Crypto & Coinbase – Deep freeze.

Coinbase has further to fall.

• Cryptocurrencies have stabilised around current levels but activity in the space has declined greatly, meaning that exchanges and banks need to make the investment case on valuation which is something that Coinbase is still not able to do.
• Coinbase reported depressing Q3 22 results with revenues / EPS of $590.3m / LOSS$2.43 compared to forecasts of $641.8m / LOSS$2.38.
• In a sign of just how much things have worsened, revenue in Q3 2021 was $1.2bn and $803m in Q2 2022.
• The only bright spot was interest rates which drove interest income significantly higher as a result of the client assets that it holds in deeply liquid and secure US government securities where yields have been rising.
• Partnerships with Blackrock and Google also help establish Coinbase as the leader in its space, but the company remains very top-heavy in terms of expenses and much more action is needed.
• For example, R&D is currently running at 94% of revenues while administrative expenses are at 62% of revenues.
• For a technology company with these revenues, R&D should be around 20-30% (including the stock-based compensation) while admin should be about 5%.
• Coinbase has a very long way to go in terms of right-sizing the businesses and dealing with the hangover of the crazy crypto party that it enjoyed.
• If this can be achieved, then Coinbase becomes an interesting proposition as long as a valuation argument can be made for it.
• This is because, at its heart, Coinbase is a bank and not an asset manager or a trading platform.
• This is a key distinction because of the way that client assets are held by banks as opposed to asset managers.
• Asset managers and trading platforms are required to segregate client assets meaning that if the company goes bankrupt, the client assets are unaffected.
• Banks are different in that they borrow money from depositors, lend it out at a higher rate and keep the difference in interest rate between what they pay and what they earn.
• There can be no segregation of assets which is why if there is a run on the bank and everyone wants to get their money out at the same time, the bank will quickly become insolvent.
• Coinbase is set up as a bank except that it does not lend the money out but makes money on fees and services when its depositors trade in crypto assets.
• The company itself has a relatively small direct exposure to cryptocurrencies as client deposits that are not invested in cryptocurrencies are stored in deeply liquid and very secure money market instruments.
• These deposits are kept in financial institutions and are covered by the usual depositor insurance.
• This means that Coinbase has not lent its clients’ money out as term loans meaning that if everyone suddenly wanted their money back, Coinbase would be able to oblige them although it might take a week or two.
• This has happened to some degree as client assets have fallen significantly which Coinbase has been able to meet without any hiccups.
• Furthermore, the chance of the company going bankrupt is very very low even if there is a total crypto meltdown and the sector goes into a nuclear winter.
• This is because the company still has $5bn on its balance sheet and $3.4bn in debt giving a net cash position of $1.6bn.
• Client assets have fallen to $6.5nm from $10bn around 6 months ago and this will be the key factor to watch going forward.
• Client assets need to stop declining and stabilise before anyone can have any real idea where to right-size this business in terms of expenses.
• Here there still remains a lot to do and I am not very comfortable that management is really committed to the deep and hard cuts that are now needed.
• This is because Coinbase has the classic technology company voting structure where Mr Armstrong, founder and CEO controls the company through a super-voting distribution of shares which carry 20x the number of votes that other shareholder hold.
• Like Mr Zuckerberg, if Mr Armstrong chooses to run the company into the ground, there is very little that anyone can do to stop him.
• This is what makes me nervous as the commentary in the results is not nearly aggressive enough when it comes to managing expenses which to me sounds like a lack of commitment.
• This is a shame because Coinbase has the potential to be a fantastic business as it has gross margins of 83%, is the leader in its field and does not have the classic duration mismatch on assets and liabilities that can cause banks to collapse when depositors demand their money back.
• It is also a shame because the price-to-book ratio (the classic way to value a bank) is 2.2x which compares very unfavourably with the best quality US banks which trade at 1.0x and 1.5x.
• Hence, I think Coinbase has much further to fall and it will need to be a lot cheaper before I would consider it over the classic banking sector.
• This is another one of those to watch as a further deepening of the current crypto crash is likely to push what is a pretty well-capitalised bank into deeply discounted, highly attractive territory.