Coinbase: An Opportunity To Take Advantage Of Volatility

Summary Coinbase faces headwinds such as declining services and subscriptions revenue, potential SEC fine/ban, and a challenging Q2, but also has tailwinds such as a healthy balance sheet, positive Q1 earnings, and international opportunities. The crypto exchange market is unpredictable and fragmented, making it difficult to value and assess the impact of competition and the institutionalization of crypto as an asset class. A neutral view on Coinbase supports a strategy of writing upside calls and downside cash secured puts to capture price volatility, with the mean reverting level seen within the $55-65 range. Investment thesis Coinbase (COIN) is littered with headwinds, but I believe that each negative is offset by a potential tailwind that essentially places the stock rangebound rather than having a strong bullish or bearish view. There are several unknowns such as the US regulatory landscape concerning the SEC fine, the broader implications for trading in the US and the competitive space for the industry after the launch of the Fidelity/Charles Schwab (SCHW)/Citadel (EDX) exchange launch . Having said that, there is a significant amount of price volatility that could be captured through cash secured puts and call overwriting which can enhance returns within this price range. Factors limiting the upside (headwinds) Declining services and subscriptions revenue Coinbase and the stablecoin issuer Circle (USDC) have a profit-sharing agreement whereby interest payments are made on US dollar deposits which is representative of 32.7% of Coinbase's total revenue in Q1 2023 (see table below). The total market cap for USDC has declined from $44.5bn to now $28.4bn, resulting in a 36% fall year-to-date. This was due to Circle having reserves in the now liquidated Silicon Valley Bank (SIVBQ). The lack of transparency at the time has raised questions about what else lurks behind the scenes and has also resulted in a de-pegging to the US dollar on several occasions which has impacted the usage of the stablecoin. Despite Coinbase opening up USDC rewards to institutional clients and optimising retail rewards, the market cap of USDC has continued to decline. If this trend continues, the amount of interest income will continue to be lower compared to previous quarters which has made up a large part of the shortfall in transaction-based revenues recently. Staking revenue (blockchain rewards) is also vulnerable after the SEC shut down Kraken and may follow through with Coinbase. Although this is a small revenue source, representing 10% of revenue, a potential staking ban will dampen their total services and subscriptions revenues further. To sum up, interest income and blockchain rewards were seen as a reliable and predictable source of revenue which was mitigating the volatility in transaction-based revenue, but as this starts to become more uncertain, a lower valuation is appropriate. Coinbase Impact of a potential SEC fine/ban On the 6th of June, Coinbase were charged by the SEC for operating as an unregistered securities exchange. Whilst I am no lawyer, I do believe that this could take years to play out especially as Coinbase are prepared to fight their corner. The worst-case scenario is that Coinbase are issued a multi-billion dollar fine and a potential banning of alternative crypto asset trading in the US which could fundamentally change the business. 64% of total transaction revenue comes from ex-bitcoin trading. Over the past four quarters, their total transaction-based revenues were $1717.5bn with total revenues being $2720.3bn. So ex-bitcoin trading represents approximately 40.4% ((0.64*1717.5)/2720.3) of total revenues. Approximately 84% of their revenues come from the US and therefore, I estimate that roughly 34% of their US based revenues are coming through alternative crypto trading which would be impacted by a potential ban. However, I do believe that the most likely scenario would be a moderate sized fine with no banning of alternative crypto trading since the adoption is already quite large in the US and is growing internationally. A potential end to this case could also be a positive catalyst in the long run since we would finally have some regulatory closure on the issue. Nevertheless, in the meantime, this litigatory overhang will continue to hurt the upside potential on the stock. Rough Q2 in the making So far, Q2 Bitcoin trading has been rather subdued with price staying in the range of $24.8k to $31k. Trading volumes are also low along with volatility which implies that transaction-based revenues are likely to show a modest decline from Q1 numbers. Most of crypto is still in a winter and projects will need to be delayed given the macroeconomic picture. Stock based compensation is also quite high as a proportion to total operating expenses (currently at 22%) which I believe needs to come down further to under 15%. Coinbase will likely need to cut more R&D spend, which is nearing 40%, and focus more on efficiency and prioritising customer retention. So in anticipation of more cutting in R&D and potentially personnel, I believe that this can hinder growth in the short to medium term. Coinbase, Author Factors creating a floor (tailwinds) Healthy balance sheet Coinbase has piled a large US dollar liquidity balance of $5.3bn which has been their historical approach in crypto winters. I believe they have earnt the reputation of prudently managing their books in times of distress, and although their debt as a percentage of cash has been rising, it's still admirably below a 100% (see below chart), suggesting that they can cover their entire debt with their cash balance. Interest payments are also low, currently at 2.4% of total outstanding debt, suggesting no near-term liquidity issues. It's worth mentioning that 41.7% of their debt expires in 2026 with 29.2% expiring in 2028 and 29.1% expiring in 2031 respectively. So with no near term principal repayments and the big refinancing wall not appearing until 2026, liquidity constraints remain quite low. Coinbase also recently bought back roughly 5% of their 2026 convertible bonds at a 29% discount to par . Although this is small, it's encouraging to see them actively managing their treasury books in opportunistic conditions. In summary, I believe that they have ample access to capital which is rare for the crypto industry, and although stock based compensation remains high, they have levers to pull to streamline the business further if they need to. Coinbase, Bloomberg, Author Q1 earnings had some bright spots Q1 2023 results generated positive EBITDA which was driven mostly by an increase in services and subscriptions-based revenue ($362m vs expected $300-325 in their outlook) and lower R&D and G&A expenses ($607m vs $625-$675m forecast). On their 2023 Q1 report they revealed their active decision to eliminate the discounts made for trading and increasing prices for transactions with the focus being on increasing average revenue per user. Furthermore, it was also interesting to see that they saw an increase in customer deposits of 6.5% for the quarter, which could be due to a flight to quality with the notable failures of Signature and Silvergate Bank. Tying it together, the flight to quality plus the increase in prices worked well for Coinbase and I'm sure this is the message they will try to send as they expand abroad. International opportunities Brian Armstrong ((CEO)) expressed a desire for international expansion with each incremental dollar of capital to be invested abroad. This was also evident by approval for a Bermuda license and Brian taking multiple trips in the EMEA region this year to explore opportunities . They are also looking to expand their derivatives offerings to essentially compete more with Binance internationally. Whilst it's a dirtier game competing with Binance, I would expect for Coinbase to gradually take some market share internationally by their approach of being compliant and transparent via their SEC filings and potentially adhering to regulatory frameworks such as MICA in Europe . If Coinbase can get a MICA passport, not only will they be able to do business fluently within Europe, but it can also provide some level of authenticity internationally, as it shows that Coinbase is following a set of legislation which is comforting for prospective customers. Factors that are tough to call (reasons for volatility) Fragmented industry The crypto exchange market is unpredictable and fragmented with low barriers to entry and exit. Binance controls most of the market worldwide with a 20% share but the others are further down the list at between 2-5%, according to Statista. However, in the US, Coinbase is estimated to have over 75% of the market since Binance and others are unregulated. The launch of the EDX exchange is a potential game changer for Coinbase and the industry. I believe this can be viewed in two ways: Short term: the EDX launch shows that the industry is maturing and the interest from big players is starting to grow. Two weeks ago we saw a filing by BlackRock ( BLK ) for a spot Bitcoin ETF and last week a filing by WisdomTree. This essentially means that the transaction fee pie could grow larger with higher transaction volumes which benefits all including Coinbase in the short term. Long term: EDX launching also means that the space is becoming more and more competitive, especially on the retail side that EDX would cater to in theory. This will add pricing pressure to Coinbase in a market that is already seeing fee compression which will eventually lead to a race to the bottom in trying to retain customers. They will need to add more trading incentives and count on the loyalty of customers which I believe is currently fragile. Customer switching costs are essentially zero since you can open a competitor fast and transfer crypto assets immediately if one platform is more advantageous than the other. Because of the two reasons mentioned above, it makes it difficult to assess the impact of further competition and the institutionalisation of crypto as an asset class for Coinbase in the long term. Challenged valuation Valuing Coinbase is challenging as we don't know whether the company will end up primarily as a broker that deals with just transactions. In this case, Coinbase should have a multiple closer to that of Robinhood (HOOD) or a traditional broking firm that is levered to spikes in crypto prices. On the flip side, it's difficult to determine whether they are on a sustainable path to grow their services and subscriptions-based revenue to greater than 50% which the CEO is aiming for. If this turns out to be the case, a multiple closer to a growing technology firm or a SaaS based company could be more appropriate. In my opinion, each scenario is possible as a base case and therefore, it is tough to build a reliable model for the long term. Of course, if we get clarity on the regulatory side, I believe a positive re-rating of multiples is suitable, but until then it's a waiting game. Technical factors TradingView, Author Because my view is neutral, I believe the condition is great for a strategy that writes upside calls and downside cash secured puts to capture the spikes in implied volatility especially with the news flow that occurs on almost a daily basis, along with the movements in crypto prices. One could be cautious and write puts/calls on days with big swings in volatility within the areas highlighted in the above chart. it's possible to profit from the movements since the mean reverting level seems to be within the $55-65 range. Risk factors and mitigation The main risks would be a breakout of this range either above $85 or below $40 and therefore, some level of hedging against this risk may be appropriate, for example, a long strangle strategy with calls above $85 and puts below $40. From a fundamental perspective, the risk of this strategy comes from a material change in any of the factors discussed in the above text or any clarity regarding the SEC situation, in which case I would be looking to exit this strategy. Conclusion To conclude, there are a number of things turning sour at Coinbase but I do see a light at the end of the tunnel which comes in the form of a potential regulatory closure, international expansion and their ability to navigate the crypto winter efficiently. The unfortunate thing is that it could be a long waiting game and there is a possibility of being rug pulled by the SEC in the form of banning crypto trading or imposing a hefty fine on Coinbase. There are also lots of unknowns such as the competitive landscape within the US and internationally which poses questions as to how we can appropriately value the business, especially if parts of their revenue sources are at risk. However, I am bullish on bitcoin as I believe the regional banking crisis put a floor onto bitcoin prices at roughly the $20k mark and any further positive surprises in crypto prices would certainly benefit Coinbase.