Coinbase isn’t a shovel

I don’t like tech IPOs (or the nuance “direct listings” for that matter). Before delving into the Coinbase IPO and my thoughts on the company, I want to explain my overall concerns with IPOs.

An IPO is the process of a company listing on a stock exchange and raising fresh capital from new investors. In other words, there is cash flowing from investors onto the company’s balance sheet.

A direct listing provides a liquidity event for existing shareholders rather than a capital raising event for the company. No new shares are issued. The only exchange of cash is between new investors and existing shareholders who choose to sell.

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The stage before a listing: how do venture capitalists make money?

Venture Capitalists (VCs) make money by punting at ten companies in the hope that just one of them will turn into a unicorn (a tech company with valuation over $1bn).

It’s a shotgun approach of note and explains why you hear stories of pimply kids from Harvard raising gazillions of Dollars on the strength of a one-page business model. The other nine can go to zero and it still won’t matter, as the partners in the VC fund will spend their time choosing what colour stitching they want on the seats of their Lamborghinis.

Well, that’s what I would be doing at least. In contrast, many of the successful VCs seem to keep themselves entertained by tweeting about a coin with a dog on it while changing their Twitter profile picture to incorporate laser eyes.

More on crypto to come.

Venture capitalists aren’t good at sharing

In the world of finance, VC firms are the kids with only child syndrome who aren’t great at sharing their toys. In this case, the toys are profits.

I don’t mind new listings of companies that were built the old-fashioned way (by entrepreneurs using their own capital and bank debt) but such listings have dried up. Instead, VCs bring red-hot companies to market with great promises of growth and enormous revenue multiples.

In my view, the “readiness” for listing is an assessment by VCs on the risk-return profile. For as long as the returns are incredibly juicy, VCs aren’t going to share them with retail investors.

Why on earth would they? If the returns are so wonderful, why would the VCs be willing to dilute their holdings?

It’s not like there is a lack of funding available in the private market. We get all excited about Naspers and Prosus in South Africa but there are private companies in the US that are more valuable and still aren’t ready to come to market. Companies don’t need an IPO to keep growing in the US.

Instead, I believe that VCs bring these companies to market at a time when investors are so desperate for more tech investments that they will pay big multiples for them. The VCs only share their toys when they are bored of them.

Often, it’s too late

The problem in the tech space is that the lion’s share of profits goes to VC firms and a handful of institutional investors. The companies are brought to market once the party is largely over. By listing at an enormous revenue multiple, the VCs lock in massive gains and retail investors come in at a full valuation.

It’s great that the underlying company is growing quickly, but not if you are paying over 10x sales (and often much more). Retail investors are only allowed into this nightclub once the champagne specials are finished and the famous people have left the VIP section.

Occasionally, the little people can skip the queue.

Berkshire Hathaway managed to get into the Snowflake IPO in 2020 at a pre-listing price, generating a cute little profit for Berkshire shareholders (like me). It’s a rare example of retail investors being able to profit from an IPO, thanks to Berkshire buying a block of shares at a price far below those achieved on the first day of trade.

Buying into the hype is always dangerous. I prefer to let things cool off, allowing price discovery to take place over a few months. Once the hype dies down, a more reasonable valuation typically emerges.

HODL in a prospectus?!?

This brings us to an historic moment in the markets: the first public listing of a cryptocurrency exchange. Coinbase ($COIN) has officially listed on the Nasdaq.

Seeing “HODL” in the glossary of terms in a prospectus is peak 2021.

Whether you stick to the ultimate boomer coin (Bitcoin) or dabble in utterly ridiculous concepts like Dogecoin, you need a crypto exchange to help you get rid of old-fashioned money like Dollars and transform it into digital magic.

For all the fun I poke at crypto by the way, I think there’s an exciting future ahead for DeFi, smart contracts, Ethereum and the like. Unfortunately, nonsense like NFT artworks and canine coins do nothing to improve crypto’s difficult image.

None of this stopped retail investors and Cathie Wood (obviously) from piling into Coinbase at high multiples.

Coinbase isn’t a shovel

Coinbase is the largest cryptocurrency exchange in the US. It plays a critical role in the crypto boom by enabling investors and traders to buy and sell cryptocurrencies. The exchange also helps people stake or lend out their coins.

There’s an old saying that goes something like this:

“During a gold rush, sell shovels.”

In other words, when everyone is rushing for a particular asset, the best way to make money could be to sell the infrastructure that those people need. In that way, one is reliant on people chasing wealth rather than people successfully obtaining it. Betting on human greed sounds sensible to me.

I’ve seen some rhetoric in the market that compares Coinbase to this concept. Unfortunately, I don’t believe it is correct.

Coinbase is an exchange and a broker. It earns brokerage based on the value traded. If the price of cryptocurrencies keeps rising and volumes remain high, Coinbase will make profits. If the prices or volumes collapse, Coinbase will make losses.

The sale of the shovel generates a profit regardless of whether that shovel finds gold or not. Long-term of course, nobody will want shovels if the price collapses, but clearly it is far less volatile to sell shovels than it is to earn a share of the gold that is found.

Coinbase doesn’t offer shovel benefits. In fact, in the founder letter by Brian Armstrong (who is still the CEO of Coinbase) in the SEC filing documents, Brian states:

You can expect volatility in our financials, given the price cycles of the cryptocurrency industry. This doesn’t faze us, because we’ve always taken a long-term perspective on crypto adoption. We may earn a profit when revenues are high, and we may lose money when revenues are low, but our goal is to roughly operate the company at break even, smoothed out over time, for the time being. We are looking for long-term investors who believe in our mission and will hold through price cycles.”

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I’m not paying these multiples

The first quarter of 2021 saw Coinbase generate an estimated $1.8bn in revenue. Annualising that result suggests over $7bn in revenue, implying a forward Price / Sales ratio of around 9x based on the current market cap.

That’s simply too rich for my liking, especially given the underlying risks. At its core, Coinbase is an exchange and a brokerage. Neither of these are business models that I get excited about. In both cases, barriers to entry are relatively low and the fee structure is a race to zero.

Intercontinental Exchange ($ICE), which owns the New York Stock Exchange among others, trades at a high revenue multiple of 11.3x despite only achieving return on equity (ROE) of 11.4%.

Nasdaq ($NDAQ) achieves ROE of 15.5% and trades at a revenue multiple of 4.7x. Close to home, our very own Johannesburg Stock Exchange Limited ($JSEJSE – gotta love it) generates ROE of over 19% and trades on a revenue multiple over 4x.

Over 5 years, the share price returns for each have been:

  • NDAQ +143%
  • ICE +123%
  • JSE -31%

The best in this group, the Nasdaq, achieved a share price CAGR of 20% over 5 years. The Nasdaq-100 index achieved a CAGR of 25% over the same period.

So, due to its brokerage income, Coinbase isn’t necessarily the shovel that provides exposure to crypto with lower volatility. It’s also not clear that exchanges perform as well as the underlying companies or assets on the exchange, due to pressures on fees and low barriers to entry.

The ROE of mature exchanges in the market isn’t terribly attractive, so investors don’t seem to be buying a growth story that ends in either super profits or winner-takes-all economics.

Other people were happy to pay it

None of this stopped people buying into the story.

In recent direct listings on the New York Stock Exchange (including Spotify, Slack and Palantir), the opening price was on average more than 35% above the reference price. The reference price is provided by the exchange based on consultation with the investment bankers and the valuation achieved in private market deals before the listing.

The Nasdaq reference price for the Coinbase listing was $250 per share. It closed at $328 per share, 31% above the reference price. The next two days of trading saw it drop -1.7% and then rally nearly 6%.

It’s a trader’s dream. I’m an investor and I’m happy to watch it play out from the sidelines.

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  • TraderJoe

    Comparing a Coinbase to the Nasdaq or JSE is a false equivalency. Yes its a brokerage/exchange now, but the opportunity to diversify to other financial services (DEFI) opens the door to the entire financial sector. I agree that it’s currently overpriced, however using these simple CAGR multiples doesn’t paint the full picture and opportunity.

  • TraderJoe

    Comparing a Coinbase to the Nasdaq or JSE is a false equivalency. Yes its a brokerage/exchange now, but the opportunity to diversify to other financial services (DEFI) opens the door to the entire financial sector. I agree that it’s currently overpriced, however using these simple CAGR multiples doesn’t paint the full picture and opportunity.

    • The Ghost

      I agree it definitely has more scope than generic exchanges, but it also has plenty of competition. Will be interesting to see where the price lands – it’s traded down since the listing thus far.

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