To The Moon

Coinbase: Should have seen this coming

Investment thesis and why I bought COIN

I started investing in $Coinbase Global, Inc.(COIN)$at the start of 2022 as I believed that the company would become a successful marketplace for cryptocurrencies in the future. At the time of my investment, the following investment thesis led me to believe that I would generate positive returns on my Coinbase investment:

1. I was bullish on the long-term potential of cryptocurrencies and their potential to be a medium of exchange in the future. I strongly believe that the decentralized networks that crypto leverages on bring many benefits such as insulating customers from exorbitant bank fees, allowing for seamless and cheap international payments as well as serving as a hedge against inflation. With over 98 million verified users, 11,000 institutions in over 100 countries, I thought that customers would use Coinbase as a platform to transact and invest in cryptocurrencies.

2. When I started invested in Coinbase, I thought that the company was attractively valued at a trailing PE of less than 20x, with reasonable prospects of growth in the future. With the crypto boom, Coinbase had increased their revenue by over 1500% in two years while still being profitable and free cash flow positive. I believed that as the adoption for crypto continued to increase, Coinbase would not only be able to grow its user base but transform these users into paying customers to grow their revenue and profits.

My mistakes

However, it seems that I have made two mistakes in valuing the company in the past

Firstly, I underestimated the effect of rising interest rates on risk assets namely Bitcoin and other cryptocurrencies. With the Fed raising interest rates to combat inflation, risk assets appear to be almost uninvestable in the current macroeconomic environment. As inflation continues to drive fear in the market, equity and crypto markets continue to plunge with no signs of a bottom. Investing in risk assets now in hopes of pursuing a buy-and-hold strategy seems almost reckless or indifferent as smart money continues to pour out from the markets in an effort to de-risk their portfolios.

Secondly, I overestimated the economic moat of Coinbase and its position as the largest cryptocurrency platform in the world. As Coinbase continues to face challenges from the selloff in cryptocurrencies, it also faces stiff competition from rivals to attract and retain new customers. According to reports, some customers claimed that the company erratically overcharges users and withdrew unauthorized money out of their bank accounts. There have been further reports which have slammed Coinbase for terrible customer service after hackers wiped out several customer accounts. As customers are key to a business and its ability to generate value for stakeholders in the long-term, these developments are definitely not a good sign for the company and investors.

Final nail in The Coffin

Yesterday, Coinbase released its quarterly results for the first quarter of 2022 and its financial results were the final nail in the coffin which made me decide to sell my shares.

Operating income swung to a loss this quarter

It was reported that Coinbase experienced a 27% decrease in its revenue this quarter on a year-on-year basis, which some investors may argue is understandable given the fall in crypto interest over the past few months. However, despite this drawdown, the company not only continues to spend heavily and incur larger expenses, it has also continued to dilute shareholders, almost doubling its number of shares outstanding yoy. It is extremely difficult to justify the excessive amount of stock-based compensation given to employees and executives at this point of time given how the company is failing to not only grow its revenue but also losing its customers to rivals. With the rise of other crypto platforms such as Crypto.com and FTX as well as Coinbase’s recent poor financial results, I have lost faith in management’s ability to execute on its plans and have decided to sell my shares in search of better-quality investments in the markets.

While shares outstanding nearly doubled

Lessons learnt

If I had the ability to go back in time and re-evaluate my investment thesis these are a few pointers I would have noted:

1. Using P/E ratios to value companies is useless if their future earnings are unpredictable. I was caught off guard by the magnitude of the impact of quantitative tightening on the earnings of tech companies. In the case of Coinbase, while I expected some sort of slowdown in the growth of the crypto space, I failed to recognise that revenue would be slashed tremendously in a rising rate environment, far worse than analysts expected.

2. It is important to know the priorities of management and how they plan to execute on their goals. Coinbase’s management is so focused on growing its company in the long term and attracting the top talent through excessive stock-based compensation. However, it appears that investors and customers are leaving the company in pursuit of more viable alternatives. This presents opportunities for its rivals to capitalise on the dissatisfaction towards the company.

3. Wait at least two years after a company’s IPO before investing in a company. Usually when a company IPOs, its share price is driven by short-term momentum instead of its fundamentals. The longer a company has been public, the more information you will have about its business and whether it is a sustainable long-term investment.

Conclusion

I made the mistake of investing in Coinbase while being attracted to the long-term growth prospects of the company. Had I known of what was coming this year, I would have been more stringent on the criteria used to value the company and avoided investing in this speculative asset without any real economic moat.