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AnalysisU.S.

Coinbase: A pick-and-shovel play on cryptocurrency

The gold rush in California in the 1840s inspired many prospectors to seek their fortune. Sadly, many ended up returning home with little or even nothing to show for theirs. However, the businessmen who sold the fortune seekers the picks and shovels to mine for gold made a very tidy profit without actually taking on the risk the miners faced.

To sum up, that’s the idea behind the ‘pick-and-shovel’ investment strategy. Rather than attempting to guess who will be the winners in a new industry that is full of uncertainty, an investor can instead invest in companies supplying the tools required for those striving in that new market.

Similarly, instead of investing and taking on the risk of cryptocurrencies (gold mining), investors can invest in companies serving the cryptocurrency market (selling picks and shovels). A great example is Coinbase, an exchange for buying and selling cryptocurrencies. By investing in a crypto exchange like Coinbase, an investor can gain exposure to the cryptocurrency market without needing to bet on riskier cryptocurrencies whose success hinges on mass-market adoption.

Business model

Coinbase was founded in 2012 by Brian Armstrong, an ex-Airbnb engineer, who initially wanted to help people easily store, send, and receive Bitcoin. Over the years, it has become the largest virtual currency exchange in the western hemisphere, with the vision to ‘create an open financial system for the world.’

Brain Armstrong. Coinbase CEO and co-founder.

Coinbase’s revenue comes from three main segments: retail trading, institutional trading, and subscription & services. The company makes 96% of its revenue via the first two segments. Subscriptions are still a tiny part of Coinbase’s total revenue, but it is an essential tool for attracting and retaining customers.

Retail and institutional trading

While the institutional segment generates the majority of trading volumes on Coinbase, the revenue generated from the retail segment far dwarfs that from institutions. In the third quarter of 2021, the average retail take rate was 1.1%, while institutional take rates were at 0.3%.

Source: Coinbase

Subscription & services

Subscriptions & service comprises the remaining 4% of revenue. This segment is driven by staking revenue (Coinbase takes 25% of all staking income) and custodial fees. Coinbase is currently the world’s largest provider of cryptocurrency cold storage solutions for institutions. They have built out a variety of services that are specifically targeted at banks and other financial institutions.

Economic moats

Regulatory moat

Coinbase prioritised regulatory compliance when expanding its operations, unlike many other cryptocurrency companies. As early as 2013, it embarked on a nationwide campaign to obtain licences for state money transfers, registered with FinCEN, and generally aligned with government agencies.

With various regulatory agencies tightening regulatory control on cryptocurrency, smaller competitors will have difficulty obtaining the necessary licences. Whereas Coinbase already has a team of regulatory-facing staff, lawyers, and lobbyists working with regulatory bodies.

Its regulatory-first approach extends to their global ambitions. Foreign governments are more willing to cooperate with Coinbase due to their track record of compliance. Coinbase is also the first company in Germany to be granted a license for cryptocurrency custody and trading.

Brand equity

Coinbase has established a strong brand in the minds of cryptocurrency holders due to its first-mover advantage and having a well-earned reputation for security. Coinbase is also one of the most trusted crypto exchanges in the U.S. market which has allowed the company to expand its customer base by attracting those who are unfamiliar with this asset class.

As the cryptocurrency space is still arguably the wild west, reputation is especially important for retail clients. On top of that, being publicly traded gives Coinbase additional transparency, credibility, and makes it more recognisable among investors.

‘The process starts with Coinbase’s brand, which we see as representing access to the cryptocurrency market for US and European investors. For retail, it represents simplified and intuitive access, and for institutional/corporate customers, it represents secure access and custody with the best execution.” JP Morgan’s research team

Market leadership

Coinbase holds US$278 billion in crypto assets as of 31 December 2021. With the total crypto market capitalization at approximately $2.3 trillion, Coinbase represents 11.5% of the entire crypto capitalization. (Imagine if 11.5% of all the world’s fiat currency were held at a single bank!)

Source: Coinbase

The crypto economy

While it’s too early to tell what applications and use cases will emerge to be most important in the coming years, right now we’re seeing the building blocks of what the crypto economy could be in the future.

As this occurs, an increasing number of people will enter the crypto economy, and I believe Coinbase will become a necessary tool as an on-ramp into this space. In a way, I think of Coinbase as a ‘tollgate’ of the cryptocurrency ecosystem. By the time, this system is widely adopted, they will be in a prime position to benefit.

The fifth perspective

What’s intriguing about Coinbase as an investment is that its current valuation isn’t exceptionally high, especially given its position in the rapidly growing crypto market. Coinbase is currently trading at a trailing P/E of 13.9 with an expected growth rate of more than 30% over the next five years.

Coinbase P/E with comparable businesses (as of 9 March 2022). Chart: YCharts

I believe Coinbase merits the attention of investors looking to explore the cryptocurrency market, but are averse to investing directly in cryptocurrency. Not everyone can be successful gold miner, but the business of selling shovels will never grow old.

Choon Leo Wang

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term.

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