Coinbase Needs Some Good News. Ethereum Could Give Some.

The attention of the crypto world is rightly on how Ether, which has a market capitalization of around $190 billion, will be affected. But the Merge is also likely to have a bearing on the stock market, where it could juice up revenues at Coinbase (ticker: COIN) by more than 5% each quarter.

At the heart of the Merge is a shift away from the proof-of-work system that underpins Ethereum. In proof-of-work—which is used by Bitcoin—crypto validators or “miners” secure the blockchain network and update it with transactions by completing cryptographic puzzles that expend vast amounts of computer energy.

Proof-of-stake, on the other hand, relies on validators that stake, or lock up, a pile of Ether tokens—32 ETH, or about $50,000 at current prices—as collateral while they validate a transaction. When multiple validators complete this process, the transaction is cleared. As a reward for their work, validators receive a yield on the Ether they stake, which currently sits at around 4%. Ethereum generates revenue from collecting fees for projects hosted on its network and transactions.

Coinbase stands to benefit from the Merge because the platform is popular for holding Ether as well as staking it—for which Coinbase collects 25% of the yield. Assuming the Merge goes smoothly and barring any “black swan” regulatory setbacks, staking could bring Coinbase $176 million in high-profit-margin revenue annually, or $44 million each quarter, according to John Todaro, an analyst at Needham. The regulatory risks Todaro highlights include potential regulation limiting staking services for retail investors.

Coinbase reported annual revenue of $7.4 billion following a blockbuster 2021, though revenue collapsed to $803 in the last quarter amid a collapse in crypto prices and a linked fall in trading. Either way, the Merge should be accretive to overall sales.

Wall Street knows this. “While we have been excited about Coinbase’s staking product for some time, we note that our base case assumptions are baked into the Street’s numbers until the second half of 2023,” Todaro wrote in a note published last week. Needham rates Coinbase stock at Buy.

And there remains significant upside. As of its last filing, Coinbase was custodying about 19 million Ether, with some 1.9 million of those tokens already committed to staking Ethereum, according to Todaro, who noted that Coinbase only stakes assets that users specifically opt into. That is about a 10% conversion rate for crypto holders to become stakers.

Todaro believes Coinbase has potential to increase this conversion rate. One way is through the launch of a liquid-staking product, which would provide immediate liquidity to traders who stake, instead of requiring them to lock up their tokens. A decrease in the required lockup period could similarly boost the popularity of staking, as would an expected rise in staking yields from 4% to 7% after the Merge. All three of these scenarios would mean Coinbase’s 25% take of Ether staked on its platform could balloon.

Needham’s base case of $176 million in annual revenue rests on a number of assumptions, including that ultimately 25% of the Ether supply is staked and that post-Merge yields do rise to 7%. Todaro’s estimates also rely on Ether prices remaining in the $1,500 to $1,700 range, where they have been since late May, and that Coinbase captures 20% of all stake Ether, up from about 15% currently.

It gets a whole lot better in a bull case, which assumes 38% of the total Ether supply is stake—near the top of Needham’s expected range—and that yields top 9% as a result of considerably higher transaction activity on the network. That could see Coinbase reap $517 million from Ether staking each year, or almost $130 million each quarter.

To say the least, the added revenue would be welcome for Coinbase, which has suffered a near-75% decline in its share price this year as trading volumes—which account for most of its revenues—dried up in the crypto crash. While it has embarked on layoffs in a bid to save money, it continues to face a problem from costs and grim growth prospects in the near term, according to analysts.

“Coinbase’s trading volume continues to disappoint, and market share continues to dwindle,” Dan Dolev, an analyst at

Mizuho

Securities, wrote in a note Wednesday. Mizuho rates Coinbase at Neutral.

“With two of three months in [the current quarter] behind us, Coinbase’s share amongst the 30 largest exchanges further declined to ~3% vs. ~4% in 2Q …and 7-8% last November,” Dolev added. “This is happening despite considerable spend on marketing, which does not appear to be moving the needle.”

But the Merge, and a windfall from staking, could help change Wall Street’s mind over Coinbase. Needham is estimating total subscription and services revenue at the trading platform of $163 million in the current quarter, steadily increasing to $219 million by the second quarter of next year, which accounts for the Merge.

“In order for Coinbase to beat ours and the Street’s expectations, Coinbase would have to exceed our base case and near our bull case expectations,” said Todaro. “Or the price of Ether would have to increase considerably from current levels or a combination of both.”

Needham’s bear case for Coinbase considers a flop, with less Ether staked, low yields, and a loss of market share for Coinbase. In that instance Coinbase might see less than $11 million in annual staking revenue. There is a huge difference between the bull and bear case, but the risk represents uncertainty over a sea change in a nascent industry with little precedent.

Write to Jack Denton at jack.denton@dowjones.com