April 7, 2022

Inflation is hot and the Fed just began raising rates. It is expected to hike ten more times by the end of next year.

While yield curve inversion and recession risk is out there, many banks are flush with cash. And consumers are in great shape. As rates go steadily higher, bank stocks are poised to significantly grow earnings.

The most aggressive way to play this is with a bank that’s leveraged to short-term rates. That’s the strategy we’ll take today with a pure-play digital currency bank.

Enjoy!

Company Overview

The Big Idea
In 1988 a small thrift opened in California to offer saving accounts and home mortgages to consumers.

It did just fine for two decades, growing at a conservative pace and remaining well capitalized. But it lacked a high-quality, low-cost deposit franchise. So, most loans were funded with high-cost sources like CDs and money market deposits.

Seeking a way to fund asset growth with lower costs, the thrift converted to a California commercial bank in 2009. It began to roll out relationship-focused business products and look for low-cost deposit niches.

When the financial crisis hit, many banks were forced to slash lending and focus on internal credit issues. But this little bank grew. From 2008 to 2013 assets doubled.

Around this time Bitcoin burst on the scene, marking the beginning of the digital currency industry. The bank’s CEO, Alan Lane, who had initiated the strategic shift to a commercial bank, saw opportunity.

His team dug into Bitcoin, blockchain technology and other cryptocurrencies, noting that capital from respected institutions continued to flow into the space. They also saw that most banks steered clear because of regulatory and compliance risk. Plus, leadership teams just didn’t know what to make of this new asset class.

This was just the niche market the bank had been looking for.

It began to offer deposit and payment services for crypto players. The first deposit account for a digital currency customer was opened in 2014.

A key early customer was Genesis (a leading digital currency exchange) which opened doors to institutional crypto investors and other digital currency exchanges, including Coinbase (COIN).

Fast forward to today and this one-time little thrift is now one of the leading pure-play crypto banks in the U.S. It has first mover advantage in a highly regulated industry and continues to offer new products. A stablecoin is set to hit the market this year.

Moreover, with all deposits coming from crypto clients – which use funds for trading not to generate yield – the bank is highly leveraged to short-term rates.

In short, this bank is a way to play the current rise in short-term rates while also positioning for the bigger opportunity in the evolving digital currency industry.

New Recommendation and Updates

The Company
Silvergate Capital (SI) is a commercial bank located in La Jolla, CA providing financial infrastructure and services to the digital currency industry. It has a market cap of $3.6 billion.

The bank acts as an intermediary executioner for customers that need to convert cash to digital currency and/or digital currency to cash. This is achieved via the bank’s proprietary global payments platform, Silvergate Exchange Network (SEN), which can complete transfers almost instantaneously.

The SEN offers huge advantages as compared to more traditional electronic funds transfers (ACH, wire, etc.) that take hours or even days. As the size of the crypto economy has grown, Silvergate’s SEN has helped the bank pull in a huge amount of deposits, most of which are digital currency deposits.

In Q4 2021 total deposits reached $14.3 billion, up 172% from $5.25 billion in the prior year quarter. At the end of 2019 total deposits were just under $2 billion.

Stepping back, the stock offers investors a way to gain leverage to both rising interest rates and growth in the crypto economy.

Regarding interest rate exposure, roughly 90% of assets are in securities and/or cash that can be redeployed quickly as rates rise. At the same time, nearly all deposits are in non-interest-bearing accounts (crypto customers use deposits for trading, not earning income).

In other words, almost the entire benefit of rising rates should flow to Silvergate’s bottom line.

Silvergate also has a growing portfolio of products aimed at serving the digital currency industry, including the SEN payments network, a stablecoin, a leveraged lending solution and digital asset custody solutions.

This is helping to drive digital currency players to the bank. Since 2018, Silvergate’s customer base has more than doubled. Customer count now stands at 1,381.

The company has three types of customers.

First are digital currency exchanges through which digital currencies are bought and sold. It has 94 such customers, including the five largest U.S. exchanges. Coinbase (COIN), Genesis, Binance.US and Bitstamp are all customers.

Second are institutional investors, including hedge funds, venture funds, private equity funds, family offices and traditional asset managers. There are currently 894 institutional customers. Examples include Blocktower and Polychain Capital.

And finally, Silvergate serves 393 companies that are developing new protocols, platforms and applications (think bitcoin mining operations). Examples include Figure and Kiva.

Platform & Solutions
Silvergate is working to build a portfolio of solutions that allow it to pay very little for its deposits, earn relatively high risk-adjusted returns on the loans in its portfolio, and generate significant fee-based income.

Here are more details on the solutions behind the growth strategy.

Silvergate Exchange Network (SEN)
When Silvergate opened its doors to the digital currency industry, one of the biggest problems was that there was no efficient way for customers to send money across different exchanges. The financial infrastructure just wasn’t there. No prime brokerages, custody services or settlement rails.

This meant a trader would need to have digital currencies and U.S. dollars on several exchanges in order to move things around. That required a lot of capital.

Silvergate started working on a software solution to address the problem. It came up with the Silvergate Exchange Network (SEN).

The SEN is an API-powered global payments network platform that enables real-time, 24/7/365 transfers of U.S dollars (USD) and Euros between digital currency exchange customers and institutional investor customers. For example, SEN allows Coinbase and Genesis to seamlessly allow the transfer of money.

The SEN is offered for free to digital currency customers. Management says SEN creates a powerful network effect because it is a two-sided network (connects crypto exchanges and institutional investors). As more customers jump on the platform more are attracted to it.

As the network has grown, transfer volumes on SEN have surged, from just $4 billion in Q4 2018 to $219 billion in Q4 2021.

While transfer volumes will certainly fluctuate based on crypto trading volumes, it should go without saying that handling several hundred billion in transfers every quarter means Silvergate has a meaningful presence in the digital currency ecosystem.

Stablecoin Infrastructure
Silvergate is currently building out its stablecoin infrastructure, which will allow 24/7 real-time conversion of USD in and out of digital dollars on the blockchain. The company was poised to launch its own stablecoin in 2022. Then, in January it acquired Diem technology assets from Meta Platforms (FB). Management said this acquisition will significantly advance the company’s stablecoin infrastructure. We’re awaiting more clarity on the stablecoin strategy based on recent meetings with regulators.

Collateralized Lending
Silvergate’s SEN Leverage product was started in 2020 to provide access to capital through USD loans collateralized by Bitcoin. Loan yields are around 7.5%. This is now one of the bank’s biggest loan growth drivers and accounts for $336 million (38%) of total loans held for investment (these loans are listed as “Commercial and Industrial” in the loan portfolio). Institutional investors use SEN Leverage so they have an alternative to selling their crypto when they need cash, to adjust positions, pursue arbitrage opportunities, etc.

Digital Asset Custody
Silvergate provides custody services to safely and securely store bitcoin and other digital assets for customers.

Growth Initiatives
DIEM Investment: Silvergate struck a partnership with Facebook-backed Diem Association in May 2021 in which it was poised to be the exclusive issuer of the Diem U.S. dollar-backed stable coin (Diem USD). This was to be the first stablecoin issued on Diem’s own blockchain. Regulatory uncertainty continuously delayed this project from launching.

On January 31, 2022, Silvergate announced it had purchased Diem technology assets for $182 million from Meta. While we don’t know the details of the plan, this acquisition of a blockchain-based payment network (which the SEN is not) should significantly advance the company’s stablecoin infrastructure. Silvergate’s familiarity with the infrastructure, regulatory hurdles (at least as they are best understood) and merchants on the Diem network, including Farfetch (FTCH), Lyft (LYFT), Shopify (SHOP), Spotify (SPOT) and Uber (UBER), will make this an intriguing development to follow in the coming quarters.

Stablecoin Rollout: Silvergate’s stablecoin (digital assets designed to maintain stable value relative to a currency) offering is in its infancy but could gain scale quickly given the company’s customer base. It could add material growth in non-interest-bearing income. Silvergate’s stablecoin (not Diem, that’s different) was built in-house to comply with regulations.

SEN Leverage Growth: Management has been gradually moving away from real estate lending and toward digital currency collateralized loans (and mortgage warehouse loans) as popularity of the SEN Leverage product grows. SEN Leverage accounts for $336 million today and has the potential to grow to several billion in the coming years. Silvergate’s expansion into the Ethereum-collateralized lending market could grow that market further.

Demand From Corporate Treasurers: Corporations with cash on their balance sheets look at inflation and interest rate risk and see crypto assets as one way to diversify and hedge their holdings. Tesla (TSLA), BlackRock (BLK), Block (SQ) and MicroStrategy (MSTR) are just a few examples.

The Business Model
Silvergate Capital is a pure-play crypto bank. It serves players in the digital currency industry and derives the bulk of its funding from these participants in the form of non-interest-bearing deposits. This low-cost source of capital allows Silvergate to generate revenue from a conservative portfolio of investments in cash, short-term securities and loans. It also generates non-interest income from a variety of fee-based solutions. This source of revenue is expected to grow significantly in the years to come.

The Bottom Line
Silvergate generated Q4 2021 revenue of $49.5 million (+83%) and EPS of $0.66 (+40%). Total deposits grew 172% to $14.3 billion.

Net interest income grew 74% to $38.2 million on the back of securities and SEN leverage balances. Non-interest income grew 128% to $11.1 million thanks to digital currency fee income.

These results missed expectations, partly because of lower-than-expected yields on newly purchased securities, a dynamic that has since changed (yields rising sharply).

Q4 volume on the SEN was $219 billion, up 271% from Q4 2020 and up 35% from Q3 2021. Total SEN Leverage commitments at year end were $570 million, up 591% from Q4 2020 and up 77% from Q3 2021.

New clients added were 76 (to 1,381) while the pipeline of prospective customers jumped (according to management) to over 300 (on the Q3 call they had said over 200).

For full-year 2021, revenue grew 78% to $175.7 million while EPS grew 114% to $2.91.

Given Silvergate’s exposure to short-term rates forward estimates are necessarily a rough guess. That said (assuming seven rate hikes this year) analysts see 2022 revenue up 71% to $300 million and EPS rising by around 15% to $3.33. EPS is seen jumping by 85% (to $6.17) in 2023.

Risk
Share Price Highly Correlated with Bitcoin: Despite being a crypto bank SI stock exhibits over 90% correlation with Bitcoin, a volatile asset. If SI trades all over the place – especially relative to other banking stocks – investors may just steer clear. However, if we look back at major Bitcoin corrections, such as mid-2021 (Bitcoin fell by over 40%), digital currency deposits at Silvergate have remained very strong. Over time, as product offerings diversify, correlation with Bitcoin should drop.

Quickly Evolving Market/Competition: Silvergate has first mover advantage now but that could fade as the crypto economy evolves and more financial institutions release solutions.

Silvergate Exchange Network (SEN) Replicated or Becomes Obsolete: While the SEN is a strategic advantage today there are plenty of examples over time where one technology becomes outdated when a better one comes along. This could happen with SEN.

Credit Risk: While safeguards are in place, some of Silvergate’s crypto-backed loans could go south if Bitcoin crashes or other significant liquidity events occur.

Regulatory Risk: There still is not a clear regulatory roadmap for financial institutions in the digital currency industry.

Competition
Other banks and financial institutions are working on products for digital currencies, including Signature Bank (SBNY), which has a blockchain-based Signet payment platform, and Customers Bank (CUBI), which offers real-time transfers of U.S. dollars. Genesis, Unchained Capital, Coinloan, BlockFi and more offer crypto-backed loan solutions for institutional investors. There are bound to be more if the industry continues to grow.

The Stock
Trading Volume: SI trades and average of 945,000 shares daily. We shouldn’t move this stock.

Historical Price: SI came public at 12 on November 7, 2019 and rose 8.5% the first day. The stock didn’t do much until late-2020 when it began a massive rally that carried it to an intra-day high of 188 on February 16, 2021. For the next two months SI chopped around mostly in the 100 – 180 range then it sold off and traded in the 80 – 126 range through September. Another Q4 rally sent the stock up to 240 by Thanksgiving. But SI sold off with the market, ultimately falling back near 100 in late January. Since then, SI has been up and down mostly in the 100 – 135 range, though a recent run to 163 showed promise. We can jump in during this pullback to around 135, which is right on SI’s 200 DMA.

Valuation: SI trades at roughly 22-times 2023 estimated EPS of $6.17. However, with rates rising 2023 EPS could be closer to $7.50, implying a forward PE closer to 18.

Buy Range: In the near term, look to buy in the 110 to 150 range.

The Next Event: Q1 2022 earnings are scheduled for Tuesday, April 19 before the market opens. Conference call at 11:00 a.m. ET.

Updates on Current Recommendations

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.

Glossary
Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying t Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.

Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.

The next Cabot Small-Cap Confidential issue is scheduled for May 5, 2022.