Coinbase ($COIN) #5 - Earnings Calls, Raw Inversion & Margin of safety
After a two day break to think, I read the Earnings Call Transcripts
03-06-2022
I took a two-day break after doing the competition deep dive. I needed to meditate, think, and let my brain do some work behind the scenes. This is something I am cloning from Josh Tarasoff. After he does a thorough analysis he steps away from the investment and let’s his brain do some behind the scenes work. I am sure he wasn’t implying a couple of days, for him this may be a week or even longer. Either way I am cloning it, because of all the things I have read over the power of learning when sleeping and when doing nothing. Cannot ignore Biology when it is so clearly valuable.
So, when I came back to it today, I read the latest earnings calls. I haven’t read them yet. I don’t really have a specific system of when I read what, because there I clone Li Lu and follow my passion, but I have to say it was valuable to read them at the end of my deep dive, because now I can judge their words so much more objectively without being influenced as much. This was so good; I might make that into an actual process: read earnings call transcript history last. I’ll keep you guys posted. Either way, I was encouraged and again thrilled by what I read.
Conference Calls & Culture
VC is an investment into learning and understanding the long-term crypto trends. It is not made because of a specific profit target in mind. The investment is a long-term knowledge investment. Wow. How many companies would say this to Wall Street? We’re investing $320 million just to learn some things, but not to profit from it. A company I truly admire for their honesty. Of course, they will end up benefitting from this approach, it just cannot be measured or forecasted.
They are building their NFT marketplace as a one stop shop experience combining, Wallett, Crypto, Marketplace and social media all into one. The Network Effect of this could be a big deal if others are not first. We will exclude this from our inversion case later, but it sure has potential. 1 million people signed up already and of course they will use it. There is Amazon, Walmart, Etsy and Ebay so why wouldn’t there be multiple NFT marketplaces?
ETH2.0 and sharding will end up lowering transaction costs. This will widen margins even further. The economics would look even better at that point and currently the company is trading as if there will be no improvement and no growth. I believe a margin of safety is truly revealing itself. I will also exclude this improvement from the inversion, but again it is simply something that will happen, just by the nature of what sharding does.
Overall, I simply really like the fact that they do not disclose information sometimes, that they say we simply do not know and that they openly discuss that they are long term oriented. There is a lot of culture here, which I really like.
They provided us with a range of 5 to 15 million MTU's. Why such a broad range? Because they simply do not know. They have no idea what will happen over the next few quarters or even year due to so many factors that or not in their control. So, they will focus on what they can control: building great products that are simple and easy to use. Most of the market reacted to this as if this approach was something bad. They probably think if the company doesn't know even their next quarters, how can we trust them for years out? Somehow everyone seemed to miss this little 10x revenue growth for subscription services. 10x more humans have voted that their subscription services, which are brand new are worth paying for. I loved this earnings call. Everything they said in it made me feel confident in the true culture of COIN: Long Term customer oriented, regulation first, do it right the first time even if it is slow. Long term we will succeed.
Regarding their possible loss of $500 million Brian simply stated that they have said from the beginning they are going to invest in high volume trading periods as well as low volume trading periods and they are well positioned to do so with $7 billion in cash and are happy to take a $500 million loss one year if it means continuing to innovate. I don’t want $500 million today, I want the $50 billion tomorrow.
I have decided to add the Inversion section below, because I already wrote some of it down. It felt disingenuous to the idea of the blog to only show the finalized version. This is the process I go through, and I want to share it unedited. Please keep in mind that I might put out a second version if I think of new things.
INVERSION
The inversion process for COIN will paint a bleak outlook of market share in a world where tightly controlled crypto markets are functioning, but growing slower. The markets I am including are the USA, UK, Europe and Japan. Within that context what are the various disastrous events that could destroy our company?
Crypto trading / staking remains as the only viable revenue source.
Crypto volume and prices experience another winter with a 50% to 80% drop in activity.
Exchange competition will take the lion share of the market at 75% to 90%.
I am excluding a total halt of crypto trading in the bear scenarios, because:
Governments are beginning to adopt regulations, making crypto legal
The president is set to issue an executive order
Blockchain technology and crypto are too big of a technological advance to be ignored
The growth of blockchain adoptation is simply too big (Goldman, Banks)
Human psychology and history would indicate that speculation will continue even after a collapse.
DATA
Crypto Market Cap
https://www.statista.com/statistics/730876/cryptocurrency-maket-value/
Visualization of total crypto market cap between $1.5 and $3 trillion and growing.
With growing adoption and regulatory support the growth of crypto will continue. It is similar to the adoption of the internet back in 1997 (https://bitcoinist.com/comparing-bitcoin-and-crypto-to-the-internet-in-1997/). Conservative estimations place the growth rate of crypto at doubling every 2 to 4 years. It grew 182.7% in 2021, but that could be a fluke.
Scenario 1
Revenue & NI
If that is the case COIN's revenues would double with the crypto economy from $7.8 billion to $15.6 billion. This would imply that there is no additional growth in other revenue as indicated above and that trading remains at 94% of the total. At a 39% margin of NI (in reality higher, because they are investing into their business right now). we would have $6.084 in NI., implying a Pabrai quick valuation of 10x FCF (NI in this case) + Cash Assets we would have a Market Cap of $67.84 if the crypto economy doubles and COIN can partake in the double.
Scenario 2
Crypto Winter of 80%
If we assume that in the next 6 months there is a 80% decline in trading volume and a corresponding decline in revenue and NI we would have $1.56 billion in revenue + $7 billion in cash. Looking at the 10K we know that trading expenses would decline with revenue and remain stable at a %, technology and development could be reduced and investments slowed and Administrative expenses and stock options could be paused.
Transaction Expenses (16%): $249 million
Development: $1.2 billion (10K)
Sales & Marketing: $663 million
Administrative: $909 million
That would be a total of $2.9 billion if nothing at all is changed. That would imply 2.9 years of own funding capability in a worst case scenario. A doomsday seems unlikely.
Valuation Range
COIN is currently (03-04-2022) valued at $35 billion. This implies no growth in NI if cash flows are worth 10x.
Scenario 3*
In this scenario we are looking at future growth potential.
* This is not yet completed. It may also not be necessary, because of Scenario 1.
The culture / earnings call portion of my analysis was twofold. First a lot of it was about the future. I know there is a lot of potential and I also know that Crypto is here to stay (as explained above). This part I ignored when discussing my inversion. What I am taking into serious consideration though, given that Scenario 1 is promising, is the evidence of the culture. The way they think about the long term, about innovation, about doing a lot of smaller things with 10% of their budget and how they approach customers, easy to use products and regulations first without a care in the world about quarter-to-quarter forecasts just continuous to remind me of Jeff. I can’t help it. Now of course it’s one thing to talk like Jeff and another to execute like Jeff. Only time will tell, but it seems more and more improbable that none of their investments and initiatives will produce something.
So where am I in my thinking? I can currently (03-06-2022) purchase COIN for ~$36 billion. My company is producing $3.1 billion in NI as of last year. This implies an ~8% return on investment. According to Mohnish a quick gauge of the value of a company that is not growing is to take Free Cash Flow, multiply it by 10 and add Cash assets. If we do that with Net Income, we will end up with a value of ~$38 billion ($3.1 x10 + $7). This means that the company is priced fairly if it continues to produce $3.1 billion a year.
I know that Crypto is not stopping to grow in the next few years. Worst case the market will double in 4 to 5 years, doubling the value of my company based on 2021 margins and past growth with the industry. I know that my company will survive for over two years should the market collapse by 80%. In this case, many other companies would need to dilute their shares or take on debt to survive. So, while this would be a tough ride, I can stomach it and my company would end up stronger, but it would take a lot longer to make money on my investment.
So, what is the probability that Crypto is a fad and will go away? I estimate it to be less than 10%, low. What is the probability that crypto will grow, but much more slowly because most of it was speculation after all and the meaningful product development will take a decade to develop? I think that is 15% to 20% likely, because the speed of innovation and the amount of capital flowing into the space is simply too big. What is the likelihood that there will be growth and that at least one or two things COIN is doing will pay off? I think it is 50% to 75%. That is a wide margin, which is of course the reason why I invest with a margin of safety in case I am wrong.
Currently my margin of safety is 0% if I expect no growth. If I am expecting worst case scenario growth it is about 50%, but for a 5-year investment. So, the return isn’t that great, but my downside is not that big. However, if I am right and COIN continues to grow as it has, the institutional side of their business grows, they are diversifying more revenue from trading and even one of their big bets pays off, the next 10 years will look strong.
Does COIN have a moat? Brand, Regulation, UX. I won’t dive into it too much more, I explained it in my research process. So here we are. Now, IF I decided to invest (I have not yet decided!) I would place COIN in the range of a 5% to 10% of assets and I would begin buying 2.5% this week and simply dollar cost average into the position over the next few weeks. Hopefully as it declines.