising expenses would hurt margins.
Coinbase stands out against recent IPOs due to the fact it actually generates a profit. Coinbase grew revenue by 139% y-o-y in 2020, while core earnings turned around from a loss to US$317 million. In 1Q2021, revenue grew more than 9x y-o-y.
New Constructs’s reverse discounted cash flow (DCF) model shows that in order to justify its expected US$100 billion valuation, Coinbase must maintain a 25% net operating profit after tax (Nopat) margin (above Nasdaq’s 19% but below ICE’s 31% in 2020); and grow revenue by 50% compounded annually (well above Nasdaq’s highest seven-year revenue CAGR [2004-2011] of 30%) for the next seven years. In this scenario, Coinbase would earn US$21.3 billion in revenue by 2027, which would be 1.5 times ICE’s and Nasdaq’s combined 2020 revenue.
But what if Coinbase is not the largest exchange in the world? Coinbase’s profitability would fall in-line with traditional brokerages as competition enters the market and cryptocurrency trading becomes a more commoditised business.
If Coinbase’s Nopat margin falls to 23% and revenue grows by 21% compounded annually for the next decade (Nasdaq’s greatest 10-year revenue CAGR), then Coinbase is worth just US$18.9 billion — an 81% downside to the expected valuation. If cryptocurrency fails to break through on a more mainstream level, and trading volumes remain dwarfed by stock trading, Coinbase’s growth story would end and the stock could drop.
