Chit Chat Stocks - Coinbase (COIN) | Not So Deep Dive

Episode Date: January 11, 2022

Coinbase is a leading end-to-end provider for the cryptoeconomy. The company provides a platform where individuals can buy and sell a variety of cryptocurrencies. Listen closely as Ian, Brett, and Ryan go through the history, financials, and future prospects of Coinbase. Enjoy the show! This episode is sponsored by Commonstock, a social network for smart money investors. Check-out the platform here: https://commonstock.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Interested in more of Ian's work? Follow him on Twitter: https://twitter.com/IanGrayLive  Contact us: [e-mail] Timestamps Company Background | (3:39) Industry | (11:28) Management & Ownership | (14:15) Valuation | (20:02) Earnings | (21:25) Balance Sheet | (25:15) Our Analysis | (27:37) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. All right, welcome in. This is the Tuesday Not So Deep Dive episode. First one we're recording in the new year. It's 2022. It's been a while, so we're a bit sluggish maybe in the script here.

Don't blame us. It's been like three weeks since we recorded, but I'm really excited to talk about this episode, which is Coinbase. Ian, you're joining us today. You're more, I think, into the crypto economy without putting words in your mouth, know about more of that stuff than us. So you know about Coinbase. Can you kind of give an overview of what they're like? Not overview, but like how do you think of Coinbase when looking at them? Yeah, I would say it's, I would hesitate to say I'm more in the, maybe more in the crypto economy than you guys but i'm still very limited but that being said i think coinbase um from the way i look at it is kind of the gold standard bank for lack of a better term um it's not a bank but it's kind

of it's the it's the financial institution of uh cryptocurrency um as it stands today right and it seems like it's the one thing that if you think about uh cryptocurrencies anything about a company associated with it coinbase is likely the first company that comes to mind i'm gonna let ryan introduce the business but first i have to talk about our new sponsor that we have this year this is the first time we're talking about them we're very excited to have them join the show and it is common stock so today's episode is brought to you by common stock it is a social network for smart money investors which um we forgot to sound the alarm for the new new sponsor all right sound the alarm we want to put a yeah there you go thank you ryan it is a smart it's for

smart money investors which if you're you're not a smart money investor i mean what are you doing but it's more important than ever to find trustworthy information from people who actually know what they're talking about. Common Stock built a platform to show the portfolios, real-time trades, and analysis of the smartest retail investors. It lets people link their existing brokers to verify their portfolios and performance, helping you distinguish signal from noise. So if you're a retail investor, this can be a great place for you to post things. and it can also be a great place to read analysis with connected accounts to show people that actually have skin in the game. And it has a community of experienced traders that amplify

insights, trades. If you're more longer term, shorter term, whatever, you can find your community on there and you can see who the best performers are. And it can kind of show their track record over time. Someone has a great track record. They do a write-up. It's kind of like Value Investors Club or something like that. It's a fantastic service and it gives you an easy, connection to your existing brokerage account without having to move your money. So they can make it more of a social aspect, all those great things. So if you want to sign up for CommonStock, you want to visit commonstock.com today, commonstock.com. If you can't find them, make sure that- Yeah, there's also the app.

There's also the app. You can find them on Twitter. You can find them, reach out to us and we can connect them with you. It's a great service. Hope you'll try it out. All right, Ryan, do you want to introduce Coinbase? Yeah. And I'm going to preface this, by saying we are not brett and i specifically are not as up to date with the crypto nomenclature um and so we may uh so we might not know all the terms and we're not as just involved in i guess the crypto economy generally but we're going to try to look at coinbase from a business standpoint and from kind of our investing lens and so coinbase describes themselves as a leading provider of end-to-end financial infrastructure and technology for the crypto economy.

Basically, from what I understand, Coinbase is a platform where anyone can buy or sell a number of different cryptocurrencies or crypto-related products. It's basically the leading crypto exchange, as Ian touched on earlier. And they break up their revenue into two sources. So they have transaction revenue and subscription and services revenue. Transaction revenue makes up about 90% of their revenue, and it's comprised of three basic products. So, they have one, sending and receiving crypto, two, investing in crypto, and then three, spending it.

Transaction revenues are also split up between retail users and institutions. So, institutions tend to get much lower commission fees as they are typically transacting bigger dollar volumes. So, despite institutions accounting for 55% of the assets on the platform in the latest quarter, they only accounted for 6% of the total revenue. So if you're a retail user, that might sound a little concerning, but I think the commissions come out to like one and a half percent on average for retail users. I think that's what I saw from the Hayden Capital report on there, but it can range widely. Do you guys know how the transaction fees are, I guess, priced? I think it's just percentage of the amount. It's not a dollar figure?

I think there might be a minimum. Ian, have you used Coinbase? you know, I have used it, but it's been a while. I was just checking it right now, but it's, it's basically, um, a percentage base, but it drops in a percentage based on how much you're, uh, transacting. Right. If it's like a thousand bucks, it might be, it might be less. Yeah. All right. Okay. And then the subscription and services segment is a little more diverse. So these products include, um, and get ready for some maybe unfamiliar terminology. Uh, The products include distribute, pay, store, save, staking, borrow, and lending, and build.

And I spent some time researching all of these. And I could explain most of them, I believe, now. I think I'm in a position to do that. But it's really probably not worthwhile, judging as they are such a small portion of the business currently. And so, I would say the majority of the subscription side comes from the services that they add. uh so including things like coinbase pro coinbase prime and well they just launched coinbase prime and coinbase cloud which we'll talk about but then staking is also a very big portion of it um but once again small portion of the overall business and we'll touch on some of the coinbase

prime coinbase cloud stuff and future growth opportunities history of the business though brian armstrong is the ceo today he originally came up with the idea for coinbase while he was working at Airbnb. So Airbnb launched in 2008, and he was hired there as one of their early software engineers. And while he was there, he came across the Bitcoin white paper in Hacker News. And apparently the paper struck a chord for him. And he kind of grew fascinated with the idea. And so in 2010, he started working nights and weekends on what was basically a Bitcoin wallet. And he wanted to go through the Y Combinator program. I think he applied there and they basically said, you got to go get a co-founder. He searched for one. The first one didn't really

work out. And then he ended up finding a second one on a second try named Fred Ursham, who ended up being that Y Combinator co-founder for him. And there wasn't really that much traction at the start because it was just designed for storing Bitcoin. But after talking to customers, they added the ability to buy or sell. I know it sounds like buying and selling would have been the obvious thing to add at the start. And he talked about that, but he's like, we didn't think about it until the customers told us and he said as soon as they added that feature they started to grow really really quickly um and they also the company was known as bit bank at the time but a y combinator lawyer said uh apparently told them you're not allowed to have

bank in your name unless you're technically like an actual bank do you guys think that was a good name change i think it was what about you i don't know you know if if if they were allowed to have banking their name without being a bank i kind of you know bit banks probably bank yeah that's not bad coinbase though like it's your coin base like that that's just so good he said he wasn't sold on the idea he said he wasn't even sold on the name for like the first two years and then he's kind of like well it's you know i think their name is one of the big parts of their like success because people just understand it so easily yeah although crypto.com is going way bank be the same yeah but what's no one knows bit is like what is bit bank like it could not be bitcoin you know

what i mean like bit is very vague it doesn't have to be bitcoin but like crypto.com that's just going flat out like boom like all right you know what this is i'm sorry right and what do you think of the name yeah i think the name um like bit bank is a little more interesting and uh a little more fun maybe but coinbase i think has probably been better for the long term especially as it has expanded. And there's so many cryptocurrencies out there. And so it's not kind of tied to the Bitcoin nomenclature. Right. Interesting. Yeah. And after, I guess, after a few years, they had amassed close to 200,000 users and they started encountering two big problems at this point. So there was fraud and then there was the working

capital issue. So the fraud part early on with Bitcoin, apparently a lot of like stolen credit cards. People would log in, buy Bitcoin, then move it around. They would basically get it out. And then Coinbase would be on the hook for the cash that was sent out or spent or whatever. And so this became a huge problem for them, obviously, and it's kind of hard for them to tell. And so this was a big point of focus. They spent a lot of time trying to put in, I guess, hurdles to limit fraud. And so they haven't really had any security problems since then that I'm aware of, no security breaches. So they've kind of been a good trusted brand in crypto because of that. And then the working capital part, they had to pay in Bitcoin to

the users when they bought, but then they had to sometimes wait five to six days before the cash actually was like transferred because they had to go through like traditional banking processes. If it was over the weekend or like a holiday, you sometimes had to wait like a really long time. And so this became a huge problem for them, obviously, because Bitcoin was very volatile and they can kind of be on the hook for that. And they were able to things, I guess, helped them. They were able to get insurance on it. And then secondly, they were able to raise their series A, which kind of gave them enough cash to not be so worried about that. And then I would also say that go listen to the how I built this with Brian Armstrong.

He really details all this pretty thoroughly, and it's kind of fun to hear from his perspective. But since then, they've obviously added tons of different cryptocurrencies, tons of different features, and they went public in April of 2021. So we're lapping, I want to say, nine months now? Yeah, basically, yeah, they're not a new IPO anymore. They're kind of hitting like standard. No 10K though. No 10K yet. Yeah, they went right after that period of when you'd want to file one.

I'll hit industry and competition. Pretty simple. If you're looking at Coinbase, what matters is the size of the crypto market cap and how much people are transacting. And I'm sure we'll talk about that maybe in the earnings too. But the crypto market cap, it hit around $3 trillion at some point in 2021. Now it changes a lot every day. I mean, sometimes 10% a day, usually less, but it changes a lot each day. And I guess Coinbase is kind of part of the reason for because people are buying and selling. So you really want the industry to be bigger. And you also want for Coinbase's perspective for people to be transacting as much as possible because that's where they earn their fees. Now with services and subscriptions or basically non-transaction

part of their revenue, there's a bit of a different industry with that. And I would look at say the DeFi stuff, which I don't know much about, but it's growing really quickly. There's infrastructure stuff for Coinbase that they provide. Those are separate industries, but really right now I would look at the size of the crypto economy and that's kind of what you need to look at for their industry. They're estimated though to have slightly less than 10% of total crypto assets at Coinbase. So they're one of the largest holders, probably the largest holders in aggregate. I mean, I know they're holding it for third parties, but they're the biggest, I think at about 10% of crypto assets. So quite large competitors, quite a few of them, FTX, crypto.com, a lot of

the DeFi stuff, which always have the craziest names. I think one that's coming to mind is what like SushiSwap, which you might laugh if you have no idea what this stuff is, but yeah, the DeFi stuff, I guess is competitor. NFT marketplaces, like what's it called? OpenSea. I guess that's a competitor, but we can talk about this later. Coinbase actually owns a lot of a stake in a lot of these companies, they own some stake in OpenSea. And I think maybe some of the other stuff as well. Facebook could potentially be a competitor because they're launching DM. I think they launched in one market that could be a competitor for transacting and stuff, but with investing, not so much. And then the last one I have here as a joke is the Fed.

They can be a competitor if they launch the standard, whatever, what are they called? USD? no, what is it called? Standard bank, digital, no, no. Central bank, excuse me, digital currencies, whatever those would be called. There's the rumors of those might come out, which could potentially disrupt Bitcoin. And well, I don't want to say that. Don't get mad if you're a Bitcoin guy and I just said that, but it could potentially disrupt some of the market. I know a lot of the crypto people hate central banks, so it might not actually disrupt it, but that's a potential threat coming after all the cryptocurrencies. All right, management and ownership. Ian, what do you got for us? Yeah, first, I'm going to just do a quick clarifying note on

the transaction fees. So what Coinbase says about the transaction fees are, quote, fees are calculated the time you place your order and may be determined by a combination of factors, including the selected payment method, the size of the order and market conditions such as volatility and liquidity. So for retail accounts, it's a little bit opaque about exactly what you're going to be paying in fees for Coinbase Pro accounts, which are their subscription product. If you subscribe, then they have clearer guidelines about what the fee levels are at different breakdowns and things like that.

But on to management and ownership. So as Ryan was talking about, Brian Armstrong is still the CEO. They've got a relatively new, I think in the last three years, COO and president named Emily Choi. She was previously at LinkedIn. I think she was at Yelp before that. She seems to be kind of more the operator type person. So Brian's visionary personality, it seems like Brian's kind of more of a big thinker, big ideas, looking to push the company forward. And it seems like Emily has come alongside to kind of help just execute on a lot of this stuff. Brian has kind of been

in some controversy at different times. One of the things that came out back in 2020 was he wrote a blog post that he titled Coinbase is a mission focused company. And it was in response to a lot of the kind of political unrest that was going on at the time and COVID. And he was starting to worry that his company was getting dragged down into some issues that weren't really part of its mission. And so he wrote this blog post that was somewhat controversial that we're going to be a mission focused company. We're going to focus... Our best way to impact the world is to focus on what we do really well and everyone else can kind of pursue their political aspirations outside of the company but while we're at work it's it's about um our collective mission and that um he

says that went over well with most of the company and that some people left but they've moved forward stronger um there's been some at the time there was some backlash but that seems to have subsided um there's also a twitter thread he wrote a couple months back that kind of started with the the phrase, some really sketchy behavior coming out of the SEC recently. And he was basically upset that they were, with some of the ways that the SEC had interacted with Coinbase regarding their, basically their interest accounts, and that they wanted to launch some products that were similar to some competitors. And the SEC wasn't being very helpful with that. I think it does kind of, it's an interesting spot that Coinbase is in because

it's kind of what Reid Hoffman calls like the pirates to the Navy, I think. And he talks about it with Uber that originally you're kind of the pirates and you're doing everything. You're out in the wild west, you're breaking the rules, all that type of stuff. But eventually you have to transition into the Navy and that we're actually working with the government. We're working with the regulations and we're helping to set the regulations. And Coinbase seems to be in that phase where it was kind of on the cutting edge of a lot of stuff, but now it's at the top position and is looking to kind of build good regulations and be a partner with the SEC and some other things. And that it really benefits Coinbase, at least from what I can tell from what Brian

Armstrong thinks, that it will benefit Coinbase if the SEC issues clear guidance and enforces the rules. Then they'll be playing on a level playing field and they'll probably have a better ability than some of their other competitors to actually meet the guidance because of their resources. Just a couple more little notes on Brian Armstrong quickly is prior to Coinbase, he actually had a tutoring business that I think was called Tutor Connect. And it kind of made a little bit of money, funded his life, but didn't have the runaway potential that he was looking for. And as Ryan was talking about, he was really early in crypto. It's hard to remember, but crypto wasn't a part of everyone's thoughts in 2010 and 2012. For as big as it is today,

it was back in 2009, crypto literally didn't exist. So pretty crazy stuff to think about how far it's come in just a relatively short amount of time. He owns about 16% of the company, which is a little over $8 billion. And Andreessen Horowitz, one of the early investors, is the second largest holder with about 6.5% of the company. I think we may get into this a little bit later, but he also, he received a pretty big equity grant in the last year. So you'll see some headlines about that, about bringing in about $60 million in compensation. So definitely highly compensated, but they've been doing, they've been doing a pretty incredible job so far. Yeah. One thing you can say about him is he, or can't say about him as he doesn't have skin in

the game. Definitely has a lot of skin in the game with Coinbase. I think with that tweet, whoever approved him to start, started off with some sketchy behavior coming out of the SEC, See, that just ruined the rest of it. Like when you see that, you're like, who is this clown? But it was actually not that bad of a thread. Like it's just that starting point. You're like, what are you doing here? The other thing is he has talked about before how he kind of prides himself on or Coinbase prides itself on being friendly with regulators and like trying to be sort of this bridge between a quote unquote new financial system and the legacy one.

and to start the tweet with that just seemed counterproductive to being friendly with regulators true that's supposed to be part of their moat is that they are the one that's actually going to be legit instead of these kind of crazy offshore things that a lot of people do but let me hit valuation so we get going here market cap 50.4 billion dollars ticker is coin so just coin Good choice. Nice choice there. Very memeable, I guess, if that's your thing. Enterprise value is $47.4 billion, approximately.

They got a lot of weird crypto assets on their balance sheet, and they got customer payable stuff. So make sure to not include that with it. But I think it was about $47.4 billion. EV to sales is $8. EV to operating income of $14.8. So margins are really, really strong. And the valuation doesn't look that...

it looks really cheap, but you got to remember there can be some lumpiness. We're right into a huge crypto bull market right now. So operating income like Rhino get into has soared. And that's part of the thing here. And they are very profitable. So enterprise value is something I'm going to use here. Operating cashflow is going to look inflated. So I would do something where you do operating cashflow, but then X out their change in operating assets, because that can go up a ton. If people deposit, Ryan can get into that. They have around 50 million options in RSUs outstanding versus a share count of 215 million. That's not good from an investor and outside investors perspective. So I'd expect dilution. I'm sure we'll talk about that in

highlights and lowlights as well. All right, Ryan, do you want to hit earnings? Yeah. And I'll give, it is as Brett alluded to, it's very lumpy. So they're some of the year-over-year numbers look a little insane. And then the quarter-over-quarter also look insane. So I guess try to take a long-term view. They had $5.9 billion in trailing 12-month revenue. That's up 600% from Q3 of last year or for the trailing period. And they are profitable, as Brett mentioned. Over the last 12 months, they've generated $3.2 billion in adjusted EBITDA. That's a 54% adjusted EBITDA margin, but they've spent 590 million on stock-based compensation over the last 12 months. So the way I'd go about it is I would take adjusted EBITDA, back out

stock-based compensation as probably a useful metric. Yeah, EBITDA is a good metric for them because they're not going to have too much depreciation. They did have some long-term debt on there. So there will be some interest expense, but their depreciation and amortization was negligible. And I think Ian's going to talk about the balance sheet here. So just there is some interest expense. But the reason the cash flow is kind of wonky is in Coinbase's working capital, they have to account for custodial funds. And over the last year, there was a huge influx of assets onto the platform. So a lot of people moved money. Maybe it was the stimmy checks. Maybe it was just the excitement of crypto at the time. But a lot

of people move money on there. So there's this huge increase in custodial funds, which isn't actually theirs. And so that makes operating cash flow look way higher than it is. So for reference over the last nine months, it shows $7.7 billion in operating cash flow, but $5 billion of that was an increase in custodial funds. Still generating cash, but not as high as it seems. Yeah. I would maybe just, as Brett said, I'd go operating cash flow minus changes in working capital as sort of a metric to use. And assuming that there's some sort of stabilization and there isn't this continued influx, which who knows what's going to happen, then maybe it'll get smoothed out and it'll be kind of normalized. Yeah. And the reason this company specifically,

I think not including the working capital is smart is because it's not predictable what their working capital would be. For example, Amazon has had a great working capital advantage that has grown over time. So using operating cash flow seems like a better metric for how much cash they have to reinvest in their business because while maybe not permanent, it's very predictable what their working capital deficit will be or not deficit, however you want to talk about it. And then another one, like a manufacturing company, it might be the opposite where you want to include it because they're always going to have that working capital headwind against them, if that makes sense. Sorry, Ryan, continue. Yeah. And I would just say either way,

No matter how you back out the numbers, you're still getting around 40% to 50%, maybe even 55% earnings margins on that revenue. So pretty impressive profitability. And then in the most recent quarter, they reported 7.4 million monthly transacting users. That's up 250% year over year, but down 16% from the second quarter. And I do think they report overall registered users, but I think the most important is monthly transacting because there could be a whole bunch of idle users with empty accounts, which I imagine there is. So just pay attention to the monthly transacting. Trading volume is also up substantially year over year, but it's down almost 30% quarter over quarter. And keep in mind, the majority of their revenue, 90% plus, still comes from fees on transactions.

So it's going to ebb and flow with the amount of transacting users and just the volume that's on the platform. Yeah, and the size of the crypto market. So if stuff's worth more, then that percentage will be higher. All right, Ian, you want to hit balance sheet and liquidity? Yep. So Coinbase has $6.3 billion in cash on the balance sheet, and that's cash that they can use for operations. They've also got some other cash items that I'll mention in a second. But in May, they issued one and one and a quarter billion, half percent 2026 convertible notes.

So those those notes, low interest rate, but are convertible 2026 date. They issued $2 billion, $1 billion each of 2028 and 2031 notes, senior notes at 3.375% and 3.625% respectively. So, you know, a reasonable interest rate, especially at the time. They probably looks good in a rising rate environment. So they really kind of added, you know, over $3 billion in cash to their balance sheet through financing, debt financing in this past year. And I think they're probably gearing up for really to try and solidify their spot. And the balance sheet is kind of proof of that. They've also got a large line item called customer custodial funds.

And this is the funds that Brett and Ryan were referring to. It's not cash that the company can use for operations, but they do earn interest on that cash. And so it does have a little bit of a benefit to the company. they've got nearly $9 billion in these customer custodial funds, but it only generated about $8 million in interest income last quarter. So fairly nominal. But it could become a little bit more meaningful in a rising rate environment if they started being able to earn a higher yield on that $9 billion, or if they continue to grow the cash and custodial accounts. So it's something to keep an eye on. I don't think it's a major part of the business, but

you you will want to make sure that you're not including that cash number um and the idea of like what they can use for acquisitions or what they can use for operations or things like that the other thing if i'm not mistaken they added like 500 million dollars in bitcoin to their balance sheet too didn't they didn't they announce that i didn't see it on the balance sheet uh yeah it might have been not classified as like bitcoin i think it was there i can't remember exactly small amount right in something like that i think yes they do have some crypto holdings on the balance sheet and I'll I'll flip those maybe we'll talk about that after the break okay yep let's take a break and we'll get back and Ian will update us on that this episode is brought to

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welcome back next up we have anecdotal evidence but ian do you want to give the exact number on their crypto holdings on their balance sheet yep so they've got a little over 800 million in crypto assets held. That's broken up into about 200 million of crypto assets that are held as investments, around 200 million that are held for operating purposes, and around 440 million crypto assets that are borrowed. And so that's up, and this was as of September 30th, 2021, that's up from 316 million in crypto assets in December 31st of 2020. So nine months later, they've almost tripled the amount of crypto assets that they hold. Yeah. And I think they said they want to accelerate that or something. I don't know.

Armstrong has been talking about that a bit. They've gone a bit down to the square slash block, I guess now route, where they're trying to put that as a little bit of a cash replacement on their balance sheet. I'm sure people have opinions on that because it does that a little bit more risk, but it's interesting nonetheless. Let's hit anecdotal evidence next. Ian, uh what have you had any interactions with coinbase in the past how has your experience been with it yep i bought about oh not very much very little bitcoin i think it was like 200 worth or something in 2017 and i had researched and tried to figure out what's a legitimate place to do this because even in 2017 there wasn't a whole lot of information out um it's not like

it is today where everyone knows about crypto and stuff like that and so i looked around and i was like okay where's a legitimate place that i can actually buy crypto and that i'm not worried about like getting stolen or not being able to figure out how to access it or something like that what's an easy way to do this and coinbase appeared to be far and away the most legitimate and easy way to do it and so um that's where i first bought bitcoin i bought a little bit of ethereum there a little bit later and then uh in 2020 i moved i moved the ethereum and bitcoin out of coinbase um into blockfi to start earning uh some yield on it just because it seemed like a decent opportunity but can you not earn yield in coinbase you couldn't at the time

they have been that was actually what the um they're in the process of adding that i think they do have it now that was part of what was the subject of brian armstrong's tweet thread um that i mentioned earlier and so they have been i think they have added it i think from what i can tell their rates are generally lower than the rates at other places which is probably a good thing because it's um i assume it's a little bit more sustainable but that's that's been my experience so far yeah the rates are high sometimes which is interesting uh ryan what is what's your experience with coinbase uh i i think i do have an account because i get emails all the time that are like fund your account and i'm pretty sure it's just like an empty idle account but uh i

if i were going to buy crypto it would probably be through coinbase for me and i think probably for most people the big thing is there's a lot of froth in the quote-unquote crypto economy or or i guess scammy stuff that goes on and if you think there isn't scammy stuff just go look at any one of elon musk's tweets and just go into the comments section and you're gonna see what i'm talking about um but it's uh the one thing for me is trust and security uh if i were going to do it and coinbase seems to be the place for that um i guess maybe i'd use the cash app just because it's convenient and it you know there's another business beyond that but yeah probably those two are the top yeah yeah yeah yeah anecdotally for me cash app maybe is more

well you can only buy bitcoin which i guess is probably negative for some people but it's more more uh easy to connect back to the real world quote unquote and get back to say like spending money with stuff where you can go back to you know cash right away with coinbase it's a little more difficult i know they have a debit card and stuff like that but that might be the downside there but for me it seems like the most reliable i used to use it back in the day um when i bought some bitcoin i forget what year it was uh it's a it's very disappointing has a history with everyone yeah well you know i don't like to think about it because the amount of money i would have made would be not like life-changing, but it would have been quite a bit. I'm sure Ian would be in

the same boat if you were in 2017 as well, which can be, well, you may be holding on a little bit longer than I did, but it's a bit disappointing to think about sometimes. But yeah, I mean, I'd use them. The fees are high, which was the one thing that had me down, but everything else seems so much riskier, like you guys alluded to, that I think I'd probably eat the fees. And that's kind of what people's bull thesis seem to be. All right. Future growth opportunities. Ian, what are your thoughts? You had an interesting one here, huh? Yeah. So first, I want to mention the Coinbase NFT marketplace. They're planning to launch that very soon. And you can join a beta list right now. It's supposed to compete with OpenSea, which is the big NFT marketplace right now. And that's something that I think a lot of

Coinbase investors are excited about and that Coinbase itself has been pushing a lot recently. That being said, I actually want to talk about smart contracts. I think that's smart if if coinbase could create a platform that helps people create their own smart contracts i think that just everybody know code that everybody can just create their own smart contracts through these various protocols i think that would be a really interesting use and i think coinbase is in prime position to be able to have users do that the problem is then you start getting into some weird securitization uh you know laws and regulations If all of a sudden I was trying to do a smart contract with you guys that was based on the price of Coinbase or something, we were going to enter into some sort of derivative contract basically together.

We could do that through smart contracts, but then it becomes, like I said, then it gets in this gray area about securitization. So there's a lot of regulation there, but I think that that's something that's interesting. And I was actually just looking at the Coinbase app today. I pull it up every once in a while because they have those earn things where you can learn about the cryptocurrency and earn $3 in it or whatever. And so every once in a while, I'll go through and do one of those when they get it. And so then I'll have all these $3 of these random cryptocurrencies. But one of the things that I noticed when I got on today was... I'm trying to see where it is now. But on one of their tabs, they had a little thing that said on their trade tab in the categories, they had smart

contracts and it's not, there's nothing there except it shows what type of assets are smart contracts, which are the protocols. And so Ethereum, Solana, Cardano, one called Polkadot. So there's a number of them that are, you know, blockchain networks that can run smart contract powered applications and protocols. I think it's, I don't know, it just, it got my mind thinking that if you could actually just get on here and make your own smart contract, that would be pretty cool. And I don't think they're probably that close to it, but it's something, um, that I think is potentially down the line. Um, I think you guys have had a couple of the more relevant timely ones, but it is, it's a, it, the, the NFT marketplace and the smart contracts seem like a

great place for them to be. Um, and it's little risk to them as the marketplace. Could you explain a smart contract for anyone who like doesn't understand it that typically isn't listening explain it for a plan for someone that doesn't know anything about crypto yeah so i know we're putting it on the side i'll probably butcher this a little bit but but basically the idea of a smart contract is that uh the buyer and the seller of the contract can can code some conditions and that the contract will automatically execute based on those conditions. So if I say, like, if I coded a contract with you that said, if this podcast hits a million views, you'll pay me $30.

It's tied into whatever the data source is for that. And once it sees that it's clear, then it's coded into the money that it will automatically give me that $30 of Ethereum or Solana or Cardano or whatever it is. And so the idea is it's trying to create zero trust contracts that are unbreakable and are based completely on the data and you don't need escrow or banks

or anything like that as intermediaries. But you could do it about anything. You could do it based on the weather. You could do it based on traffic patterns, sports betting. Yeah, that type of stuff. So essentially no takebacks, just no takebacks. Yeah, exactly.

Yeah. All right, Ryan, what do you got? Mine's Coinbase Prime. And I should also note that all three of these came out, they launched all these in the latest quarter. So it seems like a pretty big quarter in terms of product launches. So Coinbase Prime, this is basically the institutional interface for advanced trading. So for simplicity purposes, I put Think Interactive Brokers for crypto, or maybe what's another good one? Bloomberg for crypto.

No, Bloomberg you don't trade. it would be like prime what are the prime broker i mean like the banks are the prime brokers or something like that i mean ibkr is kind of like probably the best example okay uh and they added in their announcement that they said in quotes we will continue investing in the future of institutional crypto by building on these services and launching a mobile app that enables portfolio access and collaboration on the go i just like that they're leaning into the institutional side But I have to admit, I don't have a great grasp on the competitive landscape for institutional exchanges. Yeah, when I did research on it, I think FTX is a big one for professionals and more complicated trading.

So they're trying to move into FTX's territory where Coinbase is traditionally for maybe people like us who don't know anything or retailers versus FTX was more for those pro guys. They're trying to eat into that market a bit. Okay. I like anything that diversifies the business away from purely transaction revenue on Bitcoin or crypto. That for me is where they have to head to build some durability outside of this reliance on the crypto market. Yeah. All right. I'll hit minus the Coinbase cloud. I heard it described as the AWS for crypto infrastructure. And that's a red flag whenever I hear someone call something the AWS of something, because no one's actually doing that. Like it's, I don't know. It's like when someone says the Airbnb for something,

typically that's a bit of a red flag, but it really goes under their other services revenue, small part of their current revenue right now, but it's growing really quickly. So this is kind of like, if you listen to our SoFi episode, or if you know that market, it's sort of like their Galileo product where Coinbase has APIs to help people build other crypto projects very easily. I guess another easy comparison is Twilio. That's the best one to do. That's easy to understand for something like that. Think of that. But with crypto stuff, they bought a company called Bison Trails, which is a crypto company for almost $500 million to help build out this. So they're really investing heavily into it. And they kind of

to enable other people to build crypto projects not on top of coinbase's retail app but on top of the infrastructure they've already built one of the interesting things about them is they are basically like the comparison is they are if schwab or excuse me one of them if nasdaq and charles schwab were the same company so they're so vertically integrated that they have all the whatever, exchange needs, everything is basically in-house. So if you outsource that to someone, it can easily build another project on top of it, among other things that they can do as well with the scale of their company. But this line item went from only 0.6 million in revenue last year in Q3 to 8.6 million in this quarter. So it's growing rapidly. It seems like it has a lot of

promise. And that would be another way to diversify away from just 1% transaction fees on retail crypto customers all right highlights and low lights in what do you like and dislike about this business the highlight for me is that the company's in a great position and it's trusted i think that it hasn't had a breach and that people can trust that their uh cryptocurrency is safe at coinbase is probably the biggest competitive advantage in this industry it's a growing industry and i think they also have the tailwind of a lot of talent moving toward it i there's a lot of engineers who are interested in uh in cryptocurrency and blockchain and nfts and by being at the cutting edge of this i think that and being in the the kind of at the front of

the pack as uh the leading company i think coinbase benefits from a lot of talent moving towards cryptocurrency the low light for me is i i don't like that fees are still making up the the vast majority of the business. I think that Coinbase has to watch what happened in stock trading and how commissions went to zero and find a way to be like Schwab, where they had many value ad services around trading and that trading was just one of the things they did, not the thing they did, and not be like Ameritrade that ended up getting taken out by Schwab or acquired by Schwab because it was so dependent on trading revenue. So I think Coinbase needs to be in the position of power and not the position of weakness over the next five years.

Yeah, I think I agree. Ryan, what are your thoughts? Yeah, I'd say the good thing on commissions for the time being is that users don't really care about a 1% transaction fee when they think the coin will 10X or 100X or something like that. Whereas stocks, it's just a very different mindset where it's like, all right, I'm going to try to get a 15% annualized return. oh i don't want to pay a two percent commission or whatever um it just it seems like just the the

mindset going in feels very different but highlights for me uh coinbase spends less than 10 of revenue on sales and marketing i would not have guessed this at all uh because i see their ads before youtube videos and stuff all the time but well you're the target mark yeah i suppose yeah young man they continue to grow their mark despite having less than 10 of revenue being spent on sales and marketing they continue to grow their market share across all crypto exchanges i think there's a huge network effect built on jealousy or maybe envy um if you make money here so you know people see like oh he made money on coinbase i'm going to go download coinbase or people share it like it's one of the biggest i feel like network effect areas well i

Well, I wouldn't call it a network effect because it doesn't improve the product when another person comes on. It's more of virality. Okay. The viral nature of the business means that they don't have to spend much for future users to onboard. They're also extremely profitable. And I think they could have 70% EBITDA margins if things continue to go well. Yeah. And I mean, I would love to look at Crypto.com's financials because I think that would be the exact opposite, like hemorrhaging money and spending 200% of the revenue on marketing, something like that.

Yeah, it really, it surprises me. I would have thought they were spending just more on sales and marketing to begin with. But low lights for me, and I think this is a low light that comes across for all of us, is right now they are completely reliant on the overall success of one Bitcoin. They are tied to Bitcoin's price. And this is something that they've been completely candid about and then crypto overall. And so you have to be very comfortable with that bet. And the other thing is crypto can drop 16 or 15% in the middle of the night, you know, so it's one that's not easy to sleep with.

And so I guess that's just something to think about as well. Yeah. And I wonder what their sales and marketing spend would be. a bear market well i mean maybe they got back i don't know 2020 i guess it then wasn't that bad but like last year it stayed it was like five percent of revenue and they had you know uh one sixth of the sales right but they they went through if they wanted to grow yeah if they wanted to grow quickly though they would definitely would have to spend more in marketing but i guess you know they were just choosing to be more uh conservative um all right my highlights

established brand, like you guys said, locked in millions of users, great unit economics. The moves to the ancillary products definitely makes sense if you're bullish on crypto. That's the big holdup, like Ryan was saying. But if you are bullish on this stuff, it seems like what they're doing to make it sort of the API stuff is a fantastic idea. The carrying value of some of their strategic investments could be much larger than what is carried out now. So right now, it is marked at $269 million. But for example, they invested in OpenSea, and that just got marked up at $13 billion from another investor. I don't think OpenSea is worth that much, and that's definitely bubbly. But the value of all

these investments they made could be a lot larger than they actually are. I don't know what their ownership stake is in OpenSea, but it's definitely worth much more than $200 million now. Low lights though, and this comes back to the investments, is they have marked up their own book a lot, which is not a big deal, but it's kind of a negative for me. Like, I don't know, are you trying to fake the profits? Like when they invested in bison trails and then they bought it out, marked up their own book. It's a small low light. Oh yeah, you have to, but I'm just saying it's a way to inflate what your profits look like. It's not a big deal. The other things are more real low lights for me. I mean, the reliance on transaction fees, like you guys said,

and then the unproven industry, which is the elephant in the room, like Ryan mentioned. Let's see. I talked about the bear market, S&M spend. The only thing I've mentioned that we haven't talked about yet is the CEO performance award. It really left me queasy. I don't have the exact details on it, but they did it before the IPO and it had a ton of, it was worth like three, 4 billion, I think. And the last tranche was a $400 share price, I believe. So they basically got most of them right around the IPO time. And Brian Armstrong, who already owns stock worth like $10 billion, I think, maybe it's a little less now. He was getting a billion dollars. Why did he need that? It may be very uncomfortable with him as a manager, I'd want to

back because it kind of reminds me of the quote from, and I'm bringing up Munger and Buffett, but I think it was Munger that said that if you're in a position to give that money, it's not always the right move to get it, even if you can. Like if you're in those positions of power, you have a moral obligation to take lower than you could get just because you don't necessarily need it. And this type of CEO performance award, especially for a founder who already has such a large stake always raises a red flag to me that maybe they're greedy and they're thinking about themselves more than the shareholders who it's affecting. That is, yeah, that does kind of make

me sick because you're the largest shareholder. If, what could the company have done with that cash? Exactly. I mean, it's not, it's not cash, but it's like, you can sell out like it's dilution. With the value that, that was rewarded to you. Yeah. Like, I don't know. It makes me sick. Like that's just uh i just don't like it personally it's not going to change the company from investment perspective but it's probably the biggest red flag for me outside of the crypto stuff in general all right i'm talking too long let's move to bull case ian what's your bull case for uh coinbase my bull case for coinbase is that crypto is just the beginning of coinbase it's the first iteration and that it becomes uh somewhat paradoxical centralized

decentralized finance that it is the the bastion of uh respectability and um and the financial institution of decentralized finance which i think is like i said a little bit of a paradox but i think that's the bull case for coinbase uh ian bringing out the big brain today huh the uh with yeah sorry that just made it remind me that that i mean ryan what's yours uh well i think the bull case is, I guess, pretty obvious is that the overall success of the crypto economy continues and more money flows into it. If that happens, I assume Coinbase, as the trusted brand, will succeed. And at an EV to EBITDA multiple of like 13 times, which first of all, it's way more exciting to be doing these shows when these valuations look as reasonable as they do. And EV to EBITDA

of 13 times the ceiling for this is really high if the money does continue to flow into crypto yeah but i would hesitate and say that's trailing what's the forward there's a lot of variance on that well i've got my bear case too all right yeah my bear my bull case is uh crypto goes whatever goes burr like like with like the mean is the that's all you need that's i mean that's kind of your bet you're making it seems like a better investment to me than going along bitcoin because you're diversified you get the exposure and it's a lot more profitable like i right am i getting that like am i am i thinking about that incorrectly like why would you own bitcoin over coinbase on both if you're interested i think you yeah i think the reason to own bitcoin would just

be more of a uh bet on on bitcoin uh what's the word more concentration right that you don't want the diversification of all the the other coins that bitcoin or that coinbase is dependent on and you can just okay that bitcoin is going to be the one true winner in the cryptocurrency space and i kind of prefer that because that's what dorsey's basically done is he's taken this like purist approach where it's like there's there can only be one the one true yeah the one true coin one coin to rule them all i don't know all right bear case ian what's your bear case the bear case for me is that crypto cat crashes while coinbase is still largely dependent on fee revenue that they're not able to build out enough of these ancillary services and and spread their wing

or spread their tentacles into other parts of the decentral decentralized finance um world and so that if crypto crashes and you lose a lot of that inflow of funds and transaction fees fall apart or fall off the cliff that um that it's very damaging to coinbase yep and just remember that it's a percentage of transactions so if the crypto market cap crashes 80 that crushes their business All right, Ryan, what's your bear case? The bear case is that we hit a peak in the crypto economy last year. And I know crypto believers probably just rolled their eyes, but let's look at what happened last quarter. It was, you know, a falter in the crypto space and Bitcoin in general is detrimental to Coinbase's business.

There's no getting around the fact that the two are tied at the hip. So being as reliant as they are on transaction volume, a big decline, that's the bear case for them. And as Ian said, if that happens before they are able to diversify their business, then they're really screwed. Yeah. And is it a catch-22? Could they even diversify their business if crypto goes bust? So here's the other thing is the Coinbase, I think it was like the, I forget where I saw it, but the subscriptions revenue declined in tandem. Everyone's like, well, subscriptions revenue will give them some sort of a steady stream of income,

but it declined in tandem with transaction revenue. Yeah. Not exactly like for like, but I think it all goes bust if, if, if one of them does. Yep. And that's my bear case. Crypto goes bust. Let's move to more or less interested in what are your final thoughts here? I'm slightly more interested. I think that Coinbase is going to go onto my watch list, and I'm going to keep an eye on it.

Like you guys have mentioned, with the trailing numbers, the valuation looks reasonable. Obviously, we have to take that with a large grain of salt about what's going to happen in the future. It's not something I'm going out and investing in right now, but it's definitely something that's going on the watch list. All right. Ian, or Ryan, sorry. More interest. Yeah, more interested because the risk reward feels good here. you could lose all your money potentially as with any investment risk reward is good but you could

lose all your money that's uh the ceiling i mean the ceiling is really really high that's true yep so in that sense uh i guess i like the risk reward there is obviously the reliance on factors outside their control but i think if i were going to make a bet on the crypto space this is probably how i'd do it yeah i'm less interested because i just think cryptos oh the big worry for me is like the tether stuff if you're bullish on crypto if you're into this type of stuff i would go listen to our interview we did with bennett tommen on tether to get the bear case to the side of what things could go wrong there that's kind of the big concern for me i'm less interested but i'm going to caveat what this was saying if you're bullish on the

crypto economy whatever that is i don't understand why you're not you wouldn't own coinbase that seems like the logical investment to make it seems like way safer than betting on one coin um this seems like the like if you think crypto is going to be big and take over the world i do not know how you not how are you not long coinbase like it seems so simple um but i'll leave with that i'm less interested in your bets and you don't have to just buy yeah you don't have by one and i don't know like i mean what do you guys think like why why would you own i i don't know how you own other stuff except except coinbase yeah i want to pick there there's no way i'd especially being so naive to the space in general there's no way i'd pick one coin and just kind of

go for it i this is a way to really diversify across all of them if you believe in the industry yeah and that's the thing i don't believe in the industry so i'm less interested and i would just i just throw one more thing out there real quick that i think some of these and i think this will be an interesting thing and it's a discussion for another day but as you're looking at this crypto economy and decentralized finance i think it's important to see that there's sort of some new types of things developing and so it's not like we've got the companies and we've got the assets but there's also like the protocols that these are on and the and the and i don't even know if that's quite the right word but the basically the blockchain of bitcoin is actually like

like something different in a sense than just like the asset Bitcoin and that the same thing with Ethereum or Solana or Cardano that they have these assets that are tied to them. And like Ethereum isn't its own company, but it's also not just the coin. There's this there's this piece behind it. So it's, it's, it's an interesting ecosystem. And it's, it's one of those things that does kind of go into my too hard pile at times because it's just so it is a little bit hard to figure out how all these factors play together. But I think that's just to give one case for why someone might invest in individual coins. I think that that's the case, is that there's actually some of these coins that have better rules, better communities, better potential

projects that are built on top of them, all of those types of things. And so even though they're not themselves companies, there are ways to evaluate the coins are different from each other in a way that's different than just they have different names and different people like them for no apparent reason. Yeah. Okay. That makes sense. I'm going to say, yeah, I don't understand the exact specifics like you were saying, but I think that, okay, that does make sense. Maybe there's a reason not to, I don't want to, you know, I don't want to deal in absolutes there, but stock for next week. Was this your choice, Ryan? I don't know. Coinbase. I think Coinbase was your choice. Coinbase was mine. So Ian's turn. Ian, do you have one for next week? We put you on

the spot here yeah for next week let's do um let's take a look this is this might be a little bit boring but let's take a look at apple i think apple's been in the news a lot just hit a three trillion dollar market cap i think there's a lot of debate right now about is apple at its peak valuation and i think that would be kind of a fun show to do oh yeah that no that's actually fun people just forget about it like they got wearables ryan gotta i gotta watch uh airpods And then the, what the, the car AR app store stuff, plenty of talk services. Yeah. Yeah.

That's a sneaky, good one. All right. That's going to do it for this episode. We're talking about something new now. Oh, Ryan, you have something. Yeah. Before, uh, before we do our disclosure, if you listen on Spotify, I was going to say that, but go ahead.

All right. Feel free to drop a rating. It helps. I think it's getting more people kind of interested in the show. So if you like us or if you hate us, like, feel free to just, you know, just leave a rating for us. easiest thing to do to support the show is to give us a rating on Spotify logo on our Spotify page. It takes literally three seconds. All right. That's going to do it for this episode. Thank

you all for listening. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. Ryan and I are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time. We'll be right back.