Thu 05/19/2022 12:29 PM
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Relevant Documents:
2021 10-K
Q1’22 10-Q
Q1’22 Shareholder Letter
Bond Offering Memorandum

Cryptocurrency exchange Coinbase has committed to protecting EBITDA losses up to negative $500 million on an annual basis and said it would manage costs in a prolonged downturn. The company maintains a healthy balance of $6.1 billion of unrestricted cash, which does not include customer custodial funds, as of March 31, but did burn almost $800 million in free cash flow in the first quarter, while guiding to sequential declines in most operating metrics and higher costs. In a letter to employees, the company said it would slow hiring after the number of full-time employees has nearly tripled over the past year.

The company’s 3.375% guaranteed senior notes due 2028 were recently indicated at a price of 69/70, according to Solve Advisors, down from approximately 77 on May 9, prior to the company’s first-quarter report, and down from 89 on March 31. The 0.5% convertible notes were recently indicated at 65/66, according to Solve, down from approximately 95 on March 31.

Coinbase describes its technology as enabling any person or business with an internet connection to discover, transact and engage with crypto assets and decentralized applications. The company serves both retail and institutional customers.

For retail customers, Coinbase serves as the users’ primary crypto account, both hosted and self hosted. For institutions, Coinbase provides a platform to access and transact in crypto markets serving asset managers, hedge funds, banks, wealth platforms, registered investment advisors, payment platforms, and public and private corporations.

Capital Structure

In 2021, Coinbase raised a total of $3.4 billion of debt across three issues: $2 billion of 2028 and 2031 senior unsecured notes and $1.4 billion of 0.5% convertible notes. The convertible notes have an initial conversion price of $370.45 per share, and therefore, based on a recent stock price of $67 per share, are deeply out of the money.

The company’s capital structure as of March 31, with pricing as of May 18, is shown below:

The series of senior notes and the convertible notes are both issued out of parent company Coinbase Global Inc. However, the senior notes also have a guarantee from Coinbase Global subsidiary Coinbase Inc. The company says that in April 2014, it completed a corporate reorganization whereby Coinbase Inc. became a wholly owned subsidiary of Coinbase Global Inc. and Coinbase Global Inc.’s principal assets are the equity interests of Coinbase Inc.

However, Coinbase Global Inc. has other subsidiaries. It is also the parent company “of a number of other operating subsidiaries, including (i) CB Payments, Ltd, a private limited company incorporated under the laws of the United Kingdom, which provides fiat currency payment processing services to our international customers and (ii) Coinbase Custody Trust Company, LLC, a New York limited liability trust company, which is authorized to exercise fiduciary powers under New York state banking law and holds certain crypto assets in trust for the benefit of our institutional customers.”

Coinbase lists the following “significant” subsidiaries in an exhibit to its 10-K:

According to an offering memorandum for the senior notes, for the year ended Dec. 31, 2020, and the six months ended June 30, 2021, nonguarantor subsidiaries accounted for approximately $299.3 million, or 26.3%, and $772.8 million, or 21.3%, respectively, of consolidated net revenue and $218.3 million, or 49.3%, and $533.6 million, or 28.1%, of Coinbase’s reported consolidated EBITDA.

As of June 30, 2021, nonguarantor subsidiaries accounted for approximately $2.7 billion, or 17%, of consolidated total assets, including customer custodial funds but excluding intercompany assets, and approximately $1.9 billion, or 17.4%, of consolidated total liabilities, including trade payables and custodial funds due to customers.

In total, as of June 30, 2021, Coinbase reported on its balance sheet a total of $9 billion of custodial funds due to customers.

Coinbase made $149 million of short-term borrowings in the first quarter but did not provide detail on the type of borrowings or ranking. Reorg includes this as senior debt for conservative purposes. As of March 31, short-term borrowings in the aggregate principal amount of $50 million were secured by bitcoin with a value equal to 200% of the outstanding principal, according to the 10-Q. The short-term borrowings are included in accrued expenses and other current liabilities.

In addition to the above liabilities, the company also borrows crypto assets, including bitcoin and ether, from third parties on an unsecured basis. Coinbase does not disclose in its financials the purpose of these borrowings, but as of March 31, it had a liability for crypto asset borrowings of $485.6 million. However, due to the appreciation of value of the underlying currencies, Coinbase also recognized an asset of crypto assets held for $1.333 billion as of March 31.

Historical Financials

Coinbase’s revenue fluctuates with the amount of transaction revenue it generates. The company generates transaction fees in connection with the purchase, sale and trading of crypto assets by customers. Transaction revenue is generated either through a flat fee or a percentage of the value of each transaction. Revenue includes subscription from both products and services, which the company said also fluctuates based on the price of crypto assets.

However, only certain of the company’s costs appear to fluctuate with the amount of transaction revenue reported. Instead, the majority of costs have increased in all periods, regardless of the amount of revenue Coinbase generates.

Transaction expense, according to the company, includes costs incurred to operate the platform, process crypto asset trades and perform wallet services. These costs include account verification fees, miner fees to process transactions on blockchain networks, fees paid to payment processors and other financial institutions for customer transaction activity, and crypto asset losses due to transaction reversals. Transaction expense also includes rewards paid to users for blockchain activities conducted by the company, such as staking.

However, the company also spends money on technology and development, marketing, and general and administrative. These costs have increased over time. Technology and development expenses include personnel-related expenses incurred in operating, maintaining and enhancing the platform. These costs also include website hosting, infrastructure expenses, costs incurred in developing new products and services.

(Click HERE to enlarge.)

As of Dec. 31, 2021, Coinbase had 3,730 employees. In the first quarter or 2022, it hired over 1,200 full-time employees. Employees as of June 30, 2021, totaled 2,176 and as of March 31, 2021, totaled 1,717.

Coinbase measures its performance based on users, transactions and the assets on its platform. Monthly transaction users, or MTUs, have fallen twice sequentially since 2020: in the third quarter of 2021, which was one quarter after a steep drop in the price of bitcoin, and in the company’s most recent quarter. These two periods also experienced a steep drop in revenue, EBITDA and cash flow.

The company provided the following chart of historical transaction revenue per user in its shareholder letter:

As more coins have been developed, Coinbase has experienced a shift in the makeup of assets on its platform. As of the end of 2020, 70% of assets was bitcoin. However, in the most recent quarter, just 42% of assets on the company’s platform was bitcoin.

Outlook

The company’s guidance for the second quarter anticipates a slowdown sequentially in top-line operating statistics including trading volume and MTUs. In terms of expenses, consistent with prior periods, transaction expenses appear variable, changing with volume. The company said it expects to stay in the low 20% area as a percent of revenue, but technology, development and G&A costs are expected to grow sequentially, even with the expected decline in volume:

The company has acknowledged a potential need to contain costs, stating, “While we are navigating uncertain and volatile markets, we have a decade of experience to draw from and will continue to invest wisely to drive long-term growth.” Coinbase asserted that if the slowdown is prolonged, it would “aim to manage our 2022 potential Adjusted EBITDA losses to approximately $500 million on a full-year basis.”

In a letter addressed to employees, the company announced plans to slow hiring and “reprioritize” against what it calls its “highest-priority business goals.” COO Emile Choi said, “Heading into this year, we planned to triple the size of the company. Given current market conditions, we feel it’s prudent to slow hiring and reassess our headcount needs against our highest-priority business goals. Headcount growth is a key input to our financial model, and this is an important action to ensure we manage our business to the scenarios we planned for, specifically the potential Adjusted EBITDA we are aiming to manage to.”

Cash Equivalents and Cash Flows

Reorg calculates that during the first quarter, Coinbase burned $797.3 million of free cash flow, driven by a $738.8 million outflow from the change in custodial assets.

The company said that “the decrease in our cash and cash equivalents was primarily driven by our investments in crypto assets (including USDC), cash payments for acquisitions, and the timing of corporate cash transfers from customer custodial funds” (emphasis added).

Custodial Funds

As shown above, the biggest swings in cash flow quarterly typically come from movements in customer custodial funds. Coinbase includes customer custodial funds within its cash balance but separates them when reporting unrestricted cash equivalents, which the company says consists of primarily cash deposits and money-market funds denominated in U.S. dollars.

Customer custodial funds, however, represent restricted cash and cash equivalents maintained by the company in segregated accounts for the exclusive benefit of customers. Custodial funds due to customers represent cash deposits held by customers in their fiat wallets and unsettled transaction payables. The company retains segregated funds in excess of the custodial liability in order to minimize the risk of underfunding due to timing of in-transit deposits and payments. Excess funds are sourced from corporate cash.

Coinbase restricts the use of the assets underlying the customer custodial funds, which it says is meant to meet regulatory requirements. Coinbase adds that certain jurisdictions require it to hold eligible liquid assets equal to at least 100% of the aggregate amount of all custodial funds due to customers.

Coinbase says that it relies on bank accounts to provide its platform and custodial services. In particular, it asserts, customer cash holdings on its platform are held with one or more of its banking partners.

M&A

Similar to other technology companies, Coinbase has acquired companies as it looks to expand its offerings. The company states, “As part of our business strategy, we have made and intend to continue making acquisitions to add specialized employees, complementary companies, products, services, licenses, or technologies. We routinely conduct discussions and evaluate opportunities for possible acquisitions, strategic investments, entries into new businesses, joint ventures, and other transactions.”

In the last 12 months ended March 31, Coinbase spent $224.1 million cash on business combinations. On Jan. 4, it paid $151.4 million cash, plus other consideration, for Unbound Security, which Coinbase describes as a “pioneer in a number of cryptographic security technologies, which the Company believes will play a key role in the Company’s product and security roadmap.”

Investment in Crypto Assets

Coinbase uses cash to invest in cryptocurrencies. As of March 31, the company reported $1.3 billion in crypto assets held. In the last 12 months ended March 31, Coinbase spent $313.7 million on investments, according to its reported cash flow from investing on its cash flow statement. The company also showed a net purchase of $742 million of crypto assets held.

Management stated, “And big picture, our goal is to become [the] vast majority, if not 100%, crypto over time. We want to have all of our revenue and expenses be crypto-denominated as we think about the future. And so this is one step in that direction. We’ve made two commitments. The first was to invest $500 million of our cash and cash equivalents into crypto; and second, we’re allocating 10% of quarterly net income into crypto investments. We are dollar-cost averaging into a diverse portfolio over time. So you will not see a $500 million step-up in our investments as of Q3, but you should expect to see this balance continue to grow.”

--Mark Fischer
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