In the first part of this deep-dive series, I covered the high-level stuff, looking at Coinbase’s business proposition, product market fit, competitive position, and the key risks to its business.

In this second part, I take a closer look at the financial and operational aspects of the business. In doing so, I try to answer one of the first fundamental questions facing a prospective investor in Coinbase:

Does an investment in shares of Coinbase represents a (levered) bet on the price appreciation of Bitcoin and other crypto assets, and if so, why not just invest in those underlying assets?

The analysis I set out here lays the crucial groundwork for Part 3 of this series, in which I attempt to value the company using conventional valuation methods.

Let’s dive in!

Before we begin, it may helpful to first explain the why of what we cover in this section.

Unpacking the build-up of Coinbase’s revenues is important for two reasons: first, it allows us to better understand the composition of Coinbase’s customer base, and second, it allows us to better understand Coinbase’s business model in terms of the services it offers to its customers. Both of these go to the ultimate question we are trying to answer.

Coinbase reports its revenues across multiple revenue streams. These include:

• Transaction revenues: earned from transaction fees charged to customers for the purchase, sale and trading of crypto assets. As discussed in Part 1, crypto purchases are charged a base transaction fee of 4%, but this can potentially be reduced depending on payment method and location. Retail transactions are charged a further 0.5% spread and a ‘Coinbase Fee’.
• Custodial fee revenue: revenue from the dedicated cold storage solution provided by Coinbase to its customers. The custodial fee is calculated as a percentage of the value of assets held under Coinbase’s custody.
• Staking revenue: revenue from staking rewards earned on proof-of-stake assets, which are calculated as a percentage of the total value of staked assets.
• Earn campaign revenue: revenue from Coinbase’s ‘Earn’ programme, a platform for retail users to learn about new crypto assets through educational content. Retail users are eligible to earn rewards denominated in the crypto asset upon completion of pre-determined tasks. Coinbase earns a commission from the crypto asset issuer on these distributed assets.
• Interest income: interest earned on customer custodial funds and cash and cash equivalents deposited with third-party banks.
• Other subscription and services revenue: one-off, non-recurring revenue from “early stage services being offered by the Company, such as subscription license revenue”. I suspect that this includes revenues from services such as Coinbase Analytics and Coinbase Commerce that have yet to be monetised at scale.
• Crypto asset sales revenue: revenue from the sale of crypto assets owned by Coinbase itself. At times, Coinbase uses its own assets to accommodate transactions that do not meet the minimum trade size, or otherwise to maintain customer trade execution during system disruptions. The cost of these sold assets is recognised under ‘other operating expenses’.

The table below summarises Coinbase’s different revenue streams. As shown, substantially all of its revenues are generated from transactions, particularly those conducted on behalf of its retail customers.

Coinbase earns a far higher margin on its retail customers than on its institutional customers. In fact, the majority of trading activity taking place on Coinbase’s platform, as measured by volume, is conducted on behalf of its institutional investors (e.g. hedge funds, financial institutions, and institutional market makers). Yet, their large share of trading volumes is responsible for a comparitively small proportion of revenues. This is a function of the significant premium levied by Coinbase on its retail customers, which is likely to become eroded by both internal and external competition over the long-term (see discussion in Part 1).

The interim takeaway is that:

• at present, a large majority of Coinbase’s revenues are earned from transaction fees charged on the purchase and sale of crypto assets, most of which are generated from its retail customers. The margin earned by Coinbase on its retail customers is significantly higher than that earned on its institutional customers.
• the other sources of income, classified under ‘subscription and services revenue’, are mostly a function of the total assets held on Coinbase’s platform. I would expect that the value of these assets remains highly correlated with the price of crypto assets over the short to medium term, but that the extent of correlation reduces over time as Coinbase continues to build up its recurring revenue streams.

Next, taking a closer look at the sensitivity of Coinbase’s revenues to market prices, there are a number of business metrics reported by Coinbase in its S-1 filing that are helpful for understanding the major revenue drivers of the business.

Monthly Transacting Users (MTUs)

The largest component of Coinbase’s revenues — retail transaction revenues — is generated from its transacting base of retail users, referred to as Monthly Transacting Users (MTUs). The chart below shows that MTUs have generally been correlated with the price of Bitcoin in the recent past.

The sensitivity of MTUs to asset prices shows that retail users tend to vary their participation in crypto markets on a pro-cyclical basis (i.e. increasing investment when asset prices are high and reducing investment when asset prices are low).

Trading volumes

Next, trading volume is also correlated with crypto asset prices as one would expect, but there is an interesting bifurcation between retail and institutional trading activity over periods of high price volatility.

For example, in Q1 2018 (shortly after the previous market cycle top), retail trading volumes fell far more rapidly than institutional trading volumes, and at a rate that outpaced the rate of price decline. The growth of institutional trading volumes has since outpaced that of retail, with a more pronounced increase in volume over the recent period of price movement.

Coinbase does not report the number of institutional investors transacting on its platform, but it does note that:

• c. 7000 institutions have accessed Coinbase’s services in the past
• in 2020, there was an acceleration of institutional investment into Bitcoin, as a hedge against inflation
• retail trading volume has been more influenced by volatility in crypto asset prices than institutional trading volume.

This last point makes sense: from Coinbase’s perspective, institutional investors are likely to represent a more stable (albeit lower margin) source of revenues because institutional investors tend to invest for the long-term and over the course of the market cycle. Institutions also tend to trade on behalf of other investors, meaning they must comply with strict procedures with respect to the measurement, allocation and monitoring of risk. These factors all come into play in shaping the sensitivity of trading volume to macro volatility.

Average revenue per transacting user (ARPTU)

ARPTU is not an official business metric per say, but is nonetheless important for understanding the directional movement of transaction revenues. Average revenue per transacting user (or ‘ARPTU’) is calculated by dividing total retail transaction revenues by the number of MTUs over a given period. In effect, it serves as a proxy for Coinbase’s complex fee structure, which is far too onerous to model in full.

The figure above shows that ARPTU is somewhat sensitive to crypto asset prices, but to a much lesser extent than MTUs. This is likely because:

1. elements of the transaction fees charged by Coinbase are fixed fees that would not scale with the notional size of an order
2. Coinbase operates a regressive fee model that charges lower variable fees on orders of a larger size
3. while the volume of a particular user’s trading activity may increase as the notional value of their portfolio rises, at a certain point this becomes capped by their investment risk appetite in fiat terms — e.g. I may be comfortable with trading 20% of my portfolio at any given time, but this is subject to 20% being no more than $10,000.

Assets on Platform

Lastly, much of the subscription and services revenues generated by Coinbase is earned on the value of crypto and fiat monetary assets held on its platform (Coinbase calls this ‘Assets on Platform’). The figure below plots the correlation between Assets on Platform and Bitcoin prices. My educated guess is that the observed correlation reflects a combination of two effects:

1. the direct effect that a fluctuation in crypto asset prices has on the dollar value of crypto-denominated assets held by Coinbase
2. the indirect effect of asset price fluctuation on capital flows moving in and out of the platform.

Of course, not all subscription and service revenues are a function of Assets on Platform:

• Other subscription and services revenue are one-off in nature and relate to early-stage services that Coinbase has yet to scale. I would expect these services to be recurring in nature and far less exposed to asset price volatility.
• Earn campaign revenue is a function of the partnerships formed between Coinbase and asset issuers and the extent of users’ participation in Earn activities. While I am not aware of any metrics relating specifically to Earn activities, I would expect user participation in these services to be less correlated to market price than other aspects of Coinbase’s ecosystem.

Let’s now turn to the costs side of the business to answer the second part of our question: whether (and to what extent) Coinbase shares represent a levered bet on the price of the underlying crypto assets.

As a primer, an analysis of cost structure normally proceeds on two bases:

1. an assessment of the extent to which a business’s costs are variable (i.e. correlated with revenues) as opposed to fixed
2. relatedly, the level of its fixed costs relative to its revenues (also known as its operating leverage).

Coinbase, like other technology companies, incurs a high proportion of fixed costs and relatively low variable costs. That is, it commits high periodic spending to things like R&D and general overheads that are relatively insensitive to revenue, but is able to on-board new users relatively inexpensively.

In the table below, I summarise the costs incurred by Coinbase for 2019 and 2020.

The following costs incurred by Coinbase vary directly with the level of platform activity and have historically summed to around 20% of total costs (or 15–20% of revenues):

• transaction expenses: account verification fees, payment processing fees and fraud loss expenses
• sales and marketing expenses: costs related to customer acquisition, advertising and marketing programs and sales and marketing personnel

Meanwhile, the other costs incurred by Coinbase are generally uncorrelated with revenues, although they may still be varied at the discretion of Coinbase:

• technology and development expenses: the cost of developing new products and services, operating and maintaining Coinbase’s platform and network, and acquriing developed technology.
• general and administrative expenses: legal, finance, compliance, human resources, general overheads and other operational costs. Also includes depreciation and amortisation, amongst other costs.
• cost of crypto asset sales: the cost of sold crypto assets owned by Coinbase itself (see ‘revenues from crypto asset sales’ above).
• other income and expenses: gains and losses on investment and realised impacts of foreign exchange
• taxes: corporate income taxes levied in the US (at the federal and state levels) and internationally.

The high operating leverage of Coinbase — a symptom of its high proportion of fixed costs, has meant that the company has experienced relatively volatile earnings in the past. I would expect that, as Coinbase continues to scale its business, the level of its operating leverage and earnings volatility will fall over time.

Taking into account all the above, I would conclude that the equity of Coinbase does represent a levered bet on the price of the underlying crypto assets traded / held on its platform. Whether that changes in the future will depend on Coinbase’s ability to scale its institutional and subscription-based service offerings and generate recurring revenues for its investors. To go back to our original question, one reason to buy Coinbase shares today (in favour of the underlying crypto assets) may be the belief that Coinbase will be able to execute on this aspect of its business.

That’s it for Part 2! In the next and final part, I use everything we have compiled so far to build my valuation model and construct an investment thesis for Coinbase. See you all there!

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Source: https://parkyeung.medium.com/coinbase-deep-dive-and-investment-thesis-part-2-6f1dfc170980?source=rss——-8—————–cryptocurrency