Leon Neal
Last year ended with fireworks in the cryptocurrency market. Bitcoin (BTC-USD) and its peers performed poorly throughout the year as investor confidence declined. As the market slowed, cracks began to appear among cryptocurrency exchanges, leading to the implosion of FTX (FTT-USD) in the middle allegations of significant misuse of customer funds. This event led to a massive drop in the value of major cryptocurrencies as contagion concerns grew and investor confidence collapsed.
Stocks in the cryptocurrency sector also exploded. Coinbase (NASDAQ: COIN) has lost 86% of its value in 2022 and has recently seen short interest jump to 24%. COIN is essentially a proxy investment for Bitcoin and has a very high correlation with “beta” Close to 1 (meaning that COIN typically rises or falls by 1% for every 1% change in Bitcoin). See below:
Many speculators are betting against the company, potentially assuming contagion in the cryptocurrency market. Coinbase is a publicly traded company, so the company is less likely to bear the same risks as private companies like FTX. However, it is a financial institution that operates outside the vast and strict regulations of traditional banks and exchanges, opening the door to unusually high “bank-like” risks (poor liquidity, etc.).
At the moment COIN is a high risk stock. However, it is far cheaper than a year ago. The stock is also susceptible to selling high in the short term, making a significant “dead cat bounce” or “short squeeze gain” more likely – especially if it beats weak expectations. I believe the company deserves a closer look at its risk exposure and growth potential, as a potential “high-risk, high-reward bet” for 2023.
Coinbase risk analysis
One key problem with investing with Coinbase is number potential risk factors to which the company is exposed. Even if no particular risk is too likely or too large, there are so many that it seems likely that at least one will have a huge negative impact on the company at some point in the future. In my view, these include (in order of severity): widespread loss of confidence in cryptocurrencies, liquidity and solvency risks, business model risks, competitive pressure, and regulatory risks. “Side risk” is, of course, the potential for fraud or “FTX-like” problems, which is difficult to assess; however, since Coinbase is older and public trading company, I believe this risk factor is generally low.
The value of COIN is highly correlated with price fluctuations of Bitcoin and other prominent cryptocurrencies, making it a primary risk factor for the stock. This risk is also almost entirely outside the company’s control. For example, the problems at FTX led to a broader loss of confidence in cryptocurrencies, creating losses for Coinbase. Amidst the debacle, giant exchange Binance (BNB-USD) has lost its auditor Mazars, no longer guaranteeing proof of the company’s reserves. The auditor has also pulled out of other major exchanges, raising potential contagion risks. Although cryptocurrency was “supposed” to function under a “decentralized banking” platform, it has become highly centralized among a small number of exchanges. If more of these changes are shown to have poor liquidity or inconsistencies in reserve evidence, then a complete loss of confidence is possible.
In my opinion, this risk factor is quite significant for Coinbase as it could lead to the end of the cryptocurrency industry – or at least its form of currency. Additionally, since Coinbase is a rare public crypto exchange, it is the only one audited by a “big four” accounting firm (Deloitte). While Coinbase isn’t as big as Binance and is significantly more expensive than its peers, it has the highest “trust rating” – largely due to its additional regulations associated with being a public company. So as long as there is fundamental trust in cryptocurrencies, Coinbase could become a huge net benefactor as crypto investors turn to trusted companies.
Although Coinbase is more reliable than (in my opinion) all other exchanges, it is not as secure as traditional financial institutions. First, it does not carry the same regulatory burdens as conventional financial institutions. Second, its assets and liabilities are highly volatile due to the volatility of cryptocurrency values. This year, Coinbase suffered a decline in book value of cash and tangible assets and a sharp increase in debt. See below:
Comparing Coinbase’s solvency and liquidity profile to traditional financial exchanges, Coinbase appears far riskier with high leverage and low cash liquidity compared to assets (~$110 billion). These risks are compounded by the volatility of cryptocurrency values ​​as they cause huge fluctuations in Coinbase’s balance sheet. Although not as widespread as other exchanges, Coinbase has a margin trading (and asset lending) program. A significant decline in major cryptocurrencies could dramatically harm Coinbase’s remaining liquidity if counterparty risk rises (or Bitcoin becomes less liquid amid volatility). If 2023 is like 2022 for the cryptocurrency market, then I believe Coinbase is at high risk of bankruptcy due to its low solvency. However, this risk generally seems to be factored into the value of COIN (as seen in its steep decline last year).
In addition to the “macro” risks facing Coinbase, a number of company-specific risk factors are required. Coinbase is a relatively expensive trading platform with fewer options and tradable cryptocurrencies than most of its peers. For this reason, Coinbase has not grown significantly in recent years, while peers such as Binance, (former) FTX, Kraken and others have grown significantly. Coinbase has lost significant market share due to higher fee structures, opening the possibility of business failure if the trend continues. On that note, if higher fees equate to higher trust and investors shift to platforms with higher trust, Coinbase could indirectly benefit from its higher fee structures.
Still, Coinbase has struggled to turn a steady profit despite higher fees. The company has not been publicly traded for a long time and was profitable in 2021. Of course, 2021 was an exceptional year for the cryptocurrency market, so it is not clear whether Coinbase is operating according to a viable long-term business model. However, this risk has been largely factored into the share price after its significant decline, and if the outlook recovers, it could be significantly reduced.
Reward potential at Coinbase
As an analyst, I’m generally skeptical of unprofitable tech companies and, over the past two years, I’ve been bearish in most of my research. In my opinion, Coinbase is one of the few examples where I see a solid contrarian bullish argument today. It goes without saying that COIN is a very risky stock subject to tremendous volatility and numerous fundamental risks that could threaten the company. However, COIN’s price relative to book value has fallen by a a staggering 95% from inception to 1.4X today. Two years ago, COIN’s valuation was tremendously high compared to traditional brokers; today it is well below Schwab (SCHW), Interactive Brokers (IBKR) and others (from a price-to-book standpoint). Therefore, I believe that the risk profile of COIN has generally been taken into account in its assessment.
If we assume that the “bottom not drop” from the cryptocurrency market, Coinbase could return as the leader in market share among exchanges. Due to its age, business focus and public status, Coinbase objectively has the highest reliability and security in the industry. Crypto investors pay a premium to use Coinbase’s service. However, by in my opinion, that premium is relatively small compared to the huge losses suffered by FTX users who lost their “insured” funds.With auditors pulling back from giants like Kraken, I believe more prominent long-term crypto investors may gravitate toward safer public companies like Coinbase.
Additionally, with bitcoin (and similar) at extremely low levels, there is likely to be an increase in long-term investors in the market as opposed to short-term traders and speculators. Coinbase is a bad cryptocurrency trading platform because of its higher fees, but it is a superior option for long-term investors because of its security. Therefore, I believe that Coinbase could have a competitive dominance with Bitcoin at low prices and however weak the confidence of crypto investors.
The potential growth of COIN is difficult to calculate since there are many paths the future may hold. If the company manages to recover its end-2021 TTM EPS level of $9-$12, its “P/E” today would be ~3-4X – which is extremely low. This could happen if trading activity and bullish flows return to the cryptocurrency market, potentially causing COIN to rise above $100. Of course, if there is a widespread shift in assets toward Coinbase as investors move toward more reliable exchanges, COIN could rise much higher as it regains the market share dominance it had years ago.
The bottom line
Although COIN is exposed to significant downside risks, its upside potential is also huge. In my opinion, the company is rated as likely to fail the cryptocurrency industry. Indeed, I don’t believe it’s impossible because there is no physical value in cryptocurrencies, and their value in my opinion comes largely from belief in fiat currencies and trust in alternatives. The value of emotional beliefs should not be overlooked, but they are changeable. However, with faith in traditional fiat currencies waning and objective risks rising rapidly, I tend to believe that some cryptocurrencies will retain value in the long term as more people globally seek to reduce their exposure to government-controlled assets.
Public trust in institutions is at (or near) record lows in almost every category, creating enormous potential value for alternative structures. Although there are considerable risks within the cryptocurrency industry, it is a potentially viable alternative structure. In this sense, COIN is a potential protection against general social, political and economic risks.
Looking at today’s market, I am not so bullish on COIN that I would buy the stock; but I have a positive long-term view on the state of the stock. COIN also carries significant near-term upside potential should short pressure occur due to its massive short exposure. Personally, I wouldn’t bet on that particular speculative bet today, but it’s a factor that could lead to quick gains for the stock. Once cryptocurrency volatility calms down and Bitcoin reaches a more stable level of support, I might become very bullish on COIN.