Bitcoin miners are going to be up Schitt’s Creek without a paddle if the Web 3.0 community decides that conserving the electricity used to mine bitcoins is more important than the joys of decentralized finance. That’s the direction Ethereum 2.0 is going, so nothing says bitcoin couldn’t make the same move. It takes about $12,500 dollars to mine a single bitcoin which you can then sell to a greater fool crypto investor for (checks Coinbase) $41,953.
Just make sure you don’t use Tether to conduct your transaction because that cryptocurrency has systemic risk that’s almost too incredulous to believe.
If you want exposure to blockchain and crypto, there are few good ways to get it when it comes to equities. We recently vetted The Amplify Transformational Data Sharing ETF (BLOK) and found mostly a bunch of bitcoin miners along with the usual names like Silvergate, MicroStrategy, and Coinbase. Other names like NVIDIA and CME Group are less compelling ways to get blockchain exposure. Nonetheless, few investors today seem to understand what they’re investing in as 1 in 10 Americans dabbles in the 8,000 cryptocurrencies readily available, thanks to the proliferation of free trading apps.
Robinhood likes to talk about democratizing access to wealth when in fact they’re pissing on investors’ shoes and telling them it’s raining. Robbin-the-hood makes the most of their money from peddling cryptocurrencies and options to retail investors who – on average – carry an account balance of just $240. These small account balances lead to risky bets and mistakes that are usually repeated when the next round of stimmy checks arrives.
An investment in Robinhood as it exists today is a bet on the irrational behavior of the Reddit types as they desperately pursue whatever get-rich-quick shitecoin being peddled to them by Web 3.0 “thought leaders.” Unfortunately, you’re making a similar bet with Coinbase Global Inc.
About Coinbase Stock
Last February we wrote a piece on Why We’re Liking Coinbase Stock At $128 a Share in which we praised the apolitical stance of the company’s CEO, Bryan Armstrong. That was prior to the initial public offering (IPO) and we suspected that shares would come out of the gate overheated. Indeed, they did, but that’s quickly changed as Coinbase transaction revenues have absolutely soared. We concluded the piece by mentioning that Coinbase was “building some businesses to reduce the company’s reliance on transaction fees.” That’s what we want to focus on today.
We created our simple valuation ratio so that we can quickly and easily value companies based on revenue growth. We use annualized revenues (last quarter X 4) so that the ratio is more responsive to growth. Unfortunately, that doesn’t work so well in the face of extreme revenue volatility such as what’s taken place over the past year for Coinbase. Here’s what that ratio looks like using today’s market cap of $57.5 billion and the revenue numbers from each of the past four quarters.
- Q4-2020: 57.5 / 1.26 = 45
- Q1-2021: 57.5 / 7.2 = 8
- Q2-2021: 57.5 / 8.92 = 6
- Q3-2021: 57.5 / 5.2 = 11
Coinbase’s revenues are volatile because they’re entirely dependent on the fickle whims of retail investors who will eventually realize that the crypto market is not the stock market.
Update 01/21/2022: A subscriber suggested we use market caps that match the time frames so we’ve modified the above a bit. Since Coinbase only began trading in April 2021, we only have market cap values for 3 quarters. These are as follows (using market cap at IPO for Q1 and then end of time period for the rest):
- Q1-2021: 100 / 7.2 = 14
- Q2-2021: 63 / 8.92 = 7
- Q3-2021: 59.6 / 5.2 = 11
Retail vs. Institutional Investors
An initial look at the Q3-2021 Coinbase letter to shareholders appears promising. (This letter format is great by the way.) Institutional investors are depositing assets on the Coinbase platform at a scale that far outweighs retail investors now.
But the devil is in the details. Just look at the percentage of transaction fees coming from retail vs institutional investors.
While institutional investors may have double the crypto assets and trading volume as retail investors, they’re only contributing a fraction of transaction revenues. That means Coinbase’s fortunes are heavily reliant on the sporadic behavior of retail investors right now. For example, between Q2-2021 and Q3-2021, retail investor transaction fees plummeted -44%. What happens when all these speculators realize that getting rich trading cryptocurrencies is a fool’s errand? The house money effect isn’t helping things as crypto investors demand higher and higher returns while hoping their new-found wealth doesn’t evaporate into the hands of scammers and criminals.
Coinbase bulls will correctly point to the company’s expansion into other areas outside of just transaction fees. That’s certainly happening, but quite slowly. Last quarter, 12% of Coinbase revenues weren’t related to transaction fees.
Indeed, revenue streams outside of transactions are growing at a decent clip. Here’s a breakdown of revenue streams not related to transaction fees.
“Custodial fees” appear to be in sync with the amount of assets on the platform which makes sense. If crypto prices are falling, custodial fees will probably fall too. Blockchain rewards are largely driven by “staking,” and Ethereum 2.0, now makes up the majority of their staked assets. In our recent piece on Ethereum, we talked about how the Ethereum cryptocurrency platform has decided to move away from the energy-intensive activity of mining in favor of something called “staking.” Should the Ethereum 2.0 release go pear-shaped, then the “Blockchain rewards” revenue segment will probably suffer.
Investing in Coinbase Stock
Some ESG types won’t shut up about the unfair distribution of wealth, but fail to condemn Robinhood for making the problem even worse. We believe companies that mislead investors as to how wealth gets created should be condemned. Is Coinbase guilty of this? You could probably argue it either way. The reality is, we’re all adults who are responsible for our own investment decisions. If you believe Zack on Twitter who says you can day trade your way into a Lambo, that’s on you. Unless you’re born into money, accumulating wealth is a long, slow, boring process that also requires you to work your ass off for decades.
Coinbase provides enough rope for you to hang yourself if you choose. While their fees stop just short of highway robbery (not to mention the not-so-obvious spreads), they do provide a platform that allows us to safely invest in bitcoin or any other cryptocurrencies we choose. But right now, the firm’s overreliance on retail investors means the stock is too risky for our tastes. They’re also heavily dependent on two cryptocurrencies for over 40% of transaction revenues – Bitcoin (21%) and Ethereum (22%).
Operating expenses surpassed a billion dollars for Coinbase last quarter, and the need for retail investors to keep spending $50 a month on transaction fees is paramount. We’d be interested in taking another look at Coinbase once they’re able to sufficiently diversify their revenue streams so that the majority of revenues don’t come from retail investor transaction fees. Until then, we’re avoiding the stock.
Conclusion
Coinbase provides an excellent pick-and-shovel play on the growth of cryptocurrencies and their ilk but relies too heavily on retail transaction fees for a majority of their revenues. While subscription and services revenues are growing, they also come with their own risks. We like the idea of a pick-and-shovel play on cryptocurrencies but will be avoiding Coinbase shares until the firm has sufficiently diversified their revenue streams.
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