Coinbase ($COIN) #2 - The 10K came out
The research project called $COIN has officially begun
03-01-2022 to 03-02-2022
On February 5th, 2022 I decided that $COIN was a worthy condidate for my “Four Filter Process” (Cloned from Buffett / Munger - 1. Circle, 2. Moat, 3. Management, 4. Margin of Safety). However due to the Market Cap at the time (~$44 billion), the youth of the company (no 10K’s at all) and my feeling that it was a little expensive I decided to wait for the 10K. From that day until March 1st, 2022 I did not look at the price or the news.
On March 1st, 2022 I reviewed my notes (iPad + Notability) of the S-1/A & all 10Qs and then read the 10K of $COIN. The night before I came accross Hayden Capital thanks to @bkaellner. He posted a video discussing a Guy Spier interview related to $SRG, which I wanted to hear. I found the Guy Spier Interview on Sound Cloud and began to listen and towards the end it briefly mentioned $COIN. @bkaellner then mentioned Hayden Capital’s shareholder letters and the $COIN memo. He has guided me to various great content and I would strongly recommend to follow him.
Below are my raw internal notes on their Investment Thesis. These do not contain my thoughts or comments. Those follow below.
Notes: Hayden Capital - COIN 21.Q3 Investment Memo ($240)
http://www.haydencapital.com/wp-content/uploads/Hayden-Capital_Coinbase-Memo.pdf
The Business
Current margins are based mostly on retail revenues, not business client revenue growth in the future.The Competition
Binance Competitor from Asia
Kraken in the US
FTX - More like a specialized trading platform, COIN more a retail customer
find out the regulatory licenses the competition holds. Regulatory troubles?
Does the competition have a VC arm as well?
Regulations
Regulations shut down fiat to crypto access due to big banks. Regulations that remove existing approvals. China has gone down this road, which indicates the power of the blockchain to improve freedoms across the world.Coinbase regulation first approach makes it safe against unforeseen regulatory hurdles on their products. Competition without licenses could be shut down for example. COIN is truly following their mission statement by including regulators.
COIN is offering strong support services. This is a cost which FTX (trader focused) may not need. Either it will enable them to build a bigger moat due to their scale OR this is just a drag on their profits.
If the worst case regulations kick into gear would the current COIN business be impacted? ie would current NI x10 + Cash still exist and therefore keep our money safe.
I judged the thesis to be value adding overall, detailed and especially insightful on the regulatory aspects and how they relate to the moat. I would advise not to pay too much attention to their valuation and forecast, because it is too detailed. As soon as I see Graphs and forecasts talking about statistical models instead of rough probabilities I am gone (Pabrai). You can see, I clone anything I can without feeling 1% bad about it. Below are my notes that I took subsequently after having meditated on the thesis and the 10K.
Please do not be afraid to rip this apart with brutal honesty.
Thoughts on: Hayden Capital - COIN 21.Q3 Investment Memo ($240)
http://www.haydencapital.com/wp-content/uploads/Hayden-Capital_Coinbase-Memo.pdf
The Business
Based on the 2021.Q4 - 10K COIN has the following financial metrics:Cash: $7,619,599
Sellable Assets: $988,193 (Crypto, with an Audit Report stating difficulty in estimating)
LT Debt: $3,384,795 (Senior Notes, some redeemable for Stock, need details for dilution)
Revenue: $7,839,444 (94% is from trading)
Net Income: $3,190,404
Op.Cash: $4,038,172 (excluding custodial funds)
Cap.Ex: $85,783 (seems low? Could be true, they aren’t building a Metaverse yet)
FCF: $3,952,389
The company currently generates 94% of it's revenue from people trading crypto assets on it's platform. This is generated by a % commissions on each trade mostly through the Retail App and some through the Pro App. All of the trading that is currently done is approved by regulators and conducted 100% in accordance with the law. I will use Net Income as the more conservative measure as well as excluding the Crypto Assets held for sale in our Pabrai Quick Valuation:
x10
$39,523,639
x12
$45,904,447
x15
$55,475,659
Currently we have a $43 billion Market Cap. The company is currently trading between x10 to x12 of Net Income. This is an intriguing valuation considering it is conservative and implies very little growth. The crypt economy however is definitely growing. Research in the letter implies that it could x2 or x4 by 2025. Human nature and the current hype surrounding crypto would imply that there will be continued adoption, even if it is of a purely speculative nature.
Additionally COIN is creating several additional businesses which have growth potential, which are currently free. The cloud infrastructure similar to AWS, staking and education to just name a few. Another source of value is the VC arm, which is invested in a lot of up and coming crypto startups. COIN has their fingers not only on the pulse of the economy, but inside it as well. Opensea currently has $3.3 billion in transactions (quick Google) through their NFT marketplace, COIN is invested in them and has their own NFT marketplace coming out.
I believe that COIN is currently priced as if there will be very little success in their new businesses and as if non of their investments in the crypto economy will pay off at all. I consider the likelihood of that happening quite low and believe a deep dive is warranted.
After coming to the conclusion that the feasibility of the investment warrants a deep dive I placed $COIN into my Circle of Competence Filter (Asana) and proceeded.
The Competition
The three main competitors to study are Kraken, Biance and FTX. Kraken is operating in the US and is our main competitor. Biance is the largest crypto platform in the world operating in Asia under a much different regulatory environment and FTX is a platform focused on professional traders rather than the retail customers. This leads us to the following topics I need to evaluate:Binance
The largest crypto exchange by volume which operates out of the caymen islands. They are facing a lot of regulatory investigations in the USA and the UK, but are big in Asia. I need to explore the following:
How popular are they in Korea, Japan and the other regulated economies?
How in-depth are their legal troubles in the US and the UK?
What licenses does BianceUS hold?
What do customers say about it?
Do they have a VC arm?
Kraken
Kraken is the runner up behind COIN. I believe that the main factor in competing will be the UX, because the better the UX, the more the ensuing Network Effects will be.
Is Kraken licensed to operate like COIN?
Is Kraken's UX amazing or does it lack behind COIN?
Do they have a VC arm?
FTX
They are focused as a platform specialized for professional traders, assuming that pro's have knowledge. This could become a great niche. However COIN could also out-scale them and then open their own PRO platform (which they already have) when they beat FTX financially.
Is FTX truly superior for traders?
Is the UX superior?
What does a pro trader want that COIN doesn't have?
Regulatory troubles / licenses they currently hold?
Do they have a VC arm?
Initial thoughts on Moat:
COIN has first mover advantage in the industry. It started in 2012. COIN has taken the regulation first approach, which creates a lot of piece of mind in the general public. There are no investigations into COIN, no accusations of illegal activity as compared to Binance for example. This supports a brand image in the publics mind. They associate COIN with safety and security and legality. COIN is also scaling already. They are producing 40.6% profit margins.Can COIN simply out-scale the competition?
Regulations
Currently the largest perceived danger to the MOAT is regulation. Competition is of course a danger as well, but from the initial look I think regulation poses the biggest threat.COIN has a regulations first approach, which as mentioned has many positive side effects. Due to this all current trading activity is legal. Their lending business has not launched, because of the SEC and they are working with them on approvals. COIN wants to create an open and free financial system and by continuing their slow, legal regulation approval first approach they are sticking to their mission. The financial system cannot have more freedom if the government shuts it down and users drop the platform. COIN is creating a lot of trust. There is no need to get customers into a situation where they are breaking the law. I believe this is a big advantage over other trading platforms due to the head start.
Worst Case
Big risks would involve the US Government taking away current licenses and simply making blockchain trading illegal. Considering the current craze with NFT's, the involvement of the NBA and celebrities I don't believe this will be the case. However this would be worst case. If that were the case, COIN would be in big trouble and I would most likely lose a lot of money. The company would then most likely be sold to a big bank in order to use the technology. However many large financial institutions are applying for crypto licenses (Goldman ETF) and are investing into blockchain startups. This worst case future seems unlikely. Current regulators also stated they do not intent to shut it down, but to regulate it effectively. China has gone down the road of banning certain practices, which shows that they are afraid of the power of the technology to liberate freedoms further.
Confirm the regulatory environment and stance in the US, Europe and open market Asia.
What are the SEC's concerns?
A much more likely scenario would involve the regulation of crypto in a more serious manner. This for example could restrict fiat to crypto access, make many crypto assets illegal and thereby lowering the volume which runs through the coinbase platform. However even if that happens, we're in the beginning stage of growth and the current business model would still be perfectly in tact, capturing the growth of legal assets.
Support Services
COIN is offering strong support services. This is a cost which FTX (trader focused) may not need. Either it will enable them to build a bigger moat due to their scale OR this is just a drag on their profits. I can see that FTX may simply not need such a detailed support system, because the professional traders are simply smart enough. Or I could see that people will want to switch to coinbase.This brings up the question of switching costs. If I want to switch from Kraken to COIN, how would I do that?
How difficult is it to switch from one platform to the other?
This concluded my thoughts about the Hayden Letter. At this point I did not yet investigate their claims. I simply wrote down what I knew myself and debated the possible outcomes in relation to a worst case scenario. I also came to the conclusion that Hayden seems to be highly optimistic, but that I currently tend to agree with them that crypto is here to stay. Now it is time to present proof to that fact.
Hayden had a lot of external links in their presentation. Next I went through them all, read them, did more research on my own and wrote down the following thoughts. By the way I have already read all the whitepapers of bitcoin, ethereum and various blockchain companies in the past. One of my friends is a programer (I guess that’s not as cool anymore as it was 10 years ago) who I have had a few long talks about the blockchain with, so I have a good understanding of how it works (needs to get better still).
Notes: References from Hayden Capital COIN Memo
REGULATION
https://decentralizedlegalsystem.com/us-crypto-currency-regulation/
Other references included:
https://decentralizedlegalsystem.com/fatf-bitcoin-regulations-summary/
Banning Crypto (Armageddon Scenario)
Coins are a natural by product of a blockchain. The system doesn't function without it. Therefore any regulation created cannot ban coins from being created, because if they do, there is no blockchain. Now it makes sense that if a coin is produced and it can be traded that this activity should be regulated much like currency, commodities or securities are traded today. While this is something the freedom advocates of blockchain will not want, it makes sense that this will happen. Therefore coins and company issued tokens should be treated like currencies and stocks are right now. This regulation would imply that blockchain and crypto are totally legal, but that an approved and regulated exchange needs to be in charge of trading. While this could potentially reduce the overall volume that is being traded on the exchanges it strengthens the regulatory moat for COIN, by being approved and licensed already.——
They will not ban blockchains or crypto
https://www.newsweek.com/us-wont-follow-china-banning-crypto-sec-chief-says-1635940
https://www.forbes.com/sites/ktorpey/2019/07/30/us-lawmakers-are-realizing-they-cant-ban-bitcoin/
——
The two most concerning aspects of the articles were the banning of stable coins (coins tracking a fiat currency) and the Fed going digital. Stable coins are a fantastic idea and would allow people to 1 for 1 earn interest on money they could lend through the system. This of course would hurt the banks, which is most likely one of the reasons why it will not be allowed (I digress from any possible consipracy theories). This simply takes too much power away from the government. Stable coins in the least will be regulated like money market funds at a bank. So I think the government will win this fight.
Find out what Banks say about stable coins (ASNWERED CHASE)*
What does the Fed say about stable coins (ANSWERED WSJ)*
*Through my reading I answered these questions, so I made a note
Now if the FED becomes digital the implications would be far more reaching than just COIN and how it affects the exchange, because it affects everyone and the entire economy. As a matter of fact we can probably expect that the USD will run on a private blockchain in the future, simply because it offers so much visibility into all financial transactions. Cash is the enemy of control. So I will assume that this will happen and that stabe coins should be disregarded, at least for major financial transactions.
Summary
In conclusion I find it probable that the trading regulations are a net benefit for COIN. It creates legal barriers of entry for competitors and will favor the company with the largest influence on the government. While the idea of a totally free digital economy is great, we need to face reality and realize that the likelihood of that happening is low. Therefore I believe the regulatory impact on the blockchain will be most felt in DeFi, but not as much in the trading of coins and tokens itself, even if many will be classified as commodoties or securities. There should still be plenty more than there are today. Especially more meaningful and productive assets compared to today.SEC vs COIN
https://www.ft.com/content/bd09f8bf-e65b-4870-affe-55b5346af3e1
COIN stopped it's launch of a lending platform based on USD stable coins. This came after the SEC said it classifies the stable coin as a security and COIN would need to register it as such. This is in line with the move of the FED and Government to ban stable coins all together. I am not surprised at the consistency in their actions. Blockchain is attacking the traditional currency system and they are fighting back. My money is on the government winning the fight. However, the positive aspect is that COIN has again gone the legal route, while others are under investigation. These investigations costs money, create bad PR and could cause a bad Brand image in the long run. Also here, I believe that this is a good marketing exposure to the public. COIN is legal and follows the rules.
Single Regulator
COIN is a firm believer that the current regulatory framework is not ideal to include digital assets. In COIN's opinion one single government agency needs to be created just to oversee crypto. I have no opinion or forecast on the matter. I need to judge the future by what will happen not what is ideal to happen. Given the nature of governments, momentum, inertia and incentives I find it most probable that at least for the short and medium term crypto will be regulated under the current framwork.
At this point I felt no more drive to read about regulations. Li Lu ones said that following your passion in building your circle of competence is a big competitive advantage. I never force it and follow where my heart leads me so to speak. Therefore I digressed a little and decided to focus on the Culture next. However, there are still many questions needing to be answered, which I have to come back to later. HOLD ME TO IT!!!
CULTURE
https://blog.coinbase.com/culture-at-coinbase-fe510fe9c098 (2019 Culture Doc)
https://blog.coinbase.com/culture-at-coinbase-f0e1c2a99aff (2021 Culture Doc)
https://blog.coinbase.com/coinbase-is-a-mission-focused-company-af882df8804 (Post)
Reading this culture post gave me a déjà vu. Maybe not as intense as that, but it was the first time in a while that I read something that strongly reminded me of a fellow who once launched an online bookstore. There were several themes and traits which reminded me so much of Amazon it was uncanny (or was this my desire? Got to be careful!). Immediately I remind myself that while this may be good, it is a dangerous preconceived notion and I must watch myself carefully from here on out.
Feedback loops & Team
The culture document describes a company which operates like a winning sports team, but not like a family. That is a big plus, because we saw the impact a family oriented approach can have at $PTON last year. A Championship team is the much better approach. The culture therefore wants the best players to play and everyone to be able to reach their full potential, rather than be dragged along. They encourage open feedback, even if it hurts, but require it to be delivered with kindness. The same goes for bad news, deliver them right away, because they don't age well. I think this is the right approach.
Are they living up to their promise? (I emailed IR, let’s see)
Customer first & long term
When it comes to focus the company document is clearly favoring the customers. They have taken the long term approach from the start. This is why they want everything to be legal, because their customers should never be afraid of accidentally breaking the law. Each product or service that is launched should deliver value to the customer, even if it hurts the companies financials. If the company has a new product that makes the customers money, but reduces their margins, they will launch the product. If the product makes the company money, but doesn't deliver value to the customer, they do not launch it. They also consider the loss of $1 for one customer to be of the same importance as the loss of $100,000 or $1 million to another customer. Regardless of the size of the customers account, they are all treated the same. They even state that if it comes down to delivering shareholder value or customer value they will always choose the latter. This is the best approach in my opinion and lends itself well to shareholder value in the long term anyway. Similarly to Steve Jobs approach, the company wants everything to be as simple as possible for their customers, especially in communication and explanation of their products.Innovation
The company invests 10% of their resources into innovative projects. This mimics the amazon culture of investing. They throw a lot of things at the wall and see what sticks (would be great if Mohnish agrees. Someone should ask him). Much like Jeff, Brian believes that if the company doesn't fail often, that their ideas aren't big enough. This same DNA is reflected in their VC arm, which is invested across a lot of different areas of the crypto economy. They do not hold a controlling stake, but they support it by investing as a VC. Based on their filings of 2021 they also purchased one of their VC's outright.CEO Post
Brian A. is clear in his goal. The company needs to focus on it's mission of creating financial tools for people to access the cryptoeconomy. That is the goal and he doesn't want people to work at the company that believe the company is there to solve social problems. They paid severance packages (according to Hayden Capital) for people to leave after that post. That is putting money where your mouth is. I believe that the power of focus, without distraction, is a big advantage in a company. It is more difficult to do as the company gets bigger, but when it is done well (Amazon, Costco) the effects can be value creating. I believe this post and the severance packages paid show:
Brian A. means business and upholds the companies values and mission
Brian A. is focused on customers, by eliminating "outside work" distractions
Brian A. is in charge at this company
Summary
Anytime a company posts something they want it to be in the best light. That is of course natural. So I will take the document with a grain of salt and focus on the open questions to disprove my initial impression that I am seeing a little bit of Amazon DNA in this company.
Find videos etc. of Brian A. talking about Amazon, role models etc.
Find failed investments
Study acquisitions and investments of the company to show that they are NOT like Amazon
Study the Board of Directors and governance documents to find more evidence
Next I found it truly interesting that Meta (FB) chose COIN for a partnership regarding their own crypto ambitions. So I dove right in.
COIN & FB Partnership
https://insights.paxos.com/hubfs/USDP-whitepaper.pdf
FB and COIN will use a NY bank regulated stable coin for their project. FB will issue the coin and COIN (coin and COIN lol) will provide the custodial wallet service. This is a big deal, because of the sheer volume of transactions that could flow through FB user base. The stable coins are legal under the NY laws as well.
https://www.cnbc.com/2021/10/19/facebook-taps-coinbase-for-digital-wallet-novi.html
https://finance.yahoo.com/news/coinbase-becomes-custody-partner-facebook-133512092.html
Facebook chose the current arrangement with COIN and paxos because the coin has been running for three years and there are many regulatory requirements satisfied. The fact that the entire coin is backed up by USD Cash assets is important a well. This speaks to the business model of COIN. The biggest player in connecting people in the world wants to go with COIN. This is a big indicator that regulation first approach was the best possible way to go.
The initial project is limited and a test run. I am not too focused on the details for the FB side, but the fact that when it comes to security COIN is the #1 choice for FB. Even if the entire project false apart and FB rethinks their libra etc. approach again, the main point to consider here is: FB chose COIN.
https://coinmarketcap.com/alexandria/article/facebook-and-coinbase-partnership-sparks-controversy
FB could pose competition to a central bank digital currency. That is an ineresting thought. But just a side note. Competing against the FED is probably a bad idea and we will therefore exclude this partnership from any future earnings forecasts.
More on Stable Coins
Stabe coin approvals are on the way, which contradics the original references made by Hayden Capital through their referenced article and some other things that I found. This is not mean to cast a bad light on their research since they only need to worry about their capital allocation, thereby focusing on worst case scenarios. What it does point towards is that our original idea of a heavily regulated blockchain as the worst case scenario seems more likely.
https://www.coindesk.com/policy/2021/11/02/unpacking-europes-looming-mica-crypto-regulation/
The EU regulations considered are very tough and costly for new entrants to operate in. This again would have a “two sided coin” effect on COIN. On the one hand we have a regulatory moat and scale to absorb high regulation costs, but on the other hand it will lower trading volumes by decreasing new tokens and assets in the system. Again, I think it is more probable that the decrease in potential assets will have less of a negative impact than the positive impact of the regulatory moat, because there will still be so many new approved assets coming in the next 5 to 10 years. BUT, I could be wrong.
What type of assets will be created in the future? (may not be knowable)
https://www.europarl.europa.eu/RegData/etudes/BRIE/2021/698803/EPRS_BRI(2021)698803_EN.pdf
To me it seems likely that new entrants into the market will have to back stabe coins with phhysical USD deposits instead of other assets (see Tether); and so they should. I agree with Munger & the EU that backing coins with other assets opens up a 2008 type slippery slope. I think that being regulated under the banking laws makes perfect sense, because in essence a stable coin should represent the currency it is tied to in almost every way. This again would give COIN a moat advantage, because of it's scale and financial ability to independently (without a bank) hold these custodial funds (which it already is).
Summary
By looking at how FB is operating and by where the EU believes regulations need to go I am of medium to high certainty that companies who can back their crypto assets with fiat currency cash will receive regulatory approvals first. This in turn will support their scale and brand image, further strengthning their moat. COIN would have a big advantage under this scenario.
This concludes my two day research marathon. I started out with a worst case scenario of blockchains and current approvals going down the China path and landed at a worst case scenario of a heavily regulated industry, similiar if not identical to current regulations. I am happily investing in stocks under current regulations, so why would that change anything at all in the blockchain sphere? I think Defi will be hit hardest by regulation, but NFT’s, Tokens, coins and smart contracts should be fine. The government will use them themselves at some point. This leads me to a few thoughts about NFT’s.
NFT’s & some thoughts
Currently the public thinks that NFT’s are some strange digital art buying / selling craze. They think of NFT’s and digitial art in the same way they think of the Blockchain and Bitcoin: that they are identical. That is of course not the case. Bitcoin is the coin of one blockchain in the same way that digital art created as an NFT is simply one application of NFT’s. Munger is 100% correct when he says that NFT’s, Bitcoin etc. is a bad idea, when one isolates the current speculative frency regarding buying and selling individual tweets. Of course that is a casino. But what is currently not priced into COIN at all is the fact that in the near future NFT’s will represent smart contracts to buy and sell Cars, houses, collectibles and anything else you can think of. I have no idea when it will happen, what will be approved when and which use cases will end up creating true value in the economy, but I would say the probability is high that eventually some will and COIN will be there to let you buy and sell them. This may be the biggest MOAT aspect of all: No matter what Token, coin or NFT application ends up winning, COIN will be the two sided marketplace facilitating it all.
So what is next? First I need to go back and answer all the open questions. I think I did most of them, but I need to write them all down and go through them. Second I need to do a deep dive into the competition and come to a conclusion / probability idea of how strong the MOAT is. Then I will run a serious Scuttlebutt (anyone know a talented investigative journalist?). And then we will try and paint the future.
Our current margin of safety would imply descend growth. We’re trading at ~x10 NI, which is the value of a business without growth (Pabrai). However we’re not 50% or 30% off from that. So COIN is trading kind of like FB is right now, but FB doesn’t have to convince me that their earnings will continue.